PHILIP ARESTIS

Washington consensus and

financial liberalization

Abstract: The aim of this contribution is not to assess the overall performance
of the Washington Consensus. It is, rather, to look critically at the Washington
Consensus from the point of view of interest rate liberalization. Not only is the
theoretical angle of financial liberalization discussed in this contribution, but
the empirical side will also be appraised. The paper argues that from this per-
spective, the Washington Consensus has been a failure. Based on this assess-
ment, the paper also evaluates the revised Washington Consensus, always
from the financial liberalization perspective. The latter argues for completing
the first-generation liberalizing reforms, which, of course, include the finan-
cial liberalization point of view. In this regard, the paper concludes that both
the Washington Consensus and the revised Washington Consensus are not
very promising. This conclusion is pertinent despite the concession by the Wash-
ington Consensus/revised Washington Consensus supporters that two impor-
tant prerequisites of earlythat is, the 1970sfinancial liberalization
attempts were not mentioned initially when proposing the initial ten command-
ments of the Washington Consensus. These two prerequisites were: sequenc-
ing in financial liberalization policies, where capital flows should follow the
establishment of liberalized and robust domestic financial systems, and institu-
tional preconditions, where sound financial institutions should be in place be-
fore financial liberalization is introduced. As shown in this contribution, the
problematic nature of the financial liberalization aspect of Washington Con-
sensus/revised Washington Consensus is by far deeper and more serious than
the two preconditions alluded to in Williamson (20045). In fact, the evidence
of the past 30 years or so demonstrates that the implementation of the 10 com-
mandments of the Washington Consensus has proved to be a disaster for devel-
oping and other countries that pursue the Washington Consensustype of policies.
Our critique, therefore, of the Washington Consensus/revised Washington

The author is University Director of Research at the University of Cambridge; Senior

Research Fellow, Wolfson College, Cambridge; and Professor of Economics at the
Levy Economics Institute, Annandale-on-Hudson.
Journal of Post Keynesian Economics / Winter 20045, Vol. 27, No. 2 251
2005 M.E. Sharpe, Inc.
01603477 / 2005 $9.50 + 0.00.
252 JOURNAL OF POST KEYNESIAN ECONOMICS

Consensus is based both on the theoretical underpinnings of the financial

liberalization thesis and on the experience with the implementation of these
policies in a number of countries.

Key words: financial liberalization, Washington Consensus.

The Washington Consensus (or the ten commandments) is actually

very specific in its policy approach: Williamson (2002; see also 1990,
20045, this issue) summarizes it as follows: (1) fiscal discipline, (2) re-
ordering public expenditure priorities, (3) tax reform, (4) liberalizing
interest rate, (5) liberalization of inward foreign direct investment,
(6) trade liberalization, (7) a competitive exchange rate trade,
(8) privatization, (9) deregulation, and (10) property rights.
The application of these ten commandments has not been a resound-
ing success. But the interesting question is whether it is right to blame
the Washington Consensus for the disappointing news of economic out-
comes such as repeated crises, low growth, and continuation of high
poverty. Opinions on the achievements of the Washington Consensus
are actually not so divided. The opponents are united in registering a big
vote in favor of the motion. An interesting view has been voiced on the
performance of Washington Consensustype policies:
The IMF [International Monetary Fund] tends to tie its loans to condi-
tions that favor high taxes and devalued currencythe worst medicine
for ailing economies. The Fund also likes to meddle in local patronage
arrangements, demanding reforms that, when imposed wholesale from
outside, too often succeed not in registering a system, but in fracturing it.
That in turn leads to more crises, more IMF loans and more worship to
the altar of high taxes and budget surplusall at the expense of the client
countrys ordinary people, the folks least able to cushion themselves.
Recall the nexus of downward spirals and growing IMF programs in In-
donesia, Russia and Argentina. (Wall Street Journal, April 20, 2003)
The proponents suggest that the Washington Consensus policies may
need reform rather than complete abandonment. It is thereby suggested
(Kuczynsky and Williamson, 2003) that the changes required should
take the following shape: (1) crisis-proofing (including fiscal discipline
and inflation targeting); (2) completing the first-generation liberaliz-
ing reforms; (3) second-generation reforms (institutional reforms geared
to enabling government to create business-friendly environments, finan-
cial reforms designed to create better banking supervision); and (4) broad-
ening the reform agenda to include income distribution (switch to direct
 WASHINGTON CONSENSUS AND FINANCIAL LIBERALIZATION 253

