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, macroprudential 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