Dani Rodrik's weblog

Financial crisis does things to people

This just in from the highest authority in the land:

[T]he fact is that Larry Summers right now is very comfortable making arguments, often quite passionately, that Bob Reich used to be making when he was in the Clinton White House.

Why do poor nations continue to be enthralled with capitalism?

Arvind Subramanian is onto something: he asks why the crisis has spawned a debate on capitalism in the advanced countries, but not in the developing nations.  As he notes, there is very little clamor for rolling back markets once one moves to the periphery of global capitalism:

Surprisingly, in the emerging markets, including India, there has been no such existential angst about capitalism, no serious questioning of the role of the market. It is not that these countries have not been affected by the crisis. Indeed, all countries—rich and poor—have found themselves in the same financial maelstrom, if not in the same boat, and the effects have been substantial. There has also been serious discussion and action on the appropriate short-term responses to the crisis. But, there have been no serious calls or indeed actions to roll back capitalism, to erect protectionist barriers, or to re-nationalise the economy. Most surprising, there has not even been a pitch to restrict inflows of fickle foreign capital that were arguably at the centre of this crisis for many emerging markets. The crisis may have exposed the claim of a decoupled world economy, but it seems to have emphasised the decoupling in policy debate and long-term policy choices.

What is the explanation?  Arvind's preferred interpretation is that the advanced country debate is largely irrelevant to the poorer nations:

[The] big question thrown up by the crisis in the core countries [is] the role of the state and the appropriate demarcation between state and markets, especially in the financial sector. In the emerging markets, particularly in the more successful ones such as China and India, this is simply not an issue. The line still favours state over markets and in the financial sector heavily so: in both these countries, most of the banking system assets and liabilities are still controlled by the government. The issue is not how to claw back the role of the state so much as how to continue reducing its role in the gradual and pragmatic manner that these countries have been doing over the last two decades. In India, for example, the only bank threatened by the crisis was a private one that chose to deal in the toxic assets that wreaked havoc in western financial markets, resulting in a flight of deposits to the safety of public sector banks. Yet, it is remarkable that the debate on finance in India has not lurched in the direction of triumphalism about the public sector model of finance and the need to ensure its permanence.

Perhaps the most important reason for the decoupled debate phenomenon is that the big development challenge in the developing world is not the state-market boundary but the more mundane yet fiendishly difficult question of how to improve the state and its basic capacity to deliver law and order, security and other essential services such as health, water, sanitation and education. That was so before the crisis. That will remain true in its aftermath.

Arvind is being a bit too charitable here to the developing nations.  I am afraid one cannot rule out the possibility that poor nations are yet again falling behind the curve. 

Barry Eichengreen reads my mind

Or vice versa. 

It began with this paper, which I found out later had exactly the same title as this one by Barry.  Then, when I wrote my guest Economics Focus column for The Economist, Richard Baldwin chided me for repeating arguments that Barry had made elsewhere and which he assumed I was familiar with and had borrowed.  And now Barry has come out with an excellent piece (what else would I call it?) which I wish I had written.  (A more vain version of me thinks that I actually have, some of it published, some not.)  

There are quite a few points in Barry's piece that are really noteworthy.  One is that the problem with economists is not that we did not have the models and the tools needed to understand that the crisis was on its way, but that we focused excessively on the more benign models that we had. 

... it was not that economic theory had nothing to say about the kinds of structural weaknesses and conflicts of interest that paved the way to our current catastrophe. In fact, large swaths of modern economic theory focus squarely on the kind of generic problems that created our current mess. The problem was not an inability to imagine that conflicts of interest, self-dealing and herd behavior could arise, but a peculiar failure to apply those insights to the real world.

And why did this happen?  Part of the reason is that economists are subject to all the same heuristic biases that behaviorists amongst us study in others--over-confidence, willingness to conform, tendency to discount contradictory evidence, and so on.  Part of it is that economists did not have the guts to speak out when financiers and policy makers engaged in cherry-picking their results--using those that were favorable to their cause to buttress their case, while disregarding others.    

[T]he problem was a partial and blinkered reading of [the economics] literature. The consumers of economic theory, not surprisingly, tended to pick and choose those elements of that rich literature that best supported their self-serving actions. Equally reprehensibly, the producers of that theory, benefiting in ways both pecuniary and psychic, showed disturbingly little tendency to object. It is in this light that we must understand how it was that the vast majority of the economics profession remained so blissfully silent and indeed unaware of the risk of financial disaster.

It is indeed hard to escape the sense that many leading economists became complicit in the financial crisis by remaining so complacent about the risks of financial liberalization.  Interestingly, some of these same economists have now become advocates of financial controls much more draconian than what the early liberalization-skeptics had contemplated.  But that's another story...  

