The Globalization Wars: An Economist Reports From the Front Lines

Stiglitz's critique of the IMF recommendation that crisis-stricken countries raise interest rates so as to restore monetary balance, however, remains more controversial. Stiglitz's own work after the crisis seemed to demonstrate that rather than strengthening exchange rates, as the IMF's simple textbook models predicted, higher interest rates weakened them (by placing pressure on banks and firms with heavy loads of short-term debt). But for various reasons not all the skeptics were convinced, and no professional consensus exists on this point even now.

Just as academics do not enjoy all the perks of officials, so officials do not have the intellectual luxury of academics. They must decide before the markets reopen whether to lend money or to recommend increases in interest rates, and they have to rely on back-of-the-envelope calculations, not complex and controversial models that reek of the lamp. The IMF's managers, who also have Ph.D.'s in economics from the best universities, understood that higher interest rates would place pressure on debt-laden banks and firms. And they understood that the resulting adverse impact on investor confidence could, in theory, cancel out any chance that the higher interest rates would bring back capital that had been pulled out. But they questioned whether what was true in theory would be true in practice. They feared that not raising interest rates (and thereby failing to lure back foreign capital) could lead to a weaker exchange rate, causing even more severe distress for banks and firms with debts denominated in U.S. dollars. In short, they were not oblivious to the risks Stiglitz highlights, but they felt that the other risks were even greater.

CAPITAL CONTROL GANG

Acknowledging the critic's obligation to offer an alternative, Stiglitz suggests that the IMF should have recommended restrictions on the freedom of residents and nonresidents to withdraw money from banks and to take funds out of a crisis country. Such controls, he claims, can prevent a panic from doing irreparable damage to financial markets and need not diminish a country's growth prospects. As evidence, he cites the case of Malaysia, arguing that controls worked well there when Prime Minister Mahathir bin Mohamad imposed them in 1998.

This assessment is controversial, however, and will be even more so now that Argentina's application of the remedy has had no palliative effects -- if anything it has only made that country's crisis worse. Indeed, rather than preventing crises, repeated recourse to capital controls may only increase their frequency. If investors know that the authorities will reimpose controls at the first sign of trouble, any minor uptick in volatility may prompt a rush for the exits.

Stiglitz is hardly unaware of this critique, and he does not suggest that countries liberalizing financial markets should restore controls at the first sign of trouble. Rather, he urges governments to think twice about deregulating capital flows in the first place, arguing that neither theory nor experience suggests that the benefits of such liberalization exceed the costs.

But such advice is problematic if one believes that financial liberalization is important for financial development. Financial markets do not materialize out of thin air. Markets must be allowed to operate to acquire depth and liquidity. Only by competing against and copying foreign rivals will banks and corporations learn to protect themselves against financial volatility. This is the basis for the argument that competition -- achieved by liberalizing prices, privatizing public enterprise, and opening the economy to international transactions -- is a key ingredient of economic and financial development.

Stiglitz's counterargument is that deregulation will not promote financial development when information is asymmetric and competition is inadequate. There is no guarantee that financial liberalization will enhance economic efficiency, nor that privatization will guarantee competition. Privatization without adequate regulatory oversight, for example, may allow a few formerly state-owned enterprises to dominate the economy. It will spur corruption and create an oligarchic elite that opposes the emergence of competitive markets.

That Stiglitz should display these concerns is not surprising. They were themes of his Wicksell lectures at the Stockholm School of Economics, published in 1994 as Whither Socialism? Those lectures can be read as a warning against precipitous privatizations such as those that were carried out in Russia. The partisans of the pro-liberalization "Washington consensus," he continues to stress, overlooked the importance of economic and corporate governance, underestimated the difficulty of building institutions, and forgot that many countries lack the sophisticated public administrations needed to ensure adequate competition. A Californian still recovering from the botched deregulation of his state's electricity market feels the author's pain.

But liberalization and market opening must be more than economically efficient, Stiglitz goes on to observe -- their consequences must also be socially acceptable if they are to endure. Sustainable development thus requires not just liberalization and privatization but also initiatives to ensure that all of society shares in the benefits. The IMF, he argues, has failed to heed the consequences of its own advice for social and political stability. By insisting that governments privatize quickly, it neglects the negative impact on the distribution of wealth. By demanding austerity while insisting on liberalization, it disregards basic social needs. And by forcing elected officials to violate their social contract with their citizens in the name of fiscal balance, it undermines the legitimacy of governments and the very process of market liberalization to which it attaches such value.