Dani Rodrik's weblog

Economics as craft

I have an article in the IAS’s quarterly publication, the Institute Letter, on the state of Economics.  Despite the evident role of the economics profession in the recent crisis and my critical views on conventional wisdom in globalization and development, my take on the discipline is rather positive.

Where we frequently go wrong as economists is to look for the “one right model” – the single story that provides the best universal explanation.  Yet, the strength of economics is that it provides a panoply of context-specific models. The right explanation depends on the situation we find ourselves in. Sometimes the Keynesians are right, sometimes the classicals. Markets work sometimes along the lines of competitive models and sometimes along monopolistic models.The craft of economics consists on being able to diagnose which of the models apply best in a given historical and geographical context.

This is how my article opens:

When the 2013 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (colloquially known as the “Economics Nobel”) was awarded to Eugene Fama and Robert Shiller, along with Lars Peter Hansen, many were puzzled by the selection. Fama and Shiller are both distinguished and highly-regarded scholars, so it was not their qualifications that raised eyebrows. What seemed odd was that the committee had picked them together.

After all, the two economists seem to hold diametrically opposed views on how financial markets work. Fama, the University of Chicago economist, is the father of the “efficient market hypothesis,” the theory that asset prices reflect all publicly available information, with the implication that it is impossible to beat the market consistently. Shiller, the Yale economist, meanwhile has spent much of his career demonstrating financial markets work poorly: they overshoot, are subject to “bubbles” (sustained rises in asset prices that cannot be explained by fundamentals), and are often driven by “behavioral” rather than rational forces. Could both these scholars be right? Was the Nobel committee simply hedging its bets?

You can read the rest here.

No wrath like that of a free trader scorned

Martin Wolf's review of two books that favor trade protection for developing countries has led to an interesting debate, including a contribution from Ned Phelps. I find some of the comments there astonishing. Here are a couple.

Arvind Panagariya:

few free-trade advocates argue that free trade by itself is enough to launch a country into high-growth orbit. My own forthcoming book India: An Emerging Giant (OUP, NY) is 500-pages long precisely because it carefully spells out the reforms needed in various areas to achieve and sustain a double-digit growth in India.

Panagariya has apparently set a new length record for the list of complementary reforms that ensure trade liberalization works. With such a comprehensive list, we can always blame countries ex post for having neglected reforms on p. 325 and 483 in case their reforms come to nought...

Anne Krueger:

economists and policy makers [in the 1950s and 1960s] regarded trade protection as a major policy instrument for achieving rapid growth through industrialization. Much sad experience has shown that not to be the case. Many countries adopted policies of “import-substitution”, protecting new industries (indefinitely) with import prohibitions or very high walls of protection. There is enough experience to show why that strategy does not work.

...

It was not neoclassical economic theory, but primarily the failures of the “import-substitution” strategies that resulted in unsatisfactorily low growth rates. In country after country, high-cost domestic monopolies or duopolies were developed in industry after industry. They achieved little total factor productivity growth, and remained high cost behind high walls of protection.

I cannot believe Krueger is not aware of the actual TFP numbers. Why does she say things that are, at best, misleading?

Martin Wolf sounds like a very wise man in his response. And you should also read Ha-Joon Chang's comments, which I think get it exactly right. I agree with him when he says "Trade is simply too important for economic development to be left to free trade economists."

Why do economists disagree?

Non-economists are often baffled by the disagreements among professional economists on the issues of the day--from international trade to the minimum wage, from economic development to health policy.

I think the best way to understand the source of these disagreements is to recognize that there are two genres of economists. I call them "first-best economists" and "second-best economists." Here is my guide to them.

You can tell what kind of an economist someone is by the nature of the response s/he offers when confronted with a policy issue. The gut instinct of the members of the first group is to apply a simple supply-demand framework to the question at hand. In this world, every tax has an economic deadweight loss, every restriction on individual behavior reduces the size of the economic pie, distribution and efficiency can be neatly separated, market failures are presumed non-existent unless proved otherwise (and to be addressed only by the appropriate Pigovian tax or subsidy), people are rational and forward-looking to the first order of approximation, demand curves always slope down (and supply curves up), and general-equilibrium interactions do not overturn partial-equilibrium logic.  The First Fundamental Theorem of Welfare Economics is proof that unfettered markets work best.  No matter how technical, complex, and full of surprises these economists' own research might be, their take on the issues of the day are driven by a straightforward, almost knee-jerk logic.

