overview - world bank · theil coefficient mean ln deviation figure 1.4 fraction of world...

ECONOMIC GROWTH IS A RECENT

event in the history of humanity.During most of 4 million years of

evolution, people made limited economic progressand their material well-being changed very little. Inthe last few centuries, however, goods and servicesstarted to be produced at increasingly lower cost inhours of effort.The hours of work needed to pro-duce basic goods such as water or heat at the dawnof civilization were several hundred times thoseneeded today (DeLong 2000). Similar increases inproductivity have been achieved for an expandingrange of goods and services. Most of this progresshas taken place in the last two centuries, duringwhich technological progress has been exception-ally rapid, and economic growth unprecedented(figure 1.1).

It is only in the last 50 years that mainstreameconomics has focused on the determinants ofAdam Smith’s “natural progress of opulence” andon how growth could be accelerated. Many ques-tions about growth still lack satisfactory answers.Yetfew issues are more important for the world’s futurethan the ability of developing countries to raiseboth productivity and the rate at which they accu-mulate capital.

This overview chapter first briefly reviews ourunderstanding of growth before turning, in section2, to the facts and controversies of growth and pol-icy reforms in the 1990s. Section 3 draws the broadlessons coming out of the growth experience of the1990s, and section 4 offers lessons specific to key

policy and institutional reforms. Section 5 sketchesoperational implications. Subsequent chapters setout the facts about growth in more detail, and thenexamine the main areas in which economic andinstitutional reforms concentrated during the1990s—macroeconomic stabilization, trade, finan-cial sector, privatization and deregulation, modern-ization of the public sector, and political reforms.The chapters aim to draw lessons from gapsbetween expectations and outcomes.Most chaptersare also followed by a Country Note that expandson issues insufficiently dealt with in that chapter, orthat considers country-level perspectives.

Overview

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Chapter 1

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FIGURE 11

Worldwide Growth in Real GDP per Capita, 1000–Present

Source: DeLong 2000.

Up to then, thinking about growth had beendominated by the Solow model, the basic modelwith which we still think about economic growth,in which growth is a function of the accumulationof capital, accumulation of labor, and productivitygrowth.This model leaves out much of what needsexplaining. In particular, it views long-run growthas entirely determined by exogenous factors, inde-pendent from structural characteristics of the econ-omy such as openness, scale, and saving rate, and,most important, from the policies influencing suchvariables.Also, while left unexplained in the model,productivity growth drives the empirical story.Solow himself estimated that technological changeexplained more than half of per capita outputgrowth in the first half of the 1900s in the UnitedStates.Calculations by the World Bank indicate thatit explained one-third of the increase in per capitaincome in East Asia up to the early 1990s (WorldBank 1993). Other exercises reach similar conclu-sions on the large role of productivity gains ingrowth experiences.

At first the New Growth Theory seemed to holdthe promise of linking policies to growth perform-ance. It appeared at a time when evidence was accu-mulating—from the growth experience of the 1970sand 1980s—suggesting that the accumulation of cap-ital was not a panacea, and that misguided policieswere costly for growth.The new evidence providedthe conceptual foundation for aggregate cross-coun-try regressions, which throughout the 1990s soughtto capture the effect of policies on long-term growth(Barro 1991; Temple 1999) and provided thestrongest intellectual foundation for the view thatbetter policies would deliver faster growth.

A number of empirical problems became evi-dent, however, related to the crude manner inwhich policy variables enter the cross-countryregressions; the fact that differences in the institu-tions underlying policy design and policy imple-mentation are not captured; the lack of robustnessto changes in time periods and specifications; thecrudeness of the assumption that the same modelexplaining growth in the Republic of Korea orBrazil could be used for Bolivia or Rwanda; and the

E C O N O M I C G ROW T H I N T H E 1 9 9 0 s2

1. Understanding EconomicGrowth

Absent definitive theories, views on growth havebeen shaped by facts and changed by experience.Until the 1970s, the growth strategies of developingcountries focused on accelerating the rate of capitalaccumulation and technological adoption. Importsubstitution, state-owned enterprises, controls overthe financial sector, central planning, and a variety ofprice controls and state interventions in the econ-omy were some of the policies that governmentsused to take the “commanding heights”of the econ-omy and guide resource allocation to areas thoughtto be most conducive to long-term growth. Confi-dence in governments was born from their (partial)success in addressing the Great Depression, inexpanding production during World War II, andreconstructing Europe and Japan. Economists andpolicy makers saw that market forces disruptedgrowth and that governments were able to restore it,and to expand capacity efficiently.The generation ofeconomists that followed, however, familiar withexperiences of developing countries in the 1970s and1980s, saw the waste of enormous resources in ill-conceived government initiatives, the costs of poormacroeconomic management, and the ease withwhich well-intentioned public policies could bediverted to serve narrow political or economic inter-ests. Understandably, this later generation of econo-mists and policy makers came to believe that the costof government failures was considerably larger thanthe cost of market failures, that government inter-ventions interfered with development, and that con-taining the role of the public sector in the economy,reducing its use of resources, and limiting its discre-tion were essential for economic growth.

New Growth Theory This shift in views was supported by a new strand ofacademic research that started in the second half ofthe 1980s and gathered impetus during the 1990s,when there was a resurgence of academic andempirical work on growth.

poor predictive power of policies as indicators ofperformance.

If, as suggested by the growth regressions, poli-cies matter for growth, policy improvements shouldlead to higher growth.Both in the 1980s and 1990s,policies improved relative to other decades, butgrowth performance remained well below that ofthe 1960s and 1970s (Easterly 2001). More recently,empirical research has argued that when a measureof “institutional quality” is included in cross-countryregressions, the explanatory power of other vari-ables, including all measures of “policies,” becomesnegligible (Acemoglu, Johnson, and Robinson2001; Rodrik, Subramanian, and Trebbi 2002; East-erly and Levine 2003; and IMF 2003e).This suggeststhat “good” institutions matter more for growththan “good” policies—that “institutions rule.”

In hindsight, the breakthroughs expected fromthe New Growth Theory have not materialized.

I N T RO D U C T I O N 3

Nonetheless, in the process, greater clarity wasreached on the facts about growth, analysts paidgreater attention to the role of institutions,and stud-ies brought the issue of inequality—both withinand between countries—increasingly to the fore.

Growth in Developing Countries:Divergence,Variability, and UnpredictabilityResearch during the 1990s was able to extend theavailability of data over long periods.This made itclear that growth was not a linear process, and thatit did not conform to the theoretical predictionthat per capita income in developing countrieswould eventually converge with that of industrial-ized countries. In fact, there has been “divergencebig time” in the evolution of per capita incomes(Pritchett 1997), both between industrialized anddeveloping countries and among developing coun-

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FIGURE 12

Economic Growth in Perspective, 1960–2002

Source: WDI 2003.

Note: Regions’ GDP per capita is shown as a percentage of the OECD GDP per capita (total regional GDP over total population).

half that rate. Korea has only had only three years ofnegative per capita growth since 1961.1

The variability of growth helps to explain whygrowth in the developing world is so difficult topredict. Instances of economists (including, forexample, 1977 Nobel Laureate James Meade onMauritius) making highly inaccurate predictionshave become part of the economic folklore. Manyof the economic successes of today—Bangladesh,Indonesia, Korea, or Mauritius—were considered“basket cases” in the 1960s, when Africa’s growthprospects were seen as superior to those of over-populated Asia—a view captured in Asian Drama(Myrdal 1972). In the later 1990s, just before thesecond most dramatic economic crisis in its history,Argentina was seen as a model for developing coun-tries and believed to have found the path to sus-tained growth. At a more technical level, WorldBank growth projections, as well as growth projec-tions by other forecasters, tend to be systematicallyoveroptimistic (a point that was highlighted in theWorld Bank’s World Development Report 1991).

While a rare occurrence thus far, sustainedgrowth has improved the lives of millions. Coun-


tries themselves.This is the case whether the periodbeing considered is the last 40 years (figure 1.2) orthe last 10 (figure 1.3).

As a result, worldwide inequality has changedfrom being the result almost exclusively of differencesamong people within countries to being the result pri-marily of differences across countries (figure 1.4).

The consideration of growth over longer periodsalso highlights the variability of growth in developingcountries.The experience of Latin America sincethe 1980s, the collapse of growth in Africa in the lasttwo decades, and the economic collapse of EasternEurope after several decades of sustained growthstand in sharp contrast to the stability of growthamong industrialized countries, which have grownat roughly a constant rate (except for the interrup-tion of World War II and recovery years) for morethan 100 years. It also contrasts with the experienceof East Asian countries.What is remarkable aboutEast Asia is not that it experienced a crisis in 1997,but that it experienced so few crises over the pre-ceding decades. By and large, developing countrieshave one year of negative per capita growth roughlyonce every three years. In East Asia, the average is

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FIGURE 1.3

Regional Perspectives on Growth in the 1990s

Source: WDI 2003.

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Theil coefficient Mean ln deviation

FIGURE 1.4

Fraction of World Inequality Accounted forby Differences across Countries

Source: Source: Bourguignon and Morrison 2002.

tries where sustained growth has taken place(mostly in South and East Asia, includingBangladesh, China, Indonesia, India, and Vietnam)account for a large proportion of world population.Out of 117 countries with populations of morethan half a million people, only 18 have been ableto sustain growth rates exceeding industrializedcountries’growth and hence narrow their per capitaincome gap with those countries.2

InstitutionsDefined as the rules and norms constraining humanbehavior (North 1990), institutions include theinformal rules and norms that govern personal andsocial behavior and the formal rules and normsgoverning economic, social, and political life. Insti-tutions enable societies to organize themselves andfunction in an orderly manner by solving problemscentral to life in society, particularly agency prob-lems, containment of predation by individuals orthe state, and collective decision making. Societies’performance depends on how effectively their insti-tutions resolve these problems.

