Rodrik Economic Reform

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American Economic Association

Understanding Economic Policy ReformAuthor(s): Dani RodrikReviewed work(s):Source: Journal of Economic Literature, Vol. 34, No. 1 (Mar., 1996), pp. 9-41Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/2729408 .

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Journal of Economic Literature,

Vol. XXXIV (March 1996), pp. 9-41

Understandingconomic P o l i c y

R e f o r m

ByDANI RODRIK

Columbia University

This paper has benefited from the comments of Herschel Grossman,Anne Krueger, GustavRanis, Jeffrey Sachs, John Williamson,and three referees.

I. Introduction

T" HIS GOVERNMENT will be austere,

uncompromising, and tinpopular if

that is what is required to achieve eco-nomic recovery," declared Mario Soaresin 1983 upon taking office as prime min-

ister of Portugal.1 This kind of talk ismusic to the ears of economists. Reform

requires austere policies which respectbudget constraints. It also precludes

compromising with the narrow, specialinterest groups that have been the bene-ficiaries of the deleterious policies of the

past. Policy makers who have coura-

geously taken on such interest groupsand pursued market-oriented policiesare the heroes of the economics profes-sion (see Arnold C. Harberger 1993).

That such policies should also be un-popular (as Soares feared they would),however, requires a lot more explaining.What is the point of loudly proclaimingreforms if these are not aimed at improv-ing the well-being of a large majority ofthe population? And if that is their goal,

why should reforms be unpopular?In many areas of policy, there may ex-

ist "technical" uncertainty as to what theappropriate solution is to the problemsat hand. Think of President Clinton'shealth care plan, for example, or ofglobal warming. Consequently, reformswill arouse opposition if they are viewedas applying the wrong fix or if they areperceived as being primarily redistribu-tive (that is, zero-sum). What is remark-

able about current fashions in economicdevelopment policy (as applied to bothdeveloping and transitional economies),however, is the extent of convergencethat has developed on the broad outlinesof what constitutes an appropriate eco-nomic strategy. This strategy emphasizesfiscal rectitude, competitive exchangerates, free trade, privatization, undis-torted market prices, and limited inter-vention (save for encouraging exports,

education, and infrastructure). Faith inthe desirability and efficacy of thesepolicies unites the vast majority of pro-fessional economists in the developedworld who are concerned with issues ofdevelopment.2

1 Quoted by Jose Maria Maravall n Luiz Carlos

Bresser Pereira, Maravall, and Adam Przeworski(1993).

2 The convergence is not complete of course.But compared to two decades ago, the varioussides have moved substantially closer to eachother. One indicator of this is the recent book byBresser Pereira, Maravall, and Przeworski (1993),

which advocates a "social democratic" approach.The views exDressed in this book concede an inor-

9



10 Journal of Economic Literature, Vol. XXXIV (March 1996)

Hence economists are often torn be-

tween two conflicting perspectives: on

the one hand, good economic policyshould produce favorable outcomes and

therefore should prove also to be goodpolitics; on the other hand, the imple-

mentation of good economic policy is

often viewed as requiring "strong" and

"autonomous" (not to say authoritarian)

leadership. The experience of Chile, a

country which has perhaps gone further

than any other in implementing liberal

economic policies, provides a good exam-

ple. An essay on Chile's reform strategy

by Jose Pifiera (1994), an economist andminister of labor and social security un-

der General Pinochet, concludes: "[i]nthe end, good policy is good politics" (p.231). The irony is that most of the re-

forms the author glowingly discusses in

the preceding pages required the sus-

pension of normal politics and as heavy a

dose of authoritarianism as seen any-where.

Good economics does often turn out

to be good politics, but only eventually.Policies that work do become popular,but the time lag can be long enough forthe relationship not to be exploitable bywould-be reformers. In Chile's case, free

market policies (implemented after

1973) were eventually resoundingly en-dorsed in the presidential elections of

1989 and have become the envy of Latin

America.3 Conversely, bad economics

can be popular, if only temporarily.President Alan Garci a's popularity

soared in Peru during his first two yearsin office (1985-86), thanks to expansion-

ary fiscal policies whose medium-term

unsustainability should have been obvi-ous to anyone with common sense (seeRicardo Lago 1991). The puzzle is why

we observe such instances of collectiveirrationality.

The events of the last decade have un-

derscored the need to understand thepolitical-economy of policy making. Oneof the eventual consequences of theglobal debt crisis that erupted in 1982was a wave of market-oriented economicreforms, the likes of which have neverbeen seen. The reforms were strongestand most sustained in Latin America,where countries like Bolivia, Mexico, Ar-gentina, Peru, Colombia, and Braziljoined Chile in orthodoxy. But this was

very much a global phenomenon. "Stabi-lization" and "structuraladjustment"be-came the primary preoccupation of gov-ernment leaders in Asia and Africa aswell, even though the commitment toeconomic orthodoxy varied across coun-tries and over time. These countrieswere in turn soon joined by the pre-viously socialist economies of EasternEurope and the former Soviet Union.Economists who had cut their teeth in

Latin America's economic quagmires be-came the advisors and analysts of thesetransitional economies. Even India, thegiant archetype of a closed, import-sub-stituting economy among developingcountries, embarked on a process of eco-nomic liberalization in 1991 (see JagdishBhagwati 1993 and Arvind Panagariya1994).

These reforms were encouraging toeconomists and a vindication of sorts tothose among them who had long advo-cated market-oriented reforms. But theyin turn raise their own puzzles. Mostfundamental of all, why are so many gov-ernments reforming now, after decadesof adherence to policies of an oppositekind? This question poses a particularlyimportant challenge to political econo-mists: an understanding of these coun-tries' experiences now requires a theory

that explains not only why seemingly dys-functional policies had been initially un-

dinate amount to the consensus view, and departfrom it in remarkably few details. I will discussthis book in Section IV.

3 For a recent evaluation, see Barry Bosworth,Rudiger Dornbusch, and Ral Labn (1994).



Rodrik: Understanding Economic Policy Reform 11

dertaken and then maintained for solong, but also why these policies weresuddenly abandoned en masse during the1980s, often by the same politicians who

had been among their most ardent sup-porters. Second, while the reforms wereinspired at least in part by the East Asianexperience, they took place much morequickly and, in many areas, are goingconsiderably beyond those undertaken inEast Asia. This raises the question ofwhether the new wave of reformers haveinternalized the correct lessons from theEast Asian experience. Finally, are thereany helpful rules for reformers to followin guiding their policies through compli-cated political terrain? Can one hope todevelop a "how-to"manual for the refor-mist politician?

Puzzlement over such questions hasled to a large and growing literature. Avery short bibliography would includebooks by Merilee Grindle and JohnThomas (1991), Robert Bates and Krue-ger (1993), Krueger (1993), Przeworski

(1991), Ranis and Syed Mahmood (1992),Bresser Pereira, Maravall, and Przewor-ski (1993), Stephan Haggard and RobertKaufman (1992), Dornbusch and Se-bastian Edwards (1993), Haggard andSteven Webb (1994), Lance Taylor(1994), Williamson (1994), and Ian Littleet al. (1993), not to mention countlesspapers.4 As this partial list indicates,both economists and political scientistshave devoted their attention to these is-

sues, often together in coauthored orcoedited works. Indeed, no other area ofeconomics or political science that I canthink of has spawned so much interdisci-plinarywork.5

In this essay, I will provide an econo-

mist's perspective on the political econ-omy of policy reform. I begin by examin-ing the origins and analytical content ofthe new orthodoxyin development policy

(Section II). I will focus here on two is-sues in particular which I feel remainin need of clarification. One of theseconcerns the distinction between (a)macroeconomic policies aimed at eco-nomic stability, such as fiscal, monetary,and exchange rate policies, and (b) liber-alization policies aimed at structural re-form and growth, such as the removal ofrelative-price distortions and the reduc-tion of state intervention. It has becomecommonplace to conflate these twogroups of policies, but for analytical pur-poses they are best kept apart. As weshall see, they also have different politi-cal-economy underpinnings. Moreover,maintaining the distinction reminds usthat the consensus on what constitutesappropriate structural reform is based onmuch shakier theoretical and empiricalgrounds than is the consensus on the

need for macroeconomic stability. Thesecond issue concerns the appropriatelessons to be drawn from the experienceof East Asian success stories. The neworthodoxy has tended to draw a some-what biased picture that needs correc-tion.

Next, I will turn to the reforms of the1980s and 1990s. This experience hasopened an important window on the mo-tivations of politicians, as well as on the

nature of interactions between the econ-omy and the polity. As indicated above,an important question is why so manycountries have suddenly caught the re-form bug. The confluence of economiccrisis with reform has led to the naturalsupposition that crisis is the instigator ofreform, a hypothesis that keeps reap-pearing in the literature and yet is inade-quately analyzed. Section III discussesthis issue, as well as related questionssuch as: what, if any, are the short-term

4 One recent survey-Mariano Tommasi andAndres Velasco 1995-which overlaps with thisone deserves special mention.

5 The literature on the economics of policy re-form is of course even larger. For recent surveys,see Vittorio Corbo and Stanley Fischer (1995) andRodrik (1995b).




costs of reform? and does foreign aidhelp or hamper reform?

Finally, I will discuss some normativeaspects related to the politics of policyreform (Section IV). In particular, I willanalyze what kind of guidance, if any,the literature provides to the reformistpolitician regarding the appropriatestrategies for carrying out his program.The focus here will be on the conflictbetween top-down versus participatoryapproaches. This discussion will take usback to some of the deeper questionsabout the collective rationality of politi-

cal institutions and behavior.

II. The New Orthodoxy in DevelopmentThinking and Enduring Puzzles

Once upon a time, there was some-thing called the Third World and wethought we understood how it worked(or did not work). Countries of the ThirdWorld followed import-substitution poli-cies, so called because the overarching

objective of economic policy was to de-velop domestic manufacturing capabilityfor goods previously imported. Suchpolicies included import controls, over-valued exchange rates, binding ceilingson interest rates, a heavy dose of publicownership, and pervasive price regula-tion. The political-economy counterpartof these policies was the predominanceof urban over rural interests, and withinthe' urban sector, an uneasy alliance of

sorts between the protected industriesand the bureaucrats administering theprotection.

Perhaps no other economist has doneas much as Anne Krueger in document-ing and popularizing the shortcomings ofimport-substituting policies. As shepoints out in her Ohlin Lectures (1993),there was a multitude of reasons for theinitial adoption of these policies. Newly

independent governments had a strongdesire for industrialization, and the ap-

parently successful example of Sovietplanning invited emulation. Moreover,

the economic ideas of the 1950s and

early 1960s tended to dismiss the bene-fits from trade and emphasized the need

for physical capital accumulation and in-

fant-industry promotion. As Krueger

puts it,

[t]he underlying premises regarding marketsand governments implicit in these policy pre-scriptions are obvious: There was a strongemphasis on the primacy of market imperfec-tions. Market failures were thought to berelatively strong, while it was assumed thatgovernments could correctly identify and per-form economic functions. Virtually no atten-tion was given to the possibility that theremight be government failure. (p. 49)

And there was plenty of governmentfailure. Not only did many infant indus-

tries fail to mature, but many countriessuccumbed to stop-go cycles driven byexcessive government spending. Krueger

explains that in viewing the governmentas a "benevolent social guardian" most

economists had ignored a number ofimportant forces at work. Individualsin the public sector were apt to follow

their own selfish interests. They would

be lobbied by pressure groups aiming to

impose their own agenda on a largely

docile majority. Policy interventions

would create rent-seeking incentives

diverting entrepreneurs from productive

activities. Finally, the informational

disadvantage of government bureaucra-

cies over market participants woulddoom even the best-laid plans to ineffi-

ciency.

