Rethinking Development Joseph E. Stiglitz Bangalore January 2013

Brief review of development thinking From projects to policies The failure of the Washington Consensus policies − They were predicated on the notion that markets by themselves were efficient and stable, − and that the benefits of growth would trickle down to all citizens − Crisis has shown fallacy with these propositions − But from a developmental perspective, perhaps the greatest failing of the WC was just that: it was not concerned with development

From policies to institutions Can’t be sure what constitutes good institutions − Crisis revealed deficiencies in US Central Bank and regulatory institutions − Countries without independent central banks performed better in crisis Even if we did, we may not know how to create one. Institutions, like markets (which can be thought of as a particular kind of institution), are instruments. They can be used to promote development or a “good society”, or to impede it. Details matter.

Political economy Ideology served some special interests Some gained from privatizations Some gains from liberalization − Liberalization and privatization agendas were captured, just as regulatory (protectionist) agenda can be captured

A balanced role for government and markets Work to improve performance of both − Large problems of corporate governance played major role in crisis − Major failure of government was not restraining markets − Waste of markets is greater than that associated with any democratic government But government also has a positive role − Innovation − Catalytic − Developmental Modern theory of market failures has helped clarify roles

The comprehensive approach to development Single minded approaches won’t work Need to have clear view of objectives − Beyond just GDP − Commission on the Measurement of Economic Performance and Social Progress explained why GDP was not a good measure − Inclusive (distribution), sustainable, democratic development focused on increasing well-being of all citizens

Rethinking Every Aspect of Policy in the Wake of the Crisis Macro: 1.Monetary policy old view: Ensuring low and stable inflation was necessary and almost sufficient for growth and stability governments should target inflation independent central banks best institutional arrangement

New view on monetary policy More objectives: real stability, financial stability, growth, employment, and inflation – Single minded focus on inflation diverted attention from first order problems – Loss from crash was orders of magnitude greater than costs of inflation – Inflation targeting can be pro-cyclical with supply shocks Need to design responses appropriate to source of shock More instruments – Regulatory instruments (capital adequacy, macro- prudential regulations) just as important as interest rates Independent central banks performed poorly

Other macro issues Severe limitations on monetary policy – Poor monetary policies can cause crisis, but may not be able to restore economic strength Understanding credit is essential – Transactions based demand for money inadequate basis for monetary policy – Central message of Greenwald and Stiglitz, Towards a New Paradigm – Real issue today is not zero lower bound, but break down of “transmission” mechanism, credit channel – Credit linkages, diversification may lead to more instability (Stiglitz, AER and JGD, 2010) (contrary to earlier view that diversification always lead to more stability) Assumptions concerning convexity/concavity critical Old models made strong and unrealistic assumptions without understanding import

Other macro issues Constructing automatic stabilizers – Many reforms (moving from defined benefits to defined contribution pension systems) weakened automatic stabilizers – Countries with good social protections, welfare systems performed better (even if labor market seemed more “rigid”) Flexible labor market not panacea

Macro models Didn‘t predict crisis—most important economic event in three quarters of a century – Test of any science is prediction – Worse: Theory said “couldn’t happen” Markets are rational So bubbles can’t exist Even after bubble broke, monetary authorities said effects were contained—they were wrong – Predictions again predicated on bad models

Macro models Models provided little guidance on how to respond to crisis Euro-crisis—another failure – Europe in double dip recession Again, models failed in prediction And many of the models have failed in prescription – Economies of Europe, US not likely to return to full employment any time soon Resources today same as they were before the beginning of the recession No good reason in standard theory that they should not be fully deployed Waste amounts to trillions of dollars Greater than the waste associated with markets in misallocation of capital before the crisis

Regulatory Policy Old theory: – Could rely on self regulation – Least intrusive regulation as possible – Capital market liberalization – Financial market liberalization Would lead to greater efficiency and stability Capital flows would help stabilize

New Views Self-regulation doesn’t work – Pervasive agency problems – Pervasive and deep externalities Regulation has to be comprehensive—affecting incentives, structure, behavior Capital flows are destabilizing—pro-cycle – Capital controls (capital account management) desirable Financial market liberalization can be anti-growth and destabilizing – Less money to local SME’s

Trade Policy Old trade-and-growth orthodoxy − Trade liberalization leads to more trade − More trade leads to more growth − Growth results in everyone being better off New trade framework (i) Trade liberalization often does not lead to increased trade (ii) Trade liberalization may not lead to increased growth or increased welfare (iii) Trade-generated growth may not make everyone better off − There may be large losers − With imperfect risk markets, everyone could be worse off (Newbery-Stiglitz, 1982)

Industrial Policy Old view Government shouldn’t interfere with markets Government shouldn’t try to pick winners New View Market failures are pervasive They affect industrial structure Governments should correct market failures – Not a matter of picking winners, but identifying externalities Governments can’t avoid industrial policy – Implicit in budgetary policies – Implicit in legal frameworks Development is about changing economic structure – Markets do a bad job in structural transformation

A Deeper Rethinking of Economics Old view Individuals are fully rational With well-identified preferences Markets are competitive and well-functioning Role of government is to enforce contracts and property rights

A Deeper Rethinking of Economics: new view Pervasive irrationalities—but individual’s behavior is still predictable (systematic) Pervasive information imperfections/asymmetries Pervasive lack of competition Preferences shaped by social context

Breaking down boundaries of social sciences Behavioral economics—understanding psychological foundations of behavior Sociology and economics—understanding the social formation of preferences and beliefs – And how they evolve over time Social rigidities and social change – Concepts of race and caste Law and economics – Law is more than just the enforcement of property rights and contracts – Has to be seen within a social context Which is why legal transplants don’t work

These issues are especially important in development Exciting time for development—rethinking all of premises