Those in the second group are inclined to see all kinds of complications, which make the textbook answers inappropriate. In their world, the economy is full of market imperfections (going well beyond environmental spillovers), distribution and efficiency cannot be neatly separated, people do not always behave rationally and they over-discount the future, some otherwise undesirable policy interventions can generate positive outcomes, and general-equilibrium complications render partial-equilibrium reasoning suspect. The First Fundamental Theorem of Welfare Economics is proof, in view of its long list of prerequisites, that market outcome can be improved by well-designed interventions. Since they have given up on the textbook model, members of this group have an almost-infinite variety of "models" to choose from as they think of public-policy issues.

The first group's instinct is always to apply the first-best reasoning to the case, ignoring market imperfections in related markets, while the second group almost always presumes some market imperfections in the system. I am over-simplifying a bit, but not a whole lot.

Among commentators in the blogosphere, I think Gary Becker, Tyler Cowen, Greg Mankiw, and Brad De Long (more often than not) are first-best economists. In is commentary on globalization, Jagdish Bhagwati is an unadulterated first-best economist, even though his best scholarly work is solidly cast in the second-best mold. Meanwhile, the undisputed king of second-best economists is Joe Stiglitz. He is joined by George Akerlof, Bob Shiller, Alan Blinder (recently) and Paul Krugman (especially when he writes on deregulation and health policy, and increasingly, but not always, on trade). I am definitely in the second-best camp as well.

When first-best economists are taken to task for ignoring real world complications--i.e., second-best interactions--they provide a range of answers. One is to downplay the significance of these issues by arguing that they are not convinced of the presence of the market imperfections in question. Sure enough, empirical evidence is hardly ever strong enough to move prevailing priors.

A second argument is that the presence of additional market imperfections does not change the first-best logic; it simply calls for each market imperfection to be treated with its own first-best solution. This allows each expert in a field to propose first-best solutions in that field, leaving complications elsewhere to be dealt with by others. Larry Summers had a nice point to make about this approach in his comments on a paper on banking reform in China (Brookings Papers on Economic Activity, 2006:2):

Like experts in many fields who give policy advice, the authors show a preference for first-best, textbook approaches to the problems in their field, while leaving other messy objectives acknowledged but assigned to others. In this way, they are much like those public finance economists who oppose tax expenditures on principle, because they prefer direct expenditure programs, but do not really analyze the various difficulties with such programs; or like trade economists who know that the losers from trade surges need to be protected but regard this as not a problem for trade policy.

(Come to think of it, is Larry Summers a first-best economist or a second-best economist?)

A third argument is that the government could never get complicated interventions right, so we are better off sticking with simple solutions. I have discussed this type of argument in an earlier post.

So at the end of the day, these disagreements are often grounded not in economics per se, but in strongly held prior views about the world in which we live in. Which is why non-economists are right to get exasperated with us.

UPDATE: Bill C. reminds us that Keynes had some very apt things to say in his General Theory on this very same distinction. His fight at the time was with the Classicals. Here is Keynes, via Bill C.:

The completeness of the Ricardian victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.

As usual, Keynes puts it best.

UPDATE2: The link in the following paragraph was incorrect; I have now corrected it:

A third argument is that the government could never get complicated interventions right, so we are better off sticking with simple solutions. I have discussed this type of argument in an earlier post.

It is highly relevant to Tyler Cowen's response.

 

Lies some economists tell

Foreign Policy has a list of five lies economists are supposed to have told everyone:

1. High productivity and low unemployment make us all better off
2. It’s hard to grow without good banks and private property
3. Capital must always be let free to flow
4. The euro will never work
5. Japan—no wait, China—is going to take over the world economy

Whoever told these fibs better own up. It wasn't me.

Saving globalization from its cheerleaders

A few months ago I published an oped in the Financial Times arguing that in order to sustain globalization we need to change the way we go about negotiating international agreements. I emphasized that the binding constraint on globalization is the narrowing of policy space for countries, not inadequate market opening.

Here is a longer paper which makes the case in fuller form. An excerpt from the introduction

In this paper I present a forward-looking evaluation of globalization. I accept as my premise that globalization, in some appropriate form, is a major engine of economic growth .... But I will argue that several paradoxical features require us that we rethink its rules. First, ... globalizations’ chief beneficiaries are not necessarily those with the most open economic policies. Second, globalization has come with frequent financial crises and considerable amounts of instability, which are both costly and in principle avoidable. And third globalization remains unpopular among large segments of the people it is supposed to benefit (especially in rich countries).