Meanwhile, four East Asian economies

were making a mockery of the export

pessimism that had persuaded policymakers elsewhere to follow an inward-

oriented strategy. South Korea and Tai-

wan, in particular, were able to engineera remarkable increase in their growth

rates, thanks to sharp jumps in their in-vestment and export efforts during the




TABLE1COMPARATIVERowTHEXPERIENCE

Per capita GDP, Per capita GDP, Per capita GDP

1960 1989 growth,Country (1985 dollars) (1985 dollars) 1960-89 (%)

South Korea 883 6206 6.82Taiwan 1359 8207 6.17Ghana 873 815 -0.54

Senegal 1017 1082 0.16Mozambique 1128 756 -2.29Brazil 1745 4138 3.58Mexico 2798 5163 2.36Argentina 3294 3608 0.63

Source: Penn World Table 5.5 (1993).

mid-1960s. Table 1 summarizes this im-

pressive performance in comparative

context. Recent work by Jong-Il Kim and

Lawrence J. Lau (1992) and Alwyn

Young (1993, 1994) has shown that thesewere miracles of accumulation rather

than of productivity: the sharp increasesin physical and human capital as well as

in labor-force participation account forvirtually all of the rise in output, and

consequently the East Asian tigers' per-

formance with respect to total factor

productivity (TFP) growth does not look

outstanding. Of course, for accumulation

to have taken place at such rates, the

profitability of investment in the regionmust have been very high, which needs

explanation.What was the key to these economies'

success? Among professional economists,there soon developed the view that theEast Asian miracles could be attributed

to market-oriented policies and the re-

duced role of government intervention.

Hence, Ranis and Mahmood (1992, p.138) attribute the Taiwanese and SouthKorean successes to

the willingnessof the governmentsn bothcountries-albeit somewhat ess so in SouthKorea-to allow growthto proceed along a"natural"ath and an aversion o use covert

measures of resource transfers in order topromote growth artificially.

And Krueger (1993, p. 30) writes:

To be sure, the Korean economy has notbeen characterized and is not characterizedby laissez-faire. But in contrast to the over-controlled, overregulated, highly distortedeconomies described above, the Korean econ-

omy has been characterized by diminishingintervention in most spheres of economic ac-tivity, and the degree of distortion is consid-erably smaller.

Indeed, in both Korea and Taiwan,there was an extensive set of reformsduring the late 1950s and early 1960s, onwhich more later.

So the new orthodoxywas built on twomutually reinforcing pillars: one was theset of policies that had been tried by the

import-substituting countries and hadfailed; the second was the set of success-ful policies implemented by the EastAsian tigers. These two sets of policiesbear close scrutiny, as they overlap to amuch greater extent than the orthodoxcase likes to admit.

A. MacroeconomicDisequilibrium orImport-Substitution Policies?

In describing the experience of devel-

oping countries it has become common




to lump together a wide range of poli-cies, as I too have done above, under thelabel of "import-substitution policies."For descriptive purposes, this makes per-fect sense. Except for a handful of coun-tries in East Asia, most developing coun-tries did combine illiberal trade andprice policies with (at least occasional)fiscal profligacy and overvalued exchangerates. So there was a common syndrome,which perhaps does deserve to go undera single name. However, the practice hasalso frequently led economic analysisastray and generated confusion. The

trouble is that failures were often misat-tributed to microeconomic policies,when their sources lay either with unsus-tainable macroeconomic policies or bu-reaucratic and institutional shortcomings.

Consider for example two trade-re-lated policies: import restrictions (e.g.,import quotas) and overvalued exchangerates. These two have rather differentimplications for economic stability andlong-run performance. The effect of im-

port restrictions is to repress trade (im-ports as well as exports in the longerrun). While this is costly insofar as it en-genders some resource misallocation, itdoes not inherently generate economicinstability, nor does it necessarily reducelong-term growth.6 Overvalued exchange

rates are different. By definition, theyresult in trade deficits that are unsus-tainably large, and therefore in balance-of-payments crises (unless they arecorrected quickly). Consequently, ex-change rate misalignments are closely as-sociated with economic instability andwith the deterioration of economic per-formance over the medium to long run.The confusion between these two typesof policies often reveals itself in empiri-cal studies that uncover a negative rela-tionship between measures of exchange-rate distortion and economic growth, and

then attribute the effect to the lack ofopenness in the sense of trade protec-tion.7

Similarly, consider subsidies to spe-cific industries versus large fiscal defi-cits. The former can be damaging if thetargeted industries do not produce posi-tive externalities or if the subsidies leadto rent-seeking activities. But the dam-age done by large, sustained budget defi-cits is often much larger. An unsustain-

able deficit can be financed by foreignborrowing or by monetization, and ineither case a crisis is often not too faraway.8 Usually, external sources are thefirst resort, and an inflation problem fol-

lows on the heels of a payments crisis.

The World Bank recently undertook a

large-scale research project on the con-

sequences of public-sector deficits in de-

veloping countries. The findings were

unequivocal: "Deficits . . . are unambigu-

ously bad for growth."9 This distinc-

6 In traditional economic theory, trade restric-tions have level effects, but no growth effects.That is, a 20 percent tariff may reduce real incomeby, say, 0.5 percent of GDP (permanently), but it

will not affect the economy's long run growth rate.In the more recent endogenous growth literature,trade restrictions may have growth effects, butthese growth effects can go either way dependingon the model. For a small economy, the effecttends to depend on whether the comparative-advantage efTect pulls resources in or out of thegrowth-sectors of the economy (those with techno-logical externalities or learning-by-doing). Empiri-cal work on growth has often claimed to discover anegative relationshipbetween trade protectionan growth. However, this literature is marredbysevere analytical and conceptual confusions, withmacroeconomic policies often confused for trade

restrictions and the endogeneity of trade policynot fully accounted for.

7 See for example the use made of David Dol-lar's (1992) "real exchange rate distortion" ndex inWorld Bank(1993).

8 Of course, foreign borrowing or moderateamounts of monetization (seignorage or inflationtax) need not be bad things. The focus here is onunsustainable levels of borrowingor seignorage.

9 William Easterly, Carlos Alfredo Rodrguez,and Klaus Schmidt-Hebbel (1994, p. 1). It is ofcourse possible, as a referee pointed out, that adeeper underlying cause (i.e., political instability)

is jointly responsible for both the deficits and lowgrowth.




TABLE 2

DETERMINANTSOF THE DEBT CRISIS, 1982

Failure o adjustmonetary nd fiscal Indexof relative-price

Largeexternal hock policy distortion

TroubledCountiesArgentina No Yes 0.3054Brazil Yes Yes 0.2019Chile Yes Yes 0.4460CostaRica No Yes 0.2818Coted'lvoire Yes Yes 0.2438Mexico No Yes n.a.Morocco No Yes 0.2675Nigeria No Yes 0.2306

UnweightedAverage 0.2824

ModeratelyTroubledCountriesColombia No Yes 0.2744Kenya Yes Yes 0.1218Sri Lanka Yes No 0.8606

UnweightedAverage 0.4189

UntroubledCountriesCameroon Yes No 0.2344India No No 0.2620Indonesia No No 0.4503Korea Yes No 0.2128Pakistan No No 0.3814Thailand Yes No n.a.

Turkey No No n.a.UnweightedAverage 0.3082

Source:Littleet al. (1993),Table4.4, exceptfor the relative-price istortionndexwhichis takenfrom Easterly(1993).Thelatter ndex s the variance f the log inputprices (relativeo U.S.prices)across ommodities,measuredin 1980.See Easterly 1993) forthe methodof calculation ndthejustificationorthe index.

tion-between micro and macro-is lostin many studies that attribute balance-of-payments crises to activist industrial

policies (ratherthan the unwillingness orinability to balance budgets).

The watershed event of the 1980s formost developing countries, the general-ized debt crisis that followed the Mexi-can moratorium of August 1982, was adramatic confirmation of the importanceof prudent macroeconomic policies.Looking below the surface, it was evi-dent that the crisis affected only thosecountries that did not respect budgetconstraints. India, the import-substitut-

ing country par excellence, managed to

escape the debt crisis during the 1980s,thanks to its tradition of conservative

monetary and fiscal policies.10 At theother end of the spectrum, South Korea

experienced a payments crisis in 1979-

80, before the Latin American countries,as a consequence of an ambitious invest-

ment program running ahead of availabledomestic savings. But the quick adoption

10 During the 1980s, however, a growing public-sector deficit began to endanger macroeconomicbalances. In 1990, the deficit reached 8.3 percent

of GDP, culminating in a balance-of-paymentscri-sis in 1991 (Panagariya1994, pp. 205-06).



16 Journal of Economic Literature, Vol. XXXIV(March 1996)

of expenditure-reducing and expendi-ture-switching policies enabled a swiftrecovery, after a five percent contractionin 1980 (see Susan Collins and Won-AmPark 1989). Before long, Korea's crisiswas forgotten. More broadly, there wasno correlation between the propensity tofall into crisis and the nature of micro-economic policies proper. As Table 2 in-dicates, the countries that experienceda debt crisis in 1982 were those thatfailed to adjust their monetary and fiscalpolicies, and not those that had large mi-croeconomic distortions or were con-

fronted with particularly large externalshocks.There is little question that the mi-

croeconomic distortions in themselveswere often costly. A series of team ef-forts led by Little, Tibor Scitovsky, andMaurice Scott (1970), Bela Balassa(1971), Bhagwati (1978), and Krueger(1978) had documented in detail the re-source-allocation costs of high protec-tion. These studies used measures of ef-

fective rates of protection (ERP) anddomestic resource costs (DRC) to dem-onstrate that the governments' price andtrade policies had led to the creation ofwildly inefficient industries, at timesproducing negative value-added at worldprices! Moreover, the net incentive ef-fects of these policies seemed hap-hazard, judged by the variabilityof ERPsand DRCs across industries. More recentwork has shown that particular relative

price distortions, those affecting capitaland intermediate goods, can be costly togrowth as well (Bradford De Long andLawrence Summers 1991; Easterly1993). However, what eventually drovemany import-substituting countries toruin were not such microeconomic in-efficiencies, but macroeconomic imbal-ances and the inability to correct themwith sufficient speed. Mexico's currrency

crisis in December 1994-January 1995 isa poignant example of how one can get

most everything right on the micro-economic front, but still face a deep cri-sis if macro policies-in Mexico's case an

overvalued exchange rate aggravated bypre-election credit expansion-are not

managed well.This distinction between microeco-

nomic distortions and macroeconomic

stability is one that economists have long

recognized. Yet it is also one that has

made little impression on the develop-ment profession. In an essay publishedin 1975, for example, Carlos Diaz-Ale-

jandro (1975) faulted the Little-Sci-

tovsky-Scott (1970) study mentionedabove for lumping

togetherall features of the import-substitu-tion sydrome, uch as importand othercon-trols, tariffs,overvalued ndpeggedexchangerates, spectacular alance-of-paymentsrises,inflationarypressures, and stop-go cycles.Followinga "guiltby association"rocedure,they then tend to blamemuchof whatis go-ing wrong n less developedcountrieson thatill-defined syndrome.Unsophisticated ead-ers mayindeed concludethat nearly every-

thing gone wrong n those countriess due tothatwickedsyndrome.Considera mentalexperiment.Whatwould

havehappened f, say, Argentina nd Colom-bia had adopted lexibleexchangerates backin 1945, while adopting also an across-the-boardimport tariff of 150 per cent ad valo-rem? I suspect their record, at least ongrowthand exports,wouldhave been muchbetter. Theirharmful top-gopoliciesmaybeblamed to a large extent on exchange-ratemismanagement . . and on other short-runpolicies that could be analyticallyeparated

from the long-run effects of protection.(Diaz-Alejandro 975, pp. 115-16, emphasisin the original)

