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Dutch Tulips and Emerging Markets Paul Krugman ANOTHER BUBBLE BURSTS DURING THE first half of the 1990s, both economic and political events in developing countries defied all expectations. Nations that most thought would not regain access to world financial markets for a generation abruptly became favorites of private investors, who plied them with capital inflows on a scale not seen since before World War I. Governments that had spent half a century pursuing statist, protec- tionist policies suddenly got free market religion. It was, it seemed to many observers, the dawn ofa new golden age for global capitalism. To some extent the simultaneous reversals in government policies and investor sentiment were the result of external factors. Low inter- est rates in the advanced countries encouraged investors to look again at opportunities in the Third World; the fall of communism not only helped to discredit statist policies everywhere but reassured investors that their assets in the developing world were unlikely to be seized by leftist governments. Still, probably the most important factor in the new look of developing countries was a sea change in the intellectual Zeitgeist: the almost universal acceptance, by governments and mar- kets alike, ofa new view about what it takes to develop. This new view has come to be widely known as the "Washington consensus," a phrase coined by John Williamson of the Institute for International Economics. By "Washington" Williamson meant not only the U.S. government, but all those institutions and networks of opinion leaders centered in the world's de facto capital—the Interna- PAUL KRUGMAN is Professor of Economics at Stanford University.

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Page 1: Dutch Tulips and Emerging Markets - ieu.edu.trhomes.ieu.edu.tr/~ibagdadi/INT230/Krugman - Dutch Tulips and... · Dutch Tulips and Emerging Markets Paul Krugman ANOTHER BUBBLE BURSTS

Dutch Tulips andEmerging Markets

Paul Krugman

ANOTHER BUBBLE BURSTS

D U R I N G T H E first half of the 1990s, both economic and politicalevents in developing countries defied all expectations. Nations thatmost thought would not regain access to world financial markets for ageneration abruptly became favorites of private investors, who pliedthem with capital inflows on a scale not seen since before World War I.Governments that had spent half a century pursuing statist, protec-tionist policies suddenly got free market religion. It was, it seemed tomany observers, the dawn ofa new golden age for global capitalism.

To some extent the simultaneous reversals in government policiesand investor sentiment were the result of external factors. Low inter-est rates in the advanced countries encouraged investors to look againat opportunities in the Third World; the fall of communism not onlyhelped to discredit statist policies everywhere but reassured investorsthat their assets in the developing world were unlikely to be seized byleftist governments. Still, probably the most important factor in thenew look of developing countries was a sea change in the intellectualZeitgeist: the almost universal acceptance, by governments and mar-kets alike, ofa new view about what it takes to develop.

This new view has come to be widely known as the "Washingtonconsensus," a phrase coined by John Williamson of the Institute forInternational Economics. By "Washington" Williamson meant notonly the U.S. government, but all those institutions and networks ofopinion leaders centered in the world's de facto capital—the Interna-

PAUL KRUGMAN is Professor of Economics at Stanford University.

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tional Monetary Fund, World Bank, think tanks, politically sophis-ticated investment bankers, and worldly finance ministers, all thosewho meet each other in Washington and collectively define the con-ventional wisdom ofthe moment.

Williamson's original definition of the Washington consensusinvolved ten different aspects of economic policy. One may, however,roughly summarize this consensus, at least as it influenced the beliefsof markets and governments, more simply. It is the belief that Victo-rian virtue in economic policy—free markets and sound money—isthe key to economic development. Liberalize trade, privatize stateenterprises, balance the budget, peg the exchange rate, and one willhave laid the foundations for an economic takeoff; find a country thathas done these things, and there one may confidently expect to real-ize high returns on investments.

