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 No Short-cuts to Development Remarks by Lawrence H. Summers Deputy Secretary of the Treasury To the IDB Conference on Development Thinking and Practice


9/4/1996

I am honored to have this opportunity to address so distinguished a group of people concerned about development thinking and practice. I would like to thank President Iglesias for inviting me to speak.

Consider for a moment the purpose of development. It is not just about low inflation rates or vibrant stock markets, although these are important. The ultimate objective of development is improved living standards for all people.

In the last 25 years we have seen unprecedented progress in improving living conditions. Average infant mortality rates, for example, have been nearly halved, and average per capita incomes have doubled. But there has been enormous diversity of experience. Among regions, striking dissimilarities have emerged.

Per capita growth rates in Asia reached an impressive 7% last year, while in Africa the average has been just 1-2% per year in good years.

Income distribution in East Asia is much more equitable than in Latin America. In Indonesia, the richest fifth of the population averaged about 5 times more income than the poorest fifth, while in Brazil the ratio is 32 and in Guatemala it is 30.

In 1994, the average infant mortality rate in Africa was more than double the infant mortality rates in both East Asia and Latin America.

What policies have shaped these disparate outcomes? And what have we learned as a result?

There are no short-cuts...

It’s clear that there are no short-cuts in development. We have learned some profound lessons from those countries that have tried them.

The first is that inflation produces no enduring output benefit but carries a wide variety of costs. Inflation corrodes markets, discouraging the accumulation of capital and distorting its allocation. Inflation tends to hurt the poor most -- either they are ravaged by the inflation tax or they get ejected from the formal economy entirely.

And inflation undermines democracy, as Latin America has sadly seen during the course of the 20th century. Citizens will not trust governments that cannot maintain the value of their currencies and protect their savings. And governments have resorted to progressively more authoritarian measures to try maintain control while avoiding genuine economic adjustment.

Let me be clear -- I am against a high rate of inflation not because it is morally bad, or because it hurts bond-holders. Rather, experience has shown that in countries where inflation is 30% or higher, the poor stay poor.

The second lesson is that price and exchange controls inevitably create harmful economic distortions. Both the distortions and the economic damage get worse with time. Take the case of exchange controls. In most instances, they lead to layer after layer of restrictions on imports and capital flows. And when they are finally lifted, as inevitably they are, price shocks burst onto the population. These often hurt the poor most, because they have the thinnest, most thread-bare cushion for absorbing adjustments to relative prices.

Meanwhile, attempts to preserve price controls induce otherwise avoidable rationing schemes and goods shortages. And when goods disappear from official markets -- except perhaps those designated for privileged consumers -- they reappear in unofficial ones, but at much higher prices. Anyone who lived in Eastern Europe during the last 50 years, or in Cuba today, understands this phenomenon well.

A third lesson is that closed markets lock in inefficiencies and, in the long run, suppress real wages. Import substitution has been discredited as an approach to development. It has led to protection that often has been used not to nurture nascent industries but to safeguard the interests of the wealthy and well-connected.

I would even include in this last group the relatively well-off labor groups that work for protected enterprises. Not only have other workers been deprived of opportunities for employment in industries outside the system of protection, but all consumers have endured higher prices and inferior products and services.

A fourth lesson is that state-run enterprises, including state-owned banks, have a disappointing record of performance. While there are exceptions, the reality is that politics usually intrude in the operation of a public enterprise, and efficiency, financial performance and quality of service are often sacrificed.

That is why governments around the world have already shed many state-owned enterprises. The results are beginning to show. Companies that were chronic drains on public treasuries now pay taxes and plow profits back into productive investment. And services to the people improve -- the lights stay on, the phones stay connected, buses operate, the water is kept clean. Basic public services matter most to those who can’t afford to buy themselves generators or water tanks, and who depend on public transportation to get to work.

A fifth lesson is that excessive and inappropriate regulation can strangle an economy and corrupt markets. Even if they start small and are well-intentioned, regulations tend to propagate, as both the regulated and the regulator start to see mutual advantages in their relationship. Moreover, when regulation becomes pervasive, business decision-making shifts to governments, and political entrepreneurship displaces economic entrepreneurship. The poor and politically powerless don’t stand a chance when governments literally rule them out of the formal economic system.

To boil down these five lessons, we must: One, avoid inflation -- macro stabilization is an essential first step; Two, let markets set prices for goods, services and currencies; Three, open trade regimes and allow economic integration; Four, privatize state-owned companies; Five, reduce the size of government by eliminating excessive regulation.

It is tempting to assert that at least these five lessons are commonly agreed. But this does not seem to be the case.

There really are no short-cuts...

