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Inequality and Keynesian Economics

Paul Krugman and Robin Wells have an interesting article in the Occupy Handbook edited by Janet Byrne that has just come out that has just been reprinted at salon.com. (Actually, it turns out we also have a paper in the volume, see this post).

Krugman and Wells articulate and expand on a thesis that they have suggested previously. They start by arguing that the huge increase in income inequality has also had major political consequences. So far so good. This is in line with our perspective in Why Nations Fail, and it’s something we have argued elsewhere, for example here. Next comes the original part of Krugman and Wells’s argument: the main corrosive effect of this inequality is in preventing Keynesian policies to combat the recession 2007-2008 and the sharp increase in unemployment that resulted. The idea here is that the “right” (the GOP) opposes any government intervention, and Keynesian fiscal policies and work programs that would have increased employment and combatted the recession are opposed by the right because, with increased inequality, they have become more beholden to the very wealthy.

Though intriguing, this idea is not backed up with direct evidence by Krugman and Wells. It may well be true, but it is also a curious thesis. Here are some of the things we find less than fully clear about this thesis.

First, the distinction between “right” and “left” (or perhaps pro-elite and anti-elite) is not a natural one when it comes to Keynesian economics and policies. Many conservative politicians, and not just Nixon and Reagan, have embraced Keynesian economics. Both Fascist Italy and Nazi Germany were big-time Keynesians. Work creation via government programs was a cornerstone of Nazi economic policy, so much so that an economic history of Nazi Germany by Dan P. Silverman is entitled Hitler’s Economy: Nazi Work Creation Program, 1933-1936 — though Adam Tooze, The Wages of Destruction: The Making and Breaking of the Nazi Economy, argues that work creation was only a secondary objective. (See also Peter Gourevitch’s Politics in Hard Times: Comparative Responses to International Economic Crises for a comparative and nuanced picture of how political attitudes and coalitions influenced macroeconomic policies during the crisis of 1873-96, in the aftermath of the Great Depression, and in the 1970s).

Second, the argument that elites are generally opposed to government involvement in the economy reveals the very US-centric focus of Krugman and Wells. Even a perfunctory look at recent or distant history (or at our book!) should have been enough to convince one that in most societies, even in the supposedly laissez-faire 19th century Britain, elites work very hard to make the government intervene in the economy — of course, in a very specific way, to support them. It should thus be no surprise that extractive institutions are rarely built on the foundations of laissez-faire economics — think of slavery, labor draft systems such as the mita, government monopolies, institutions such as the “colour bar” in South Africa designed to keep blacks disadvantaged and forced to supply cheap labor, and government corruption. This is not to argue that laissez-faire is inherently pro-poor or anti-elite, but to emphasize that the opposite perspective is also plainly false.

Third, even in the current US context it is not clear why the wealthiest Americans should be opposed to Keynesian policies. After all, wealthy Americans are the owners of the major corporations or at the very least are strongly vested in the US corporate sector, which would also be one of the main beneficiaries of expanded aggregate demand.

Fourth, even if Krugman and Wells’s emphasis is right, we find it hard to place lack of sufficient Keynesian stimulus as one of the most corrosive effects of soaring political inequality and political polarization in the US. What about the failure of our educational institutions; the huge incarceration rate, particularly for African-Americans; erosion of civil liberties; increasingly inefficient subsidies and tax breaks to select corporations and sectors; distortions created by implicit and explicit subsidies to the financial industry? Lack of sufficient Keynesian zeal seems a little less important.

Having said all of that, Krugman and Wells are probably right to some degree. Republicans prevented more aggressive Keynesian measures, and this has likely contributed to the persistence of very high unemployment (though there is no conclusive evidence showing a very large multiplier from government spending, which is something that needs to be factored in). All the same, the reasons for this hostility to Keynesian economics are still mysterious. Perhaps it was just politicking, with small p — a way of frustrating Obama’s economic policies. Perhaps it was based on a “slippery slope argument” — if the government starts being active now, what is there to stop it from becoming even more active in the future? Perhaps and just perhaps, it was for the same reason that some economists had a blanket opposition to Keynesian policies — on “ideological” grounds not clearly based on pure economic interest. Not as big a story, but a possibility.


What future for the World Bank?

There is now a healthy — and heated — debate about the nomination of Jim Yong Kim by President Barack Obama to be the next President of the World Bank, whether Mr. Kim is the right person for the job, and whether he will clinch it. (For example, for Lant Pritchett’s contributions see here and here; for Bill Easterly’s here and here; and for some more positive views, see here, here and here).

