1995 Summer July, 1995 /August, 1995
SECTION: ESSAYS; Pg. 28

LENGTH: 6339 words

HEADLINE: Dutch Tulips and Emerging Markets

BYLINE: Paul Krugman; PAUL KRUGMAN is Professor of Economics at Stanford University.

BODY:

ANOTHER BUBBLE BURSTS

SYNOPSIS: Examines how the Washington Consensus has been punctured by Economic reality

DURING THE first half of the 1990s, both economic and political events in developing countries defied all expectations. Nations that most thought would not regain access to world financial markets for a generation abruptly became favorites of private investors, who plied them with capital inflows on a scale not seen since before World War I. Governments that had spent half a century pursuing statist, protectionist policies suddenly got free market religion. It was, it seemed to many observers, the dawn of a new golden age for global capitalism.

To some extent the simultaneous reversals in government policies and investor sentiment were the result of external factors. Low interest rates in the advanced countries encouraged investors to look again at opportunities in the Third World; the fall of communism not only helped to discredit statist policies everywhere but reassured investors that their assets in the developing world were unlikely to be seized by leftist governments. Still, probably the most important factor in the new look of developing countries was a sea change in the intellectual zeitgeist: the almost universal acceptance, by governments and markets alike, of a new view about what it takes to develop.

This new view has come to be widely known as the "Washington consensus," a phrase coined by John Williamson of the Institute for International Economics. By "Washington" Williamson meant not only the U.S. government, but all those institutions and networks of opinion leaders centered in the world's de facto capital -- the International Monetary Fund, World Bank, think tanks, politically sophisticated investment bankers, and worldly finance ministers, all those who meet each other in Washington and collectively define the conventional wisdom of the moment.

Williamson's original definition of the Washington consensus involved ten different aspects of economic policy. One may, however, roughly summarize this consensus, at least as it influenced the beliefs of markets and governments, more simply. It is the belief that Victorian virtue in economic policy -- free markets and sound money -- is the key to economic development. Liberalize trade, privatize state enterprises, balance the budget, peg the exchange rate, and one will have laid the foundations for an economic takeoff; find a country that has done these things, and there one may confidently expect to realize high returns on investments.

To many people the rise of the Washington consensus seemed to mark a fundamental turning point in world economic affairs. Now that the dead hand of the state was being lifted from Third World economies, now that investors were becoming aware of the huge possibilities for profit in these economies, the world was set for a prolonged period of rapid growth in hitherto poor countries and massive capital flows from North to South. The question was not whether optimistic expectations about growth in the big emerging markets would be fulfilled; it was whether advanced countries would be able to cope with the new competition and take advantage of the opportunities this growth now offered. n1

n1 The strategy of promoting U.S. exports and investment in emerging markets remains central to the Clinton administration's economic strategy. In a March 1995 speech, Under-secretary of Commerce Jeffrey Garten declared that "our exports and jobs are dependent on gaining a larger market share in the big emerging markets. No U.S. firm will be a world-class company without substantial involvement in the big emerging markets."

And then came the Mexican crisis. The country that was widely regarded as a model for the new regime -- a once-protectionist nation that had not only greatly lowered its trade barriers but actually signed a free trade pact with the United States, whose economic policy was run by articulate American-trained technocrats, and which had emerged from seven lean years of debt crisis to attract capital inflows on a scale unimaginable a few years earlier -- was once again appealing for emergency loans. But what is the meaning of Mexico's tailspin? Is it merely the product of specific Mexican blunders and political events, or does it signal the unsoundness of the whole emerging market boom of the previous five years?

Many claim that Mexico's problems carry few wider implications. On one side, they argue that a currency crisis says more about short-term monetary management than about long-run development prospects. And to some extent they are clearly right. Currency crises are so similar to one another that they are a favorite topic for economic theorists, who lovingly detail the unchanging logic by which the collision between domestic goals and an unsustainable exchange rate generates a sudden, massive speculative attack. The December 1994 attack on the peso looked a lot like the September 1992 attack on the pound sterling, which looked quite similar to the 1973 and 1971 attacks on the dollar and the 1969 run on gold. So perhaps one should not draw broad conclusions from the fact that a developing country has managed to make the same mistakes that nearly every advanced country has made at some time in the past.

