• Achieve budget surpluses in times of prosperity so as to provide scope for stabilizing deficits to emerge by operation of the automatic stabilizers in bad times. It is no good complaining that Argentina or Brazil were discouraged from running budget deficits in 2002; the time to start running an anticyclical policy is during the boom.
• Make sure that sub-national governments are subject to hard budget constraints, and define their entitlement to transfers from the central government as a proportion of national public expenditure rather than tax revenue, so that they cannot undermine an anti-cyclical policy run by the central government.
• Accumulate reserves and build a stabilization fund when exports (particularly those of cyclically unstable primary commodities) are strong.
• Adopt a sufficiently flexible exchange rate regime to allow external competitiveness to be improved through currency depreciation when there is a sudden stop to capital inflows or other balance of payments difficulties emerge, but do what is possible (e.g. by using measures like Chile’s encaje during much of the 1990s) to avoid this leading to overvaluation if capital inflows threaten to become excessive.
• Except in countries that have close relations with the United States in terms of both trade and financial flows, where full dollarization makes sense, aim to minimize use of the dollar both as an asset in terms of which residents hold savings and in terms of which loans are contracted. Unless and until this aspiration is achieved, make banks insure risks that they incur in lending in dollars to the non-tradable sector.
• Complement a flexible exchange rate with a monetary policy focused on targeting a low rate of inflation.
• Strengthen prudential supervision of the banking system and enforce capital adequacy ratios above the Basel minimum to minimize the danger of banking collapses.
• Increase domestic saving so that investment can rise without undue dependence on capital imports. This will involve a further strengthening of structural fiscal positions, and it can also be promoted by completing the process of pension reform that has already been started in many countries.

One idea we endorse is for some regional body to develop an analogy to the Maastricht criteria for fiscal discipline in the European Union. These should be more sophisticated than Maastricht’s limits of a 3 percent of GDP cap on the non-cyclically adjusted budget deficit and a 60 percent cap on the public debt/GDP ratio, and should instead aim to build pressure for a consistent anti-cyclical policy. For example, the growth of government expenditure might be capped at the estimated trend rate of growth of the economy, while tax revenue could be required to grow at least in line with nominal GDP. A government that wished to enlarge government expenditure, or cut taxes, by more than this allowed would be expected to demonstrate to its peers in the regional monitoring organization that its plans did not prejudice the maintenance of fiscal discipline. Hopefully its peers would not tolerate any chicanery of “supply-side economics” that might be presented to them to rationalize fiscal lapses. Where there is a convincing need for higher public expenditure, this should be financed soundly, if necessary by raising taxes.
We do not nominate an organization to take responsibility for this task, because none of those available really fit the bill. The IMF has the right expertise, but it is not controlled from within the region and up to now it has signally failed to display a concern for cyclical stabilization. The IDB, the OAS, and CEPAL all cover the right geographical area, but none has up to now developed the appropriate expertise. It would make a nice function for an FTAA to take on, but judging by US use of its bilateral free trade area agreement to force Chile to curb potential future use of the encaje, it seems unlikely that an FTAA will be allowed by the United States to play a constructive role. There is another important institutional issue that would need to be resolved: specification of a penalty for breaking the rules and an enforcement mechanism to secure payment of the penalty when it is due. We leave both of these institutional issues open, and limit our contribution to identifying the need for such a mechanism.

First-generation reforms
Of course, we do not argue that Latin America should be content with the growth that would result simply from crisis-proofing the economies of the region. Countries also need a faster rate of growth than they achieved in the first half of the 1990s (except for Chile, which grew impressively), before the crises started erupting. Although a lot was done in the last decade and a half to implement what are now referred to as “first-generation” reforms (the sort of reforms I included in the Washington Consensus), and the evidence says that these did indeed serve to accelerate rather than retard the growth rate (Fernandez-Arias and Montiel, 1997; Lora and Panizza, 2002; Stallings and Peres, 2000), the process is still incomplete in several dimensions.

