Hernando de Soto is an extremely interesting Peruvian economist who is simultaneously deeply conservative and highly innovative. He published a column in the Washington Post on October 7, 2011 entitled “The Cost of Financial Ignorance” that caused me to reexamine “The Washington Consensus” [TWC]. I agree with de Soto, but his title would have been more accurate if it read: “The Costs of Theoclassical Economics and Economists.” The nature of the TWC is itself highly contested, so I will hold off providing “the” definition of TWC other than to warn that its originator and its proponents are engaged in historical revisionism to try to hide the damage TWC has done.
I agree with de Soto’s criticisms of financial deregulation. Indeed, I will (briefly) add to those criticisms. But de Soto’s argument that the deregulators violated TWC is not correct. Indeed, the opposite is true – TWC encouraged the disastrous deregulation. TWC had 10 points of supposed consensus. Three of them are of greatest relevance to de Soto’s column and my response.
John Williamson is a deficit hyper-hawk with the Peterson Institute for International Economics. The Peterson Institute’s mission, if you are a supporter, is to save the Republic from an avalanche of debt by making major cuts to Social Security, etc. Williamson created the ten-point TWC in preparation for a November 1989 conference as a purported statement of consensus policies favored by economists in the U.S. government, IMF, and the World Bank as to how best to spur development in Latin America.
Three of Williamson’s points are of particular relevance to de Soto’s column and my response. In reviewing them, I discovered that Williamson, stung and embittered by the criticism of TWC, began to rewrite the original points. That would have been fine; of course, if what he was doing was changing his recommendations based on the facts. However, Williamson, and now de Soto, are passing off the revisionist points of the TWC as if they were Williamson’s original points when the actual TWC doctrines contradict the revisionism and caused catastrophic crises. I will also show (briefly) that this revisionism establishes the validity of a broader criticism of TWC by economists such as Luiz-Carlos Bresser Pereira (Brazil’s former finance minister) that most distresses Williamson.
Williamson has created a revisionist history for two TWC policies that are the subject of this column.
“However, the main rationale for privatization is the belief that private industry is managed more efficiently than state enterprises, because of the more direct incentives faced by a manager who either has a direct personal stake in the profits of an enterprise or else is accountable to those who do. At the very least, the threat of bankruptcy places a floor under the inefficiency of private enterprises, whereas many state enterprises seem to have unlimited access to subsidies. This belief in the superior efficiency of the private sector has long been an article of faith in Washington (though perhaps not held quite as fervently as in the rest of the United States), but it was only with the enunciation of the Baker Plan in 1985 that it became official US policy to promote foreign privatization. The IMF and the World Bank have duly encouraged privatization in Latin America and elsewhere since.”
“Another way of promoting competition is by deregulation. This was initiated within the United States by the Carter administration and carried forward by the Reagan administration. It is generally judged to have been successful within the United States, and it is generally assumed that it could bring similar benefits to other countries.”
“Productive activity may be regulated by legislation, by government decrees, and case-by-case decision making. This latter practice is widespread and pernicious in Latin America as it creates considerable uncertainty and provides opportunities for corruption. It also discriminates against small and medium-sized businesses which, although important creators of employment, seldom have access to the higher reaches of the bureaucracy.”
Williamson made his TWC proposals at a time when the three “de’s” – deregulation, desupervision, and de facto decriminalization had created the criminogenic environment that unleashed the epidemic of accounting control fraud that drove the second phase of the S&L debacle. The debacle was widely described as the nation’s worst financial scandal and Williamson’s original TWC article mentions it but ignores the accounting control fraud and its ties to financial deregulation.
The original TWC did not recognize or warn of the risk of corrupt private parties (i.e., the CEOs running control frauds) that drive financial crises. TWC did the opposite; it provided strong, unambiguous support for deregulation. Indeed, he expressly argued that there was a consensus in Washington that deregulation, which had just caused the U.S.’s worst financial scandal in its history, was “successful.” This supposed consensus on the success of deregulation ignores the severe crisis that the deregulation caused and the dramatic reregulation of the industry that we had implemented in 1983-86. It also ignores the adoption of the Financial Institution Reform, Recovery and Enforcement Act of 1989. FIRREA reregulated and “bailed out” the S&L industry. President Bush, who had chaired President Reagan’s Financial Deregulatory Task Force, had recognized the catastrophic error of the very consensus deregulatory policies that had led to the S&L debacle and drafted FIRREA to undue his errors. It is remarkable that Williamson presented a discredited deregulatory policy that had caused catastrophic losses and been repudiated by its leader as a desirable “consensus” policy that Latin America should adopt.
Williamson’s privatization discussion further confirms his fallacious theoclassical dogma that private elites could not be accounting control frauds and could not survive bankruptcy. The language he uses reveals the dogmatic nature of the consensus. He explains that it is “an article of faith” that the private sector is efficient (despite the S&L debacle) because of modern executive compensation and the discipline of bankruptcy. It is the combination of the powerfully perverse incentives produced by modern executive and professional compensation with the three “de’s” that combined to produce the criminogenic environments that drive our recurrent, intensifying financial crises.