On the other side, defenders of the Washington consensus point to the many uniquely Mexican aspects of the current crisis. Certainly the combination of peasant uprisings, mysterious assassinations, and bizarre fraternal intrigue has no close counterpart anywhere else in the world.

And yet Mexico's crisis is neither a temporary setback nor a purely Mexican affair. Something like that crisis was an accident waiting to happen because the stunning initial success of the Washington consensus was based not on solid achievements, but on excessively optimistic expectations. The point is not that the policy recommendations that Williamson outlined are wrong, but that their efficacy -- their ability to turn Argentina into Taiwan overnight -- was greatly oversold. Indeed, the five-year reign of the Washington consensus may usefully be thought of as a sort of speculative bubble one that involved not only the usual economic process by which excessive market optimism can be a temporarily self-fulfilling prophecy, but a more subtle political process through which the common beliefs of policymakers and investors proved mutually reinforcing. Unfortunately, any such self-reinforcing process unfortunately must eventually be faced with a reality check, and if the reality is not as good as the myth, the bubble bursts. For all its special features, the Mexican crisis marks the beginning of the deflation of the Washington consensus. That deflation ensures that the second half of the 1990s will be a far more problematic period for global capitalism than the first.

THE REAL PAYOFF TO REFORM

ECONOMISTS HAVE, of course, long preached the virtues of free markets. The economic case for free trade in particular, while not completely watertight, is far stronger than most people imagine. The logic that says that tariffs and import quotas almost always reduce real income is deep and has survived a century and a half of often vitriolic criticism nearly intact. And experience teaches that governments that imagine or pretend that their interventionist strategies are a sophisticated improvement on free trade nearly always turn out, on closer examination, to be engaged in largely irrational policies -- or worse, in policies that are rational only in the sense that they benefit key interest groups at the expense of everyone else.

Yet there is a dirty little secret in international trade analysis. The measurable costs of protectionist policies -- the reductions in real income that can be attributed to tariffs and import quotas -- are not all that large. The costs of protection, according to the textbook models, come from the misallocation of resources: protectionist economies deploy their capital and labor in industries in which they are relatively inefficient, instead of concentrating on those industries in which they are relatively efficient, exporting those products in exchange for the rest. These costs are very real, but when you try to add them up, they are usually smaller than the rhetoric of free trade would suggest. For example, most estimates of the cost of protection in the United States put it well under one percent of GDP. Even that cost is largely due to the United States' preference for policies, like its sugar import quota, that generate high profits for those foreign suppliers granted access to the U.S. market. Highly protected economies, like most developing countries before the rise of the Washington consensus, suffer more. Still, conventional estimates of the costs of protection have rarely exceeded five percent of GDP. That is, the standard estimates suggest that a highly protectionist developing country, by moving to completely free trade, would get a one-time economic boost equal to the growth China achieves every five or six months.

Admittedly, many economists argue that the adverse effects of protection are larger, and thus the growth boost from trade liberalization is greater, than such conventional estimates suggest. Roughly speaking, they have suggested three mechanisms. First, protection reduces competition in the domestic market. The monopoly power that is created for domestic firms that no longer face foreign competition may be reflected either in slack management or, if a small number of firms are trying to secure monopoly positions, in wasteful duplication. Second, protectionist policies -- and other policies like interest rate controls -- create profits that accrue to whoever is influential enough to receive the appropriate government licenses. In a well-known paper, Anne Krueger, who later became the chief economist at the World Bank, argued that in many developing countries, the resources squandered in pursuit of these profits represent a larger net cost to the economy than the distortion that protectionism causes in the industrial mix. n2 Finally, many people have argued that protectionism discourages innovation and the introduction of new products, thereby having sustained effects on growth that a static estimate misses. The important point about these arguments for large gains from trade liberalization, however, is that they are all fairly speculative; one cannot say as a matter of principle that these effects of protection discourage growth. It is an empirical question.

n2 Anne Krueger, "The Political Economy of the Rent-Seeking Society," American Economic Review, June 1974.