Some of the criticism has focused on the arrangement that essentially reserves World Bank Presidency to a US citizen. This is not an easy arrangement to defend, and one could definitely see a principled position that opposes Mr. Kim’s nomination just for this reason (see this interesting article on the history of this arrangement).

Nevertheless, it seems unlikely that this antiquated arrangement will end this year. It may still be worth opposing Mr. Kim’s presidency just as a way of criticizing this arrangement. But perhaps this year offers another historic opportunity: to change the vision and structure of the World Bank.

Many of the critics of Mr. Kim would agree that the World Bank’s mission has been unclear, and the Bank has done little to alleviate poverty despite its massive workforce and resources.

One reason for this has been the World Bank’s approach to economic development — outsiders trying to kickstart economic growth with aid and advice, and for the most part, ignoring politics and institutions.

Another reason has been the unclear mission of the World Bank. It’s a bank, it’s a charitable organization, it’s a think-tank, it’s an advocacy group, it’s a project management consortium, it’s a research institution, it’s a think-tank, it’s whatever you like it to be. In economics, it is generally believed that multiple — potentially conflicting — objectives weaken incentives and lead to inefficiencies. They also make capture more likely. One can justify organizations designed to perform many tasks at the same time, but only when these tasks are strongly complementary and cannot be performed more effectively when housed in different organizations. This is not the case for the many missions of the World Bank. For example, it’s not clear why providing (subsidized) loans and aid should be bundled with running development projects or with playing a leadership role in formulating the international community’s approach to economic development (if such an approach indeed needs to be formulated at all by a body in DC Washington which is quite doubtful). And why should all of this be bundled together with the very useful role that the World Bank plays in collecting and disseminating economic data.

The appointment of somebody like Mr. Kim with a proven track record of running very specific and narrow pro-poor health programs and hospitals — and equally notably, with no track record of being a banker, finance minister, or a development guru — might exactly be the opportunity to rethink what the World Bank is about and for the World Bank to focus on some of its missions. Perhaps the Bank under Mr. Kim’s leadership can stop feeling obliged to give loans to almost every government in the world provided that they undertake some — any — project. Perhaps the Bank could focus on doing a few things such as investing in health infrastructure, hospitals, perhaps some educational facilities targeted for the most disadvantaged populations in only the parts of the world that are most in need. Perhaps this could be the beginning of a conversation about what the future of the World Bank should be given that most would agree its future shouldn’t be the same as its past — though it must be said that Mr. Kim has not himself articulated this vision….


Industrial policy déjà vu 

Much of development economics is about coming up with ways of solving the problem of development. Some people emphasize the need to create more randomized experiments to validate specific programs. Others advocate foreign aid and other outside interventions. Yet others draw inferences from macroeconomic success, for example from the East Asian experience, and advocate “industrial policy” — government support for specific industries or firms that create jobs or generate positive spillovers on others.

All countries use some sort of industrial policy. Moreover, one specific type of industrial policy is clearly much needed all around the world today: support for clean energy to reduce global carbon emissions.

Is industrial policy the next big thing in economic development? Perhaps even for the United States? Some people think so (see, for example, this Washington Post column by Ezra Klein).

Actually, the real question is not whether industrial policy is the next big thing, but whether it should be.

Industrial policy is not new as a solution to development problems. Indeed, it was all the rage in the early 1960s as many former colonies became independent nations. Just at this time a young English economist, Tony Killick, straight out of university, went off to work for the government of Ghana just as it launched its own industrial policy. It did this in the light of the then existing state of the art economic theories, such as the Big Push (see our blog post on this).

But it all went terribly wrong.

In a sense the government did achieve a big push. It presided over an 80% increase in the capital stock between 1960-1965, 60% of which being by the public sector (80% of non-residential investment). The problem was in the way this investment was allocated. Years later Killick sat down and wrote one of the most important books on solving the problems of poverty Development Economics in Action.

The book starts by describing the theories and then shows how they all went wrong because they ignored politics. Take his description of a big public project designed to be part of the big push: a fruit canning factory “for the production of mango products.” Unfortunately “there was recognized to be no local market” and the output of the factory “was said to exceed by some multiple the total world trade in such items” (p.229). The government’s own report on this factory is worth quoting at some length (from p. 233 Killick’s book)

Project: A factory is to be erected at Wenchi, Brong Ahafo, to produce 7,000 tons of mangoes and 5,300 tons of tomatoes per annum. If average yields of crops in that area will be 5 tons per acre per annum for mangoes and 5 tons per acre for tomatoes, there should be 1,400 acres of mangoes and 1,060 acres of tomatoes in the field to supply the factory.

