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Don’t Throw the Baby with the Bathwater!

Zahid Hussain's picture

Paul Krugman’s September 6 article in the New York Times (How Did Economists Get It So Wrong?) is a humbling warning to the economics profession against the pitfalls of intellectual complacence. It challenges the profession to re-examine the validity of its existing knowledge particularly in relation to globalization and the workings of local and global financial markets.

Granted that economists have to face up to the unpalatable fact that our theoretical apparatus falls far short both as descriptions of how economies function and as prescriptions of how they can be made to function better. The crisis has exposed the limits of economic knowledge. According to Krugman: “The vision that emerge as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but one can hope that it will have the virtue of being at least partly right.”

In this process of reappraising existing economic knowledge, there is a real risk of going overboard and wrong the right knowledge. Using the global economic crisis as an excuse, there are emerging tendencies to reject tested economic wisdoms in areas such as the role of foreign capital and trade policy in economic development.

One school of thought that is attempting to rise from the ashes is known as (old) Structural Economics.

This school views foreign capital as an instrument to perpetuate the dependence (or should we say subservience) of developing economies on the developed countries. They favor tight restrictions on all forms of international capital movements. Their biases against international trade in assets have been hardened by the cataclysmic global propagation of the financial crisis. The latter has painfully reminded us that asymmetric information and “noisy” (a euphemism for Idiotic) behavior on the part of some participants in the financial markets often gives rise to adverse selection, moral hazard, and herding. Foreign portfolio investments have proven to be most susceptible with its dominant tendencies to get into equities market.

The same is not true for foreign direct investments (FDI). These are targeted towards the real sector and are less prone to sudden and sharp reversals. FDI not only brings finance but also technology, management, and access to markets. Without these developing countries will be doomed to follow the learning-by-doing path that the currently developed countries had to follow because they did not have the “advantage of backwardness”. Avoidable costs of innovation will thus not be avoided.

Structuralists also maintain that integration into the world economy sustains the existing global power structure with western governments and multi-national corporations expropriating all the gains (and more) from trade. Import substitution strategies and direct state interventions in key areas of the economy are therefore needed to counter these “forces of imperialism”. The global economic crisis has badly bruised the belief in the effectiveness of outward oriented development strategies and emboldened the proponents of inward orientation. Lets’ not forget that outward orientation is the only way for the developing countries to capitalize on the advantage of backwardness. It helps the developing countries accelerate the rate of innovation through leapfrogging to catch up with the developed countries. As the recent Special Report of the World Bank’s Commission on Growth concludes “the crisis was a failure of the financial system, not the market per se….an outward-looking, market friendly strategy……remains broadly valid.”

Thus, while there is a clear need for rethinking on key development questions, please, let us not throw the baby with the bathwater. In this regard, David Brook’s October 29 NYT column (The Behavioral Revolution) makes a couple of very salient observations: “If you start thinking about our faulty perceptions, the first thing you realize is that markets are not perfectly efficient, people are not always good guardians of their own self interest and there might be limited circumstances when governments could usefully slant the decision-making architecture……..But the second thing you realize is that government officials are probably going to be even worse perceivers of reality than private business types. Their information feedback mechanism is more limited, and, being deeply politicized, they are even more likely to filter inconvenient facts.”

Lets us do the best we can to avoid jumping from the frying pan to the fire!


Structural economists are right in light of this global recession which has exposed the large trade imbalances that exist between the developed and developing countries. Developing countries have been constantly persuaded by Western political and economic ideologues, who have defined developing countries economic interests in terms of theirs, all in the name of globalization. For example when a close look is taken at the trade policies, shows that the developing countries exporters are not being trained and assisted in the relevant areas of attaining an export oriented model, that can sustain itself on a certain level of development. Instead trade policies have resulted into the discouraging of developing countries, from exporting because they cannot compete with the goods of the developed world, which has lead to a fall in investment. The decline in investment means that local consumption declines hence Gross Domestic Product (GDP) follows suite. The trade policies have resulted in the decline of incomes, GDP, and the devaluation of developing countries currencies to promote exports and reduce imports. This has created a backlash because the exportable base and taxable base of developing countries is one or two major commodities. Therefore, there isn’t much gained from exports, because of the quotas placed on such goods by importing countries, which are mainly comprised of the developed world.

Submitted by Anonymous on
Economics as a study seems all too willing to mold itself intellectually around theories that promote policies which are beneficial to those in power; whether its classical theory, Keynesian or neo-classical/Friedmanite coming out of Chicago. It remains to be seen whether or not it is accepted that things like the market efficiency theory is descredited or if freshwater economics schools (like Chicago) continue to produce "science" about self-correcting markets and the wonders of the free market

Submitted by Laura Melkonian on
The contrition of our economists comes too late. They had warnings enough. Even when we fully discount (which we should not) the voices of socialist economists in the mid-19th century, feminist and postmodern economists in the 70s and 80s of the 20th century, we must acknowledge that Casandra also called from within the field of professional economics. Institutional economists since the days of Veblen warned against the reductionistic nature of the most axioms of neoclassical economics. So did various "historical schools" in Europe and Latin America, pointing to the eminently societal nature of economic frameworks and policies. Then came behavioral economics in the midst of the 20th century, somewhat later entered the psychologists with their observations on the less than rational nature of economic man, and at last neuroeconomics contributed to this array of deviating opinions with its own methods and insights on the social and moral nature of economic agents. In short, that economic man does not exist in the form and format given to him by John Stuart Mill and Co., but that there are a host of economic men and women, who follow agendas that undercut and/or supervene the predictions of their behavior resulting from the neoclassical paradigm, was readily available information. Yet, those in charge chose not to factor it into their (often neoliberal) calculus. So, it is not really academe that failed the world but political bias, I feel, that chose all too selectively from the academic offerings, preferring conventional wisdoms over inconvenient truths.

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