From Vox, via Economist's View

Institutional and policy reforms are promoted as a way to improve economic performance and growth in poor countries. Reforms that have received substantial attention over the past decade or so are often referred to as the "Washington consensus". These include trade opening, financial liberalisation, judicial reform, privatisation, reduction of entry barriers, tax reform, removal of targeted industrial subsidies and central bank independence. Although there are sound economic theories suggesting why these reforms might be important in improving economic performance, the experience of many developing nations that have embraced these reforms over the last two decades shows that the gains anticipated by the proponents of reform have often not materialized.

Although one can undoubtedly dream up reasons why sensible reforms will lead to bad economic outcomes because of "second best" reasons, it is fairly implausible that the removal of the very high entry barriers and the corruption-ridden targeted industrial subsidies or putting an end to hyperinflation will be counterproductive. So why has the result of the Washington consensus reforms been so dismal?

To provide a satisfactory answer to this question one first needs to consider why there was a need for reform in the first place. Reforms are necessary because of the serious and endemic policy distortions in many developing nations. One can find instances where the root of these distortionary policies is in mistaken economic theories. But this is the exception rather than the rule. Few policymakers create insurmountable entry barriers, hyperinflations or large budget deficits because they think this is good for the economy. Instead, the root of distortions lies in political economy.

In most instances, bad policies are adopted because of political economy constraints and distorted incentives facing politicians in many societies with poor general institutions, such as weak checks and balances and lack of political accountability. These institutional weaknesses make it possible for certain constituencies to demand policies that are costly for the society at large and make it beneficial or convenient for politicians to pursue such distortionary policies to satisfy these constituencies or to enrich themselves. The success and effectiveness of policy reform have to be understood in the context of these existing political economy problems.

In this light, the ineffectiveness of many sensible reforms is not surprising. Few people would expect privatisation, financial liberalisation or Central Bank independence to miraculously transform the economy and jumpstart growth in Zimbabwe as long as Robert Mugabe is in power or in Sudan as long as Omar al-Bashir’s kleptocratic and genocidal regime remains in place. ...

Basic political economy theory suggests that policy reform can be effective only when the political context is right. If the context provides political constraints and accountability mechanisms so that there is a strong tendency to adopt good policies, there is little room for reforms to have major effects. If the context is bad, so that politics and policymaking are highly non-representative, reforms are likely to be irrelevant because they can easily be undermined. It is in intermediate situations that reforms will have bite: constraints are weak enough to generate bad policy, but not so weak that all reform is undermined. However, even when policy reform is effective in one dimension, it can create countervailing distortions via the seesaw effect. Policymakers can make use of other distortionary instruments in order to satisfy the same politically powerful constituencies served by the previous distortions.

The most important lesson from the political economy perspective is that contrary to what many of the critics of the Washington Consensus reforms claim, these reforms did not fail because of second-best reasons or because they were not the right remedies for the ills of developing economies. Rather, they are more likely to have failed because they were implemented in the context of the same political economy problems and political circumstances that led to the distortions in the first place. These political circumstances undermined the reforms either directly, or as in the seesaw effect, indirectly through the use of alternative instruments.