by Lance Taylor While external liberalisation has generated a range of economic and social outcomes, for developing countries it seems to go hand-in-hand with falling growth and rising inequality. Economic policy in developing and post-socialist states during the past 10-15 years has had a single dominating theme: liberalising the balance of payments, on both current and capital accounts. This wave of external deregulation was the central feature of globalisation for the non-industrialised world.      In two recent research projects, the implications of external liberalisation have been investigated through the use of quantified narrative histories for a number of countries1. The results are sobering. At its infrequent best, liberalisation generated modest improvements in economic growth and distributional equity; at worst it was associated with sharp deterioration in economic performance. The obvious implication is that the liberalisation strategy needs to be seriously re-thought. A good place to start is with current views about its likely effects. The Liberalisation Debate The ‘import substitution’ policy model that liberalisation replaced had been criticised for failing to promote efficient and competitive industrial production, for creating insufficient employment, and for failing to reduce income inequality. The new package was supposed to remedy these defects by creating visible increases in economic efficiency and output growth. Advocates were less explicit about its distributional consequences. The predominant, or ‘Washington Consensus’, view is that deregulated markets are likely to lead to better economic performance, at least in the medium to long term. Even if there are adverse transitional impacts, they can be cushioned by social policies; in any case, after some time, they will be outweighed by more rapid income growth. These conclusions rest on supply-side arguments. The purpose of trade reform is to switch production from non-tradable goods and inefficient import-substitutes towards exportable goods in which poor countries should have a comparative advantage. Postulated full employment of all resources (labour included) enables such a switch to be made painlessly. Opening the capital account is supposed to bring financial inflows that will stimulate investment and productivity growth.      A second position is reflected in the annual Human Development Reports issued by the United Nations Development Programme. It is more radical in arguing that social policies should be used to help the poor, on the implicit assumption that the forces determining income distribution, the extent of poverty, and social relationships are largely independent of liberalisation, globalisation, and macro-level market processes. Finally, a third group believes that, while there may be supply-side benefits from trade and capital market reforms, one should not overlook aggregate demand, its potentially unfavourable interactions with distribution, and the impact of capital inflows on relative prices.      Import substitution relied on expansion of internal markets with rising real wages as part of the strategy. Under the new regime, controlling wage costs has come to centre-stage. If wage levels are seriously reduced, and/or workers with high consumption propensities lose their jobs, contraction of domestic demand could cut labour income in sectors that produce for the local market. Income inequality could rise if displaced, unskilled workers end up in informal service sector activities for which there is a declining demand.      Rising capital inflows following liberalisation lead to real exchange rate appreciation (a ‘stronger’ local currency), offsetting incentives for traded goods production and forcing greater reductions in real wages. Appreciation in turn may be linked to high real interest rates, which add to production costs and penalise capital formation.      Via the banking system, capital inflows feed into international reserves and domestic credit expansion. On the positive side, more credit may stimulate aggregate spending through increased domestic investment. However, it can also trigger a consumption boom (with purchases heavily weighted toward imports) or a speculative asset price bubble (typically in equity and/or real estate). The demand expansion may prove to be short-lived, if the consequent widening of the external balance is unsustainable, or if capital flees the economy when the bubble begins to deflate. Effects of Liberalisation      An immediate conclusion from the studies is that the effects of globalisation and liberalisation have not been uniformly favourable. In a suggestive classification, Table 1 presents changes in growth rates and the primary income distribution for the countries in the studies.      The general impression in the table is a tilt toward the southeast – slower growth and rising inequality. Just two countries had a clear distributional improvement and only Chile, after 1990, combined high growth with decreasing inequality (in contrast to increasing inequality over the preceding liberal 15 years). Stable or more rapid growth was observed in a few small, open economies that applied a somewhat illiberal policy orientation, as discussed below. Two thirds of the countries had rising inequality, and the five toward the extreme southeast were, to a greater or lesser extent, ‘disasters’. Results of Social Policy The macroeconomic conditions emerging from external liberalisation were scarcely favourable for an often outdated traded goods sector making the transition to a free-trade environment. Productivity increased, yet output gains were usually not strong enough to offset employment and wage losses via other sectors of the economy. The result has been a loss of relatively high-paying jobs, replaced by underemployment and lower wages in the service sector, often in the informal economy. Such labour market adjustments contributed to greater inequality in almost all countries. Social policy is a tool that can in principle be used by governments to cushion the adverse effects of external liberalisation. Authors of the nine studies in Taylor (2000) paid special attention to this issue. Their findings show that the countries can broadly be divided into three groups in terms of their social spending during liberalisation: those that did increase spending, those that couldn’t, and those that chose not to.      