Contents:
Introduction
Equity Affects Efficiency: The Case of the Distribution of Land
Second Generation Reforms
The Role of Voice and Participation in Policy Reform and Institutional Design
Concluding Comments
References
Notes

Introduction

One of the main insights of modern economics is overturning the traditional neo-classical idea that issues of efficiency and equity could be completely separated. In the 1950s the Second Fundamental Theorem of Welfare Economics established that any Pareto efficient allocation could be supported as a competitive equilibrium, given appropriate lump sum taxes and transfers. This result had profound implications: it stated that we could let the government achieve the equity it desired by redistributing resources and then leave the market to achieve an efficient equilibrium. But the Second Fundamental Theorem was also based on extremely strong assumptions. Most obviously, in practice the government cannot use lump sum taxes and transfers to serve distributional goals; and basing taxes and transfers on income and other variables that are affected by individual action is necessarily distortionary.

More profoundly, developments in the economics of information have established that in the presence of imperfect information, that is always, markets are not even constrained Pareto efficient; there is some government action that, while itself bound by the same informational limitations, can make at least some people better off while not making anyone worse off (Greenwald and Stiglitz 1986). A direct implication of this result is that distribution does matter; changing the distribution of income or wealth can affect the efficiency of the economy. In a sense this result was obvious: economists complain bitterly about the distortionary effects of a 50 percent tax on income, and it should have been equally clear that a sharecropping contract that required that the tenant pay 50 percent of his returns to the landlord would discourage work, investment in the land, and innovation. Enabling sharecroppers to buy their land could result in greater agricultural productivity, resulting in what would seem (at least with compensation) a Pareto improvement. ¹

In the first part of this talk I will generalize on this issue to make some points about the effects of inequality in land and other assets on efficiency. But efficiency is a relatively narrow goal. The process of development is about much more than just increasing measured GDP. In the second part of this talk I will discuss the second generation of reforms, which go beyond the so-called "Washington Consensus" in seeking broader goals of development and employing a wider range of instruments in doing so. One of the widely recognized objectives of the second generation of reforms is institutional development, the topic of the third part of my talk. I will extend the argument in the first part of my talk that equity affects economic efficiency, to argue that participation and voice affect institutional performance, including the goals of institutions and their effectiveness in achieving those goals.

Equity Affects Efficiency: The Case of the Distribution of Land

Inequalities in wealth will generally require the owner of assets, the "principal," to delegate the use of assets to another, the "agent." In the presence of incomplete information, it will be impossible to write down a complete contract to specify what actions the agent should undertake in each contingency or at least impossible to monitor (and thus enforce) that contract. As a result, a principal-agent problem arises, creating what are sometimes called "agency costs." Agency costs and the steps taken to mitigate them, like engaging in costly monitoring, affect efficiency in a number of ways. If the extent of inequality affects the extent of agency costs, then it will also affect the overall efficiency of the economy.

Perhaps the clearest illustration of the principal-agent problem is the relationship between the landlord (the principal) and his tenant (the agent).² If the landlord could costlessly monitor the tenant, his contract would specify the amount of labor that the worker would provide. But monitoring is costly, and hence the landlord designs contracts like sharecropping³ that ensure that the worker has an incentive to make an effort. These contracts, however, are imperfect for several reasons:⁴

	The sharecropper only receives a fraction (usually one-half to two-thirds) of his or her marginal product and will thus undersupply effort.
	The sharecropper will not enjoy the benefits of improvements to the land (or bear the costs of deterioration) and thus will underinvest in the land by, for instance, not taking sufficient care to avoid erosion. Similarly, the sharecropper will have insufficient incentives to invest in other inputs, like better seeds or fertilizer.5
	The sharecropper is typically more risk averse than the landlord, but the sharecropping contract does not allow him or her to transfer this risk. Also, the different risk incentives mean that the tenant may use techniques (such as the choice of crop or fertilizer) that have a lower risk, but also a lower expected return.

Thus, inequality in wealth or land distribution led to an economic organization which had markedly adverse effects on output.

These narrow economic concerns with efficiency may not have been the primary motivation for land redistribution, but they provide the hope that land redistribution would lead to increases in output and standards of living. Yet many land reform initiatives around the world have been disappointing. In many cases output has actually fallen. Also, the effects of land redistribution have often proven only temporary, with land becoming more concentrated again as time passed. This is why many recent reforms have imposed restrictions on sales of land, although, as I discuss later, they have often been unsuccessful in stemming the reconcentration of land and have brought their own efficiency problems.

The two problems are related, because the falling output induce farmers to resell the land. To put it another way, evidently the value of land under tenancy seemed to be higher than the value of land on self-managed farms. How can this be?

