Dani Rodrik's weblog

If you are a progressive, you've got to love neoclassical economics

Or so says Brad DeLong in an insightful contribution to the ongoing debate on economic heterodoxy. His point, I think, is not just that neoclassical economics provides the right (sorry!) way to think, but also that it gives you plenty of ammunition for tearing to shreds market fundamentalists. But then this raises an obvious question: why are the heterodox critics of "mainstream" economics mostly on the left of the political spectrum?

Every first-year graduate student learns the First Fundamental Theorem of Welfare Economics, which says essentially that provided a long list of conditions are satisfied, a market equilibrium is efficient in a particular way--that is, you cannot make someone better off without making someone else worse off. Now you can read the theorem in two, radically different ways. One is to say: "There you have it! We knew Adam Smith was right all along, but here it is stated in mathematically precise way and proved to everyone's satisfaction. Now let the government get out of the way and have the markets work their magic."  The other is to say: "Wow, hold on! You mean we need so many conditions for markets to produce efficient outcomes? No externalities, no returns to scale, no market power, markets for everything and for every point in time... I better get my theorems of the second-best straight!"

If you are the first kind of person... Well, I have never understood how you could be the first kind of person if you have also understood the First Fundamental Theorem of Welfare Economics. Which is what I think Brad is also saying (although you would not know it from some of his posts...)

      

Does empirical analysis ever settle a policy question?

Economics has gotten intensely empirical over the last decade, which makes many of the debates on theoretical methodology and on heterodoxy versus orthodoxy frankly irrelevant. When I received my PhD in 1985, anyone who was academically ambitious and whose fields were international trade or economic development (as mine were) would not think of doing an empirical dissertation. Only labor economics was somewhat different.

It is a very different world now. You can hardly publish an applied theory piece in these areas if you do not have at least a few regressions to go with it--and you better make sure you pay serious attention to specification and endogeneity. In the (bad) old days, I remember that it was often enough to say that you had instrumented for a potentially endogenous variable, while hiding the (typically inadequate) instrument list in a footnote.

But does empirical analysis ever help resolve important policy questions? This is the question that a post from my colleague George Borjas got me thinking about. I asked myself: is there something about the world that I believe in that I may have not have, absent some empirical evidence that convinced me?

I must confess answers did not come very easily. But here are three important examples.

1.  Many development economists have been traditionally concerned that the "structural" features of low-income economies make them unresponsive to the typical market-based, price signals. If there were not ample evidence that poor country exports respond robustly to real exchange rates, or that poor farmers respond strongly to prices of their crops, I may have become a structuralist too.

2.  Another strand in development thinking--going back to Sir Arthur Lewis and Simon Kuznets at least, contends that inequality is not only inevitable in the earlier stages of growth, but that it is actually good for growth as it enables the rich (who are the only ones assumed to save and invest) to have the resources with which they can stimulate economic growth. But by now we have enough accumulated evidence to discount this story. The least that can be said is that more inequality is not conducive to higher economic growth. It may even go in the reverse direction, but the evidence is not terribly strong on that either (despite one of my own early papers).

3. I might also have believed that democracy, whatever its other merits, is not very good for growth, and that the kind of reforms required to generate development require some form of authoritarianism. One again, the empirical evidence soundly refutes this view. Democracies do not pay a growth penalty, and on top have other redeeming economic features (such as better distribution, lower instability, and greater predictability).

Can readers come up with other examples?

UPDATE: Gallagher asks whether I am backing off from my reading of the empirical literature that there is no systematic relationship between trade liberalization and economic growth. No, I am not, but I did not want to seem like a broken record, so I left this off.   While on this topic, I see much of the profession--at least those who are empirically oriented--from having moved away from an unconditional linkage between trade liberalization and growth. The reigning conventional view is that trade liberalization produces growth only if a number of other conditions are present--if the right institutions are in place, if the macro environment is stable, and so on. The "so on" piece is important, because it leaves us off the hook, in case things still do not work out...