Elementary as these points may be,

they were largely overlooked in the af-

termath of the debt crisis. The consensus

post mortem view held the whole com-

plex of import-substitution policies re-

sponsible for what was essentially a crisis

of overspending exacerbated by the fick-

leness of international capital markets. It

became commonplace to view the debt




TABLE3THE 'WASHINGTON CONSENSUS" AND EAST ASIA

Elementsof the

WashingtonConsensus South Korea Taiwan

1. Fiscaldiscipline Yes, generally Yes

2. Redirection f public Yes Yesexpenditure riorities owardshealth,educationandinfrastructure

3. Taxreform, ncluding he Yes, generally Yesbroadening f the taxbaseandcuttingmarginalaxrates

4. Unifiedandcompetitive Yes(except or limited ime Yesexchange ates periods)

5. Secureproperty ights PresidentPark tartshis rule Yesin 1961 by imprisoningleadingbusinessmenandthreatening onfiscation ftheirassets.

6. Deregulation Limited Limited

7. Trade iberalization Limiteduntil the 1980s Limiteduntilthe 1980s

8. Privatization No. Government stablished No. Governmentmanypublic enterprises establishedmanypublicduring1950s and 1960s. enterprisesduring1950s

and 1960s

9. Elimination f barriers o DFI heavilyrestricted DFI subject o governmentdirect

foreignnvestment

DFI)control

10. Financialiberalization. Limiteduntilthe 1980s Limiteduntilthe 1980s

Source:Williamson1994)forfirstcolumn,and author's valuation.

crisis as the consequence of import-sub-stitution ("inward-oriented") policies."The intellectual ground was thereforecleared for the wholesale reform of pre-vailing policies in Latin America, Africa,and Asia. Orthodox economists who hadthe ear of policy makers now had theirchance to wipe the slate clean andmount a frontal attack on the entirerange of policies in use. After some de-

lay, this produced dramaticresults, espe-cially in Latin America.

B. What Did the East AsianGovernments Do Right?

Ironically, many governments (notablyin Latin America) ended up implement-ing policies that went far beyond whatthe East Asian governments themselveshad adopted since the 1960s. As inti-mated above, many of the discreditedpolicies had long been in use in SouthKorea, Taiwan, and Singapore, and ap-parently to good effect. (Hong Kong'spolicies have come closest to the laissez-faire ideal, even though there is plenty of

11This view was (and is) strongly held in theWorld Bank, which shaped development policy inmanycountries during the 1980s through its struc-turaY djustment loans. See for example the WorldBank volume edited by Vinod Thomas et al.(1991), and especially the essays by the editorsand by Ernest Stern.




intervention in the housing market.) To

appreciate this point, it is useful to spell

out in somewhat greater detail the ele-

ments of the new orthodoxy, so we can

compare them to East Asian policies.Fortunately, we have a useful list of

policy desiderata compiled by William-

son, who has dubbed it the "Washington

consensus." Williamson originally com-piled the list in 1990, and a summary is

included in Williamson (1994). In Wil-

liamson's words, "[t]he 'Washington con-

sensus' offers a description of what is

agreed about the set of measures that are

typically called for in the first stage ofpolicy reform. . . ." (p. 17).12 The list is

shown in Table 3, along with my own

summary comments on the degree of

compliance exhibited by Taiwan and

South Korea in each area of reform.

How well did South Korea and Taiwan

do according to this list? Judging by the

number of the prescriptions these coun-tries did or did not follow, we wouldhave to award South Korea a score of

about five (out of ten), and Taiwan aboutsix. Both countries managed fiscal expen-

ditures and revenues rather well, avoid-

ing macroeconomic stop-go cycles and

high inflation. They also consistentlymaintained unified exchange rates (Tai-wan since 1961 and Korea since 1964)and competitive parities for the most

part. But the rest of the scorecard is less

spectacular. Taiwan welcomed DFI, but

Korea much less so. Korea repressed in-

terest rates and made heavy use of subsi-dized credit; Taiwan did not do so, but

did give priority to public enterprises in

credit allocation. Neither country signifi-

cantly liberalized its import regime until

the 1980s. Both countries heavily inter-

fered in the investment decisions of pri-vate enterprises. And far from privatizingpublic enterprises, both countries actu-ally increased their reliance on such en-terprises during the crucial decade of the1960s.13 In short, where South Koreaand Taiwan followed the orthodox pathmost closely was in maintaining conser-vative fiscal policies and competitiveexchange rates; this accounts for theirability to avoid protracted periods ofmacroeconomic instability, particularlyin the crisis-ridden decade of the 1980s.In the area of microeconomic interven-

tions, however, their experience di-verged from the orthodoxpath.By contrast, it is striking how many

Latin American countries have comewithin reaching distance of completingthe items on the "Washington consen-sus" in a period of no more than a fewyears during the 1980s. Mexico, Bolivia,and Argentina, to cite some ofl the moredistinguished examples, have undertakenmore trade and financial liberalization

and privatization within five years thanthe East Asian countries have managedin three decades.

I will discuss the reforms of the 1980sat greater length later. First we have toconfront two puzzles that arise from thecontrasting experiences of the East Asiantigers and other developing countriesprior to the 1980s. How could the EastAsian countries avoid the disasters thataccompanied interventionist policies

elsewhere? And why did most develop-ing countries succumb so easily, andoften periodically, to unsustainable fiscaland exchange-rate policies? Neither ofthe puzzles is handled very well in theexisting literature, although we do have anumber of useful leads.

12Williamson is quick to say that there remainsa number of disagreements among economists onsome of the narrower issues, for example thespeed of trade liberalization or the need to elimi-

nate indexation. See pages 17-18 for his list ofdisagreements.

13 Probablythe two best known works on theseissues are Alice Amsden (1989) and Robert Wade(1990). Leroy Jones and Il Sakong (1980) and

Ching-yuanLin (1973) are two older books whichare extremely detailed and informative.




TABLE4HUMAN CAPITAL NDICATORS N EAST ASIA: ACTUAL VERSUSPREDICTEDVALUESFORTHE EARLY1960s

Primary nrollment atio,1960 Secondary nrollment atio,1960 Literacy ate, 1960

Act. Pred. Diff Act. Pred. Diff Act. Pred. DiffHong Kong 0.87 0.83 0.04 0.24 0.23 0.01 0.70 0.59 0.11

Indonesia 0.67 0.51 0.16 0.06 0.07 -0.01 0.39 0.25 0.15

Japan 1.03 0.92 0.11 0.74 0.29 0.45 0.98 0.70 0.28

Korea 0.94 0.57 0.37 0.27 0.10 0.17 0.71 0.31 0.40

Malaysia 0.96 0.68 0.28 0.19 0.15 0.04 0.53 0.43 0.10

Singapore 1.11 0.78 0.33 0.32 0.21 0.11 0.50 0.54 -0.04

Taiwan 0.96 0.62 0.34 0.28 0.12 0.15 0.54 0.36 0.18

Thailand 0.83 0.57 0.26 0.12 0.10 0.02 0.68 0.31 0.37

Source:Authors' alculations.Note:Predictedvaluesof the indicators re obtained rom a cross-country egression unon a 118-country ample,withper capitaGDP in 1960 and its squareused as independentvariables.Source of the data:AlanHestonandRobertSummers 1988) and RobertBarroand HogerWolf(1989).

C. How Did East Asian Countries

Manage to Intervene withoutInviting Rent Seeking?

One major puzzle noted above had to

do with the apparently successful pursuit

of interventionist microeconomic poli-cies by South Korea and Taiwan. Why

did trade protection, industrial policy,and subsidized credit work in these

countries when it failed most everywhere

else? There has been much debate about

these questions, not the least about the

degree of intervention itself. The extent

to which activist government policies en-abled these miracles of accumulation to

take place is an issue that is not yet set-

tled.14 From our present perspective, wecan ignore purely economic aspects and

narrow down the question to the follow-ing: how were the East Asian govern-

ments able to avoid the rent-seekingactivities that typically accompanied mi-

croeconomic interventions?While we have some clues, the answer

is that we do not really know. There was

clearly something special about the abil-ity of the Taiwanese and South Koreanpolicy makers to discipline their privatesectors and their bureaucracies-an abil-ity to which the label of "strong" or"hard" tate is often attached. But wherethis ability came from, and whether itcan be replicated in other settings, re-mains a mystery.

Authoritarianismmay have had some-thing to do with the East Asian gover-nance style, but there are too many mis-managed dictatorships around the worldto take the hypothesis seriously. Oneneed only look at Sub-Saharan Africa.Krueger is clearly thinking of the East

Asian cases when she writes:

14 For two recent contrasting viewpoints, see

World Bank (1993) and Albert Fishlow and others(1994).

The adoption of the same economic policiesin response to the same (economic) circum-stances will ... have different consequencesunder a politically strong leadership of a gov-ernment with a well functioning bureaucracycapable of carrying out the wishes of theleadership than it will when a weak leader-ship of a coalition attempts to do the samethings in circumstances where bureaucratsbelieve that they can generate support for op-

position to those policies . . . (Krueger 1993,p. 9)




But we do not get much more help thanthis acknowledgement that governmentsand bureaucracies differ.

It is reasonable to suppose that at least

part of the explanation has to do withwith some of the special initial condi-tions that the East Asian countriesshared prior to their economic take-off.Two such conditions stand out. First, bythe late 1950s the East Asian economieshad for the most part a much better edu-cated labor force than would have beenexpected on the basis of their incomelevels (Table 4). This may have made it

easier to establish a competent bureau-cracy (as well as enhancing the product-ivity of interventions aimed at boostingprivate investment, as argued in Rodrik1995a). Second, and perhaps more im-portantly, in all of them the distributionof income and wealth around 1960 was

exceptionally equal by cross-countrystandards (Table 5). Equality may havebeen conducive to better governance forat least three different reasons.

First, these governments did not gen-erally have to contend with powerful in-dustrial or landed interest groups: there-fore, policy making and implementationcould be insulated from pressure-grouppolitics. Second, the absence of large-scale inequities meant that governmentsfelt no immediate need to undertake re-distributive policies; they could concen-trate on expanding the pie instead. Note

that this point is analytically distinctfrom the previous one. Even a govern-ment which is completely insulated fromlobbying groups would wish to redistrib-ute income as long as its objective func-tion looks anything like a conventionalsocial welfare function. This redistribu-

TABLE5DISTRIBUTIONAL NDICATORSFOR EAST ASIAN AND COMPARATOR OUNTRIES,

AROUND1960

Gini Coefficient GiniCoefficient orCountry for Income, c. 1960 LandOwnership, . 1960

EastAsiaHong Kong 0.49 n.a.Indonesia 0.33 n.a.Japan 0.40 0.47Korea 0.34 0.39Malaysia 0.42 0.47Taiwan 0.31 0.46Singapore 0.40 n.a.