Increasing Output After Land Reform

Again, the concept of agency costs provides us insights into the why this may be so. I have just been discussing the distortions which arise from the agency problems associated with the disparity in the ownership of "labor" and land. But there are agency costs associated with the distribution of wealth more generally. Successful agricultural production requires not only labor and land, but also capital and know-how (technology). Poor tenants are often lacking in all three and simply granting them land does not resolve the other two gaps. The agency problem associated with capital is as serious as that associated with land. Credit rationing (see Stiglitz and Weiss 1981), resulting from the combination of limited liability (the borrower does not bear the full cost of failure) and the costliness of screening and monitoring for riskiness, ensures that many poor tenants will not have access to credit or will be forced to borrow from informal lenders at very high interest rates.⁶ Thus, poor farmers have been unable to buy the high-cost seeds, fertilizer, or small-scale tractors necessary for productive farming.⁷

In the absence of government action, a more egalitarian distribution of land can actually increase the agency costs vis-à-vis technology. Knowledge, as is now widely recognized, has the properties of a public good (when an additional person uses the knowledge, it does not detract from what I know; and the costs of exclusion are often high). As such, it will be underprovided privately. If there were a single large landowner, he could capture the full benefits of investing in technology. It does not pay, however, for each tenant to invest in knowledge on his own and thus innovation will be inhibited. Each small farmer may wait for his neighbor to try the new seed to see if it works. Each wants to free ride off of the innovation efforts of others. Land reform can exacerbate the free rider problem, leading to less innovation and even delays in implementing best practices. This is another example of a way in which, contrary to neo-classical economics, distribution affects efficiency.

Both of these problems can be remedied by the design of the land reform program and by appropriate government interventions. The World Bank, for instance, is supporting the Brazilian government in accelerating its land reform program through a market-based mechanism in which communities of landless rural workers themselves select and negotiate the purchase of land. Not only does this approach increase the ownership, literally and more broadly, of the new small landowners, but it also eliminates the conflictual aspects of land reform. Together with extended credit and an increased emphasis on education, the initial indications are that this project will be able to help thousands of families, increasing their productivity and incomes, allowing them to accumulate enough savings to repay the original loans used for the purchase of the land.

A number of countries and programs, most notably the Grameen Bank in Bangladesh, have demonstrated that credit can be made available to small farmers on reasonable terms, with high repayment rates.⁸ Peer monitoring, whereby non-hierarchical monitoring structures are used to reduce agency costs, can make an important contribution to the success of these programs (see Varian 1990 and Stiglitz 1993). Small credit programs in Indonesia and Thailand have also had high levels of success, although based on different principles.

Governments have long played an important role not just in the development of new technologies, but also in their dissemination, through extension programs. Well-designed extension programs, which depend on the circumstances of the country and the education level of the farmers, can successfully transfer knowledge. Furthermore, the farmers who benefit from these extension programs often act as role models to others, spreading the dissemination more widely⁹ - another example of the public goods characteristics of knowledge. There is also evidence that even a few years of schooling makes farmers far more receptive to the new technologies, and so government programs to extend education can play an important indirect role in a successful land reform program (World Bank forthcoming).

Sustaining Land Reform

The second concern about land reform is that it has not had sustainable consequences. The dynamic processes of the market have led to the reconcentration of land, undoing the land reform.

Some years ago, Avishay Braverman and I (1989) formulated a general model attempting to capture these dynamics. Institutional arrangement that are constrained by costly monitoring are typically characterized by imperfect risk sharing,¹⁰ and as a result will lead to some redistribution. We can divide the population into groups according to the amount of land they own and describe the number of people in, say, the jth decile by x_j,t and the entire distribution at time t by the vector x_t. For simplicity, assume that that the distribution at time t+1 is governed by the transition matrix A^k where the superscript denotes the institutional arrangement:

x_{t +1} = A^kx_t.

In this model with fixed coefficients in the transition matrix, the prognosis for land reform could be bleak. For almost all transition matrices¹¹ there will be a unique equilibrium distribution of land x^* which is the eigenvector of the transition matrix:

(1)x^* = Ax^*.

If the economy is perturbed from x^* it will asymptotically return back to its original distribution - any land reform will eventually be undone, with a return to the original land distribution.

But the institutional arrangements are themselves endogenous, and depend on the land (wealth) distribution. In circumstances of great inequality, the institution of sharecropping will emerge, solidifying the unequal distribution. In contrast, when land is distributed in a more egalitarian manner farms will be owner-managed, resolving the agency costs and making it easier for small farmers to maintain or even extend their property. In our simple algebraic exposition, we can think of the transition matrix itself as a function of the land distribution:

(2)x_{t +1} = A(x_t) x_t.

In this case there may be multiple equilibrium land distributions:

x^* = A(x^*) x^* and x^** = A(x^**) x^**

If so, a land redistribution can lead to a change the institutional arrangements and thus be sustained. To be sure, it is unlikely that the government will, in its initial land redistribution, hit upon an equilibrium. But this model also holds out the promise that a small redistribution could eventually, and without further intervention, lead to a lead to a large shift from one equilibrium to another. Even if we see some reconcentration after the land reform, the final equilibrium may still be far more egalitarian than the pre-land reform equilibrium.

These conclusions are strengthened if we treat the transition matrix as being dependent on government policies, A(G). For instance, the provision of micro-credit and extension programs may increase the chance that a very small-holder can increase his or her holdings. In this case the equilibrium land distribution will be a function of government policies:

(3)x^*(G) = A(G) x^*(G)

and changes in G can change the ultimate distribution of land in ways that simply changing x^* through land redistribution, at least in the framework of equation (1), cannot.