Perhaps the most egregious omission has been to fail to make the labor market more flexible. The reason for this is not difficult to comprehend, insofar as those who regard themselves as beneficiaries of the status quo – those who have unionized formal-sector jobs – constitute an interest group that is sufficiently powerful politically to deter potential reformers, and sufficiently underprivileged economically to evoke public sympathy. Nevertheless, the rigidity in the labor market constitutes a major obstacle to an expansion of employment in the formal economy. This does not just impede faster growth, but it does so primarily at the cost of some of the poorest members of society, namely those who are denied the opportunity to move out of the informal economy and achieve even the most basic elements of the social wage (health insurance, a pension, safeguards against unemployment).

Is there therefore a dilemma in choosing between the interests of organized labor in maintaining the rigidities of the labor market and the interests of those in the informal sector? A crude program focused on nothing but rolling back the benefits that labor has won over the years, from severance payments to the social wage to restrictions on hours worked to prohibitions on what children (for example) are allowed to do, would indeed pose such a dilemma. But it is possible to envisage ways of restoring flexibility that would not prejudice the interests of organized labor (as has been achieved over the last 20 years in the Netherlands). For example, severance payments can be replaced by a system of individual accounts, as in Colombia. The social wage can be modified to forms that give the individual worker a direct stake in the payments made on his or her behalf (for example, by adopting defined-contribution rather than defined-benefit pension schemes, which also benefits workers by allowing much greater portability of pensions). Existing workers can be grandfathered (if they so desire, and by no means all of them would) in arrangements allowing for more flexible working hours. Not all regulations, certainly not those limiting child labor, deserve to be scrapped. And improvements in labor market information, skill certification, and occupational training systems could improve the functioning of the labor market so as to raise productivity and reduce the waste that results from mismatches between demand and supply. It is in fact possible to design a program that would liberalize the labor market and that enlightened trade unionists would recognize as consistent with their interests.

A number of other first-generation reforms are also incomplete. In terms of trade policy, a lot of progress has been made in liberalizing imports, but apart from Mexico (with NAFTA), more recently Central America, and in the future Chile, there has been essentially no progress in improving access to the markets of developed countries. Latin America certainly needs a Free Trade Area of the Americas, and a successful Doha round in the WTO, to open up export opportunities in the developed countries, as well as to provide stability in the regulations that govern intra-regional trade. Similarly, while a lot of privatization has happened, there remain sectors--most notably in banking, with the continued existence of many state banks--where the process is seriously incomplete. Privatization is by far the most unpopular of the first-generation reforms with the Latin American public, but the evidence simply does not support the view that privatization has not brought benefits to the general public. Admittedly privatizations have sometimes been done badly, but the remedy is not to stop the process of privatization but to make sure it is done with proper care, and with newly privatized firms either exposed to competition or subject to proper regulation. Finally, in the financial sector, there remain countries where the process of liberalization has not been supplemented by the necessary strengthening of prudential supervision.

Second-generation reforms
But it would be wrong to give the impression that the main task at this juncture in history is to complete “first-generation reforms”. The major thrust of development economics in the 1990s was recognition of the crucial role of institutions in permitting an economy to function effectively. The importance of institutional reforms in complementing first-generation reforms in Latin America was first emphasized by Moisés Naím (1994), who dubbed these “second-generation reforms”¹, and a recent paper of Ross Levine and William Easterly (2002) concludes that the state of institutional development furnishes the only variable that reliably predicts how developed a country is. An important role for the state of institutions is perfectly consistent with mainstream economics, which posits a crucial role for the state in creating and maintaining the institutional infrastructure of a market economy, in providing public goods, in internalizing externalities, and, depending on political views, in correcting income distribution. (Note that none of these roles serve to rationalize a government responsibility for running steel mills or electricity generators or banks.)

Second-generation reforms have sometimes been pictured as politically boring esoterica like creating budget offices or Securities and Exchange Commissions. Our book argues that in fact they are liable to involve political confrontation with some of society’s most potent and heavily entrenched interest groups, such as the judiciary and public school teachers. The judiciary in Latin America are notorious for ignoring economic considerations, for example by over-riding creditor rights to the point where creditors are reluctant to lend. Or, worse still, they are so corrupt that judges have to be paid to permit money to be recovered. Similarly, many teachers’ unions have been captured by small groups with political agendas unrelated to the teaching profession. The answer, it is argued, is not to initiate a campaign to “break the unions”, but rather to seek to professionalize teaching so that teachers will want their unions to become positive partners for reform. A third politically powerful group whose attitudes and working practices often need to be transformed is the civil service.