Thailand 0.41 0.46UnweightedAverage 0.39 0.45

OthersArgentina 0.44 0.87Brazil 0.53 0.85Egypt 0.42 0.67India 0.42 0.52Kenya 0.64 0.69Mexico 0.53 0.69Philippines 0.45 0.53Turkey 0.56 0.59

UnweightedAverage 0.50 0.68

Source:Rodrik 1994a)




tive motive figures more heavily theworse the pre-tax distribution of re-sources among the population.15 Third,

and related to these, the fact that the

top political leadership was free to focuson economic goals meant that it could

supervise the bureaucracy closely and

make sure that the bureaucrats assistedrather than hindered private entrepre-

neurship. For bureaucracies are prone to

two problems that are fatal to economic

performance: they can be captured by

the interests they are supposed to regu-

late, and they can create excessive red

tape discouraging economic activity. In

Korea and Taiwan, these problems were

avoided because the bureaucracies werevery closely supervised by the top politi-

cal leadership.These points have recently received

some indirect empirical support in a

number of papers which have found a

positive relationship between equalityand subsequent economic growth. See in

particular Alesina and Rodrik (1994),

Persson and Tabellini (1994), GeorgeClarke (1993), and Nancy Birdsall, David

Ross, and Richard Sabot (1994). In these

papers, the initial level of income equal-ity around 1960 is shown to be robustly

and positively correlated with growth

over the next three decades, controllingfor other initial conditions such as percapita income and educational attain-

ment. The theoretical models proposedby Alesina and Rodrik (1994) and Pers-

son and Tabellini (1994) to explain thisphenomenon rely on a political-economy

argument. When distributive policy is

sensitive to the preferences of the me-

dian voter, it can be shown that the equi-librium level of redistribution is increas-

ing in the gap between the median

voter's income and average income.

More equality usually (but not necessar-ily) goes with a lower difference between

median and average incomes. Conse-

quently, and assuming that redistributive

policies act as a tax on accumulation, so-cieties with lower inequality will resort

to less redistribution and grow faster.

The empirical literature to date has

not been successful in testing directly for

the presumed political channel through

which equality affects growth. Therefore

the precise links between equality and

growth remain to be demonstrated(Roberto Perotti 1992b). As the East

Asian cases suggest, it is at least plausi-

ble that governance plays some role in

this relationship. Nonetheless, this too is

an area in need of more research. We

need to understand better why broadly

similar policies can produce quite differ-

ent outcomes in different societies.

D. The Political Economy ofMacroeconomic Cycles

The continued existence of some of

the policies that make up the "importsubstitution" syndrome, despite mount-

ing evidence of their inefficiencies, can

be understood in distributional terms:

such policies redistribute income or

rents to favored groups in society. Their

beneficiaries-business and labor groups

protected from foreign and domestic

competition-are naturally resistant to

their reform. But what is distinctive

about large-scale deficit spending and

overvalued currencies is that these poli-cies are by their very nature temporary,and the longer they are pursued the

more drastic their eventual reversal must

be. Groups that benefit during the up-

swing of the joyride have to suffer losses

during the downswing. Labor, for exam-

ple, normally gains from expansionary

"populist" policies, but also ends up as

the greatest loser when the eventual cri-

sis takes its toll on real wages and em-

ployment. Businessmen benefit from

15The analytics backing up this statement canbe found in Aiherto Alesina and Rodrik(1994) and

Torsten Persson and Guido Tabellini (1994). Theresult is explained later in the text.




TABLE6CONSEQUENCES OF POPULISM IN PERU

Average1980-84 1985 1986 1987 1988 1989

Publicsectordeficit (%of GDP) 7.8 5.8 9.1 12.9 15.6 9.8

Currentaccountdeficit (%of GDP) 3.9 0.3 6.0 7.2 7.4 1.0

Real GDP growth -1.0 2.4 9.5 7.8 -8.8 -10.4

Real consumption rowth -0.4 2.3 13.3 8.3 -11.5 -7.5

Inflation 87.0 158.3 62.9 114.5 1722.3 2775.3

Realwages (1979=100) 95 64 73 79 60 29

Source: Lago (1991, Table 9.4).

cheap imported inputs while the cur-rency overvaluation lasts, but they arecondemned to take a hit when the inevi-table devaluation takes place (or when alarge black-market premium makes itsappearance). Therefore, short of attrib-uting myopia or irrationality to the mainpolitical actors, it is hard to understandwhy such policies find support in the

first place.16A fascinating case in point is the expe-

rience of Peru under President Garcia(1985-90). Facing a stagnant economy,the new Garcia administration launcheda "heterodox program"in August 1985.The main thrust of the program was toboost consumption demand by increas-ing real wages, subsidizing consumption,and creating public-works programs.Thegovernment also instituted a freeze on

prices, interest rates, and the exchangerate. And consumption did boom for acouple of years, raising output alongsideit (Table 6). According to Lago, "[p]riorto 1987, private-sector confidence in andsupport of the government's economicpolicy could only be described as beingunanimous"(1991, p. 281). However, theprocess was clearly unsustainable: the

public-sector and current-account defi-cits both rose substantially and foreignreserves were depleted. By late 1988, theeconomy had collapsed and prices werenear hyperinflation levels. Real wages,which had increased until 1988, took asharp nose dive and in 1989 stood at athird of their 1987 level (Table 6). (Forthe full account, see Lago 1991.)

Peru's case may be extreme, but it isby no means unique. Observers of the

developing world have long been fasci-nated by the prevalence of such boom-and-bust cycles. Ranis and Mahmood(1992) document how governments em-bark on unsustainable spending boomsduring periods when resources are tem-porarily plentiful (due either to improve-ments in the terms of trade or the avail-ability of external finance), and thenresist retrenchment when the inevitabledownturn arrives. What is the explana-tion for these cycles? The answers pro-

16 Political scientists too often ignore this issue,by treating all policies as benefiting some groupsnecessarily at the expense of others. Therefore thepresence or absence of reform is viewed in purelypartisan terms. This view is taken to its logical ex-treme by Bates in his comment on Williamson's(1994) introduction. He explains reform thus:"Economic technocrats become powerful, andthus reform becomes politically sustainable, whenthey serve the interests of powerful groups: in-dustries, sectors, or regions of the economy" (inWilliamson 1994, p. 32). The fact is that reform-particularly in the macroeconomic area-often

benefits the politically influential groups thatblock it.




vided in the case-study literature, as inRanis and Mahmood, tend to be me-chanical. Ranis and Mahmood (1992, p.vi) summarize their conception of politi-

cal economy thus:

we accept the concept that the typical LDCstate is an instrument of the most powerful-if often myopic-interest groups, the new in-dustrialistclass, public or private.

The operative termnhere, for our pur-poses, is "myopic."Ranis and Mahmooddo not offer an explanation for these pol-icy cycles, save for suggesting short-sighted behavior.

At least these authors are- explicitabout their assumption of myopia. Morecommonly the attribution of myopia topolicy makers and interest groups is im-plicit. For example, Krueger (1993, p.19) writes:

Regardless of the form of government-be-nevolent guardian, predatory authoritarian orbureaucratic, or factional-the political pro-cess typically demanded more resources thanwere available from tax revenues in the early

stages of growth.

She then lays out in great detail the cor-rosive and cumulative long-run conse-quences of deficit spending and fixed ex-change rates. But she considers theseconsequences as largely unanticipated bythe relevant groups.

But myopic behavior can take us onlyso far in understanding these policy cy-cles. For one thing, the underlying eco-

nomics is straightforward: t does not re-quire a Ph.D. in economics to realizethat spending money one does not havecan result in unpleasant consequences.17For another, people ought to learn fromtheir mistakes. To take one-not alto-gether extreme-example, since the1950s Turkey has gone throughfour fullboom-and-bust cycles, one per decade.

Because economists hate to give up onrationality (at least until they becomeolder-wiser?-and distinguished), it isnot surprising that a small analytical lit-

erature has developed around this set ofissues. Several recent papers have pro-posed formal models that generate po-litical outcomes that are inefficientfromthe standpoint of the politically powerfulgroups themselves, even though thesegroups behave rationallyand non-myopi-cally. The trick is usually performed bypositing some kind of coordination prob-lem among the contending actors. Someof these models focus on providing anexplanation for the adoption of unsus-tainable policies, while some focus onthe timing of reform (usually fiscal stabi-lization). A few attempt to do both.

In the near-classic of this field, Alesinaand Allan Drazen (1991) show how a sta-bilization can be delayed, at great cost tothe parties involved, thanks to a "warofattrition" between two groups, each ofwhich is uncertain about the costs being

incurred by the other group. It is indi-vidually rational to wait in this model be-cause the group that caves in first is as-sumed to bear a larger part of thepost-stabilization tax burden. Each grouphas the incentive to wait and see if theother group will throw in the towel first.Stabilization takes place only when oneof the groups figures that it stands togain more from assuming the cost of sta-bilization than from waiting another in-

stant to see if its rival will do so instead.In other papers, Alesina and Tabellini(1989), Sule Ozler and Tabellini (1991),and Alex Cukierman, Edwards, and Ta-bellini (1992) have shown how macro-economic problems can arise from politi-cal instability (i.e., expected turnover ingovernments) as well as polarization. Inthese papers, governmental "myopia"arises not from a war of attrition, butfrom the realization by groups in powerthat they may be replaced by future gov-

17 Of course, that does not prevent some people

from trying it anyhow. But we'd like to think ofthis as the exception rather than the rule.




ernments with different ideological orredistributive preferences.

More recent papers by Lab-an andFederico Sturzenegger (1994a and1994b) generate results with the sameflavor, by relying not on asymmetric in-formation or uncertainty but on the dy-namics of the flight from the domesticcurrency once inflation sets in. These pa-pers assume two contending socialgroups-the rich and the poor-whichprefer, at low levels of inflation, not tosubmit themselves to a costly stabiliza-tion. The key dynamic is generated by

the presence of a "financial adaptation"technology (i.e., bank accounts in Mi-ami), which is available only to the rich(at a fixed cost), and which leads to bothincreased inflation and a greater burdenon the poor over time. The main result isthat at some point the poor may there-fore become willing to accept conditionsthey would have earlier rejected.Guillermo Mondino, Sturzenegger, andTommasi (1992) generalize this frame-

work to generate the possibility of recur-ring cycles of inflation and stabilization.In this model, two political groups inter-act strategically and demand transfersfrom the government, with the transferspaid for by the inflation tax. In addition,members of each of these groups haveaccess to financial adaptation, and theybehave atomistically in deciding when toindulge in it. Because 'the demand fortransfers is determined at the grouplevel while the flight from domestic cur-rency is decided at the individual level,socially suboptimal outcomes and cyclesboth become a possibility. Under low in-flation it may be optimal for groups todemand high levels of transfers, whichsets into motion rising levels of inflationthrough the flight from local currency.In turn, at high levels of inflation, it maybe optimal for the groups to agree on a

stabilization.A variantalong the same lines is devel-

oped by Velasco (1994), who considers amodel in which two organized groupstreat the state's resources as a commonpool, and decide every period how muchto extract from the pool. For simplicityand tractability, the choice is limited toone of two options: One option is to ex-tract a "large" share, which leads to abuild-up of government debt and a re-duction over time in the state's netwealth. The other is to extract a "small"share, which leaves net governmentwealth unchanged. Velasco demonstratesthe existence of a switching equilibrium

in which the two groups demand largetransfers until the public debt stockreaches a critical amount, after whichthey both switch to the more moderatestrategy. The latter is a cooperative out-come maintained by trigger strategies,and stands for the stabilization stage.The intuition is that once governmentnet wealth becomes very low (i.e., oncethe state's resources are sufficientlyplundered), the benefits of the defec-

tion strategy become low compared toits costs (which are modeled here as be-ing constant and independent of netwealth).