To many people the rise ofthe Washington consensus seemed tomark a fundamental turning point in world economic affairs. Nowthat the dead hand of the state was being lifted from Third Worldeconomies, now that investors were becoming aware ofthe huge pos-sibilities for profit in these economies, the world was set for a pro-longed period of rapid growth in hitherto poor countries and massivecapital flows from North to South. The question was not whetheroptimistic expectations about growth in the big emerging marketswould be fulfilled; it was whether advanced countries would be ableto cope with the new competition and take advantage of the oppor-tunities this growth now offered.^

And then came the Mexican crisis. The country that was widely-regarded as a model for the new regime—a once-protectionist nationthat had not only greatly lowered its trade barriers but actually signeda free trade pact with the United States, whose economic policy wasrun by articulate American-trained technocrats, and which hademerged from seven lean years of debt crisis to attract capital inflowson a scale unimaginable a few years earlier—^was once again appeal-

' The strategy of promoting U.S. exports and investment in emei^ng markets remainscentral to the Clinton administrations economic strategy. In a March 1995 speech, Under-secretary of Commerce Jeffrey Garten declared that "our exports and jobs are dependenton gaining a larger market share in the big emerging markets. No U.S. firm will be aworld-class company without substantial involvement in the big emerging markets."

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ing for emergency loans. But what is the meaning of Mexico's tail-spin? Is it merely the product of specific Mexican blunders and polit-ical events, or does it signal the unsoundness of the whole emergingmarket boom of the previous five years?

Many claim that Mexico's problems carry few wider implications.On one side, they argue that a currency crisis says more about short-term monetary management than about long-run developmentprospects. And to some extent they are clearly right. Currency crisesare so similar to one another that they are a favorite topic for economic

theorists, who lovingly detail the unchangingThe reign of free trade °S ^ by which the collision between domestic

J J goals and an unsustainable exchange rate gen-and sound money was a erates a sudden, massive speculative attack.speculative bubble. The December 1994 attack on the peso looked

a lot like the September 1992 attack on thepound sterling, which looked quite similar to

the 1973 and 1971 attacks on the dollar and the 1969 run on gold. Soperhaps one should not draw broad conclusions from the fact that adeveloping country has managed to make the same mistakes thatnearly every advanced country has made at some time in the past.

On the other side, defenders of the Washington consensus point tothe many uniquely Mexican aspects of the current crisis. Certainly thecombination of peasant uprisings, mysterious assassinations, and bizarrefraternal intrigue has no close counterpart anywhere else in the world.

And yet Mexico's crisis is neither a temporary setback nor a purelyMexican affair. Something like that crisis was an accident waiting tohappen because the stunning initial success of the Washington con-sensus was based not on solid achievements, but on excessively opti-mistic expectations. The point is not that the policy recommendationsthat Williamson outlined are wrong, but that their efficacy—theirability to turn Argentina into Taiwan overnight—was greatly over-sold. Indeed, the five-year reign of the Washington consensus mayusefully be thought of as a sort of speculative bubble—one thatinvolved not only the usual economic process by which excessive mar-ket optimism can be a temporarily self-fulfilling prophecy, but a moresubtle political process through which the common beliefs of policy-makers and investors proved mutually reinforcing. Unfortunately, any

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such self-reinforcing process unfortunately must eventually be facedwith a reality check, and if the reality is not as good as the myth, thebubble bursts. For all its special features, the Mexican crisis marks thebeginning of the deflation of the Washington consensus. Thatdeflation ensures that the second half of the 1990s will be a far moreproblematic period for global capitalism than the first.

THE REAL PAYOFF TO REFORM

E C O N O M I S T S HAVE, of course, long preached the virtues of freemarkets. The economic case for free trade in particular, while notcompletely watertight, is far stronger than most people imagine. Thelogic that says that tariffs and import quotas almost always reduce realincome is deep and has survived a century and a half of often vitrioliccriticism nearly intact. And experience teaches that governments thatimagine or pretend that their interventionist strategies are a sophis-ticated improvement on free trade nearly always turn out, on closerexamination, to be engaged in largely irrational policies—or worse,in policies that are rational only in the sense that they benefit keyinterest groups at the expense of everyone else.