One institutional reform that we think would be a mistake is introduction of an industrial policy, meaning by this a program that requires some government agency to “pick winners” (to help companies that are judged likely to be able to contribute something special to the national economy). There is little reason to think that industrial policies were the key ingredient of success in East Asia (see Noland and Pack 2003); while it is true that several of those countries had some form or other of industrial policy at some stage of their development, it is also true that one of the most successful of those economies, namely Hong Kong, never did. It is difficult to explain the success of a group of countries by something that one of them conspicuously lacked: one needs to search for the common features of those countries, like their high saving rates, outward orientation, macroeconomic stability, work ethic, and strong educational systems. This is not to say that an industrial policy would necessarily be a disaster, because in a country with strong private firms one can expect these to ignore misguided government pressures (such as the attempt of the Japanese MITI to rationalize the Japanese car industry by telling Honda not to make cars). But we believe that government has more useful things to do than issue advice that can only be defended by arguing that firms are free to ignore it.

Specifically, while government should stay out of making business decisions, and leave those to the people who stand to gain if the decisions made are good ones and lose if they are not, it has an important role in creating a business-friendly environment. This is partly the good old-fashioned business of providing decent infrastructure, a stable and predictable macroeconomic, legal, and political environment, and a strong human resource base. But it also includes the modern task of building a national innovation system to promote the diffusion of technological information and fund pre-competitive research, as well as providing tax incentives for R&D and encouraging venture capital, and may extend to encouraging the growth of industrial clusters. Latin America (though less so Brazil) has lagged badly in developing high-tech industries, as shown in the region’s poor placement in the proportion of technically sophisticated exports as well as its low ranking in the Competitiveness Indices of the World Economic Forum. While there is still ample scope for productivity to increase in the region by copying best practices developed in the rest of the world, it may need an act of Schumpeterian innovation – and therefore the sort of technologically supportive infrastructure that comprises a national innovation system – to bring world best practice to Latin America.

In addition to reforming the judiciary, teachers, and the civil service (especially budget offices, SECs, and central banks, which deserve autonomy even if not complete independence of the political process), and building up national innovation systems, second-generation reforms need to address two major economic areas. One involves modernizing the institutional infrastructure of a market economy. Unlike the economies in transition, which had the challenging task of creating such an infrastructure from scratch, Latin America already had the essential features of a market economy in place when the present wave of reform started in the late 1980s. Nonetheless, there are deficiencies in terms of property rights (particularly the lack of property rights in the informal sector to which Hernando de Soto has repeatedly drawn attention) and, in many countries, bankruptcy laws.²

The other major need for institutional reform is in the financial sector. What is needed here, in addition to the strengthening of prudential supervision, is a whole series of apparently minor changes like improving transparency, upgrading accountancy, strengthening the rights of minority creditors, facilitating the recovery of assets pledged as collateral, and developing credit registries. While such reforms may appear minor, in fact they are of fundamental importance – but quite difficult to implement.

Doubtless none of these economic institutions begin to compare in importance to the political institutions that can allow a Hugo Chavez to capture control of the state and ravage an economy as is happening in Venezuela. Our book also has a chapter about the political reforms that might increase the likelihood of the political process generating the sort of progressive but responsible reforms that we advocate. It is argued that the presidentialist systems characteristic of Latin America would benefit by a balance of power between president and legislature, rather than gutting the legislature, with the legislators consisting of career professionals responsible to their constituents rather than either the executive or party bosses. Elections for different positions should be held simultaneously, rather than subjecting countries to almost permanent electioneering.

Income distribution and the social agenda
The final major thrust of the book concerns income distribution, a topic of major importance throughout Latin America and certainly in Brazil, which has one of the most unequal distributions in the world. The starting point is recognition that there are two ways through which poor people can become less poor. One is by an increase in the size of the economic pie from which everyone in society draws their income. The other is by redistribution of a given-sized pie, so that the rich get a smaller proportion and the poor get a bigger proportion. On a longer time scale the most effective way to give the poor a bigger proportion tends to be to equalize opportunities by paying more attention to the social agenda.