taxation, property rights to the informal sector, land reforms, political

reforms, micro credit). There are still others that suggest the Washing-
ton Consensus constitutes a damaged brand . . . its chief mistake was
in not pushing Latin American reform far enough (Economist, April
26, 2003).
The aim of this contribution is not to assess the overall performance of
the Washington Consensus. It is, rather, to look critically at the Wash-
ington Consensus from the point of view of interest rate liberalization
that is, the fourth commandment. In fact, this was meant to be financial
liberalization in Williamsons view: In retrospect I wish I had formu-
lated this in a broader way as financial liberalization, and stressed that
views differed on how fast it should be achieved (2002, p. 1). Not only
is the theoretical angle of financial liberalization discussed in this con-
tribution, but the empirical side will also be appraised. The paper argues
that the Washington Consensus from this perspective has been a failure.
Based on this assessment, the paper also evaluates the revised Wash-
ington Consensus, always from the financial liberalization angle. The
latter argues for completing the first-generation liberalizing reforms,
which, of course, include the financial liberalization point of view. In
this regard, the paper concludes that both the Washington Consensus
and the revised Washington Consensus are not very promising. This
conclusion is pertinent despite the concession by the Washington Con-
sensus/revised Washington Consensus supporters that two important
prerequisites of earlythat is, the 1970sfinancial liberalization at-
tempts were not mentioned initially when proposing the ten command-
ments. These two prerequisites were sequencing in financial
liberalization policies, where capital flows should follow the establish-
ment of liberalized and robust domestic financial systems, and institu-
tional preconditions, where sound financial institutions should be in place
before financial liberalization is introduced (see Williamson, 20045,
this issue, n. 2). As shown in this contribution, the problematic nature of
the financial liberalization aspect of the Washington Consensus/revised
Washington Consensus is by far deeper and more serious than the two
preconditions alluded to in Williamson (ibid.). In fact, the evidence of
the past 30 years or so has demonstrated that the implementation of the
ten commandments of the Washington Consensus has proved to be a
disaster for developing and other countries that pursed the Washington
Consensustype of policies. Our critique, therefore, of the Washington
Consensus/revised Washington Consensus is based both on the theo-
retical underpinnings of the financial liberalization thesis and on expe-
rience with the implementation of these policies in a number of countries.
254 JOURNAL OF POST KEYNESIAN ECONOMICS

Financial liberalization: theoretical underpinnings

A number of writers questioned the wisdom of financial repression, the
practice of setting financial prices by central banks, especially in devel-
oping countries, a fairly common practice in the 1950s and 1960s. Gold-
smith (1969), in the late 1960s, and McKinnon (1973) and Shaw (1973),
in the early 1970s, challenged that practice, arguing that it had detri-
mental effects on the real economy. They propounded instead the thesis
that has come to be known as financial liberalization, which can be
succinctly summarized as amounting to freeing financial markets from
any intervention and letting the market determine the allocation of credit.
Goldsmith (1969) argued that the main transmission channel of finan-
cial liberalization was the effect on the efficiency of capital. McKinnon
(1973) and Shaw (1973) stressed two other channels: first, financial lib-
eralization affects how efficiently savings are allocated to investment;
and, second, through its effect on the return to savings, it also affects the
equilibrium level of savings and investment. In this framework, there-
fore, investment is affected not only quantitatively but also qualitatively.
The policy implications of this analysis are quite straightforward: liber-
alize financial markets and let the free market determine the allocation
of credit. With the real rate of interest adjusting to its equilibrium level,
low-yielding investment projects would be eliminated, so that the over-
all efficiency of investment would be enhanced. Also, as the real rate of
interest increases, savings and the total real supply of credit increase,
which induce a higher volume of investment. Economic growth would,
therefore, be stimulated not only through the increased investment but
also due to an increase in the average productivity of capital.1
Even though the financial liberalization thesis encountered increasing
skepticism over the years, it nevertheless had a relatively early impact
on development policy through the work of the IMF and the World Bank.
In their traditional role as promoters of free market conditions, both the
IMF and the World Bank were keen to encourage financial liberaliza-
tion policies in developing countries as part of more general reforms or
stabilization programs. Events following the implementation of finan-
cial liberalization prescriptions did not justify the theoretical premises.
The response of the proponents of the financial liberalization thesis has

1 Moreover, the effects of lower reserve requirements reinforce the effects of higher
saving on the supply of bank lending, whereas the abolition of directed credit pro-
grams would lead to an even more efficient allocation of credit, thereby stimulating
further the average productivity of capital.
 WASHINGTON CONSENSUS AND FINANCIAL LIBERALIZATION 255

