Dani Rodrik's weblog

Rhetorical numbers

Suppose you read the following statement: 

In 2006 the measured economic output of the entire world was around $47 trillion. The total market capitalization of the world's stock markets was $51 trillion, 10 percent larger.... Planet Finance is beginning to dwarf Planet Earth.

Are you impressed? You shouldn't be.

A year's output is the value of goods and services produced over that year, while equity values reflect the (discounted) value of all future streams of profits. If you are comparing the two, you must at least have a sense of what a decent benchmark for comparison would be.

So if, say, half of GDP originates in the corporate sector and profits are one-third of value added, the present value of profits discounted at a continuous rate of 8% amounts to 208% of GDP (=0.5x0.33/0.08).  This suggest that the value of stock markets should be more than double that of annual output, not the mere 10 percent extra that the above numbers suggest.  Planet Finance is not all that huge after all--at least given the numbers we are presented.

What is somewhat disconcerting is that the above statement comes from Niall Ferguson's new book, The Ascent of Money. Ferguson knows no doubt the difference between flows and stocks, or income and wealth.  But the way he sets this up is misleading nonetheless. 

Trade policy as riding bicycles

I think it was Fred Bergsten of the Peterson Institute who first formulated the theory that trade liberalization is like riding a bicycle: you can never stop doing it, because if you do you will fall off, and that will be the end of it. The theory has been used to justify why there had to be a succession of trade negotiation rounds at the GATT/WTO. And now it is used to fend off the argument that further trade liberalization may not be an important priority for the world economy given how open it already is: you need to keep liberalizing, otherwise you risk giving up all the gains. The latest example of this line of reasoning comes from Dan Drezner (in response to a question from Kevin Drum):

The trouble with populism is (mostly) not about the remaining 10% of barriers to trade (though see below), it's about efforts to f$%& up the 90% of barriers that have been dismantled. The Baucus-Grassley-Schumer-Graham bill, for example, isn't about halting new trade openings -- it's about finding new ways to clamp down on existing openness.

Furthermore, this is never going to go away. Protectionism is a great way to reward concentrated interests with diffuse costs, so members of Congress will always have an incentive to act in this way. The current populist mood makes it easier to do it out in the open, but as Daniel Kono has shown, it will also be done behind closed doors as well.

This is why I'm so adamant about trade liberalization -- the status quo never stays the status quo, but creeps back ever so slowly towards economic closure.

As I have said before, beware when economists start talking in metaphors. I don't know whether the Bergsten rule was ever valid, but I am pretty sure it does not apply currently. The notion that if you start putting a few chinks on the existing trade policy architecture, you end up back in the 1930s is quite implausible--and totally unsupported by any empirical evidence that I know of. If the bicycle theory were true, most countries would have long ago driven a protectionist train right through the anti-dumping provisions of the GATT/WTO, a set of rules expressly designed to provide protection where none is needed.

I think the underlying political balance of interests favors an open economy in most countries of the world today, and it will take a major shock to get us back into rampant protectionism.   

What gives trade a bad name

... are statements like this from U.S. trade representative Susan Schwab:

“America’s economic future depends heavily on more free trade agreements like the one we are signing today with Korea,” Ms. Schwab said at a signing ceremony in Washington.

Does anyone really believe this?

How to make global poverty history

There are two schools of thought on this question--and the chasm that divides them is deep and wide.

One group of people believe the answer lies in spending a whole lot of money on schools, clinics, and new drugs in poor countries. What keeps poor people poor is that--well, they are too poor to help themselves. So the best thing that we can do is increase the resources they have command over.

But then there are those who think that poverty is caused by not inadequate resources--which is after all sort of tautological--but with inadequate opportunities. People do not invest in education or in health, or save enough, because they do not see enough (private) returns to doing so. So the way to get them to climb from poverty is to enhance the incentives that they face to help themselves and their community. 

If you are the first kind of person, you think development proceeds one school, one clinic, or one project at a time, and emphasize foreign aid as a key part of the solution. If you are the second kind of person, you believe development happens one policy reform at a time, and you think the answer lies in improving the market and policy environment that poor people face.

People in the first group have names like Bono, Angelina Jolie, Bob Geldof, Bill Gates, John Edwards, and Jeffrey Sachs. People in the second group have names like Abhijit Banerjee, Tim Besley, Francesco Caselli, Esther Duflo, Lant Pritchett, and Mark Rosenzweig. Guess which point of view gets the bulk of media coverage and of public attention.