When textbook macro pays off

Macroeconomics doesn't get much plaudits around now, but here is a real-life story that should hearten those who think the field is really broken.  It concerns Andres Velasco, a distinguished macroeconomist who is currently the minister of finance in Chile, and who also happens to be a good friend, colleague and co-author. 

Until the current crisis hit, Chile's economy was booming, fueled in part by high world prices for copper, its leading export.  The government's coffers were flush with cash.  (Chile's main copper company is state-owned, which may be a surprise to those who think Chile runs on a free-market model!)  Students demanded more money for education, civil servants higher salaries, and politicians clamored for more spending on all kinds of social programs. 

Being fully aware of Latin America's commodity boom-and-bust-cycles and recognizing that high copper prices were temporary, Velasco stood his ground and decided to do what any good macroeconomist would do:  smooth intertemporal consumption by saving most of the copper surplus.  He ran up the largest fiscal surpluses Chile has seen in modern times. 

This didn't make Velasco very popular.  Last November, public sector workers marched in downtown Santiago, burning an effigy of Velasco.

But by the time the financial crisis hit Chile, Velasco (and the Central Bank governor Jose de Gregorio, another fine macroeconomist) had accumulated a war chest equal to a stupendous 30% of GDP.

The price of copper plummeted 52 percent from Sept. 30 to year-end, and Velasco dusted off his checkbook. In the first week of January, he and Bachelet unveiled a $4 billion package of tax cuts and subsidies...  Velasco’s stimulus spending, includ[ed] 40,000-peso ($68.41) handouts to 1.7 million poor families...

The surpluses accumulated during the good years has given the Chilean government unusual latitude in responding to the crisis.  As a result, the economy is doing much better than its peers.  As Bloomberg reports, "the country’s economy is expected to grow 0.1 percent in 2009, as the region contracts 1.5 percent, according to the International Monetary Fund."

And does good economics pay off politically?  Eventually, yes.  Five months after being burned in effigy, Velasco is currently President Bachelet's most popular minister.

Understatement of the day

“One would be forgiven for concluding that the assumed benefits of financial innovation are not all they were cracked up to be,” the Fed chairman said today in a speech at the central bank’s community affairs conference in Washington. “The damage from this turn in the credit cycle -- in terms of lost wealth, lost homes, and blemished credit histories -- is likely to be long-lasting.”

(HT: Mark Thoma).  Obvious perhaps, yet noteworthy nonetheless because it comes directly from Ben Bernanke himself.

Well, let's not put down all financial innovation.  We can all agree this one was pretty useful and made all our lives easier. 

More bad news on the recovery

The IMF's partially-released World Economic Outlook makes two points which significantly alter my priors with respect to the speed and vigor of the recovery in the advanced nations--for the worse. 

First, the IMF authors find that recessions created by the bursting of financial bubbles are different--they are more severe and last longer--from recessions that are produced by other causes (for example, supply shocks). The likely reason is that pre-crisis growth in the former case is based on an illusion of rising wealth and is more artificial. 

Second, synchronized crises (in which several major economies are simultaneously hit) are also more difficult to get out of.  You cannot rely on other economies to pull you out of it through their demand for your exports.

The current crisis is both finance-driven and synchronized. So we are in the worst of all possible worlds.

In hindsight, both of these points are rather obvious, but it is remarkable that so few of the comparisons with previous experiences have taken them on board. 

Are the good times really over?

Globalization is responsible for the vast increase in economic growth that we experienced in recent times, right? 

Well, yes and no.  It all depends on what you mean by globalization and when you think it began.  As the following chart illustrates, clearly something fundamental happened in the early years of the postwar period (the data are from Angus Maddison).  Starting around 1950, the world economy became able to support levels of economic growth that were a multiple of (three to four times higher than) levels observed at any time before then.  You may call this the miracle of globalization, but it would be more accurate to call it the success of the Bretton Woods regime.

Note by contrast that the period of gung-ho globalization, which we may date from the early 1990s on, presented no improvement over the preceding post-war arrangements.  In fact average growth in the world as a whole lagged behind the rates experienced in the immediate post-war period. And the Chinese growth miracle is slightly less distinguished than the Japanese miracle of the earlier era (at least according to Maddison's numbers). 

The lesson?  While it is important to ensure that deglobalization doesn't go too far, we should not lose sleep over the possibility that we might not restore openness in trade and financial policies to the levels that prevailed in the last couple of decades.  The world economy can do very well indeed, thank you very much, with Bretton-Woods levels of openness.        

A second lesson has to do with the post-1950 growth champions identified in the chart above: Japan, South Korea, and China.  What was common in the policies of these countries is that they were all "productivist."  They prioritized productive structural change--the movement of resources from traditional to modern activities--above all else.  They employed not only "orthodox" instruments (such as investment in infrastructure and human capital) but also subsidization of new industries, undervaluation of currencies to promote tradables, and repression of finance whenever it stood in the way.   

So the good times need not be over (at least for developing nations) even with some deglobalization as a result of the present crisis.  Less finance may even do them some good.    