It is not that these features have gone unnoticed in the recurrent debate on globalization. In fact, we can talk of a new conventional wisdom that has begun to emerge within multilateral institutions and among Northern academics. This new orthodoxy emphasizes that reaping the benefits of trade and financial globalization requires better domestic institutions, essentially improved safety nets in rich countries and improved governance in the poor countries. With these institutions in place (or in construction), it remains safe and appropriate to pursue a strategy of “more of the same, but better:” continue to open markets in trade and finance, while strengthening institutions. Enhanced trade adjustment assistance (and perhaps more progressive taxation) in the advanced countries, the Doha trade agenda, IMF surveillance over exchange rate policies, the World Bank’s governance agenda, “aid-for-trade, and international financial codes and standards are some of the visible markers of this approach.

This strategy is predicated on the presumption that insufficiently open markets continue to pose an important constraint on the world economy. Its proponents’ concerns therefore center on the question: what institutional reforms are needed at home and internationally to render further market opening politically acceptable and sustainable?

But is this presumption really valid? I shall argue here that lack of openness is (no longer) the binding constraint for the global economy. I will provide a range of evidence on trade and capital flows that indicates the obstacles faced by developing countries do not originate from inadequate access to markets abroad or to foreign capital. The gains to be reaped by further liberalization of markets are meager for poor and rich countries alike.

This leads me to an alternative approach to globalization, one that focuses on enhancing policy space rather than market access. Such a strategy would focus on devising the rules of the game to better manage the interface between national regulatory and social regimes. A good argument can be made that it is lack of policy space—and not lack of market access—which is (or likely to become soon) the real binding constraint on a prosperous global economy. This argument can be buttressed both by current evidence from rich and poor countries, and by reference to historical experience with the previous wave of globalization.

But what do we mean by policy space and can we really create it without running into the slippery slope of creeping protectionism? By the end of the paper, I hope I will have given the reader some reason to believe that an alternative conception of globalization—one that is more likely to maintain an enabling global environment than the path we are on currently—is worth thinking about and potentially workable.

Comments are welcome and appreciated.

UPDATE: Thank you all for the comments, and paine, Steveb, and Andrew in particular for the corrections.

Britain a free trade leader in the 19th century, right?

Wrong!  This revisionist piece of economic history comes from Jonh Nye, whose new book War. WIne, and Taxes is forthcoming from Princeton University Press (thanks to Marginal Revolution for the reference). Take a look at the graph below, which shows average tariffs in Britain and France during the 19th century.

Even though trade protection comes down rapidly in Britain, it lies above that in France--an alleged foot-dragger in trade liberalization--for most of the century. Nye writes:

the example of Britain and France in the 1800s challenges us to rethink and reanalyze the relationship between trade policy and growth. The story of Britain and France shows how easy it is to be misled by the fables of conventional wisdom.

Clive Crook's very astute observation

Reflecting on suggestions by Slaughter and Scheve and others that globalization's losers should be compensated by increasing the progressivity of the tax system and other reforms, Clive Crook lays bare a logical inconsistency in many arguments of this kind:

The connection between globalisation and middle-class stress is by now a commonplace. Mr Scheve and Mr Slaughter have taken it one step further by designing a policy that links them explicitly. Their approach seems sensible enough, until you think about it. Globalisation is not an end in itself. If it is failing to raise living standards for the great mass of the public, as the authors suppose, why rescue it in the first place? If you were running for office, you might wonder, why not promise more redistribution, if that is good for most Americans, together with less globalisation, if that is also good for most Americans? Many in Congress have exactly this combination in mind.

The authors answer that globalisation is a good thing overall, and quote the standard estimates of large whole-economy gains. But then they seem to accept that stagnant incomes for all but the very rich are a natural consequence of liberal trade. They talk of downward pressure on wages from the integration of China and India, from the outsourcing of services and so forth. “Given the lack of recent real income growth for most Americans, newfound scepticism about globalisation is not without cause,” they concede.

If globalisation is benefiting only a sliver of the richest people and impoverishing the rest of us, I say get those tariffs up, put those outsourcing chief executives in jail and make Lou Dobbs US trade representative. Later, we can talk about tax reform.

Clive Crook is pointing to the illogic of accepting on the one hand that globalization is a raw deal for the middle class, and arguing on the other that trade policies should not be part of the arsenal of tools with which you deal with the consequences. Clive Crook doesn't mention him by name, but one has to assume that one of his targets is his fellow FT-commentator Larry Summers, who has made middle-class malaise a big theme of his recent writings while also arguing that any restriction on increases in international trade would be very dangerous.   

Of course Clive Crook believes globalization has been beneficial to the middle class (and that all the worrying about how to make the middle class feel better is besides the point). He points to a paper by my colleague and friend Robert Lawrence, discussed here previously,which argues that there isn't a tight connection between wage trends in the U.S. and the ebb and flow of globalization. 