The Problem: The present supply of mangoes in the area is from a few trees scattered in the bush and tomatoes are not grown on commercial scale, and so the production of these crops will have to start from scratch. Mangoes take 5-7 years from planting to start fruiting. How to obtain sufficient planting materials and to organize production of raw materials quickly become the major problems of this project.

Killick’s acerbic comment on this, stated a whole year before the factory was constructed, sums it up:

it is difficult to imagine a more damning commentary on the efficiency of project planning.

This was not an isolated case. Such “white elephants” of development were widespread and Killick discusses many more. What on earth was going on?

The Ghanaian government had good economists advising them, like Killick and even Nobel Laureate Arthur Lewis. The problem was that the whole industrial policy was subservient to politics. If the government of President Nkrumah needed support in Brong Ahafo, for example, then he needed to give people jobs, and he built a factory there to achieve that. Politics came before economic efficiency. This, unfortunately, has been the general pattern with industrial policy. The problem is not thinking of situations in which industrial policy might be a good thing, of which there certainly are some. The problem is trying to identify the political situations in which industrial policy can actually be used to address these situations, and that is a much taller order.

There is little reason to think that the new version of industrial policy in the developing world or in the United States will be any different. 


Extractive growth: response to Matt Yglesias

Matt Yglesias followed up his fascinating Slate article on how Why Nations Fail can be used to interpret the economics of the Hunger Games with a blog post raising interesting questions on the nature of extractive growth.

Yglesias asks the following question: Colombia, Pakistan, Syria, Yemen, Ethiopia and China have all of extractive institutions, but Colombia has income per capita of about $10,000 and China’s stands at over $8000 (all in PPP), while Pakistan, Syria, Yemen and Ethiopia are much poorer. So perhaps we should focus more on why Syria, Yemen and Ethiopia aren’t more like Colombia than on why Colombia isn’t more like Denmark.

This is a fair point. It really has two parts. First, it would indeed be a mistake to just focus on the differences between countries with the most inclusive institutions and those with the most extractive institutions. Almost all countries are in shades of gray, and that matters enormously for the prosperity of their citizens. Looked at it that way, the comparison of Colombia and, say, Syria and Yemen should not be a major puzzle. Though Colombia has on balance extractive institutions, with perhaps one third of the country still under the influence or direct control of paramilitaries and armed groups, it also has developed certain fairly inclusive institutional elements since its independence in 1819. Some people’s property rights are secure and businessmen operating in the big cities like Bogotá and Medellín have access to high skilled workers and efficient finance. Though public services are non-existent in large parts of the country, for instance in La Danta (see our previous blog post), where the paramilitaries provide the services instead, in Bogotá and Medellín it is a different story, and in the last decades independent reformist mayors such as Antanas Mockus and Sergio Fajardo have made big improvements. 

On the one hand there is a lot of corruption in the judiciary. Take, for example, the ex Senator Juan Carlos Martinez (who you may recall from this blog post). He was released from prison for a weekend by a judge ostensibly to see his sick mother. It just so happened that this was the same weekend in October last year when all the local elections were taking place, and Martinez was heavily involved in helping fix election outcomes. What a coincidence! Yet on the other hand, the Colombian Constitutional Court in 2010 was able to stop President Uribe re-writing the constitution and removing presidential term limits, which was quite an achievement.

This juxtaposition of functional and dysfunctional elements is why Colombia is referred to as an “orangutan in a tuxedo”; the orangutan signifies extraction while the tuxedo signifies, if not inclusivity, at least functional institutions which create some prosperity. The fact that the tuxedo exists and operates is why Colombia is much more prosperous than Syria.

Syria is a much more viciously extractive regime under the control of a family and its minority ethnic group, the Alawis. The majority of the population has little security of property rights and limited access to public services or education. The situation in Yemen is even more dire. Extraction is just much more extreme in Syria and Yemen than in Colombia, so it should be no surprise that Syria’s and Yemen’s extractive institutions have condemned their population to much more abject poverty than those of Colombia.

Second, as we discuss in the book, extractive growth can take countries quite far — witness how much more prosperous the average Chinese is today than 30 years ago. But then, what are the factors that make extractive growth possible? We emphasize two preconditions for extractive growth.

The first precondition for extractive growth is some degree of state centralization. Most nations in Africa, for example, have not achieved sufficient state centralization to permit extractive growth. Afghanistan and Yemen are obvious non-African examples here. In fact, in many countries that gained independence, there was a rolling back of whatever degree of state centralization there was under colonialism, and state institutions were built only gradually as chaos and instability subsided. Colombia is a case in point. The inclusive elements of its institutions did not emerge overnight. There was no economic growth for 70 years after independence and the peculiar mix of inclusive and extractive emerged after a series of critical junctures; a civil war which ended by centralizing power with a new constitution in 1885; the take-off of the world coffee market in the 1890s giving elites an incentive to promote some reforms, such as building infrastructure; and attempts to structure institutions to avoid further civil wars (see this paper). Yemen and Syria are in the midst of instability, and likely to remain that way for quite a while. For example, if Alawi rule is finally overthrown in Syria, we may then expect a new regime that gradually achieves some degree of state centralization and hopefully also more inclusive elements. Even if this doesn’t take 70 years as in Colombia, it will certainly take more than a few years.