If we combine (2) and (3) so the transition matrix depends both on the distribution of land and on government policy (which itself may be affected by the distribution of land) then government policies can affect each of the equilibria, and indeed, government programs can even create a second more egalitarian equilibrium, where in the absence of the government program there would only be a unique equilibrium. As a result government credit and technology programs not only enhance the effectiveness of the land redistribution programs, they may be necessary for its very success.

Active government programs, facilitating the provision of credit and technology which have limited the success of land reform programs in many parts of the world, have been far more attractive than limiting land transactions, the approach pursued by other countries.¹² Farmers often find ways, like leasing arrangements, to circumvent these policies, which not only lead to effective reconcentration but are associated with ancillary problems, like underinvestment in the land. Even if these reforms manage to sustain the egalitarian land redistribution they do so at a high economic cost. Because land cannot be bought and sold, it cannot be used as collateral. Because it cannot be used as collateral, it exacerbates the capital market agency problem. Policies to limit land transactions also make it more difficult for the economy to adapt to changing circumstances and the process of development. Over time, it may be desirable for there to be some increase in the average size of farms, as some workers move off the land to higher paying jobs in other sectors. Frequently, countries with these strong land regulations hold that individuals who move off the land lose their rights to the land, and thus these regulations inhibit the development of more productive industries and the reallocation of labor to more productive uses. The consequences of these arrangements is thus in many cases a lowering of standards of living after the land redistribution program.

But even if we reject these strong forms of land restrictions, and even if we engage in active government programs designed to overcome limitations on credit and technology, there remains a question: are some restrictions on land transactions (such as taxes on the purchase of land by large landowners) desirable? From the perspective of efficiency, that is a social welfare function which only takes into account individual well-being, with no explicit account of distinctions, these restrictions might seem hard to justify. After all, in a perfect market, individuals would only enter into contracts to buy and sell land if they were made better off than they otherwise would have been, that is if the transaction were Pareto improving.

There are, however, several possible market failures that might justify such interventions even from the perspective of efficiency. First, individuals may not take fully into account the benefit of the land bequest to their children, including the benefits which arise from the reduction in agency costs. Second, because of capital market imperfections poor individuals have much higher discount rates than richer individuals. As a result, even if the sale to the higher-income farmer lowers the returns to the land (because of the increased agency costs), evaluated at the lower discount rate, its value might still rise. As a result, although the transaction would be rational from the perspective of the two participants, it could still lower national income. Although the general theory of the second best makes it ambiguous whether such sales might still be desirable (even though output is lower, the value of consumption by the tenant which it supports can be higher), it is clear that if there are taxes related to output (such as an export tax), then sales will occur which are undesirable.

But all of this takes a too narrow view of the object of land redistribution: it is more than just a matter of economic efficiency, or even equity as measured by a conventional social welfare function. It is part of a broader social and institutional change that is the central component of the second generation of reforms, the topic I turn to now in the second part of this lecture.

Second Generation Reforms

Land reform is an example of a policy that can increase both equality and output. The old trade-off between equity and efficiency seems to have been put aside. There are other examples of such reforms. In the absence of public education, there will be underinvestment in education because poor people typically cannot pay the full cost of their education up front and have difficulty in borrowing against future earnings. As a result, more public support for education, especially when it is well targeted, may not only increase educational opportunity, increasing equity within society, but also increase economic efficiency. Heavy investments in human capital are widely considered to have made an important contribution to the success of the East Asian economies over the last three decades (World Bank 1993).

Brazil, because of its high degree of income and wealth inequality, may have even greater scope than any other country in the world for these win-win reforms that improve efficiency and equity. Brazil’s Gini index is around 60 (with 0 indicating complete equality and 100 indicating complete inequality), compared to 50 for Mexico, 40 for the United States, 34 for Indonesia, 30 for India, and 25 for Norway and Sweden (World Bank 1998). Indeed, virtually no major countries have Gini indices even nearly as large as that of Brazil.

These considerations, both thinking of equity as a goal and as a broader means for achieving the goal of increased efficiency, are strengthened by the experience with the first generation of reforms which have now been completed by many countries. These countries have followed the dictums of the Washington consensus - bringing down inflation and budget deficits, liberalizing trade, privatizing state-owned enterprises, and "getting the prices right" - but are still waiting for development. If it is coming at all, it is coming too slowly. The reason for the failure of the Washington consensus to fulfill its promises is that it not only pursued too narrow a set of objectives - an increase in GDP per capita - but that it saw development from too narrow a perspective in two senses.