been to argue that where liberalization failed, it was because of the ex-
istence of implicit or explicit deposit insurance coupled with inadequate
banking supervision and macroeconomic instability (for example,
McKinnon, 1988a, 1988b, 1991; Villanueva and Mirakhor, 1990; World
Bank, 1989). These conditions were conducive to excessive risk-taking
by the banks, a form of moral hazard that can lead to too high real
interest rates, bankruptcies of firms, and bank failures. This experience
led to the introduction of new elements into the analysis of the financial
liberalization thesis in the form of preconditions, which should have to
be satisfied before reforms are contemplated and implemented. These
are due to problems that emanate from differential speeds of adjustment
and possible competition of instruments. This analysis leads to rec-
ommendations that include adequate banking supervision, aiming to
ensure that banks have a well-diversified loan portfolio, macroeconomic
stability, which refers to low and stable inflation and a sustainable fis-
cal deficit, and sequencing of financial reforms.
Differential speeds of adjustment are thought of as possible causes of
serious problems to attempts at financial liberalization (McKinnon, 1991).
There are different speeds of adjustment in the financial and goods mar-
kets, whereby the latter are sluggish. Thus, financial markets could not
be reformed in the same manner and in the same instance as other mar-
kets without creating awkward difficulties. Recognition of these prob-
lems has led the proponents of the financial liberalization thesis to suggest
the desirability of sequencing in financial reforms. Successful reform of
the real sector came to be seen as a prerequisite to financial reform.
There occurred a revision of the main tenets of the thesis. Gradual finan-
cial liberalization was to be preferred. In this gradual process, a se-
quencing of financial liberalization is recommended, emphasizing the
achievement of stability in the broader macroeconomic environment and
adequate bank supervision within which financial reforms were to be
undertaken (McKinnon, 1988a; 1991). Furthermore, there is the possi-
bility that different aspects of reform programs may work at cross-pur-
poses, disrupting the real sector in the process. This is precisely what
Sachs (1988) labeled as competition of instruments. Such conflict can
occur when abrupt increases in interest rates cause the exchange rate to
appreciate rapidly, thus damaging the real sector. Sequencing becomes
important again. It is thus suggested that liberalization of the foreign
markets should take place after liberalization of domestic financial mar-
kets. In this context, proponents suggest caution in sequencing in the
sense of gradual financial liberalization emphasizing the achievement of
macroeconomic stability and adequate bank supervision as precondi-
256 JOURNAL OF POST KEYNESIAN ECONOMICS

tions for successful financial reform. These post hoc theoretical revi-
sions were thought of as sufficient to defend the original thesis of a dis-
appointing empirical record. But it was not, for, subsequently, that
experience repeated itself (Demirg-Kunt and Detragiache, 1999). The
new message then became that institutional preconditions were paramount,
where sound financial institutions should be in place before financial lib-
eralization is implemented (Williamson, 20045, this issue, n. 2).
Despite all these modifications, however, there is no doubt that the
proponents of the financial liberalization thesis do not even contemplate
abandoning it. No amount of revision has changed the objective of the
thesis, which is to pursue the optimal path to financial liberalization,
free from any politicalthat is, stateintervention. Sequencing does
not salvage the financial liberalization thesis for the simple reason that
it depends on the assumption that financial markets clear in a Walrasian
manner, whereas the goods markets do not. But in the presence of asym-
metric information, financial markets are also marred by imperfections.
Even where the correct sequencing took place (i.e., Chile), where trade
liberalization had taken place before financial liberalization, not much
success can be reported (Lal, 1987). The opposite is also true, namely,
that in those cases, such as Uraguay, where the reverse sequencing
took place, financial liberalization before trade liberalization, the expe-
rience was very much the same as in Chile (Grabel, 1995).
The appalling performance of financial liberalization policies should
not be surprising. It can be readily explained by its problematic theoreti-
cal nature and its poor performance at the empirical level. We examine
both in what follows.

The problematic nature of the theoretical framework of

financial liberalization
This section deals briefly with the critical issues of the financial liberal-
ization thesis, in an attempt to draw conclusions on its problematic theo-
retical nature. There are five such issues that can be succinctly
summarized: (1) free banking leads to stability of the financial system,
(2) financial liberalization enhances economic growth, (3) savings cause
investment, (4) absence of serious distributional effects as interest rates
change, and (5) there is no role for stock markets and speculation.
Free banking leads to stability of the financial system
The underlying assumption of the financial liberalization thesis is that
market forces produce stability in the banking and financial sectors, as
 WASHINGTON CONSENSUS AND FINANCIAL LIBERALIZATION 257

they do in other sections of the economy. Rigidities and instabilities,

therefore, emanate from interference with the normal working of the
market. There are three drawbacks with this view. The first is asym-
metric information. This drawback originates from the work on asym-
metric information (see, for example, Stiglitz and Weiss, 1981) that leads
to two types of problems: adverse selection and moral hazard. Adverse
selection refers to cases when selection is likely to produce adverse re-
sults. In the market for loans, for example, the problem refers to bor-
rowers who may not be able to repay their loans; they use the loans for
excessively risky investments, but lenders do not know about them due
to lack of information. Moral hazard describes a situation where the
borrower acts immorallythat is, in a way that is not in the best inter-
est of the lenders who possess incomplete information. For example,
depositors due to incomplete information cannot observe the high risks
banks may undertake, which encourages unscrupulous behavior.
The second is uncertainty. There is the argument that, given the very
special economic role of money and the intrinsic uncertainty associated
with it, they imply that financial laissez-faire, if ever implemented, would
at best give way to its own form of central banking. Uncertainty is
unquantifiable risk, and in order for the economic process to proceed in
spite of uncertainty, society adopts conventions, supported crucially by
the state, to create elements of stability to aid decision-making. The
legal system enables the establishment of contracts, whereas the provi-
sion of outside money and bank regulation, as well as supervision, sup-
ports the evolution of a banking system, which produces money as an
asset to hold in times of particular uncertainty. What is, in fact, needed
is not deregulation but better regulation (Dow, 1996).
The third we may summarize under financial distress, financial fra-
gility, and crises. Financial distress is a situation when loan portfolios
contain a large volume of nonperforming or bad debts. Distressed finan-
cial institutions are bound to cause increases in real interest rates with
further adverse effects on investment and growth. If government inter-
vention is not forthcoming, financial distress becomes widespread, a
situation that is referred to as financial fragility. Under these circum-
stances, financial institutions may very well collapse, leading to a finan-
cial crisis. The existence of a lender-of-last-resort or explicit deposit
insurance schemes enables economies to avert financial crises. Even so,
financial fragility may contribute to serious macroeconomic instability
when governments are forced to intervene, which makes it impossible
for them to maintain fiscal and monetary discipline. Financial liberal-
ization has actually been at the root of many recent cases of financial
258 JOURNAL OF POST KEYNESIAN ECONOMICS

