Neoliberalism: Oversold?

• Author: Jonathan D. Ostry, Prakash Loungani, and Davide Furceri

Neoliberalism: Oversold? Finance & Development, June 2016, Vol. 53, No. 2

Jonathan D. Ostry, Prakash Loungani, and Davide Furceri

Instead of delivering growth, some neoliberal policies have increased inequality, in turn jeopardizing durable expansion

Milton Friedman in 1982 hailed Chile as an “economic miracle.” Nearly a decade earlier, Chile had turned to policies that have since been widely emulated across the globe. The neoliberal agenda—a label used more by critics than by the architects of the policies—rests on two main planks. The first is increased competition—achieved through deregulation and the opening up of domestic markets, including financial markets, to foreign competition. The second is a smaller role for the state, achieved through privatization and limits on the ability of governments to run fiscal deficits and accumulate debt.

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There has been a strong and widespread global trend toward neoliberalism since the 1980s, according to a composite index that measures the extent to which countries introduced competition in various spheres of economic activity to foster economic growth. As shown in the left panel of Chart 1, Chile’s push started a decade or so earlier than 1982, with subsequent policy changes bringing it ever closer to the United States. Other countries have also steadily implemented neoliberal policies (see Chart 1, right panel).

There is much to cheer in the neoliberal agenda. The expansion of global trade has rescued millions from abject poverty. Foreign direct investment has often been a way to transfer technology and know-how to developing economies. Privatization of state-owned enterprises has in many instances led to more efficient provision of services and lowered the fiscal burden on governments.

However, there are aspects of the neoliberal agenda that have not delivered as expected. Our assessment of the agenda is confined to the effects of two policies: removing restrictions on the movement of capital across a country’s borders (so-called capital account liberalization); and fiscal consolidation, sometimes called “austerity,” which is shorthand for policies to reduce fiscal deficits and debt levels. An assessment of these specific policies (rather than the broad neoliberal agenda) reaches three disquieting conclusions:

•The benefits in terms of increased growth seem fairly difficult to establish when looking at a broad group of countries.

•The costs in terms of increased inequality are prominent. Such costs epitomize the trade-off between the growth and equity effects of some aspects of the neoliberal agenda.

•Increased inequality in turn hurts the level and sustainability of growth. Even if growth is the sole or main purpose of the neoliberal agenda, advocates of that agenda still need to pay attention to the distributional effects.

Open and shut?As Maurice Obstfeld (1998) has noted, “economic theory leaves no doubt about the potential advantages” of capital account liberalization, which is also sometimes called financial openness. It can allow the international capital market to channel world savings to their most productive uses across the globe. Developing economies with little capital can borrow to finance investment, thereby promoting their economic growth without requiring sharp increases in their own saving. But Obstfeld also pointed to the “genuine hazards” of openness to foreign financial flows and concluded that “this duality of benefits and risks is inescapable in the real world.”

This indeed turns out to be the case. The link between financial openness and economic growth is complex. Some capital inflows, such as foreign direct investment—which may include a transfer of technology or human capital—do seem to boost long-term growth. But the impact of other flows—such as portfolio investment and banking and especially hot, or speculative, debt inflows—seem...