First, the instruments it chose to focus on - trade liberalization, privatization, and macroeconomic stability - although important, sometimes confused means with ends, and in any case ignored other equally important instruments.¹³ Take the example of China which has seen its per capita incomes quadruple in the last 20 years, making it by far the most successful developing country in the world. If the 30 separate provinces of China were treated as separate economies - and most of these provinces are far larger than most of the countries in Africa - they would account for 20 of the 20 fastest growing economies since 1978 (World Bank 1997). Put another way, China accounts for two-thirds of the increase in the total income of low-income countries over the last 20 years, even though at the beginning of the period it accounted for only one-quarter of their total GDP and two-fifths of their population (calculations based on World Bank 1998). Yet China did not follow the dictums of the Washington consensus. It emphasized competition over privatization: standard economic theory says both are required for an effective market economy. The Washington consensus emphasized one; China the other. We see the track record. It should not be surprising: privatizing a government monopoly is often likely to create a private monopoly with high prices and continued inefficiency. Similarly, one of the objectives of trade liberalization is to enhance competition, but when there is a monopoly importer, tariff revenues may simply be converted to rents accruing to the monopoly importer.

The topics that were left out by the Washington consensus are perhaps even more telling: financial markets, competition and regulation, the transfer of technology, the development of institutions - to name but a few whose importance has been increasingly recognized.

This brings me to the second sense in which the Washington consensus saw development from too narrow a perspective. In my WIDER lecture (Stiglitz 1998c) I emphasized that we seek not just increased GDP, but also increased living standards, reflected in health and literacy; we seek sustainable development, not only in sense that the environment should be improved, but also in the sense that the reforms are durable with respect to changing political vicissitudes; we seek democratic development, so that individuals have a say in the decisions that affect their lives; and we seek equitable development, so that the fruits of economic growth are widely shared.

Today I want to go even further. Development represents a transformation of society, a movement from traditional relations, traditional ways of thinking, traditional ways of dealing with health and education, traditional methods of production, to more "modern" ways. For instance, a characteristic of traditional societies is the acceptance of the world as it is; the modern perspective recognizes change, it recognizes that we, as individuals and societies, can take actions which, for instance, reduce infant mortality, increase lifespans, and increase productivity. Key to these changes is the movement to "scientific" ways of thinking, identifying critical variables which affect outcomes, attempting to make inferences based on available data, recognizing what we know and what we do not know.

All societies are a blend. Even in more "advanced" societies there are sectors and regions which remain wedded to traditional modes of operation and people wedded to traditional ways of thinking. But while in more advanced societies, these constitute a relatively small proportion, in less advanced societies, they may predominate. Indeed, one of the characteristics of many less developed countries is the failure of the more advanced sectors to penetrate deeply into society, resulting in what many have called "dual" economies in which more advanced production methods may coexist with very primitive technologies.

The Washington consensus saw development as little more than initially solving a set of difficult technical problems and later removing certain (usually government imposed) barriers. That having been done, development would simply come. This approach - which emphasized getting governments out of the way to allow markets to function - actually shares many of the premises of the indicative planning models from the 1960s. Both models saw development as the solution of a dynamic programming problem, which focused on the level of capital (with the main control variable being the foreign loans and assistance) and its allocation to different sectors. Lack of capital and inefficient sectoral allocations were portrayed as the only differences between a country like India and the United States. One argued that central planning was needed to solve the problem, the other that the decentralized market economy was the best way of finding the solution. But both saw development through the same narrow lens,¹⁴ although their prescriptions differed markedly.

The new philosophy saw the central role that government played in the planning/programming approaches as part of the problem of development, rather than as part of the solution. Governments took too large a role, a role for which they were intrinsically unsuited. Not only did they lack the capabilities, but the incentives of the political process ensured that whatever capabilities they had were directed not at increasing national production, but at diverting rents to the politically powerful. The solution, in this perspective, was reliance on markets, and in particular, the elimination of government-imposed distortions, associated with protectionism, government subsidies, and government ownership.

With the debt crisis in the 1980s, the focus shifted to macroeconomic problems, to "adjustment" to fiscal imbalances and misguided monetary policies. Given the macroeconomic imbalances, it was impossible for markets to function, or at least to function well.

Notice that all three of these development strategies saw development as a technical problem requiring technical solutions: better planning algorithms, better trade and pricing policies, better macroeconomic frameworks. They did not - and they did not believe that one needed to - reach deep down into society. The laws of economics were universal - demand and supply curves and the fundamental theorems of welfare economies applied as much to Africa and Asia as they did to Europe and North America. These scientific laws were not bound by time or space.

The Lessons of History

Perhaps the greatest limitation of these approaches was their ahistorical nature. They failed to notice that (a) successful development efforts in the United States, as well as many other countries, had involved an active role for government; (b) many societies in the decades before active government involvement - or interference, as these doctrines would put it - failed to develop; indeed, development was the exception, around the world, not the rule; and (c) worse still, capitalist economies, before the era of greater government involvement, were not only characterized by high levels of economic instability, but also by high levels of social/economic problems, as large groups, such as the aged and the unskilled, were often left out of the progress which occurred, and were left destitute in the economic crashes which occurred with great regularity.

Two Puzzles

Indeed, one of the puzzles of explanations of income levels based entirely on variables like openness and macroeconomic policy is the huge disparities within countries. Take southern Italy, which trades freely with northern Italy, shares northern Italy’s macroeconomic framework, and even benefits from redistribution and other policies designed to encourage the development of the south. Yet while the north has boomed, the south has stagnated and declined. This by itself suggests that there is more to development than just the elements of the Washington consensus.

