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Stiglitz's New Book and the Developing Countries

Otaviano Canuto's picture

Joe Stiglitz, Nobel Laureate and former World Bank Chief Economist, is out again making headlines. This time because of his new book Freefall - America, Free Markets and the Sinking of the World Economy (W.W. Norton & Company, New York, 2010).   I had the pleasure of hosting his presentation at the World Bank’s Infoshop a few days ago – see video conference here -, and there were several things that struck me from what he said. Freefall might be mainly about the US economy but we can draw some very important lessons relevant for our development work.

Let’s see. Stiglitz provides considerable evidence that the US and others got into trouble by ignoring standard economic and financial guidelines that we recommend to developing countries, and which –by and large—the latter have been following in recent years. Mainly, rich countries overindulged in weak financial sector regulation, the housing bubble, and ended up giving out financial sector bailout packages that are almost textbook examples of what not to do.

"As chief economist of the World Bank, I had seen gambits of this kind," writes Stiglitz. "If this had happened in a Third World banana republic, we would know what was about to happen - a massive redistribution from the taxpayers to the banks and their friends. The World Bank would have threatened cutting off all assistance. We could not condone public money being used in this way, without the normal checks and balances."  (p. 122). 

As I mentioned earlier, Stiglitz book focuses almost entirely on the US, so at this point it is pertinent to highlight to ourselves some interesting aspects of the crisis at the global level –particularly that developing countries as a group suffered a smaller fallout from the financial crisis than had been initially feared, mainly thanks to prudent macroeconomic policies.

Many countries in the Europe and Central Asia region had indeed been highly exposed because of large current account deficits financed by private capital inflows, and have had to undergo extremely severe economic adjustments.  But in many other regions and countries, while growth has certainly slowed it has remained well above that in the recession-affected developed countries.  This continues a trend that emerged during the 2000s where developing country growth accelerated to about 3-4 percentage points above that in developed countries, whereas in preceding decades it was about the same.

Was this merely due to temporary boom conditions? Or did it reflect better underlying policies in developing countries?

We can point to such standard factors as relatively restrained fiscal and external deficits and generally falling levels of national net indebtedness among developing countries as a group in the years leading up to the crisis. These prudent basic macro policies have undoubtedly helped these countries come through the crisis more robustly than expected.  And we can also point to good policies to manage the impact of the crisis, for example, efforts to at least maintain fiscal expenditures despite temporary increases in deficits, and in some cases to even undertake counter-cyclical fiscal stimulus, generally with the support of the Bank and the Fund.  Unlike the crises of the late 1990s many more countries allowed their exchange rates to devalue rather than severely tighten monetary policies in an ultimately fruitless quest to support pegged exchange rates. 

So what can developing countries and development practitioners learn from the crisis and Stiglitz?

First of all, through his strong advocacy in the policy debates surrounding the emerging market crises of a decade ago, Stiglitz himself has already played a large part in changing the climate of policy opinion and the different crisis management policies adopted this time around.

And in terms of "the model," there will clearly be a further rethinking on the cost-benefit trade-offs associated with financial globalization.  Over the last 30 years there have been three huge boom-bust cycles in private capital flows to emerging markets – as we approached here. These have notably added to volatility and vulnerability but with little clear evidence of significant benefits, for example in terms of a contribution to growth. Even now, we are hardly out of the crisis, and there has already begun another major surge in flows to emerging markets, the so-called carry trade attracted by yield spreads in emerging markets.  Without robust regulation and careful management in both the receiving and sending countries, another boom in flows could fuel asset bubbles, over-heating and new vulnerabilities and crises, this time in emerging markets.

We are clearly moving towards a more favorable view on whether asset price bubbles need to be a target of economic policy, and on the role of broad macro-prudential or macro-financial policies in achieving this, including rethinking the role of monetary policy and of financial regulation.   There is an important agenda for research, policy experimentation and learning here.

 There is a major research and learning agenda on the political economy of regulation.  Joe rightly stresses the important role played by weakening of regulations or the failure of regulators to properly enforce them. As it happened, in an era of prosperity it is hard for some decision-makers to appear on the side of "over-regulation." So what sorts of institutional innovations do we need to further accountability while also protecting regulators from destabilizing pro-cyclical political pressures?  Is it even possible?

Perhaps this will be a good topic for Joe's next book!