Yet there is a dirty little secret in international trade analysis. Themeasurable costs of protectionist policies—the reductions in realincome that can be attributed to tariffs and import quotas—are notall that large. The costs of protection, according to the textbook mod-els, come from the misallocation of resources: protectionist econ-omies deploy their capital and labor in industries in which they arerelatively inefficient, instead of concentrating on those industries inwhich they are relatively efficient, exporting those products in ex-change for the rest. These costs are very real, but when you try to addthem up, they are usually smaller than the rhetoric of free trade wouldsuggest. For example, most estimates ofthe cost of protection in theUnited States put it well under one percent of GDP. Even that cost islargely due to the United States' preference for policies, like its sugarimport quota, that generate high profits for those foreign suppliersgranted access to the U.S. market. Highly protected economies, likemost developing countries before the rise of the Washington con-sensus, suffer more. Still, conventional estimates ofthe costs of pro-

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tection have rarely exceeded five percent of GDP. That is, the standardestimates suggest that a highly protectionist developing country, bymoving to completely free trade, would get a one-time economicboost equal to the growth China achieves every five or six months.

Admittedly, many economists argue that the adverse effects ofprotection are larger, and thus the growth boost from trade liberal-ization is greater, than such conventional estimates suggest. Roughlyspeaking, they have suggested three mechanisms. First, protectionreduces competition in the domestic market. The monopoly powerthat is created for domestic firms that no longer face foreign compe-tition may be reflected either in slack management or, if a small num-ber of firms are trying to secure monopoly positions, in wastefulduplication. Second, protectionist policies—and other policies likeinterest rate controls—create profits that accrue to whoever isinfluential enough to receive the appropriate government licenses. Ina well-known paper, Anne Krueger, who later became the chief econ-omist at the World Bank, argued that in many developing countries,the resources squandered in pursuit of these profits represent a largernet cost to the economy than the distortion that protectionism causesin the industrial mix.^ Finally, many people have argued that protec-tionism discourages innovation and the introduction of new prod-ucts, thereby having sustained effects on growth that a static estimatemisses. The important point about these arguments for large gainsfrom trade liberalization, however, is that they are all fairly specula-tive; one cannot say as a matter of principle that these effects of pro-tection discourage growth. It is an empirical question.

And the empirical evidence for huge gains from free market poli-cies is, at best, fuzzy. There have been a number of attempts to mea-sure the benefits of free trade by comparing countries. An influential1987 study by the World Bank classified 41 developing countries as"closed" (protectionist) or "open" and concluded that openness wasassociated with substantially stronger growth. But such studies haveoften been critiqued for using subjective criteria in deciding whichcountries have freer trade; the decision to class South Korea as "open,"

^ Anne Krueger, "The Political Economy of the Rent-Seeking Society," AmericanEconomic Review, June 1974.

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for example, has raised many doubts. A survey by UCLAS SebastianEdwards concluded that studies which purport to show that countrieswith liberal trade regimes systematically grow more rapidly than thosewith closed markets "have been plagued by empirical and conceptualshortcomings [that have] resulted, in many cases, in unconvincingresults whose fragility has been exposed by subsequent work."^

There are surely additional gains to reforming economies fromdomestic liberalization, privatization, and so on. These gains havenot been as thoroughly studied as those from trade liberalization.They are, however, conceptually very similar, and there is no reasonto expect them to be dramatically larger or to change the picture ofreal but limited gains from reform.

All this does not mean that trade liberalization is not a good idea.It almost certainly is. Nor does it necessarily mean that the modestconventional estimates of the gains from such liberalization tell thewhole story. But it does mean that the widespread belief that movingto free trade and free markets will produce a dramatic acceleration ina developing country's growth represents a leap of faith, rather thana conclusion based on hard evidence.

What about the other half of the Washington consensus, the beliefin the importance of sound money? Here the case is even weaker.

If standard estimates of the costs of protection are lower than youmight expect, such estimates of the cost of inflation—defined as theoverall reduction in real income—are so low that they are embarrass-ing. Of course very high inflation rates—the triple- or quadruple-digitinflations that have, unfortunately, been all too common in LatinAmerican history—seriously disrupt the Rinctioning of a marketeconomy. But it is very diflicult to pin dovm any large gains from areduction in the inflation rate from, say, 20 percent to 2 percent.

