[Joseph E. Stiglitz]
It is a pleasure to write this foreword to Karl Polanyi’s classic book describing the great transformation of European civilization from the preindustrial world to the era of industrialization, and the shifts in ideas, ideologies, and social and economic policies accompanying it. Because the transformation of European civilization is analogous to the transformation confronting developing countries around the world today, it often seems as if Polanyi is speaking directly to present-day issues. His arguments—and his concerns—are consonant with the issues raised by the rioters and marchers who took to the streets in Seattle and Prague in 1999 and 2000 to oppose the international financial institutions. In his introduction to the 1944 first edition, written when the IMF, the World Bank, and the United Nations existed only on paper, R. M. Maclver displayed a similar prescience, noting, “Of primary importance today is the lesson it carries for the makers of the coming international organization.” How much better the policies they advocated might have been had they read, and taken seriously, the lessons of this book!
It is hard, and probably wrong even to attempt to summarize a book of such complexity and subtlety in a few lines. While there are aspects of the language and economics of a book written a half century ago that may make it less accessible today, the issues and perspectives Polanyi raises have not lost their salience. Among his central theses are the ideas that self-regulating markets never work; their deficiencies, not only in their internal workings but also in their consequences (e.g., for the poor), are so great that government intervention becomes necessary; and that the pace of change is of central importance in determining these consequences. Polanyi’s analysis makes it clear that popular doctrines of trickle-down economics—that all, including the poor, benefit from growth—have little historical support. He also clarifies the interplay between ideologies and particular interests: how free market ideology was the handmaiden for new industrial interests, and how those interests used that ideology selectively, calling upon government intervention when needed to pursue their own interests.
Polanyi wrote The Great Transformation before modern economists clarified the limitations of self-regulating markets. Today, there is no respectable intellectual support for the proposition that markets, by themselves, lead to efficient, let alone equitable outcomes. Whenever information is imperfect or markets are incomplete—that is, essentially always—interventions exist that in principle could improve the efficiency of resource allocation. We have moved, by and large, to a more balanced position, one that recognizes both the power and the limitations of markets, and the necessity that government play a large role in the economy, though the bounds of that role remain in dispute. There is general consensus about the importance, for instance, of government regulation of financial markets, but not about the best way this should be done.
There is also plenty of evidence from the modern era supporting historical experience: growth may lead to an increase in poverty. But we also know that growth can bring enormous benefits to most segments in society, as it has in some of the more enlightened advanced industrial countries.
Polanyi stresses the interrelatedness of the doctrines of free labor markets, free trade, and the self-regulating monetary mechanism of the gold standard. His work was thus a precursor to today’s dominant systemic approach (and in turn was foreshadowed by the work of general equilibrium economists at the turn of the century). There are still a few economists who adhere to the doctrines of the gold standard, and who see the modern economy’s problems as having arisen from a departure from that system, but this presents advocates of the self-regulating market mechanism with an even greater challenge. Flexible exchange rates are the order of the day, and one might argue that this would strengthen the position of those who believe in self-regulation. After all, why should foreign exchange markets be governed by principles that differ from those that determine any other market? But it is also here that the weak underbelly of the doctrines of the self-regulating markets are exposed (at least to those who pay no attention to the social consequences of the doctrines)! For there is ample evidence that such markets (like many other asset markets) exhibit excess volatility, that is, greater volatility than can be explained by changes in the underlying fundamentals. There is also ample evidence that seemingly excessive changes in these prices, and investor expectations more broadly, can wreak havoc on an economy. The most recent global financial crisis reminded the current generation of the lessons that their grandparents had learned in the Great Depression: the self-regulating economy does not always work as well as its proponents would like us to believe. Not even the U.S. Treasury (under Republican or Democratic administrations) or the IMF, those institutional bastions of belief in the free market system, believe that governments should not intervene in the exchange rate, though they have never presented a coherent and compelling explanation of why this market should be treated differently from other markets.
The IMF’s inconsistencies—while professing belief in the free market system, it is a public organization that regularly intervenes in exchange rate markets, providing funds to bail out foreign creditors while pushing for usurious interest rates that bankrupt domestic firms—were foreshadowed in the ideological debates of the nineteenth century. Truly free markets for labor or goods have never existed. The irony is that today few even advocate the free flow of labor, and while the advanced industrial countries lecture the less developed countries on the vices of protectionism and government subsidies, they have been more adamant in opening up markets in developing countries than in opening their own markets to the goods and services that represent the developing world’s comparative advantage.
