The debate of the last few days on this blog reminded me again of how strong is the visceral negative reaction to an argument for “free markets” (those dreaded words are practically an epithet by now) in development. Part of this may be justified; let’s explore this in a Q and A.
Q. Isn’t the case for markets a purely ideological one, which just serves to protect the interests of the rich?
A. True, it often has been. There is an ideological camp that will twist evidence to support free markets. They overpromise on how soon and how much development “markets” will deliver. They coerce other countries to accept “markets,” bypassing the democratic process, which leads to a xenophobic backlash. And some in this camp do just want to defend the rich against ANY policy that hurts the rich even if it is a “free market” policy, so some are hypocritical.
However, beware of the fallacy called “Affirming the consequent.” If you are a Nazi, Then you like Wagner’s operas. It does not follow that: If you like Wagner’s operas, Then you are a Nazi. Similarly, suppose we agree: If you are a free market ideologue, Then you will defend free markets. However, it does not follow that If you defend free markets, then you are an ideologue. My posts presented evidence for markets as a development strategy. Feel free to disagree with the evidence, but don’t jump to the “ideologue” conclusion (see earlier blog discussion of how “ideologue” accusations are used as trump cards to try to win an argument).
Q. Don’t defenders of markets understand the role of the government to provide public goods, like institutions and infrastructure?
A. Yes, of course they do. The frequency with which this question comes up itself illustrates the strength of the negative reaction to pro-market arguments. Is it really likely that a Ph.D. economist would never have heard of public goods?
Q. So why criticize the Rosenstein-Rodan 1943/Collier and Unido 2009 argument for state-led industrialization?
A. These arguments argue for an industrialization “poverty trap” because of increasing returns in industry, which requires vigorous state “coordination and planning” in the poorest economies to escape. This is way beyond the “state covers public goods, market covers private goods” consensus of mainstream economics. In development, there were many attempts at force-fed industrialization based on this constantly-recycled idea (especially Africa, Middle East, and Latin America), which failed. Historically, industrialization arose in initially poor countries which have since become rich, with the common theme a heavy reliance on both domestic and international market opportunities and decentralized private entrepreneurship. First, we had UK, US, the rest of Western Europe, Australia, New Zealand, then Japan, then late industrialization in the European periphery (Ireland/Greece/Spain/Portugal), East Asian Gang of Four, and most recently China and India. Some of these cases had some kinds of industrial policies in common with the failures mentioned above, but they also had a heavy reliance on markets in common with other successes, to pass the ultimate verdict on scaling up successes. If you have a successful case that follows both policies A and B, and A has a record of success elsewhere and B has a record of failure elsewhere, shouldn’t you give more credit to A than B for the success of this case?
Q. What about Dani Rodrik’s questioning of the Jong-Wha Lee results on the negative effects of Korean industrial policy?
A. Dani, You are right to call me on this when I have other papers scornful of identifying policy effects from cross-country growth regressions. I thought the Lee paper deserved a little more consideration because it was NOT a typical cross-country regression; it was such a rare attempt to study within-country and cross-period effects of a policy regime, it had a parsimonious specification that alleviates the usual concerns about data mining; and and in particular it is even more rare to do all this to systematically test Korean industrial policy variations across period and industry. Lee’s systematic empirical approach contrasts with the anecdotal quality of most discussions of Korean industrial policy. Another paper by E. Kim in JDE in 2000 tends to confirm Lee’s results on Korean cross-time, cross-sector variations in response to industrial trade policies. Beason and Weinstein had a 1996 paper in RE Stat that also questions the conventional wisdom about positive effects of industrial policy in Japan.
Q. But hasn’t the current crisis discredited “free markets”?
The history of markets is one of periodic crises (especially financial crises) and recoveries, including major episodes of creative destruction, but with steady positive long run growth despite severe fluctuations around the trend. The huge fallibility of human actors makes the case for markets stronger, not weaker. The market itself triggers the corrective actions by both public and private actors when these actors do stupid things, like give too many mortgages to people who were not creditworthy and then try to cover it up with fancy securitization. The collapse of financial markets was a severe wake up call to change this stupid behavior; creative destruction is wiping out firms that made huge mistakes (despite some well-publicized cases of individual CEOs getting bonuses despite their stupid actions). New firms or restructured firms will not make the same mistakes (even if they find new mistakes to cause some new crisis). Since we recovered from all the previous crises of capitalism, it seems likely we will recover from this one. A knee-jerk rejection of markets (especially in poor countries) will likely postpone rather than accelerate the recovery, which made the anti-market arguments of the Collier/UNIDO report particularly ill-timed.