The mafiosi take on the heterodox

.. at the TPMCafe book club.  Fascinating discussion featuring James Galbraith, Tyler Cowen, Max Sawicky, Nathan Newman, David Warsh, Diane Coyle, Thomas Palley, David Ruccio, Mark Thoma, and Paul Krugman.

The World Bank has a new president

Well, Bob Zoellick is it.  The good news is that he is a graduate of the Kennedy School. The bad news is that I do not think he spent much of his time there or since thinking seriously about development policy. While at USTR and at State, his approach to developing countries was largely shaped by the narrow perspectives that these positions inevitably impose. And his take on the reforms needed by developing countries remains, as far as I can tell, quite conventional, circa 1980, with a splash of "augmented" Washington Consensus thinking added in.  This is from a speech he gave in 2002:

Latin America today stands in the middle of a bridge spanning the chasm between statist stagnation and free market dynamism. It is unwise to stop in the middle of a bridge and say, “I have walked in this direction long enough-I will now turn left or right.”

The first generation of economic reforms often depended on executive actions to counter crises. The second generation necessitates executive-legislative compacts to achieve long-term transformations:fiscal controls in federal systems; transparent legal and regulatory regimes backed by honest judiciaries;tax codes and pensions savings that build public trust, not undermine it; and schools and education systems that draw all of society toward opportunity, not protect isolated privilege.

In a global economy, Latin America must keep looking outward to prepare for competition. Trade barriers remain high for many products and sectors. State enterprises have been privatized, but burdensome regulations still make starting and running a business needlessly costly, often impossible.

The financial sector-the critical circulatory system of a capitalist economy-has been virtually untouched by reform in many places.

Look at the performance of the countries that have faced the inevitable trials by deepening reforms:Chile…Costa Rica…Mexico…and Brazil have not escaped the global slowdown, but they are weathering economic cycles within the framework of democracy and continued reforms. And they are succeeding.

Describing the challenge facing Latin America as late as 2002 as the conflict "between statist stagnation and free market dynamism" misses out on a whole lot of things--and most critically the bothersome detail that all successful economies have in fact had a good deal of statism mixed into their recipes of "market dynamism."  And yes, this is so not just with the East Asian tigers and China, but even in Chile, where the most dynamic exports (table grapes, forestry, salmon) have all benefited greatly from state assistance and where the largest exporter (Codelco) still remains state-owned. One needs to go beyond these old-fashioned ideas that pit states against markets if one wants to make progress against global poverty.

When needed, Bob Zoellick can be quite a pragmatist. As head of USTR, he was hardly a purist, as his defense of steel tariffs or bilateral trade agreements reveals--whatever one may think of the correctness of these particular departures. I hope he will be equally pragmatic when it comes to shaping the World Bank. The last thing the Bank needs is a free-market zealot.   

The financial globalization debate, played out in India

Financial globalization was supposed to be a boon for developing countries: it would spur growth by providing much needed foreign capital, and it would help smooth consumption. Neither has happened. So proponents are taking a new tack, arguing that the benefits come indirectly, in the form of improved institutions and enhanced competition, which financial capital is supposed to stimulate. In today's WSJ, this argument is made by Eswar Prasad in the context of India:

The real benefits of financial globalization to an emerging market economy have less to do with the raw financing provided by foreign capital. Instead, the indirect "collateral" benefits associated with such capital are far more important. These indirect benefits may be crucial for India's development.

One of the key benefits is that openness to foreign capital catalyzes financial market development. Foreign investment in the financial sector tends to enhance competition, raise efficiency, improve corporate governance standards and stimulate the development of new financial products. For instance, in India, even the limited entry of foreign banks has already given domestic banks a much-needed kick in the rearside and forced them to improve their efficiency in order to compete and stay viable.

Liberalizing outflows has the salutary effect of giving domestic investors an opportunity to diversify their portfolios internationally. This means greater competition for domestic financial institutions but also an opportunity for them to cultivate the financial savvy to offer products that would help their customers invest abroad.

Other indirect benefits associated with foreign capital include transfers of expertise -- technological and managerial -- from more advanced economies. When supported by liberal trade policies, foreign investment can help boost export growth. Foreign-invested firms also tend to have spillover effects in generating efficiency gains among domestic firms.