fragility and crises (see Arestis and Glickman, 2002, for a relevant analy-
sis in the case of the 1997 Southeast Asian crisis). National govern-
ments either abandoned attempts at financial liberalization or were forced
to intervene by nationalizing banks and guaranteeing deposits (Gibson
and Tsakalotos, 1994). Consequently, a free banking system is unlikely
to be in a position to tackle financial crises. If anything, under free banking
circumstances, the situation is bound to deteriorate.
Financial liberalization enhances economic growth
The financial liberalization thesis in propounding that a positive rela-
tionship exists between financial liberalization and economic develop-
ment ignores a number of aspects that are of significant importance.
The first relates to hedge effects and curb markets that emanate from the
structuralist theory (Taylor, 1983; Van Wijnbergen, 1983). It suggests
that higher interest rates from financial liberalization might leave un-
changed or, indeed, decrease the total supply of funds. This is due to
hedge effects, which may not materialize, in which case the total supply
of funds may not be affected, or to curb effects, which may reduce it.
Hedge effects are due to substitution of hedge assets, gold and land are
the most obvious examples, for bank deposits brought about by higher
interest rates. Neostructuralist theorists maintain that risk-averse inves-
tors may not choose to substitute hedge assets for bank deposits. Conse-
quently, financial liberalization would fail to stimulate an increase in
savings. Curb effects emanate from the possibility that increased depos-
its may very well come from the curb markets where there are no re-
serve requirements. Because in the official markets there are reserve
requirements, it follows that financial liberalization may produce a lower
volume of loans than without it. Furthermore, to the extent that the as-
sumptions adopted by the structuralist theoryespecially of markup
pricing, increased interest rates, and higher exchange ratesare vali-
dated, there is the real danger that financial liberalization may lead to a
slower level of economic activity. All in all, structuralist theory predicts
stagflationary outcomes as a result of financial liberalization.2
The second dimension relates to the lack of perfect competition and
other related problems. The McKinnon and Shaw types of models are
based on the unrealistic assumption of perfect competition, which is par-
ticularly arbitrary in the case of less-developed countries (LDCs). Given

2It should be readily conceded that both the hedge and curb effects have not been
unambiguously validated empirically (Ghate, 1992).
 WASHINGTON CONSENSUS AND FINANCIAL LIBERALIZATION 259

that banking sectors are oligopolistic, the result of financial liberaliza-

tion could very well be monopoly, whereby the decrease in loans and the
increase in the real interest rate are of higher magnitudes than that under
perfect competition. This result may occur for reasons that have to do
with inadequate regulation over banking practices, which leads to undue
risk-taking, especially in the presence of deposit insurance. Under such
circumstances, the banks are beneficiaries of an unfair bet against the
government: if the projects they have financed do well, they make a lot
of profit, if they do badly, they rely on the government to rescue them.
Such a situation has been termed as upward financial repression. Other
problems can emanate from asymmetric information, which could very
well produce monopolistic tendencies in view of restrictions on compe-
tition among banks. The related problems of adverse selection and moral
hazard are very real in the case of financial liberalization. These prob-
lems suggest that the existence of operators in the financial markets who
are prepared to take excessively high risks implies higher interest rates
than would otherwise be and, presumably, a lower total supply of funds,
thereby inducing financial instability. A further related problem is that
of liquidity constraints that both firms and households can be faced with,
which can arise as a result of financial market imperfections. These im-
perfections may be caused either by asymmetric information in liberal-
ized markets, which can lead to equilibrium credit rationing (Stiglitz and
Weiss, 1981), or by government regulations of, for example, interest rates.
There is evidence that households face liquidity constraints, particularly
in developing countries, caused by the presence of incomplete informa-
tion in credit markets (Rosenzweig and Wolpin, 1993).
The third dimension of this critique relates to public finance aspects
and low interest rates for development. The public finance aspects of
financial liberalization are important and can produce serious destabi-
lizing effects. Financial repression, by keeping interest rates at a low
level, enables governments to borrow cheaply, which, beyond the normal
stabilizing influence, has beneficial consequences for the level of public
debt as a result. Thus, financial liberalization by producing higher inter-
est rates is likely to be accompanied by destabilizing consequences for
the macroeconomy. In addition, the thesis ignores the advantages of us-
ing low interest rates and thus credit selection for development purposes,
a practice that used to be frequently pursued by developing countries.
Savings cause of investment
In the McKinnon and Shaw models, of course, savings take place before
investment. But savings can only fund investmentthat is, it can only
260 JOURNAL OF POST KEYNESIAN ECONOMICS