21 Comments
I am not sure about your claim that “New firms or restructured firms will not make the same mistakes (even if they find new mistakes to cause some new crisis)”. Many of these actors new what they were doing but the personal incentives to go the wrong way were strong (e.g. bonuses).
Just a question: should health care in poor countries be based on a free market, pay-for-service model? Or, a public system emphasizing equity of access?
I agree with your points. But, health in my opinion is unique in that it can never equitably, or even efficiently, be governed by free market principles.
Sorry, that last comment was mine, didn’t mean to be anonymous.
-Jon
“If you have a successful case that follows both policies A and B, and A has a record of success elsewhere and B has a record of failure elsewhere, shouldn’t you give more credit to A than B for the success of this case?”
That is extremely reductionist, and it’s that kind of reductionism that I suspect prompted such a critical response to your two posts so far on this topic, rather than some sort of knee-jerk reaction to the concept of ‘free markets’ as you claim. By the same logic, being in Sub-Saharan Africa has ‘a record of failure’, as do a whole host of other policies, because the growth experience in SSA has been so awful. You need a much more sophisticated analysis to identify growth effects of individual policies, as several of your commenters were kind enough to point out.
Similarly, presenting the issue as a markets v government dichotomy obscures more than it reveals. Firstly it obscures the realities of the historical record – that government intervention in industry is often initially high but tends to fall away over time if sustained growth is achieved. Secondly it seems fairly obvious to me that a strong (but not too strong) and effective government characterises most if not all of the ’success stories’ you mentioned. Those who equate any government intervention with a lack of ‘freedom’ and argue against it on that basis are of no help whatsoever to poor countries.
Thirdly, I would invite your readers to look over the UNIDO publication in question and assess whether your description of it as advocating central planning is accurate or not. Because having read it myself that seems to be a pretty skewed interpretation. The only mentions of ‘planning’, for example, seem to be quite critical of the idea of the state leading the market. It all seems pretty mild to me, so who’s really being knee-jerk?
Sorry, since when did free markets favour the rich? They certainly favour consumers, but the rich as well? I tend to think government interference in markets as favouring the well-connected and the wealthy, and necessarily at the expense of those at the bottom of the chain.
I think the discussion of “free” markets sheds more heat than light on an important debate about what role the state should play in markets. No market can function without having a state ensuring that players in the market adhere to a common set of rules. This is true whether you are talking about a legal system to enforce contracts or an FDA to ensure that there isn’t samonella in the peanut butter. The 60 Minutes piece on the Madoff whistle blower articulated this problem quite well. Other competitors to Madoff wanted him out of the game because he was atracting capital through unfair means. The government failed to understand this and did not enforce the rules of the game to the regret of millions of investors who counted on the SEC to do their job.
I like your line: “The history of markets is one of periodic crises (especially financial crises) and recoveries, including major episodes of creative destruction, but with steady positive long run growth despite severe fluctuations around the trend.”
When thinking about the US economy as a discrete stochastic model, I picture it (and other market-oriented economies) as a process of Brownian-motion with positive drift. There are periods of decline, but on the whole we expect it to trend upward.
I hate discussions which use the term “markets”. It is totally undefined, especially “free” markets.
There are no free markets of any importance. Every country has some sort of industrial/agricultural policy. So, at best, “free” is a relative term. Does a country which prohibits GMO seeds have a free market? How about one that regulates which pesticides can be used and when?
How about banking regulations. Is it free if there are limits on foreign investment, such as those in China?
As for international development, there seem to be two models, those countries which have had the foreign investment guided by the IMF, WB and international banks, and those who have resisted. The former are seen as having “free” markets while the latter don’t.
But, it turns out that many who stayed away from IMF-type prescriptions or kept them to a bare minimum did better than the others. Why is this so hard to figure out. Foreign investors are interested in making a profit. Any profit they do make is shipped out of the country that they invested in. This is true for the IMF as well, they want to get the funds back with interest.
Countries which can manage development on their own terms can keep more of the profits for themselves and reinvest them in projects. Apparently every peasant can figure this out which is why there are riots every time a country makes a deal with a foreign mining or oil company.
This concept seems to stump economists, however.