Today, however, the battle lines are drawn at a far different place than when Polanyi was writing. As I observed earlier, only diehards would argue for the self-regulating economy, at the one extreme, or for a government run economy, at the other. Everyone is aware of the power of markets, all pay obeisance to its limitations. But with that said, there are important differences among economists’ views. Some are easy to dispense with: ideology and special interests masquerading as economic science and good policy. The recent push for financial and capital market liberalization in developing countries (spearheaded by the IMF and the U.S. Treasury) is a case in point. Again, there was little disagreement that many countries had regulations that neither strengthened their financial system nor promoted economic growth, and it was clear that these should be stripped away. But the “free marketeers” went further, with disastrous consequences for countries that followed their advice, as evidenced in the recent global financial crisis. But even before these most recent episodes there was ample evidence that such liberalization could impose enormous risks on a country, and that those risks were borne disproportionately by the poor, while the evidence that such liberalization promoted growth was scanty at best. But there are other issues where the conclusions are far from clear. Free international trade allows a country to take advantage of its comparative advantage, increasing incomes on average, though it may cost some individuals their jobs. But in developing countries with high levels of unemployment, the job destruction that results from trade liberalization may be more evident than the job creation, and this is especially the case in IMF “reform” packages that combine trade liberalization with high interest rates, making job and enterprise creation virtually impossible. No one should have claimed that moving workers from low-productivity jobs to unemployment would either reduce poverty or increase national incomes. Believers in self-regulating markets implicitly believed in a kind of Say’s law, that the supply of labor would create its own demand. For capitalists who thrive off of low wages, the high unemployment may even be a benefit, as it puts downward pressure on workers’ wage demands. But for economists, the unemployed workers demonstrate a malfunctioning economy, and in all too many countries we see overwhelming evidence of this and other malfunctions. Some advocates of the self-regulating economy put part of the blame for these malfunctions on government itself; but whether this is true or not, the point is that the myth of the self-regulating economy is, today, virtually dead.
But Polanyi stresses a particular defect in the self-regulating economy that only recently has been brought back into discussions. It involves the relationship between the economy and society, with how economic systems, or reforms, can affect how individuals relate to one another. Again, as the importance of social relations has increasingly become recognized, the vocabulary has changed. We now talk, for instance, about social capital. We recognize that the extended periods of unemployment, the persistent high levels of inequality, and the pervasive poverty and squalor in much of Latin America has had a disastrous effect on social cohesion, and been a contributing force to the high and rising levels of violence there. We recognize that the manner in which and the speed with which reforms were put into place in Russia eroded social relations, destroyed social capital, and led to the creation and perhaps the dominance of the Russian Mafia. We recognize that the IMF’s elimination of food subsidies in Indonesia, just as wages were plummeting and unemployment rates were soaring, led to predictable (and predicted) political and social turmoil, a possibility that should have been especially apparent given the country’s history. In each of these cases, not only did economic policies contribute to a breakdown in long-standing (albeit in some cases, fragile) social relations: the breakdown in social relations itself had very adverse economic effects. Investors were wary about putting their money into countries where social tensions seemed so high, and many within those countries took their money out, thereby creating a negative dynamic.
Most societies have evolved ways of caring for their poor, for their disadvantaged. The industrial age made it increasingly difficult for individuals to take full responsibility for themselves. To be sure, a farmer might lose his crop, and a subsistence farmer has a hard time putting aside money for a rainy day (or more accurately a drought season). But he never lacks for gainful employment. In the modern industrial age, individuals are buffeted by forces beyond their control. If unemployment is high, as it was in the Great Depression, and as it is today in many developing countries, there is little individuals can do. They may or may not buy into lectures from free marketeers about the importance of wage flexibility (code words for accepting being laid off without compensation, or accepting with alacrity a lowering of wages), but they themselves can do little to promote such reforms, even if they had the desired promised effects of full employment. And it is simply not the case that individuals could, by offering to work for a lower wage, immediately obtain employment. Efficiency wage theories, insider-outsider theories, and a host of other theories have provided cogent explanations of why labor markets do not work in the manner that advocates of the self-regulating market suggested. But whatever the explanation, the fact of the matter is that unemployment is not a phantasm, modern societies need ways of dealing with it, and the self-regulating market economy has not done so, at least in ways that are socially acceptable. (There are even explanations for this, but this would draw me too far away from my main themes.) Rapid transformation destroys old coping mechanisms, old safety nets, while it creates a new set of demands, before new coping mechanisms are developed. This lesson from the nineteenth century has, unfortunately, all too often been forgotten by the advocates of the Washington consensus, the modern-day version of the liberal orthodoxy.