Finally, Perotti (1992a) builds a modelwith three groups-the poor, the middleclass, and the capitalists-to show howunsustainable policies can emerge as aconsequence of a "populist"alliance be-tween the poor and the capitalists. Threekey features lead to this result. First, it isassumed that capitalists can insulatethemselves from the costs of stabilizationin the long run because capital is mobilein the long run (and only in the longrun). Second, the poor are too poor tobe taxed, so they do not bear any ofthe costs of stabilization. Third, thepoor derive a positive externality fromthe profits made by capitalists at home.Now suppose that the economy is hit

with a negative shock which makes long-run capital flight the dominant strategy




for capitalists. Because domestic capitalwill be abroad in the long run anyhowand the burden of stabilization does notfall on the poor, the latter's well-being

is maximized by expansionist policiesthat increase domestic profits in theshort run. Hence the poor and the capi-talists ally themselves against the middleclass in pursuit of unsustainable policiesthat they know will be reversed eventu-ally.

In these models, political agents orgroups are assumed to be rational andforward-looking, with expectations that

are consistent with the properties of theunderlying model. Behavioral rules arederived from solving optimization prob-lems with well-defined objective func-tions. The political-economic outcome isderived as a Nash equilibrium in whicheach individual or group is doing thebest it can given the actions of others. Ofcourse, none of these models is capableof providing the full political-economicstory of the boom-and-bust cycles dis-

cussed above. But they each capture anaspect of the phenomenon, and perhapsmore importantly, they confirm that wecan do better than resort to myopia orirrationality when explaining social phe-nomena.

There are several directions in whichthis literature could be usefully ex-tended. First, we now need theoreticallyinformed case studies-or more formaltest-that attempt to discriminate among

these alternative stories. Second, thenormative implications of these modelsfor policy and institutional design haveto be worked out. Third, there are sev-eral relevant aspects of reality whichhave yet to receive attention. For exam-ple, in many political organizations (par-ties, unions, etc.) principal-agent prob-lems prevent the leadership frominternalizing in full the interests of therank-and-file. It is plausible that thiswould be one source of inefficiency in

economic policy making.18 Similarly,there is no room in these models for

learning about the way the economy

functions: if it is people that learn rather

than organizations, each generation willrepeat the mistakes of the previous

ones.19 Finally, and most fundamentally,

these papers leave hanging a key ques-

tion: if distributional struggles are at the

heart of inefficient policy choices and

macroeconomic policy cycles, why do

policy makers not design compensation

schemes to neutralize political opposi-

tion? In the Alesina-Drazen (1991)

model, for example, the distribution ofthe costs of stabilization is taken as ex-

ogenous. This is unsatisfactory because

the design of the stabilization package

can surely influence the distributional

impacts. I will return to the issue of

compensation toward the end of the pa-

per.

III. Crisis and Reform During the 1980s

The 1980s experienced two events oflasting significance. First, much of the

developing world became engulfed in a

protracted debt crisis. Second, many

countries began to shed their import-

substitution policies and endorsed mar-

ket-oriented ones. The reforms did not

come immediately after the crisis (Table

7). In fact, the typical pattern was for

governments to respond to crisis by

tightening their restrictions. Even Chile,

which had already opened up during the1970s under General Pinochet, initially

chose to increase its (uniform) importtariff when the crisis hit. But after some

delay, which differed across countries,

countries in Latin America, Africa, and

Asia jumped on the bandwagon of re-

18 John Pencavel has suggested that the policiesof the Mexican petroleum labor union at PEMEXcan be explainei in such a framework.

19The relevance of these considerations was

suggested by Pencavel in his comments on this pa-per.




TABLE7TIMINGOFREFORMSNDINFLATION

Annualized inflation rate

Stabilization Structural Reform prior to stabilization (%)

Boliva 1985 1985 23,455

Mexico 1987-88 1985-1988 159

Argentina 1991 1987-1991 1,344

Peru 1990 1990 12,378

Brazil 1994 1988-1990 2,103

India 1991 1991 16

form. Governments endorsed reformwith varying degrees of enthusisasm. Themost enthusisastic reformers by far werein Latin America, where the Chilean ex-

ample played a major role. (For more on

Latin America, see Edwards 1994.) The

developing countries were followed after1989 by the socialist countries of Eastern

Europe and the former Soviet Union,

which embarked on their own transition

to market economies.

A. Does Crisis "Cause" Reform?

It is natural to suppose that crisis and

reform were somehow related. Indeed, if

there is one single theme that runs

through the length of the political econ-

omy literature it is the idea that crisis is

the instigator of reform. This theme

keeps reappearing in different guises.Ranis and Mahmood write that

resistance [to] vested interests can be over-come only when the systemhasno other wayof avoiding he requiredadjustment.n otherwords, it has to be "up against t," withoutany easy alternative y whichthe day of reck-oningcanbe delayed-either becausea coun-try's own resources or the resourcesmadeavailable rom the outside are considered n-sufficient o keep the systemoperatingalongthe old rails. 1992,p. vi)

"When populist leaders in Argentina, Bo-

livia, Venezuela, Peru, and Brazil

adopted nonpopulist policies," claims

Bresser Pereira, "it was because the cri-

sis in these countries was so deep that

even the costs of sticking to populist

policies became higher than the costs of

adjustment" (1993, p. 57). According to

Krueger, economic reforms were under-

taken when "economic conditions dete-riorated sufficiently so that there

emerged a political imperative for better

economic performance" (1993, p. 109).Moreover, the idea is not limited to

developing countries. "The 'golden rule'of recent Spanish economic history,"writes Guillermo de la Dehesa "is: 'Only

when the level of reserves was suffi-

ciently low and/or the current accountbalance was in large deficit have neces-

sary economic adjustment and structural

reform measures been taken' . . ." (inWilliamson 1994, p. 137; footnote omit-

ted). Explaining why Australia undertookfewer reforms than New Zealand, Max

Corden writes "[t]he reforms have beenless dramatic than New Zealand's be-cause things never got so bad: inflation

did not rise so high, and considerabletrade liberalization had taken place sincethe 1950s" (in Williamson 1994, p. 112).

The idea that governments have to be

up against the wall before they act maybe valid, but it is not entirely free of

problems from an analytical standpoint.First, note that there is a strong element

of tautology in the association of reform




with crisis. Reform naturallybecomes anissue only when current policies are per-ceived to be not working. A crisis is justan extreme instance of policy failure.

That policy reform should follow crisis,then, is no more surprising than smokefollowing fire.20 Furthermore, the hy-pothesis is virtually nonfalsifiable: if aneconomy in crisis has not yet reformed,the frequently proffered explanation isthat the crisis has not yet become "se-vere enough." Bresser Pereira, who wasbriefly Brazilian finance minister in1987, argues that the reason his fiscalpackage was not supported

by Presi-dent Sarney was that the crisis was notyet perceived as serious (in Williamson1994, pp. 333-54). True, perhaps, butnot very helpful for explanation or pre-diction. What we surely need to under-stand is why South Korea's politiciansare ready to change course at the slight-est hint of a crisis, while Brazil's willbring their economy to the brink of hy-perinflation several times before they

tackle the problem. The political-econ-omy literature recognizes this issue, butis largely silent on it.

Some helpful hints come from the ana-lytical literature mentioned previously.Alesina and Drazen (1991) show in their<'warof attrition" model that the lowerthe "degree of cohesion" in society,which they model as the expected asym-metry in the burden of stabilization, thegreater the delay before a stabilization

takes place.2' One can loosely interpretthis in the following terms. In societieswhere resources are evenly distributed,and the government has a good distri-butional track record, groups are less in-

clined to believe that the burden of ad-justment will be one-sided. This placesthe East Asian countries in an advanta-geous situation, once again, where crises

are concerned.In addition, the emphasis on crisis has

in itself little predictive content as towhat form the response will take. LatinAmerican countries eventually adjustednot only by balancing their fiscal ac-counts, but also by overhauling theirtrade and industrial policies and under-taking privatizationon a major scale. As Ihave discussed above, these trade and in-dustrial

policieshad little to do with in-

stigating the crisis, and consequentlytheir reform was not a logical necessityonce decisive action was taken. In fact,some of the reforms in the area of tradeliberalization almost surely complicatedthe macroeconomic stabilization effort.22Therefore, the comprehensiveness of thereforms that the Latin American coun-tries undertook still requires explanation.

Part of the explanation has to do with

the advice that these governments re-ceived. As mentioned previously, manyprofessional economists themselvestended to lump together all "importsub-stitution" policies and to hold themequally responsible for the crisis. Thatwas certainly the approach taken by theWorld Bank, the most important conduitof economic ideas to developing-countrypolicy makers.

But how could these wide ranging

20 Williamson and Haggard (in Williamson1994, p. 564) mention several cases where reformwas undertaken despite the absence of crisis (no-tably Australia, Colombia, and Portugal).

21 This is also possibly what Krueger has inmind when she argues that a "strong"government

such as Korea's will react quickly to crisis, while a"factional"one will delay (Krueger 1993, p. 126).

22That is so for several reasons. The reductionof tariffs resulted in losses in fiscal revenue. Fur-thermore, trade liberalization aggravated the ad-verse effect of stabilization policies on aggregatedemand and domestic output. Last but not least, itcreated an important conflict in exchange-ratemanagement: trade liberalizationrequired a "com-pensating" devaluation of the currency, whichoften could not be undertaken for fear of upset-ting fragile price expectations. The recent Mexi-can debacle could possibly have been avoided, orat least its impact minimized, if the authorities had

not removed controls on trade and capital flows soenthusiastically.



28 Journal of Economic Literature, Vol. XXXIV(March 1996)

trade and industrial policy reforms berendered palatable to the interest groupsthat had been their beneficiary for solong? How were they persuaded to go

along? Here again it is plausible that theatmosphere of crisis played a role. Crisisenabled reformist governments to pack-age fiscal reforms, which were absolutelycrucial for the return of price stability,with trade and industrial policy reforms,which were viewed as desirable in thelonger run but were incidental to the im-mediate crisis. In other words, policymakers acted as agenda setters: Theypresented domestic interests with a

package of both macroeconomic and mi-croeconomic reforms. Because high in-flation and macroeconomic instabilityhurt pretty much everyone across theboard, influential interest groups feltcompelled to go along. They may havepreferred to have only the macro-economic component of the package, butthat was not the choice that they con-fronted.

The argument can be illustrated by us-ing a simple heuristic concept that wemay call the "political cost-benefit ratio"(PCBR, Rodrik 1994b). Assume that re-distributing income is politically costly,and that this cost has to be traded offagainst the efficiency benefits of reform.Define the PCBR as the ratio of the totalredistribution generated by reform to itsefficiency benefits. This index answersthe question: how many pesos are re-

shuffled among different groups forevery peso of efficiency benefit? ThePCBR takes values between zero and in-finity. The higher the value of the index,the more difficult reform is likely toprove.