facilitate the finance of investment. Savings cannot finance capital ac-

cumulation; this is done by the banking sector, which provides loans for
investment without necessitating increases in the volume of deposits.
With a credit-creating financial system, it is banks, and not savers, that
finance investment. Consequently, it is finance, and not saving, along
with entrepreneurial long-term expectations, that are the prerequisites
to capital accumulation. A second problem with the McKinnon and Shaw
models is the assumption that deposits create loans. In modern banking
systems, including most LDCs, loans create deposits, not the other way
around. The liquidity preference of the banks is very important in this
context as well as the ability of the banking sector to innovate, with
liability management being a good example (Arestis and Howells, 1996).
A more important determinant of investment is profit expectations and
the level and pace of aggregate demand, both affected adversely by higher
real interest rates. But the volume of investment and consumer spending
are likely to decline when interest rates increase. High real interest rates
are thought to have further adverse effects on aggregate demand through
the exchange rate in the case of open economies. In these economies,
high real interest rates following financial liberalization can cause ap-
preciation of the exchange rate, which can adversely hit domestic pro-
duction of tradable goods and expected profitability, thereby affecting
investment adversely. Thus, the maintenance of low real interest rates
through financial repression may help to stimulate employment and
real output through their effects on aggregate demand.
Absence of serious distributional effects as interest rates change
The proponents of the financial liberalization thesis argue that the ensu-
ing freeing of credit markets following financial reforms improves in-
come distribution and decreases industrial concentration, due to widening
access to finance and reduced degree of credit market segmentation (see,
for example, Fry, 1995). There are, however, more important and sig-
nificant factors that are ignored by the financial liberalization thesis.
The first factor relates to pricing in demand-determined and cost-deter-
mined sectors. In the competitive sector, essentially agriculture and raw
materials, prices are determined by supply and demand, as in the finan-
cial liberalization framework. This is a demand-determined price sec-
tor. The other sector, which is dominant, is the cost-determined price
sector, manufacturing and services, where prices are set at some stable
markup over average variable costs. Prices in this sector are adminis-
tered on the basis of some expected normal rate of capacity utilization
through a markup process over normal average variable costs, sufficient
 WASHINGTON CONSENSUS AND FINANCIAL LIBERALIZATION 261

to cover fixed costs, dividends, and the internal finance of planned in-
vestment expenditures. The markup is chosen to produce a level of re-
tained profits, after depreciation, interest, and dividend payments,
sufficient to provide for the required internal finance as dictated by
planned investment expenditure. Clearly, the cost-determined price
sector has very different distributional implications than the demand-
determined price sector of the financial liberalization theoretical frame-
work.
The second factor relates to savings in small and big firms. An
important redistributional effect emerges from the distinction between
cost-determined and demand-determined price sectors. The de-
mand-determined price firms, the small firms such as farming and small
retailing, save very little, and thereby, they are very sensitive to interest
rate changes. Cost-determined price firms, which are big firms, by
contrast, possess a preponderant amount of savings. They prefer to have
too much rather than too little savings, which gives them independence
from lenders, and thereby, they are able to substitute capital for labor as
necessary. It is internally created funds that are utilized for investment
purposes, so that these firms are insulated from capital markets. It fol-
lows that high interest rates hit the small firms rather harshly but leave
the big firms fairly unscathed.
The third effect relates to household, government, and financial sec-
tors. The extent to which the household sector is affected by interest rate
changes depends crucially on the size of its ratio of debt to assets. The
higher this ratio, the more adversely the household sector will be af-
fected by an increase in the rate of interest. The wealthy receive a large
proportion of their income from interest payments, but they can also
maintain a higher ratio of debt to assets. Similar redistributional effects
of increases in interest rates apply in the case of governments. But there
is another problem with the government sector. To the extent that its
ratio of debt to assets incorporates a substantial proportion in foreign
debt, global increases in interest rates can have serious redistributional
effects across countries. The recent third-world debt crisis clarifies this
case vividly. Financial intermediaries are likely to increase their profit-
ability by raising the interest rate spread. This, however, should be set
against the possibility of increased risk on financial intermediary loan
portfolios: higher interest rates are likely to attract high-risk customers,
and poor lending decisions would reduce the possibility of higher prof-
its. In any case, borrowers would be faced with increased borrowing
costs, which would redistribute income from households and firms to
the financial system. This analysis clearly corroborates Keyness (1973)
262 JOURNAL OF POST KEYNESIAN ECONOMICS

