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Changing Development Paradigms

Raj Nallari's picture

This global crisis in not only about financial market failures but also government failures in several countries as reflected in failure to contain the housing bubbles and credit booms, bad regulations, and lack of supervision and enforcement). Both in advanced and developing countries, there are second thoughts on open markets, private ownership of nationally ‘strategic’ industries (autos, banks), and movement of transnational financial and industrial firms, and migrant labor. Trade and financial protection is on the increase as countries that have been less reliant on exports and foreign capital are weathering the storm better. In this semi-open global environment, would export-led growth strategy be combined with industrial policies to protect domestic industries, and/or emphasize resource-dependent growth, where possible?

Before we respond to these questions, it will be useful to focus on what went wrong in economics in 2007-08. Some economists are re-inventing economics to respond to such a query.

Rationality vs. Animal Spirits. The economic profession as a whole has failed to anticipate the global crisis. Economic models have basically failed to predict such a crisis. At the core of the problem is that economists have over-extended the ‘rationality’ assumption, wherein individual economic agents, such as consumers and investors, behave rationally. Rationality means that each economic agents knows the probabilities of future events and therefore has all the information needed to make decisions about all future events. If actors are rational, then no “bubbles” which are irrational market responses should occur.

But Akerlof and Shiller (2009) argue in their recent book Animal Spirits, that the “current financial crisis was driven by speculative bubbles in the housing market, the stock market, and energy and other commodities markets.” Bubbles are caused by feedback loops: rising speculative prices encourage optimism, which encourages more buying, and hence further speculative price increases – until the crash comes. Shiller and Case (2009) point out that a random survey of people indicated that they were (mistakenly) expecting housing prices to rise by 10 percent per year prior to the crash and that this expectation was based on a misunderstood belief that land was limited, housing materials were costing more and so on. Managing “bubbles” is therefore an important short term policy objective but the economics profession has failed to emphasize this point.

While rationality is a useful assumption for most microeconomic situations of supply and demand for certain goods and services, people almost never know the probabilities of future economic events. We live in a world where economic decisions are made under uncertainty and are fundamentally ambiguous, because the future is not a linear extrapolation of the past – past is not prelude. For most people, it always seems that “this time is different.”

Greed & Fear. We now know from work of neuroscientists and others that (i) “different parts of the brain and emotional pathways are involved when ambiguity is present”; (ii) “bull markets are characterized by ambiguity-seeking behavior and bear markets by ambiguity-avoiding behavior” and that changing confidence is an under-pinning factor. So when an economy is experiencing a positive or negative shock, people do not respond in a completely rational way to the shock. Moreover, the people’s responses to events are asymmetric – people hate to lose money more than they love to win money.

In the brain, monetary gain and cocaine stimulate the same circuitry and release of dopamine. Fear of financial losses activates the same circuitry as physical attacks and release of adrenaline and cortisol into the blood, which coincides with elevated heart rate and blood pressure.

Periods of economic prosperity coincide with a doped stupor and results in unnecessary risk-taking. So it is not surprising that one sees repeated episodes of rising house and stock prices, over-confidence and over-investment by investors, and risky behavior. The trust in and money placed with Madoff is a case in point.
It is easy to see how people’s greed becomes a drug and they are unable to resist the temptations, which lead to financial bubbles in tulip bulbs, internet stocks, gold, real estate, and fraudulent hedge funds. Such gains are unsustainable, and once the losses start mounting, our fear circuitry kicks in and panic ensues, a flight-to-safety leading to a market crash. This is where we are today.

Greed can be contained and need not lead to excess. Excess is just another word for greed combined with misaligned incentives and inadequate or defective regulation and supervision. Like hurricanes, financial crises are a force of nature that cannot be legislated away, but we can greatly reduce the damage they do with proper preparation. Because the most potent form of fear is fear of the unknown, the most effective way to combat the current crisis is with transparency, accountability and education.

