IAS Gyan

Blogs

THE WASHINGTON CONSENSUS

3rd February, 2021 Mains

THE WASHINGTON CONSENSUS

Introduction

A British economist named John Williamson coined the term Washington Consensus in 1989. The Washington Consensus refers to a set of free-market economic policies supported by prominent financial institutions such as the International Monetary Fund and the World Bank.

The ideas were intended to help developing countries that faced economic crises. In summary, The Washington Consensus recommended structural reforms that increased the role of market forces in exchange for immediate financial help. Some examples include free-floating exchange rates and free trade.

 

Principles of Washington Consensus

The ten principles originally stated by John Williamson in 1989, includes ten sets of relatively specific policy recommendations.

  1. Low government borrowing. Avoidance of large fiscal deficits relative to GDP;
  2. Redirection of public spending from subsidies (“especially indiscriminate subsidies”) toward broad-based provision of key pro-growth, pro-poor services like primary education, primary health care and infrastructure investment;
  3. Tax reform, broadening the tax base and adopting moderate marginal tax rates;
  4. Interest rates that are market determined and positive (but moderate) in real terms;
  5. Competitive exchange rates;
  6. Trade liberalization: liberalization of imports, with particular emphasis on elimination of quantitative restrictions (licensing, etc.); any trade protection to be provided by low and relatively uniform tariffs;
  7. Liberalization of inward foreign direct investment;
  8. Privatization of state enterprises;
  9. Deregulation: abolition of regulations that impede market entry or restrict competition, except for those justified on safety, environmental and consumer protection grounds, and prudential oversight of financial institutions;
  10. Legal security for property rights.

 

Implications of Washington Consensus

  • Support of free trade through WTO and NAFTA – reduce tariff barriers.
  • IMF bailouts tended to involve free market reforms as a condition of receiving money.
  • Belief in free trade suggests countries, should specialize in goods/services where they have a comparative advantage. This may mean developing economies need to stick with producing primary products.

Criticisms of the Washington Consensus

  1. Strategic trade theory. Some economists argue that free trade is not always in the best interest of developing economies. A strict adoption of free trade and comparative advantage can leave developing economies producing low-income growth and volatile priced primary products. If countries promoted new industries, it might require both selective tariffs on cheap imports and also government subsidies. For example, the Brazilian government’s support and development of Embraer, helped Brazil become successful in airline manufacturing.
  2. Low government borrowing is not always appropriate. Implementing fiscal rules can cause unnecessary economic hardship if the government cuts spending at an inappropriate time. For example, fiscal consolidation during the great recession has caused low growth rates, and a failure to reduce debt to GDP ratios. If governments are pressured to cut spending it can also cause welfare support programmes to be hit, increasing poverty. However, in the long term, most economists would suggest it is prudent to reduce structural borrowing to manageable levels.
  3. The Chinese approach. An interesting development in recent years is that Chinese firms have invested substantial sums in developing economies, such as Africa and Latin America. The interesting thing about the Chinese approach is that it involves substantial investment in infrastructure and public sector investment – showing that for economic development, an interventionist approach can have a bigger return than leaving it to free markets.
  4. Problems of privatization - Privatisation can increase efficiency and improve the quality of the product/service. However, for key public sector industries, privatisation may mean companies ignore wider social objectives. For example, in the 1990s, under World Bank pressure, Bolivia privatised its water industry. But, this led to water supplies being cut off from the poorest members of society. (politics of water in Boliviaat the Nation)
  5. Mis-interpretation - The second point about redirecting of public spending towards public sector initiatives like primary education, primary health care and infrastructure investment, has often been ignored. Instead the ‘Washington Consensus’ has come to refer to more market oriented policies, which have focused on less government intervention.
  6. The macro-economic crisis of Latin America in the 1980s and South East Asian crisis in 1990s made these free market policies unpopular in the countries where they were implemented. 
  7. Credit crisis and instability of free markets. The credit crisis beginning in 2007 has illustrated the potential for free markets to create instability and high unemployment. Financial deregulation has created the potential for financial instability.

 

Rationale behind the Consensus

  • The 10 principles of the Washington consensus all have considerable economic validity. Broadening the tax base, investment in education, sustainable government borrowing, flexible exchange rates etc. can all help improve economic welfare.
  • Under certain situations, privatization and increased competition can have potential benefits. Most economists would support the notion that free trade has potential benefits.
  • It’s always easy to criticise when things go wrong. When South East Asian economies were in great difficulties in the 1990s, it is likely that any policies would be unpopular. When you have a crisis there tends to be no easy way out.
  • The problem with any broad set of economic principles is that it always depends on how and when they are implemented. For example, generally free trade is good. It’s generally desirable to have lower tariffs and encourage international trade. However, that doesn’t necessarily mean there isn’t room for targeted economic diversification.
  • Some developing economies may benefit from limited trade protectionism to develop new industries. But, even this depends on how it is implemented. If African countries, tried to use tariffs to develop a motor industry, it would probably lead to government failure because the infrastructure isn’t there to support a new motor industry. However, if there was some support to develop primary product processing within the country, it is more likely to be successful.
  • An important point is that an economic policy may have sound justification, but it might not be universally applicable, e.g. free trade. Free trade can tend to give greater benefit to developed economies than developing. But, at the same time, developing countries would benefit if the developed world (EU and US) actually cut agricultural tariffs.