The importance of institutions for economicprosperity is not a novelty learned from the 1990s.From different perspectives, Adam Smith, KarlMarx, and Max Weber highlighted the role of insti-tutions in the development of a market economyand formation of a capitalist society. Economistsdealing with development in the 1950s and 1960swere aware that the development challenges facedby a plantation economy differed from those facedby a society where economic and political powerwere not concentrated (Rostow 1952, 1960;Adel-man and Morris 1965). Latin American economistsof the Structuralist school saw in the legacy of colo-nialism, embedded in institutions serving the inter-ests of a small, landed elite, the source for economicperformance inferior to that of the United States orCanada (Furtado 1963).This imbalance formed apart of the justification for an activist state: inflationhelped to mobilize resources from the wealthy elitewho resisted more efficient forms of taxation; statessponsored investments in manufacturing, particu-


larly in capital-intensive industries,because old eco-nomic interests resisted change and were unwillingto take on risks inherent in new industrial activities;price controls did not have serious economic con-sequences because the concentration of wealth pre-cluded the redeployment of resources in responseto changes in demand (Seers 1962).

While there are some functions that institutionsneed to perform in any society, the form throughwhich institutions can perform these functions canvary considerably (Virmani 2004). Most of theempirical work on the importance of institutionsleaves open the question of how to improve institu-tional performance. Merely adopting some othercountry’s laws and formal regulations is no guaran-tee of achieving the same institutional performance.Recently, accession to the World Trade Organiza-tion and integration into regional supra-nationalentities such as the European Union and the NewEconomic Partnership for Africa have strengthenedincentives for institutional improvements.East Asiancountries have long realized the importance ofinstitutional change and innovation, and the 1997crisis made this realization all the more acute, creat-ing renewed impetus to modernize institutions,including political institutions. But for most devel-oping countries, improving the quality of theirinstitutions remains a challenge.

Fairness, Growth, and InstitutionsAnother important strain of ideas in the 1990s camefrom the resurgence of interest in inequality as anapparent influence on growth and institutional per-formance.A recent body of literature suggests sev-eral channels through which inequality affectseconomic growth. Fairer societies offer their citi-zens more public goods, more social support, andmore social capital. Hence they are more capable ofsharing the costs and benefits of improving eco-nomic policies, and in turn facilitating consensusbuilding and decision making (Deaton 2003a).Fair-ness also facilitates agreement on the provision ofpublic goods that have strong beneficial side effectson society, such as health services, water supply, or

States in the early 1900s, when the governmentdecided to regulate matters hitherto left to privateparties and the courts; the reason for the shift was aperception that judges and the courts, having beencorrupted by powerful economic interests, wereunable to render fair and equitable judgments.WorldDevelopment Report 2001 provides other examples ofhow economic incentives affect the emergence ofinstitutions that sustain the functioning of markets,and the different coordination or risk-reducingproblems that they are meant to resolve.

2. Facts and Controversies of the1990s

At the beginning of the 1990s, most economistsworking on development and many policy makersshared the conviction that more efficient use ofresources would lead to growth.This was believedto require, first, macroeconomic prudence, domes-tic liberalization, and outward orientation,which inturn required freeing market incentives and open-ing the economy. Hence fiscal deficit reduction,realignment of exchange rates to eliminate blackmarket premia, lifting controls on prices, deregula-tion of interest rates and liberalization of the finan-cial sector, and reduction of tariffs and otherrestrictions on imports all became central to thepolicy reform programs implemented in the 1990s.

Second, conventional wisdom held that toachieve greater efficiency required a reduction inthe role of the state.There was evidence that thestate discretion that was inherent in growth strate-gies based on infant industry, import substitutionpolicies, and the growth of public enterprises hadbeen misused more often than anticipated, hadoften been captured by narrow interest groups, andserved as the source of endemic corruption.Addressing this problem required reducing statediscretion, downsizing governments, and encourag-ing a much greater role for the private sector.Henceprivatization, deregulation, elimination of quantita-tive restrictions and of licensing requirements, anddismantling agricultural marketing boards and


waste disposal. Other channels through whichinequality affects growth are market structures andmicroeconomic incentives.A better distribution ofwealth reduces credit constraints, and broader avail-ability of credit is found to have a significant andpositive effect on growth rates. If individuals arelimited in their borrowing capacity, reallocatingcapital toward the poorest will increase aggregateproductivity.

Even if one concludes that greater equalityinfluences growth positively, there is still consider-able ignorance about the means through whichgreater equality can be achieved.Governments havelong sought,with varied degrees of success, to redis-tribute income through land redistribution,employment programs, subsidies, and promotion ofbroad access to credit, infrastructure, health, andeducation.The large, underresearched area for fur-ther study includes questions related to the impactof public spending on equity, both in a static sense(incidence of public spending) and a dynamic sense(changes in individuals’ earnings potential).

Recent literature has emphasized the importantlinks between the distribution of assets in a societyand the institutions that emerge. Knowledge is stillrudimentary about how institutions emerge and areestablished in a society,but economic research in the1990s has provided some insights. First, economicincentives influence what type of institutionsemerge and when. The enforcement of propertyrights to land, for example, will depend on the ben-efits of enforcement relative to its costs, which foreach owner depends on the extent to which otherowners enforce their property rights. In an extrac-tive economy, for example if landowners in generaldo not enforce their property rights, it is uneco-nomical for one landowner to enforce his: workerswill find it attractive to exploit land and appropriatethe rents for themselves. Only when this coordina-tion problem is resolved will economic incentivesbe sufficient for enforcement of property rights(Hoff and Stiglitz 2001). Second, concentrated eco-nomic and political interests influence institutions.This can be seen from experiences with land distri-bution in Latin America, and also from the United

other forms of state monopoly all became centralto reform programs. Seeing the need to strengthenthe organizational effectiveness of the state, and theefficiency with which the state used publicresources, reformers rationalized government func-tions and undertook civil service, legal, and budgetreforms. Democratic processes were expected toprovide checks and balances and further incentivesto this process.

Third, it was believed, reforms had to be rapid.Earlier, some of the first authors to argue in favor ofabandoning the dirigiste framework of early devel-opment economics (notably Little, Scitovsky, andScott 1970; McKinnon 1973) had argued explicitlyin favor of a gradualist reform strategy (in respect totrade and the financial sector, respectively).3 But inthe course of the 1980s the economics professionbegan to be influenced by the enthusiasm of lead-ing politicians for “the magic of the market.”Argu-ments in favor of “big bang” and “shock treatment”became prominent. By the time that the transitionto a market economy got under way in the formersocialist economies, “a belief in gradualism hadalmost become tantamount to a confession of a lackof reforming virility” (Williamson and Zagha2002).

A Decade of Significant ChangeThe 1990s provided ample opportunity for theseviews to be implemented.The Russian Federation,Eastern Europe, and Central Asia embraced capital-ism and a new generation of leaders made it a pri-ority to rebuild their economies on the basis ofcapitalist principles, markets, and privatized firms.Regarding the speed of reform, while there weredivergences, the balance of opinions supportedrapid rather than gradual reform. China, the largestdeveloping economy, continued the reforms it hadbegun in 1978 with further liberalization of thedomestic economy, and increased openness. Afterits crisis in 1991, India, the second-largest develop-ing economy, speeded up liberalization started inthe 1980s. President Collor of Brazil announced aradical program of economic reform aimed at


reducing hyperinflation and reversing severaldecades of state-led import-substituting industrial-ization. In Argentina, President Menem set thecountry on a course of eliminating hyperinflationthrough a currency board as well as ambitious mar-ket reforms, which saw the privatization of state-owned businesses and liberalization and opening ofthe economy. In Bolivia, reforms by Paz Estensorothat had brought hyperinflation to a halt in themid-1980s were continued in the 1990s, regardlessof the parties in government. In Africa, the devalu-ation of the African Financial Community (CFA)franc increased competitiveness and many otherreforms were implemented throughout the region.In Tanzania, President Mkapa started an ambitiousprogram of reforms. In South Africa, the transitionto a multiracial democracy was followed by stepstoward liberalizing the economy.

Leaders such as Rawlings of Ghana and Musev-eni of Uganda strengthened fiscal fundamentals,achieved macroeconomic stability, liberalized theeconomy, and reduced the role of the state. Privati-zation, retrenchment of the public sector, and liber-alization of trade were the focus of economic policychanges in countries as diverse as the CentralAfrican Republic,Ghana, and Tanzania.Reforms inthe Middle East and North Africa were less ambi-tious but were nonetheless significant in the ArabRepublic of Egypt, Jordan, Morocco, and Tunisia.On the political front, democracy spread in formercommunist countries and Africa, and was consoli-dated in Latin America.These and other changesgave rise to expectations that the 1990s wouldaccelerate growth and social progress in the devel-oping world.

Rapid Growth, Take-offs, and Social ProgressIndia and China, together accounting for 40 per-cent of the developing world’s population,grew fastin the 1990s for a second decade in a row, as didmany other countries in South and East Asia,including Bangladesh, Sri Lanka, and Vietnam.Chile continued to grow in Latin America,Tunisiain North Africa, and Botswana and Mauritius inAfrica. New high performers appeared and annual

positive developments occurred in the later 1990s,such as in Mozambique,Tanzania, and Uganda, andstill persist at the time of writing, it is too early toconclude that Africa has turned the corner.

Financial CrisesFinancial crises in the 1990s were less predictablethan in the 1970s and 1980s. Macroeconomists,bank restructuring experts, and emerging-marketprivate traders rolled from crisis to crisis: from Mex-ico during 1994–95, to Korea, Malaysia,Thailand,Indonesia during 1997–98, Russia in 1998, Brazilin 1998, and Turkey in 2001 to the latest and per-haps most worrisome of all, in Argentina during2001–02.The evolution of spreads in the monthspreceding the financial crises suggests that few wereanticipated.

Delay in Recovering Growth, Particularly inLatin AmericaIt was hoped that the “lost decade” of the 1980swould be reclaimed in the 1990s. Macroeconomicstabilization, fiscal austerity, trade liberalization, andprivatization were expected to lead to rapid growth.Although growth was the fastest in two decadesuntil 1998, its collapse thereafter following thereversal in capital flows created the general percep-tion that the growth payoffs have been smaller thanexpected.

Argentina: The Collapse of the Hard PegArgentina was the most successful example of atrend in the 1990s to create macroeconomic stabil-ity by legal and institutional changes intended toreduce the scope and latitude of government’s dis-cretion.Exchange-rate arrangements that set a fixedrate for peso convertibility were not only incorpo-rated into law but also made especially difficult toalter, and changes were made in the operation ofthe central bank to make these limitations a reality.As part of a package of reforms, this convertibilityplan eliminated Argentina’s hyperinflation and, for aperiod, it restored economic growth.