I find these arguments not to be compelling, because they overlook what is in effect the most important collateral damage that openness to financial capital inflicts: the tendency for the currency to appreciate, with the usual adverse consequences for investment in tradables and for economic growth. If we should have learned anything from the last two decades, it is that the exchange rate is too important a price to leave to financial markets. Countries that open up to financial capital lock themselves into an inescapable dilemma. Either they let the currency float freely in response to the whims of financial markets, or they have to undertake very costly actions, such as sterilized intervention. Is this what India wants or needs?

No, according to Arvind Subramanian, Prasad's co-author and former IMF colleague, and I agree. For another take on India's policy options, and a much more sensible one, turn to Subramanian:

So, India cannot really follow China [and undertake costly sterilization on an ongoing basis] and yet, India cannot afford to neglect the real exchange rate. Commentators suggest that currency appreciation is less of a problem today either because exports are mostly of IT-services, where profit margins are large enough to absorb adverse currency movements; or because exchange rate changes reflect productivity developments and hence are not a matter for concern. But we have to beware of the “Bangalore Bug,” whereby currency appreciation driven by the productivity of skill-intensive services undermines the competitiveness of low-margin, labour-intensive manufacturing, which is going to be crucial for India’s long-run ability to boost employment creation. Here, we should be thinking of the incentives facing not just existing low-skilled manufacturing firms but also firms that are potential entrants into this sector. We have not yet sorted out the regulatory problems that would allow Indian unskilled manufacturing to come into its own but a necessary condition for that to happen is a competitive exchange rate, and one that is not determined entirely by the performance of skill-intensive services.

What should India do? Three policy responses, one each in the short, medium and long run, might be considered. All of these will make clear that "doing something" about the exchange rate is a call that is easier made than implemented. We should not harbour any illusion of easy, painless solutions.

The first follows from a lesson that is essential to absorb: India’s ability to manage the real exchange rate has been severely undermined by capital flows. There is no need for India to take further policy actions that will lead to greater capital inflow. Indeed, there may even be a case for tightening, especially of external commercial borrowings, which were surprisingly relaxed in the last year, and, if feasible, some tightening of other short-term (hot) flows. It has to be recognised, though, that major restrictions on capital flows will damage market confidence, and minor ones, while helping minimise future problems, cannot fully address current ones.

In the medium run, improving the fiscal position remains one of the key policy tools that can help counter real appreciation. Unlike monetary policy and sterilisation, which largely affect nominal variables, fiscal consolidation can increase domestic savings and hence exert downward pressure on the real interest rate, causing a depreciation of the real exchange rate. Fiscal consolidation is desirable in its own right, but the government should consider making a special effort at improving government finances in response to episodes of sustained appreciation.

In the longer run, the ability to sustain a competitive exchange rate will require strengthening the key factor that underlies value creation in India—its labour. This includes attacking the last bastion of the licence raj—higher education—to augment the supply of skilled labour. Wage increases averaging 12-14 per cent in the last few years signal emerging shortages in the supply of skilled labour. Policy actions also include, crucially, addressing the impediments—labour laws and better basic education—that prevent the utilisation of India’s vast pool of unskilled labour. Perhaps a deeper reason for China’s competitive exchange rate might simply be that it has used—more effectively than India—its vast pool of labour, which has kept a lid on wage growth and inflationary pressures.

India's continued growth will depend in no small measure on playing its exchange-rate card well, and that in turn will require that it take a very cautious attitude towards capital inflows.

UPDATE: Formatting problem with the Subramanian quote has been fixed. Thanks to happyjuggler0 for the pointer. I am beginning to hate Typepad... Truth be told, I picked Typepad because of Brad DeLong's site, but he seems to be able to do things with it that I could never imagine doing....

