Getting the Diagnosis Right

• Author: Ricardo Hausmann, Dani Rodrik, and Andrés Velasco
• Position: Director of Harvard University's Center for International Development/Professor of International Political Economy/Sumitomo Professor of International Finance and Development at Harvard's John F. Kennedy School of Government

A new approach to economic reform

During the past 15 years, there has been a tremendous focus on achieving growth in developing countries in an effort to reduce poverty and boost living standards. To help them achieve this goal, many countries have adopted the policies known collectively as the Washington Consensus-the enforcement of property rights, maintenance of macroeconomic stability, integration with the world economy, and creation of a sound business environment. Results have been extraordinarily varied. In fact, what the experience of the past 15 years has shown is that policies that work wonders in one place may have weak, unintended, or negative effects in other places.

In this article, we propose a new approach to reform-one that is much more contingent on the economic environment. Countries, we argue, need to figure out the one or two most binding constraints on their economies and then focus on lifting those. Presented with a laundry list of needed reforms, policymakers have either tried to fix all of the problems at once or started with reforms that were not crucial to their country's growth potential. And, more often than not, reforms have gotten in each other's way, with reform in one area creating unanticipated distortions in another area. By focusing on the one area that represents the biggest hurdle to growth, countries will be more likely to achieve success from their reform efforts.

We propose a decision tree methodology to help identify the relevant binding constraints for each country. While our methodology does not specifically identify the political costs and benefits of various reform strategies, its focus on alternative hypotheses will help clarify the options available to policymakers for responding to political constraints. We are concerned mainly with short-run constraints. In this sense, our focus is on igniting growth and identifying constraints that inevitably emerge as an economy expands, not on anticipating tomorrow's constraints on growth.

We demonstrate how this approach would work through case studies of Brazil, El Salvador, and the Dominican Republic. In the first two countries, policymakers sought to implement wholesale reform following international best practice during the 1990s. But the results in both countries were disappointing, with low growth throughout most of the period. The Dominican Republic also implemented reforms, but on a much more limited scale, and yet it exhibited strong growth throughout the 1990s until it was hit by a banking crisis in 2002. The Dominican Republic, as we will see, managed to find a way around the most important binding constraint on its economy with minimal reform effort, whereas Brazil and El Salvador still have not overcome the main obstacles to growth in their economies.

Drawbacks of current reform strategies

Economists define an underperforming economy as one that is characterized by rampant market distortions. Such distortions, whether government-imposed or inherent to certain markets, prevent the best use of the economy's resources, hindering its productivity and driving wedges between the value attributed to specific economic activities by society on the one hand and by individual citizens on the other. For policymakers, the challenge becomes how to maximize social welfare while taking into account standard resource constraints and the distortions prevailing in the economy. A market distortion can be thought of as a tax that reduces the equilibrium level of activity by keeping the net private return below the social return. Reducing a distortion is expected to increase aggregate welfare-the more costly the distortion, the larger the increase in welfare. And this is indeed the case when there is only one distortion-only its direct effect will matter. But when there are others, as is typical in a reforming economy, interaction effects in other areas of the economy need to be tracked. If reducing a distortion also alleviates other distortions, the result will be an additional welfare benefit. But if these interactions exacerbate other existing distortions, the welfare gain is reduced. A reduction in one distortion may thus end up producing an actual welfare loss-a phenomenon known as second-best interactions. This is why second-best interactions are a crucial consideration for policymakers to keep in mind when designing reform strategies.

One way to eliminate uncertainties about the effects of reforms is to...