Once Argentina achieved stability with growth,there was considerable discussion—particularly


gross domestic product (GDP) growth for thedecade was rapid in an array of countries: Mozam-bique (7.8); Uganda (6.8), Dominican Republic(6.0), Tunisia (5.0), and Poland (4.5). Countriesaffected by the crisis in East Asia made an unex-pectedly rapid recovery.

Notwithstanding unevenness across regions, theincidence of poverty continued to decline through-out the 1990s—more rapidly in East Asia than inSouth Asia and more rapidly in South Asia than inLatin America. In Africa, however, the incidence ofpoverty increased slightly. Growth was the mainforce behind virtually all cases of significant reduc-tions of poverty, including in China and India. Butparticularly in Latin America, there were instancessuch as Brazil and Bolivia where social indicatorsimproved without significant growth.

Alongside these positive developments, how-ever, there were several negative surprises.

“Transition Recession” in the Former SovietUnion and Eastern EuropeThe transition from a communist, centrally plannedeconomy to a capitalist one was expected to be dif-ficult. But the depth of the output collapse was notwidely predicted.The length of the transition—inwhich many countries in 2003, more than a decadelater, remain far below their previous levels of out-put—was not widely forecast.Nor was the variabil-ity among countries in the depth and duration ofthe output collapse.Though recoveries have startedto emerge—in the Czech Republic, Hungary, andPoland, for example—it will take years, and in somecases, decades, for most former Soviet countries toregain their per capita income levels prevailing atthe beginning of the transition.

Continued Stagnation in Sub-Saharan AfricaThe failure of growth in Africa—either of powerfuland rapid growth in a single large country or in asubstantial number of smaller ones—was a surprise.Despite good policy reforms, debt relief, continuedhigh levels of official assistance, promising develop-ments in governance, and a relatively supportiveexternal climate,no take-off has ensued.While some

after the devaluation of Brazil’s real in January1999—as to whether the country should abandonits rigid exchange rate system. Views divergedamong economists.Looking back, the former Gov-ernor of Argentina’s Central Bank described theabandonment as a marriage to be broken when itwas going well (Mario Blejer,World Bank 2005b).For fear that markets could overreact, Argentina’sauthorities maintained the system.When the plancollapsed, the result was politically and economi-cally costly by design.Thus the damage was not asurprise. But the demise of the convertibility planitself was a surprise, for two reasons. First, its initialsuccesses had suggested longevity was possible; ithad reduced rapid inflation and initiated a boom inthe early 1990s, and it had weathered the “Tequila”after-shocks of the Mexican crisis reasonably well.Second, while the end of convertibility was costlyby design, its actual cost exceeded the most pes-simistic forecast.

Interpreting the ResultsFrom a growth perspective, the net result of thecontrasting experiences of the 1990s is that devel-oping countries as a group grew faster than in the1980s. In East and South Asia this reduced theincome gap with industrialized countries, but inother regions, the gap increased. In Latin America,there were clear gains up to 1998, reversed in thelate 1990s and early 2000s (figures 1.2 and 1.3).

Analyzing policy reforms of the 1990s, severalstudies (Loayza,Fajnzylber, and Calderon 2002;Lora2001a; Easterly 2001) find that countries thatimproved their policies—strengthening macroeco-nomic management, opening up their economies,liberalizing their financial sectors—grew faster in the1990s. However, they also find a large unexplainednegative effect associated with both the 1990s andthe preceding decade.Together with analysis of indi-vidual country experiences and overoptimistic fore-casts by international financial organizations andprivate entities, these studies give an empirical baseto perceptions that the economic policy reforms ofthe 1990s yielded results below expectations.


It has been suggested that lower OECD growthmight have depressed developing countries’ growthin the 1990s (Easterly 2002). In reality, the 1990swas favorable for developing countries, even if notevery country found ways to benefit. Exports fromdeveloping countries as a group grew much fasterthan in previous decades. Real interest rates werelower. Debt obligations claimed fewer resources,and foreign direct investment and financial flows todeveloping countries were much larger. If com-modity prices affected developing countriesadversely, the damage was not dramatic and shouldhave been offset by the increasing share of manu-facturing exports—except in a small group of leastdeveloped and Sub-Saharan African countries thatremained highly dependent on agricultural exports.

All in all, while external factors played a role,explanations of performance must be sought pri-marily in developing countries’ domestic policies.

Good performance has been associated withdomestic and external liberalization; Chile, India,China, and other countries in East Asia are all moreopen than in previous decades and have movedtoward greater reliance on market forces. But manyaspects of these countries’ policies are still far fromcompliant with conventional wisdom. For example,India has registered fiscal deficits several times higherthan Brazil’s or Argentina’s, with lower inflation andlower interest rates.While this fiscal trend is clearlyunsustainable in the long run, and measures havebeen taken to correct it, it is clear that there is moreto macroeconomic stability than a superficial read-ing of the size of the fiscal deficit. China has builtextremely large contingent liabilities related tounfunded pensions and nonperforming loans in thebanking system.While, again, this is not a sustainablesituation, it suggests that economies do not operatein mechanical ways, and that dynamism in one sec-tor can offset the cost of inefficiency in others. Sim-ilarly, India’s and China’s industries, thoughincreasingly competitive in export markets, remainprotected and state enterprises still play a large(though declining) role in these economies.

The mismatch between predictions and results,and the successes of China, India, and Vietnam

intermediaries channeled to state enterprises andrelated borrowers,contributing to the massive crises.In some cases, lack of competitive political forcesand such institutions as a free press allowed thosewho were politically well connected to take advan-tage of privatizations and to take control of naturalresources while enabling corruption to flourish.

These explanations are not mutually exclusive;one or more may apply to specific country circum-stances.The experience also holds some deeper les-sons. For example, while at one level Argentina’sexperience teaches that fixed exchange regimesrequire a very demanding set of conditions,a deeperlesson is that rigid rules are no substitute for credi-bility, and that government’s discretion needs to bechecked, not replaced with rules. Another deeperlesson is that the reforms of the 1990s did not focuson the binding constraints. For example, theyreduced fiscal deficits when perhaps the bindingconstraints were lack of public capital and aggregatedemand. Or they reduced tariffs on imports whenperhaps the binding constraint was the workings ofthe financial sector. Or they focused on correctinggovernment failures, when the binding constraintswere market failures.

3. Lessons from the 1990s

Promote Growth, Not Just EfficiencyReforms need to go beyond the generation of effi-ciency gains to promote growth.The policy focusof reforms in the 1990s enabled better use of exist-ing capacity but did not provide sufficient incen-tives for expanding that capacity. While thisemphasis on efficiency was warranted at a time ofextremely large distortions and waste, it alsoexplains the frequent instances of stabilization with-out growth or liberalization without growth.Theexperience highlights the importance of the invest-ment climate, and of providing predictable condi-tions for investors and other economic agents.

It also highlights that growth entails more thanthe efficient use of resources. Growth entails struc-


where there were substantial deviations from thefull package of reforms, suggest several possibleexplanations. First, sufficient time may not have yetelapsed for results to emerge in all countries. Overtime,market-oriented reforms may ultimately yieldthe results expected. Growth rates in African andother developing countries have rebounded since1997; Argentina is experiencing its second year ofrapid growth after the collapse of 2001–02; andgrowth rates in Eastern Europe have increased. Sec-ond,perhaps the reforms implemented in the 1990swere not sufficiently ambitious. Insufficient fiscaladjustment in Latin America, very partial privatiza-tion in Africa, and insufficient openness to interna-tional trade in the Middle East and Northern Africamay explain performance below expectations inthese regions. A third possible explanation is thatthere were incoherencies in the implementation ofpolicies.Argentina introduced a rigid exchange ratewithout the fiscal and financial conditions neededto sustain it. Fiscal adjustments in some Africancountries were achieved at the cost of reducing pro-ductive public spending. Open capital accountsencouraged pro-cyclical flows. Correction of theseincoherencies may enable growth to resume.

Perhaps most important, while reforms in the1990s focused on increasing the role of markets anddecreasing the role of the state, they tended to neg-lect the role of institutions. Francisco Gil Diaz,Mexico’s Minister of Finance (as quoted in Krueger2004), recently suggested that

The policies that have been undertaken arenot even a pale imitation of what marketeconomics ought to be, if we understandmarket economics as the necessary institu-tional framework for a sound economy tooperate and flourish.What has been imple-mented throughout our continent is agrotesque caricature of market economics.

State enterprises were privatized without muchattention to the operation of the markets in whichthey would function.Financial liberalization swelledthe resources, foreign and domestic, that ineffective

tural transformation, diversification of production,change, risk taking by producers, correction of bothgovernment and market failures,and changes in poli-cies and institutions.It is also a process of social trans-formation: people will change activities and live indifferent places. Social relations will change, and theinformal networks of rural life will be lost as othermore formal networks and organizations are estab-lished. Entrepreneurs will invest in new machineryto produce new products and adopt new organiza-tional forms.Farmers will adopt new farming meth-ods and change their product mix.The economy willproduce and demand different goods and services.These changes take place over time, alongsidechanges in institutions that render them possible.Anygrowth strategy needs to include actions, both onthe policy and the institutional front, that address andsupport this process of change.

Better policies can bring efficiency gains, andmay increase incentives for investment, but withoutamounting to a growth strategy.They will not nec-essarily induce the behavior by private investorsand the public sector that is needed to put an econ-omy on a sustained growth path. For this, fasteraccumulation of physical and human capital byboth the private and the public sector are essential,as are gains in productivity.

This may explain why the growth impact of thereforms of the 1990s was smaller than expected.The incentives needed to expand productive capac-ity (“expanding the frontier” in economists’ parl-ance) differ from those that are needed to useexisting capacity better (“movements toward thefrontier”). What matters for growth is less thedegree to which policies approximate the ideal than“the extent to which a given development strategyis able to mobilize the creative forces of society andachieve ever-higher levels of productivity” (Alejan-dro Foxley, in World Bank 2005b). And, in AlbertHirschman’s words (1958):

Development depends not so much on find-ing optimal combinations for givenresources and factors of production as oncalling forth and enlisting for development


purposes resources and abilities that are hid-den, scattered, or badly utilized.

