Promoting Growth Diagnostics

Sta. Ana coordinates Action for Economic Reforms. This article was published in the June 29,2009 edition of the BusinessWorld, pages S1/4 and S1/5.

The Washington Consensus (WC)—systemic market-oriented reforms that have to be undertaken simultaneously—has long been dead.

Even before the current global recession’s onset, the WC as applied to developing countries or emerging markets had already fallen out of favor.  The mantra of deregulation, liberalization, and privatization could no longer cast its magic spell in developing countries.  Latin America was the WC’s laboratory.  It was here where lessons were drawn to systematize, consolidate and codify the WC.  Perhaps unsurprisingly, it was also in Latin America that WC first tasted a series of political defeats.  The WC decline is correlated with the rise to power of Left if not populist regime.

The global recession originating in the US merely confirmed that the ideology of the Milton Friedman school—manifested in the deregulation of the financial markets—creates as much damage to mature economies as developing countries. The worldwide crisis is the last nail in the Washington Consensus’s coffin.

It was more than 10 years ago—to be precise, the Asian financial crisis in 1998—that marked the beginning of WC’s end.  WC prescriptions, especially capital account and financial liberalization, led to over-borrowing and currency overvaluation, which eventually resulted  in economic busts.  And to highlight the contrast, countries that did not follow the WC path—countries with capital control or with a distorted exchange rate (undervalued currency)— the prime example is China—avoided the Asian crisis and continued to post high growth.

Also at this time, just before the turn of the millennium, the WC’s intellectual dominance was being challenged and undermined by star economists–like the eminent Joseph Stiglitz and then rising Dani Rodrik.  They not only criticized the dogmatism and impracticality of the WC; they likewise elaborated on real-world, also called second-best, solutions.

An alternative to the WC is the growth diagnostics (GD) framework, introduced and popularized by Ricardo Hausmann, Dani Rodrik, and Andres Velasco.  In gist, GD eschews the spray-gun method of putting in place all reforms in one blow or executing a long list of reforms.  The problem with “wholesale reform” or a laundry list is that it is impossible to effectively apply them to peculiar characteristics—say, institutions and culture—of a country. Further, it disregards the real possibility that the consequence of one reform can do damage to other reforms and more importantly to the over-arching goal of the reform package, which is to enable sustained growth.

Take the case of capital account liberalization.  In many emerging markets, we have seen how premature or hasty capital account liberalization precipitated crises as it fomented asset bubbles and facilitated the decline of the real economy by way of currency overvaluation.

What GD does, replacing the method of having a laundry list of reforms that is assumed to work wherever, is do an economic diagnosis for a particular country towards pinpointing the problems that create the biggest distortions in the economy at a given time and emphasizing the reforms that address these distortions.  The biggest distortions are likewise called the economy’s main binding constraints.  In the process, the list of essential reforms is very narrow.  This enables policymakers and implementers to: a) prioritize and focus, b) steer clear of measures that can upset the priority reforms and c) avoid wasting scarce political capital, when too many reforms—many of which are controversial—are being presented.

The GD can be described as a framework, a strategy, and/or a methodology.  The paper co-authored by Hausmann, Rodrik, and Velasco simply titled Growth Diagnostics, (revised, March 2005), has become a new canon, so to speak, of economic reforms in developing countries.

GD has been done in many countries, not similarly situated and having varying levels of development.  In alphabetical order, Rodrik lists those countries that have been the subject of GD: Afghanistan, Argentina, Belize, Brazil, Cambodia, Colombia, Dominican Republic, Egypt, El Salvador, Kenya, Pakistan, Moldova, Mongolia, Morocco, Paraguay, Peru, Philippines, and South Africa.

Hausmann, Rodrik, and Velasco have pioneered the GD framework and analysis, especially in Latin American countries. In some countries, the GD projects and reform proposals are nationally owned (e.g., Moldova and South Africa).  And the good news is that international development agencies that previously championed the failed WC are the ones sponsoring some of the GD papers:  World Bank, Asian Development Bank (ADB), and the United Kingdom’s Department for International Development.

Rodrik, too, has a collection of the GD documents for these countries, which can be found at his Kennedy School of Government website.

The World Bank and ADB have used the GD approach in the Philippines.

Alessandro Magnoli Bocchi is the author of the World Bank paper titled Rising growth, declining investment: the puzzle of the Philippines (2007). The paper identified currency appreciation resulting in overvaluation, the fiscal imbalance arising from low revenue collection, and elite capture as the Philippines’ main binding constraints.

New developments since the WB released the paper have not reduced the paper’s significance. The global crisis has led to capital flight and a fall in portfolio investments, thereby temporarily halting the appreciation of the peso.  In the meantime, the fiscal problem is worsening; the dip in revenue effort (revenues as a proportion of gross domestic product) to below 12 percent in the first quarter of 2009 is very disturbing.  Obviously elite capture, the technical term used by the author to define corruption and bad governance, remains entrenched.

The ADB’s GD project for the Philippines is broader in scope. The main GD paper, focusing on “critical development constraints,” is supplemented and enriched by reports on growth and poverty reduction, growth and equity, human development, institutions and governance, macroeconomic management, the financial sector, and trade and investment.  The reports are inputs to the main paper, as they validate whether the constraints are binding at the macro level.

The ADB study identifies four “critical constraints” Why it uses the term “critical constraints,” not “binding constraints” is not explicitly explained.  These constraints, similar to the World Bank findings, are: a) poor fiscal performance (low revenue effort), b) lack of infrastructure, c) corruption and political instability, and d) incapacity to correct market failures, which stymie production of industrial tradeables.

The ADB is more advanced than other multilateral organizations in promoting GD.  For one thing, ADB has institutionalized GD.  ADB has a technical assistance project that aims to strengthen the country diagnosis and analysis of binding constraints in developing member countries.  The Philippine study is the product of this technical assistance project.

In addition, the ADB—as seen in the Philippine study—has done innovations on GD so that it can be applied as well to addressing inclusive growth and poverty reduction.  In other words, it takes off from the GD model to develop a diagnostic framework for poverty reduction.  The study identifies lack of employment opportunities, inequitable access to development opportunities, and inadequate social protection as constraints on poverty reduction.  Note how closely linked the constraints on growth and on poverty reduction are.

And as part of institutionalizing GD and introducing it to a wider public towards strengthening national ownership, the ADB will publish its Philippine GD study in book form.  We eagerly await the launching of Diagnosing the Philippine Economy Toward Inclusive Growth (2009), a co-publication of ADB and Anthem Press (London).

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