Another more recent puzzle concerns the collapse of the economies of the former Soviet Union. Almost a decade after the transition to a market economy began, according to the most generous estimates output in the former Soviet Union remains one-third below where it was in 1989. This is after the inefficient system of central planning was replaced by a more decentralized, market oriented system, after the distortionary pricing patterns were, by and large, eliminated, and after private property was supposed to restore incentives that seemed so lacking under the previous regime. This collapse cannot be explained by changes in human capital and knowledge, which remain roughly the same, or by changes in physical capital, which may have deteriorated slightly, but not in proportion to the decline in output. Instead, the explanation for the protracted economic problems of the former Soviet Union economies is that the destruction of organizational and social capital, a process which began under the previous regime, continued, with inadequate efforts to develop new bases. Indeed, the way the transition was handled may have undermined these efforts. In any case, insufficient attention was paid even to the provision of the scaffolding, the legal and institutional infrastructure, including bankruptcy, competition, and contract laws and their effective enforcement.

These examples, and the contrast with the success of China, is perhaps the strongest motivation for insuring that the second generation of reforms emphasize the creation of competition, the development of institutions, and effective functioning of organizations and social networks. This depends on more than just getting the policies right, how the dials are set, but on who is included in the policymaking and the process by which these policy decisions are made. This brings me to the third topic of my lecture: the role of voice and participation in policy reform and institutional design.

The Role of Voice and Participation in Policy Reform and Institutional Design

The third topic brings me back to my theme of distribution and reform, although viewing it from the broader perspective of development that I have just outlined. Throughout the world, concerns about the concentration of power were not based on the narrow economic reasoning I elaborated earlier; after all these concerns predate the concept of agency costs, which has been developed over the past 25 years, but on broader social, and more particularly political, concerns. The concentration of economic power (wealth or land) has consequences, some of which are exercised through the marketplace, but some of which are exercised through other channels. Examples abound. Studies of sugar mills in India, for instance, have shown the potentially adverse effect even on economic efficiency of the concentration of wealth at the village level.

Earlier, I discussed how market institutions, like sharecropping, are a function of the distribution of wealth (or land). The same is also true of non-market institutions, including public institutions which influence economic behavior.

Thus, if reforms intended to promote development are to transform entire societies, they must involve entire societies. This has led to an increasing concern over ownership and participation in development strategies, and in creating institutions which give expression to ownership and participation. Indeed, participation is necessary if there is to be ownership and if the transformation is to reach down deep into a society. Ownership and participation are also necessary if the development strategy is to be adapted to the circumstances of the country, and if it is to elicit the kind of commitment, the kind of long-term involvement, that is necessary for sustainability.

Until recently, the emphasis on participation was only supported by anecdotal evidence and case studies. Although suggestive, this research was not definitive. At the World Bank we have conducted careful, systematic reviews of the evidence on participation. The results are striking. In one study of 121 aid-financed rural water supply projects, two-thirds of the projects with substantial local participation met the Bank’s criteria for success; only one-tenth of the projects without participation were successful (Isham et. al. 1995). Other studies also confirm this result.

Complementary research has found similar effects at the macro-political level. One study using a cross-national data set of World Bank projects found a strong empirical link between civil liberties and the economic return to projects (Isham et. al. 1997). Countries in which citizens are allowed to freely exercise their voice tend to also have more successful government projects.

Ownership can come through persuasion, through the presentation of evidence (theory and facts) that particular strategies and policies are more likely to bring success than other strategies and policies. But the degree of ownership is likely to be even greater when the strategies and policies are arrived at by those within the country itself, when the country itself is in the driver’s seat.

The importance of ownership and participation is perhaps clearest in the development of social/organizational capital, without which no society can function. Earlier, I noted that the limited success, so far, of the transition in Russia can be attributed to the failure to develop the institutional infrastructure. In the process of development, the social capital associated with traditional society is destroyed before the creation of new social capital. Social/organizational capital cannot be borrowed from abroad; it cannot be handed over to a country. It must be developed from within, though to be sure, knowledge about key ingredients can facilitate the process of the creation of this social/organizational capital. The pace of change, the pattern of reforms, must be adapted to each country’s ability to create social/organizational capital. This may, in fact, be the binding limit on the speed of transformation. China has demonstrated that a country can absorb enormous amounts of capital quickly. In the early stages of development, the need for roads, schools, energy, telecommunications, and other elements of infrastructure are huge, and it is hard to believe that more resources could not be productively used. But the provision of these ingredients is not development.

I want to draw out two implications of this, one for how international financial institutions interact with our developing country clients, and the other for the design of institutions within a country.

The Relationship Between Lenders/Donors and Their Clients

Change cannot be imposed from outside. Indeed, the attempt to impose change from the outside is as likely to engender resistance and create a barrier to change, as it is to facilitate change. At the heart of development is a change in ways of thinking, and individuals cannot be forced to change how they think. They can be forced to take certain actions. They can even be forced to utter certain words. But they cannot be forced to change their hearts or minds.

This point was brought home forcefully at a meeting I attended of finance ministers and central bank governors from the countries of the former Soviet Union. All of them could perfectly articulate the requirements of sound macroeconomic policy, and each announced that he subscribed to those policies 100 percent - including those whose practices deviated markedly.

