Dani Rodrik's weblog

Who said economics is about forecasting the future?

Gideon Rachman of the FT wants to dethrone economists. I am all for it, but what grates in his article is the view that economics as a science is defined by its ability to forecast the future. No, it is not, and whoever said that is not very knowledgeable about economics as a discipline.

Well, except that Rachman takes his definition from … Joe Stiglitz! 

I am sure Stiglitz would recant, or at least argue that his comment was taken out of context, upon close examination.  At best, economics can help us make contingent predictions -- a long way off from forecasting.

There is plenty wrong with the way that economists have behaved in the run-up to the financial crisis without ascribing such grandiose claims to economics. 

My take is that you should blame economists, not economics:      

The problem is that economists (and those who listen to them) became over-confident in their preferred models of the moment: markets are efficient, financial innovation transfers risk to those best able to bear it, self-regulation works best, and government intervention is ineffective and harmful.

They forgot that there were many other models that led in radically different directions. Hubris creates blind spots. If anything needs fixing, it is the sociology of the profession. The textbooks -- at least those used in advanced courses -- are fine.

Non-economists tend to think of economics as a discipline that idolizes markets and a narrow concept of (allocative) efficiency. If the only economics course you take is the typical introductory survey, or if you are a journalist asking an economist for a quick opinion on a policy issue, that is indeed what you will encounter. But take a few more economics courses, or spend some time in advanced seminar rooms, and you will get a different picture.

Labor economists focus not only on how trade unions can distort markets, but also how, under certain conditions, they can enhance productivity. Trade economists study the implications of globalization on inequality within and across countries. Finance theorists have written reams on the consequences of the failure of the “efficient markets” hypothesis. Open-economy macroeconomists examine the instabilities of international finance. Advanced training in economics requires learning about market failures in detail, and about the myriad ways in which governments can help markets work better.

Macroeconomics may be the only applied field within economics in which more training puts greater distance between the specialist and the real world, owing to its reliance on highly unrealistic models that sacrifice relevance to technical rigor. Sadly, in view of today’s needs, macroeconomists have made little progress on policy since John Maynard Keynes explained how economies could get stuck in unemployment due to deficient aggregate demand. Some, like Brad DeLong and Paul Krugman, would say that the field has actually regressed.

Economics is really a toolkit with multiple models – each a different, stylized representation of some aspect of reality. One’s skill as an economist depends on the ability to pick and choose the right model for the situation.

Economics’ richness has not been reflected in public debate because economists have taken far too much license. Instead of presenting menus of options and listing the relevant trade-offs – which is what economics is about – economists have too often conveyed their own social and political preferences. Instead of being analysts, they have been ideologues, favoring one set of social arrangements over others.

Furthermore, economists have been reluctant to share their intellectual doubts with the public, lest they “empower the barbarians.” No economist can be entirely sure that his preferred model is correct. But when he and others advocate it to the exclusion of alternatives, they end up communicating a vastly exaggerated degree of confidence about what course of action is required.

The Myth of Authoritarian Growth

On a recent Saturday morning, several hundred pro-democracy activists congregated in a Moscow square to protest government restrictions on freedom of assembly. They held up signs reading “31,” in reference to Article 31 of the Russian constitution, which guarantees freedom of assembly. They were promptly surrounded by policemen, who tried to break up the demonstration. A leading critic of the Kremlin and several others were hastily dragged into a police car and driven away.

Events like this are an almost daily occurrence in Russia, where Prime Minister Vladimir Putin rules the country with a strong hand, and persecution of the government’s opponents, human-rights violations, and judicial abuses have become routine. At a time when democracy and human rights have become global norms, such transgressions do little to enhance Russia’s global reputation. Authoritarian leaders like Putin understand this, but apparently they see it as price worth paying in order to exercise unbridled power at home.

What leaders like Putin understand less well is that their politics also compromise their countries’ economic future and global economic standing.

Read the rest here.