argument that increases in interest rates enhance the degree of income

inequality substantially. This inequality suggests that monetary policy
that aims to sustain high levels of interest rates entails a certain degree
of moral responsibility. We have argued this for the case of developing
economies where, in addition to the redistributional issues, there is also,
in many cases, the awkward problem of external debt. Higher interest
rates at a global level are accompanied by an increase in third world
debt, which implies redistributional effects across countries. The im-
portance of the ethical issues that arise from this analysis cannot be
exaggerated (Arestis and Demetriades, 1995). It is also for this reason
that we would support interest rate policies that aim at a stable and
permanently low level of interest rate.
The role for stock markets and speculation
These are two interrelated aspects that have received scant attention by
the financial liberalization proponents. The first aspect is the role of stock
markets. There has been an enormous growth of stock markets over the
past 10 to 15 years (Arestis and Demetriades, 1997; Singh, 1997). Not
only have stock markets played a significant role in domestic financial
liberalization, they have also played an important role in external finan-
cial liberalization due essentially to external inflows, especially in LDCs
where foreign portfolio flows, as opposed to bank financing, have been
dominant. Despite these developments, financial liberalization supporters
have paid very little attention to stock market development. Essentially,
the reason for this neglect is the belief that there is very little flow of funds
from the household to the business sector via the stock market (Fry, 1997).
There are, of course, exceptions to this rule. Levine and Zervos (1998),
utilizing cross-country regressions for a number of countries covering
the 197693 period, demonstrate that various measures of equity mar-
ket activity are positively correlated with measures of real activity and
that the association is particularly strong for developing countries. The
volatility characteristic of stock markets has been investigated from the
point of view of its relationship to the size of stock markets and capital
control liberalization. Demirg-Kunt and Levine (1996) find that in a
sample of 44 developed and emerging markets from 1986 to 1993, large
markets tend to be less volatile. Also, internationally integrated markets
tend to be less volatile. Levine and Zervos (1998) have examined vola-
tility in a relationship that concentrates on stock market liquidity and
economic performance. They conclude that in a cross-sectional approach,
this link is not statistically robust (and it is unexpectedly positive in
most cases). Arestis et al. (2001) investigate this link further and are
 WASHINGTON CONSENSUS AND FINANCIAL LIBERALIZATION 263

able to improve substantially on previous results; they show that the link
between stock market volatility and economic growth is significantly
strong and negative in a time series analysis.
The second aspect relates to speculation. Financial liberalization in-
duces two types of speculative pressures: expectations-induced and com-
petition-coerced, both of which contribute to the increased presence of
short-term, high-risk speculative transactions in the economy and to the
increased vulnerability to financial crises. The first emanate from ex-
pectations-induced pressures to pursue speculative transactions in view
of the euphoria created by financial liberalization. Given the prolifera-
tion of speculative opportunities, this euphoria rewards those specula-
tors who have short time horizons and punish the investors with a
long-term view (Keynes, 1936, ch. 12; see also Arestis et al., 2001, for
evidence supportive of these arguments). The competition-coerced type
of pressures emanate from the pressures on nonfinancial corporations
that may feel compelled to enter the financial markets in view of higher
returns, induced by financial liberalization, by borrowing to finance short-
term financial speculation. A critical manifestation of this possibility is
increasing borrowing to finance short-term financial speculation. Lend-
ers, in turn, may feel compelled to provide this type of finance, essen-
tially because of fear of loss of market share (Minsky, 1986). An
undesirable implication of these types of pressures is that economies
are forced to bear a greater degree of ambient risk and thus uncer-
tainty with financial liberalization than without it (Grabel, 1995). This
may very well lead to a reduced volume of real sector investment (Federer,
1993), while exerting upward pressures on interest rates in view of the
higher risk. The types of speculation just referred to are particularly
acute in the case of stock markets, and they represent a source of macro-
economic instability in that stock market financial assets are highly liq-
uid and volatile. This makes the financial system more fragile rather
than less fragile, thereby encouraging short-term transactions at the cost
of long-term growth (Arestis et al., 2001). Financial liberalization, there-
fore, is less likely to enhance long-term growth prospects, especially
those of developing countries.

Financial liberalization: empirical evidence

We examine three types of evidence. The first relies on the experience
of individual countries. The second piece of evidence is deduced from
the elasticity of the savings and investment relationships, which are, of
course, at the heart of the thesis. The third is of the econometrics type.
264 JOURNAL OF POST KEYNESIAN ECONOMICS