Moreover, the methods used to achieve disinflation in developingcountries—above all, the use ofa pegged exchange rate as a way to buildcredibility—have serious costs. A country with an inflationary historythat tries to end inflation by establishing a fixed exchange rate almostalways finds that the momentum of inflation continues for a consider-

^ Sebastian Edwards, "Openness, Trade Liberalization, and Growth in DevelopingCountries,"yo""''^'' of Economic Literature, September 1993.

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able time, throwing domestic costs and prices out of line withthe rest of the world. Thus an exchange rate that initiallyseemed reasonable usually seems considerably overvalued by the

time inflation finally subsides. Furthermore, an exchange rate thatis tolerable when introduced may become diflicult to sustain whenworld market conditions change, such as the price of oil, the value ofthe dollar, and interest rates. Textbook international economics treatsthe decision about whether to fix a country's exchange rate as a difliculttradeoff, which even countries committed to low inflation often end upresolving on the side of exchange rate flexibility.

Nonetheless, during the first half of the 1990s a number of develop-ing countries adopted rigid exchange rate targets. (The most extremecase was Argentina, which established a supposedly permanent one-for-one exchange rate between the peso and the U.S. dollar). In largepart this was a move designed to restore credibility after the uncon-trolled inflation of the 1980s. Nonetheless, both governments and mar-kets seem to have convinced themselves that the painfiil tradeoffs tra-ditionally involved in such a commitment no longer applied.

THE DISMAL CYCLE

I N SUM, then, a cool-headed analysis ofthe likely effects of the eco-nomic reforms undertaken in developing countries in recent years did

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not and does not seem to justify wild enthusiasm. Trade liberaliza-tion and other moves to free up markets are almost surely goodthings, but the idea that they will generate a growth takeoff representsa hope rather than a well-founded expectation. Bringing downinflation is also a good thing, but doing so by fixing the exchange ratebrings a mixture of benefits and costs, with the arguments against asstrong as the arguments for. And yet the behavior of both govern-ments and markets during the last five years does not suggest thatthey took any such measured view. On the contrary, governmentseagerly adopted Washington consensus reform packages, while mar-kets enthusiastically poured funds into reforming economies. Why?

Everyone is familiar with the way that a speculative bubble candevelop in a financial market. Investors, for whatever reason, come totake a more favorable view of the prospects for some traded asset—Deutsche marks, Japanese stocks, shares in the South Sea Company,tulip fixtures. This leads to a rise in the asset's price. If investors theninterpret this gain as a trend rather than a one-time event, they becomestill more anxious to buy the asset, leading to a Rirther rise, and so on.In principle, long-sighted investors are supposed to prevent such spec-ulative bubbles by selling assets that have become overpriced or buyingthem when they have become ob\dously cheap. Sometimes, however,markets lose sight of the long run, especially when the long run is com-plex or obscure. Thus speculative bubbles in soybean fiitures tend to belimited by the common knowledge that a lot more soybeans will begrown if the price gets very high. But the chain of events that musteventually end a speculative bubble in, say, the mark—an overvaluedmark reduces German exports, leading to a weak German economy, sothe Bundesbank reduces interest rates, making it unattractive tohold mark-denominated assets—is often too long and abstractto seem compelling to investors when the herd is running. ^

It seems fairly clear that some of the enthusiasm forinvesting in developing countries in the firsthalf of the 1990s was a classic speculativebubble. A modest recovery in economicprospects from the dismal 1980s ledto large capital gains for those fewinvestors who had been willing to ' ^ ^ '^',^>^._:—4^ <^

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put money into Third World stock markets. Their success led otherinvestors to jump in, driving prices up still further. And by 1993 or so"emerging market funds" were being advertised on television and thepages of popular magazines.

