Find option to neoliberalism or seek to prevent its abuse

Dani Rodrik, Professor, Political Economy, John F. Kennedy School of Government, Harvard University

Two decades of applying neoliberal economic policies to the developing world have yielded disappointing results. Latin America, the region that tried hardest to implement the "Washington Consensus" recipes -- free trade, price deregulation, and privatization -- has experienced low and volatile growth, with widening inequalities.

Among the former socialist economies of Eastern Europe and the Soviet Union, few have caught up with real output levels that prevailed before 1990. In Sub-Saharan Africa, most economies failed to respond to the adjustment programs demanded by the IMF and World Bank.

The few instances of success occurred in countries that marched to their own drummers -- and that are hardly poster children for neoliberalism. China, Vietnam, India: All three violated virtually every rule in the neoliberal guidebook, even as they moved in a more market-oriented direction.

It is time to abandon neoliberalism and the Washington Consensus. But the challenge is to provide an alternative set of policy guidelines for promoting development, without falling into the trap of promulgating yet another impractical blueprint, supposedly right for all countries at all times.

The record suggests that an adequate growth program needs to be anchored in two strategies: An investment strategy designed to kick-start growth in the short term, and an institution-building strategy designed to provide an economy with resilience in the face of adverse shocks.

The key to investment strategy is to get domestic entrepreneurs excited about the home economy. Encouraging foreign investment or liberalizing everything and then waiting for things to improve does not work.

An effective strategy must accomplish two tasks: Encourage investment in non-traditional areas, and weed out projects and investments that fail. For this, governments must deploy both the carrot and the stick.

Learning what a country is (or can be) good at producing is a key challenge of economic development. The carrot is needed because there is great social value in discovering, for example, that cut flowers, or soccer balls, or computer software can be produced at low cost, because this knowledge can orient the investments of other entrepreneurs.

The entrepreneur who makes the initial "discovery" can capture only a small part of the social value that this knowledge generates, as other entrepreneurs will quickly emulate him. Consequently, entrepreneurship of this type -- learning what can be produced -- will typically be under-supplied in the absence of non-market incentives. In turn, the stick is needed to ensure that these incentives do not lock in unproductive and wasteful investments.

Implementing such a strategy may differ from country to country, depending on administrative capacity, the prevailing incentive regime, the flexibility of the fiscal system, the degree of sophistication of the financial sector, and the underlying political economy.

Time-bound subsidy schemes, public venture funds, and export subsidization are some of the ways in which this approach can be implemented, but there are many others.

No single instrument will work everywhere. Governments without adequate capacity to exercise leadership over their private sectors are likely to mess things up rather than improve allocation of resources.

The job can be done, but economic growth requires more than eliciting a temporary boost in investment and entrepreneurship. It also requires effort to build four types of institutions required to maintain growth momentum and build resilience to shocks:

* Market-creating institutions (for property rights and contract enforcement);

* Market-regulating institutions (for externalities, economies of scale, and information about companies);

* Market-stabilizing institutions (for monetary and fiscal management);

* Market-legitimizing institutions (for social protection and insurance).

Building and solidifying these institutions, however, takes time. Using an initial period of growth to experiment and innovate on these fronts can pay high dividends later on.

A key point here is that institutional arrangements are, by necessity, country-specific. Discovering what works in any one country requires experimentation. After all, institutions are not hot-house plants capable of being planted in any soil and climate. Reforms that succeed in one setting may perform poorly or fail completely in others.

Such specificity helps explain why successful countries -- China, India, South Korea, and Taiwan, among others -- usually combined unorthodox elements with orthodox policies. It also accounts for why important institutional differences persist among the advanced countries of North America, Western Europe, and Japan in areas such as the role of the public sector, the legal system, corporate governance, financial markets, labor markets, and social insurance.

While economic analysis can help in making institutional choices, there is also a large role for public deliberation and collective choice. In fact, we can think of participatory democracy as a meta-institution that helps select among the "menu" of possible institutional arrangements in each area.

Designing such a growth strategy is both harder and easier than implementing standard neoliberal policies. It is harder because the binding constraints on growth are usually country- specific and do not respond well to standardized recipes. But it is easier because once those constraints are appropriately targeted, relatively simple policy changes can yield enormous economic payoffs and start a virtuous cycle of growth and institutional reform.

Adopting this approach does not mean abandoning mainstream economics -- far from it. Neoliberalism is to neoclassical economics as astrology is to astronomy. In both cases, it takes a lot of blind faith to go from one to the other. Critics of neoliberalism should not oppose mainstream economics -- only its misuse.