The failure of these social coping mechanisms has, in turn, contributed to the erosion of what I referred to earlier as social capital. The last decade has seen two dramatic instances. I already referred to the disaster in Indonesia, part of the East Asia crisis. During that crisis, the IMF, the U.S. Treasury, and other advocates of the neoliberal doctrines resisted what should have been an important part of the solution: default. The loans were, for the most part, private sector loans to private borrowers; there is a standard way of dealing with situations where borrowers cannot pay what is due: bankruptcy. Bankruptcy is a central part of modern capitalism. But the IMF said no, that bankruptcy would be a violation of the sanctity of contracts. But they had no qualms at all about violating an even more important contract, the social contract. They preferred to provide funds to governments to bail out foreign creditors, who had failed to engage in due diligence in lending. At the same time, the IMF pushed policies with huge costs on innocent bystanders, the workers and small businesses who had no role in the advent of the crisis in the first place.
Even more dramatic were the failures in Russia. The country that had already been the victim of one experiment—communism—was made the subject of a new experiment, that of putting into place the notion of a self-regulating market economy, before government had had a chance to put into place the necessary legal and institutional infrastructure. Just as some seventy years earlier, the Bolsheviks had forced a rapid transformation of society, the neoliberals now forced another rapid transformation, with disastrous results. The people of the country had been promised that once market forces were unleashed, the economy would boom: the inefficient system of central planning, that distorted resource allocation, with its absence of incentives from social ownership, would be replaced with decentralization, liberalization, and privatization.
There was no boom. The economy shrank by almost half, and the fraction of those in poverty (on a four-dollar-a-day standard) increased from 2 percent to close to 50 percent. While privatization led a few oligarchs to become billionaires, the government did not even have the money to pay poor pensioners their due—all this in a country rich with natural resources. Capital market liberalization was supposed to signal to the world that this was an attractive place to invest; but it was a one-way door. Capital left in droves, and not surprisingly. Given the illegitimacy of the privatization process, there was no social consensus behind it. Those who left their money in Russia had every right to fear that they might lose it once a new government was installed. Even apart from these political problems, it is obvious why a rational investor would put his money in the booming U.S. stock market instead of a country in a veritable depression. The doctrines of capital market liberalization provided an open invitation for the oligarchs to take their ill-begotten wealth out of the country. Now, albeit too late, the consequences of those mistaken policies are being realized; but it will be all but impossible to entice the capital that has fled back into the country, except by providing assurances that, regardless of how the wealth is acquired, it can be retained, and doing so would imply, indeed necessitate, the preservation of the oligarchy itself.
Economic science and economic history have come to recognize the validity of Polanyi’s key contentions. But public policy—particularly as reflected in the Washington consensus doctrines concerning how the developing world and the economies in transition should make their great transformations—seems all too often not to have done so. As I have already noted, Polanyi exposes the myth of the free market: there never was a truly free, self-regulating market system. In their transformations, the governments of today’s industrialized countries took an active role, not only in protecting their industries through tariffs, but also in promoting new technologies. In the United States, the first telegraph line was financed by the federal government in 1842, and the burst of productivity in agriculture that provided the basis of industrialization rested on the government’s research, teaching, and extension services. Western Europe maintained capital restrictions until quite recently. Even today, protectionism and government interventions are alive and well: the U.S. government threatens Europe with trade sanctions unless it opens up its markets to bananas owned by American corporations in the Caribbean. While sometimes these interventions are justified as necessary to countervail other governments’ interventions, there are numerous instances of truly unabashed protectionism and subsidization, such as those in agriculture. While serving as chairman of the Council of Economic Advisers, I saw case after case—from Mexican tomatoes and avocados to Japanese film to Ukrainian women’s cloth coats to Russian uranium. Hong Kong was long held up as the bastion of the free market, but when Hong Kong saw New York speculators trying to devastate their economy by simultaneously speculating on the stock and currency markets, it intervened massively in both. The American government protested loudly, saying that this was an abrogation of free market principles. Yet Hong Kong’s intervention paid off—it managed to stabilize both markets, warding off future threats on its currency, and making large amounts of money on the deals to boot.
The advocates of the neoliberal Washington consensus emphasize that it is government interventions that are the source of the problem; the key to transformation is “getting prices right” and getting the government out of the economy through privatization and liberalization. In this view, development is little more than the accumulation of capital and improvements in the efficiency with which resources are allocated—purely technical matters. This ideology misunderstands the nature of the transformation itself—a transformation of society, not just of the economy, and a transformation of the economy that is far more profound that their simple prescriptions would suggest. Their perspective represents a misreading of history, as Polanyi effectively argues.