Comments

The financial regulators introduced an incredible regulatory bias in favour of what is perceived as having low risk of default, by the credit rating agencies, without the slightest considerations to the fact that having a perceived low risk of default, does not have one iota with serving a useful purpose for the society. When a bank lends or invest with anything related to AAA they need only 1.6 percent in capital while when lending to a citizen, an entrepreneur or a small business they need to put up 8 percent in capital. The above started the greatest race ever in search of AAAs and the market responded, unfortunately by fabricating those false AAAs that led the world over the precipice of the badly awarded mortgages to the subprime sector. While an Executive Director of the World Bank I specifically warned about this crazy regulatory paradigm over and over again, to no avail, and it is with sadness and concern that I note that regulatory discrimination against risk-taking, the oxygen of economic growth and human development, is still not an issue at the World Bank. Joe Stiglitz and many others should have spoken out against this crazy regulatory paradigm... but not a word was said... and so why should we believe they now know the way out of our current difficulties... because they are PhD’s and got a Nobel price?

Submitted by Otaviano Canuto on
Per. Maybe it was the lack of due discrimination against risk- taking that allowed the bubble economy to be built (or better, blown).

Absolutely, but try to get your hands around what “due discrimination against risk” really means in terms of the advancement of society and you will collide immediately with an impossible high wall. Who can be empowered so much as to determine what the right and what the wrong risks are for the society to take? A regulator in Basel? A Joe Stiglitz? At least I know that an Otaviano Canuto and a Per Kurowski would not dare to be so presumptuous so as to do that. By the way, here is a Q for you. Given that capital is generally considered to be coward why should not instead the highest capital requirement be on what is perceived as being less risky, since that perception could induce some carelessness?

Submitted by Wagner Guerra Júnior on
Otaviano,Thanks for your provocative insights. A simple remark: Perhaps the debate on globalization benefits and trade-offs will last enough for more 2 or 3 books from Prof. Stiglitz, but a more balanced approach to international economy seems to be developing. The key is in your sentence, quoted below, particularly by the emphasis on a consistent policies framework for receiving and sending countries. It allows seeing interdependence another way from now on, as contamination can run either way, more recently from developed to emerging markets: "Without robust regulation and careful management in both the receiving and sending countries, another boom in flows could fuel asset bubbles, over-heating and new vulnerabilities and crises, this time in emerging markets." Wagner

Wagner. You've got it. In fact, that interdependence and the corresponding need of a two-sided symmetric regulatory framework were the core of my arguments in a previous post on "The arrival of asset prices in monetary policy".

Submitted by Jaime on
Stiglitz makes sense again. Had a "banana republic" done what the USA did with its banking system during the crisis, the World Bank and the IMF would have been demanding jail time for the bankers and government officials of such "banana republic". Indeed we knew the political economy of regulation and yet decided to activate that bubble because it was done for "the poor". Well, the poor who got their homes are now homeless and paying the price for the folly of intervention. What's Joe prescription? There was no de-regulation of any sort in housing lending, and Joe knows it. It is called Congress mandating to banks to lend to quasi-indigents. "King" Canuto would not propose this policy, I wonder whether "Joe" would. We know he did not proposed supressing it when he was economic counsel to the President, why is he now pontificating?

Submitted by Meg on
The support for lending to low income people to acquire housing may be one factor in the US case, but I think the stronger points were other regultory changes/loosening (not deregulation of housing loans, but looser prudential standards for the "too big to fails" that ended up exacerbating the whole thing), lax oversight and lenders pushing risky loans, including through fraud. On top of that the complicit role of the investment banks in betting against the investments they sold cannot be ignored. I dont think anyone would have recommended the laxity in prudential regulation and supervision to any "banana republic", just the opposite!

Submitted by Richard Newfarmer on
Nice posting, this. Enjoyed it. Here in Geneva, several of our client governments have been asking whether the Great Recession signals the end of the Washington consensus... I've responded - and this is consistent with your argument -- that, to the contrary, it underscores the wisdom of fiscal prudence, low inflation, debt management and good financial regulation, all hallmarks of John Williamson's 1989 essay. Developing countries took this to heart - and as a result entered the Great Recession with strong fiscal balances and solid reserves. The problem is that Washington forgot the Washington Consensus.... Of course, it takes more than the WC to grow.. but that's another story

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