The evidence says pretty clearly that growth benefits the poor, even if nothing is consciously done to make it “pro-poor growth”. Benefits do trickle down. One influential analysis concluded that the poor typically benefit more or less in proportion to what they already have (Dollar and Kraay, 2000), although others have concluded that the elasticity of low incomes with respect to aggregate growth is significantly less than one (Foster and Székely, 2002). But even if the poor do benefit in as great a proportion as others, they will not gain an awful lot from economic growth if they do not have very much to start with, as is the case in Brazil and almost everywhere else in Latin America. Since most people believe that improving the lot of the poor matters more than securing an equal income gain to the rich, there is an abstract case for supplementing the gains from growth by a measure of income redistribution. And since a country where the poor receive a very small proportion of income needs to reallocate a relatively small part of the income of the rich in order to make a big dent in poverty, that case applies in spades to Latin America. If one learns that poverty increased in Mexico in the 1990s even though average per capita income increased (Székely, 2001), one may feel that the case for action to improve the distribution of income is pretty compelling.

Arthur Okun (1975) described the trade-off between the level of income and its equitable distribution as “the big trade-off”. If society were efficiently organized, then we would be on the efficiency/equity frontier, where any gain in equity would have to be paid for by a reduction in the level of income. If, for example, a country tried to redistribute income from rich to poor through higher taxes and increased welfare benefits, then there would be a cost in terms of the disincentive effects of high marginal tax rates reducing effort and therefore income. In practice most societies are usually operating somewhere within the efficient frontier so that there are opportunities for win-win solutions, and obviously one wants to identify and exploit these wherever one can. Birdsall and de la Torre (2001) offered a list of 10 reforms that they argued would improve equity without reducing growth. Their ten reforms constitute a sensible list³, even if one can debate whether they all quite fit the rubric of improving equity without diminishing growth. For example, their first two proposals concern the development of fiscal rules that would secure an anti-cyclical fiscal policy, such as were discussed above under the heading of crisis-proofing; one could argue these are at least as important for increasing the average rate of growth as for improving income distribution. But the more fundamental point is that there is no intellectual justification for arguing that only win-win solutions deserve to be considered. One always needs to be aware of the potential cost in terms of efficiency (or growth) of actions to improve income distribution, but in a highly unequal region like Latin America opportunities for making large distributive gains for modest efficiency costs deserve to be seized.

Progressive taxes are the classic instrument for redistributing income. One of the more questionable aspects of the reforms of the past decade in Latin America has been the form that tax reform has tended to take, with a shift in the burden of taxation from income taxes (which are typically at least mildly progressive) to consumption taxes (which are usually at least mildly regressive). While the tax reforms that have occurred have been useful in developing a broader tax base, we argue that it is time to consider reversing the process of shifting from direct to indirect taxation. In particular, one needs an effort to increase direct tax collections. For incentive reasons one wants to avoid increasing the marginal tax rate on earned income, which suggests that attempts to collect more from direct taxes should be focused on the following three elements:

• The development of property taxation as a major revenue source (it is the most natural revenue source for the sub-national government units that are being spawned by the process of decentralization that has become so popular).
• The elimination of tax loopholes, which not only can increase revenue but can also simplify tax obligations and thus aid enforcement.
• Better tax collection, particularly of the income earned on flight capital parked abroad, which will require the signing of tax information-sharing arrangements with at least the principal havens for capital flight.

Any increase in tax revenue then needs to be devoted to spending on basic social services, including a social safety net as well as education and health, so that the net effect will be a significant impact in terms of reducing inequality, particularly by expanding opportunities for the poor. But it may be a mistake to limit the benefits exclusively to the poor, because at least in some circumstances it is only a middle-class stake in public spending that gives the extra spending a chance of being politically sustainable. At the same time, it must always be remembered that spreading expenditures more broadly to include the non-poor inevitably reduces the anti-poverty impact of a given level of expenditure.