At the same time that this self-reinforcing process was under wayin the financial markets, a different kind of self-reinforcing process,sociological rather than economic, was taking place in the world ofaffairs—the endless rounds of meetings, speeches, and exchanges ofcommuniques that occupy much of the time of economic opinionleaders. Such interlocking social groupings tend at any given time toconverge on a conventional wisdom, about economics among manyother things. People believe certain stories because everyone impor-tant tells them, and people tell those stories because everyone impor-tant believes them. Indeed, when a conventional wisdom is at itsfullest strength, one's agreement with that conventional wisdombecomes almost a litmus test of one s suitability to be taken seriously

Anyone who tried, two or three years ago, to express even mildskepticism about the prospects for developing countries knows howdifficult it was to make any impression on either business or politicalleaders. Views contrary to the immense optimism of the time weretreated not so much with hostility as bemusement. How could any-one be so silly as to say these gloomy things?^

While both a speculative bubble in the financial markets and the stan-dard process whereby influential people rally around a conventional wis-dom surely played a role in the astonishing rise of the Washington con-sensus, there was, however, an additional, distinctive self-reinforcingprocess that arguably played an even greater role. This was a politicaleconomy cycle, in which governments were persuaded to adopt Wash-ington consensus policies because markets so spectacularly rewardedthem, and in which markets were willing to supply so much capital be-cause they thought they saw an unstoppable move toward policy reform.

* Academic economists with expertise in the macroeconomics of developing coun-tries were issuing clear warnings about excessive euphoria, which Wall Street simplyshrugged off, as early as the beginning of 1993. See, in particular, Rudiger Dornbusch,Stabilization, Debt, and Reform: Policy Analysis for Developing Countries, EnglewoodCliffs: Prentice Hall, 1993, and "Mexico; Stabilization, Reform, and No Growth,"Brookings Papers on Economic Activity, No. 1,1994.1 gave a speech warning of a pesocrisis in Mexico City on March 25,1993.

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One must begin with a key insight of Dani Rodrik of ColumbiaUniversity. Rodrik pointed out that economists and internationalorganizations like the World Bank had beenarguing for a long time in favor of freer trade in y - j|-j^ fullest Strength,developing countries.^ The intellectual case for • i . jprotectionism to promote industrialization, convent ional Wlsdomwhile popular in the 1950s, has been pretty much beeomeS a HtniUS test ofmoribund since the late X960S. Nonetheless, the » <iennii*;ne*;t;stake of established interest groups in the exist-ing system blocked any major move to free trade.When limited liberalization was attempted, it usually ended up beingabandoned a few years later. Why did this suddenly change?

One seemingly obvious answer is the Third World debt crisis of the1980s, which made the previous system untenable. But economic crises,especially when they involve the balance of payments, traditionally leadto more protectionism, not less. Why was this case different?

Rodrik's answer was that in the 1990s, advocates of free trade indeveloping countries were able to link free trade to financial andmacroeconomic benefits. If trade liberalization is presented as adetailed microeconomic policy, the industries that stand to lose willbe well-informed and vociferous in their opposition, while those whostand to gain will be diffuse and ineffective. What reformers in a 'number of countries were able to do, however, was to present tradeliberalization as part of a package that was presumed to yield largegains to the country as a whole. That is, it was not presented as, "Let sopen up imports in these 20 industries, and there will be efficiency-gains"; that kind of argument does not work very well in ordinarytimes. Instead it was, "We have to follow the strategy that everyoneserious knows works: free markets—including free trade—and soundmoney, leading to rapid economic growth."

Calling a set of economic measures a package does not mean thatthey need in fact be undertaken together. One can bring inflationdown without liberalizing trade, and vice versa. But voters do not

5 Dani Rodrik, "The Rush to Free Trade in the Developing World: Why So Late?Why Now? Will It Last?" in Voting for Reform: The Politics of Adjustment in New Democ-racies, ed. Stephan Haggard and Steven B. Webb, New York: Oxford, 1994.

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usually engage in hypothetical line-item vetoes, asking which ele-ments of an economic program are essential and which can bedropped. If a program of economic stabilization-cum-liberalizationseems to work, the political process is easily persuaded that all of thepackage is essential.

And the point was that such packages did work, and in factinitially did so astonishingly well—but not necessarily because oftheir fundamental economic merits. Rather, the immediate payoff toWashington consensus reforms was in the sudden improvement ininvestor confidence.