In retrospect, it is clear that in the 1990s we oftenmistook efficiency gains for growth.The “one-sizefits all”policy reform approach to economic growthand the belief in “best practices” exaggerated thegains from improved resource allocation and theirdynamic repercussions, and proved to be both theo-retically incomplete and contradicted by the evi-dence. Expectations that gains in growth would bewon entirely through policy improvements wereunrealistic. Means were often mistaken for goals—that is, improvements in policies were mistaken forgrowth strategies, as if improvements in policieswere an end in themselves. Going forward, the pur-suit of policy reforms for reform’s sake should bereplaced by a more comprehensive understanding ofthe forces underlying growth. Removing obstaclesthat make growth impossible may not be enough:growth-oriented action, for example on technolog-ical catch-up, or encouragement of risk taking forfaster accumulation, may be needed.

Common Principles and Diverse Ways toImplement ThemAnother mistake often made in the 1990s has beenthe translation of general policy principles into aunique set of actions.The principles of the 1991World Development Report, “macroeconomic stabil-ity; domestic liberalization, and openness,” havebeen interpreted narrowly to mean “minimize fiscaldeficits, minimize inflation, minimize tariffs, maxi-mize privatization, maximize liberalization offinance,”with the assumption that the more of thesechanges the better, at all times and in all places—overlooking the fact that these expedients are justsome of the ways in which these principles can beimplemented.

There are many ways of achieving macroeco-nomic stability, openness, and domestic liberaliza-tion. As seen above, for example, the goal ofachieving macroeconomic stability does not imply aneed to minimize fiscal deficits at all times.A lower

successful growth experiences in eight East Asianeconomies, reported in the World Bank’s East AsianMiracle (World Bank 1993), resulted from diversepolicy and institutional paths, but common func-tions were fulfilled along these paths.4This perspec-tive has several implications.

First, different policies can yield the same result,and the same policy can yield different results,depending on country institutional contexts andunderlying growth strategies. This nonformulaicresult holds not only for the eight East Asianeconomies featured in the 1993 study, but also for alarger set of countries 10 years later.Countries withremarkably different policy and institutional frame-works—Bangladesh, Botswana, Chile, China,Egypt, India, Lao PDR, Mauritius, Sri Lanka,Tunisia, and Vietnam—have all sustained growth inper capita income at rates above the U.S. long-termgrowth rate of close to 2 percent a year.

Second,common to all successes is that four func-tions have been fulfilled: rapid accumulation of capi-tal, efficient resource allocation, technologicalprogress, and sharing of the benefits of growth.Ratesof progress in these four functions have not alwaysbeen uniform,but successful countries have achieveda balance among them over time, and disruptionshave ensued when the balance was not achieved.While there can be substitution temporarily, the bal-ance will need to be reestablished at some point.

For example, Korea’s policies in the 1960s and1970s sought to encourage risk taking by the pri-vate sector. Import protection and priority lendingcontributed to higher levels of capital accumula-tion, at the cost of efficient allocation, whichbecame a more important priority in the 1980s.The Soviet Union, well into the 1960s, grew rap-idly on the basis of sacrificing consumption, accu-mulating capital, and maintaining a relativelyequitable income distribution. But its considerableprogress in science and technology was not effec-tively deployed in production and,more important,resource allocation was enormously wasteful.Even-tually, the costs of this inefficiency and the politicalreforms of the late 1980s combined to bring growthto collapse. In India, a “big push” in capital forma-


fiscal deficit achieved today through off-budget con-tingent liabilities, or through cutting back publicinvestments and thus reducing long-run growth andthe future tax base, may mean a higher fiscal deficitin the future. A lower fiscal deficit does not evenguarantee greater macro-stability if it is based onexternal borrowing in which interest rates arereduced at the cost of greater vulnerability toexchange rate fluctuations, or if it is based on build-ing off-budget liabilities through the banking sys-tem, which eventually translate into an increase inpublic debt—as Latin American countries andTurkey found to their cost in the 1980s and 1990s.Similarly, trade integration can be achieved throughvarious means that offset the effect of tariffs andreduce the implicit tax on exports. Duty rebateschemes, subsidized credit to exporters, and otherforms of export promotion, export processingzones, infrastructure, and transport corridors have allhelped China, India, Korea, and Mauritius to inte-grate into the world economy while keeping theirtariffs relatively high in the initial phases of integra-tion and reducing them gradually over time.Thai-land’s and Indonesia’s foreign domestic investmentregimes had few restrictions,whereas those of Koreaand India had many until very recently—but bothKorea and India found alternative instruments toaccess and adopt modern technologies. Financialintermediation can be increased by relaxing entryrestrictions in the banking system, or by improvingthe workings of the legal system, particularly thoseparts that deal with the repossession of collateral.

To sum up,“getting the policies right” mistakesmeans for ends. Clearly not everything can be rightat once, and not everything needs to be “right” forgrowth to take place—as witnessed in examplesfrom Bangladesh,China, India, Indonesia, and manyother countries.

Common Functions and Diverse Ways toAchieve ThemTo sustain growth requires key functions to be ful-filled, but there is no unique combination of poli-cies and institutions for fulfilling them. The

tion in the decades following independence wascomplemented in the 1980s—when evidence ofmisallocation and low productivity growth beganto emerge—by policies that gradually freed marketforces and increased efficiency in resource alloca-tion (Virmani 2004), thus ensuring not only thesustainability of growth but also its acceleration.

Factoring these four functions into analyses ofgrowth makes it easier to understand why bothpolicies and institutions play a role. For example,capital accumulation by the public sector requiressound tax policies and administration, sustainablemacro policies, and a bureaucracy that is capable offormulating and managing public expenditureprograms effectively and of choosing programswith high returns. Accumulation by the privatesector requires at least reasonably secure privateproperty rights, stable expectations about thefuture, a stable macroeconomy, and access tofinance. One country might strengthen privateinvestment by, say, improving expectations,whereasanother country could achieve the same result by,say, reforming the financial sector.5 Similarly, effi-ciency in allocation requires not only reasonablysound policies—such as competitive exchangerates and an open trade regime—but also institu-tions that can enforce contracts and enable marketsto function (World Bank,World Development Report2001).Technological catch-up requires not onlyinvestment and trade policies that enable a countryto attract foreign direct investment (FDI) andimport equipment, but also institutions that,depending on the country’s development stage,promote adaptive research or a patent regime.Indeed, in some instances, it is institutions andpolitical realities that define the set of feasible poli-cies, as testified by Russia’s former Minister ofFinance Yegor Gaidar (World Bank 2005b):

If I were the tsar of Russia, I would havedone everything differently… But if I weredeputy prime minister and finance minister,in a government without a parliamentarymajority and under many pressures, I wouldhave done more or less what we did.


Different policies can have the same effect, andthe same policy can have different effects, dependingon the context. In large economies, with access toforeign technology and equipment, competition andeconomies of scale lessen the efficiency cost of traderestrictions and markedly widen the scope for suc-cessful inward-oriented industrialization. Brazil,China, and India were able to develop manufactur-ing,many segments of which became internationallycompetitive, whereas in small countries such asJamaica and Uruguay, or Sri Lanka in the 1960s and1970s, the market was too small; the benefits ofinward-looking industrialization were negligible anddid not justify its costs. Sri Lanka became successfulonly after it began to liberalize imports in late 1977and follow export-oriented policies.Thus, the sameinward-industrialization policy produced differentoutcomes because country characteristics differed.

Conversely, a given policy can yield differentresults because of institutional variation. In Japanduring the Meiji industrialization and, morerecently, in Korea, public institutions were able toresist pressures from narrow interest groups. Publicenterprises were run efficiently, and state ownershipbuilt capacity in sectors that the private sector hadnot entered because of perceived high risks.Thesame policy in Bolivia, however, where publicenterprises were run for the benefit of narrowinterest groups, did not play a strategic role in theindustrialization process, and most of the enter-prises were liquidated when Bolivia had to stabilizeits economy in the 1980s. In the case of India, it hasbeen shown that in the presence of poor institu-tions, liberalization can lead to less growth thanexpected (Virmani 2004).

Like that of policies, the effect of institutionsdepends on the context. Security of ownershiprights has been achieved in different ways and todifferent extents in different country contexts. InSoeharto’s Indonesia, securing returns depended onconnections with the ruling elite. In contemporaryChina, the definition and enforcement of propertyrights depend on party and local government sup-port—and only recently have initiatives been takenin this direction. And in India, success depends on

ways in which it can be exerted effectively.Whatwas learned in the 1990s is not only that soundpolicies do not necessarily engender the institutionsof a modern economy—that institutions are notentirely endogenous—but also that institutions canprevent the adoption of growth-oriented policiesor offset their impact. Experience showed howmuch institutions matter, and how hard it is to workaround their absence or to improve their quality.Above all, the experience showed that governmentdiscretion cannot be bypassed. It is needed for awide range of activities that are essential for sustain-ing growth, ranging from regulating utilities andsupervising banks to providing infrastructure andsocial services. Improving institutions that supportthe implementation of policies, and strengtheningchecks on the use of discretion, are more promisingguiding principles than seeking to eliminate gov-ernment discretion.

Much of the complexity encountered in therealm of economic institutions is also found in theinstitutions governing political life. The formalinstitutions of democracy, for example, do not nec-essarily ensure appropriate checks on discretion,nor are those checks always absent in authoritarianregimes. Mechanisms and levels of accountabilitycan take very different forms, rarely amenable tothe simplicity of formal political institutions. Muchof the growth success of East Asian countries can beattributed to these countries’ ability to allow discre-tion by different government agencies, alongsidechecks on this discretion that made them account-able.The forms of these checks varied: an authori-tarian development-oriented political leader insome cases (Soeharto’s Indonesia, Korea in the firstdecades of its take-off), the checks and balancesinherent in complex one-party systems (China), orthe normal checks and balances of a democraticregime (India, Sri Lanka).

Prudent Macroeconomic Management Is atthe Heart of Successful Growth StrategiesAvoidance of busts usually requires avoidance ofbooms.The costs of the crises of the 1990s in terms


the functioning of a judiciary modeled after west-ern legal systems.

Sharing the benefits of growth has been impor-tant in all sustained growth experiences, and partic-ularly in countries with authoritarian forms ofgovernment, where it has helped to legitimizeregimes that often were neither fully representativenor democratic.Various policies have been used topromote the sharing of the benefits of growth.Theyinclude land reform and redistribution of otherassets; public expenditures on infrastructure (the 8-7 program in China); social spending (Tunisia);poli-cies to increase opportunities to economicallyunderprivileged groups (affirmative actions forbumiputra in Malaysia); and poverty-targeted pro-grams (food stamps in Sri Lanka or employmentprograms in India and Bangladesh).