And the empirical evidence for huge gains from free market policies is, at best, fuzzy. There have been a number of attempts to measure the benefits of free trade by comparing countries. An influential 1987 study by the World Bank classified 41 developing countries as "closed" (protectionist) or "open" and concluded that openness was associated with substantially stronger growth. But such studies have often been critiqued for using subjective criteria in deciding which countries have freer trade; the decision to class South Korea as "open," for example, has raised many doubts. A survey by UCLA's Sebastian Edwards concluded that studies which purport to show that countries with liberal trade regimes systematically grow more rapidly than those with closed markets "have been plagued by empirical and conceptual shortcomings [that have] resulted, in many cases, in unconvincing results whose fragility has been exposed by subsequent work." n3

n3 Sebastian Edwards, "Openness, Trade Liberalization, and Growth in Developing Countries," Journal of Economic Literature, September 1993.

There are surely additional gains to reforming economies from domestic liberalization, privatization, and so on. These gains have not been as thoroughly studied as those from trade liberalization. They are, however, conceptually very similar, and there is no reason to expect them to be dramatically larger or to change the picture of real but limited gains from reform.

All this does not mean that trade liberalization is not a good idea. It almost certainly is. Nor does it necessarily mean that the modest conventional estimates of the gains from such liberalization tell the whole story. But it does mean that the widespread belief that moving to free trade and free markets will produce a dramatic acceleration in a developing country's growth represents a leap of faith, rather than a conclusion based on hard evidence.

What about the other half of the Washington consensus, the belief in the importance of sound money? Here the case is even weaker.

If standard estimates of the costs of protection are lower than you might expect, such estimates of the cost of inflation -- defined as the overall reduction in real income -- are so low that they are embarrassing. Of course very high inflation rates the triple- or quadruple-digit inflations that have, unfortunately, been all too common in Latin American history -- seriously disrupt the functioning of a market economy. But it is very difficult to pin down any large gains from a reduction in the inflation rate from, say, 20 percent to 2 percent.

Moreover, the methods used to achieve disinflation in developing countries -- above all, the use of a pegged exchange rate as a way to build credibility -- have serious costs. A country with an inflationary history that tries to end inflation by establishing a fixed exchange rate almost always finds that the momentum of inflation continues for a considerable time, throwing domestic costs and prices out of line with the rest of the world. Thus an exchange rate that initially seemed reasonable usually seems considerably overvalued by the time inflation finally subsides. Furthermore, an exchange rate that is tolerable when introduced may become difficult to sustain when world market conditions change, such as the price of oil, the value of the dollar, and interest rates. Textbook international economics treats the decision about whether to fix a country's exchange rate as a difficult tradeoff, which even countries committed to low inflation often end up resolving on the side of exchange rate flexibility.

Nonetheless, during the first half of the 1990s a number of developing countries adopted rigid exchange rate targets. (The most extreme case was Argentina, which established a supposedly permanent one-for-one exchange rate between the peso and the U.S. dollar). In large part this was a move designed to restore credibility after the uncontrolled inflation of the 1980s. Nonetheless, both governments and markets seem to have convinced themselves that the painful tradeoffs traditionally involved in such a commitment no longer applied.

THE DISMAL CYCLE

IN SUM, then, a cool-headed analysis of the likely effects of the economic reforms undertaken in developing countries in recent years did not and does not seem to justify wild enthusiasm. Trade liberalization and other moves to free up markets are almost surely good things, but the idea that they will generate a growth takeoff represents a hope rather than a well-rounded expectation. Bringing down inflation is also a good thing, but doing so by fixing the exchange rate brings a mixture of benefits and costs, with the arguments against as strong as the arguments for. And yet the behavior of both governments and markets during the last five years does not suggest that they took any such measured view. On the contrary, governments eagerly adopted Washington consensus reform packages, while markets enthusiastically poured funds into reforming economies. Why?