Linearity vs. non-linearity. To be sure most regular economic events follow a certain amount of predictable, linear and continuous path. For example, if the supply of cars does not keep pace with the demand then prices will increase. But there are also once in a life-time events – the black swan, and little is known about the abrupt, discontinuous, and jumpy behavior found in some markets. Economic models do not capture such ‘rare’ events. Nonlinear dynamics is not a favorite tool of economists. As economics is about human behavior ‘on an average’ the normal or Gaussian distribution is deemed quite adequate to relate to regular economic activities and behavior of representative economic agent. The recent crisis has exposed the fact that ‘bubbles’ and ‘herding’ behavior lead to fat tail distribution or other forms of distribution. For example, Haldane (2009) describes in detail economic and financial variables that had smaller and slimmer tails during the years prior to the crisis compared with more normal distribution during the golden decade of 1995-2004. Risk models are developed around the assumption of normal distribution and stress-testing almost seldom is conducted on very extreme or rare event occurrence. There are also ‘threshold effects’ where up to a certain level economic variables do not pose any major problem, but beyond that certain level, there is a sudden and discontinuous jump in economic variables and impact. The sudden jump in oil-price hikes, debt dynamics, and financial crises are some examples of nonlinear behavior or threshold effects.

State vs. Markets. The Depression of 1930s gave rise to the Keynesian economics, which had at its core the theory that when an economy is faced with declining aggregate demand, there is uncertainty about future amongst households and firms, and government is the only player that can actively ‘prime the pump’ and stabilize the economy. This lesson of depression economics was used and abused by governments all the over world up until early 1980s. So the statist paradigm reigned supreme until 1980s when the neoclassical prescriptions of market-friendly ‘getting the prices right’ and minimal role of government gained momentum. The Washington Consensus of the international financial institutions captured this spirit of the market. The 1990s witnessed an augmentation of the Washington Consensus or also called the Third Way which extended market principles with social policies (e.g. social safety nets, labor protection, and sustainable development). The Consensus was challenged by (i) the disappointing results in Africa and to some extent in Latin America; (ii) the rise of some fast growing countries without full trade or capital liberalization (e.g. China, India, Vietnam); (iii) the sharp increase in income inequality during fast growth period in advanced and emerging economies despite falling rates of poverty.

In the aftermath of the Asian crisis in 1997-98, and as the frequency of financial crises rose in the 1990s, there was some change in new thinking on:

  1. the role of government as governments began to accumulate foreign exchange reserves; China and Gulf countries even built war-chests in the form of sovereign wealth funds, which were invested in advanced countries;
  2. reliance on financial flows, especially as there was a sudden stop and even reversal of financial flows from emerging markets during the Asian crisis and more recently during late-2008 as over $700 billion in flows reversed during a couple of months after the Leahman collapse in September 2008;
  3. market exchange rate as governments resorted to currency manipulation especially when backed by large foreign exchange reserves as in China, Russia, etc.

 

The Asian crisis therefore led us to a Beijing Consensus where practical solutions are being found with less reliance on Keynesian or neoclassical ideologies. The underlying idea is that “One Size Does Not Fit All”. Each country context is different and there are different paths to development – As Dani Rodrik reminds us: One economics but many recipes.

Regulated vs. unregulated markets. Ever since the Soviet Union disintegrated in late 1980s, capitalism was proclaimed as triumphant until the recent crisis. Bailing out the rich bankers and auto makers in US and Europe is only feeding into cynicism about the capitalist model. The current crisis is not a crisis of ‘capitalism’, defined as an economic system characterized by private ownership of most of the means of production, distribution and exchange, reliance on the profit motive and self-enrichment (i.e. greed) as the main incentive in economic decisions, and reliance on markets as the main co-ordination mechanism. Rather it is a failure of unregulated financial capitalism and financial risk management. Unregulated profit-seeking individuals and greed unchecked by appropriate institutions has resulted in rent-seeking, corruption and crime in free markets.

The key question is whether markets are inherently stable or unstable. In other words, markets correctly price goods, services, stocks, and other assets. Free-marketers believed that economies never go wrong or astray while Keynesians and others believed that economies usually deviate from the path of prosperity unless the governments regulate, intervene and correct. Neither side predicted the events of 2008-09

While Keynesians thought financial markets were a “casino” the neoclassical economists adhered to an “efficient market” theory and right pricing of assets at all times. Discussion of investor irrationality, of bubbles, of booms and busts, of destructive speculation, of ‘imbalances’ persisting for a long time disappeared. Investors were assumed to behave rationally and balance risk against reward -- the so-called Capital Asset Pricing Model, or CAPM. CAPM tells you the stock price and the value of company stocks, how best to choose a financial portfolio, how to price a financial derivative. More recently, as financial innovation increased complexity of computing risk that in part was related to complex firm structure and claim on claims etc, the CAPM needed mathematicians and physicists – so called quants – to compute risks and rewards. But none of them seem to ask the question whether stock prices made sense when economic fundamentals are being considered. Larry Summers, once mocked finance professors as “ketchup economists” who “have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup,” and conclude from this that the ketchup market is perfectly efficient.

