One Economics, Many Recipes

Dani Rodrik

Sir Arthur Lewis Distinguished Lecture

March 26, 2009

Has (neo-classical) economics failed us? Economic development policies

The disappointments of the Washington Consensus

Financial globalization The disappointments of capital flows

Countries that have performed the best in recent times are countries with “non-standard” policies:

Heritage Foundation Index of "Economic Freedom"*

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China India Vietnam Argentina Bolivia Brazil Chile El Salvador Mexico Uruguay

World Bank's star economic globalizers

*The index is a composite quantitative measure of “the 10 key ingredients of economic freedom such as low tax rates, tariffs, regulation, and government intervention, as well as strong property rights, open capital markets, and monetary stability.”

Capital flows have gone in the wrong direction …

Capital flows to emerging and developing economies

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1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

$ b

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gross capital inflows

gross capital outflows

net flows

16% of EM GDP

11% of EM GDP

Capital flows have not promoted risk diversification and

consumption smoothing …

Source: Kose et al. (2007)

Source: Jeanne and Ranciere (2005)

Capital flows have been associated with frequent and painful

financial crises …

Foreign reserves (excluding gold) in months of importsindustrial and non-oil developing countries

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Industrial Countries

Developing Countries (excl. oil-exportingcountries)

… which in turn have forced developing nations to engage in costly self-insurance strategies

The resulting “saving glut” was a key determinant of the current crisis:

“it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. In the simplest terms, these imbalances reflected a chronic lack of saving relative to investment in the United States and some other industrial countries, combined with an extraordinary increase in saving relative to investment in many emerging market nations. The increase in excess saving in the emerging world resulted in turn from factors such as rapid economic growth in high-saving East Asian economies accompanied, outside of China, by reduced investment rates; large buildups in foreign exchange reserves in a number of emerging markets; and substantial increases in revenues received by exporters of oil and other commodities. … the United States and some other advanced countries experienced large capital inflows for more than a decade, even as real long-term interest rates remained low.”

-- Ben Bernanke (2009)

The fundamental problem

The failures of development policy and financial globalization have the same root cause:A habit of applying first-best thinking when second-best thinking is required

What does the theory of second-best say?“… in an economy with some unavoidable market failure in one

sector, there can actually be a decrease in efficiency due to a move toward greater market perfection in another sector…. Thus, it may be optimal for the government to intervene in a way that is contrary to laissez faire policy. This suggests that economists need to study the details of the situation before jumping to the theory-based conclusion that an improvement in market perfection in one area implies a global improvement in efficiency.”

-- from Wikipedia

Two policy mindsets• First-best economists:

• we can always approximate the conditions under which the First Fundamental Theorem of Welfare Economics (“markets are efficient”) applies

• either because those conditions are already fulfilled• or because it is feasible and practical to fulfill them

• by removing a (relatively) small number of (government-imposed) impediments

• and applying the appropriately targeted remedies (e.g., anti-trust, prudential regulations)

• so policy can safely be guided by first-best logic: freer markets are always better

• Second-best economists:• market and institutional failures are endemic• they are highly context-specific• it is neither practical nor feasible to remove them all• policy must be made in a way that explicitly takes these imperfections

(“second-best interactions”) into account• non-standard (“heterodox”) policies will often dominate

Why the Washington Consensus failed (I)

The Washington Consensus relied on rules of thumb based on first-best thinking, rather than solid application of second-best reasoning

The problem is not simply that it overlooked the institutional underpinnings of sound policy

But that it overlooked the impossibility of removing all distorted margins, institutional or otherwise, simultaneously

Why the Washington Consensus failed (II)

Markets work poorly in developing nations because of both Government failures (institutional shortcomings)

Weak property rights, poor contract enforcement, excessive taxation, macro instability…

Inherent market failures In particular, informational and coordination failures

imply that markets generically under-provide structural transformation from low- to high-productivity activities, which is the essence of development

The WC and today’s “governance agenda” presume the first set of reasons can be removed in short order, while the second can be ignored

Because of the impossibility of addressing all these “distortions” simultaneously, sound reform policy is always strategic and context-specific

The art of development policy consists of diagnosing areas of reform with biggest bang for the

buck and designing policy approaches that economize on

administrative resources while taking into account second-best complications

In practice successful reforms tend to be selective, sequential, and unorthodox targeted at “binding constraints” rather than a laundry

list and focused on promoting structural change

making appropriate use of “industrial policies”

Why the Washington Consensus failed (III)

Why did financial globalization fail? (I)

Financial markets operate in a highly second-best environment (1)

a) Inherent market imperfections information asymmetries agency problems systemic externalities … that can be targeted only imperfectly by

supervision and regulation … and therefore cannot be fully neutralized even

under the best of circumstances As the financial crash of 2008 has made painfully clear

A tale of financial innovation

Who wouldn’t want credit markets to serve the cause of home ownership? So:

introduce some real competition into the mortgage lending business by allowing non-banks to make home loans

let them offer creative, more affordable mortgages to prospective homeowners not well served by conventional lenders.

enable these loans to be pooled and packaged into securities that can be sold to investors

reducing risk in the process. divvy up the stream of payments on these home loans further into tranches of varying

risk compensating holders of the riskier kind with higher interest rates

call on credit rating agencies to certify that the less risky of these mortgage-backed securities are safe enough for pension funds and insurance companies to invest in

just in case anyone is still nervous, create derivatives that allow investors to purchase insurance against default by issuers of those securities.