Mexico is particularly noteworthy. Mexico began a major programof trade liberalization in the late 1980s, with no obvious immediateresults in terms of faster economic growth. The turning point camewhen the country negotiated a debt reduction package, which wentinto effect in 1990. The debt reduction was intelligently handled, buteveryone involved realized that it was fairly small, not nearly enoughto make much direct difference to Mexico's growth prospects.

And yet what followed the debt reduction was a transformation ofthe economic picture. With stunning speed, Mexico's problemsseemed to melt away. Real interest rates were 30 to 40 percent beforethe debt deal, with the payments on internal debt a major source offiscal pressure; they fell between 5 and 10 percent almost immediately.Mexico had been shut out of international financial markets since1982; soon after the debt deal, capital inflows resumed on an ever-growing scale. And growth resumed in the long-stagnant economy.

Why did a seemingly modest debt reduction spark such a majorchange in the economic environment? International investors saw thedebt deal as part of a package of reforms that they believed wouldwork. Debt reduction went along with free markets and soundmoney, free markets and sound money mean prosperity, and so cap-ital flowed into a country that was following the right path.

In the 1990s, advocates of the Washington consensus have not hadto make abstruse arguments about the benefits of better resource allo-cation nor plead with the public to accept short-term pain in theinterest of long-run gain. Instead, because the financial marketsoffered an immediate, generous advance on the presumed payoff fromfree trade and sound money, it was easy to make a case for doing the

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right thing and brush aside all the usual political objections.So much for one side of the political-economic cycle. The other

side involved the willingness of financial markets to provide lavishrewards for economic reform. In part, of course, the markets believedthat such policies would pay off in the long run. But most of the devel-oping countries that suddenly became investor favorites in the 1990shad long histories of disappointed expectations, not just the debt cri-sis of the 1980s, but track records of abandoned economic reformsreaching back for decades. Why should investors have been soconfident that this time the reforms would really stick? Presumably,this time reforms were taking place so extensively, and in so manycountries, that investors found it easy to believe that it was a com-pletely new world, that runaway inflation, populist economic policies,exchange controls, and so on were vanishing from the global scene.

But I have just argued, following Rodrik, that the unprecedenteddepth and breadth of policy reform was largely due to the perceptionthat such reforms brought macroeconomic and financial recovery—aperception driven by the way that financial markets rewarded thereforms! So once again something of a circular logic was at work.

During the first half of the 1990s, a set of mutually reinforcingbeliefs and expectations created a mood of euphoria about theprospects for the developing world. Markets poured money intodeveloping countries, encouraged both by the capital gains they hadalready seen and by the belief that a wave of reform was unstoppable.Governments engaged in unprecedented liberalization, encouragedboth by the self-reinforcing conventional wisdom and the undeniablefact that reformers received instant gratification from enthusiasticinvestors. It was a very happy picture. Why couldn't it continue?

THE REALITY CHECK

F R O M A mere trickle during the 1980s, private capital flows to de-veloping countries soared to about $130 billion in 1993. Relatively littleof this money went to those East Asian countries that had alreadyachieved rapid economic growth during the 1980s. Less than 10 percentof the total, for example, went to China, and the four Asian tigers—Singapore, Hong Kong, South Korea, and Taiwan—were all net

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exporters of capital. Instead, the bulk of the money went to countriesthat had done poorly in previous years, but whose new commitment toWashington consensus policies was believed to ensure a dramatic turn-around: Latin American countries, plus a few others such as the Philip-pines and Hungary. How well were these economies doing?

In one respect, the performance of the main recipients of massivecapital inflows did represent a break with the past. The new insistence

on sound money had, indeed, led to impres-Investorswere ^ ^ reductions in inflation rates. Between

. 1987 and 1991, Mexico's inflation rate hadCOnndent in broad averaged 49 percent; in 1994, it was less thanreform, in turn driven 7 percent. In Argentina the contrast was eveny c. - 1 J more spectacular, from an average inflation

by financial rewards. ^ ^ ^f ^ ^^^^^^^ -^ ^ ^ . ^ ^ f^^^^ ^ j ^ ^ ^than 4 percent last year.

