An agenda for the Federal Reserve’s review of its monetary policy framework


An agenda for the Federal Reserve’s review of its monetary policy framework


Raising the Stakes: Involving the Public and Enhancing Equity in Market Reforms

Worldwide resource constraints and ideological shifts are pushing more and more countries—not just communist and other state-led economies, but advanced industrial economies as well—toward the market. Many are moving beyond economic reform to reevaluate the role of government. Countries as diverse as Great Britain, Chile, Spain, Ghana, Poland, Argentina, Ukraine, and Vietnam are engaging in similar debates about trade-offs between current consumption and future growth, fiscal constraints, and the need to reform oversized and inefficient public-sector bureaucracies.

Is the move to the market politically sustainable? Uncertainty about the equity effects of market-oriented reform is already an issue. Voters in many countries are rejecting continued market reforms and opting for “populist” politicians who promise cost-free transitions to prosperity. At best the result is the stalling of reforms, as in Russia, Hungary, and Slovakia. At worst it is a dangerous combination of economic disorder and political instability, as in Venezuela. And once reform is stalled, its costs, both economic and social, increase greatly—and are not easily contained within national borders.

If market reform is to prove sustainable, its benefits must be broadly based. The public as a whole must have a clear stake in reform. Newly developed stock exchanges and capital markets give the wealthy a big stake early in the process. But such macroeconomic reforms offer few immediate benefits to the majority, for whom the salient issues are more difficult ones involving equity, social welfare, social security, and basic public service delivery. Unfortunately, the consensus that reigns among policy makers concerning the principles of economic reform breaks down completely when it comes to the role of social welfare institutions and how to reform them. And the vast sums governments spend on social welfare and social insurance (41 percent of all federal spending in Chile, 50 percent in the United States, 60 percent in Costa Rica) give the issues fiscal as well as ideological significance.

Institutional reforms are also much harder to implement. Macroeconomic reforms require swift and decisive measures that can be carried out by a small group of policy makers, usually concentrated in the executive branch and relatively isolated politically. Popular acquiescence is necessary, but active cooperation on a widespread scale is not. In contrast, changing institutions and the way they deliver services is time-consuming and involves many actors. It also usually requires challenging powerful groups that deliver essential services, such as health care and education.

Despite these difficulties, an increasing number of countries are undertaking institutional reforms. And a convergence of thinking, if not a consensus, on reform is emerging. Some of the most successful reform efforts employ two strategies simultaneously. First, they increase the role of market incentives and individual initiative while reducing the role of the state. And, second, they involve local government and community organizations in managing reforms. The objective in both cases is to give more citizens a stake in reform.

One key to this stakeholders’ approach is to ensure that reforms benefit as many citizens as possible (for example, through enabling them to acquire shares in public companies) so that beneficiaries are motivated to vote, lobby, and even protest to prevent the reversal of the reforms. A second, equally critical, key is to increase public awareness and understanding of reform. Whether in reforming social service delivery, in redesigning social security systems, or in privatization, the stakeholders’ approach means reorienting public institutions to respond to new incentives given to a broad base of citizens. In political terms, the aim is to counter the array of incentives that encourage actors within the public sector to oppose reform.

Ideally, these institutional reforms will be part of the market reform process and complement its macroeconomic and fiscal rationale. Reform of the pension system that raises individual contributions, for example, can increase national saving and contribute to capital market development. Reform of the education system that increases local responsibility in management can distribute public resources more efficiently and equitably, while encouraging private alternatives. Privatizing large state-owned enterprises reduces the fiscal burden on the state and can encourage private sector development, parceling out resources and responsibilities to new stakeholders.

Though not specifically directed at the poor, stakeholder reforms can also benefit them, as poor citizens rely more than the wealthy on public services and thus stand to benefit from their reform. Increasing the participation of the poor may also strengthen their political voice, which will ultimately shift public spending in their direction.

Privatizing Industry

Political support for market reform is fragile in many of the former Soviet bloc nations, and many electorates have voted reformist governments out of office because of concerns about equity and social welfare. Among this group of nations, the Czech Republic has gone farthest in building a market system, and its polity is the most supportive of the market approach. Part of this popular support is cultural, part the result of a relatively healthy economy. Yet the role of Prime Minister Vaclav Klaus in presenting and marketing reforms has also been crucial. Early in the transition, the government gave citizens the option to purchase vouchers in privatized enterprises. The vouchers, which could either be kept or sold at auction, were worth $35, the equivalent of one week of the average wage. Out of an eligible population of 10.5 million, 8.5 million people participated in the program. Its success is one reason that Czech voters have consistently voted to continue the reforms.