With the best will in the world, however, what is achievable through the tax system is limited, in part by the fact that one of the things that money is good at buying is advice on how to minimize a tax bill. Really significant improvements in distribution will come only by remedying the fundamental weakness that causes poverty, which is that too many people lack the assets that enable them to work their way out of poverty. The basic principle of a market economy is that people exchange like value for like value. Hence in order to earn a decent living the poor must have the opportunity to offer something that others want and will pay to buy: those who have nothing worthwhile to offer because they have no assets are unable to earn a decent living. The solution is not to abolish the market economy, which was tried in the communist countries for 70 years and proved a disastrous dead end, but to give the poor access to assets that will enable them to make and sell things that others will pay to buy. That means:

• Education. There is no hope unless the poor get more human capital than they have had in the past. Latin America, and especially Brazil, has made some progress in improving education in the last decade, but it is still lagging on a world scale.
• Titling programs to provide property rights to the informal sector and allow Hernando de Soto’s “mystery of capital” to be unlocked (De Soto, 2000).
• Land reform. The Brazilian program of recent years to help peasants buy land from latifundia landlords provides a model. Landlords do not feel their vital interests to be threatened and therefore they do not resort to extreme measures to thwart the program. Property rights are respected. The peasants get opportunities but not handouts, which seems to be what they want.
• Microcredit. Organizations to supply microcredit are spreading, but they still serve only about 2 million of Latin America’s 200 million poor. The biggest obstacle to an expanded program consists of the very high real interest rates that have been common in the region. These high interest rates mean either that microcredit programs have a substantial fiscal cost and create an incentive to divert funds to the less poor (if interest rates are subsidized), or (otherwise) that they do not convey much benefit to the borrowers. A macro program that lowers market interest rates would also facilitate the spread of microcredit.

Mechanisms like these are becoming increasingly realistic because of the strengthening of civil society, which is one of the most positive trends in Latin America. They will nonetheless take time to produce a social revolution, for the very basic reason that they rely on the creation of new assets, and it takes time to produce new assets. But, unlike populist programs, they do have the potential to produce a real social revolution if they are pursued steadfastly. And they could do so without jeopardizing the interests of the rich, thus holding out the hope that these traditionally fragmented societies might finally begin to develop real social cohesion.

Concluding comments
Anyone looking for a new paradigm for economic development will doubtless be disappointed by our agenda. The view of the authors of the book is that past alternatives have failed and that the anti-globalization movement has not begun to provide a coherent policy alternative. The need of the hour is to press forward, prudently but boldly, with the sort of agenda discussed above. One blueprint is not right for all countries, but the sorts of proposals explored in our book seem appropriate for Brazil as for most other Latin American countries.

References
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DE SOTO, H. The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else. London: Black Swan, 2000.
DOLLAR, D.; KRAY, A. Growth is Good for the Poor. Journal of Economic Growth 7, no. 3, p. 195-225, 2000.
FERNANDEZ-ARIAS, E.; MONTIEL, P. Reform and Growth in Latin America: All Pain, No Gain? Working Paper 351. Washington: Inter-American Development Bank, 1997.
FOSTER, J.; SZÉKELY, M.. Is Economic Growth Good for the Poor? Tracking Low Incomes Using General Means. Research Department Working Paper 453. Washington: Inter-American Development Bank, 2001.
KUCZYNSKI, P.-P., WILLIAMSON, J. After the Washington Consensus: Restarting Growth and Reform in Latin America. Washington: Institute for International Economics, 2003.
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LORA, E.; PANIZZA, U. Structural Reforms in Latin America under Scrutiny. Washington: Inter-American Development Bank, 2002.
NAÍM, M. Latin America: The Second Stage of Reform. Journal of Democracy 5, no. 4, p. 32-48, oct 1994.
NOLAND, M.; PACK, H. Industrialization Policy in an Era of Globalization: Lessons from Asia. Washington: Institute for International Economics, 2003.
OKUN, A. Equality and Efficiency: The Big Trade-Off. Washington: Brookings Institution, 1975.
STALLINGS, B.; PERES, W. Growth, Employment, and Equity: The Impact of the Economic Reforms in Latin America and the Caribbean. Washington: Brookings Institution, 2000.
STIGLITZ, J. E. Globalization and its Discontents. New York: Norton, 2002.
SZÉKELY, M. The 1990s in Latin America: Another Decade of Persistent Inequality, but with Somewhat Lower Poverty. Research Department Working Paper 454. Washington: Inter-American Development Bank, 2001.
WILLIAMSON, J. Latin American Adjustment: How Much Has Happened? Washington: Institute for International Economics, 1990. Chapter 2 is available at <http://www.iie.com/jwilliamson.htm>

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*John Williamson is Senior Fellow, Institute for International Economics, Washington DC, USA.