Dani Rodrik's weblog

My candidate for IMF chief

... is Arminio Fraga, central banker extraordinaire and a terrific economist. In any meritocratic search, he would have to come out on or very near the top. But he has the wrong nationality for the job. Europeans are mulling European names, as tradition demands.   

UPDATE: Mali asks what my views are on

the new IMF decision on exchange rate surveillance .... Basically now for each country's report, Fund staff have to provide a view whether the exchange rate is misaligned, and by how much, according to various methods/measurements (which the results sometimes vary in great magnitude and direction).

This is a complicated one, because a country's exchange rate policy has obvious externalities for other countries. So this cannot be a free-for-all and there is indeed some role for exchange-rate surveillance. But if you take the view, as I do, that exchange-rate undervaluation is a second-best policy to overcome distortions in tradable industries, then it is also the case that you must provide developing countries with some leeway in their conduct of exchange-rate policy.  The IMF gets it particularly wrong when it says it will use management of the capital account as an indication of currency manipulation--but that is yet another story. My concern is that the developmental role of currency policies is being neglected in all the focus on "external stability." I hope to return to this topic later.

The inescapable trilemma of the world economy

Sometimes simple and bold ideas help us see more clearly a complex reality that requires nuanced approaches.  I have an "impossibility theorem" for the global economy that is like that. It says that democracy, national sovereignty and global economic integration are mutually incompatible: we can combine any two of the three, but never have all three simultaneously and in full.

Here is what the theorem looks like in a picture:

To see why this makes sense, note that deep economic integration requires that we eliminate all transaction costs traders and financiers face in their cross-border dealings. Nation-states are a fundamental source of such transaction costs. They generate sovereign risk, create regulatory discontinuities at the border, prevent global regulation and supervision of financial intermediaries, and render a global lender of last resort a hopeless dream. The malfunctioning of the global financial system is intimately linked with these specific transaction costs.

So what do we do?

One option is to go for global federalism, where we align the scope of (democratic) politics with the scope of global markets. Realistically, though, this is something that cannot be done at a global scale. It is pretty difficult to achieve even among a relatively like-minded and similar countries, as the experience of the EU demonstrates.

Another option is maintain the nation state, but to make it responsive only to the needs of the international economy. This would be a state that would pursue global economic integration at the expense of other domestic objectives. The nineteenth century gold standard provides a historical example of this kind of a state. The collapse of the Argentine convertibility experiment of the 1990s provides a contemporary illustration of its inherent incompatibility with democracy.

Finally, we can downgrade our ambitions with respect to how much international economic integration we can (or should) achieve. So we go for a limited version of globalization, which is what the post-war Bretton Woods regime was about (with its capital controls and limited trade liberalization). It has unfortunately become a victim of its own success. We have forgotten the compromise embedded in that system, and which was the source of its success.

So I maintain that any reform of the international economic system must face up to this trilemma. If we want more globalization, we must either give up some democracy or some national sovereignty. Pretending that we can have all three simultaneously leaves us in an unstable no-man's land.   

More wisdom from Martin Wolf

Martin Wolf outlines his proposals for the international financial system, as promised:

Is it possible to take advantage of the financial brain’s abilities, while limiting its capacity for irresponsible, short-sighted and destructive behaviour? What are the policy issues that we would be examining if we wanted to do so.

First, for essentially political reasons, we must re-examine the taxation of income and wealth.

Second, we should recognise that emerging and small economies have to manage their involvement with the global financial system cautiously.

Third, we must also realise that the mixture of floating exchange rates with a number of important pegged rates is creating huge distortions.

Fourth, we must look more closely at how monetary policy interacts with the financial sector and asset prices.

Fifth, we should also look once again at how well vast rewards are aligned with risk in financial markets.

Finally, we must encourage regulatory and fiscal authorities to achieve higher levels of co-ordination.

We will have to live with today’s financial markets, since policymakers would seek to curtail them only after a disaster. Even their critics should fear such a disaster. The task is, instead, to exploit the many benefits, while managing the risks. This will never be done perfectly. But it can be done at least tolerably well. The alternative is too awful to consider.

These all make a lot of sense. But do they go far enough? Stay tuned.