Price reforms (such as trade liberaliza-tion and removal of subsidies) tend togenerate a lot of redistribution relativeto their efficiency benefits. Consider theremoval of an import tariff, t. To a first-

order of approximation,the PCBR asso-

ciated with this reform can be expressedas 1/get, where j is the share of affectedimports in domestic consumption and E

is the absolute value of the import de-

mand elasticity. With reasonable valuesof t = 0.5, j = 0.2, and E = 2, the formulayields a value of five for the PCBR.23That is, five pesos of income have to bereshuffled among groups in society toyield a single peso of efficiency gain!This is one way of capturing the politicaldifficulty of achieving microeconomic re-form in normal times.

Now suppose that the economy getscaught up in a deep macroeconomic cri-

sis, recovery from which would provideall-around gains. The idea here is thattriple-digit inflation and the associatedinstability hurt pretty much all groups insociety, although some may naturallyprotect themselves better than others.Suppose further that a reformist govern-ment packages the stabilization programneeded to end the crisis with the pricereform discussed above. Let y stand forthe percentage increase in income thataccrues to all groups in society as a resultof the stabilization. We can think of y asan index of the depth of the macro-economic crisis. Under reasonable as-sumptions on the value of y (e.g., y =

0.10) the PCBR plummets to well belowunity (from five previously). The point isthat the opportunity to do somethingthat will benefit most everyone by a largemargin-an opportunity that arises only

when the economy is mismanaged terri-bly and falls into deep crisis-allows re-formist policy makers to sneak in, along-

23 There are three groups that matter in this ex-ample, consumers of the importable, producers ofthe importable and the rest of the economy as af-fectedTby the government budget. Let the worldprice of the importable be p*, the domestic pricep, and the quantities of consumption, production,and imports c, q, and m, respectively. Consumersgain -cdp, producers gain qdp, and the govern-ment budget changes by mdp + tp *dm. The effi-

ciency gain is tp*dm. See Rodrik(1994b).




side the stabilization, microeconomic,and structural reforms which have sig-nificant distributional implications andwhich would be difficult to implement

under normal circumstances.B. Does Reform Have Short-Term

Costs?

The proposition that some of the ma-jor structural reforms of the 1980s and1990s were adopted despite interestgroups, rather than because of them,naturally raises the question of the sus-tainability of the reforms. Here we facetwo other conventional wisdoms of the

political-economy literature: First, re-forms become sustainable when theygenerate "winners"with a stake in theircontinuation. Second, and this one is thedowner, reforms tend to make thingsworse before they make them better.

For a proposition that is startlinglylacking in empirical support, the secondpiece of conventional wisdom is surpris-ingly strongly held. It permeates practi-cally every discussion of the politicaleconomy of reform. "The results of manyworthwhile reforms lie on a J-curve,"writes Piniera,"they tend to make thingsa good deal worse before they get bet-ter" (1994, p. 227). Bresser Pereira, Ma-ravall, and Przeworski (1993, p. 2) statecategorically:"the effect of economic re-form on growth must be negative in theshort run." "A key political problem ofsustaining support for reform programs,"

argues Joan Nelson "is the long delay inreaping visible benefits for much of thepopulation." She continues: "Quite sim-ply, in most cases there are not enoughearly winners to ensure the political sus-tainability of the program . . ." (in Wil-liamson 1994, p. 476-77).

The facts do not support such pessi-mism about long-delayed response. Onceone makes allowance for the likelihoodthat the counterfactual-no reform-

produces even worse results in the short

run, the consequences of reform actuallylook pretty good. This shows up in anumber of different areas. With regardto disinflation, most of the recent cases

of exchange-rate based stabilizations,such as those in Israel (1985), Mexico(1987), and Argentina (1991), have beenaccompanied by consumption booms,rather than recessions.24 With regard tobroader structural adjustment policies,the best statistical evidence to date isthat such policies tend to significantly in-crease, rather than decrease, growth ofoutput within two or three years, even ifnot immediately (Corbo and Patricio Ro-

jas 1992).25 Even in Eastern Europe,where there is genuine reason to believethat the transition may have short-term

costs, the evidence indicates that reform

reduces rather then intensifies the short-

term costs. Output has fallen the least in

countries like Poland and the Czech Re-

public which have had the most exten-

sive reforms, and the most in countrieslike the Ukraine which have had theleast (Table 8). Furthermore, consump-

tion statistics indicate that much of themeasured contraction of GDP in transi-tional economies is illusory. (For the

Polish case, see Andrew Berg 1993.)

Of course, structural reforms (and pos-

sibly stabilization as well) may have

sharp distributional consequences, as

discussed previously. But this is not a

matter of the short run versus the longrun, as with the worries reflected in the

quotes above. Saying that reform is diffi-

24 See for example Guillermo Calvo and CarlosVegh (1994). Dornbusch and Fischer (1993) arguethat it may be unavoidable to incur output costswhen disinflating from moderate inflation (40-80percent per year, but their evidence on this is notso clear cut.

25Corbo and Rojas use a control-group ap-proach and focus on the 1985-88 performance ofcountries that received at least two Structural Ad-justment Loans (SAL) from the World Bank start-ing in 1985 or before. They find that adjustmentraised GDP growth rates by an average of two per-

centage points.




TABLE8REFORM IN ECONOMIES IN TRANSITION

Averageannualreal GDP

changeduring irst hree Annual nflation,yearsof transition %)* 1994(%)

Countrieswith StrongReformProgramsPoland -5.5 30Czech Republic** -8.2 9Hungary -6.2 19Estonia -10.1 47

CountrieswithWeakReformProgramsRussia -14.7 336Ukraine -14.4 1000Moldova -17.8 245

Source: Calculated rom IMF (Oct. 1994, Table11).* The firstyear of the reformprogram s taken to be 1990 for Poland and

Hungary, nd 1991forothers.**The figures or Czechoslovakia re used for 1991 and 1992.

cult because some powerful groups willbe inevitably made worse off-in thelong run as well as the short run-is dis-tinct from claiming that reform is diffi-cult because the net benefits from thereform come too late for politicians toreap the gains. It is the latter that seemsempirically problematic.

None of this is to dismiss the obviousfact that reforms do arouse opposition,and that the opposition often tends to bestrongest early on. The point is that wecannot really attribute these phenomenato presumed (rather than demonstrated)short-term costs of reform. Once irra-

tionality and myopia are dismissed, thepolitical economy of reform turns outonce again to contain more puzzles wait-ing to be worked out.

C. Does Foreign Aid Help Reform?

If reform has short-term costs, as somany believe, then foreign aid shouldhelp reforms get launched (and sus-tained) by alleviating these costs. Thisindeed is the standard justification for

the World Bank's and the IMF's "struc-

tural adjustment" lending as well as forofficial bilateral credits. But the logic ofthis statement is not unassailable, even ifthe premise is accepted. The reason isthat external resources reduce the costsboth of reform and of doing nothing-that is, avoiding reform. In addition,the prospect of aid can actually exacer-bate the delay in stabilization, by induc-ing groups to postpone making sacrificesuntil aid actually materializes.26The ef-fect on reform is consequently ambigu-ous.

One of the strongest proponents offoreign aid has been Jeffrey Sachs, who

has served as a high-profile advisor to re-formist governments in Bolivia, Poland,and Russia among other places. In hiscontribution to Williamson (1994) enti-tled "Life in the Economic EmergencyRoom," he complains that economiststend to neglect the role played by for-eign assistance in most of the major post-war reforms. He provides capsule histo-

26 This argument is worked out in AlessandraCasella and Barry Eichengreen (1994), using the

Alesina-Drazen model.




ries of the economic reforms in postwarGermany, Japan, Bolivia, Mexico, Chile,Poland, Israel, and Turkey, stressing thecritical contribution of aid in each case.Sachs is explicit that a government com-mitted to reform is needed before aidcan do any good. But once such a gov-ernment is in place, the internationalcommunity should be forthcoming. Whataid can do, even if it is small in relationto the country's problems "is help goodgovernments to survive long enough tosolve problems" (in Williamson 1994, p.512).

The problem is that aid can also help

bad governments survive. For debatingpurposes, one can cite at least as manycases as Sachs does to demonstrate anassociation between plentiful aid and de-layed reform.27As mentioned previously,one of the themes of the book by Ranisand Mahmood (1992) is that the avail-ability of external resources tends to pro-mote irresponsible policies. Scarcity ofresources, on the other hand, is good forreform. (Note the obvious parallel to the

crisis hypothesis.) One of the pieces ofconventional wisdom about the Koreanand Taiwanese reforms of the 1960s isthat these reforms took place in largemeasure because U.S. aid, which hadbeen plentiful during the 1950s, wascoming to an end (see for example Ranisand Mahmood 1992, p. 139).

Sachs would respond that donors mustensure the recipient governments willundertake the reforms before doling outthe cash. More generally, aid must comewith a heavy dose of conditionality. Thisis well recognized, and both the IMFand the World Bank make access to theirresources conditional on good behavior

on the part of the borrowing govern-ments. But conditionality is no panacea,as conditionality can last (at best) only aslong as net transfers are positive. In theend, sovereign governments are just that:sovereign. There is a fairly large litera-ture on conditionality and its effective-ness (see Manuel Guitian 1982; PaulMosley 1987; Jacques Polak 1991; and V.Thomas et al. 1991). Some emergingconclusions are that conditionality ismost effective when it focuses on a smallrange of quantifiable indicators andwhen governments are already commit-ted to the reforms. However, it may not

be easy to tell governments apart, andeven governments that are genuinely re-formist may be tempted by aid to deliverless than they promised.

IV. In Search of a Manualfor ReformistPoliticians

All of which raise the question, "what'sa poor reformist politican to do?" Re-cently Williamson had the interesting

idea of gathering a group of high-rankingtechnocrats ("technopols" in William-son's jargon) to talk about their experi-ences, in the hope that some commonlessons may emerge. The resulting book(Williamson 1994) opens with a list ofhypotheses drawn from the literatureabout what makes reform feasible andsuccessful, and which contributors wereasked to examine from their own individ-ual perspective. I have reproduced thelist in Table 9. The list includes someitems that I have already discussed, aswell as manyothers.

In the end, however, Williamson isforced to concede defeat. In his conclud-ing chapter (written with Haggard), hewrites "there are no fully robust empiri-cal generalizations; in every case there isat least one partial counterexample.None of the 15 hypotheses investigated

was either necessary or sufficient for

27 Some of Sachs' case histories can also bechallenged. It is true that aid played an importantrole in the Turkish reforms of the early 1980s, butit is also true that it delayed the fiscal day of reck-oning, with ultimately debilitating consequences

for the Turkisheconomy.