When someone can define markets and free markets then perhaps we can see if having them is a good or bad thing for development. In the mean time they are just the same sort of obfuscating terms as are socialism, nationalization and regulation.
Sorry, comment 4 above (the overly-long one) was me, also accidentally posted anonymously.
Who said this?
“The market is the best mechanism ever invented for efficiently allocating resources to maximize production. And I also think that there is a connection between the freedom of the marketplace and freedom more generally.”
BARACK OBAMA said it:
http://hayekcenter.org/?p=429
Obama thus endorsed 1) the Hayek Hypothesis; and 2) the Hayek-Friedman Hypothesis.
Is anyone charging Obama with the canard that he’s being “ideological” when he expresses his beliefs in these things? No. Because the “ideology” and “faith in the market” charges are dishonest weapons used by people who don’t think as a substitute for thinking and argument — a practice of the “genetic fallacy” made the knee-jerk default substitute for argument and thought on the left role modeled for fellow leftists by Karl Marx.
Greg, quite a lot of people are now calling Obama ’socialist’ for advocating a more government involvement in health, education and public good provision, funded by more progressive taxation. So he certainly is a useful example of knee-jerk reactions, from a variety of perspectives. I wonder would Prof Easterly call Obama a ‘Planner’ or a ‘Searcher’?
Dr. Easterly,
I’ve always enjoyed your writings, notably White Man’s Burden, an unfortunately titled, perspicacious and honest discussion of development issues. I sincerely believe and agree with you that markets can be an efficient development tool. Malinvaud, the French mathematician, demonstrates as much showing the relationship of markets to idealized voting mechanisms assuring optimum outcomes when they function fairly. Once while studying Economics in Belgium I was called a “radical Socialist” – - there was a small french Socialist Party given this epithet – - for my unholy marriage of free market ideology with socialist distributiive outcomes, a state of mind associated with this minor political movement with a faith in the plausibility of markets as an economic and social tool.
Nevertheless, while markets can in the abstract, as well as in practice, be very useful development tools, the international market as experienced by developing countries is one conducive only to their subjugation. The weaker the developing country is economically and politically the more it will be subject to the effects of domination spread through market mechanisms. We can begin with Lizt’s infant industry argument to make the case but the fact is the development of the third world is not wished for or hoped for in the West, except to the extent they are dominated by us.
The travesty goes so far as to expose World Bank economists arguing for coffee development in Ethiopia with the explicit argument that we can have cheap coffee here. No thought for Ethiopian development in their calculations that I could see. As you so correctly stated regarding markets all those arguing in favor of coffee may not have this desired outcome in mind and I do not wish to argue the merits of coffee here, but the point is that the international market system is conceived for purposes other than market efficiency and development and in the end serves well its masters.
There are not enough megabytes of memory here to demonstrate this conclusively other than that it seems to me to be self-evident, but if I may say so I find the best argument for this state of affairs to be your aforementioned book. There are points at which leftist and conservative analysis merge in their eagerness to understand the root causes of things and this I dare say appears to me be one of them.
SS
So there are no failures with A?
And what of the fact that the successes in B were more successful than the successes in A?
Bill:
I understand that you are primarily engaged in a skirmish with the anti-marketeers, but I would ideed appreciate if the “incentives matters” line of reasoning so brilliantly explained in “The elusive quest for growth” where applied on this issue as well.
Let alone some intellectual jibjab around possible connections between this line of reasoning and the findings in your paper “Inequality is bad for development” (and perhaps in relation to the rest of the litterature on institutions as well).
Just a thought – looking forward to any reflections you may have!
Just to clear things up, my question about our current financial crisis pointed to the need for good institutions and regulation, again re-affirming my point that good government combined with free markets is the best way to achieve economic development in the long run. In no way did I mean to imply that this “discredits” free markets.
All of this ties in to an intellectual issue I myself am grappling with, which is whether or not we’ll ever be able to create a regulatory system that can preempt the gales of destruction inherent in capitalism, or whether we need to put up with these forever. Can a government regulatory structure (and macro policies) ever keep up with (potentially deleterious) market innovations? On the one hand, probably not, because the economy is such a huge, quickly evolving ecosystem, actors will quickly find ways to get around regulation, and thus creative destruction is necessary to purge the system of bad practices, debt, etc etc. It ensures that we reap what we sow (feedback). On the other hand, the human suffering associated with creative destruction is not something Id like to see in a human-made system, and the progressive in me wants to see this aspect of capitalism go away. Humans should not be subservient to an impersonal system like “the market”, and their suffering should not be seen as necessary if it need not be.