To be sure, there are many differences of views among the development economists that belong in the second group. Some of these economists emphasize policies directed at economic growth, while others stress health and education interventions. Some believe governments are the problem, while others think markets have a way of going wrong even when governments are not screwing things up. There are also important methodological debates within this group on how to "do" proper development research. But these differences reflect the vitality of the field and the diversity of approaches it houses.

Which is why it is a pity that the general public sees hears so little from the second group. Mention global poverty, and most people start thinking of debt relief, foreign aid, and (perhaps) cheap pharmaceuticals. Never mind that most development economists do not think these are where the real action is. Hey, Bono makes for much better copy.      

Bono and company deserve great credit for the enormous success they have had in consciousness raising, and for bringing Africa to the center of attention in the rich countries.  But it is time that the outreach made a better connection with the research.

Whose Alexander Hamilton?

While I am on the subject of industrial policy, David Brooks' column today in NYT reminds me that  Alexander Hamilton, one of the giants of American history, was also a great believer and promoter of industrial policy.  But Brooks gets this wrong:

These days there seem to be four schools of political economic thought. First, there are the limited government conservatives, who think taxes should be low and the state should be as small as possible. Second, there are the Hamiltonians, who believe in free market capitalism but think government should help people get the tools they need to compete in it.   

Third, there are the mainstream liberals, who think government should intervene in small ways throughout the economy to soften the effects of creative destruction. Fourth, there are the populists, who believe the benefits of the global economy are going to the rich and we need to fundamentally rewrite the rules.

If you are reading this column, you're keeping company with somebody in group No. 2. We Hamiltonians disagree with the limited government conservatives because, on its own, the market is failing to supply enough human capital....

We Hamiltonians disagree with the third group, the mainstream liberals, because their programs haven't worked out. Retraining programs for displaced workers have flopped. Tax code changes to reduce outsourcing are symbolic. Federal jobs programs aren't effective. Moreover, the high taxes you need to pay for these programs sap the economy. There's now a pile of evidence showing that higher taxes mean reduced working hours. In the face of Chinese and Indian competition, we don't need Americans working less.

We Hamiltonians disagree with the populists because we don't find their storyline persuasive. The populists argue that global trade is creating a race to the bottom that is leading to stagnant wages and vast inequality. But when you look at the details, you find that most inequality is caused by a rising education premium, by changes in household and family structure, by the fact that the rich now work longer hours than the less rich and by new salary structures that are more tied to individual performance. None of this can be addressed by changing global trade rules.

The global economy radically decreased poverty and increased living standards. It's crazy to upend this complex system to return to some nostalgic vision of a 1950s industrial wonderland.

When it comes to what Hamiltonians are actually for, two big themes stand out. First, the overall economy has to remain dynamic....

The second big theme is a human capital agenda. No one policy can increase the quality of human capital, but a lifelong portfolio of policies can make a difference.

Whatever you may think of the human capital agenda, Brooks' take on Hamilton does not do justice to the author of the famous Report on Manufactures.  Those who look for a robust case for industrial policy and for possible ways of implementing it can still profitably turn to this classic.

Can anyone be in favor of corruption?

I don't know, but I certainly am not. However, this is different from believing that corruption is the most serious problem facing developing countries.  Many development newbies suffer from the corruption obsession, the view that anti-corruption policies ("governance reform") is the most direct route to achieving growth and equity.  Wolfowitz  exhibited severe symptoms of this, and much of the commentary around his departure has been marked by a similar misunderstanding.  In today's NYT, for example, Christopher Burnham, a former Bush administration official, writes:

When Mr. Wolfowitz took over the bank in 2005, he preached the anti-corruption gospel with a zeal that alarmed many career bank staff members and more than a few of its 185 member countries. With his departure, it is eminently possible that his laser-like focus on corruption will go with him.

Well, for one thing, the anti-corruption gospel at the Bank predates Wolfowitz. It was Wolfensohn who made anti-corruption a focal point at the Bank (as Burnham acknowledges in his oped).  For another,  I am not sure that it is good policy for the Bank to prioritize corruption--as a rule--over other problems that developing nations face.  As I have stressed in my work with Ricardo Hausmann and Andres Velasco, the binding constraint on growth differs from country to country. In some cases (Zimbabwe?), governance problems are indeed the most serious binding constraint. In many others, the problems lie elsewhere--in low savings, poorly functioning financial markets, low entrepreneurship, poor infrastructure, and myriad other syndromes of underdevelopment.