Indeed, interactions between lenders and clients may actually impede the transformation. Rather than learning how to reason and developing analytic capacities, the process of imposing conditionality undermines both the incentives to acquire those capacities and confidence in the ability to use them. Rather than involving large segments of society in a process of discussing change - thereby changing their ways of thinking - it reinforces traditional hierarchical relationships. Rather than empowering those who could serve as catalysts for change within these societies, it demonstrates their impotence. Rather than promoting the kind of open dialogue that is central to democracy, it argues at best that such dialogue is unnecessary, at worst that it is counterproductive.

There is likely to be greater acceptance of reforms - a greater participation in the transformation process - if there is a sense of equity, of fairness, about the development process, a sense of ownership which is derived from participation, and if there has been an effort at consensus formation. Brazil’s Real Plan, which managed to bring the inflation rate down from over percent 5,000 percent in 1994 to only 3 percent today, while the unemployment rate was essentially unchanged,¹⁵ is an example of a successful domestic-led stabilization program. Other good illustrations come from the consensual process with which Ghana and Israel have tackled their macroeconomic problems (see Bruno 1993).

The ability to achieve this kind of consensus is enhanced by a greater sense of equity, which can be supported by reforms such as land reform and greater educational opportunity. By contrast, when an international agency imposes on the ruling elite an agreement which requires them to, say, eliminate food subsidies, regardless of the economic consequences, this action is not going to help the consensus-building process - and will ultimately make it harder to undergo a successful transformation.

The Independence of the Central Bank

How decisions are made - the decisions which affect the lives and livelihoods of the citizens of a country - can affect both the nature of the decision and the degree of consensus around it, the societal ownership. Both equity and efficiency are at stake. If there is no consensus, groups may work to undermine the decision, and the net result may be Pareto inferior to a decision that might have been arrived at through a process more likely to generate widespread support. And if the decision is made through a process in which certain important voices are not heard, it is more likely that these concerns will not be reflected in the decision, or not reflected adequately, and therefore there is good reason that there would not be a consensus behind the decision.

Nowhere are these considerations more important than in macroeconomic policymaking, which directly affects everyone in the country through its influence over unemployment rate, wage rates, interest rates, and inflation rates. There may be important tradeoffs in making macroeconomic policy, with, for instance, some decisions hurting workers but helping bondholders. Too often, however, macroeconomic policies are Pareto inferior: bad macroeconomic policies can make almost everyone better off. But there is often a fear that moving away from these policies will disadvantage some significant group, even if national income as a whole is increased (the compensation that would have enabled such reforms to be Pareto improvements are seldom made). If there are significant disadvantaged groups, the whole reform can be sabotaged.

I want to argue that we should begin to reconsider the institutional design of the central bank from this perspective.¹⁶ This is issue is getting increasing attention lately in both developed and developing countries because of the recognition of the critical role that central banks play in determining and implementing economic policy. In the last decade many countries have increased the independence of their central banks in response to concerns that monetary policy was being swayed by the vicissitudes of the political process. They were genuinely worried that politicians would have the incentive to take advantage of voter myopia to increase employment in the run-up to an election, with the consequent inflationary pressures only realized after the election.¹⁷ To be sure, after the election unemployment will be increased in order to bring the inflation rate back down again, but the voters will have forgotten this pain by the time they are enjoying the short-run prosperity in the run-up to the next election. The instability associated with the political business cycle is costly, and politicians who have been persuaded of this cost have agreed to have their hands tied by turning over the control of monetary policy to an independent central bank. There is a certain irony in this: Econometric models show that the outcome of the electoral process is determined largely by economic performance, even in countries like the United States, where fiscal constraints have meant that the most important determinant of short-run economic performance is probably the independent central bank, not the Congress or the President (see Fair 1996).

To some degree, institutional changes may not be enough to buy low and stable inflation. Germany does not only have a highly independent central bank, but it also has a culture that is highly averse to inflation. This culture itself, and not the institutional arrangements, may in fact be sufficient to keep inflation down. The Indian Central Bank, for instance, has relatively little legal independence from the government but has consistently delivered low inflation in response to political pressure from the electorate. In contrast, one transition economy has witnessed the spectacle of a highly independent central banker pushing inflation higher and higher while the government was, initially, unable to remove him.

There is evidence that, at least in OECD countries, central bank independence leads to lower average inflation. There is, however, no evidence showing that it improves real economic performance, either in terms of the level or variability of growth or unemployment (Alesina and Summers 1993). But even if it did, that is not the key issue.

First, if it were shown that an economy with an independent tax authority - where taxes are imposed by an independent agency beyond the control of elected officials - were to perform better, would that provide justification for removing control of taxation from the democratic process? In the end, there must be political responsibility for the determination of taxes and of macroeconomic policies, these are key collective decisions.