As much as I like Lawrence's paper though, I do not think it makes the strong case Crook would like to see made. It doesn't argue that globalization has made the middle class better off, and its analysis of globalization's impact is limited to one particular mechanism (the Heckscher-Ohlin channel on relative wages). My guess is that Robert Lawrence would say the jury is still out on the question. In fact, just after I wrote the previous sentence, I read the following in a piece he recently co-authored:

Today many American workers feel anxious—about change, and about weak or nonexistent income growth. These concerns are real, widespread, and legitimate. What role the forces of global engagement have played in this recent poor labor-market performance of most Americans remains an open question.

Interestingly, Lawrence's co-author on this piece is the very same Matt Slaughter (along with Grant Aldonas). The piece reprises the Scheve-Slaughter recommendations on the tax system along with others on adjustment assistance. I wonder what Clive Crook would make of that...

Markets without states--in China!

The ugly consequences of having only a weak state in the face of opportunistic behavior by producers are exemplified in a news story reported in today's NYT. David Barboza, a business writer for the Times, reports how he was detained for nine hours in a Chinese factory supplying the Thomas & Friends train sets.

“You’ve intruded on our property,” one factory boss shouted at me. “Tell me, what exactly is the purpose of this visit?” When I answered that I had come to meet the maker of a toy that had recently been recalled in the United States because it contained lead paint, he suggested I was really a commercial spy intent on stealing the secrets to the factory’s toy manufacturing process.

“How do I know you’re really from The New York Times?” he said. “Anyone can fake a name card.”

Thus began our interrogation, which was followed by hours of negotiations, the partial closing of the factory complex and the arrival of several police cars, a handful of helmet-wearing security officers and some government officials, all trying to free an American journalist and his colleagues from a toy factory.

Factory bosses, I would discover, can overrule the police, and Chinese government officials are not as powerful as you might suspect in a country addicted to foreign investment.

Read the last sentence again and again.

What is striking is not that this kind of thing happens, but that it happens in a place like China, which is still nominally a socialist country.

More on the complementarity between markets and states

I have argued before that states are not the antithesis of markets, unlike what many libertarians (and their fellow travelers) believe. Mike Huben directs me to some relevant and useful writings by Stephen Holmes, the NYU political theorist. Here are a few good passages:

It is implausible [...] to view liberal rights as naturally incompatible with political power, as if such rights flourish only when the state withers away. Authority and liberty are interdependent, not simply opposed. As Kant, among others, made dear, rights (including property rights) are defined and enforced by the state. Referring to "natural rights," Emile Durkheim convincingly wrote that "the State creates these rights, gives them an institutional form, and makes them into realities." To violate liberal rights is to disobey the liberal state. In a sovereignless condition, rights can be imagined but not experienced. In a society with a weak state, such as Lebanon for the past decade, rights themselves are weak or underenforced. Statelessness means rightlessness, as the story of migrating Kurds, Vietnamese and Caribbean boat people, and many others should by now have made abundantly clear.

...

Libertarian rhetoric about "getting the government off our backs" makes the positive correlation between individual rights and state power difficult to comprehend. Better guidance comes from classic liberals, who insisted that, when organized constitutionally, liberty and authority can be mutually reinforcing. Consider David Hume's famous essay, "Of Commerce." In this classic defense of liberal political economy, Hume argues that Britain should deregulate commercial and industrial life and welcome the accumulation of private wealth, because such a system will increase the resources "to which the public may lay claim." An autocratic government, intent upon controlling all economic life, will decrease the stock of private wealth and thereby indirectly undermine its own power.

...

What can we learn by looking at preliberal arguments for typically liberal political institutions? We can learn, I think, to question the conventional interpretation of classical liberal theory as ardently anti-statist. Liberals were not anarchists. They were opposed to capricious and oppressive authority, not to authority in general. They embraced state power as a means both to prevent anarchy and to enforce impartial laws (against the grain of human partiality). Because they assumed that political rulers will themselves be human, and therefore partial and potentially unjust, they also devised institutional machinery to contain authority within legal channels. The constitutionalizing of authority is anti-authoritarian. But it does not imply a weakening or crippling of the state.

Huben also maintains a web site devote to the critique of libertarianism, where you can arm yourself for any argument you may have with a libertarian.

Change is in the air...

The Financial Times says "globalization needs more than PR to be sold to its losers." It is referring to a statement by OECD secretary general Angel Gurria that "the [globalization] story has to be told better." You know something is going on when the FT berates globalization's cheerleaders for their complacency.