TABLE9HYPOTHESESBOUTEFORM

1. Policyreforms mergein response o crisis

2. Strongexternal upport aid) s an important ondition or successfulreform

3. Authoritarianegimesare best at carrying utreform

4. Policyreform s a right-wing-program

5. Reformers njoya "honeymoon eriod"of supportbefore oppositionbuildsup

6. Reformsare difficult o sustainunless the governmenthasa solid baseof legislative upport

7. A governmentmaycompensate orthe lackof a strongbase of supportf the oppositions weak andfragmented

8. Socialconsensus s a powerful actor mpellingreform

9. Visionaryeaderships important

10. A coherentand unitedeconomic eamis important

11. Successful eformrequireseconomistsnpositionsof political esponsibility

12. Successful eformrequresa comprehensive rogram apableof rapid mplementation13. Reformers houldmask heir ntentions o the generalpublic

14. Reformers houldmakegooduse of the media

15. Reformbecomes easier f the losersarecompensated

16. Sustainabilityan be enhancedby acceleratinghe emergenceof winners

Source:Williamson 1994)

successful reform" (p. 589).28 The propo-

sitions that received strong support were

"the need for a strong political base, forvisionary leadership, and for a coherent

economic team." Disproved were thehypotheses that reform requires author-

itarian regimes or that it is an exclu-

sively right wing enterprise. But the

volume itself is far from a failure. The

exchanges among former politicians,

technocrats, economists, and political

scientists that it contains make for fasci-

nating reading.

A fundamental fault line that dividesthe contributors to this literature is

the issue of how participatory reformpolitics ought to be. Most economists

are on the side of speed, stealth, and

consequently of reform from above.

Vladimir Mau, a Russian economist,

writes:

Count Sergei Witte, a prominent reformerunder the czars, used to say that there weretwo essential elements for radical reforms in

Russia: absolute monarchy, because you neednot pay attention to your critics if His Maj-esty supported you, and speed, becausesomebody might persuade the czar to changehis mind before the reform could be madeirreversible. (pp. 435-36)

Sachs cites approvingly the example of

Jacques Necker (the French finance

minister before the 1789 revolution) who

maintained that flexibility or willingnesss tocompromise, which might be harmless or

even advantageousin other ministers, was anunforgivable failing in a finance minister!

Sachs goes on:

If reformers want free prices, they should notstand around and talk about it-they shoulddo it, because everyone will be against free-ing prices until it has been done, until it is anestablished fact. (pp. 509-10)

Sachs has plenty of first-hand experi-ence in Bolivia, Poland, Russia, and else-

where, so his views perhaps ought to

28As indicated in Table 9, there were actually16 hypotheses, so the number 15 must be a mis-

print.



Rodrik: Understanding Economic Polict Reform 33

count for a lot more than those ofarmchair economists. He is especiallyoutspoken on the question of whetherreformers should strive for a consensus

with affected groups.29 "Many partici-pants have suggested that reformers suc-ceed by constructing a 'social consensus'in favor of reforms," he writes. "This ismostly not the case. In deep crises, thereis simply no consensus to build upon,only confusion, anxiety, and a cacophonyof conflicting opinions." He goes on torelate how the Polish "big bang" wasenormously controversial at the time,and the desire to "returnto Europe" did

not translate into agreement on specificpolicies. "Consensus on many specifics(e.g., currency convertibility, price de-control, budgetary discipline) has cometo Poland, but only after three years ofreform" (p. 505). In Sachs' view, it is atbest a waste of time to seek a broad co-alition for reform because most peoplehave no understanding of what is re-quired: "While the history of market-based reforms has repeatedly shown that

free markets, open trade, and an econ-omy fueled by private ownership areenormously powerful in stimulatingrapid economic growth, the generalpublic rarely knows it or believes it atthe start" (p. 506). Neither is the prob-lem limited to the person on the street:"Few Russians understand the sourceof Russia's current inflation, least of allthe [former] governor of the central

bank . . ." (p. 507). The operational im-plication of all this is that reform needs astrong and autonomous executive, unhin-dered by the search for consensus andcompromise.30

Sachs' words have the advantage ofexpressing forthrightly what a lot ofeconomists feel deep down but findpolitically incorrect to articulate. What

some may find striking in these state-ments is the lack of faith in the com-mon sense of ordinary people and in theefficacy of political institutions, espe-cially in new democracies. That econo-mists should hold to these views is notwithout irony. After all, homo econ-omicus is supposed to be rational andforward-looking, and to process all theinformation that comes his way in themost efficient way. Sachs' homo politi-

cus is none of these things, or else isbeing held hostage to some grand co-ordination failure whose nature is un-clear.3l

This irony is seized upon by Przewor-ski, who provides a serious challenge tothe economists' preference for reformfrom above (in Bresser Pereira, Ma-ravall, and Przeworski 1993). Focusingon the Polish case, he faults the stormtactics favored by Sachs and others for

both weakening democratic political in-stitutions and making errors in economicpolicy more likely. He and his two co-authors (Bresser Pereira and Maravall)summarize their argument in their con-cluding chapter thus:

we find that subjecting the reform strategyto the competitive interplay of political forcesis superior on three essential grounds: It

29 Of course, there are very few things thatSachs is not outspoken about. His sharp critique ofIMF policy in Russia in his after-dinner speech atthe Williamson conference drew a defensive re-sponse from the IMF (printed in the Williamsonvolume), and (naturally)a rejoinder from Sachs.

30 In a personal communication, Sachs has clari-

fied that -his views should not be taken to imply

that he favors authoritarian forms of governmentover democracy. He believes, however, that demo-cratically elected governments should have a fairlyfree hand in between elections.

31 One reader objected to this paragraph n thefollowing terms: "Thenotion that the conventionaleconomist may be a better judge of economic pol-icy than the man on the street contains no more'irony' than the notion that a physician may knowbetter how to diagnose and cure my illness." Mostof us, however, akeourphysician's dvice.Wereeconomists' dviceas well receivedby politicians,the puzzleson which thispaperfocuseswouldbe

far esssalient.




improves policy, it builds support for thecontinuation of reforms, and it helps con-solidate democratic institutions. We do notsee a trade-off between public discussionand the soundness of economic plans. (p.210)

These points are underscored in Prze-worski's interesting discussion of the Pol-ish program. The program began withthe famous "big bang" of January 1st,1990. Leszek Balcerowicz, a contributorto the Williamson volume (and fromwhom more later), was its principal ar-chitect and Sachs its principal foreign

advisor. Przeworski grants that the near-hyperinflation in which the Polish econ-omy found itself by the Fall of 1989 re-quired some fast action. But he faults theprogram for having had no social dimen-sion: "I could find no references tobuilding a welfare state or extending so-cial protection in any formulation of thereform program,"he declares; "this wasa pure trickle-down model of reforms"(p. 142). This may be bad enough for

some, but the real clincher in Przewor-ski's argument is that the absence of so-cial policy ended up threatening the sus-tainability of the economic reforms. Todemonstrate this, he analyzes at lengththe trend in public support for the Bal-cerowicz program. He finds that untilMay 1990 public support was high andsteady, after which a significant declinein support occurred. Thereafter it re-mained steady again, until early 1991

when "the diagnosis of the current situ-ation, optimism, willingness to bear sac-rifices, and support for the Balcerowiczprogram all began to decline again"(pp. 158-59). Eventually, of course, sup-port would fall so low that the formerCommunists would return to power inthe September 1993 parliamentaryelec-tions.

Przeworski attributes this slide in sup-port primarily to the rise in unemploy-ment, which he argues convincingly was

a terrifying prospect for most Poles.32The main shortcoming of the Bal-cerowicz plan, therefore, was its failureto put in place adequate social protec-tion to guard against the inevitable un-employment that would result.33 Prze-worski argues that this was a "technical"mistake, but one that resulted from nothaving listened to the people:

If the purposeof theirarchitectswas to makereforms politically palatable, the blueprintwas not well designed.But the reason tech-nocratscommit technical' rrors s thattheydo not consult and concertwith those whoare affected by their blueprints.There is

somethingparadoxicalwhen believers n theinformational fficiency of decentralizedde-cisionsfearthem most. . . The mainobstacleto reforms people. (p. 185)

32 That the decline in popularity was related torising unemployment is plausible enough, but thestatistical analysis that Przeworski undertakes toestablish this relationship is unconvincing. Theanalysis consists of pairwise correlations betweenpoll results and actual economic outcomes. Theresults of the exercise are unreliable for severalreasons: there are few observations (a maximumof20), there is obvious scope for omitted-variablebias, and a lot of the variables have strong timetrends leading to spurious correlations.The strongnegative correlation Przeworski obtains betweenthe program's popularity and unemployment is astatistical reflection of the fact that the first ofthese consistently went down, and the second up,afterJanuary1990.

A more telling piece of evidence comes fromthe experience of the Czech Republic (not dis-cussed by Przeworski). Alone among reformistgovernments, Vaclav Klaus' government has re-tained much of its popularity. Not coincidentally,the Czech Republic is also the only strongly re-

forming economy that has not (yet) experiencedhigh unemployment. An alternative argument forthe decline in the popularity of reforms is pro-vided in Rodrik (forthcoming), based on changesin the preferences of state-sector workers over thecourse of the transition.

33 This point would be disputed by Balcerowiczand Sachs. According to Sachs (1994, p. 3): "Con-traryto the impression of uncompromisinglaissezfaire and harsh social policies, Poland's socialspending has risen very sharply since the begin-ning of reforms. Total budgetary spending on so-cial programs (labor fund, pension fund, healthcare) has risen from 10 percent of GNP in 1990 to

21 percent of GNP in 1993, one of the highestproportions in Europe."




Moreover, Przeworski and his col-leagues believe that the top-down styleof these reforms tend to corrode nascentdemocratic institutions:

the autocraticpolicy style characteristicofWashington-styleeforms endsto underminerepresentative institutions, to personalizepolitics, and to generate a climate in whichpoliticsbecomes reduced o fixes, to a searchfor redemption.Even if neo-liberal reformpackages make good economics, they arelikely o generatevoodoopolitics. (pp.9-10)

Przeworski undertakes an interestinganalysisof the trend in public confidence

in various Polish institutions. He docu-ments how confidence in representativeinstitutions like political parties, the gov-ernment, and the Sejm gradually erodedwhile confidence in the armyand the po-lice increased, to the point where "twoyears after the transition to democracy,Poland was a country in which the threeinstitutions in which people had themost confidence were the army, thechurch, and the police" (p. 173). He at-

tributes this to the "policy style" of thereforms-the introduction and continu-ation of a set of policies "by surprise andindependently of public opinion and ofrepresentative organizations and institu-tions"34 p. 175). To paraphrase Przewor-ski only slightly, economic reform is con-sequently too important to leave toeconomists.

The alternative to which Przeworskiand his colleagues would subscribe is not

entirely clear. In terms of actual policycontent, their "social democratic" ap-proach departs only mildly from theWashington consensus, in envisioning asomewhat more active role for the gov-ernment in industrial policy and in co-ordinating private investment.35 The rest

of the program, including the emphasison a "socialsafety net" (to use the Wash-ington term), would not look out of placein a World Bank document. Przeworski

mentions the Hungarian case approv-ingly, and implies that the more gradualapproach adopted there was prefer-able because it paid greater attentionto social issues. Yet, Hungarian unem-ployment has risen nearly as high as thePolish one, and by 1994 most economistswould agree that the Polish economy hadturned the corner while Hungary wasstill struggling. The cumulative outputfall in Hungary has been larger, and

the recovery smaller, than in Poland(see John Flemming 1995, Table 4). Inany case, in 1994 former Communistswere elected to power in Hungary aswell.