I was surprised to hear of reports in a Russian newspaper that a group of well-known economists are advocating economic policies for Russia that fly in the face of these five lessons.

Citing eroding real incomes and large increases in the number of people living in poverty, the authors reportedly argue for a relaxation of stabilization policies and an increase in government intervention in Russia’s economy. A return to reactivation.

They reportedly call for a shift to reflationary policies and a return to Russia’s two steps forward, one step back pursuit of reform. This would undermine the results of stabilization which are only now beginning to be seen in the sharp reduction of inflation this year and a pickup in industrial production in some sectors.

And, they apparently call for getting government back into the business of allocating resources. They want the government to direct investment to preferred areas -- capital investment rather than inventories. And they want the government to see that export earnings are used for suitable purposes -- capital goods rather than food or consumer goods.

In Russia, where the mind set already is one of direct allocation, and where entrenched and powerful vested interests still remain, it’s clear that the result would not be a happy one. By trying to chart a short-cut for Russia, the authors have, if the report is to be believed, looked past everything we’ve learned about the hard road to economic recovery. In so doing, they risk harming most the very people that they say the government should be trying to protect -- the poor and the middle class who have borne so much of the burden of stabilization and reform and have so much at stake in its success.

Austerity with adjustment...

This is not to discount the pain of austerity. However, I would argue that the correct policy lesson to be drawn is that austerity alone is not enough -- there must be adjustment too.

Governments can't just squeeze their expenditures and wait for the day when a resumption of growth boosts tax revenues enough to fund once again the programs that are in place. Rather, governments need to make fundamental changes to both sides of their budgets. Indeed, adjustment, if done right, can and should ameliorate the pains of austerity, at least for the poor.

Adjusting expenditures. Latin governments have frequently funded specialized hospitals and universities relatively generously. They've been less forthcoming on funds for basic preventative care and primary schools, particularly for rural populations.

-- In Nicaragua, the second-poorest country in the hemisphere, the constitution requires that 6% of the budget be spent on higher education.

-- When Argentina struggled to adjust from 1980 to 1991, the share of health subsidies going to the poorest quintile actually fell from 51% to 33%, according to a recent study.

An even greater challenge is pensions. In Brazil, a country with a per capita income of just $4200, public sector pensioners can and, in many cases, do receive larger social security benefits than their counterparts in OECD countries. I don't mean in relative terms, but in absolute terms! Clearly, there is room for adjustment, so that the current generation of workers is not bearing an unjust burden.

Another important area to refocus expenditures is on infrastructure. Frequently, governments have overinvested in new facilities and underinvested in operations and maintenance. Roads, bridges, water and sewer systems -- all have been allowed to deteriorate, imposing profound costs. And the costs have been human, not just economic -- because of deteriorating water and sewage systems, for example, cholera appeared in Latin America in 1991 after an absence of more than 100 years.

This is not to say that governments should do all of this investment -- far from it. It has been estimated that Latin America needs $50-60 billion a year in infrastructure finance over the next decade. Only the private sector can come up with this kind of money, and it will do so only when the environment is receptive.

Adjusting revenues. Almost all countries in the region need to be broaden their tax bases and improve collection. Currently, tax systems are riddled with exemptions, and even taxes that are due are frequently evaded, particularly by the rich and well-connected.

-- In 1994, Venezuela introduced a lump-sum tax deduction equivalent to 1.7 times per capita income.

-- In Guatemala, according to the IDB, inefficient tax administration and tax evasion have resulted in an estimated 50% loss of VAT and income tax revenue.

-- In Chile, there was a 25% gap between actual revenue and estimated potential revenue from indirect taxes in 1981, according to a World Bank study. More efficient administration brought this down to 17% in 1993.

Raising national savings. By making adjustments to both sides of the budget, governments can control inflation and still mobilize the resources needed to cushion the impact of austerity on the poor. At the same time, they can increase public savings or, more often, reduce dissaving.

Higher national saving rates can provide a pool of resources for investment without excessive reliance on imported capital. In Latin America, where savings rates average just 19% of GDP, countries tend to attract needed foreign savings by keeping real interest rates relatively high, discouraging investment. In East Asia, by contrast, saving rates average in the mid-30s, as do investment rates.

-- Chile stands out as the high saver in Latin America, with a 27% rate, and they've seen the advantages in both their level of investment and growth. Chile's performance is a good advertisement for governments to maintain a strong fiscal position and tackle their social insurance challenges.

Taking reform to the second stage...

It is tempting for those countries that have stabilized their economies to breathe a sigh of relief and assume that the hardest stage of development has passed. The disappointing growth rates of some of Latin America's stellar stabilizers suggests that there is much more to be done.