Another take on the Asian financial crisis

This being the tenth-year anniversary of the Asian financial crisis, we are seeing a spate of retrospectives. The latest comes from Taka Ito, a highly respected Japanese economist. Ito comes down as hard on the IMF as a polite and diplomatic Japanese can allow himself. He leans towards the view that the Asian crises were essentially liquidity crises--requiring large infusions of external resources rather than extensive structural reforms. The IMF failed to provide the former, but had plenty of requirements of the latter kind. By contrast, Ito notes, the IMF condoned different approaches in post-Asian crisis cases--but those may have been precisely wrong as well:

The key element of the IMF programs for Russia, Brazil, Turkey, and Argentina,the fixed exchange rate (nominal or real), collapsed within several months after their respective first program in 1998 to 2001. Russia and Argentina fell into effective default on their external liabilities. An irony is that the IMF imposed tight fiscal policy and long lists of conditionality to countries [in East Asia] that probably did not need these conditions, while it allowed the post-Asian-crisis countries to continue a fixed exchange rate, which failed only a few months later.

The picture below shows the remarkable recovery in Asian growth rates after the crisis.

The Myth of Voter Irrationality

An article in Sunday's NYT magazine prompted me to look at Bryan Caplan's book The Myth of the Rational Voter. I haven't read the whole book, just the bits that are online. It is a thought-provoking piece, and a god read. But I am not convinced.

Here is what Caplan says:

This book develops an alternative story of how democracy fails. The central idea is that voters are worse than ignorant; they are, in a word, irrational — and vote accordingly.  [C]ommon sense tells us that emotion and ideology — not just the  facts or their "processing" — powerfully sway human judgment. Protectionist thinking is hard to uproot because it feels good. When people vote under the  influence of false beliefs that feel good, democracy persistently delivers bad policies.

And later:

On the naive public-interest view, democracy works because it does what voters want. In the view of most democracy skeptics, it fails because it does not do what voters want. On my account, democracy fails because it does what voters want.

First, I have a problem with the economics in the book. Consider the key exhibit in Caplan's case, the fact that many or most people are skeptical about free trade even though most economists are in favor. Caplan interprets this as evidence that people just don't get the argument about free trade's benefits (to themselves as well as the economy overall). But in fact there is nothing in the economic case for free trade to suggest that all or most of the individuals in the economy will be better off with free trade. The median individual/voter could well end up worse off (as may have been indeed happening during the last quarter century). So the difference of views between the economist and the person on the street may be reflecting the former's own social preferences instead of the latter's misunderstanding.

And even with respect to the aggregate gains from trade, the economist's case hinges on a large number of auxiliary assumptions. These may well be violated in the real world. I would bet my dollar on the common person having an instinctive understanding of these imperfections before I would trust a Chicago or GMU economist's priors on it.

In fact, there is good evidence that people's view on trade are shaped (at least in part) by pocketbook considerations. Anna Maria Mayda and I recently looked at individual attitudes on trade in a large sample of countries, and found that they were aligned exactly the way that the Stolper-Samuelson predicts. More skilled individuals are in favor of trade in skill-abundant countries, but against trade in skill-scarce countries. The reverse holds for less skilled people. We found that values mattered too--but the evidence that people understand how trade will work out for their own pocketbook is strikingly strong.

There is also a fair amount of empirical work on the advantages of democracy more broadly. To cite again my own work, democracies deliver more stable and more predictable growth, are better at handling shocks, and deliver more equitable economic outcomes, even if in the long-run their average growth performance is no different than autocracies'. Poor and ethnically divided countries experience higher growth after making a transition to democracy.  In short, democracies tend to do pretty well, and are much less prone to the fatal pathologies that Caplan worries about.

I think Caplan is doing us a service by taking on the holy cow of the rational voter, which permeates so much of the contemporary literature on political economy. It takes a lot of faith to believe that voters are fully rational and sufficiently well informed. But it is an equal leap to go from this to the pervasive pathologies for which Caplan wants to make the case.

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Is neoclassical economics a mafia?

