Presentation on theme: "One Economics, Many Recipes Dani Rodrik Sir Arthur Lewis Distinguished Lecture March 26, 2009."— Presentation transcript:
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: *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 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 …
… 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 todays 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 wouldnt 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 Greenspans 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 Paulsons 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
Net foreign borrowing is bad for growth Period covered is 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 managementis worse than the disease? First-best economists How prudent is it to assume that we can undertake the complementary reformsboth 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)