Good news from the World Bank

Bob Zoellick is now officially in charge, and there are indications that he may put the fight against corruption where it belongs: among a long list of  challenges, which vary in how badly they constrain development, rather than at the very top of the list. This is Wolfensohn on Zoellick:

“He [Zoellick] understands that you have to return the bank to its main thrust, which is development on behalf of the poor.

“As one of the elements, you want to combat corruption,” Mr. Wolfensohn added. “But you can’t make the bank into the attorney general of the world.”

Well said, and particularly meaningful as Wolfensohn is the person who brought the fight against corruption to the Bank.

Markets and states--and the survey says...

Risk-averse individuals are more likely to prefer protectionism to free trade, and that is true wherever people live. But their protectionist leanings are moderated in countries where the government is bigger (measured by the share of government spending in GDP). This is the remarkable finding in a recent paper  written by my student and co-author Anna Maria Mayda along with two other scholars, Kevin O'Rourke, and Richard Sinnott.  The paper is based on responses by individuals to a survey carried out in 18 countries (drawn from Europe and Asia). The authors speculate that the reason is people feel better insured against the risks of globalization in economies where the public sector is larger. Hence in their sample the country where risk aversion translates to protectionist desire the least is Sweden.

Here is how they summarize their results:

Our results provide microeconomic evidence consistent with the long-standing argument that the state and the market are in fact complementary. Openness and globalization can introduce uncertainty into peoples’ lives, and this additional risk can lead some people to oppose trade. Government expenditure can help to reduce this risk, and thus shore up support for open markets. It would seem that the ‘grand bargain’ that was embedded liberalism is politically effective. Whether that grand bargain can survive the additional political pressures which the interaction of mass migration and the welfare state can give rise to will be one of the key issues determining the sustainability of this institutional compromise in the decades ahead.

UPDATE: Here is the link to the paper from a non-password protected site (thanks to Justin Rietz).

Don't cry for Doha

Well the Doha Round appears to have collapsed yet again over disagreements on agricultural subsidies and tariffs. Even though we should never underestimate the ability of trade negotiators to resuscitate the dead, we will now likely see the usual hand-wringing about the huge costs of failure to conclude the round and about the losses to the world's poor nations. In fact, there was little to be gained from Doha, and little to lose from its collapse. Unless that is the U.S. over-reacts and turns the predictions of catastrophe into a self-fulfilling prophecy.

Not coincidentally, Oxfam just released a report on the prospective gains to poor farmers in Africa from the elimination of cotton subsidies in the U.S. The study estimates that in the absence of these subsidies, world cotton prices would be higher by about 10 percent, and the incomes of farmers in cotton-growing parts of West Africa higher by 3-6 percent. Cotton has long been the chief exhibit for the inequities of the world trade system, as Northern policies impose a straightforward loss on poor nations. In food products, the calculus is not that simple. The increase in world prices for food would on balance help the rural poor (who grow food) but hurt the urban poor (who don't) in Africa and elsewhere. This is one of the reasons Doha presents a very mixed picture overall for poor nations.      

Upon closer look, even the cotton case is not that straightforward. The estimated 10 percent increase in world prices is peanuts--if you will excuse my mixing my commodities--compared to the typical volatility in cotton prices--which has averaged around 20 percent up-and-down on an annual basis in the last quarter century. There is a real question as to whether the increase is large enough to be even noticeable.

To see the point, look at the graph below. The graph simulates the world price of cotton over a period of 40 years given its observed volatility in the recent past.

To simulate the effect of subsidy reform, I have raised the average of the series by 10 percent from time period T on. Can you tell when that change occurs? Can you tell that you were poor at the beginning of the time series, but are no longer by the end? And remember that cotton is the best possible case for demonstrating huge poverty gains from Doha.

My point is not that agricultural reform will not generate some gains for developing countries; it is that the likely gains have been vastly exaggerated. Many of the promoters of Doha have created expectations that are unlikely to be realized. The silver lining if Doha fails is that we will have an opportunity for a true development round sometime in the future.

And what might such a round look like? Here are my ideas.