Developing financial markets. Just as important as raising a larger pool of national savings is ensuring that it is well invested. I've already mentioned the economic harm that can be caused by state-owned industry and the importance of privatization. Perhaps the most damaging kind of state enterprise is in the financial sector, which is most directly responsible for directing savings to productive investment.

-- Banco do Brasil, the region's biggest bank, is a good example: under state control, it managed to lose over $11 billion in 1995 and the first half of 1996.

Privatizing banks may be a prerequisite, but it is certainly not a panacea. Indeed, in virtually every emerging market country -- including those that have privatized their banks -- we have seen banking crises that have governments and economies dearly.

-- According to the IDB, Chile’s banking crisis in the early 1980s cost an estimated 19.6% of GDP; Venezuela’s 1994 crisis cost 17.0%; Argentina’s crisis of 1982 cost 13.0%.

-- The U.S. savings and loan crisis, which we found traumatic enough, cost 2.1% of GDP.

Not only do the inevitable government bailouts add to the fiscal burden, but weak banking systems also lead to higher than necessary interest rates.

Adequate prudential regulation and supervision is one essential element in developing sound financial systems -- both banking and securities markets -- reducing risks and lowering the cost of capital for investors. This is why the work of the Committee on Hemispheric Financial Issues, that has been embraced throughout the hemisphere, is so important and encouraging. The global dimensions of the problem have been recognized by the G-7 heads of government, who have delegated to their finance ministers the responsibility for developing a coordinated approach to the task of improved supervision.

Regulation and supervision should be designed not to squelch innovation. Countries need to ensure that their financial markets are deep enough and broad enough to meet the needs of savers and investors. Right now, for the most part, Latin savers can choose between cash and savings deposits, and not much else. With capital markets so thin, investors really have just banks and retained earnings as financing sources. Financial sector innovation and development -- giving both savers and investors products that meet their preferences for risk, maturity, structure and price -- is the closest thing I can think of to a free lunch for emerging economies.

Access to financial services needs to be extended to smaller-scale entrepreneurs. Although Latin America may be overbanked in some respects, it is vastly underbanked when it comes to providing small-scale, but potentially highly-profitable, credits to tomorrow's entrepreneurs. Given the promise of small-scale enterprise to the development process, I would argue that here there is some justification for governments and multilateral institutions to promote microenterprise credit at the outset by bearing some of the administrative costs of doing so.

Improving legal systems. Whenever I travel in developing countries, I hear businesspeople complain about the complexity and uncertainties created by investor-unfriendly laws and institutions that implement them with blatant partiality. I don't know how many investment opportunities are passed by because of legal and administrative uncertainties, nor have I seen reliable estimates of how much these problems raise the costs of doing business. But I've heard it often enough to conclude that it must be significant.

My suspicion is that if countries can improve the quality of their commercial and bankruptcy law, refine property rights, simplify and streamline dispute settlement procedures, and ensure that they are applied fairly and efficiently, we would see a major boost to investment, and consequently higher levels of sustainable growth.

A Role for Government

The heavy emphasis I've placed on markets in my comments should not be understood as a denial of the important role that governments must play in any sensible development strategy. One area in which the state is essential is investing in people. Indeed, I have said before that the education of young girls -- of future mothers -- may in the long run be the highest-return investment governments can make. In these areas, Latin America continues to fall short.

-- According to the UN, governments in Latin America and the Caribbean spent 4.2% of GDP on education in 1992, even less than sub-Saharan Africa, which managed 5.7%.

-- One indicator of the outcome is the percentage of a cohort reaching grade 4. While figures are not up to date, we can make some telling comparisons: in Mexico 95% of boys, but just 74% of girls persist to grade 4. In Colombia, the figures are 74% for boys and 72% for girls. In Korea and Malaysia, the figures are close to 100% for both.

Investment in health care is another critical area. For the region, there has been progress.

-- Infant mortality, for example, has fallen from 60 per 1,000 live births in 1980 to 41 in 1994, only slightly above East Asia's 35. But the regional figures mask national disparities: in 1994, Brazil's per capita income was about twice Jordan's, but its infant mortality rate was higher -- 56 per 1,000 rather than 32.

For reform to succeed in the long-run, everyone must share in its benefits. Reform and adjustment are difficult, time-consuming, and usually painful. Making these tough decisions -- and sticking to them when the going gets difficult -- requires a considerable degree of political consensus. Such consensus is possible only if political systems are open, so that all can participate in the decision-making process, and everyone -- rich and poor, rural and urban, old and young -- feel that they have a stake in a successful outcome.

We don't know all of the answers. Far from it. But we have learned a lot: we know of some things that work, and some that don't. Even with the best practices there will be mistakes, and there will have to be reversals. But with the appropriate level of commitment and determination -- in government and society -- we can make progress.



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