To sum up, diversity in the form of successfulgrowth experiences should be no surprise. Eachsuccessful country was successful in its own way.

Government Discretion Needs to Be Managed and Checked, Not Replaced by RulesBecause developing countries’ societies resolveagency, predation, and collective decision-makingproblems less effectively than do those of industri-alized countries, much of the reform effort in the1990s sought to introduce policies that would limitthe discretion of national authorities in growthstrategies and minimize demands on institutions.Privatization, financial liberalization, and removal ofquantitative restrictions on imports are examples ofpolicy reforms meant not only to improve incen-tives for more efficient allocation but also to reducethe need for government discretion. Dollarization,fiscal rules,or integration in larger economic unionsare examples of institutional reforms meant toreplace government discretion by rigid rules; theyare consistent with the sense that, on balance, thecosts of failures outweigh the benefits of discretionin the workings of an activist, developmental state.

However, government discretion cannot be dis-pensed with altogether, so it is important to find

of forgone growth, social distress, and public debthighlight once again the importance of prudentmacroeconomic management.They also stress theimportance of avoiding macroeconomic vulnera-bilities, and the risks associated with indiscriminateopening of the capital account. Last but not least,they stress the importance of responding quickly todownturns. One difference between successful andless successful growth experiences is the frequencyof downturns: virtually nonexistent for China,Korea, or Malaysia, but numerous for Argentina,Brazil, and Turkey.

In addition to dealing with crises effectively, it isalso important to reduce financial fragilities andhence vulnerability to shocks.The financial crises ofthe 1990s differed from the many that precededthem because of their cost and their suddenness, andthey were much harder to predict.The risks of finan-cial integration had been underestimated and itsgains overestimated. In the 1990s in emerging mar-ket economies, the opening of the capital account tofinancial inflows triggered large surges that loweredthe costs of sovereign and private borrowing andhelped reduce inflation. For those reasons, govern-ments (with exceptions such as those of Chile, India,Korea in the early and mid-1990s, and Malaysia)encouraged these inflows. Of the 10 economies thatreceived the largest inflows, however, 7 sufferedsevere crises that took the form of large outputdeclines, higher incidence of poverty, and largeexchange rate devaluations.The three exceptionswere China, India, and Hong Kong (China).

Each crisis was preceded by a large surge ininflows that either led to appreciation of the realexchange rate and increased current accountdeficits or, as in some East Asian countries, createdan external debt maturity profile excessively biasedtoward the short term, and exposed unhedgedcommercial banks to currency and maturity risks.In current account crises—many of which arose inthe context of stabilization programs anchored on anominal exchange rate—the sequence of eventsfollowed a remarkably similar pattern: a surge incapital inflows put pressure on the exchange rate toappreciate; the current account deficit of the bal-


ance of payments increased; private-sector and gov-ernment debt exposures fed resistance to letting theexchange rate adjust; governments sought to sustainthe rate by drawing down reserves, but the policylacked credibility, or reserves were insufficient tosustain it; a large devaluation followed; and thetightening effect of the devaluation was amplifiedby the consequences of currency mismatches forthe balance sheets of banks or those of their bor-rowers and of firms. In Indonesia and Korea, forexample, where current account deficits were rela-tively small, the trigger was the need for a large debtrollover at a time when investors were retreatingfrom emerging markets and when risk perceptionswere on the rise.This was accentuated, in Indone-sia, by the uncertainty of the political transition.

The booms and busts of the 1990s are reminis-cent of some of the crises of the 1980s.They teachseveral important lessons. First, as with most liquid-ity surges, busts inevitably follow booms: avoidingthe bust requires avoiding the boom and strengthen-ing the fundamentals.Countries such as Chile,India,or Malaysia that managed inflows, including throughthe imposition of restrictions, were able to weatherthe crises much better than countries that took nosuch precautions.Can a boom be distinguished froma favorable lasting trend, ex ante? In most cases thedistinguishing factors are the volume of the surge,the pressure it puts on the exchange rate, and itsimpact on bank credit. Second, the crises of the1990s highlight the extent to which banks canamplify the consequences of a crisis, and the risksassociated with currency mismatches, including mis-matches on the borrowers’ balance sheets. Third,sovereign borrowing in foreign currencies is risky.While sovereign borrowing should, in theory, help acountry to access external resources on better terms,in practice it has encouraged governments and pri-vate firms to take excessive risks.

Move Away from Formulaic Policy Makingand Focus on the Binding Constraint(s)A vital lesson for policy formulation and policyadvice is the need to be cognizant of the shadow

at any point in time, the constraint that mostseverely limited growth, and the right sequence ofpolicies needed in each situation.There may be sit-uations in which a country needs to address manyconstraints at once, as during the transition of East-ern European countries.These situations are rare,however. In most cases, countries can deal withconstraints sequentially, a few at a time. Success inaddressing one or a set of constraints makes it eas-ier to deal with the others, and may help establishvirtuous circles.

4. Lessons from Policy and Institutional Reform Experiences in the 1990s

The economic policy reforms of the 1990s focusedon improving efficiency in the allocation ofresources through macroeconomic stabilization, lib-eralization of trade and the financial sector, privati-zation, and deregulation. Deregulation andreduction in the role of government were expectedto improve the governance of the public sectorthrough improvements in incentives for perform-ance, more transparency, and fewer opportunitiesfor rent seeking. Institutional reforms focused onimproving collective decision making and solvingagency problems through democratization, decen-tralization, and public sector reforms aimed atenhancing the efficiency, transparency,and account-ability of government activities. From 60 countrieschoosing their leaders through competitive elec-tions in 1989, the number rose to 100 by 2000.Del-egation to subnational levels of government ofpolitical, administrative, and financial powers hastaken place not only in federated states such asIndia, Brazil, and Russia but also in smaller statesand centralized states such as Bolivia and the CzechRepublic.Deregulation and privatization have beentrends virtually everywhere, even though the inten-sity of the reforms has varied significantly fromregion to region.

What have we learned from a decade of reformsin these areas?


prices of constraints, and to address whatever isthe binding constraint on growth, in the right man-ner and in the right sequence.This requires rec-ognizing country specificities, and moreeconomic analysis and rigor than does a formu-laic approach to policy making. Policy makersface the practical problem that no scientificmethod permits ex ante identification of the mostimportant constraint(s) binding growth in specificcountry circumstances, and hence the specificmeasures that are needed address it (them). Dur-ing the 1980s and 1990s, China’s approach was to“cross the stream by groping for the stones.” Con-straints were identified and dealt with as thegrowth process unfolded, through experimenta-tion and trial and error (chapters by Lim andHuang, in World Bank 2005a).

Which policy should be introduced, and when,varies considerably from case to case dependingon initial conditions and institutional endow-ments. For example, one can generally assume thatwhere hyperinflation is raging, or public debtdemands high real interest rates—as it does inArgentina, Brazil, Jamaica, and Turkey, for exam-ple— macroeconomic stabilization is the first pri-ority. Where trade restrictions are extreme andhinder utilization of existing capacity, as in manycountries of the Middle East and North Africa,reducing them will be essential. Where there isuncertainty regarding the future course of eco-nomic policies, as in Bolivia, Democratic Repub-lic of Congo, and Nigeria, financial sectorliberalization will do little to channel resources toprivate investment. Where property rights arepoorly defined and enforced, and regulation pre-vents the movement of domestic resources acrosssectors, as is still the case in some Central Asianand some African countries, trade liberalizationwill be of little effect.

Experimentation and learning is hence animportant part of the growth process.The East AsiaMiracle study highlighted that behind the miraclewas the East Asian countries’ willingness to exper-iment, and ability to learn from, not to persist in,their mistakes.This approach helped them identify,

Macro-stability Needs to Be Achieved in a Manner That Is Sustainable and Pro-Growth

The rise in real interest rates in the late 1970s andearly 1980s, combined with a variety of commod-ity price shocks, had rendered unsustainable the fis-cal stances, debt levels, and exchange rate regimesof most countries in Latin America, East and SouthAsia,Africa, and the Middle East. Performance dif-fered sharply between countries that rapidlyadjusted to these shocks (Korea and East Asiancountries in general) and those that did not (Brazil,Nigeria, and many other countries in Latin Amer-ica and Africa).

As a result, the Structuralist view that inflationand macro instability were inevitable companions ofstructural transformation and growth was replacedin the 1990s by the strong belief that macroeco-nomic stability was needed for growth.The 1990sindeed saw considerable progress in this area: fiscaldeficits declined in most countries, exchange rateswere adjusted to reflect market realities, black mar-kets for foreign exchange disappeared, and inflationdeclined virtually everywhere. However, whilemacroeconomic policies as conventionally meas-ured improved in a majority of countries, thegrowth benefits failed to materialize. In addition,financial crises were numerous, with severe adverseeffects on economic growth and poverty.

The openness of the capital account was a keysource of fragility which, combined with unsoundpolicies in the financial sector (such as currencymismatches on banks’ or final borrowers’ balancesheets in the absence of hedging instruments) andappreciation of the real exchange rate, helps toexplain many of the crises of the 1990s. Countriessuch as India have avoided appreciation of the realexchange rate, and made the opening of the capitalaccount a medium-term goal, to be realized con-tingent on strengthened economic performance(including fiscal adjustment), export diversification,and achievement of a sound banking system. Chileand Malaysia, among others, did not hesitate to taxcapital inflows when excessive liquidity threatened


to destabilize the economy,and they maintained thecompetitiveness of the real exchange rate.Thesecountries fared much better than those that openedthemselves to external liquidity surges. Notwith-standing the theoretical arguments in favor of capi-tal account openness, the evidence on growth isinconclusive and volatility clearly increased. Amajor lesson of the decade is that restrictions shouldbe placed not so much on outflows as on inflows.Obviously, differentiating an unsustainable boomfrom a positive sustainable trend can be difficult, butstandard indicators of vulnerability such as indebt-edness, evolution of the real exchange rate, and cur-rent account deficits have proven to be reliable, ifimprecise, tools.

