TCS Daily

The Washington Consensus Gives Way to a Keynesian Consensus

By Christopher Lingle - August 31, 2005 12:00 AM

A new consensus - or, at least, a return to an old consensus - seems to be forming in response to the hiccups seen in the New Economy. The so-called Washington Consensus is being pushed out in favor of a Keynesian Consensus.

Under the Washington Consensus, countries would prosper through open trade relations with fewer government interferences in their economies, competitive financial markets and fiscally prudent macroeconomic policy. As such, these neo-liberal policies are required of countries that seek the assistance of Washington-based international financial institutions.

Among the policy changes usually required are greater fiscal discipline and tax reform that lowers marginal rates while broadening the tax base. Suggested financial sector reforms would include interest rate liberalization, introducing competitive exchange rates and liberalizing inflows of foreign direct investment. Similarly, privatization and disinvestments by government agencies are promoted as is deregulation to abolish entry and exit barriers.

Finally, there are pressures to liberalize trade to allow greater competition and choice for consumers and producers within a context of more secure property rights. But there is no consensus in Washington or elsewhere on the best combination of these remedies.

But now a new Keynesian Consensus seems to be creeping back into the policy psyche. The principal elements of Keynesian remedies include deficit spending and forcing down interest rates to expand credit. The aim is to "reflate" economies suffering from shortfalls in overall demand. Other related policies may include some form of controls on international capital. In all instances, these policies ensure that the political status quo remains unchallenged and unsullied. Little wonder they attract so much support from politicians.

Revival of this once-discredited body of Keynesian theory has encouraged more activist involvement by governments in markets, including throwing taxpayer money at public projects and easing credit policy through monetary expansions. It should be remembered that such actions led to a widespread phenomenon known as "stagflation" where rising inflation was accompanied by high unemployment and slow economic growth.

A clash of ideas on whether to liberalize an economy to change its structural components or to tinker with macroeconomic policy is prominently on display in Asia. At issue here is the nature of the current problems in the global economy as well as what might be done to correct them. In searching for answers, one must first offer an informed diagnosis. Only then can proposed remedies be deemed appropriate and credible. Like medical doctors with different opinions on the condition and fate of their patients, there are opposing views on how we got where we are and what to do next.

And so it is that Keynesian theory has been rehabilitated and is being used to guide choices of tools and economic policies. As such, many of Asia's powerhouse economies have been playing games with some combination of fiscal pumping or monetary pumping. These actions have been aimed at boosting aggregate demand including providing support for neo-mercantilist policies that encourage exports.

In Korea, the central bank has kept its benchmark interest rate at record-low levels that are now below those of its US counterpart for the first time in modern history. Thaksinomics in Thailand is merely a regional version of warmed-over Keynesian pump priming combined with ethnic nationalism.

Japan has been trying to implement macroeconomic policies to improve growth and employment since its bubble deflated in the late 1980s. Yet all it has to show for near-zero interest rates is an enduring period of slow growth and massive public-sector debts.

China's experience with macroeconomic policy intervention has had mixed results. Beijing has been running large fiscal deficits to support massive spending on fixed assets. So far, this has yielded high rates of economic growth based primarily upon an illusory and unsustainable export imbalance with the US. But China's "bubble" will pop just as surely as did Japan's and as did East Asia's in 1997.

Instead of Keynesian tinkering, it would be better if Asia's economies were subjected to a long-term adjustment process to correct systemic defects and change the "institutional infrastructure". Frustratingly, this means that the region must endure a long period of slower growth that will be brought about by rising interest rates, higher unemployment and perhaps falling per capita income. Unfortunately, these adjustments are a response to excess industrial capacity and continuing problems with excessive bad debts.

Correcting Asia's current economic problems that stem from systemic flaws requires structural and long-term remedies so that domestic institutional arrangements are more compatible with a competitive market economy.

Some of these remedies are straightforward and reasonably uncontroversial. Attention should be paid to both corporate and political governance as well as increased flexibility of labor markets. And there must be more reliable economic data from governments and enterprises so that budgets and monetary policy are more transparent while implementing international standards for accounting methods as well as for disclosure and bankruptcy. At the same time, there must be reduced corruption and greater independence of judges from influence of other branches of government.

In all events, the emerging Keynesian consensus is a mixture of wishful thinking and poor diagnosis so that the cures will be ineffective, at best. Most likely though, they will be counterproductive by providing governments with a distraction from the restructuring they must undertake if they wish to provide the basis of a robust recovery towards a sustainable growth path.

Christopher Lingle is Global Strategist for eConoLytics.


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