Williamson’s failure to understand the multiple limits of bankruptcy’s limits in restraining financial crises driven by epidemics of accounting control fraud is total. First, individual accounting control fraud can delay bankruptcy for years and become massively insolvent through accounting fraud. Creditors do not discipline accounting control frauds – they fund their massive growth. Second, epidemics of accounting control fraud can hyper-inflate financial bubbles and simultaneously delay the collapse for many more years and cause the losses to become crippling. Third, once the fraud epidemic and bubble collapse bankruptcy is not stabilizing but systemically destabilizing. Accounting control frauds, particularly if it hyper-inflates a bubble, can cause cascade failures as the losses they impose on their creditors can render them insolvent. Fourth, private sector banks, even investment banks with no deposit insurance, are frequently bailed out by the public sector when they are sufficiently politically connected or considered to be systemically dangerous institutions (SDIs) whose failures could trigger systemic collapses.
Here is how Williamson’s revisionist history of those same three points as he offered it on November 6, 2002. The title of the article shows that it was part of his effort to defend TWC: “Did the Washington Consensus Fail?”
8. Privatization. “This was the one area in which what originated as a neoliberal idea had won broad acceptance. We have since been made very conscious that it matters a lot how privatization is done: it can be a highly corrupt process that transfers assets to a privileged elite for a fraction of their true value, but the evidence is that it brings benefits when done properly.”
9. Deregulation. This focused specifically on easing barriers to entry and exit, not on abolishing regulations designed for safety or environmental reasons.”
I have no criticism of Williamson modifying his original 1989 views on privatization in a 2002 publication that acknowledges that he now has a better understanding of the risks of corruption causing privatization to become perverse. I fault him for claiming that his original statement of TWC covered only regulations restricting entry and exit. His 1990 paper does not limit his support of deregulation to easing entry barriers and it does not exempt safety and environmental rules. (I also fault him for not understanding that such regulations are essential to the safety of banking – easy entry poses critical risk.)
By April 22, 2009, Williamson had added to his historical revisionism in order to defend TWC from criticism that its policies had helped create the global crisis.
“Skeptics may also be inclined to point to the recommendation to deregulate. But in the days when Dan Quayle was Vice President I already made it clear that this was intended to endorse freeing entry and exit, rather than to advocate an absence of regulations intended to protect the consumer, or the environment, or to supervise the banking system. With that interpretation there is no contradiction.”
Williamson’s original TWC document did not “make it clear” that its deregulation recommendation excluded banking supervision.
Williamson is deeply embittered by criticisms of TWC. He refers to them as “foaming” at the mouth like rabid dogs. He dismisses economists who respect Keynes’ work as leftist cranks: “Left-wing believers in “Keynesian” stimulation via large budget deficits are almost an extinct species.” Williamson cites the following exchange as evidence that he had become a “global whipping boy” because he developed TWC.
“The other incident that I recall clearly occurred in Washington in 1993 but concerns a Brazilian, an ex-finance minister called Luiz-Carlos Bresser Pereira. He told me that just because I had invented the term, [that] did not give me the right to say what it meant. He still believes this and is still attacking it, as he told me two weeks ago when I was in Sao Paulo.”
Williamson thinks Bresser Pereira’s statement is obviously false, but the fact that Williamson has succumbed repeatedly to the temptation to improve his original statement of TWC via historical revisionism shows that Bresser Pereira’s warning to Williamson was correct. Williamson’s description of the means by which he determined the existence of a “consensus” also disqualifies him as the arbiter of judging what TWC really was.
“I looked around. I thought there was a broad agreement in Washington that these were good policies. And then I relied on the three people I asked to be discussants that spanned the range of ideological views in Washington: Allan Meltzer, Richard Feinberg and Stan Fischer. The most important reservation I got was from Feinberg, who thought I had misnamed it, that it should have been called the “Universal Convergence.””
Think about Williamson’s exchange with Feinberg in late 1989. Williamson tells Feinberg that he thinks that there is a consensus in Washington, D.C. that a particular idea, e.g., deregulation is unambiguously good, and Feinberg responds that there isn’t a mere consensus – there’s universal agreement in favor of deregulation. Meanwhile, deregulation has just caused the U.S. to suffer its worst financial scandal, a scandal so severe that the President of the United States – formerly the leader of financial deregulation – changes his policies and reregulates the S&L industry. The top industry advocate of deregulation, Charles Keating of Lincoln Savings infamy, has been revealed to be a control fraud. The S&L regulators have been reregulating for six years in a desperate effort to stem the epidemic of accounting control fraud. None of this penetrates the theoclassical bubble inhabited by Williamson and Feinberg. If the three economists Williamson chose as discussants truly “spanned the range of ideological views in Washington” then Washington has to start seeing other people. The narrow range of differences in the views of the scholars Williamson chose as his discussants for the conference made it easy for them to form a “consensus” and to conclude that all of “Washington” and “Latin America” shared that consensus. Williamson demonstrated his self-blindness with this conclusion:
“I submit that it is high time to end this debate about the Washington Consensus. If you mean by this term what I intended it to mean, then it is motherhood and apple pie and not worth debating.”