What's wrong with this picture?

And you don't need to read Turkish to get it.  I hate it when they leave the "Sir" out of the beginning of my name... 

David Warsh on John Geanakoplos

David Warsh knows how to spin a yarn about economics and economists. His latest post features John Geanokoplos of Yale and the waves he has been making in academic and policy circles with his work on "leverage cycles." His ideas have been around for a while, but Geanokoplos says they have caught on only recently:

“After it was finally published, as “Liquidity, Defaults and Crashes” in the conference volume in 2003, I gave that Seattle paper at every major university.  It was exactly about the liquidity cycle, but it didn’t really catch on,” Geanakoplos recalled last week. The time for it wasn’t ripe. The Asian financial crisis had been contained. No lender lost a dollar when LTCM failed. The consequences of the dot.com crash had been confined mainly to the stock market. For the next seven years, business as usual resumed. “This time they are more interested.”

Here is the fundamental insight, according to Warsh:

a single loan requires not one but two terms to be negotiated, and that one may become much more important than the other in certain situations was clear enough to Shakespeare four hundred years ago. Wrote Geanakoplos: “Who can remember the interest rate that Shylock charged Antonio? But everybody remembers the pound of flesh that Shylock and Antonio agreed upon as collateral. The upshot of the play, moreover, is the regulatory authority (the court) decides that the collateral level Shylock and Antonio agreed upon was socially suboptimal, and the court decrees a different collateral –a pound of flesh but not a drop of blood.” Thus did the The Merchant of Venice end happily, not with a cramdown, but with very different terms if the loan were to be foreclosed.

The trick, Geanakoplos says, is to recognize that the tendency to increasing leverage is part of the process – and that collateralization generates bigger and bigger effects on assets prices as the cycle rolls on, until, in due course, for one reason or another, participants eventually become uneasy with the situation, and the cycle comes to a crashing halt.  To reduce the foreclosure mess (the paralyzing bad news in the current situation), he recommends Fed-mandated principal write-downs for non-prime borrowers whose loans are underwater. To stop the de-leveraging, he says, the Fed should prop up leverage at moderate levels, even if the market demands more collateral.  To replace the natural optimists who have gone broke, the government must step in and do some buying.  That’s what the Troubled Assets Relief Program was for. And the market has been buoyed recently by the prospect of more of the same. But if the anticipated TARP II is not forthcoming, he says, the rescue effort probably back again.

So add John Geanakoplos to the (short) list of economists we should all have been listening to more intently (Bob Shiller, Nouriel Roubini, Raghu Rajan, ???).

An IMF we can all love?

The IMF was on the verge of irrelevance just a few months ago, running out of resources as well as raison d'etre, and downsizing.  Now its resources have been tripled and it has been given key responsibilities in halting the slide of the world economy into depression.

My newest Project Syndicate column argues that there is much to like in the "new" IMF under Dominique Strauss-Kahn's leadership.  But the IMF will need organizational changes (in addition to developing countries getting greater voting power) if it is to become an institution that we can all love:

The greatest risk is that [the IMF] will once again over-reach and over-play its hand. That is what happened in the second half of the 1990’s, as the IMF began to preach capital-account liberalization, applied over-stringent fiscal remedies during the Asian financial crisis, and single-handedly tried to reshape Asian economies. The institution has since acknowledged its errors in all these areas. But it remains to be seen if the lessons have been fully internalized, and whether we will have a kinder, gentler IMF in lieu of a rigid, doctrinaire one.

One encouraging fact is that developing countries will almost certainly get a larger say in how the Fund is run. This will ensure that poorer nations’ views receive a more sympathetic hearing in the future.

But simply giving developing nations greater voting power will make little difference if the IMF’s organizational culture is not changed as well. The Fund is staffed by a large number of smart economists, who lack much connection to (and appreciation for) the institutional realities of the countries on which they work. Their professional expertise is validated by the quality of their advanced degrees, rather than by their achievements in practical policymaking. This breeds arrogance and a sense of smug superiority over their counterparts – policymakers who must balance multiple, complicated agendas.

Countering this will require proactive efforts by the IMF’s top leadership in recruitment, staffing, and promotion. One option would be to increase substantially the number of mid-career recruits with actual practical experience in developing countries. This would make the IMF staff more cognizant of the value of local knowledge relative to theoretical expertise.

Another strategy would be to relocate some of the staff, including those in functional departments, to “regional offices” in the field. This move would likely face considerable resistance from staff who have gotten used to the perks of Washington, DC. But there is no better way to appreciate the role of context than to live in it. The World Bank, which engaged in a similar decentralization a while back, has become better at serving its clients as a result (without facing difficulties in recruiting top talent).

This is an important moment for the IMF. The international community is putting great store in the Fund’s judgment and performance. The Fund will require internal reforms to earn that trust fully.

Read the whole thing here.