Experience of individual countries

Columbia, Uraguay, and Venezuela in the early 1970s, Malaysia in the
late 1970s, Argentina, Brazil, Chile, and Mexico in the mid- to late 1970s,
Turkey and Israel in the 1980s, the Philippines and Indonesia in the
early 1980s, and later in the 1990s along with other South Asian coun-
tries, for example, Thailand, Malaysia, and South Korea, all implemented
financial reforms. In 1989, Venezuela implemented financial liberaliza-
tion as part of a standard orthodox IMF and World Bank adjustment
package and sectoral loan. Policies related to finance included the re-
moval of quotas for priority lending, the liberalization of interest rates,
the opening up of the banking sector to foreign ownership, and the
privatization of commercial banks. By 1994, the banking system was in
a full-fledged meltdown. Between January 1994 and August 1995, 17
financial institutions failed, encompassing 60 percent of the total assets
of the financial system and 50 percent of the deposits and an estimated
20 percent of the gross domestic product (GDP) to clean up (Vera, 2002).
In Mexico, liberalization and privatization in the early 1990s also proved
to be enormously costly.
In all these cases, a number of bad debts and waves of bank failures
and other bankruptcies ensued, extreme asset volatility and the whole
financial system reached a near-collapse stage. As a result, the real sec-
tors of the affected economies entered severe and prolonged recessions.
On the whole, financial liberalization policies in these, and other, coun-
tries had a destabilizing effect on the economy. Financial liberalization
typically unleashed a massive demand for credit by households and firms
that was not offset by a comparable increase in the saving rate. In terms
of bank behavior, banks increased deposit and lending rates to compen-
sate for losses attributable to loan defaults. High real interest rates com-
pletely failed to increase savings or boost investmentthey actually
fell as a proportion of gross national product (GNP) over the period. The
only type of savings that did increase was foreign savingsthat is, ex-
ternal debt. This, however, made the liberalized economies more vul-
nerable to oscillations in the international economy, increasing the ratio
of debt to assets, and thus service obligations, and promoting the debt
crises experienced in the recent past. Financial liberalization thus man-
aged to displace domestic for international markets. Long-term produc-
tive investment never materialized. Instead, short-term speculative
activities flourished, whereby firms adopted risky financial strategies,
thereby causing banking crises and economic collapse. It is thus not
surprising that the study by Demirg-Kunt and Detragiache (1999) sur-
veying banking crises in 53 countries, covering the period between 1980
 WASHINGTON CONSENSUS AND FINANCIAL LIBERALIZATION 265

and 1995, found that 78 percent of all crises were linked to periods of
financial liberalization; indeed, in some cases, the costs of banking cri-
ses (measured as increases in the stock of public debt in the year of the
crisis) amounted to 50 percent of GDP (see Honohan and Klingebiel,
2000; see also World Bank, 2001, and the discussion therein). Table 1
shows the length of crisis, gross output loss, and recovery time. On all
three accounts, and on the basis of the staggering data reported therein,
the impact of financial liberalization over the periods considered above
was devastating.
The post-1997 pattern of liberalization leading to crisis is a continua-
tion of earlier trends that have become ubiquitous in Latin America and
elsewhere. There have been major crises in Argentina, Ecuador, Russia,
Uruguay, Colombia, Kenya, and, of course, the five most affected coun-
tries during the Asian crisis: Thailand, Malaysia, Indonesia, the Philip-
pines, and South Korea (see, for example, Arestis and Glickman, 2002).
Much of this instability has been associated with rapid financial liberal-
ization, without exception. It is well known, for example, that in Korea
and in the other affected countries during the Asian crisis of 1997, it
followed the deregulation of interest rates, the opening of the capital
market, foreign exchange liberalization, the granting of new banking
licenses, and the dismantling of government monitoring mechanisms
that were part of the policy loan system. By 1999, the cost of the gov-
ernment intervention reached $65 billion, or roughly 17 percent, of the
1998 GDP (Financial Times, March 12, 1999). Other countries in differ-
ent regions, including the Caribbean and Africa, have followed ortho-
dox courses of financial liberalization, with very similar results (Stein
et al., 2002). By contrast, and as Stiglitz (1994) argued, a significant
contributory element to the success of some East Asian countries (see,
for example, World Bank, 1993) emanates from their policy of directing
credit to specific parts of their economies rather than allowing the mar-
ket mechanism to allocate credit.
Evidence from elasticities
The elasticity of the savings relationship is either insignificant or when
significant, it is rather small. Fry suggests that the real interest rate has
virtually no direct effect on the level of saving, but may exert an indirect
effect by increasing the rate of economic growth (1995, p. 188). The
investment relationship with respect to the real rate of interest is also
questionable. Demetriades and Devereux (1992), using data on 63 de-
veloping countries for the 196190 period, find that the negative effect
of higher domestic interest rates on investment, working through the
266 JOURNAL OF POST KEYNESIAN ECONOMICS

Table 1
Length of crisis, gross output loss, and recovery time

Length of Recovery GDP loss

crisis time (percent)

Argentina 198082 4 16.6

Argentina 199596 3 11.9
Australia 1989 1 0
Brazil 1994 0 1
Bulgaria 199697 3 20.4
Chile 198188 9 45.5
Colombia 198285 5 65.1
Czech Republic 1989 1 0
Ecuador 1996 1 0.9
Egypt 199194 5 6.5
Finland 199196 7 23.1
France 1994 1 0
Ghana 1982 2 6.6
Hungary 199192 3 13.8
Indonesia 1992present 9 42.3
Indonesia 1997present 4 33.0
Japan 1992present 9 27.7
Malaysia 198587 4 13.7
Malaysia 1997present 4 22.8
Mexico 1994 2 9.6
New Zealand 198792 7 18.5
Norway 198793 8 19.6
Paraguay 1995 1 0
Philippines 198386 5 25.7
Philippines 1998present 3 7.5
Poland 1992 1 0
Senegal 1988 1 0
Slovenia 1992 2 2.1
South Korea 199798 3 16.5
Spain 1977 1 0
Sri Lanka 198990 3 0.5
Sweden 199192 3 6.5
Thailand 1983 2 8.7
Thailand 1997present 4 31.5
Turkey 1982 1 0
Turkey 1994 2 9.1
United States 198182 3 5.4
Urugay 198185 6 41.7
Venezuela 199496 4 14.1
Source: Honohan and Klingebiel (2000).