Globalization clashes with the welfare state

... and globalization wins. That is one way to interpret Hans-Werner Sinn's recent article and book on Germany's economic crisis. Here is a summary of the argument:

Europe’s largest and the world’s third-biggest economy, the world’s first welfare state, is in serious difficulties. Dubbed an “economic miracle” after World War II, the country seems to have been abandoned by fortune. From 1995 to 2006, Europe was the world’s slowest-growing continent, and, next to Italy, Germany was the slowest-growing country in Europe. Even in 2006, when it experienced an extraordinarily strong export boom, Germany’s growth rate just made it to the average of the old EU countries. Once a locomotive, Germany was the laggard of the continent, if not of the world, for the past ten years. Germany has one of the lowest net investment shares of all developed countries, bankruptcies are still high and capital is fleeing to cheaper locations in Eastern Europe and Asia. Unemployment is currently falling sharply, but the level remains high by any standard, and yet the world’s poor continue to arrive at Germany’s doorstep. Although Germany will remain Europe’s biggest economy for many years to come due to its sheer population size, one European neighbour after another has overtaken Germany in per capita income in recent years. Germany was the sick man of Europe, unable to keep abreast with Austria, Denmark, Ireland, Finland, Great Britain, or the Netherlands. The Wirtschaftswunder, the much-admired German economic miracle of the post-war period, had moved on to other places. 

...

Germany needs a radical cultural and economic revolution—a revolution as courageous as the one that occurred in Great Britain under Margaret Thatcher, though not identical to it. After 50 years of progressive entanglement, Germany is ripe for this. Who knows, maybe Angela Merkel has a streak of Maggie in her.

Germany’s institutions must be transformed, uncomfortable questions must be asked, and radical rethinking must start. Can the power of the unions continue to be tolerated? Why is the welfare state permitted to pay such generous benefits for idleness? How long can the languishing economy of Eastern Germany be propped up, and at what stage will it be simply too expensive to finance a West German standard of living there? Can Europe tolerate that Germany’s debt to GDP ratio remains way above the 60% limit set by the Maastricht treaty? Must the government tax away two-thirds of even a low-earning worker’s returns to additional effort? Why is Germany’s population ageing so quickly, and can anything be done about this? Should the childless receive a full government pension? Are immigrants a burden, or a blessing? Are the Germans prepared for competition from Poles, Czechs, Slovaks, and Hungarians, whose countries joined the European Union in 2004? Where is the new Europe headed, and what tricks does the European Union have up its sleeve? These questions demand honest answers, and then Germany needs courageous economic and social reforms with which to buy back its future.

The necessary reforms will be painful, and it will take years before these produce any noticeable results. This explains why German politicians, forever with an eye on the next election, have balked at undertaking reforms with the requisite rigor.

Hans-Werner Sinn may well be right, but I can't help but cringe whenever an economist says reforms will be painful and they will take years to produce results. If the economy is under-performing so much and reform is so badly needed, shouldn't better policies produce large rewards and do so pretty quickly? Or is this just a convenient way of covering our behinds: if reforms do not produce results, economists can always say not enough time has elapsed or that the reforms have not been comprehensive enough...

Market access and developing country growth

How important is market access in rich countries to poor nations' growth prospects?  My own view is that rich countries are now sufficiently open that their remaining trade barriers do not impose a significant constraint on growth elsewhere, and on the growth of poor nations in particular. What China and Vietnam and a few other countries have managed to achieve, facing existing barriers, is prima facie evidence that at this point for most (if not all) developing countries the constraints on growth lie elsewhere--in their own domestic policies.

The picture below from a recent NBER paper by John Romalis is interesting in this context: it shows the relationship between market access in the U.S. and developing country openness over time.

It is not surprising that the trade volume of developing nations has increased as tariffs in the U.S. (and elsewhere) have fallen. But a closer look at the picture shows that the most rapid increase in developing country openness has taken place in the most recent period (since about 1980) when declines in tariffs were not as steep as in earlier times. This of course is the China phenomenon. China's export push has been supply-driven; (relatively) open markets in the West have enabled this push to take place, but they are not the reason behind it.

But perhaps there is more to the story. Romalis's detailed empirical analysis leads him to reach a different conclusion, namely that reducing market-access restrictions provides a significant boost to developing country exports and growth.  Romalis allows each country's response to changes in market access to be different and specific to that country, and I suspect this is an important determinant of the results. Unfortunately, Romalis does not say much about the sources of this heterogeneity across countries, or present the actual findings at the level of individual countries. It would have been good to know which are the countries that have positioned themselves better to take advantage of market access abroad.