Macroeconomic stabilization programs oftensuffered from other design flaws, which createdserious macroeconomic fragilities.While primarydeficits did decline over the 1990s, public debtincreased in most countries,whether because of thebank recapitalization costs of financial crises (as inIndonesia,Turkey),or because of the cost of contin-gent liabilities being shifted to the public sector(pensions in Argentina), or because of high realinterest rates on the public debt (as in Brazil andJamaica). Other design flaws help explain why thesearch for macro-stability may in some cases haveactually been inimical to growth. A preoccupationwith reducing inflation led some countries to adoptexchange rate regimes that ultimately proved desta-bilizing—price stabilization was achieved at the costof appreciating exchange rates. Fiscal adjustmentwas often based on highly distortionary taxes (forexample on external trade or on domestic financialtransactions); or on cuts in spending on productiveinfrastructure or human capital that proved detri-mental to sustained growth; or on borrowingabroad where interest rates were lower but currencyexposure increased risks. Hence a single-mindedpursuit of macro-stability sometimes came at thecost of public spending that might have bothincreased growth and made stability more durable.

There are two lessons to draw from this experi-ence. First, even with macroeconomic stability,macroeconomic vulnerabilities induced by policy

takes the form of a publicly announced inflationtarget—has succeeded among emerging marketeconomies during the past decade (Brazil, Chile,Colombia, Korea, Mexico, Peru, South Africa, andThailand).This institutional arrangement has theimportant advantages of flexibility (since the centralbank is not constrained in how it attains its inflationtarget) and commitment (since the central bank’sprestige is publicly put on the line).

Trade Openness, a Key Element of Successful Growth Strategies,Can Be Achieved in Many WaysDuring the 1980s, the performance of countriesthat responded to shocks by increasing their out-ward orientation (East Asian countries) contrastedsharply with that of countries that did not (LatinAmerica,Africa, most countries of the Middle Eastand North Africa). Most policy makers concludedthat openness mattered for growth and, as a result,during the 1990s,most developing countries signif-icantly reduced tariffs on imports and dismantledother forms of trade restrictions. As in the case ofmacroeconomic reforms, however, the results var-ied and, in general, fell short of expectations.Whereas openness helped efficiency and growth inmany cases (East and South Asian countries,Botswana, Chile, Mauritius,Tunisia), it failed to doso in many others. Several lessons emerge.

First, openness to trade has been a central ele-ment of successful growth strategies. Although thepaths taken toward greater integration with theworld economy were far from uniform during the1990s, the most successful developing countriesreduced barriers to international trade and foreigninvestment during the decade.

Second, trade is an opportunity, not a guarantee.Trade reforms in some countries yielded few gainsin terms of export expansion or increased eco-nomic growth, while creating social and economicadjustment costs. Liberalization of trade inArgentina in the 1980s and 1990s, and in Chile inthe early 1980s, for example, was accompanied byan appreciation of the real exchange rate that


flaws can be serious, and these can have tremendouscosts. However, indicators of sustainable macro-sta-bility are less self-evident than common indicatorsof fiscal and external stance suggest.The inability offinancial markets (as measured by country risk pre-mia) to predict most of the financial crises of the1990s provides further evidence that unambiguousindicators of risk are difficult to find.

Second, the institutions underlying macroeco-nomic outcomes and stability matter as much as sta-bility itself.There is ample evidence that budgetaryprocesses influence fiscal outcomes and that coun-tercyclical fiscal policy rules strengthen macroeco-nomic stability.Centralized budget processes lead tobetter balanced fiscal outcomes over time, andcountercyclical fiscal policies shorten cycles andnarrow their amplitude. Few governments find itpolitically appealing to run fiscal surpluses duringgood times, however.Transparent fiscal rules, withstipulated penalties for noncompliance, may beeffective in some contexts. In others, the creation ofinstitutions such as oil stabilization funds may beneeded to save windfalls.One promising example isChile’s Structural Surplus rule, which establishesfiscal policy targets adjusted for the variation ingrowth over the cycle. Other proposals, yet to beadopted, have focused on creating an independentfiscal policy council, modeled along lines similar toan independent central bank, that would set annualdeficit limits.Another institutional dimension of fis-cal policy is transparency. Uncertainty about thestate of the fiscal accounts probably played a largerole in generating the volatility of the risk premi-ums that developing-country borrowers faced dur-ing the 1990s. There is also evidence that moretransparent budgetary processes brought downdeficits and debt.

For monetary policy, institutional arrangementsare equally important to ensure that low and stablerates of inflation are achieved and maintained, andthat they last. However, there are no magic institu-tional shortcuts to monetary credibility, which hasto be earned through anti-inflationary perform-ance. The institution of an independent centralbank—with a commitment to price stability that

reduced the competitiveness of domestic industries,and incentives to exports—with adverse conse-quences for the balance of payments and the realeconomy. In some countries of Eastern Europe inthe 1990s, trade was liberalized while propertyrights were not well defined, and the institutionalbase for a market economy was not well developed.These, and other institutional issues preventing thefree movement of resources, often meant that tradereforms did not expand economic opportunitiesbut restricted them instead (Bolaky and Freund2004). Such experiences do not imply that lesstrade reform would have been desirable, but thattrade reform must be done sensibly, as part of aneffective growth strategy.

Third, countries that have successfully openedtheir economies have done so following a strikingvariety of policy approaches.They have opened updifferent sectors at different speeds (for exampleBangladesh and India). Some, such as China andMauritius, have achieved partial liberalizationthrough the establishment of export processingzones, and some have combined unilateral tradereforms with participation in regional trade agree-ments (Mexico and countries in Central and East-ern Europe that have now joined the EuropeanUnion).These differences, and differences in therange of complementary policies adopted, make itdifficult to pin down the statistical relationshipbetween trade integration and growth.The aca-demic debates on whether openness to trade causeshigher growth are riddled with problems of meas-urement, reverse causation (faster-growing coun-tries tend to open their markets more quickly), andomitted variable bias (countries that successfullylower tariffs and increase growth also adopt othercomplementary policies).

Fourth, the distributive effects of trade liberal-ization are diverse, and not always pro-poor. Tradereforms were expected to be pro-poor because inmost societies the relatively wealthy and urbanclasses have been more successful at using protec-tion for their own benefit.The expectation was thattrade reform would increase the incomes of theunskilled.Yet evidence from the 1990s on the rela-


tionship between trade reforms and poverty is todate mostly indirect. Even where trade policy hasreduced poverty, there are still distributive issues.Animportant policy lesson is that countries need tohelp the affected workers move out of shrinking(import-competing) sectors into expanding(exporting) sectors.

Fifth, the preservation and expansion of theworld trade system hinges on its ability to strike abetter balance between the interests of industrial-ized and developing nations. Though more sup-portive of development than at the beginning ofthe 1990s, the world trade system is still biasedagainst the poor. Notwithstanding a decade of sig-nificant expansion of international trade, globalmarkets are most hostile to the products the world’spoor produce—agricultural products, textiles, andlabor-intensive manufactures—and problems ofescalating tariffs, tariff peaks, and quota arrange-ments systematically deny the poor market accessand skew incentives against adding value in poorcountries. These problems are embedded in theremaining structure of protection in both industrialcountries and developing countries (the latterowing to their own anti-export biases and also tohigher barriers to trade in developing-country mar-kets), and they can be addressed through collectiveactions.Those actions are best achieved through theDoha Round and the World Trade Organization(WTO).Although there is a role for nonreciprocalpreferences and for reciprocal regional approaches,such preferential arrangements are economicallyarbitrary; they come at a cost to excluded countriesand are not the best way to generate the rightincentives for investment.

Design Privatization and Deregulation with regard to Institutional Strengths andWeaknessesPrivatization and deregulation have a potentiallylarge efficiency impact and can benefit the popula-tion at large, including the poor. But there is a needto keep expectations realistic as to what they canachieve, to establish the institutions that are key to

cally ensure this separation.The well-publicized dif-ficulties of doing business in countries such as Rus-sia show that a government can use a wide range oflaws to influence a firm’s decisions without owner-ship. Separating the commercial from the politicalrequires institutions that define and limit govern-ment powers. Notwithstanding the claims of someprivatization advocates, institutions to support awell-functioning market economy will not springup quickly in response to demand. The lack ofeffective institutions permits predation through sev-eral avenues, not just the government: in extractiveindustries, for example, the mining or petroleumfirm and the government are beholden to eachother, and either could act or collude at publicexpense.Vested interests could act through eitherthe public or private sector, and poor shareholderoversight over a firm, as well as poor public over-sight over governments, permits misappropriation.

Turning to utilities, the second major area ofprivatization during the 1990s, there are three mainlessons. First, expectations of private investment ininfrastructure have been overly optimistic—because(1) underpricing continued to be a problem thatgovernments did not fully address, (2) the risks ofinfrastructure investment were not appreciated, and(3) governments could not credibly to commit to apolicy and regulatory regime. At the beginning ofthe 1990s, the private sector was expected to entervirtually all areas of infrastructure, including roads,but experience has since shown that the risksinvolved in infrastructure investment are often toolarge to be taken up by the private sector.

Second, if privatization is overstated as a meansof severing the link between economics and poli-tics, regulation as a means of restoring the link isunderappreciated. The clearer the separationbetween economics and politics, the better it is foreach: commerce will be more efficient and politicsless corrupt. But the more complex the regulatoryissue, the more likely are mistakes, and the less likelythat bad regulation (and capture of the regulators byvested interests) will be detected. Even if detected,the poorer the institutions, the less likely it is thatbad regulation will be corrected.


success, and to design privatization strategies takinginto account institutional strengths and weaknesses.

Privatization and deregulation were key areas ofreform in the 1990s. Commercial public enter-prises, development banks, and other forms of pub-lic interventions in the economy, even when meantto address market failures, had become discreditedbecause in many instances they had failed to workwell in practice. State activist policies using discre-tion, combined with weak accountability in publicsector organizations and weak political accountabil-ity of states to citizens, were producing costs thatwere just too high.The end of communism,and thederegulation revolution in the United States andthe United Kingdom,added further impetus for thewave of privatization that swept across the industri-alized and developing world in the 1990s.

The results varied. In most countries, privatiza-tion brought unambiguous gains in terms of moreefficient use of resources, more investment, andenhanced welfare for consumers.At the same time,however, privatization itself failed to bring about allthe gains for investment and growth that wereexpected of it. It is also clear that too much wasexpected from privatization, particularly in someareas of infrastructure, but also in terms of the gov-ernance improvements it would bring. In caseswhere the overall package of reform failed to bringabout the expected growth, even the efficiencygains of privatization were put in question—a prob-lem that is particularly serious in Latin America andAfrica, where it has in some cases derailed the pri-vatization process.