Everyone is familiar with the way that a speculative bubble can develop in a financial market. Investors, for whatever reason, come to take a more favorable view of the prospects for some traded asset -- Deutsche marks, Japanese stocks, shares in the South Sea Company, tulip futures. This leads to a rise in the asset's price. If investors then interpret this gain as a trend rather than a one-time event, they become still more anxious to buy the asset, leading to a further rise, and so on. In principle, long-sighted investors are supposed to prevent such speculative bubbles by selling assets that have become overpriced or buying them when they have become obviously cheap. Sometimes, however, markets lose sight of the long run, especially when the long run is complex or obscure. Thus speculative bubbles in soybean futures tend to be limited by the common knowledge that a lot more soybeans will be grown if the price gets very high. But the chain of events that must eventually end a speculative bubble in, say, the mark -- an overvalued mark reduces German exports, leading to a weak German economy, so the Bundesbank reduces interest rates, making it unattractive to hold mark-denominated assets -- is often too long and abstract to seem compelling to investors when the herd is running.

It seems fairly clear that some of the enthusiasm for investing in developing countries in the first half of the 1990s was a classic speculative bubble. A modest recovery in economic prospects from the dismal 1980s led to large capital gains for those few investors who had been willing to put money into Third World stock markets. Their success led other investors to jump in, driving prices up still further. And by 1993 or so "emerging market funds" were being advertised on television and the pages of popular magazines.

At the same time that this self-reinforcing process was under way in the financial markets, a different kind of self-reinforcing process, sociological rather than economic, was taking place in the world of affairs -- the endless rounds of meetings, speeches, and exchanges of communiques that occupy much of the time of economic opinion leaders. Such interlocking social groupings tend at any given time to converge on a conventional wisdom, about economics among many other things. People believe certain stories because everyone important tells them, and people tell those stories because everyone important believes them. Indeed, when a conventional wisdom is at its fullest strength, one's agreement with that conventional wisdom becomes almost a litmus test of one's suitability to be taken seriously.

Anyone who tried, two or three years ago, to express even mild skepticism about the prospects for developing countries knows how difficult it was to make any impression on either business or political leaders. Views contrary to the immense optimism of the time were treated not so much with hostility as bemusement. How could anyone be so silly as to say these gloomy things? n4

n4 Academic economists with expertise in the macroeconomics of developing countries were issuing clear warnings about excessive euphoria, which Wall Street simply shrugged off, as early as the beginning of 1993. See, in particular, Rudiger Dornbusch, Stabilization, Debt, and Reform: Policy Analysis for Developing Countries, Englewood Cliffs: Prentice Hall, 1993, and "Mexico: Stabilization, Reform, and No Growth," Brookings Papers on Economic Activity, No. 1, 1994. I gave a speech warning of a peso crisis in Mexico City on March 25, 1993.

While both a speculative bubble in the financial markets and the standard process whereby influential people rally around a conventional wisdom surely played a role in the astonishing rise of the Washington consensus, there was, however, an additional, distinctive self-reinforcing process that arguably played an even greater role. This was a political economy cycle, in which governments were persuaded to adopt Washington consensus policies because markets so spectacularly rewarded them, and in which markets were willing to supply so much capital because they thought they saw an unstoppable move toward policy reform.

One must begin with a key insight of Dani Rodrik of Columbia University. Rodrik pointed out that economists and international organizations like the World Bank had been arguing for a long time in favor of freer trade in developing countries. n5 The intellectual case for protectionism to promote industrialization, while popular in the 1950s has been pretty much moribund since the late 1960s. Nonetheless, the stake of established interest groups in the existing system blocked any major move to free trade. When limited liberalization was attempted, it usually ended up being abandoned a few years later. Why did this suddenly change?

n5 Dani Rodrik, "The Rush to Free Trade in the Developing World: Why So Late? Why Now? Will It Last?" in Voting for Reform: The Politics of Adjustment in New Democracies, ed. Stephan Haggard and Steven B. Webb, New York: Oxford, 1994.

One seemingly obvious answer is the Third World debt crisis of the 1980s, which made the previous system untenable. But economic crises, especially when they involve the balance of payments, traditionally lead to more protectionism, not less. Why was this case different?