Colombia, Cuba, and Korea introduced programmes to offset some of the negative consequences of liberalisation. Colombia broadened its tax base, allowing expanded social security coverage as well as improved school attendance rates, access to drinking water, and housing. Cuba, during its external shock of 1989-93, suffered output, productivity and real wage contraction. Needing to generate foreign exchange, the government restructured the economy toward exports. One consequence was rising inequality between people working in export sectors and the rest of the population. To lessen this divide, the government stepped up programmes compensating workers not employed in exports. In Korea, the economic crisis provided the impetus for expanding social services, an area historically neglected in favour of growth. Government outlays for social expenditures increased from 5% of GDP in the 1980s to 7.8% in 1997.      Russia, Turkey and Zimbabwe faced fiscal resource constraints and cut back on social programmes. Russia is the most acute example. Privatisation of its energy industries, coupled with a lack of capital controls, led to external capital flight. This resource loss meant that the government did not have resources to compensate workers who lost their jobs because of liberalisation. Funding of health, education, and other services deteriorated severely. In Turkey and Zimbabwe, an unwillingness to raise taxes forced reductions in social programmes. During the 1980s, Turkey expanded public spending on social interventions via deficit finance. By 1993, this effort was no longer sustainable, leading to cutbacks. In Zimbabwe, external liberalisation has been accompanied by a tightening of government spending in an attempt to control inflation. Programmes instituted during the 1980s in an attempt to lessen inequality between racial groups have been retrenched.      In Argentina, India, and Mexico, external liberalisation has not been accompanied by increased social spending. Argentina responded to the increase in unemployment caused by liberalisation by making the labour market more flexible, leading to more underemployment and lower wages. However, a state-subsidised employment programme in health and education enabled some, mostly female, workers to get jobs. With the removal of tariffs, India lost an important source of government revenue, forcing reductions in spending on rural development, health, education, and housing. In Mexico, the government has not instituted social programmes to help those hurt by the transition. Instead, it dismantled long-standing support for peasant agriculture to the detriment of rural incomes. Policy Alternatives      Beyond the general desirability of attempts to cushion adverse shocks through social interventions, the usual caveats about policy prescriptions apply. Given the diversity of country experiences with liberalisation, it is risky to generalise about lessons and conclusions. Of course, diversity of outcomes is a result in itself. It negates general sweeping statements about whether the reforms have been exclusively beneficial or costly in terms of growth, employment, and equity. But if one is to sing a sad song, the evidence certainly shows that, in the post-liberalisation era, few of the countries considered have found a sustainable growth path. Employment growth has generally been slow to dismal and rising primary income disparity (in some cases over and above already high levels of inequality) has been the rule. Better growth performances, such as those in Mexico and Korea after their financial crises, were associated with avoiding the macro price mixture of a strong real exchange rate and high domestic interest rates. Similar conclusions apply to the handful of Latin American economies that combined adequate growth with improvement or stability of indexes of inequality. Their performances were associated with a policy mix that combined: a) less extreme real exchange and interest rates; b) maintaining targeted export incentives at the national level or as part of regional integration agreements, and c) having a system of capital controls and prudential financial regulation able to contain the negative consequences of capital surges.      Of the three views regarding liberalisation mentioned at the outset, the first ‘market friendly’ narrative is hard to discern in the country studies. In line with the second view, some might argue that virtually universal distributional deterioration was not the result of liberalisation and globalisation; though they would have to strain to make the case. For most of the countries, it is difficult to refute the third view that liberalisation and deteriorating growth and equity performances can easily go hand-in-hand. Lance Taylor is a Professor of Economics at the New School for Social Research, New York Tel: + 1 212 229 5901 Fax: + 1 212 229 5903 Email: lance@midcoast.com