In addition, the process of privatization has oftenbeen less than fully transparent and competitive, andthis has left sequels that in some cases can be costlyto repair—particularly where privatization has ledto concentration of economic power, as it has inmany parts of Africa and Eastern Europe.

Privatization is not just finding “better owners”than the government but about changing gover-nance to separate the commercial from the politi-cal. As is now widely accepted, governmentownership of a commercial firm makes this separa-tion difficult. But privatization does not automati-

Third, the reform experiences of network utili-ties clearly show that there is no universally appro-priate reform model, and that privatization is notnecessary or indispensable for every country. Everyrestructuring and privatization program needs toexplicitly consider the specific features of each sec-tor (its economic attributes and technology) as wellas the country’s institutional, social, and politicalcharacteristics. Important lessons in this respect areas follows:

• Regulatory reform should promote competi-tion, not control; competition is the most effec-tive regulator.

• Getting the economics right is key.Understand-ing the source of benefits helps in structuringthe reform.A pricing policy that does not allowadequate revenue cannot improve the situationeven if a utility is privatized or an independentregulator is established. For example, as of 2000,in almost all Commonwealth of IndependentStates (CIS) countries, household electricityprices covered less than 50 percent and indus-trial prices were less than 70 percent of the long-run marginal costs of supply.

• Institutions differ, and hence regulatory agenciescannot be easily transplanted. Countries differgreatly in their economic structures and in theirinstitutionsæthe whole chain that includescourts (where appeals are made), legislatures(where laws are passed), the press (which informsthe electorate), an engaged public (whichdemands more from governments), and acade-mia (which trains regulators and encouragesstudies of problems).These institutional differ-ences across countries determine why what issound regulation in one country is ineffectual inanother.They are analogous to the differences inperformance of state-owned firms: they are dis-appointing in some countries (India, Mexico)but not in others (Sweden or France).

Pensions are an area in which the private sec-tor’s contribution has most clearly fallen short ofexpectations. Eastern European countries with


almost universal pension coverage trimmed thebenefits of their defined benefit schemes, out of fis-cal necessity. Many Latin American countriessought to phase out their defined benefit schemesand replace them with mandatory coverage by pri-vate providers through defined contributionschemes. Few of these schemes have lived up totheir billing: despite favorable demography theircoverage remains low because of the small size ofthe private formal labor market; their administrativecosts have been high, partly because insurance costsare included and partly because of start-up costs,and they remain dependent on governmentfinances because there are few securities besidesgovernment paper to invest in.There was really noway to isolate these countries’ social security andpension schemes from their governments withoutallowing them a greater range of investment inexternal markets.

The Impact of Financial Liberalization onGrowth Depends on Underlying Institutionsand on Macroeconomic Management Over the 1980s and 1990s, as part of the generalshift to a more market-oriented economy, theapproach to finance shifted away from holdingdown interest rates, limiting competition, and rely-ing on governments to allocate credit and towardmore market-based, internationally open systems.Financial liberalization reflected the reaction to thecosts, corruption, and inefficiencies of financialrepression; the demands of government and thepublic for more financial resources and services; andthe pressures from greater trade, travel, and migra-tion, and better telecommunications.

Contrary to expectations, financial liberaliza-tion did not add much to growth, and it appears tohave augmented the number of crises.As expected,deposits and capital inflows rose sharply as a resultof liberalization.But, other than in a few East Asianand South Asian countries, capital markets did notprovide resources for new firms. Numbers of stockmarket listings declined, even in the newly createdmarkets in the transition countries that were some-

tribute to capital flight and devaluation), bank clo-sure, and handling of explicit and implicit guaran-tees to depositors; experience in the 1990s suggeststhat it is difficult to avoid socializing the losses anda fall in output. Further, open capital accounts andvolatile international capital flows place a large pre-mium on sound macroeconomic management.Internationally, few attempts have been made toreduce the volatility of capital inflows (reducingvolatility depends on limiting the upside, not justtrying to stop outflows when a crisis develops).Chile’s implicit taxes on short-term inflows appearto have had some success in extending maturities,reducing inflows, and limiting volatility againstsmall shocks, albeit at the cost of reducing creditavailability to the private sector (Edwards 1999;Forbes 2003). Part of India’s success in avoiding a1997 crisis stemmed from its limits on banks’ (andfirms’) offshore borrowing, even as it allowedinflows into the stock market and eased direct for-eign investment. Indonesia’s limits on state banks’external borrowing did reduce their growth, butexcessive inflows to private banks and corporationswere a major factor in the 1997 crisis. Except forChile’s taxes on short-term flows and someattempts to hold down interest rates, countries havemade few attempts to remove the incentives tobanks for increasing their offshore borrowings. Allattempts at limiting excessive inflows depend onpolitical will to restrict them during a boom. Inpractice, countries often have eased restrictions oncapital inflows to prolong a boom with negativeconsequences when the flows necessarily slowed.

Improvements are being made in regulation andsupervision in an attempt to limit financial crises,but experience in the industrial countries, wherepolitical and economic power is more diffuse thandeveloping countries, suggests that this will not beeasy. In the United States, for example, financialeconomists have raised concerns about some U.S.banks being too big to fail. Also in the UnitedStates, political forces and regulatory forbearanceare often cited as contributory factors in the savingsand loan crisis. In many developing countries a fewlarge banks, often state-owned, dominate the sys-


times used for privatizations. Also, although rele-vant time-series data on access are weak, and con-trary to expectations, it appears that access tofinancial services did not improve substantially afterliberalization.

The explanation for these disappointing out-comes lies largely in weak institutions, concentratedeconomic and political power, and macroeconomicshocks. The implicit and explicit guarantees thatwere extended to depositors and investors weak-ened the market discipline that might have limitedthe activities of weak lenders. By the end of the1990s, much of the deposit growth had beenabsorbed by central bank debt and governmentdeficits.The state banks, which remained importantduring the 1990s, and financial industrial conglom-erates used their increased deposits to expand lend-ing to state enterprises, well-connected borrowers,and other parts of financial-industrial conglomer-ates.Regulation and supervision were weak,reflect-ing not just technical problems but also politicalpressures for leniency. Eventually the poor qualityof lending was exposed in crises, as were the weak-nesses of the bank privatizations in the context ofthe weak institutional environment and the exclu-sion, in many cases, of international banks.

The lack of improved credit access reflected notonly the preemptive borrowing by the public sectorand central banks but also weak informational andlegal frameworks.Lack of information on borrowershindered lenders and gave borrowers no incentiveto maintain a good credit record.Weak legal andjudicial frameworks (designed to protect borrowersand often responsive to economic and politicalelites) reduced the incentives to service debts; theymade it difficult for new borrowers to gain access tofinance by pledging collateral effectively and made itdifficult for lenders to execute collateral.

The 1990s reinforced the old lesson that suc-cessful financial liberalization depends on macro-economic management. No banking system,however sound in principle, can withstand a seriousmacroeconomic crisis. Dealing with a banking cri-sis is quite complex, involving highly political issuesof liquidity support to banks (which can easily con-

tem. Bankers and major borrowers are often oneand the same. Limits on connected lending are aproblem because the industrial-financial groups arealso the main entrepreneurs in many countries,even large ones. If problems of loan quality develop,the political strength of the economic and politicalelite will likely lead to regulatory forbearance inloan classification and provisioning standards.Thesekinds of problems suggest that attempts to improvethe regulatory and supervisory framework need toinclude a substantial effort to improve market disci-pline, through better information on the banks andcredible limits on deposit guarantees. Increasedentry of well-known foreign banks, which have areputation to protect, can also improve the func-tioning of the system.

Thus, in finance, the 1990s may best be regardedas a transition period.The high expectations for lib-eralization were met only in resource mobilization.Resource allocation, which makes a key contribu-tion to development, did not generally improve.However, much of the debris of the old financialsystem was removed by the crises, albeit by govern-ment recapitalization bonds that now representmuch of the system’s assets.

As the connecting link between savers andinvestors, the contribution of finance to growthdepends not only on macroeconomic stability andreasonable interest rates, but also on the quality offinancial intermediaries and information and of thelegal and regulatory framework. Improving thecontribution of finance to development willdepend not only on market-based finance but alsoon sound institutions, appropriate incentives forlenders, further improvements in informational andlegal frameworks and, ultimately, on a more com-petitive political system that is able to reduce thepower of political-economic elites and their abilityto tap the financial system.

Pragmatic, Incremental Approaches to PublicSector Governance Are More EffectiveEconomic performance depends partly on gover-nance, which in turn is shaped by underlying insti-


tutions, defined broadly as the “rules of the game”that shape the behavior of organizations and indi-viduals in a society (North 1990, 3).6 A crisis ofgovernance of varying intensity pervades much ofthe developing world, with the poor paying theheaviest price for it.

Public sector reforms in the 1990s sought tochange the structure of organs of the state, andincentives within them, in the hope of improvinggovernment efficiency and responsiveness. Frommega-reforms such as decentralization to lesssweeping reforms in budget or personnel manage-ment, the aim was to find a balance between thediscretion of politicians and bureaucrats over policymaking and policy implementation and theiraccountability for decisions and actions.The fall ofauthoritarian regimes and the consequent spread ofdemocratic processes constrained the previouslywide discretion of many governments. Decentral-ization sought to further limit central governmentdiscretion while granting local governments moremanagerial autonomy. Legal, judicial, and legislativereforms were initiated to establish institutionalchecks on executive power. Public managementreforms sought to give public managers more flex-ibility in decision making while demanding greateraccountability from them for their decisions. Per-haps partly because of the immense difficulty ofaddressing problems in political institutions, manycountries and donors in the 1990s focused largelyon reforming legal and judicial systems—a channelof political accountability that seemed moreamenable to technocratic solutions, often usingmodels directly transplanted from industrializedcountries.

Most of the reforms had little effect on behav-ior.The ills that they sought to treat—nonmerito-cratic civil services, weak financial controls, opaqueor incoherent budget processes—are deeply rootedin local political and institutional arrangements thatfavor the status quo.