Second, even if one were to accept the principle of independence, there remains the issue of representativeness. The issue of macroeconomic policy is not just a technical issue. It is not like nuclear engineering. There are trade-offs, with large social and distributional consequences. Consider, for instance, U.S. macroeconomic policy over the past six years. Monetary policy always is conducted in the face of great uncertainty, given the long and variable lags in policy and the difficulty of predicting where the economy will be in six to nine months time. One of the key issues in recent U.S. macroeconomic policy has been the level of the NAIRU (the non-accelerating inflation rate of unemployment), that is the level of unemployment below which inflation starts to rise. The uncertainty about the precise level of the NAIRU means that there are risks associated with any monetary policy: too loose a monetary policy may result in inflation, while too tight a policy may result in increased and unnecessary unemployment.

Balancing these risks is partly a technical judgement that needs to be based on technical expertise. But it also involves trade-offs that should only be decided by a political process. The people hurt by too loose a monetary policy are Wall Street bond holders, who see their bond prices fall as interest rates rise with inflation; the people hurt by too tight a monetary policy are workers, who face slower wage growth and the threat of unemployment. But the U.S. Federal Reserve, like the central banks of many other countries, is hardly representative. It does not include any representatives of labor or even industry, and it is dominated by bankers. Is it surprising then that the central bank has been more preoccupied with dangers of inflation than it has been with those of higher unemployment?

The good fortune of the United States in successfully lowering its unemployment rate from almost 8 percent in 1992 to roughly 4½ percent today is in spite of the Federal Reserve, not because of it. In particular, it is the consequence of two simulatenous offsetting mistakes. First, the Federal Reserve has consistently overestimated the NAIRU. But second, it has consistently underestimated the robustness of the economy, and thus has not taken the contractionary actions it should have, given its estimate of the NAIRU. Thus the unemployment rate consistently came in lower than the its estimate of the NAIRU. Fortunately, the central bank acted pragmatically: so long as inflation did not rear its ugly head, it was content not to force the issue, allowing the unemployment rate to continually drift lower and lower, in spite of the fact that its models warned of inflation.

This experience has a further lesson: too often values and expertise get confused; those who have more to lose from inflation see trade-offs differently; they argue that inflation is far more of a threat, and inflation is far more likely to occur, than those who are more concerned with unemployment. Consider four technical issues associated with these policies: (a) What is the NAIRU? (b) What are the costs of inflation? (c) Is the economy on a precipice, so that a little bit of inflation is followed by more and more inflation? and (d) Is the cost of reversing inflation high, far higher than the initial benefit (in terms of lower unemployment) from allowing inflation to occur in the first place?

Many central bankers reflecting interests of inflation hawks see a high NAIRU, high costs of inflation, perceive the economy as sitting on a precipice, and believe the costs of reversing inflation are very high. There may in fact be some circumstances in which these answers are correct. But for the United States, perhaps because of the extended period of relatively low inflation, the evidence is against all four of these conclusions. Not only has the NAIRU been shown to be lower than the Fed thought in say, 1993, but there was good reason that the NAIRU should be lower and coming down.¹⁸ Although no one doubts that high inflation is costly, studies have consistently shown that there are no significant adverse effects associated with low rates of inflation (see Fischer 1993, Barro 1997, and Bruno and Easterly 1998), and some have even argued that problems may arise as the economy approaches a zero rate of inflation (Akerlof, Dickens and Perry 1997). Furthermore, rather than there being a precipice, the evidence suggests that there is actually a lower probability of an increase in inflation associated with higher rates of inflation (Stiglitz 1997a). And the costs of disinflation appear to be low - and even smaller than the (transitory) benefits of an inflationary stimulus; that is the Phillips curve appears to be linear or even concave, rather than convex (Braun and Chen 1996). The success of Brazil’s Real Plan is another striking demonstration that one can lower very high inflation rates with relatively little economic cost. In fact, many countries have actually seen output rise during the process of disinflation (Bruno and Easterly 1996).

Nor is it perhaps surprising that when speaking of indexing government benefit programs, central bank officials in the United States speak of a bias in the consumer price index (CPI) of between 1 and 2 percentage points, but in the context of monetary policy seldom mention that, once that same correction is taken into account, the true rate of inflation is close to zero.

The point is that there is, and should be, a credibility gap in the expertise of so-called independent experts that are called upon to make economic policy judgments. Ascertaining the bias in the CPI is a technical issue, but how one uses the number to shape policy is a political issue. In societies in which there is a strong sense of equity, in which there are not large divisions, in which workers are also bondholders, the consequences of the lack of representativeness in the central bank, so long as it pursues the kind of pragmatic policies which it in fact has been pursuing, are not that great. But in societies in which there is a greater degree of inequality and in which governments in the past have pursued policies which have advanced the interests of the elites, the consequences may be greater. Those hurt by tight monetary and fiscal policies may feel their interests are not being taken into account. Without a consensus on the fairness of the decisions, unions may be less willing to accept the consequences, with the kinds of adverse effects currently being witnessed in Russia.

The implications should be clear: macroeconomic stabilization measures are more likely to be successful if there is a consensus behind those policies, as the experiences in Brazil, Ghana and Israel suggest. That consensus is more likely to emerge if there is a widespread belief not only in the overall equity of the economic structure but in the representativeness of the institutions themselves: individuals are more willing to accept outcomes if they believe their voice has been heard. Brazil has demonstrated that it does not take an authoritarian government to bring inflation down - in fact, a democratic government responding to the strongly expressed wishes of the electorate may be in a better position to do so. The gains from more representative institutions may be even greater in societies with greater inequality. Institutions need to be designed to take these factors into account.