The stakeholders’ approach is much more problematic in a country where overall poverty rates are higher. Peru, where the poverty rate is almost 50 percent, also tried recently to involve the public in privatization. In 1990, amid hyperinflation and deep recession, the government of Alberto Fujimori undertook a severe stabilization and adjustment program. Inflation was curbed and growth reached 12.9 percent in 1994. By the end of 1994, Copri, the Commission for Promotion of Private Investment, had privatized 49 state-owned companies, garnering more than $3 billion in new state revenue. Yet most shares were purchased by foreign RMS, as few Peruvians could afford to participate.

In 1994 the government announced a “citizen participation” scheme, based in part on that of the Czech Republic. Obstacles were formidable: extremely low disposable incomes, public unfamiliarity with capital markets, and widespread distrust of savings schemes following the recent collapse of a large informal savings market, the CLAE. Copri offered shares on a three-year installment plan with a 10 percent down payment and a subsidized 12 percent annual interest rate for monthly payments. Copri also protects investors against falling share prices during the three-year period.

In November 1994, 4 million shares (about 5 percent of the total) in the cement firm Cementos Norte Pacasamayo were offered to the public. Maximum packages were limited to $4,500. More than 3,000 people bought the shares in only three hours. Copri then offered 3.2 million more shares, reducing the maximum to $2,000 to encourage smaller investors. In only 45 minutes, more than 6,600 investors bought all those shares. Yet a third sale, with maximum purchases reduced further to $1,404, brought the total of investors to 18,500.

The privatization scheme was aimed at Peruvians whose income is less than $500 a month. Purchasers included street vendors, housewives, public sector workers, and low-income professionals. Nine out of ten had never bought shares before. Following up its active public information campaign announcing the sales, Copri has also offered training programs for participants. Only 3 percent of all participants have sold their shares; most have kept them as savings. And only 2.5 percent have failed to pay their monthly installments. Copri now plans to sell $1.4 billion worth of shares in state-owned companies to half a million participants. For all its success, however, Copri’s program has not reached Peru’s poorest citizens—a majority of the country, whose income is less than $250 a month—who have yet to benefit from market reforms beyond the benefit of curbing inflation.

Privatizing Social Security

Chile was the first nation in the world to privatize social security. Since the new private system was set up during the mid-1980s, 94 percent of Chilean workers have elected to join. Critical to the system’s success was the governments public relations campaign, designed to educate the public and encourage participation. A higher rate of return on pension contributions also encouraged workers to opt for the private system. The reform is now credited with helping to raise the national saving rate (from close to zero in 1980 to an average of 17.1 percent of GDP in 1990-92). The average rate of return on investments in the private system is an impressive 14 percent.

The government guarantees a minimum pension to workers too poor to participate in the private system. These pensions are extremely low, resulting in a pensioner’s “underclass” of sorts. Still, the vast majority of Chileans support the new system, and the transition to democracy in 1990 brought no mention of returning to a public scheme.

Peru too has launched a pension privatization scheme, both to rescue its insolvent social security system and to stimulate the local capital market. Yet only 40 percent of Peru’s labor force is covered by either the new private or the old public system. Slightly more than 1 million workers joined the private scheme, while roughly 1 million remain in the public system. The average return of the private funds has been 9 percent.

Workers who switched to the private system tend to be younger and wealthier than average. The higher contribution rates (initially a difference of 5 percent of workers’ salaries, now only 2 percent) were unaffordable for poor workers. The government tried to correct this discrepancy last June by lowering the contribution rate for the private system, raising it for the public system, and prohibiting new entrants to the public system. The reforms also provided the legal basis for a minimum pension in the private system, though without putting it into effect. Yet most poorer workers, after years of hyperinflation and the 1992 collapse of the CLAE market, have little faith in saving in general. In addition, the government did not inform the public adequately about the new pension system, and what information was available was primarily an advertising campaign by the private pension funds.

Workers in the new private pension system have a new stake in Peru’s reform process. Yet reform has been able to reach few of the extremely poor, and low-income workers still have no guarantee of an adequate pension. Introducing market incentives into social security in Peru may have merely replaced an inefficient scheme with an inequitable one. On the other hand, if in the long term the new scheme can increase the saving rate and help develop capital markets, it may enhance growth, which is critical to reducing poverty.

Education and Health Services

At roughly the same time it undertook pension reform, Chile introduced school choice, giving students the option to choose private instead of public schools through a system of subsidized vouchers. The portion of the population in the private system rose from 20 percent to 35 percent. Few of the poorest Chileans chose to enter private schools, however. Despite the vouchers, attending private schools was more costly (extra bus fares, for example). And information about the alternative schools was inadequate. In fact, many parents did not even know of their right to find better schools for their children. In addition, higher-quality schools tended to seek out children from stable and often wealthier families through the admissions interview process. While the private system appears to have benefited from the reforms, losses of both human and physical capital have weakened the public system.

