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.