The decade was not all discouraging, however.Homegrown initiatives gave hope for improvinggovernment performance. In some instances, civilsociety engagement and participation and innova-

Politics: Checks and Balances Are Central toAccountability and Results, but There Is NoSingle Way to Achieve Them

Institutions resolve a number of problems in soci-ety, of which two are particularly important: collec-tive decision-making processes, and principal-agentproblems.7 Not all preferences can be representedin collective decision making, and principal-agentproblems can be reduced but never resolved.

Both theory and evidence suggest that the for-mal rules of democracy do not ensure efficient,accountable, and credible government, and con-versely that nonelected governments are not inca-pable of responding to citizens or of actingaccountably. Though the number of elected gov-ernments grew significantly in the 1990s, thedecade produced no clear evidence that electedgovernments perform better in delivering policiesbenefiting average citizens than do nonelectedones.The experience did confirm, however, thatrelative to the situation in richer democracies, pri-vate investors in most developing-country democ-racies receive less enforcement of their contractualand property rights, and average citizens are not aswell treated by the state as special interests.

By the close of the 1990s, we had begun tounderstand the complicated interaction of formalpolitical institutions with informal rules and norms.Elected governments are most likely to make poli-cies at the expense of the majority and in favor ofnarrow segments of the population when citizensare badly informed about what government does,when political competitors cannot make crediblepromises to voters, and when society is polarized.Evidence shows that uninformed or polarized citi-zens and noncredible politicians undermine theconnection between voters and politicians indemocracies. Long-run economic growth and theprovision of public goods are significantly higher indemocracies with more credible politicians, betterinformed citizens, and less social polarization.Non-democracies vary substantially as well: those thathave internal checks on the exercise of discretionby the executive seem to perform better, both in


tive applications of information technology led toimprovements in transparency and accountability inpublic decision making and consequently to someincrease in government responsiveness, efficiency,and effectiveness.The challenge is scaling up theseinitiatives, given political constraints and historicalinertia.

The designs of governance reform strategies inthe 1990s typically fell into two broad types: “bigbang” or ad hoc incrementalism. Big bangapproaches proved to be largely inconsistent withcapacity constraints and political realities. Theirmain results were major changes in formal rules:new or amended constitutions, new legislation,ostensibly independent courts and audit institu-tions, and so forth. Meanwhile, the informal rulesshaping the incentives that face politicians, bureau-crats, and citizens remained in place.

Ad hoc incrementalism has also been problem-atic. Many of the ad hoc reforms were symbolic,intended to preserve the old informal rules whilepretending to reform. Some represented well-moti-vated attempts of individual or small groups ofreformers who,for lack of support,were underminedby jealousy, intrigue,or fatigue.More important, theytended to be unrelated to a more coherent reformstrategy and thus over time many lost their steam.

An important general lesson is that technocraticresponses to the governance crisis work only in veryauspicious settings—where there is committedleadership, a broad-based coalition in support ofreform, and sufficient capacity to carry the reformprocess forward. Clearly, these conditions exist inonly a few developing countries, and rarely in thosethat most need governance reform.

State building is a complex process that requirestime, leadership, and social capital. Governancereforms have to find a delicate balance consistentwith the country’s politics,history, and culture.Whatmay be needed are highly focused, pragmatic inter-ventions that may be termed “strategic incremental-ism.”These interventions are opportunistic becausethey exploit the willingness to reform, but they aregrounded in political realities and consistent withthe capacity constraints of the country concerned.

terms of growth and public policy performance,than others.The lesson here is that governments ofall kinds, elected or not, are most credible and mostlikely to respect property rights when they facechecks and balances on their decision making.

Another lesson of the 1990s is that policies failwhen citizens cannot hold politicians accountablefor poor performance and when governments can-not make credible commitments. Credible, sustain-able reform depends on the checks and balancesprovided through political institutions. In democ-racies, checks and balances and elections preventarbitrary policy reversals by governments. But theyare not the only means to hold governmentsaccountable: broad-based political parties can insome circumstances substitute for democraticchecks and balances in one-party states.

5. Operational Implications

The complete operational implications of this studystill need to be fully developed. Some preliminaryideas are outlined below.

For Analysis

On the analytical front, the first implication is theneed to redress the balance between analysis of pol-icy instruments and analysis of strategies—understand-ing strategies as coherent sets of actions that areintended to initiate and sustain growth. Over theyears, in institutions such as the World Bank, thefocus of research gradually has shifted away fromcountry-specific growth experiences to focusincreasingly on policies—trade, finance, macro, pri-vatization to name a few—with secondary impor-tance given to country contexts.8 At the same time,outside the World Bank there has been increasingemphasis on individual country experiences (forexample, Rodrik 2003b, and the research programssponsored by the Global Development Network).

The second implication is the need to recognizecountry specificities in country economic analysis,acknowledging that policies are conceived and


implemented within a specific institutional, social,and historic context. Recent economic and sectorwork at the World Bank already seeks to achieve abetter balance between country specificities and thelessons from country experiences, but more isneeded fully to recognize that country-specificmarket structures and institutions have a stronginfluence on policy outcomes. In particular, thisrecognition calls for harder and more rigorous eco-nomic, institutional, and social analysis.

Third, analytical work needs to change its orien-tation, away from seeking to assess how far policiesdiverge from optimality, to seeking to assess whatpolicy and institutional conditions—for capitalaccumulation, shared growth, productivity growth,and risk taking in a country-specific context—areneeded to set the growth process in motion.

For StrategyThere is a need to rethink the focus of growthstrategies and of development assistance. Up tonow, that focus has been on the nation state withthe implicit assumptions that (1) developmentoutcomes within the boundaries of a nation stateare homogeneous, and (2) all developing coun-tries’ per capita incomes could and should con-verge with those of industrialized countries.Thereis now greater evidence and acknowledgment thatthese two assumptions do not always hold. Con-vergence is much less a force now than anticipateda decade or more ago.Within countries such asBrazil, China, and India, income differences acrossregions are as large as income differences acrosscountries, and even in relatively small Bolivia,income differences between the lowlands and thehighlands are large.This recognition implies a needto pay much greater attention to the forces drivingagglomeration and migration, both within andacross countries.

For ResearchOn the research front, two issues in particular war-rant further examination.The first relates to devel-

For BehaviorOn the behavioral front, if solutions must be foundin specific-country contexts, rather than appliedfrom blueprints, those who advise or finance devel-oping countries will need more humility in theirapproaches, implying more openness on the rangeof solutions possible, more empathy with the coun-try’s perspectives, and more inquisitiveness in assess-ing the costs and benefits of different possiblesolutions.

Notes

1. See Country Note 3, “Poverty and Inequality:WhatHave We Learned from the 1990s?”

2. Countries successful at “converging” include mostSouth Asian countries (Bangladesh, Bhutan, India,Nepal, Sri Lanka); many East Asian countries (China,Indonesia, the Republic of Korea, Lao PDR, Malaysia,Thailand, Vietnam); and Botswana, Chile, the ArabRepublic of Egypt, Lesotho, Mauritius, and Tunisia. SeeCountry Note 2, “Lessons from Countries That HaveSustained Their Growth.”

3. This point of view was reinforced by the fiasco of thecollapse of the Southern Cone stabilization programsof the late 1970s, in which strong currency apprecia-tions combined with rapid reductions in tariffs to cre-ate an adverse shock to industry, ultimately derailingthe stabilization programs. Most analysts soon blamedthe collapse on excessive speed, leading to faultysequencing of the reform program: they argued thatcapital accounts had been liberalized too soon, withoutwaiting until fiscal probity had been established andboth trade and the domestic financial system had beensuccessfully liberalized.

4. This study reviewed the growth experience of eighteconomies: China, Hong Kong (China), Indonesia,Japan, Korea, Malaysia,Taiwan,Thailand, and Singapore.The report highlighted the variations in policy andinstitutional environments under which theseeconomies reached unprecedented rates of growth. Itemphasized that, with few exceptions, the state in theeconomies studied had taken an activist role to stimu-late risk taking in both the private and the public sector.It concluded that while highly successful in East Asia,the institutions needed for replicating this activist rolemay not be present in other contexts.

5. It has been argued, for example, that the increase inIndia’s growth rate in the early 1980s was less the result


opment agencies’ role in aid-dependent countries.The agencies’ large role in financing the budgethas forced them to be involved in budgetprocesses, weakening national decision makingand rendering the concept of “ownership elusivein practice” (Kwesi Botchwey,World Bank 2005a),particularly in aid-dependent Africa.Clearly, formsof engagement developed for project finance donot apply to budget finance.There may be a needto explore new approaches to the transfer ofresources to these countries, rooted in publicfinance, such as those typically used in federatednations that have chosen rule-based, arms-lengthsystems of transfers.

Second, the unit of analysis for economic andsocial development has traditionally been the nationstate, reflecting the assumptions (outlined above)that nations are homogeneous and that all nationswould be able to catch up to the income levels ofindustrialized countries. There is a rich researchagenda on these assumptions that needs to be artic-ulated. All nations may not succeed in reachingindustrialized countries’ income levels within a rea-sonable time frame—partly because institutions cantake such a long time to develop, but also becausethe economics of agglomeration and poles of devel-opment do not necessarily follow national bound-aries. Research in this area may yield importantimplications for the role of nations and migration,and also for the optimal degree of discretion regard-ing national policies.

For OperationsOn the operational front, the recognition that noteverything needs to be right for growth to succeed,and that partial success may sometimes be a morepragmatic goal than optimal policies, has obviousconsequences for the type and extent of condition-ality associated with development lending.Again inthis case, more rigorous economic analysis shouldhelp to distinguish what are binding constraints,and thus to inform decisions.The record suggeststhat forecasts need to be realistic and mindful of theforces driving growth.

of the reforms introduced at that time than of the pri-vate sector’s changing expectations regarding thefuture—where the government was credible in ensur-ing reduced expropriation risks and a more welcomingenvironment (Rodrik and Subramanian 2004).

6. Public sector governance refers to how the stateacquires and exercises the authority to provide andmanage public goods and services. Corruption, whichrefers to the use of public office for private gain, is the


mirror image of governance: bad governance invariablyleads to corruption; but corruption can likewise perpe-trate bad governance.

7. The principal delegates the implementation of a task toan agent but must monitor the agent efficiently toensure that the task is accomplished.

8. A recent World Bank research project focusing on indi-vidual country experiences is Aid and Reform in Africa(2001).

Facts of the 1990s

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