Correction.  Due to an oversight on my part during the editing process, the sentence that started with “Democracies not only do not underperform dictatorships when it comes to long-term economic growth..”  in my original version eventually became “Democracies not only out-perform dictatorships when it comes to long-term economic growth..” in the published piece.  The change imparted a superiority to democracy in terms of growth which the evidence does not find and which I did not intend to express.  Thanks to Dr. Emmanuel Yujuico for taking me to task over this change, which I had not noticed until he pointed it out.

The market confidence bugaboo

A specter is haunting Europe – the spectre of “market confidence.”

It may have been fear of communism that agitated governments when Karl Marx penned the opening line of his famous manifesto in 1848, but today it is the dread that market sentiment will turn against them and drive up the spreads on their bonds. Governments all over are being forced into premature fiscal retrenchment, even though unemployment remains very high and private demand shows few signs of life. Many are driven to undertake structural reforms that they don’t really believe in – just because it would look bad to markets to do otherwise.

Read the rest here.

A debate on industrial policy

In which Josh Lerner and I pretend to disagree.

The next big debate in financial reform

Now that we know the shape that regulatory reform is likely to take on both sides of the Atlantic, it is time to focus on the next big question: how do we deal with the differences in the European versus U.S. approaches to reform? 

You cannot ignore these since financial transactions will have a tendency to migrate to the least-regulated jurisdictions, leading to all kinds of hue and cry about losing financial competitiveness. This is the familiar problem of regulatory arbitrage.    

The choice is clear here.  Either we put our faith in some Basel or other international process that will deliver global convergence on standards and on how to deal with systemic risk issues. Or else we go the national route, and ensure that national financial systems are ring-fenced and protected against regulatory arbitrage and contagion.

The first approach remains the conventional wisdom among the financial technocracy.  It receives support in a new report authored by Stijn Claessens, Richard J. Herring, and Dirk Schoenmaker.  Meanwhile, Simon Johnson seems to support the second approach.  Even though Simon is not very explicit in this latest piece, he has been quite clear in the past that if the U.S. faces the prospect of foot-dragging or weaker regulations on the part of the Europeans, the U.S. should just go it alone and make sure everyone that does financial business in the U.S., regardless of nationality, abides by U.S. rules.

I am with Simon Johnson on this one, for reasons explained here.

Yes, global financial integration will suffer, but frankly should we care if that is the price for better regulation, more in line with national preferences and realities?

More on Turkish politics

My latest on Turkey's ugly turn is here.  The title is over-the-top, but it was the WSJ editorialists' choice, not mine. 

(And they got the caption underneath the picture on the online version badly wrong, as of this writing.)

Some fallacies never die

My previous post on the comparative merits of import substitution (ISI) and the Washington Consensus (WC) has resuscitated some counter-arguments that I thought had long been laid to rest.  Three in particular:

1.  “ISI was responsible for the debt crisis of the 1980s.”  This confuses micro and macroeconomics.  The debt crisis was the result of a macroeconomic imbalance: an excess of aggregate spending over aggregate incomes.  The relative price “distortions” that were the hallmark of ISI do not necessarily produce macroeconomic imbalances (cf. India throughout the heyday of its ISI regime); nor do macroeconomic imbalances require relative price distortions (cf. Greece today).

2.  “Latin American countries did not try hard enough to implement WC policies in the 1990s.”  This is probably the most disingenuous comment of all.  It does great injustice to the efforts of Latin American policy makers, who led a real revolution in policy making.  It is also disturbingly reminiscent of the old chestnut about “communism didn’t fail because it was never tried.”

3.  “The check is in the mail.”  In other words, just give it more time and we will see the positive results of the WC eventually. The obvious riposte to this is to point to the experience of Asian countries that seem to get quick results from unorthodox but well-targeted reforms.  Isn’t it obvious that this experience should be a better guide to growth-promoting policies than the WC?   

I have written about all these things in various places.  See here and here.  