Rodrik's answer was that in the 1990s, advocates of free trade in developing countries were able to link free trade to financial and macroeconomic benefits. If trade liberalization is presented as a detailed microeconomic policy, the industries that stand to lose will be well-informed and vociferous in their opposition, while those who stand to gain will be diffuse and ineffective. What reformers in a number of countries were able to do, however, was to present trade liberalization as part of a package that was presumed to yield large gains to the country as a whole. That is, it was not presented as, "Let's open up imports in these 20 industries, and there will be efficiency gains"; that kind of argument does not work very well in ordinary times. Instead it was, "We have to follow the strategy that everyone serious knows works: free markets including free trade -- and sound money, leading to rapid economic growth."

Calling a set of economic measures a package does not mean that they need in fact be undertaken together. One can bring inflation down without liberalizing trade, and vice versa. But voters do not usually engage in hypothetical line-item vetoes, asking which elements of an economic program are essential and which can be dropped. If a program of economic stabilization-cum-liberalization seems to work, the political process is easily persuaded that all of the package is essential.

And the point was that such packages did work, and in fact initially did so astonishingly well -- but not necessarily because of their fundamental economic merits. Rather, the immediate payoff to Washington consensus reforms was in the sudden improvement in investor confidence.

Mexico is particularly noteworthy. Mexico began a major program of trade liberalization in the late 1980s, with no obvious immediate results in terms of faster economic growth. The turning point came when the country negotiated a debt reduction package, which went into effect in 1990. The debt reduction was intelligently handled, but everyone involved realized that it was fairly small, not nearly enough to make much direct difference to Mexico's growth prospects.

And yet what followed the debt reduction was a transformation of the economic picture. With stunning speed, Mexico's problems seemed to melt away. Real interest rates were 30 to 40 percent before the debt deal, with the payments on internal debt a major source of fiscal pressure; they fell between 5 and 10 percent almost immediately. Mexico had been shut out of international financial markets since 1982; soon after the debt deal, capital inflows resumed on an evergrowing scale. And growth resumed in the long-stagnant economy.

Why did a seemingly modest debt reduction spark such a major change in the economic environment? International investors saw the debt deal as part of a package of reforms that they believed would work. Debt reduction went along with free markets and sound money, free markets and sound money mean prosperity, and so capital flowed into a country that was following the right path.

In the 1990s, advocates of the Washington consensus have not had to make abstruse arguments about the benefits of better resource allocation nor plead with the public to accept short-term pain in the interest of long-run gain. Instead, because the financial markets offered an immediate, generous advance on the presumed payoff from free trade and sound money, it was easy to make a case for doing the right thing and brush aside all the usual political objections.

So much for one side of the political-economic cycle. The other side involved the willingness of financial markets to provide lavish rewards for economic reform. In part, of course, the markets believed that such policies would pay off in the long run. But most of the developing countries that suddenly became investor favorites in the 1990s had long histories of disappointed expectations, not just the debt crisis of the 1980s, but track records of abandoned economic reforms reaching back for decades. Why should investors have been so confident that this time the reforms would really stick? Presumably, this time reforms were taking place so extensively, and in so many countries, that investors found it easy to believe that it was a completely new world, that runaway inflation, populist economic policies, exchange controls, and so on were vanishing from the global scene.

But I have just argued, following Rodrik, that the unprecedented depth and breadth of policy reform was largely due to the perception that such reforms brought macroeconomic and financial recovery -- a perception driven by the way that financial markets rewarded the reforms! So once again something of a circular logic was at work.

During the first half of the 1990s, a set of mutually reinforcing beliefs and expectations created a mood of euphoria about the prospects for the developing world. Markets poured money into developing countries, encouraged both by the capital gains they had already seen and by the belief that a wave of reform was unstoppable. Governments engaged in unprecedented liberalization, encouraged both by the self-reinforcing conventional wisdom and the undeniable fact that reformers received instant gratification from enthusiastic investors. It was a very happy picture. Why couldn't it continue?

THE REALITY CHECK

FROM A mere trickle during the 1980s, private capital flows to developing countries soared to about $ 130 billion in 1993. Relatively little of this money went to those East Asian countries that had already achieved rapid economic growth during the 1980s. Less than 10 percent of the total, for example, went to China, and the four Asian tigers -- Singapore, Hong Kong, South Korea, and Taiwan -- were all net exporters of capital. Instead, the bulk of the money went to countries that had done poorly in previous years, but whose new commitment to Washington consensus policies was believed to ensure a dramatic turnaround: Latin American countries, plus a few others such as the Philippines and Hungary. How well were these economies doing?