If he were writing today, additional evidence would have supported his conclusions. For example, in East Asia, the part of the world that has had the most successful development, governments took an unabashedly central role, and explicitly and implicitly recognized the value of preserving social cohesion, and not only protected social and human capital but enhanced it. Throughout the region, there was not only rapid economic growth, but also marked reductions in poverty. If the failure of communism provided dramatic evidence of the superiority of the market system over socialism, the success of East Asia provided equally dramatic evidence of the superiority of an economy in which government takes an active role to the self-regulating market. It was precisely for this reason that market ideologues appeared almost gleeful during the East Asian crisis, which they felt exposed the active government model’s fundamental weaknesses. While, to be sure, their lectures included references to the need for better regulated financial systems, they took this opportunity to push for more market flexibility: code words for eliminating the kind of social contracts that provided an economic security that had enhanced social and political stability—a stability that was the sine qua non of the East Asian miracle. In truth, of course, the East Asian crisis was the most dramatic illustration of the failure of the self-regulating market: it was the liberalization of the short-term capital flows, the billions of dollars sloshing around the world looking for the highest return, subject to the quick rational and irrational changes in sentiment, that lay at the root of the crisis.
Let me conclude this foreword by returning to two of Polanyi’s central themes. The first concerns the complex intertwining of politics and economics. Fascism and communism were not only alternative economic systems; they represented important departures from liberal political traditions. But as Polanyi notes, “Fascism, like socialism, was rooted in a market society that refused to function.” The heyday of the neoliberal doctrines was probably 1990–97, after the fall of the Berlin Wall and before the global financial crisis. Some might argue that the end of communism marked the triumph of the market economy, and the belief in the self-regulated market. But that interpretation would, I believe, be wrong. After all, within the developed countries themselves, this period was marked almost everywhere by a rejection of these doctrines, the Reagan-Thatcher free market doctrines, in favor of “New Democrat” or “New Labor” policies. A more convincing interpretation is that during the Cold War, the advanced industrialized countries simply could not risk imposing these policies, which risked hurting the poor so much. These countries had a choice; they were being wooed by the West and the East, and demonstrated failures in the West’s prescription risked turning them to the other side. With the fall of the Berlin Wall, these countries had nowhere to go. Risky doctrines could be imposed on them with impunity. But this perspective is not only uncaring; it is also unenlightened: for there are myriad unsavory forms that the rejection of a market economy that does not work at least for the majority, or a large minority, can take. A so-called self-regulating market economy may evolve into Mafia capitalism—and a Mafia political system—a concern that has unfortunately become all too real in some parts of the world.
Polanyi saw the market as part of the broader economy, and the broader economy as part of a still broader society. He saw the market economy not as an end in itself, but as means to more fundamental ends. All too often privatization, liberalization, and even macro-stabilization have been treated as the objectives of reform. Scorecards were kept on how fast different countries were privatizing—never mind that privatization is really easy: all one has to do is give away the assets to one’s friends, expecting a kickback in return. But all too often no scorecard was kept on the number of individuals who were pushed into poverty, or the number of jobs destroyed versus those created, or on the increase in violence, or on the increase in the sense of insecurity or the feeling of powerlessness. Polanyi talked about more basic values. The disjunction between these more basic values and the ideology of the self-regulated market is as clear today as it was at the time he wrote. We tell developing countries about the importance of democracy, but then, when it comes to the issues they are most concerned with, those that affect their livelihoods, the economy, they are told: the iron laws of economics give you little or no choice; and since you (through your democratic political process) are likely to mess things up, you must cede key economic decisions, say concerning macroeconomic policy, to an independent central bank, almost always dominated by representatives of the financial community; and to ensure that you act in the interests of the financial community, you are told to focus exclusively on inflation—never mind jobs or growth; and to make sure that you do just that, you are told to impose on the central bank rules, such as expanding the money supply at a constant rate; and when one rule fails to work as had been hoped, another rule is brought out, such as inflation targeting. In short, as we seemingly empower individuals in the former colonies through democracy with one hand, we take it away with the other.
Polanyi ends his book, quite fittingly, with a discussion of freedom in a complex society. Franklin Deleano Roosevelt said, in the midst of the Great Depression, “We have nothing to fear but fear itself.” He talked about the importance not only of the classical freedoms (free speech, free press, freedom of assemblage, freedom of religion), but also of freedom from fear and from hunger. Regulations may take away someone’s freedom, but in doing so they may enhance another’s. The freedom to move capital in and out of a country at will is a freedom that some exercise, at enormous cost to others. (In the economists’ jargon, there are large externalities.) Unfortunately, the myth of the self-regulating economy, in either the old guise of laissez-faire or in the new clothing of the Washington consensus, does not represent a balancing of these freedoms, for the poor face a greater sense of insecurity than everyone else, and in some places, such as Russia, the absolute number of those in poverty has soared and living standards have fallen. For these, there is less freedom, less freedom from hunger, less freedom from fear. Were he writing today, I am sure Polanyi would suggest that the challenge facing the global community today is whether it can redress these imbalances—before it is too late.