The most telling chart I have seen in a long time

The Inter-American Development Bank’s new study, The Age of Productivity is a trove of neat information on productivity performance in Latin America.  My favorite nugget is this one:

Ignore the intermediate period of debt crisis (1975-90) and focus on the differences between the periods of import-substitution (IS, 1950-1975) and Washington Consensus (WC, 1990-2005).  What do we see?

1. Labor productivity under IS grew at a rate that is double the rate under WC.
2. The rate of labor productivity growth within sectors (the component identified as “within” in the chart) was comparable under the two policy regimes.
3. The worse overall performance under WC is accounted entirely by the fact that there was much less desirable structural change -- labor moving from low to high-productivity activities -- under WC than under IS.

We already knew 1, and I have long suspected points 2 and 3 to be true as well.  But I had never seen the facts laid out so clearly.

Here is what seems to have happened:

For all its faults, IS promoted rapid structural change.  Labor moved from agriculture to industry, and within industry from lower-productivity activities to higher-productivity ones.  So much for the inherent inefficiency of IS policies!

Under WC, firms and industries were able to accomplish a comparable rate of productivity growth, but they did so by shedding (rather than hiring) labor.  The displaced labor went not to higher-productivity activities, but to less productive lines of work such as informality and various services.  In other words, the WC ended up promoting the wrong kind of structural change.

This account reinforces the centrality of structural change in driving rapid economic growth. It should also cause us to be wary of productivity studies that focus on what is happening within manufacturing alone.  After all, productivity within manufacturing can be stellar, but if manufacturing or other high productivity sectors as a whole are rapidly shedding labor, economy-wide productivity performance will be disappointing. 

Arthur Lewis lives.

Europe’s fate depends on…

Germany.

Financial meltdown has been averted in Europe – for now. But the future of the European Union and the fate of the eurozone still hang in the balance. If Europe doesn’t find a way to reactivate the continent’s economy soon, it will be doomed to years of gloom and endless mutual recrimination about “who sabotaged the European project.”

European growth is constrained by debt problems and continued concerns about the solvency of Greece and other highly indebted EU members. As the private sector deleverages and attempts to rebuild its balance sheets, consumption and investment demand have collapsed, bringing output down with them. European leaders have so far offered no solution to the growth conundrum other than belt tightening.

The reasoning seems to be that growth requires market confidence, which in turn requires fiscal retrenchment. As Angela Merkel puts it, “growth can’t come at the price of high state budget deficits.” 

But trying to redress budget deficits in the midst of a collapse in domestic demand makes problems worse, not better. A shrinking economy makes private and public debt look less sustainable, which does nothing for market confidence.

So Europe needs a short-term growth strategy to supplement its financial-support package and its plans for fiscal consolidation. The greatest obstacle to implementing such a strategy is the EU’s largest economy and its putative leader: Germany.

If Germany wants the rest of Europe to swallow the bitter pill of fiscal retrenchment, it will eventually have to recognize the implicit quid pro quo. It must pledge to boost domestic expenditures, reduce its external surplus, and accept an increase in the ECB’s inflation target. The sooner Germany fulfills its side of the bargain, the better it will be for everyone.

Read the full article here.

What does Spain need to do to get out of the crisis?

I just came back from a conference in Spain, where this was the question on the table. I made the following points.

First, expenditure cuts are not going to do the job on their own, unless accompanied by policies targeted directly at improving competitiveness.

Second, "structural reforms" (which in the Spanish context means largely labor market reforms that aim to reduce firing costs and decentralize wage bargaining to the firm level) are not a substitute for competitiveness policies.  Insofar as they eat up political capital, they may even backfire in the short-run.

Third, there are no easy solutions to Spain's competitiveness conundrum.  But the least bad solution is to engineer an economy-wide reduction in nominal wages and the prices of services (utilities, etc.) through some kind of social compact.

Easy?  No.  Any other practical alternative to a prolonged period of recession and high unemployment? Probably not.

Spain could always exit the eurozone of course. But the acrimony and uncertainty that this will cause in the short-run does not make it a practical alternative to incomes policies in my view.

Here is my presentation at the conference.