In one respect, the performance of the main recipients of massive capital inflows did represent a break with the past. The new insistence on sound money had, indeed, led to impressive reductions in inflation rates. Between 1987 and 1991, Mexico's inflation rate had averaged 49 percent; in 1994, it was less than 7 percent. In Argentina the contrast was even more spectacular, from an average inflation rate of 609 percent in 1987-91 to a rate of less than 4 percent last year.

That was the good news. Unfortunately, there was also a substantial amount of disappointing news, onthree main fronts. First, while hard currency policies brought down inflation, they did so only gradually. As a result, costs and prices got far out of line with those in the rest of the world. Mexico, for example, allowed the peso to fall only 13 percent between 1990 and the first quarter of 1994, but consumer prices in Mexico nonetheless rose 63 percent over that period, compared with a rise of only 12 percent in the United States. Thus Mexico's real exchange rate -- the ratio of Mexican prices in dollars to prices in the United States -- rose 28 percent, pricing many Mexican goods out of U.S. markets and fueling an import boom. Argentina's drastic policy, which sought to end a histroy of extreme inflation by pegging the value of the peso permanently at one dollar, predictable left the country's prices even farther out of line. Between 1990 and early 1991 the Argentine real exchange rate rose 68 percent.

Second, in spite of huge inflows of foreign captial, the real growth in the recipient economies was generally disappointing. Mexico was the biggest disappointment: although capital flows into Mexico reached more than $ 30 billion in 1993, the country's rate of growth over the 1990-94 period averaged only 2.5 percent, less that population growth. Other countries did better: Argentina, for example, grew at an annual average rate of more than 6 percent after the stabilization of the peso. But even optimists admitted that this growth had much to do with the extremely depressed state of the economy before the reforms. When an economy has been as thoroughly mismanaged as Argentina's was during the 1980s, a return to political and monetary stability can easily produce a large one-shot rise in output. Across Latin America as a whole, real growth in the period 1990-94 averaged only 3.1 percent per year.

Finally, the benefits of growth, which was in any case barely positive in per capita terms, were also very unevenly distributed. Developing country statistics on both unemployment and income distribution are fairly unreliable, but there is not much question that even as Latin American stock markets were booming, unemployment was rising, and the poor were getting poorer.

In sum, the real economic performance of countries that had recently adopted Washington consensus as opposed to the financial returns they were delivering to international investors or the reception t heir policies received on the conference circuit, was distinctly disappointing. Whatever the conventional wisdom might have said, the underlying basis for the conviction of both investors and governments that these countries were on the right track was becoming increasingly fragile.

Some kind of crisis of confidence was thus inevitable. It could have come in several different ways. For example, there might have been a purely financial crisis: a loss of confidence in emerging markets as investments, leading to capital flight and only then to a loss of political confidence. Or there could have been an essentially intellectual crisis: the growing evidence that the new policies were not delivering in the way or at the speed that conventional wisdom had expected might have led to soul-searching among the policy elite. But given the way that the Washington consensus had originally come to flourish, it should not be surprising that the crisis, when it came, involved the interaction of economics and politics.

Consider the essentials of the Mexican situation as it began to unravel in 1994 -- the factors that would surely have provoked a crisis even without the uprisings and assassinations. Despite the popularity of the country among foreign investors, growth had slowed in 1993 to a virtual crawl, creating a considerable rise in unemployment. This growth slowdown was in a direct sense due to the rise in Mexico's real exchange rate after x99o, which discouraged any rapid growth in exports and caused growing demand to be spent primarily on imports rather than domestic goods. More fundamentally, the free market policies had not, at least so far, generated the kind of explosion of productivity, new industries, and exports that reformers hoped for.