Perhaps an alternative model wouldhave been the "social pacts" approach,used most conspicuously by post-Francogovernments in Spain. This experience isdescribed in Maravall's contribution tothe same volume (as well as by de laDehesa in the Wiliamson volume).The Moncloa pacts in Spain were an ef-fective device through which labor re-ceived expanded rights in return forwage moderation. But as Maravallmakesclear, this experience is probably oflittle relevance to Eastern Europeancountries, because there was still sub-stantial room for expanded governmentin Southern Europe. Regarding the ex-

perience of Spain, Portugal, and Greecehe writes:

Bothpublicexpenditure s a whole and socialexpenditure in particular increased verysharply rom the mid 1970s under the newdemocratic regimes. Welfare systems andmechanismsor incomedistributionwere ex-tended andreorganized.The role of the state

34"The televised spectacle of the governmentramming through the parliament a package ofcomplicated legislation ... took its toll" (p. 176).

35To which Sachs would retort: "Governments

that have reached hyperinflation cannot self-

evidently, be expected to develop complex indus-trial policies or structural policies. After all, theyaren't even carrying out their most fundamental

task" (in Williamson 1994, p. 510).




in the provision of health, education, andpensions was reinforced. Revenues from taxa-tion increased, and fiscal systems were mademore redistributive. (Bresser Pereira, Ma-ravall, and Przeworski 1993, p. 101)

As he later puts it, "public expenditurescould generally grow in spite of crisis"(Bresser Pereira, Maravall,and Przewor-ski 1993, p. 105).

Leszek Balcerowicz, the former dep-uty prime minister after whom the Polishreform program was named, agrees withPrzeworski's facts, but not with the con-clusions. There was no choice but tomove quickly on both the macro-

economic and structural fronts, and pub-lic debate and deliberation would havewasted valuable time: "[T]he estab-lishment of a social pact [as in Spain] inPoland in 1989 would simply have takentoo much time during a crucial period."Besides,

[w]hat would be the purpose of such a pacttoday? It could not afford to give compensa-tion, because that would conflict with thefiscal program; the real compensation had

consisted of the rapid elimination of short-ages, which has been increasingly appreciatedas time has passed. (in Williamson 1994, p.218)

Moreover, it would have allowed the op-ponents of the programto dilute it. LikeSachs, Balcerowicz has little confidencein the political process in the short term,and complains that two election cam-paigns in the first two years of the

program-presidential in 1990 andparliamentary in 1991-made his jobextremely difficult. He sees the first fewmonths of a honeymoon period in early1990 as having provided an opportunityto ram through as many reforms asquickly as possible. "[T]he period ofIextraordinary politics' was short-livedand . . one should use it to introduce

tough economic measures." Further:

[i]t was easier for the supporters of the mar-

ket-oriented reforms to defend them as fait

accompli than it would have been to build re-forms graduallyin the face of strong populistopposition in Parliament after the electionsof October 1991. (pp. 172-73)

One useful distinction in this debate,not often made, is between the initiationand consolidation of reform. Haggard ar-gues that the initiation of reform re-quires independence or autonomy forthe executive, while consolidation of re-form necessitates "buildingof legislativeand interest-group bases of support" (inWilliamson 1994, p. 468). This argumentis echoed by Joan Nelson, who says thatit may be inevitable to be somewhat

autocratic in the early stages of reform,but that in later stages one needs togenerate support and consensus (pp.472ff.).36 But what if the autocratic ap-proach early on does irreparable damageto confidence in democratic institutions,as Przeworski claims it does?

It is difficult not to feel sympathy forPrzeworski's yearning for a more demo-cratic style of reform. Yet my suspicion isthat most observers of the Polish reformswould agree with Balcerowicz and Sachsthat speed (and stealth) was of the es-sence. While there have been some re-versals in the reforms, even with thesereversals the Polish economy is in farbetter shape today than it would have

36 Perhaps Mexico (prior to its most recent cri-sis) is a good example of the Haggard-Nelsonstrategy. Jose Cordoba relates in detail the dra-matic changes in Mexican economic policy follow-

ing the 1982 crisis. An astounding turnaround inthe fiscal stance (of 10 percentage points of GDP!)was accomplished within two years, and in a fairlyunilateral manner. But the government's sub-sequent approach was more participatory (or atleast, corporatist): "The Economic Solidarity Pact[of 1987] clearly established that inflation couldnot be reduced through governmentpolicies alonebut required a social dialogue and active supportby labor, business, and peasant organizations.Thatlesson profoundly impressed policymakers, andfrom then on much greater effort was made tobuild consensus and promote the direct involve-ment of those sectors in society that would be af-fected positively or negatively by the reforms"(inWilliamson 1994, p. 254).




been under a more gradual path. Bal-cerowicz is absolutely right that his re-forms have created a new, largely irre-versible reality that his successors dare

not touch-a matter of importance whenthese successors are former Commu-nists.

This fascinating debate takes us backto the most fundamental issue in the po-litical economy of policy reform, the onewith which this essay opened: If the ob-jective of reform is to make people bet-ter off, why does reform have to beshielded from the people? "[T]he sadfact that good things-such as democ-

racy and market-oriented economic pol-icy-do not always go together," as Hag-gard puts it (in Williamson 1994, p. 467),suggests that there is a real puzzle here.Furthermore, if the problem with reformis that powerful groups are hurt by it,why can't policy makers come up withcompensation schemes that remove thehurdle? Myopia, to which many ob-servers ultimately resort, appears to meto be as unsatisfactory an explanationhere as in any area of conventional eco-nomics.

As I pointed out above, the analyticalliterature has begun to address thesepuzzles. I close this section by discussingbriefly two papers which are especiallygermane to the questions at hand. Thefirst one (Raquel Fernandez and Rodrik1991) provides an answer to why reformsthat will benefit most everyone may still

be rejected by a majorityof the elector-ate, and why compensation may not re-move distributional obstacles. The sec-ond (Mathias Dewatripont and GerardRoland 1992) discusses optimal reformdesign under dynamic political con-straints, restricting feasible policies tothose that for example will be approvedby unanimity.

In Fernandez and Rodrik (1991) weask whether a rational electorate would

ever reject a reform which is known to

benefit a majority of the voters. We showthat the answer is "yes." We also showthat political systems in general have abias towardthe status quo even when the

status quo is inefficient and individualsare risk neutral. The key to the argumentis uncertainty of a particular kind: theidentity of many of the gainers (as wellas losers) from reform cannot be deter-mined ex ante.

To see how the argument works, con-sider a democracy where a majority voteis needed before reform can be adopted.Let the economy have 100 voters andsuppose that the reform in question will

increase the incomes of 51 individuals byfive zlotys each and decrease the in-comes of the rest by one zloty each, leav-ing a net gain of (5 x 51) - (1 x 49) = 206zlotys. In the absence of uncertainty,the majority of the population wouldvote in favor and the reform would beadopted. Assume that all these conse-quences of reform are common knowl-edge. Now suppose that while 49 indi-viduals know for sure that they will gain,the remaining 51 are in the dark as towhich among them will gain and whichwill lose. However, because aggregateconsequences are common knowledge,individuals in the latter group know thattwo of them will eventually benefit while49 will lose out. (Such uncertainty mayarise, say, from incomplete informationat the individual level about the skillsneeded to suceed in the post-reform en-

vironment.) This renders individuals inthe second group identical ex ante, withan expected benefit from reform of [(5 x2) - (1 x 49)]/51 = - 0.76 zloty each.Hence the individuals in the uncertaingroup will reject reform, blocking itsadoption.

The bottom line is that uncertaintyabout the consequences of reform at thelevel of the individual can prevent re-form, even when it is recognized that re-

form will make a politically effective ma-




jority better off.37 Moreover, the samekind of argument explains why compen-sation, or the promise thereof, is not al-ways an effective device to remove the

distributional obstacle to reform. In theabove example, ex ante losers know thatif reform is passed, there will be an expost majority in support of its continu-ation-even in the absence of compensa-tion. Therefore, a promise to compen-sate losers ex post is not going to becredible. This kind of reasoning may ex-plain why many reforms that would havebeen popular ex post are passed up exante. It may also explain why reforms

that are instituted by an authoritarianre-gime against prevailing political senti-ment survive the return of democracy(e.g., Pinochet's reforms in Chile).

Inspired more directly by the EasternEuropean context, Dewatripont and Ro-land (1992) analyze the case of anagenda-setting government faced withthe task of shrinking the size of the statesector subject to political constraints.

Some of their analysis focuses on thecase where a reform must be approvedby unanimity to be passed. Efficiencycalls for immediate shrinkageof the statesector (i.e., shock therapy), as product-ivity is much lower than in the privatesector. But unanimity requires that state-sector workers who are forced to exit becompensated. Suppose that state-sectorworkers are heterogeneous in terms oftheir earning power in the private sector

(to which they will be displaced) andthat this information is private. Thebudgetary cost of shock therapy will belarge, as all exiting workers will have tobe paid a common exit fee that is basedon the income loss that would have beenincurred by the least-capable worker. If,in turn, raising fiscal revenue is distor-tionary, shock therapy maybe dominated

by partialreform, which generates less ofa budgetaryburden.

Dewatripont and Roland show that adynamic version of this set-up produces

an argument for gradualism.A partial re-form early on would induce only thehighest-ability group to leave; next pe-riod it becomes optimal to induce thenext-highest group to leave; and so on, atmuch lower cost to the budget ulti-mately. The government's assumed con-trol over the agenda of policies underconsideration allows it to dynamicallyre-lax the political constraints. A somewhatsimilar story, but using the Fernandez-

Rodrik (1991) model and based on theChinese example, is provided by Shang-Jin Wei (1992), who shows how a se-quence of reforms in different policy are-nas may be politically sustainable wherean economy-wide "big bang"would fail.

V. Concluding Comments

A political scientist or historian maywell find much of the

economics litera-ture on the political economy of reformnaive or simplistic. However, what is en-couraging about this literature is thateconomists are now doing their political-economy analysis explicitly, rather thanimplicitly as used to be the case. Mosteconomists have now come to the real-ization that good economic advice re-quires an understanding of the politicaleconomy of the situation. The result has

been a remarkable degree of collabora-tion between economists and politicalscientists, as well as more work on politi-cal economy by younger economists.Both of these are good news. The badnews is that the habit of attributing myo-pia or irrationality to political actors-whether explicitly or, more often, implic-itly-persists.

As this essay attests, there is by now awealth of case-study material on the ex-

periences with policy reform. This mate-

37The situation is worse when individuals arerisk averse. But the argument does not rely on riskaversion.




rial provides plenty to chew on for any-one interested in the interactions be-tween economics and politics. The nextstep should be to integrate evidence

from these case studies more systemati-cally into the analytical work, and in turnto use the analytical models as a spring-board for more rigorous case studies.

I close by highlighting one of the manyquestions raised earlier as requiringmore work. Because distributional issuesare at the heart of the literature dis-cussed here, we need more progress onunderstanding why institutions for com-pensating losers from reform are not

more common. There are very few pa-pers where the difficulties of compensa-tion are made endogenous to the analyti-cal framework.38 This makes theliterature somewhat incomplete in its di-agnosis of the issues. It also opens up anatural avenue for future research.

38Dewatripont and Roland (1992) and Fernan-dez and Rodrik (1991) are exceptions. In Dewatri-pont and Roland, the difficulty is created by theunobservability of individual abilities. In Fernan-dez and Rodrik (1991) compensation turns out tobe time-inconsistent when it is known that reformwill garner an ex post majority even absent com-

pensation.

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Rodrik Economic Reform