Comments

Submitted by Eduardo on
Great discussion, principally the Greed & Fear section. Maybe to change paradigms the recognition of conventional contradictions is needed. In general, people say that they value the truth more than lies or fiction. Maybe yes, if one goes to the Louvre or the British Museum is because there is an interest in appreciating original pieces of work. If someone wants to eat a hamburger, one made with100% beef meat is preferred that another made with an uncertain mixture of ingredients. One enjoys listening to Placido Domingo instead of an imitator. One prefers to be paid in real dollars, pounds or pesos than fake ones. A real beach for holidays is better than an artificial one. So, why so many people like pretending using a particular brand of clothes or accessories that are not original? Why entire populations put so much hope in the image of one person (i.e. Obamamania)? Why everyday more women have gone through any sort of aesthetic procedure? Worst, why men like that! In other words, there is also a tendency to live in an intentionally fictional dimension. The problem with this is that at some point values such as honesty and sincerity are not anymore clearly recognised. In addition, the information used to make any kind of decisions might simply not be true. Contradictions are everywhere in our daily lives and they have both direct and indirect implications in the quality of life of individuals and the development of places. I will mention just a few to exemplify. The world keeps being astonished by the performance of China’s economy despite Chinese policymakers’ acceptance that the yuan (renminbi) needs an appreciation of about 25 percent, and the main reason of not doing so is that it would put a large number of exporters out of business. Then, we are not talking here about the benefits of pursuing economic efficiency through competitive markets. Another example of contradictions and completely lack of common sense is that China’s government spent a huge amount of money in building the New City of Ordos in Inner Mongolia where few people wants to live, while China’s schools are collapsing and taking lives of pupils when snow falls or there are earthquakes . Here, we should be careful of not attributing China’s economic growth rates to a Keynesian inclination of its authorities. The same caution should be made about their free market orientations as seen in the previous paragraph. The message seems to be that doing anything that artificially or superficially achieves something else (i.e. economic growth and employment regardless of its quality) is well accepted. In the middle of a financial and economic crisis the heads of state of the most developed countries simply could not or do not want to do much to stop the ostentatious and cynic behaviour of financial executives (president Obama proposed a strict regulation of banks more than one year after discovering the default). Moreover, nobody is brave and wise enough to recognise that it is not just a problem of regulation but a deliberate omission of economic principles. Financial markets are too far away from the real economy and the main purpose for what they were created (finance the growth or birth of productive businesses). In other arenas, a well-known leftist western human geography academic publicly applauded in London (October 2009) the Venezuelan efforts towards a more democratic society in this restricted-free-speech Latin American country. Despite human right violations, the anti-democratic manoeuvres of Hugo Chávez, and his referral to president Obama in Copenhagen as the ‘Nobel War Prize’, Venezuela is the third country from which the United States buys crude oil (almost 9% of all its imports) . Here, the U.S. economic embargo to Cuba comes to my mind. Another revealing example is the popular low quality chocolate bars’ market. Some firms are ready to boast their ecological commitment by adding an attractive label to their bars’ wrapping and packing. This would be extraordinary if while protecting the forests for the cacao produce they would not be destroying vast forest areas for palm or cane sugar production. The curious aspect of all this is that by ignoring this fact the organisations involved in giving this kind of labels pretend that everything is fine and, consequently, contribute to deceive the consumers. In Mexico, politicians from opposition parties criticise the federal government administration because there were increases in combustibles at the beginning of this year (2010) saying that it had promised not to do so. Yes, that was a clearly stated one year measure established at the beginning of 2009. They also want to convince people that the actual government is responsible for the poor economic performance and lack of recovery from recession, conveniently forgetting that there was an international warning in relation of the virus AH1N1 that further affected the economic activity. They also forget that previous economic crises were accompanied by financial bankruptcy. This time this was not the case despite the collapse of the world’s financial system. Again, what seems to be important is to satisfy individual or group needs and aspirations by using public resources to lie and confuse the electorate. Substantial and meaningful proposals are simply missing. The deterioration in the public finances caused by a reduction in Mexican oil exports obliges the federal government to raise taxes making difficult the economic recovery in an electoral year. The rises are taking purchasing power away from consumers and investment incentives from entrepreneurs and established firms. Unfortunately, without a substantial fiscal reform and political will, the only short-term hope for the Mexican economy (and the health of its public finances) is the recovery of the US economy. The examples of contradictions are infinite but l will finish for now with another economic related one that is not so obvious. Many countries, mainly developed, are worried because their population growth rate is close or under the replacement fertility level. But, what is the problem? When the population is growing (i.e. China) there is a heavy pressure in the economy and society to provide services, goods and ‘quality’ jobs without negatively affecting the environment. Some argue that an aging population require expensive services and a pension to live a longer life than it was required decades ago. Then, more people are needed now than before to sustain the older people. But, I wonder where the elderly savings of their work-life are, and why the social protection systems of developed countries were created. Probably those resources were lost in one of the financial shocks; are invested in the swimming pools of bank or insurance companies’ shareholders, or politicians; or have been financing wars somewhere in the Middle East, Africa or Latin America. Why do Koreans want to increase their birth rate today with the idea of having the future labour to sustain the social security system for the elderly if they will have any way to create the jobs for all of them and in the far future to appeal again for a new increase in the birth rate to finance the needs of the elderly of the first decades of the 21st century? This outstanding lack of ideas is difficult to believe in one of the eras of high technology and innovations’ generation. Perhaps the real reason is political incompetence or lack of political will with a degree of complicity in relation of a poor contribution of firms’ in forming a solid social security system (What kind of jobs have governments managed and will be able to promote?), and in relation to the laxity of regulations involving financial institutions including insurance companies. It seems that the equation is simple; the individuals with economic power just want to earn more. In a grossly way, more population somehow means to them higher demand and profits. However, if they forgot about speculating and focused their profit seeking in innovation seeking, and paid and invested a bit more in their employees; there could be a better distribution of income contributing to improve population’s purchasing power and savings for the future; and, consequently, their chances for a better quality of life. If a luxury firm sells leather bags at a price ten times higher that its total cost, how much of this money goes to their workers? Is not this just a matter of respecting basic economic principles and human rights and values? In this world of mainstream contradictions there are development challenges that need to be faced. Alternatives are not many due, precisely, to the voluntary and pervasive character of world incongruities. However, to really give to a majority of people a say in the development process, it has to be close to them. From here stems the importance of bottom-up local economic development strategies. Many cases along the world show that this approach can work from indigenous rural communities to industrialised cities. Being aware of conventional contradictions might help to prevent wasting resources in shallow or fictional ends, and avoid using artificial means towards genuine and desirable development goals.