Given these economic realities, the Mexican government was faced with a dilemma. If it wanted to get even modest growth going again, it would need to do something to make its industries more cost-competitive -- that is, devalue the peso. But to do so, given the emphasis that the government had placed on sound money, would be very damaging to its credibility. In the event, the approach of the presidential election seems to have led the Mexicans neither to devalue nor to accept slow growth, but rather to reflate the economy by loosening up government spending. The result was a loss of credibility even worse than that which would have been produced by an early devaluation. And then the usual logic of currency crisis came into play: because investors thought, with some reason, that the currency might be devalued, they became unwilling to hold peso assets unless offered very high interest rates; and the necessity of paying these high rates, together with the depressing effect of high rates on the economy, increased the pressure on the government to abandon the fixed exchange rate which made investors even less willing to hold pesos, in a rapid downward spiral familiar to scores of former finance ministers around the world.

The point is that while the details could not have been predicted, something like the Mexican crisis was bound to happen. Without the Chiapas uprising or the assassination of presidential candidate Luis Donaldo Colosio, Mexico might not have hit the wall in December 1994, but it probably would not have gone unscathed through 1995. An early, controlled devaluation might have done less damage than the display of confusion that actually took place, but it would still have done considerable harm to the government's credibility. And even if Mexico had somehow avoided getting into trouble, the disparity between the glittering prizes promised by the Washington consensus and the fairly dreary reality was bound to produce a revolution of falling expectations somewhere along the line.

AN AGE OF DEFLATED EXPECTATIONS?

BECAUSE THE 1990-95 euphoria about developing countries was so overdrawn, the Mexican crisis is likely to be the trigger that sets the process in reverse. That is, the rest of the decade will probably be a downward cycle of deflating expectations. Markets will no longer pour vast amounts of capital into countries whose leaders espouse free markets and sound money on the assumption that such policies will necessarily produce vigorous growth; they will want to see hard evidence of such growth. This new reluctance will surely be directly self-reinforcing, in that it means that the huge capital gains in emerging market equities will not continue. It will also, more or less directly, lead to a further slowing of growth in those countries, comprising much of Latin America and several outside nations, whose hesitant recovery from the 1980s was driven largely by infusions of foreign Capital.

Because reforms will no longer be instantly rewarded by the capital markets, it will be far more difficult to sell such reforms politically. Thus the common assumption that free trade and free market policies will quickly spread around the world is surely wrong. Indeed, there will doubtless be some backsliding, as the perceived failure of Washington consensus policies leads to various attempts either to restore the good old days or to emulate what are perceived as alternative models. Many developing Country politicians will surely claim that truly successful development efforts have been based not on free markets and sound money but on clever planning and rationed foreign exchange. At the moment, most developing country governments are still reluctant even to hint at a return to interventionist and nationalist policies because they fear that such hints will be swiftly punished by capital flight. But sooner or later some of them will rediscover the attractions of capital controls. As has happened so many times in the past, some countries will in desperation impose regulations to discourage capital flight. They will discover that while such regulations do raise the cost of doing business, that cost seems minor compared with their newfound ability to contain temporary speculative attacks without imposing punitive interest rates.

And these two trends will surely reinforce each other. As it becomes clear to the markets that reform need not always advance, they will become increasingly reluctant to offer advances on reform. As it becomes clear that such rewards are not available even to the most virtuous of reformers, the willingness to suffer economic pain to placate the markets will erode all the more.

But will the conventional wisdom represented by the Washington consensus be so easily displaced? Before the Mexican crisis, when some warned that the rhetoric about a golden age for global capitalism was excessive, the reply was often that there was no alternative. Communism is dead. The old protectionist development strategies in South Asia and Latin America were unambiguous failures. Even if Victorian virtue does not yield the easy rewards some may have expected, it is still the only plausible course of action left. And such arguments have a point. It is, in fact, probably true that free markets and sound money -- if not necessarily fixed exchange rates -- are the best policy for developing countries to follow.

But it seems strangely unimaginative to assume that because there are no other popular paradigms for policy currently in circulation, nobody will be able to come up with a rationale for policies that are very much at odds with the Washington consensus. Indeed, there are already audible rumblings about emulating a supposed Asian model. Developing countries should try, some people say, to be like Japan (as they imagine it) rather than America. The intellectual basis for such ideas is far weaker than that for the Washington consensus, but to suppose that bad ideas never flourish is to ignore the lessons of history.

GRAPHIC: Illustration 1, no caption; Illustration 2, no caption