The second precondition for extractive growth is an elite that is not threatened by growth, creative destruction and some institutional opening. China started its rapid growth only when the new leadership under Deng Xiaoping decided that they could hold on to power — and in fact strengthen their power — while at the same time reforming economic institutions and encouraging economic growth. Many segments of the business and political elite in Colombia are similarly vested in economic growth — both because they own some of the businesses that will be the main beneficiaries of this growth and because, despite all of the electoral problems in many parts of Colombia, national politicians who deliver economic growth are more likely to get reelected. The situation in Syria is again very different. The Alawi elite has consistently opted for extreme repression and even shunned private-sector activity partly because they haven’t seen any institutional opening or independent economic activity as inimical to their interests.

That being said, we do not want to imply that we have a full understanding of when a country is able to embark upon a course of extractive growth. Why is it that, for example, China and Vietnam have been able to do so, while North Korea has not even tried? Part of the answer may lie in the fact that in North Korea, the dictatorship is identified with the Kim family, and an about-face, like the one that Deng Xiaoping engineered after Mao’s death, is not possible. But still, there are as many unanswered questions here.


The Big Mis-forecast

Back in the 1950s development economists viewed poor countries as being stuck in various types of “poverty traps”. The basic idea was that poverty tends to breed poverty. And poor countries just happened to be poor and trapped in poverty. The most popular version emphasized the availability of capital. Poverty made saving and capital accumulation impossible, according to this view, and as a result, it persisted — come to think of it, there are still some who subscribe to this view, but we are digressing….

One of the most famous versions of this thesis was Paul Rosenstein-Rodan’s “Big Push” thesis. Rosenstein-Rodan’s argument was similar to what many others in the 1950s and 60s formulated: development was about moving people from “backward” to more productive “modern” sectors of the economy. And this could only happen if everyone coordinated their behavior and increased their investments — so the Big Push required a big push in capital accumulation.

One thing that all of these theories had in common— and, digressing again a little bit, one thing they share with several current theories of economic development — was that they were only about economics. Politics and institutions didn’t matter; only “economic fundamentals” mattered. The ones Rosenstein-Rodan emphasized were how much a society saved and how much foreign aid they got (which in the 1950s and 1960s was assumed to simply add to capital accumulation).

How successful was this approach to development? Here’s one way to see. In 1961 Rosenstein-Rodan did something that no social scientist usually has the nerve to do (in this paper); based on his theory (and the available data he had on “economic fundamentals”), he made forecasts of how rapidly different parts of the world were going to grow over the next 15 years. The next table summarizes his forecasts together with the actual (per capita) growth rates for several countries.

As you can see from the table, he got it almost completely wrong. Let’s look at some of the numbers. In Asia, according to Rosenstein-Rodan, income per capita in India is set to grow at over 3% per year between 1961 and 76. Afghanistan and Pakistan are also predicted to grow at more than 2% a year, all of these faster than South Korea, Taiwan, Thailand and even Singapore. In Africa, Angola, Ghana, Kenya, Nigeria and Uganda were going to grow at about 2%, and Liberia wasn’t far behind with about 1.5% per year growth. All of these were supposed to grow faster than Mauritius, which was predicted to grow at less than 1% per year on average (Botswana did not even make the list, being still counted as a British protectorate at the time). In the Americas, Argentina and  Haiti were set to grow much faster than Costa Rica, the Dominican Republic and Panama.

Of course, things didn’t quite work out that way. In fact, many of the economies about which Rosenstein-Rodan was bullish are not much richer today than they were in 1961. Liberia and Haiti’s economies contracted since then. Angola, Kenya, Nigeria and Uganda haven’t done so well either. We of course know that Afghanistan, India and Pakistan grew more slowly than South Korea, Taiwan, Thailand and Singapore. Argentina and Haiti were no match for Costa Rica, the Dominican Republic and Panama.

The main reason why Rosenstein-Rodan got it so wrong is because he completely ignored the role of institutions and politics.

Now the thing is that, though most economists today would espouse more sophisticated theories than those of Rosenstein-Rodan, much of development economics — especially when it comes to the practice of development — still ignores institutions and politics.