Why So Scared of “Free Markets”?

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.

Asian Success Mythology

The blog yesterday provoked a lot of healthy debate about my claim that industrialization is mainly market-driven rather than state-driven, using Korea, China, and India as examples of industrialization out of poverty. I know I am going against the conventional wisdom of the great Asian “developmental state,” authoritarian and heavily involved in planning industrialization. So let me explain why. When I said we can only test what works on average, I am talking about what propositions are testable and falsifiable, using Karl Popper’s definition of what is “real” science. There is no way to test policies if you allow what works to be different in every year and every country, since a hypothesis about ANY policy will always fit the data perfectly under this assumption. I am not implying imposing the same blueprint everywhere, since “what works” is usually too general and can only guide general policy orientation. Of course, I agree that context matters a lot and so policy-makers should use whatever alternative sources of information or political instinct they have available to adjust the policy orientation to local circumstances.

So my general claim is that heavy reliance on markets is associated with long-run success, using as data the Asian successes, the earlier European and North America/Australia/New Zealand successes, the failure of non-market central planning in the Communist Bloc, and the failures of statist policies in Latin America, the Middle East, and Africa. It is true that Asian successes used state intervention more than the earlier European examples, but on average state intervention does poorly across all countries, so we have no Popper-standard evidence that state intervention contributed to their success. So my claim is based on evidence, not ideology.

We could also test industrial policy using within-country data. A well-known old study by Korean economist Jong-Wha Lee ("Government Interventions and Productivity Growth," Journal of Economic Growth, 1(3), September 1996, 391-414) found that government-favored sectors in South Korea actually had worse productivity growth than those that were not government-favored.

There is also the fact that South Korea (which had populist policies in the 1950s), India, and China had rapid growth after they shifted towards much LESS state intervention in the economy. I’m not sure that this one would pass the Popper test, however, since economists’ attempts to explain short- to medium-run shifts in growth have not been very successful world wide.

Now, let's go back to country data and look at the suggestion that we focus only on the success stories in East Asia. This has indeed been the predominant approach and has reinforced what I think is the fallacious conventional wisdom on the "industrial policy success" in East Asia. Looking only at the successes causes "survivor bias" about what really works.

Suppose we have a group of drivers leave New York at the same time to drive to Washington, and we interview the first 5 drivers who arrive in Washington. We find that they drove Lamborghinis at 150 mph, weaving in and out of traffic down the New Jersey Turnpike and I-95, out-running Highway Patrol cars who tried to stop them. Are they models for success getting from New York to Washington?

No, because since we only studied the “successful” first 5 drivers to arrive, we didn’t know about the vast majority of Lamborghini “failures” – the drivers who got into fatal accidents or were caught by the Highway Patrol and jailed for insanely reckless driving. On average, this approach was a disaster. On average, soccer moms driving mini-vans outperformed the Lamborghini drivers, if we study BOTH successes and failures.

So Asian success either happened in spite of statist industrial policy, not because of it, or industrial policy was an incredibly risky strategy that usually fails but occasionally has big successes, possibly in East Asia.

Either view would help explain why a huge amount of effort spent imitating East Asian success stories has NOT successfully replicated that success anywhere else.

So I stand by my claim that the 66-year-old idea of state-promoted industrialization has failed, and that it was irresponsible of Collier and UNIDO to resurrect it as a “major conceptual breakthrough.”

The UN’s 66-Year-Old Virgin

The UN has just announced a big new idea in the war on global poverty, in its just-released Industrial Development Report 2009. In the words of the United Nations Industrial Development Organization (UNIDO) Director General, Dr Kandeh Yumkella, “Our Report represents a major conceptual breakthrough on how to tackle global poverty through sustainable industrial development.” What was the breakthrough idea? Take government action to reap increasing returns to scale to industrial production, to get out of the free market’s “poverty trap” of low-scale industrial production.

The only problem with this major conceptual breakthrough is that it is 66 years old. It was presented in almost the same words in one of the first and most famous articles of development economics, by Paul Rosenstein-Rodan in 1943:

Paul Rosenstein-Rodan 1943	UNIDO report 2009
“It is generally agreed that industrialisation of "international depressed areas " …is the way of achieving a more equal distribution of income between different areas of the world by raising incomes in depressed areas ….”	“Industrialization is integral to economic development… [For] the bottom billion, manufactured exports are likely to offer more scope for long term productivity growth than either agriculture or natural resources.”
“If we create a sufficiently large investment unit by including all the new industries of the region, external economies will become internal profits out of which dividends may be paid easily.”	“Because they still do not have industrial agglomerations, they are unable to be competitive against countries that have…there is a threshold of competitiveness to be surmounted. Once that threshold is crossed, growth is explosive.”
“If the industrialization of international depressed areas were to rely entirely on the normal incentive of private entrepreneurs, the process would … be very much slower.”	“There is an important role for public action, as purely market-driven processes will yield prolonged stagnation.”

Professor Rosenstein-Rodan in 1943 can be saluted for thinking of a creative new theory. Today’s authors (such as lead author Paul Collier) seem a bit less creative for recycling the exact same theory, especially after 66 years of experience that contradicted every prediction of this theory. Initially very poor countries like South Korea and more recently China and India had no trouble with industrial growth through market forces, and virtually every attempt at state-forced industrialization has failed. UNIDO endorsed many of these state industrialization attempts in the countries that, as a result of many such failures, Collier now calls the Bottom Billion.

Recyling old failed ideas after 66 years might be another small hint that UN accountability is a wee bit deficient.