Whether or not we can get around this eludes me at the moment. But what I am NOT talking about is throwing the baby out with the bathwater and getting rid of markets altogether, simply because they have problems.
That said, Ive enjoyed the back and forth on this blog, and am looking forward to future posts and comments!
You’re doing God’s work here Dr. Easterly. Thank you for your intelligent and reasoned response.
I do have one minor quip. What has been called “creative destruction” by commentators around here is more of what I would call “market forces.” Creative destruction, at least at the institution where I am studying econ, is more related to the destruction of old technologies and replacement of entire industries from new technology (elevator operators, newspapers, horseshoe blacksmiths, ect. et al).
Rereading your post, I think this is what you were driving for, but the examples around it have caused some misunderstanding.
“I think the discussion of “free” markets sheds more heat than light on an important debate about what role the state should play in markets. No market can function without having a state ensuring that players in the market adhere to a common set of rules…”
I think statist ideologues like you heavily obscure issues and spout incredible amounts of weird bullshit. The problem here is that all of you are thinking of government in terms of the Western experience. Government provides services, establishes rules blah blah… That isn’t the way it works in the Third World. In India there are no rules. There is really no rule of law, no government and no regulations. However there is an organized criminal organization called a government whose function is to steal, take bribes, beat people, provide sinecures, and act as a patron. Saying that markets need governments to establish rules in India is similar to saying that serfs need feudal lords to oppress them. I am sure at one time these type of arguments were made about the feudal lord system.
As far as the West is concerned I don’t see how its experience is relevant to countries like India were the government is completely different. If you reduce the size of government in India than you have exactly the same system except less bribery, beatings and theft. So why not do it. It isn’t a case of government vs free market. Its a case of … government behaves like a criminal gang so lets reduce its power.
Government isn’t always the setter of rules, laws and the rest. Sometime government is the one creating disorder, uncertainty and unpredictability. Obama with his tax raises, massive stimulus’s is a good example of this.
“Countries which can manage development on their own terms can keep more of the profits for themselves and reinvest them in projects. Apparently every peasant can figure this out which is why there are riots every time a country makes a deal with a foreign mining or oil company.”
Complete bullshit. Please explain China. The Chinese have kept the value of their currency low and this does not make the terms of trade favorable to them. They are also not obtaining increased profits. In fact quite the opposite. The United States is begging China to make the terms of trade more unfavorable to the United States and increase Chinese profits. This is what a Chinese currency appreciation would do. The Chinese refuse. The Chinese strategy is to reduce profits and increase market share. Is this a good idea? In my view the Chinese are stupid and this depression will demonstrate who awfully idiotic they are. Working like a dog, expanding like mad, getting paid very poorly and loosing it all in the end with piss poor investments. Call it the Asian disease.
Asking why free markets aren’t popular with policy and regulation makers is the turkeys and christmas argument. Not only would they be out of jobs but they also wouldn’t be able to take the credit.
Is the free market an ideology or the absence of an ideology?
“Q: But hasn’t the current crisis discredited “free markets”?”
What a stupid question. What free markets can anyone point to that are the cause of the current crisis? There certainly is no free market in the banking system, which is dominated by a central bank that is given a monopoly on creating money out of thin air and is given the power to dominate other banks. There isn’t free market in the automotive sector, where unions have been permitted to dictate terms for decades and governments have hundreds of thousands of rules that interfere with design, production, distribution, marketing, sales, and service. There isn’t a free market in housing. About half the mortgage market is dominated by government sponsored entities, which by virtue of their guarantees are allowed to borrow at much lower rate than other companies. Regulations in the sector have pushed banks to lend to unqualified purchasers and have provided an oligopoly to rating agencies that permitted risky paper to be sold off to unsuspecting buyers and by doing so allowed the bubble to get out of hand. There certainly is no free market in labour, education, health care, energy and most sectors of the economy.
History shows us that the free market is capable of allocating resources more effectively and better able to make societies richer than they would otherwise be under state controlled production. But even if the free market was not more efficient it would still have the moral high ground because there is no justification for using force to interfere with voluntary economic transactions made by individuals. This debate transcends simple economics and is a matter of justice, ethics and morality. On that front the statists fail miserably, which is why they are always diverting the debate and resorting to emotion rather than logic.
ed hardy