. That was the good news. Unfortunately, there was also a substan-tial amount of disappointing news, on three main fronts. First, whilehard currency policies brought down inflation, they did so only grad-ually As a result, costs and prices got far out of line with those in therest of the world. Mexico, for example, allowed the peso to fall only13 percent between 1990 and the first quarter of 1994, but consumerprices in Mexico nonetheless rose 63 percent over that period, com-pared with a rise of only 12 percent in the United States. Thus Mex-ico's real exchange rate—the ratio of Mexican prices in dollars toprices in the United States—rose 28 percent, pricing many Mexicangoods out of U.S. markets and fueling an import boom. Argentina'sdrastic policy, which sought to end a history of extreme inflation bypegging the value of the peso permanently at one dollar, predictablyleft the country's prices even farther out of line. Between 1990 andearly 1991 the Argentine real exchange rate rose 68 percent.

Second, in spite of huge inflows of foreign capital, the real growthin the recipient economies was generally disappointing. Mexico wasthe biggest disappointment: although capital flows into Mexicoreached more than $30 billion in 1993, the country's rate of grov\^hover the 1990-94 period averaged only 2.5 percent, less than popula-tion growth. Other countries did better: Argentina, for example,grew at an annual average rate of more than 6 percent after the stabi-

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lization of the peso. But even optimists admitted that this growth hadmuch to do with the extremely depressed state of the economy beforethe reforms. When an economy has been as thoroughly mismanagedas Argentina's was during the 1980s, a return to political and mone-tary stability can easily produce a large one-shot rise in output. AcrossLatin America as a whole, real growth in the period 1990-94 averagedonly 3.1 percent per year.

Finally, the benefits of growth, which was in any case barely pos-itive in per capita terms, were also very unevenly distributed. Devel-oping country statistics on both unemployment and income distrib-ution are fairly unreliable, but there is not much question that evenas Latin American stock markets were booming, unemployment wasrising, and the poor were getting poorer.

In sum, the real economic performance of countries that hadrecently adopted Washington consensus policies, as opposed to thefinancial returns they were delivering to international investors or thereception their policies received on the conference circuit, was dis-tinctly disappointing. Whatever the conventional wisdom mighthave said, the underlying basis for the conviction of both investorsand governments that these countries were on the right track wasbecoming increasingly fragile.

Some kind of crisis of confidence was thus inevitable. It could havecome in several different ways. For example, there might have been apurely financial crisis: a loss of confidence in emerging markets asinvestments, leading to capital flight and only then to a loss of polit-ical confidence. Or there could have been an essentially intellectualcrisis: the growing evidence that the new policies were not deliveringin the way or at the speed that conventional wisdom had expectedmight have led to soul-searching among the policy elite. But giventhe way that the Washington consensus had originally come to flour-ish, it should not be surprising that the crisis, when it came, involvedthe interaction of economics and politics.

Consider the essentials of the Mexican situation as it began tounravel in 1994—the factors that would surely have provoked a crisiseven without the uprisings and assassinations. Despite the popular-ity of the country among foreign investors, growth had slowed in 1993to a virtual crawl, creating a considerable rise in unemployment. This

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growth slowdown was in a direct sense due to the rise in Mexico's realexchange rate after 1990, which discouraged any rapid growth inexports and caused growing demand to be spent primarily on importsrather than domestic goods. More fundamentally, the free marketpolicies had not, at least so far, generated the kind of explosion of pro-ductivity, new industries, and exports that reformers hoped for.

Given these economic realities, the Mexican government wasfaced with a dilemma. If it wanted to get even modest growth goingagain, it would need to do something to make its industries morecost-competitive—that is, devalue the peso. But to do so, given theemphasis that the government had placed on sound money, would bevery damaging to its credibility. In the event, the approach of thepresidential election seems to have led the Mexicans neither todevalue nor to accept slow growth, but rather to reflate the economyby loosening up government spending. The result was a loss of cred-ibility even worse than that which would have been produced by anearly devaluation. And then the usual logic of currency crisis cameinto play: because investors thought, with some reason, that the cur-rency might be devalued, they became unwilling to hold peso assetsunless offered very high interest rates; and the necessity of payingthese high rates, together with the depressing effect of high rates onthe economy, increased the pressure on the government to abandonthe fixed exchange rate—which made investors even less willing tohold pesos, in a rapid downward spiral familiar to scores of formerfinance ministers around the world.

