Saturday, November 17, 2007

My Review of Dani Rodrik's 'One Economics: Part 2

Dani Rodrik tackles the institutional question in chapter 6 (‘Getting Institutions Right’), which is crucial given that the Washington Consensus (as amended) has gotten it wrong, quite wrong, over the years since it held sway over international development.

He contrasts a country (the post-soviet Russia) with a high degree of legal private property rights that most entrepreneurs didn’t trust enough to take full advantage of their assumed primacy in development, with a country (Communist China) without significant property rights, dominated by the state that had significant positive responses to development at the local level. He asserts, unfortunately ‘the empirical literature does not tell us how that safety [where investors feel safe] is attained, only that it matters a lot’ (page 189). This leads to him concluding that the ‘best we can do as analysts is to come up with contingent correlations that are contingent on the prevailing characteristics of the local economy’ (p 190).

One size does not fit all. That should be written on every wall where development economists are at work. Homo economicus is not ‘alive and well’ across all economies, because homo sapiens live in all kinds of circumstances and institutions and they are not independent rational maximisers acting in concert, as they can’t when dealing with their dependence on others. Ration theories of individual maximisation of utilities or whatever do not cope well when two or more individuals are in conflict.

When Dani Rodrik moves onto discussing the complexities of globalisation would benefit from his re-reading Wealth Of Nations, especially Book IV. Rodrik writes:

Investment portfolios in the advanced industrial countries typically exhibit large amounts of “home bias”; that is, people invest a higher proportion of assets in their own countries than the principles of asset diversification would seem to suggest’ (p 197).

Adam Smith wrote about this in the chapter that includes the (in)famous metaphor of ‘an invisible hand’ (WN IV.ii: pp 452-72). The preference of a wholesale merchants is to ‘naturally prefer the home trade to the foreign trade of consumption’ (WN p 454) … ‘Upon equal or nearly equal profits, therefore, every individual naturally inclines to employ, his capital in a manner in which it is likely to afford the greatest support for domestick industry, and to give revenue and employment to the greatest number of people of his own country’ (WN p 455). And as the arithmetic whole is the sum of its parts, this necessarily renders the revenue of society greater than it would be if merchants dispersed their capital abroad.

Why do merchants behave this way and do not send more of their capital abroad as investments or in joint ventures? Risk aversion among merchants:

‘[The merchant] can know better the character and the situation of the persons whom he trusts, and if he should happen to be deceived, he knows better the laws of the country from which he must seek redress’ (WN p 454). This means he has ‘some part of his capital always under his own view and command’ (WN pp 454-5); ‘he saves himself the risk and trouble of exportation’ (WN p 455); and his home capitals continually circulate at home ‘and towards which they are always tending’, except when they are sometimes ‘driven off and repelled from it’ (WN p 455).

In short, it is from the intention ‘only of his own security’ that he directs his capital in this manner (WN p 456). This behaviour necessarily increases domestic capital formation higher than it would otherwise be if they were not so risk averse about foreign ventures. Whether this is advantageous if its curbs foreign trade or whether domestic tariffs are appropriate in giving a monopoly to the domestic trade is an open question.

Dani Rodrik’s analysis of the consequences of the trade biases of globalisation (chapters 7, 8, and 9) are an excellent summary of the issues that dominate the present debate and they add to the unresolved problems for development of the poorer countries, fragmented as they are in any list of performance indicators.

That the missing element in all of these discussions is the failure of mainstream neoclassical economics to produce policies that actually worked over a 50 year period is worrying for the profession.

This does not mean that there were better alternative theories or practical policies on hand, but that is of little comfort, because by general consent the ‘best and the brightest’ graduates and tutors in large numbers have been concentrated in economics departments monopolised by mainstream neoclassical economics and in a constant drift away from the real world; finding comfort in their abstract worlds and assumptions.

That Dani Rodrik raises the ‘home bias’ of investment portfolios, as if it is a new issue for the 21st century, 231 years after Adam Smith wrote about it in Wealth Of Nations – and not in an obscure chapter, because a metaphor from it is probably more quoted, more often, and in more textbooks, refereed articles, theses, dissertations and media outlets (and wrongly, to boot) than anything from any other chapter – is evidence that the narrow vision of modern economics has costs, particularly in those countries imposed upon with wrong policies.

Adam Smith commented on his contemporary economists (Dr Quesnay and his Physiocratic colleagues) who:

seem to have entertained a notion of the same kind concerning the political body that it would thrive and prosper only under a certain precise regime, the exact regimen of perfect liberty and perfect justice. He seems not to have considered that in the political body, the natural effort which every man is continually making to better his own condition, is a principle of preservation capable of preventing and correcting, in many respects, the bad effects of a political economy, in some degree, both partial and oppressive. Such a political economy, though it no doubt retards more or less, is not always capable of stopping altogether the natural progress of a nation towards wealth and prosperity and still less of making it go backwards. If a nation could not prosper without the enjoyment of perfect liberty and perfect justice, there is not in the world a nation which could ever have prospered’ (WN IV.ix.28: p

It doesn’t take a close reading of Wealth Of Nations (though I would recommend a close reading for all professional economists) to realise that Adam Smith dealt with the real world in all of its diversitry, the known history of its parts and the very real policies applied by real governments.

He didn’t assume that a single frame of reference applied to all economies and neither did he believe that the entire world or a country within it had to brazenly change everything in order to change some of the worst vestige of centuries of errors. In Britain’s case he was quite ready to accept that there would not be a total overhaul of every aspect of its society (inlcuding in matters of free trade); it could proceed to opulence (development) with more than a few flaws in terms of the philosophy of Natural Liberty, and with many flaws in its economic structures.

When I was reading Dani Rodik’s chapters on the varied performances of different systems of government and different structures of their economies, why was I not in the least surprised by many of his comments of the ‘surprising’ gains in the more unpromising political systems and disappointments in those closer to the democratic plurality we have in the West?

That’s Smithian political economy at work and not the perfection of political-economic structures that are assumed by those who advise the World Bank, the IMF and development departments in Western governments.

I certainly enjoyed reading Dani Rodrik’sOne Economics, Many Recipes’ (Prineton University Press), both for the message that mainstream economics recognises its past limitations (not to say its outright errors in policy making) of the Washington Consensus, and for confirming that critics of those wrong policies that ignored, and on occasion rode over the objections of knowledgeable local people, were right about adapting changes consistent with their histories and current realities, and not imposing neoclassical assumptions on unsuitable candidates for their failed experiments.


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