Despite the evident flaws in the system, voters did not try to reverse school choice when Chile returned to democracy. Clearly, the reform created enough stakeholders to outweigh its negative equity effects, at least in political terms. Moreover, the government has been able to address the needs of poorer Chileans through targeted programs to improve the public schools.

In 1991-92, the Fujimori government in Peru introduced a set of education reforms modeled on Chile’s. The reforms had three objectives: to transfer administrative responsibility for schools to the municipalities, to tie funding to the number of students, and to create a system of public subsidies for private schools. The reforms were never implemented. In part Fujimori feared the political power that opposition mayors could accrue as managers of education funds. In addition, during the October 1993 constitutional referendum, the opposition campaigned nationwide against the reforms, citing the negative equity effects of Chile’s voucher program. The referendum found Fujimori the winner overall, but the loser in most rural (and usually poorer) provinces, largely offer education reform. Had a Chile-style reform been implemented in Peru, where poverty is much higher and administrative capacity far weaker, it is likely that the negative equity effects would have been far more severe.

In 1991 Zambia set in motion extensive market reforms amidst a transition to democracy. In addition, the new government of Frederick Chiluba also attempted major reforms in the health sector. Local actors were given new responsibilities for management and finances, while a strong pro-reform team within the Chiluba government kept central level actors from blocking reforms.

Yet the government, which initially “sold” the health reforms to the public, has failed to keep up its public relations and education efforts, and weak public understanding has led to the reforms having unintended effects, particularly for the poor. The introduction of user fees, for example, has sharply reduced the participation of the poorest in the public health system, despite more general progress in reforming service delivery. Since the fees were introduced, health posts in poor urban areas report drops in visits on the order of 80 percent. Meanwhile, popular support for health reforms, as well as for economic reform more generally, has eroded, even as elections approach this October.

Zambia’s severe poverty and weak administrative capacity limit the potential of any stakeholders approach. Even so, when a new health minister recently tried to reverse reforms and recentralize power, his efforts were thwarted by newly empowered local managers. As the Zambian case demonstrates, devolving authority and creating some stakeholders at the community level can give momentum to reform and make it virtually irreversible.

Stakeholders, Political Sustainability, and Equity

Most countries that undertake market-oriented reforms do so because they have no alternative. Those that postpone or avoid reforms ultimately fare worse, prolonging economic hardship and increasing poverty, as the poor are particularly vulnerable to economic instability. States that have implemented timely reforms have attained higher growth rates and reduced poverty, although their records at reducing existing inequities vary.

The record of the stakeholders’ approach to institutional reform has also been mixed. Clearly it can contribute to the sustainability of macroeconomic reform: increasing the involvement of individuals gives reform a momentum of its own. Voters in the Czech Republic, Chile, and Peru have strongly endorsed reforms in successive elections. The equity effects are far less clear, however. In most cases, the benefit of reform are extended to citizens who would otherwise be left out. Yet, particularly in the poorer countries, reforms still reach only a minority of the population.

The stakeholders’ approach seems more successful in privatization or in creating private social security schemes than in public service delivery. At least privatizations and new pension schemes do not reduce the welfare of the poorest groups. Indeed, if privatizations improve the social situation or if private pension systems raise national saving, for example, they may enhance the welfare of the poor indirectly. The effects of exclusion are very different in the case of public services, which are critical to and directly affect the welfare of the poor. Negative equity effects are of particular concern in countries where the majority rather than a small minority are excluded from reforms. And public sector reforms that allow people to choose private alternatives tend to reduce the size of the public sector, but not to resolve existing problems within it, which also harms the poorest groups who remain dependent on public sector services.

One result of the worldwide move to incorporate market principles into the delivery of services is likely to be a widening gap between rich and poor countries. In countries such as Chile or the Czech Republic, only a small minority is left behind by reform and government policy targeted to that group can help correct inequities. In contrast, societies such as Peru or Zambia, where the majority is marginalized, may face severe problems in becoming competitive members of the world economic community, even if they are able to implement market- oriented macroeconomic and sectoral reforms. The ongoing process of market reform—and its related application to reform of public institutionsclearly has increased the welfare and efficiency of most participants in the world economy. And international experience to date provides no better alternative. Yet the process has also had important and unresolved effects on equity, both within and among societies, that will fuel future debates on the role of government versus the market in providing essential social welfare services. The process also calls into question the possibility of a completely integrated world economy. Some societies will fall irreversibly behind, in both relative and absolute welfare terms. The implications of these inequities for global security, as well as for the international economic system, are likely to become an increasing concern for policy makers and academics alike.