The point is that while the details could not have been predicted,something like the Mexican crisis was bound to happen. Without theChiapas uprising or the assassination of presidential candidate LuisDonaldo Colosio, Mexico might not have hit the wall in December1994, but it probably would not have gone unscathed through 1995.An early, controlled devaluation might have done less damage thanthe display of confusion that actually took place, but it would stillhave done considerable harm to the government's credibility. Andeven if Mexico had somehow avoided getting into trouble, the dis-parity between the glittering prizes promised by the Washingtonconsensus and the fairly dreary reality was bound to produce a revo-lution of falling expectations somewhere along the line.

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•. . . . I

AN AGE OF DEFLATED EXPECTATIONS?

BECAUSE T H E 1990-95 euphoria about developing countries was SO

overdrawn, the Mexican crisis is likely to be the trigger that sets theprocess in reverse. That is, the rest of the decade will probably be adownward cycle of deflating expectations. Markets will no longer pourvast amounts of capital into countries whose leaders espouse free mar-kets and sound money on the assumption that such policies will nec-essarily produce vigorous growth; they will want to see hard evidenceof such growth. This new reluctance will surely be directly self-rein-forcing, in that it means that the huge capital gains in emerging mar-ket equities will not continue. It will also, more or less directly, lead toa further slowing of growth in those countries, comprising much ofLatin America and several outside nations, whose hesitant recoveryfrom the 1980s was driven largely by infusions of foreign capital.

Because reforms will no longer be instantly rewarded by the capi-tal markets, it will be far more difficult to sell such reforms politically.Thus the common assumption that free trade and free market poli-cies will quickly spread around the world is surely wrong. Indeed,there will doubtless be some backsliding, as the perceived failure ofWashington consensus policies leads to various attempts either torestore the good old days or to emulate what are perceived as alter-native models. Many developing country politicians will surely claimthat truly successful development efforts have been based not on freemarkets and sound money but on clever planning and rationed for-eign exchange. At the moment, most developing country govern-ments are still reluctant even to hint at a return to interventionist andnationalist policies because they fear that such hints will be swiftlypunished by capital flight. But sooner or later some of them will redis-cover the attractions of capital controls. As has happened so manytimes in the past, some countries will in desperation impose regula-tions to discourage capital flight. They will discover that while suchregulations do raise the cost of doing business, that cost seems minorcompared with their newfound ability to contain temporary specula-tive attacks without imposing punitive interest rates.

And these two trends will surely reinforce each other. As itbecomes clear to the markets that reform need not always advance,

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they will become increasingly reluctant to offer advances on reform.As it becomes clear that such rewards are not available even to themost virtuous of reformers, the willingness to suffer economic pain toplacate the markets will erode all the more.

But will the conventional wisdom represented by the Washingtonconsensus be so easily displaced? Before the Mexican crisis, whensome warned that the rhetoric about a golden age for global capital-ism was excessive, the reply was often that there was no alternative.Communism is dead. The old protectionist development strategiesin South Asia and Latin America were unambiguous failures. Evenif Victorian virtue does not yield the easy rewards some may haveexpected, it is still the only plausible course of action left. And sucharguments have a point. It is, in fact, probably true that free marketsand sound money—if not necessarily fixed exchange rates—are thebest policy for developing countries to follow.

But it seems strangely unimaginative to assume that becausethere are no other popular paradigms for policy currently in circu-lation, nobody will be able to come up with a rationale for policiesthat are very much at odds with the Washington consensus. Indeed,there are already audible rumblings about emulating a supposedAsian model Developing countries should try, some people say, tobe hke Japan (as they imagine it) rather than America. The intel-lectual basis for such ideas is far weaker than that for the Washing-ton consensus, but to suppose that bad ideas never flourish is toignore the lessons of history.®

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