Ray Nahari says. “At the core of the problem is that economists have over-extended the ‘rationality’ assumption, wherein individual economic agents, such as consumers and investors, behave rationally.” Yes that is true, but yet nothing compared to how the regulators over-extended the ‘rationality’ assumption when believing they could use some credit rating agencies and some biased against risk capital requirements for banks to keep everything under control. There they were, the regulators believing everything to be fine and dandy, fooled by their own inventions that triple-A rated operations had only to be risk-weighted at 20%. Ray Nahari says: “Free-marketers believed that economies never go wrong or astray while Keynesians and others believed that economies usually deviate from the path of prosperity unless the governments regulate, intervene and correct. Neither side predicted the events of 2008-09” Not true! No real free-marketer believes in markets where bank capital requirements for the banks differ based on the perception of some few credit rating agencies. Also real free marketers are perfectly aware of the fact that mistakes and the ensuing crisis are unavoidable, and that is exactly the reason we need to get the most and best growth and development out of the periods in between. Finally that no one predicted what was to happen is also false. Many did...they just were not listened to. And why they were not listened to that should be closely analyzed. I myself, as an Executive Director in the World Bank told bank regulators during a risk-management workshop in May 2003 the following: “I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.” I invite you to read my whole statement at that workshop http://bit.ly/6B5UL and which by the way is not a fraction of the criticism of the general state of affairs of the financial sector that I expressed as a member of the Audit Committee of the World Bank.

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