India’s stance until now

Until now the economy was moving along a fiscal consolidation path, with a fiscal deficit of 3% of GDP as the eventual target. ‘Macroeconomic stability’ which is central to the Washington Consensus was a part of our Economic policy.  For well over a decade-and-a-half, we have kept up the pretence of attaining the deficit targets set out in the Fiscal Responsibility and Budget Management (FRBM) Act (2003)- i.e fiscal deficit of 3% of GDP.

Macroeconomic stability exists when key economic relationships are in balance—for example, between domestic demand and output, the balance of payments, fiscal revenues and expenditure, and savings and investment. These relationships, however, need not necessarily be in exact balance. Imbalances such as fiscal and current account deficits or surpluses are perfectly compatible with economic stability provided that they can be financed in a sustainable manner.

There is no unique set of thresholds for each macroeconomic variable between stability and instability. Rather, there is a continuum of various combinations of levels of key macroeconomic variables (e.g., growth, inflation, fiscal deficit, current account deficit, international reserves) that could indicate macroeconomic instability. While it may be relatively easy to identify a country in a state of macroeconomic instability (e.g., large current account deficits financed by short-term borrowing, high and rising levels of public debt, double-digit inflation rates, and stagnant or declining GDP.

Shift in India’s approach

In this year’s Budget, the Finance Minister’s speech is just to lower the fiscal deficit to 4.5% of GDP by 2025-26. The yearly projections of Fiscal Deficit are missing.

The Economic Survey that preceded the Budget laid the groundwork for a departure from rigid adherence to fiscal consolidation.

It has a quote from economist Olivier Blanchard,

“If the interest rate paid by the government is less than the growth rate, then the intertemporal budget constraint facing the government no longer binds.”

[The “intertemporal budget constraint” means that any debt outstanding today must be offset by future primary surpluses. In its general form, the intertemporal budget constraint says that the present value of current and future cash outflows cannot exceed the present value of currently available funds and future cash inflows.]

Enough of fiscal orthodoxy; Spend like there is no tomorrow. That is what the Budget for 2021-22 signaled with its fiscal deficit at 9.5% of GDP for FY21 and 6.8% in FY22.

Fiscal consolidation refers to the policies undertaken by Governments to reduce the underlying fiscal deficit. It is not aimed at eliminating fiscal debt.

Fiscal activism — giving a greater role to counter-cyclical policies and attaching less weight to curbing debt. Until now this was embraced by advanced economies and was not relevant for India.

Reasons behind sudden Fiscal Activism

The International Monetary Fund (IMF) and the World Bank, both flag-bearers of the Washington Consensus, have been urging a departure from fiscal orthodoxy in the wake of the pandemic.

Both these institutions used to be wary of any increase in the public debt to GDP ratio beyond 100%. But today, they are urging the advanced economies to spend more by running up deficits even when the debt to GDP ratio is poised to rise to 125% by the end of 2021.

The debt-to-GDP ratio, commonly used in economics, is the ratio of a country’s debt to its gross domestic product (GDP). Expressed as a percentage, the ratio is used to gauge a country’s ability to repay its debt. In other words, the debt-to-GDP ratio compares a country’s public debt to its annual economic output.

Where:

Debt is the cumulative amount of a country’s government debt

Gross Domestic Product is the total value of goods produced and services produced over a given year

Also, the Economic Survey argues that in India, the growth rate is higher than the interest rate most of the time. It says that, in the current situation, expansionary fiscal policy will boost growth and cause debt to GDP ratios to be lower, not higher. Given India’s growth potential, we do not have to worry about debt sustainability until 2030.

Expansionary fiscal policy is when the government increases the money supply in the economy using budgetary instruments to either raise spending or cut taxes—both having more money to invest for customers and companies.

The government is, however, happy to adhere to other elements of market orthodoxy, such as privatisation and a greater role for foreign direct investment (FDI).

Concerns

Indian fiscal policy adhered to orthodoxy even during a downturn, such as the one we faced in the years preceding the pandemic. An important consideration was the fear that the rating agencies would downgrade India if total public debt crossed, say, 10%-11% of GDP.

Also, there are concerns that Fiscal Activism can lead to “Macroeconomic Instability”

  • Inflation: It is more than likely that a change in the fiscal consolidation targets will require a change in the inflation target of 4% set for the Reserve Bank of India. And a large fiscal deficit can fuel a rise in inflation.
  • Privatisation: Large-scale privatisation is not easily accomplished in India. Selling public assets cheap is politically contentious. There will be allegations of favouring certain industrial houses. Public sector unions are a vital political constituency. Privatisation of banks raises concerns about financial stability. Job losses from privatisation are bound to evoke a backlash.
  • Low Tax to GDP ratio: With the tax to GDP ratio not rising as expected, the sale of public assets has become crucial to reduction in fiscal deficits in the years ahead. However, for years now, revenues from disinvestment have fallen short of targets. The sale of Air India, which was begun in 2018, is still dragging on.
  • Against self-reliance- Large-scale privatisation almost always involves substantial FDI. In South East Asia and Eastern Europe, privatisation of banks meant a large rise in foreign presence in the domestic economies. Atmanirbhar Bharat connotes greater self-reliance and stronger Indian companies. How does the government reconcile a rise in FDI with Atmanirbhar Bharat?

Conclusion

A departure from fiscal orthodoxy is welcome. But the government needs to think of ways to make it more sustainable.

Despite the failings of the free market, there is still merit in considering the principles of Washington Consensus. However, there needs to be greater discrimination and less blanket implementation.