The Washington Consensus?

No one I have ever come across argues a point as successfully as Dr. Paul Davidson, and this subject is certainly the one that requires the most clarity - Paul has more than accomplished the task. If this single message could reach the majority of serious minded people, we would be well on our way to improving our democracy. This is a thorough, deep paper and a very welcome addition to the body of existing knowledge. It is shining a very bright light on the fallacy of classical economic thought, and its related political lopsided and academic influences pushing the world in the wrong direction. Dr. Davidson also offers real solutions to our dire economic problems - I applaud him.

Paul Davidson

I. The Washington Consensus: Classical vs. Post Keynesian Views

John Williamson coined the term "Washington Consensus" in 1989. This Washington Consensus term, however, means different things to different people and apparently even different things to John Williamson at different times. Williamson [2002] states that this consensus requires ten reforms:
1. Fiscal Discipline. This was in the context of a region where almost all the countries had run large deficits that led to balance of payments crises and high inflation that hit mainly the poor because the rich could park their money abroad.
2. Reordering Public Expenditure Priorities.... from things like indiscriminate subsidies to basic health and education.
3. Tax reform. Constructing a tax system that would combine a broad tax base with moderate marginal tax rates.
4. Liberalizing Interest Rates. In retrospect I wish I had formulated this in a broader way as financial liberalization, and stressed that views differed on how fast it should be achieved.
5. A Competitive Exchange Rate. I fear I indulged in wishful thinking in asserting that there was a consensus in favor of ensuring that the exchange rate would be competitive, which implies an intermediate regime; in fact Washington was already beginning to subscribe to the two-corner doctrine. [William has championed the establishment of FEER (a Fundamental Equilibrium Exchange Rate) target zone for the exchange rate, i.e., a zone based on a fixed competitive rate plus or minus ten percent. Williamson has argued that FEER would simultaneously achieve internal and external balance]
6. Trade Liberalization...
7. Liberalization of Inward Foreign Direct Investment...
8. Privatization...
9. Deregulation....
10. Property Rights....
The three big ideas underlying these reforms are, according to Williamson, macroeconomic discipline, a market economy, and openness to the world. The first three reforms are, so far as I am aware, widely accepted among economists. ...

....Why have intelligent economists such as John Williamson gone so wrong on their demand for fiscal discipline, financial liberalization, and actively pursuing a competitive exchange rate policy? The fundamental analytical framework underlying Williamson's views is the same as the foundation of neoliberalist and market fundamentalists arguments (Davidson, 1992-3). For example, in an article co-authored with Marcus Miller (1989), Williamson accepts the classical belief that, in the long run, a free market economy will always revert to the optimum allocation of resources at full employment. Williamson and Marcus (1989, p. 50), however, are impatient with the length of time it takes for the market to achieve this long-run equilibrium, and therefore they argue that the economy, prodded by intelligent authorities will show a greater Aspeed of adjustment than the automatic pilot of a free market. In other words, the only analytical difference between Williamson and ideological Market Fundamentalists is the question of the length of time it requires for a free market to achieve a social optimum.

Those who profess a rational expectations approach can argue for immediate liberalization shock therapy. The common sense of mainstream economists such as Williamson suggests that such "shock and awe" medicine might severely debilitate if not kill the patient. Thus Williamson tries to direct the discussion towards the speed at which governments liberalize markets and reduce the size of government. Nevertheless, all ten reforms of the Washington Consensus are founded on classical economic theory that supports the laissez-faire doctrine as necessary to solve all our economic problems.

The evidence of the last 10-20 years, however, has demonstrated that attempting to implement the ten reforms of the Washington Consensus has ultimately proven to be a disaster for developing nations. If the empirical evidence of the failure of the Washington Consensus under the existing rules of the game is so clear, why does the G-7, the World Bank and the IMF seek to tie aid for Latin American nations' economic problems to a demand for the nation to move towards full adoption of the 10 consensus reforms? The answer to this question is nested in the classical theory belief in the beneficence of free markets. This beneficence, however, can only be aproved if one invokes three very restrictive classical axioms. If these classical axioms are not applicable to the real world, then the characteristics of the Washington Consensus market vision of the economic system happens not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience (Keynes, 1934, p. 3).

When put in the context of an open economy, Keynes' General Theory analytical framework demonstrates that the theoretical foundation for some of the reforms advocated by the Washington Consensus are not applicable to the economy in which we live. In a passage that is particularly a propos to the Washington Consensus, Keynes noted that "in a society where there is no question of direct investment under the aegis of public authority [due to the need for fiscal discipline per se], the economic objects, with which it is reasonable for the government to be preoccupied, are the domestic interest rate and the balance of foreign trade"[Keynes, 1936, p. 335].

If, however, the government institutes reform #4 of the Washington Consensus and permits capital funds to freely move across national boundaries, then "the authorities had no direct control over the domestic rate of interest or the other inducements to home investment, [and] measures to increase the favorable balance of trade [are]...the only direct means at their disposal for increasing foreign investment" [Keynes, 1936, p. 336] and domestic employment. ...Argument Continued