He thinks there really is a Universal Convergence in favor of theoclassical economic dogma and that his dogmas are universally good for the world and supported by all intelligent persons.
De Soto’s column provides the revisionist interpretation of the tenth TWC point. Williamson originally phrased it this way:
“In the United States property rights are so well entrenched that their fundamental importance for the satisfactory operation of the capitalist system is easily overlooked. I suspect, however, that when Washington brings itself to think about the subject, there is general acceptance that property rights do indeed matter. There is also a general perception that property rights are highly insecure in Latin America (see, for example, Balassa et al. 1986, chapter 4).”
In 2002, Williamson used similar phrases to describe the tenth point.
“10. Property Rights. This was primarily about providing the informal sector with the ability to gain property rights at acceptable cost.”
Here is de Soto’s revisionism about the meaning of point ten of TWC. Note that under de Soto’s account of the facts, Bernanke is also guilty of historical revisionism about TWC. De Soto uncritically asserts that TWC was a great success in Latin America and that the U.S. needs to adopt TWC. Precisely the opposite was true – TWC’s policies deregulatory and privatization policies proved criminogenic in much of Latin America, just as they did in the U.S. S&L debacle. TWC led to such severe problems that electorates through most of Latin America have voted out of office TWC supporters. The U.S. crisis was driven by the criminogenic environment that TWC principles created.
“Federal Reserve Chairman Ben Bernanke said recently that, given the ongoing credit contraction, “advanced economies like the U.S. would do well to re-learn some of the lessons” that have led to success among emerging market economies. Ironically, those economies in the 1990s accepted 10 points for promoting economic growth that were known as the “Washington Consensus.”
Advanced nations seem to have forgotten Point 10 of that consensus: how important documenting assets and transactions is to the creation of credit. Consider that most private credit is made up not of bills and coins, anchored in bank reserves, but in papers that establish rights over the assets, equity and liabilities that guarantee loans. Over the past 15 years, however, as they package, bundle and resell securities, Americans and Europeans have gradually undermined the reliability of the records that guarantee or make credit trustworthy — the deeds, titles, liens and other documentation that establish who owns what and how much, and who holds the risks.
Not having reliable information reduces confidence, which in turn leads to credit contractions, fewer or smaller transactions, and declines in demand. And these cause employment and the value of assets to fall.”
I agree with de Soto that transparency is vital and that anti-fraud provisions are essential if markets are to approach efficiency. I also agree that government must provide these functions. Contrary to theoclassical economics’ predictions, when we forbade effective regulation of financial derivatives the result was not efficient markets, an optimal level of disclosures, financial stability, or the exclusion of fraud. Theoclassical dogma, as was the norm, proved to be false.
The problem is that TWC did not embrace transparency and effective financial regulation. It proposed the opposite – deregulation – and its proponents did not serve as vigorous proponents of effective financial regulation in the U.S. or in Latin America. Economists stress the reliability of “revealed preferences” – not self-serving statements after the fact that rewrite history. The revealed preferences of Williamson during the lead up to the crisis demonstrate that he did not understand and strive to counter criminogenic environments, the perverse incentives of modern executive and professional compensation, epidemics of control fraud, Gresham’s dynamics, the hyper-inflation of financial bubbles, or the collapse of effective financial regulation led at agencies run by anti-regulators.
De Soto is correct that Williamson should have made point 10 of TWC far broader, embracing effective regulation as an essential component of effective and stable markets, but he knows that Williamson did not do so. Instead, point 10 simply held that private parties should be able to own property. De Soto errs in praising Bernanke. Bernanke was a strong anti-regulator, consistent with TWC. He appointed Patrick Parkinson as head of all Fed supervision. Parkinson is an anti-regulatory economist with no real supervisory or examination experience. Parkinson was the Fed’s lead economist urging Congress to remove the CFTC’s statutory authority to regulate credit default swaps (CDS). The effort to squash CFTC Chair Born’s proposed rule restricting CDS succeeded and created a regulatory black hole that contributed greatly to systemic risk for the reasons de Soto explained in his recent column. De Soto is correct that regulation and effective markets are not mutually exclusive choices. Rather, financial markets are better able to remain effective when regulation provides the necessary transparency and reduces fraud risks. Financial deregulation in the U.S. and the EU was the enemy of effective markets, honest bankers, customers, and shareholders. The fact that Bernanke thinks that the theoclassical anti-regulatory dogma contained in TWC was the solution rather than the problem in the U.S. demonstrates that he has failed to learn the most basic lessons about the crisis.
This post originally appeared on New Economic Perspectives and is reproduced here with permission.