Thus, while a commitment to democratic principles may provide strong motivation for questioning the desirability of an unrepresentative and independent central bank, and while historical experience suggests that little if anything of importance has been gained by foregoing more democratic processes, in some circumstances, the very efficacy of the institution may be compromised. Moreover, improvements in the distribution of wealth, by increasing a sense of overall fairness, may have ancillary benefits in the ability to achieve macroeconomic stability, as well as the acceptance of broader reforms.

Concluding Comments

This paper is one of a series of talks that I have been giving, trying to sketch out the elements of what is sometimes called the post-Washington-consensus consensus (Stiglitz 1998a,b,c,d). The Washington-consensus was borne largely of the experiences in Latin America with high and variable inflation, large government deficits, high levels of protection, and inefficient government enterprises. That these policies were dysfunctional was clear. We should not forget this painful lesson that, perhaps, cannot be repeated too often. But neither should we fool ourselves into thinking that eliminating these distortions will automatically lead to development. As I have argued, there is far more to development than low inflation and private enterprises. It includes establishing institutions and the creation and maintenance of social capital. Here, I have focused on the importance of land reform, not only for the narrower objective of increasing efficiency, but also from the broader perspective of advancing development. Just as development is broader than the narrow technical issues upon which earlier development strategies focused, so too successful land reform is broader, both in what is required for its success and its consequences. It needs, for instance, to be accompanied with reforms in credit markets and the provision of extension and other services. And if successful, its benefits include a redistribution of political power, a greater sense of equity, and a greater willingness to accept a variety of reforms, at the macro and micro levels, that are necessary as part of the developmental transformation of society.

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Notes

1 The issue turns out to be more subtle than this heuristic argument suggests, as reflected in the fact that there are some special cases, such as economies with a single output, where sharecropping is constrained Pareto efficient.

² For a survey of these issues see Stiglitz (1987).

³ Sharecropping is very prevalent in many developing countries. The share of tenanted land under sharecropping arrangements is 30 percent in Thailand, 50 percent in India, and 90 percent in Bangladesh (Otsuka, Chuma, and Hayami 1992). Although there is relatively little sharecropping in Latin America, it still serves as a simple example to make more general points.

⁴ One of the early theories of sharecropping, due to Cheung (1969), used the premise that monitoring is costless to argue that sharecropping is not distortionary. But this is an implausible assumption, especially given the widespread existence of sharecropping contracts which can best be explained by the existence of costly monitoring (see Stiglitz 1974). In fact, in general, sharecropping is not even constrained Pareto optimal in general equilibrium models where prices are endogenous, an implication of the more general theorem that competitive economies with incomplete markets and imperfect information are not in general constrained Pareto optimal. See Greenwald and Stiglitz (1986).

⁵ Sharecropping contracts sometimes attempt to mitigate these problems, but these same agency problems which give rise to sharecropping in the first place limit the effectiveness of these contractual arrangements. See Braverman and Stiglitz (1986).

⁶ One study found that average interest rates charged by informal moneylenders in one Pakistani village were around 79 percent a year, despite the very low default rates (Aleem 1993). In part this was explained by the very large cost of collecting information and monitoring loan recipients. See also Hoff, Braverman, and Stiglitz (1993) and Hoff and Stiglitz (1997).

⁷ The interaction between land, labor, capital and other markets has been emphasized in the literature focusing on the inter-linkage of markets. See Braverman and Stiglitz (1982) and Bardhan (1989).

⁸ Several of these programs have been even more successful than the Grameen Bank, yielding returns substantially in excess of both administrative and financing costs. Some of these are discussed in World Bank (forthcoming).

⁹ A survey of 676 farmers in Kenya found that 39 percent of them learned about better practices from their neighbors and other farmers without directly getting the information from extension services (cited in World Bank forthcoming).

¹⁰ That is, optimal monitoring implies that there is still some role for performance pay, regardless of the risk aversion of the agent (so long as it is not infinite).

¹¹ One sufficient condition is that all of the elements of A are positive.

¹² For one account of some of the pitfalls of counterproductive restrictions on land transfers see Hayami and Otsuka (1993).

¹³ These issues are discussed at greater length in Stiglitz (1998c).

¹⁴ More a more extended discussion of the parallel between the approach to the economics of market socialism and neo-classical economics, see Stiglitz (1994).

¹⁵ The unemployment rate has risen sharply since January 1998, but this is not the result of the Real Plan.

¹⁶ See Stiglitz (1997a) for an extended discussion of the issues in this section.

¹⁷ The traditional models of political business cycles relied on myopia. In the last decade there have been a number of models that have assumed rational expectations but still derived political business cycles (see Alesina and Sachs 1988). These models rely on incomplete information and have somewhat richer dynamics than the stylized model I am sketching.

¹⁸ See Stiglitz (1997b) and other papers in the "Symposium: The Natural Rate of Unemployment" in the Journal of Economic Perspectives.