Let me make a bolder claim.  A development strategy that focused on anti-corruption in China would not have produced anything like the growth rate that this country has experienced since 1978, nor would it have resulted in 400 million plus fewer people in extreme poverty.      

The New York Times gets it wrong on immigration

The NYT declares that the temporary worker program contained in the immigration deal reached in the U.S. Senate is nothing less than "awful."

The agreement fails most dismally in its temporary worker program. “Temporary means temporary” has been a Republican mantra, motivated by the thinly disguised impulse to limit the number of workers, Latinos mostly, doing the jobs Americans find most distasteful. The deal calls for the creation of a new underclass that could work for two years at a time, six at the most, but never put down roots. Immigrants who come here under that system — who play by its rules, work hard and gain promotions, respect and job skills — should be allowed to stay if they wish. But this deal closes the door. It offers a way in but no way up, a shameful repudiation of American tradition that will encourage exploitation — and more illegal immigration.

I think the paper's editorialists have let their liberal impulses take command over the thinking part of their brains.  I actually think (as I have written before) that a real temporary guest worker would be terrific.  And the harder the temporariness constraint the better.  I don't mind a wee bit if this makes me a Republican for a day.  I have calculated that even a minor temporary guest worker program would generate greater benefits to the developing nations than all of the Doha trade agenda taken in its entirety.

The underclass that the NYT talks about are millions of workers from developing nations who would love to have the opportunity to work in the U.S., even if for a temporary program.  And the temporariness is a good thing, not a bad thing: it allows others to take advantage of the same opportunity, and it enables home countries to benefit from the newly acquired skills and resources of the returnees. It also alleviates some of the social problems caused by long absences of parents from home.

The NYT says nothing about a real cause for concern, which is the potentially adverse effect on wages in the United States.  But since trade barriers for labor services are so much steeper in today's world economy than barriers in goods, even a small amount of liberalization in this area promises huge income gains in aggregate. This is one important difference, which accounts for why I am lukewarm about trade liberalization, but enthusiastic about enhanced labor mobility. If you like free trade, you have got to love this one.  Which is why the NYT stance is hard to understand.

Does Free Trade Bring Lower Prices?

Daniel Drezner has some nice things to say about me and my blog, but then takes me to task for understating the gains from free trade in a recent entry. He writes:

In focusing strictly on the employment effects, however, Rodrik elides the biggest gain from trade -- lower prices.

Since Drezner’s point reflects a common misunderstanding about the effects of trade, it is worth some explication.

Advocates of globalization love to argue that free trade lowers prices, and the argument seems sensible enough. Think of all the cheap goods from China that we can buy at Wal-Mart.  But anyone who understands comparative advantage knows that free trade affects relative prices, not the price level (the latter being the province of macro and monetary factors).  When a country opens up to trade (or liberalizes its trade), it is the relative price of imports that comes down; by necessity, the relative prices of its exports must go up!  Consumers are better off to the extent that their consumption basket is weighted towards importables, but we cannot always rely on this to be the case.

Consider your typical Argentinian for example, who consumes a lot of wheat and beef. Since these are export products for Argentina, free trade implies a rise in the relative price of the Argentine consumption basket. (The gains from trade are still there, of course, but they derive from the usual allocative efficiency improvements, not from lower prices across the board.) And in the U.S., the Wal-Mart effect has to be qualified to take into account the fact that the relative price of the goods that the U.S. exports (including for example agricultural commodities) is higher than it would have been absent trade.  Similarly, when the U.S. gets better market access abroad for its agricultural exports (a key demand under the Doha round), you can be sure that this will raise domestic prices for these goods, not lower them. 

Of course, if you are running a huge trade deficit like the U.S., you can have cheaper prices all around—for all to go on a consumption binge as long as the party lasts.  But this is hardly the argument we make when we teach the benefits of free trade. 

Postscript:  It is interesting that many of the commentators below have appealed to scale economies as an explanation of how production costs and prices can fall all around as market size expands thanks to trade. Yes, this is a possibility.  But scale economies raise a whole set of new conundrums (which is why I had stuck with the standard comparative advantage story). In particular, since scale economies are not compatible with perfect competition, we find ourselves in a second-best world with all kinds of strange possibilities. Opening up to trade can leave some countries worse off, and in general trade-distorting policies like tariffs and subsidies can make individual countries better off. So be careful how you describe the world we live in...