A new mainstream consensus on trade and wages?

Paul Krugman explains here why he thinks trade may be now a much larger factor behind rising U.S. inequality, compared to the 1980s and early 1990s. The reasons have to do with China and production fragmentation.

During the 1980s and 1990s, there was considerable concern about the possible role of globalisation in contributing to rising income inequality, especially in the United States. This concern was based on standard economic theory: since the 1941 Stolper-Samuelson paper, we’ve known that growing trade can have large effects on income distribution, and can easily leave broad groups, such as less-skilled workers, worse off.

After economists looked hard at the numbers, however, the consensus was that the effect of trade on inequality was probably modest. Recently, Ben Bernanke cited these results – but he recognised a problem: “Unfortunately, much of the available empirical research on the influence of trade on earnings inequality dates from the 1980s and 1990s and thus does not address later developments. Whether studies of the more recent period will reveal effects of trade on the distribution of earnings that differ from those observed earlier is to some degree an open question.”

But the question isn’t really that open. It’s clear that applying the same models to current data that, for example, led William Cline of the Peterson Institute to conclude in 1997 that trade was responsible for a 6% widening in the college-high school gap would lead to a much larger estimate today. Furthermore, some of the considerations that once seemed to set limits on the possible inequality-promoting effects of trade now seem much less constraining.

There are really two key points here: the rise of China, and the growing fragmentation of production.

Krugman was the co-author of a well-known 1994 paper (called "Trade, Jobs, and Wages") which laid out the case for trade's relative insignificance. Interestingly, his co-author on that paper, Robert Lawrence, does not see much of a footprint of trade behind the recent rise in inequality. In fact, he argues the case is even less compelling now than it was a decade ago.

How to reconcile the two perspectives? I think Lawrence is right to the extent that the skill premium has stopped rising since 2000, and therefore the type of approach that Cline and others used and which Krugman thinks would yield larger estimates of trade's contribution today, would not actually explain current inequality (which derives from the rise in incomes at the very top and from the increase in the profit share). But there are other (non-Stolper-Samuelson) models, based on bargaining for example, that could.

In any case, the trade-versus-technology debate of a decade ago is not worth reliving. What is remarkable is that a growing number of prominent economists--Bernanke, Summers, Krugman--are now willing to give globalization a starring rather than supporting role in the recent rise on inequality.

Should the U.S. respond to China's exchange rate policy by raising its import tariffs?

If you instinctively respond "no", consider that the World Trade Organization allows countries to respond to their trade partners' export subsidies by erecting retaliatory trade barriers (called "countervailing duties"). Intervening in currency markets to prevent your currency from appreciating is no different, from an economic perspective, from subsidizing your exports. So if you are expected to (and can) respond through tariffs when others subsidize their exports, why should it matter what form the subsidy takes?

And if you instinctively respond "yes", consider that the vast majority of the countries in the world today manage their currencies, rather than let them float freely. What a mess we would have on our hands if countries made a habit of responding to currency "manipulation" by imposing retaliatory tariffs.

Yes I know, China is not just another country. And yes, the economic case for countervailing duties is extremely weak. (The standard economist's line is that you should respond to other countries' export subsidies by sending them a thank-you note, not by shooting yourself in the foot in return.) But presumably there is some (second-best or political) reason why WTO rules sanction countervailing against subsidies. These reasons must operate, if anything, more strongly when such a huge economy like China is involved.   

On the Chinese side, what is involved is perhaps some degree of mercantilism--which is not excusable--but also the use of an undervalued currency as a growth strategy--which is far easier to justify and excuse. When you have hundreds of millions of people in low-productivity rural activities, a cheap currency can be a very effective, if still second-best, way of supporting employment creation in your higher-productivity tradable industries.

And there lies the rub. In an ideal world, the distributional or job-loss concerns in the U.S. would be addressed by policies that target these objectives directly (redistributive taxation and improved adjustment assistance). Also in an ideal world, China would address its productive transformation challenge directly through targeted employment and other reforms rather than currency policies. But in the real world, countries find themselves resorting to second-best policies and we must not be surprised if these create conflicts.

All of which is to say that anyone who has a quick, knee-jerk response to the question posed by this post's title has not thought long and hard about the issues.