Don’t Throw the Baby with the Bathwater!

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ImagePaul 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.

ImageThe 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.”

ImageThus, 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!


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