During the late 1950s, Argentinian academician and statesmen, Raúl Prebisch, introduced the Dependency Theory in response to concerns that the gap between rich and poor countries was becoming far too wide. Additionally, policy makers were troubled by the fact that rapid economic growth in industrialised parts of the world did not necessarily lead to growth in poorer countries through the domino effect. In essence, the Dependency Theory broke up countries into three different types of states: core, periphery, and semi-periphery. The core states were rapidly developed and growing, the semi-periphery were moderately developed, and the periphery were some of the poorest countries in the world. According to Prebisch, periphery states would always stay underdeveloped due to declining terms of trade when trading with core countries. Overtime, the value of the raw materials that periphery states export declines relative to the finished products they import. This explains why in many countries, development had still not occurred by the late 20th century. For decades, economists and social historians used the Dependency Theory to explain why many parts of the world continued to stay underdeveloped while economic growth occurred in already prosperous nations.
Managing director and head of emerging markets at CitiBank, David Lubin, published Dance of the Trillions: Developing Countries and Global Finance in 2018 that discussed topics regarding modern capital flows between high and low-income countries. Unlike the Dependency Theory, Mr. Lubin takes a more positive outlook by taking readers through a modern historical tour of economic development within emerging economies. He traces how the traditional approach of Washington DC-led liberalization is slowly being replaced by a Beijing-led approach of state-imposed restrictions.
In 1989, American economist and LSE alumni, John Williamson, coined the term “Washington Consensus” in reference to a set of market oriented policies prescribed by Washington-based policy institutions for developing countries. Although it was originally created for Latin American countries, it slowly spread to many other developing regions around the world, such as countries within sub-Saharan Africa. In essence, the “Washington Consensus” consisted of ten economic policy prescriptions that was considered to be the reform package for crisis-wracked developing economies. The ten policies consisted of fiscal expenditure discipline, public expenditure priorities, tax reform within the state, financial liberalisation, opening of exchange rate policies, trade liberalisation, foreign direct investment, privatisation of most industries, deregulation by government agencies, and securing property rights. The early 1980s debt crisis prompted fiscal policy makers to implement specific laws that tackled the negative role of fiscal deficits on economic development.
Therefore, the “Washington Consensus” stated that developing countries should have a small budget deficit without the necessary resources to tax inflation. Secondly, policy makers wanted to redirect expenditure from politically sensitive areas to fields with the potential to greatly improve income distribution within the nation, such as healthcare, primary and secondary education, and infrastructural projects. Many components of public spending – food and fuel consumption, subsidies to state-owned firms – favoured urban richer populations and led to great economic distortion. Although reducing subsidies of politically connected sectors can inflict costs on some segments of the population, it frees up expenditure for the government to spend on social and public projects. Broadening up tax reform was one of the most important aspects of the “Washington Consensus” for many of its proponents. They believed that exceptions should be removed for politically connected taxpayers and organisations so that tax collection methods will be improved and there will be less overall tax evasion. Additionally, financial and trade liberalisation meant that the free market would determine interest rates and quantitative trade restrictions would be replaced by tariffs on goods and services. Lastly, another essential part of the program was the privatisation and deregulation of a wide variety of industries. State-owned firms are often surviving on government subsidies that widen countries’ fiscal deficits and are extremely inefficient. Therefore, it was essential for these businesses to be taken out of the hands of the government and be sold off to experienced investors. Furthermore, restricting or banning foreign direct investment often gives domestic firms a monopoly and reduces competition within the market. Thus, it is important foreign investors come in and allow the country to create jobs, gain capital, and build skills, while exposing domestic firms to a high-level of competition. All of these different economic ideologies lead to what David Luben in his book coins as Capital Account Fundalism, which essentially states that a developing country’s relationship with international finance should be completely unregulated.
The “Washington Consensus” is considered to be a relatively new ideology, and was founded in response to the 1973 world economic oil crisis. Huge current account surpluses were created due to an increase in the price of oil. As a result, the surplus of oil exporters needed to be exported to other parts of the world. When the idea was first proposed, Mr. Luben talks about a lot of the backlash at the time, especially from America’s transatlantic friend. Dennis Heeley, the Chancellor of the Exchequer at the time, opposed this by saying that the government should always be at the center of this process: “The Americans were bitterly opposed because it would have meant interfering in the freedom of financial markets and freedom of American commercial banks to make enormous profits from leading to the third world.” In other words, the US spread the “Washington Consensus” by creating an intellectual ideology from an economic one.
As mentioned in the book, the common economic theme was that capital flows were extremely volatile as they depended slowly on the US market. When monetary conditions were loose, capital was pushed, and when the Central Bank tightened monetary policy, capital seemed to come back. The Federal Fund Rates (FFR) level and long-end yield curve solely determined the prosperity of developing nations. Therefore, by the end of the 1990s, emerging economies wanted the international financial system to be safer for them. However, due to the destabilising and volatile US economy, developing economies created a sense of self-assurance by making themselves safe for the financial system. In the book Mr. Luben calls this “wrapping up warmly” – in the winters, one cannot change the weather, and therefore has to prepare themselves for the cold. In order to “wrap up warmly”, developing countries accumulate foreign exchange reserves throughout the world. If there’s capital outflow from the economy, there always needs to be dollar reserves that the country has in place. Additionally, two things exponse a country to a large financial crisis: (1) having a fixed exchange crisis and (2) the absence of a stock of foreign exchange reserves.
Although Turkey and Argentina failed in the process of “dressing up warmly”, China fundamentally succeeded in this process. Between 2001-2011, China single handedly was responsible for the biggest commodity boom in 200 years. This level of international liquidity helped the country finance its deficit, and now they are acting as a supplier of funding to emerging market economies. Through the Belt and Road Initiative, China is set to become a global superpower within this generation. However, the fascinating part is that China used a modified version of the “Washington Consensus”. They never opened their capital accounts, but were very selective with their foreign direct investment. China has successfully used the government to allocate capital within the economy. Furthermore, contrary to many liberalization ideas, the country has greatly benefited from state involvement in the private sector.
As the next episode of globalisation begins, Mr. Luben wonders in the book what the world would look like moving from a “Washington Consensus” model to a “Beijing-led Consensus.” As China’s impact across developing countries increases, will developing markets never fully liberalize their capital accounts?
This article was written by: Dhruv Mathur, currently a student at the London School of Economics, pursuing BSc Economic History.