Expert Opinion

At the end of the 1980s and the beginning of the nineties the so-called Washington consensus was thought to represent revealed truth on the proper way to step from stabilization to growth. According to the consensus a tough financial policy, accompanied by deregulation and trade liberalization, would be enough to end stagnation and launch economic expansion. The proposals for reform that were based on the Washington consensus were used to address structural crises in various regions, despite the fact that they had been developed mostly as solutions to problems in Latin America. There was also a crossover effect, a process of learning by doing. This orientation in policy reform thus came to have an important impact on the course of the postsocialist transition. Later, the new agenda was introduced, shaped mainly by the encounter with the difficulties of Latin American economies in the first half of the 1990s. It did out take into consideration all the lessons that might have been learned in other regions, including especially Eastern Europe and the former Soviet republics.

The policies of the Washington consensus were not drafted or initially proposed in order to solve the crisis in postsocialist countries entering a period of transition toward a market economy. The early consensus was actually aimed at economies which were already market economies and not in transition. For this reason, nations facing other challenges have never found satisfactory answers to their most pressing questions in the Washington consensus. The consensus interpretation vis-а-vis the postsocialist transition economies suggests that it would be sufficient to fix the financial fundamentals and privatize the bulk of state assets. Subsequently, growth should occur and be sustainable. This is an oversimplification, and things have not turned out as expected or promised.

Nonetheless, although the problems of transition countries seem not to have been a main concern in the policy reforms proposed by the Washington consensus, the mainstream line of thought that seems to dominate in Washington-based organizations, including the ones dealing with the international economic and financial order, have had a significant influence on policy attitudes toward the transition countries. Moreover, the transition experience has certainly generated modifications in the policy proposals of the consensus. This interaction has had both merits and drawbacks.

The Washington consensus has partially failed with respect to the transition economies because it has neglected the significance of institution-building even when the other fundamentals are by and large in order. This oversight explains why so many Western scholars did not at first properly understand the true nature of the challenge. Institutions can be changed only gradually, and they exert a very strong influence on economic performance. It was quite naive to expect robust economic growth so soon after the fundamentals (but not the institutions) were in place. In fact, in the real economic affairs, it is not possible to sustain fundamentals if they are not backed by solid institutions.

Douglass C. North, the 1993 winner of the Nobel Prize in economics, has written that, because, "Western neoclassical economic theory is devoid of institutions, it is of little help in analyzing the underlying sources of economic performance. It would be little exaggeration to say that, while neoclassical theory is focused on the operation of efficient factor and product markets, few Western economists understand the institutional requirements essential to the creation of such markets since they simply take them for granted."

The problem is also that, if institutions should not be taken for granted in general, there is all the more reason they must be taken seriously under conditions of transition.

Rapid growth was anticipated because it was assumed that market institutions, if they did not appear out of thin air, would rise up quite spontaneously virtually the next day after liberalization and stabilization. It was thought that policy need only secure a foothold for stabilization and lay the groundwork for the sound fundamentals. Thereafter, the economy would regain momentum on its own, and development would advance quickly.

However, the day after liberalization and stabilization was even more depressing than the day before. Because of the "neither plan, nor market" systemic vacuum, productive capacity was being employed even less; savings and investment were declining, and instead of rapid growth there was rapid recession. The lack of appropriate institutions turned out to be the key element missing from the transition policies counseled by the Washington consensus. Liberalization and privatization, unsupported by well-organized market structures, generated not sustained growth, but a lengthy period of contraction. This was not an inherited problem; it was the result of bad policy.

Under some circumstances, the reasoning of the Washington consensus may be relevant in dealing with the challenges faced by distorted, less-developed market economies. However, in these economies, market organizations have already been in place for years. The postsocialist economies possessed no basic market organizations, since such organizations had not existed under the centrally planned regime. Hence, because the absence of these organizations had apparently gone unnoticed until after the beginning of the transition, the market had no place to take root and grow. Especially if the liberalization was rapid and the privatization radical, but in other cases as well there could be no adequate and timely positive supply response. The misallocation of resources and of investments merely continued, although now for different reasons.

Clearly, the Washington consensus underestimated the extent to which appropriate institutional arrangements were essential early on for a takeoff in growth in postsocialist countries and in other economies going through the process of structural adjustment.

The economic policy orientation of the Washington consensus had a tremendous influence on the theory and practice in Eastern Europe and the former Soviet republics, as well as in the Asian socialist economies, but from the results it appears as though these nations did not all draw the same policy conclusions. A number of less-developed and transition economies realized quickly that there can be no sustained growth without sound fundamentals.

Lessons were eventually learned in Washington and London also, and since the mid-1990s the Bretton Woods institutions, that is the International Monetary Fund and the World Bank, have been paying more attention to the way market structures are organized and to the behavioral aspects of market performance. Now they know that liberalization and structural organization are both required for the market and economic growth. Because of both bitter experience of transitional contraction it has become clear that there will be no sustained growth unless the sound fundamentals - a balanced budget, balance in current accounts, low inflation, a stable currency, liberalized trade, and a vast private sector - are supported by appropriate institutional structures. There is now a consensus that the Washington consensus ought to be reconsidered, revised, and adjusted to reflect the lessons learned under real conditions.

By Prof. Grzegorz W. KOLODKO,
Washington, January 1999

From The Day's files

Prof. KOLODKO, a key architect of Polish economic reforms, is Senior Research Fellow at Yale University and Advisor to the President of Poland. He also has served as a consultant and Visiting Fellow to the World Bank and International Monetary Fund. In 1994-97 he was First Deputy Premier and Minister of Finance in Poland.