Reforming economic reform

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

Economists have been more influential over the last 15 years than at probably any other time in history. The policies of central planning, dirigisme, and import substitution, which many newly independent countries adopted in the 1950s and 1960s, could be labeled as the ideas of communists, Fabian socialists, and nationalists, not trained economists. The policies of deregulation, privatization, and trade liberalization (the so- called Washington Consensus) that countries adopted in the 1980s, supposedly marked the victory of professional economists over populist politicians.

The paradox is that this was no victory for economics. Indeed, the last two decades have proved dismal for the practice of the "dismal science." With few exceptions, countries in which the U.S.-educated economic technocracy gained the upper hand performed worse than they did prior to the 1980s.

Latin America's stalled and stagnant economies, which embraced the Washington Consensus more than most, stand out as exhibit "A." The biggest development successes in recent years have been in places like China and Vietnam, where Western economic ideas, to the extent that they were considered at all, lost out to more practically oriented policymakers.

The puzzle is not "why did economics fail us?" but "why were economists so overconfident?" After all, much of the Washington Consensus cannot be deduced from proper economic analysis. Any graduate student in economics knows that deregulation, privatization, and trade liberalization cannot be expected to produce economic benefits without a long list of unlikely conditions being satisfied.

Moreover, there is nothing in economic theory that should have made economic technocrats think that Anglo-American institutions of corporate governance or "flexible labor markets," to pick just two examples, produce unambiguously superior economic performance when compared to German-style insider control or institutionalized labor markets.

On closer scrutiny, what passed as state-of-the-art thinking on economic policy turns out to have been based on some crude rules of thumb. More often than not, the advocacy of simple panaceas was based on one or more of the following pathologies:

o Flimsy empiricism. South Korea has done better than North Korea, and Burma's path is hardly one that leads to prosperity. Therefore we know that markets do better than central planning, and that foreign trade is better than autarky. But it takes a huge leap of faith to conclude from this that one can't go wrong by deregulating, privatizing, and opening domestic markets as much as possible. Even in areas where the empirical record appears clear, closer analysis reveals major flaws. Analysts who focused only on those elements of China's or South Korea's experience that fit their beliefs missed the larger story that these countries were undergoing massively heterodox experiments.

o Implicit political theorizing. Economists who become policy advisors are great fans of simplicity, uniformity, and arm's- length relations between government and the private sector, not because of economic theory or empirical evidence, but because of unexamined and untested assumptions. Governments, they believe, are run by crooks, so tie their hands; bureaucrats are beholden to rent-seeking private agents, so ensure non-discretion and apply uniform taxes and incentives; domestic political systems cannot be trusted, so import laws and institutions from abroad; external influences are always more benign than domestic ones, so ensure maximum openness to international trade and investment; reformers have a limited "honeymoon period," so implement reforms fast. Economists ended up practicing public administration without license.

o Lack of institutional imagination. No Western-trained economist could have envisioned China's household responsibility system or township and village enterprises--institutional innovations that lie at the core of the Chinese miracle. Any economist from Washington (or Harvard) would have pushed a recipe of privatization and across-the-board liberalization if asked in 1978 to advise the Chinese government. Only with hindsight can we see that China's innovations were truly demanding reforms.

Of course, economic principles do not work differently in different places. Property rights and the rule of law are always important so that investors--both current and prospective--can expect to retain the money they make. Private incentives always need to be aligned with social costs and benefits if productive efficiency is to be achieved. Macroeconomic and financial stability require debt sustainability, prudential regulation, and sound money.

Any economist can mouth these platitudes to his/her hosts immediately upon arrival in a foreign land, without fear of going astray. The trouble is that these universal principles are not self-executing: they do not automatically translate into clear- cut institutional arrangements or policy prescriptions.

For example, the principle that property rights should be protected implies very little about the best way to achieve this under a society's existing institutional preconditions. It certainly does not imply that a system of private property rights and Anglo-American corporate governance is the right approach for all countries at all times.

Consider the vast investment and entrepreneurial activity that China has elicited through a hybrid system of property rights and a legal regime that is as far as imaginable from the Anglo- American system. Similarly, the principle that private incentives should be aligned with social costs and benefits hardly results in unconditional support for policies of trade liberalization, deregulation, and privatization.

Neither does it preclude the use of activist trade and industrial policies in pursuit of economic restructuring. Finally, debt sustainability, fiscal prudence, and sound money are also obviously compatible with diverse institutional arrangements.

For economists, the challenge is to work out the operational implications of these universal principles in specific economies. We must take full account of predicates, conditionals, and contingencies in order to specify more completely which countries should adopt what policies. Failing that, it is time for economists to stop pretending that we have all the answers.