Sort of, says Christopher Hayes in a very well-written and very interesting piece in The Nation. He says orthodox economists are a close-knit group and are quick to penalize those among them or from outside who overstep the boundaries. Here is an excerpt:

So extreme is the marginalization of heterodox economists, most people don't even know they exist. Despite the fact that as many as one in five professional economists belongs to a professional association that might be described as heterodox, the phrase "heterodox economics" has appeared exactly once in the New York Times since 1981. During that same period "intelligent design," a theory endorsed by not a single published, peer-reviewed piece of scholarship, has appeared 367 times.

It doesn't take much to call forth an impressive amount of bile from heterodox economists toward their mainstream brethren. John Tiemstra, president of the Association for Social Economics and a professor at Calvin College, summed up his feelings this way: "I go to the cocktail parties for my old schools, MIT and Oberlin, and people are all excited about Freakonomics. I kind of wince and go off to another corner or have another drink." After the EPI gathering, Peter Dorman, an economist at Evergreen State College with a gentle, bearded air, related an e-mail exchange he once had with Hal Varian, a well-respected Berkeley economist who's moderately liberal but firmly committed to the neoclassical approach. Varian wrote to Dorman that there was no point in presenting "both sides" of the debate about trade, because one side--the view that benefits from unfettered trade are absolute--was like astronomy, while any other view was like astrology. "So I told him I didn't buy the traditional trade theory," Dorman said. "'Was I an astrologer?' And he said yes!"

Hayes makes a number of good points about how ideology permeates a lot of thinking by orthodox economists. Anybody who strays from conventional wisdom is in danger of being ostracized. Some years ago, when I first presented an empirical paper questioning some of the conventional views on trade to a high profile economics conference, a member of the audience (a very prominent economist and a former co-author of mine) shocked me with the question "why are you doing this?" 

On the other hand I have never found neoclassical methodology too constraining when it comes to thinking about the real world in novel and unconventional ways. See the Carlos Diaz-Alejandro rule here. To me it represents nothing other than a methodological predilection for deriving aggregate social phenomena from individual behavior--and as such it is a very useful discipline for any social science. You say people have some preferences, they face certain constraints, take others' actions into account, and go from there. Neoclassical economics teaches you how to think, not what to think.

So it has always been a bit difficult for me to understand the critique that neoclassical economics is necessarily driven by ideology or leads to foregone conclusions. Just as it puzzles me why so many neoclassical economists are ready to jettison what they teach in the classroom and espouse simplistic rules of thumb on policy.

UPDATE: Fadi, you guess right, and you win this.

UPDATE: Peter has some very perceptive comments in the thread below. I recommend them to all.

UPDATE: Christopher Hayes responds in an e-mail:

Your point about neoclassical economics as an approach as opposed to a substantive set of principles is an important one, and gets at the crux of the issue. To what point does the toolbox determine what the carpenter fashions? If all you have is a hammer, does everything begin to look like a nail?

I don't get Paul Krugman

In today's NYT, Krugman says a guest worker program is a bad idea:

Meanwhile, the bill creates a guest worker program, which is exactly what we don’t want to do. Yes, it would raise the income of the guest workers themselves, and in narrow financial terms guest workers are a good deal for the host nation — because they don’t bring their families, they impose few costs on taxpayers. But it formally creates exactly the kind of apartheid system we want to avoid.

I must say that this leaves me confused. Krugman is the author of the justly famous "In Praise of Cheap Labor," which, correctly in my view, chastised opponents of globalization for not understanding that the poor working conditions and low wages they see in developing nations would be only worse in the absence of the trade and outsourcing the critics rile against. But now he is against a guest worker program because the labor conditions for these workers may not be up to some high standard which these guest workers would never hope to reach in their home countries?

What am I missing?

Majority of Americans favor a guest worker program

This according to a new poll reported in today's NYT.  Sixty-six percent of respondents are in favor of a guest worker program, and only 30 percent are against. (Check question 69 here.)  Frankly, I am surprised this is so popular, given how unpopular many other aspects of globalization are. For example, the Pew Research Center reports that only a minority of Americans (44%) believe free trader agreements are good for the U.S., and the balance is sharply in favor of those who believe such agreements destroy jobs.

Maybe most people instinctively understand the point made here...