cost of capita, outweighs the effect of an enhanced supply of investible

funds on investment, so that interest rate liberalization has, on balance,
a negative effect on investment. Greene and Villanueva (1991) find a
statistically significant negative effect of real interest rates on invest-
 WASHINGTON CONSENSUS AND FINANCIAL LIBERALIZATION 267

ment in 23 developing economies over the 197587 period (for a com-

prehensive review of the literature, see Fry, 1995). Even so, Arestis and
Demetriades (1997) utilize time series methods that take into account
individual country circumstances, including institutional and policy con-
siderations. In this context, it is suggested that there is merit in examin-
ing the direct effects of changes in the regime of financial policy.
Capturing its influence is undoubtedly not a straightforward empirical
exercise, but may well prove to be more fruitful than the one that looks
for interest rate elasticities in saving and investment functions.
Econometric evidence
The second type of evidence we refer to is a more important and signifi-
cant step in terms of the empirical evidence of the financial liberaliza-
tion thesis. This is the attempt by King and Levine (1993) to tackle the
issue of the strength and causation of the relationship between finance
and economic development. It is more aggregate and more recent, but
also refers to the need for further work. The difficulty of establishing the
direction of causality between financial development and economic
growth was first identified by Patrick (1966) and further developed by
McKinnon (1988b), who actually questioned the direction of causation.
The causality between financial development and economic growth is,
therefore, a controversial issue that could potentially be resolved by re-
sorting to empirical evidence. King and Levine (1993) attempted to sug-
gest that Schumpeter may very well have been right in his argument
that the banker is the ephor of the exchange economy (Schumpeter,
1959, p. 74), with the distinct implication that financial intermediaries
promote economic development. Using data for a number of countries,
covering the 196089 period, King and Levine find that higher levels
of financial development are significantly and robustly correlated with
faster current and future rates of economic growth, physical capital ac-
cumulation and economic efficiency improvements (1993, pp. 717
718). From these results, King and Levine conclude that the link between
growth and financial development is not just a contemporaneous corre-
lation and that finance seems importantly to lead economic growth
(ibid., p. 730).
It has been demonstrated elsewhere (Arestis and Demetriades, 1999)
that the results of King and Levine (1993), which are obtained from
cross-sectional country studies, are not able to address the issue of cau-
sality satisfactorily. Two types of evidence are produced in this context.
The first is to show that King and Levines (ibid.) causal interpretation
is based on a fragile statistical basis. Specifically, it is shown that once
268 JOURNAL OF POST KEYNESIAN ECONOMICS

the contemporaneous correlation between the main financial indicator

and economic growth has been accounted for, there is no longer any
evidence to suggest that financial development helps predict future
growth. The second type of evidence demonstrates that cross-sectional
data sets cannot address the question of causality in a satisfactory way.
To perform such a task, time series data and a time series approach are
required. A taxonomy is proposed based on different institutional char-
acteristics and financial policies. Using data for 12 representative coun-
tries and cointegration techniques, it is shown that there are systematic
differences in causality patterns across countries (Arestis and
Demetriades, 1999). In another paper, Arestis and Demetriades (1997)
review existing empirical evidence and offer new such evidence relating
to the relationship between financial development and economic growth.
They show that the oversimplified nature of results obtained from cross-
country regressions does not accurately reflect individual country cir-
cumstances. Time series estimations on individual countries reveal that
substantial variation across countries is exhibited, even when the same
variables and estimation methods are used. There are, thus, important
differences in the links between finance and growth across different coun-
tries.
It is clear from this excursion in the literature that no convincing evi-
dence has been provided in support of the propositions of the financial
liberalization hypothesis. On the contrary, the available evidence can be
interpreted as indicating that the theoretical propositions of the thesis
are at best weak, and as such, they ought to be abandoned.

Summary and conclusions

We have considered in this paper an important aspect of both the Wash-
ington Consensus and revised Washington Consensus, the financial
liberalization thesis. We have demonstrated that this critical issue of the
Washington Consensus/revised Washington Consensus is marred by
serious difficulties on both theoretical and empirical grounds. We may,
therefore, conclude by agreeing with Stiglitz that the financial liberal-
ization thesis is based on an ideological commitment to an idealized
conception of markets that is grounded neither in fact nor in economic
theory (1994, p. 20). Indeed, our overall conclusion is that attempting
to implement financial reforms in the form of the liberalization of finan-
cial markets has created severe problems for Latin America and other
countries worldwide (see Davidson, 2003). Surely, this must have been
the main reason behind the World Bank presidents declaration: [t]he
 WASHINGTON CONSENSUS AND FINANCIAL LIBERALIZATION 269

Washington Consensus has been dead for years. Its been replaced by all
sorts of consensuses. But today were approaching our discussions with
no consensus (Wolfensohn, 2004, p. 2).

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