Who or what is the culprit? (1)

unscrupulous mortgage lenders who devised credit terms? such as “teaser” interest rates and prepayment penalties perhaps, but these strategies would not have made sense for lenders unless

they believed house prices would keep on rising a housing bubble that developed in the late 1990s?

and the reluctance of Alan Greenspan’s Fed to burst it? even so, the explosion in collateralized debt obligations (CDOs) and other

securities went far beyond what was needed to sustain mortgage lending especially true of credit default swaps, which became an instrument of

speculation instead of insurance and reached an astounding $62 trillion in volume.

Irresponsible financial institutions of all types leveraging themselves to the hilt in pursuit of higher returns?

credit rating agencies that fell asleep on the job?

high-saving Asian households and dollar-hoarding foreign central banks that produced a global savings “glut”?

which pushed real interest rates into negative territory, in turn stoking the U.S. housing bubble while sending financiers on ever-riskier ventures

macroeconomic policy makers who failed to get their act together and move in time to unwind large and unsustainable current-account imbalances?

the U.S. Treasury, which played its hand poorly as the crisis unfolded? bad as things were, what caused credit markets to seize up was Paulson’s

decision to make an example of Lehman Brothers by refusing to bail it out. might it have been better to do with Lehman what he had already done with Bear

Stearns and would have had to do in a few days with AIG: save them with taxpayer money.

all (or none) of the above?

We can be certain that no future regulation will prevent similar occurrences unless leverage (i.e., borrowing) itself is directly restrained

Who or what is the culprit? (2)

Financial markets operate in a highly second-best environment (2)

b) … augmented by the political fragmentation of the world economy sovereign risk absence of a global regulator absence of an ILLR resulting in:

small net flows incomplete risk sharing inability to prevent import of “toxic” assets (cf. trade in

damaged goods”) EMs as innocent victims of the subprime crisis

Why did financial globalization fail? (II)

Financial markets operate in a highly second-best environment (3)

c) … exacerbated by market failures associated with the structural transformation process in developing nations

Non-traditional tradable economic activities as the dynamic source of economic growth The challenge of economic development is to shift resources

from traditional to modern (tradable) activities Capital-account liberalization prevents the use of

the real exchange rate (RER) for developmental purposes The RER determines the relative profitability of investment in

tradables Capital inflows cause overvaluation, and move the RER in the

wrong direction Countries that grew rapidly avoided capital inflows and

undervalued their RER

Why did financial globalization fail? (III)

Undervaluation is good for growth

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coef = .01821394, (robust) se = .00360935, t = 5.05

Net foreign borrowing is bad for growth

Period covered is 1970-2000. Source: Prasad, Rajan, and Subramanian (2006)

Recap

The theoretical benefits of financial globalization presume a first-best setting

… in the absence of which we get multiple complications arising from second-best interactions

How should policy makers react? Two types of advice

Second-best economists presume the second-best complications are an irremovable part of

the landscape and hence propose to throw “sand in the wheels of finance”

J.M. Keynes, James Tobin, Joe Stiglitz, Jagdish Bhagwati (cf. his stance in trade)

First-best economists Who either ignore the second-best interactions, or (more typically

these days) presume they can be removed through complementary reforms

Stanley Fischer, Rick Mishkin, Ken Rogoff, Larry Summers (until recently?)

Questions each group should ask:

Second-best economists Might there be instances when the remedy—

capital-account management—is worse than the disease?

First-best economists How prudent is it to assume that we can

undertake the complementary reforms—both at the national and global level--when those comprise a long list of prerequisites that even advanced countries do not satisfy?

Concluding remarks There is a backlash against mainstream economics and against

economic globalization But the real problem lies with inappropriate application of

mainstream economics Economics is a tool-kit

Multiple models, based on multiple assumptions about the nature of second-best problems

Economic policy is a craft, not a science, and depends on skillful choice of models that apply

When used well, economics can help us understand the world and clarify the strategies moving forward As I have tried to illustrate using experience with economic

development and financial globalization The key is to go beyond Econ 101 and the habit of first-best

thinking Will make economists less certain of their prescriptions and

more humble (appropriately so)