Neoclassical models (plus economists) failed!

A good narrative about how neoclassicals and rational expectationists assumed general equilibrium in everything (and created an economic mess, emanating from the Wall Street):

[...] New thinkers say they are still having trouble breaking in. Among the new NSF grant awardees is J. Doyne Farmer, a physicist at the Santa Fe Institute who is trying to bring the idea of complexity back into economics by making use of advanced computing power to map human economic behavior the way weather or climate change is tracked. But Farmer says he got his $450,000 grant for a three-year study of systemic risks in markets only after a sympathetic NSF case officer overruled negative assessments by “neoclassical economists” who reject any model that doesn’t tend toward general equilibrium. “The established view just holds this stuff back,” Farmer says. “One of the dangerous cultural patterns that economics has fallen into is an excessive emphasis on theorem proof for its own sake rather than what gives you scientific results. That’s led to a disdain for computer simulation.” Johnson, who is director of the new Institute for New Economic Thinking funded by George Soros, says: “You do see some new thinking, but it doesn’t get traction in terms of policy. It’s a symptom of how far right society has gone.”

The great names in the profession have not necessarily helped. The top economists in the Obama administration—Summers; Christina Romer, the just-departed chair of the Council of Economic Advisers; and her replacement, Austan Goolsbee—are all part of the orthodoxy. Critics say Summers should know as well as anyone how the old thinking has been outstripped. As a Harvard professor, Summers wrote after the 1987 stock-market crash that it was impossible to believe any longer that prices moved in rational response to fundamentals. He even cautiously advocated a tax on financial transactions. Yet Summers, one of the world’s most astute economists, later abandoned these positions in favor of Greenspan’s view that markets will take care of themselves. And in the current era, Summers and the rest of the Obama team seem to have underestimated the depth and systemic nature of the economic crisis. Stimulus spending was timid (in deference to political antipathy to big government), mortgage workouts meager, and financial reform minimalist. The administration maintains it did as much as it could under the political constraints, but others disagree. “The financial-reform bill and other changes in the regulatory landscape are more incremental,” says MIT’s Lo. “It’s a reaction to the most immediate set of events as opposed to a more profound rethinking about the underlying causes of the crisis.”

A little history is in order here: it was largely because the field of economics came to be dominated by “neoclassical” thought—or the idea that markets are rational and can reach “equilibrium” on their own—that so-called financial innovation on Wall Street was allowed to run amok in recent decades. That led directly to the crisis of 2007–09. No matter how crazy or complex the products got, the theory was that, with little government oversight, the inherent stability of markets would keep things from getting too out of hand. It was in large part because of this way of thinking that government intervention of any kind in the markets, including regulation, came to be seen as a kind of heresy, especially after the Soviet Union collapsed and command economies and “statism” were thoroughly discredited.

The new financial-reform law has changed that to some degree, but it still leaves most of the major decisions about government oversight to the same regulators who failed last time. We are still, to a large extent, flying blind in conceptual terms. Just as the Great Depression demonstrated to John Maynard Keynes and his followers that markets often behaved badly—leading to the Keynesian reinvention of economics in the ’30s—this present crisis drove home the truth, or should have anyway, that rational models of markets don’t work well because there are too many unknowns. People most often don’t behave as rational actors. There is no real equilibrium in the real world. Above all, market economies are capable of destroying themselves. This is especially true in the world of finance, which has always worked according to different rules than other sectors of the economy and is much more prone to panics and manias. In 1983, a young Stanford economist named Ben Bernanke published the first of a series of papers on the causes of the Great Depression. The financial system, Bernanke said, was not unlike the nation’s electrical grid. One malfunctioning transformer can bring down the whole system. “I’ve never had a laissez-faire view of the financial markets,” Bernanke told me, “because they’re prone to failure.” Even Friedrich Hayek, the godfather of 20th-century laissez-faire thinking, believed that financial markets were more subject “to bouts of instability,” says one of his biographers, Bruce Caldwell of Duke University, a self-described libertarian scholar.

Yet amid the free-market triumphalism of the post–Cold War era, all this hard-won wisdom about the differences in finance was forgotten or ignored. To policymakers in Washington, it seemed silly and nitpicky to treat finance as a different animal. The dominant thinkers were the “rational expectations” economists of the Chicago school who simply assumed capital flows, no matter how open, would be stable.

Consequences of high-skilled “brain drain”

This paper presents the results of innovative surveys which tracked academic high-achievers from five countries to wherever they moved in the world in order to directly measure at the micro level the channels through which high-skilled emigration affects the sending country. The results show that there are very high levels of emigration and of return migration among the very highly skilled; the income gains to the best and brightest from migrating are very large, and an order of magnitude or more greater than any other effect; there are large benefits from migration in terms of postgraduate education; most high-skilled migrants from poorer countries send remittances; but that involvement in trade and foreign direct investment is a rare occurrence. There is considerable knowledge flow from both current and return migrants about job and study opportunities abroad, but little net knowledge sharing from current migrants to home country governments or businesses. Finally, the fiscal costs vary considerably across countries, and depend on the extent to which governments rely on progressive income taxation.

More here. The study was done in Tonga, the Federated States of Micronesia, Papua New Guinea, Ghana, and New Zealand. The authors estimate that the best and the brightest gain US$40,000-75,000 per year from emigrating from these five countries. Gains disaggregated are: annual remittances are $2000-7000, trade and FDI effects are close to the remittances value, and annual fiscal impacts are at most $1000 for Tonga and Micronesia, $6000 for Ghana, $10,000 for New Zealand, and $17,000 for Papua New Guinea. They also find that migration leads to large increases in human capital of migrants, but little net knowledge transfers to home governments or business. The gains are estimated to be much higher relative to the magnitude of possible negative externalities.

Nepalese economy still stuck in mess

My latest piece is based on the latest macroeconomic review  2009/10 published by the central bank of Nepal. My point is that despite substantial reduction in BOP deficit, the economy is still in a mess: low growth, low employment, high inflation, growth less investments in few sectors, and consumption fuelled economy, thanks to remittances, among others. The way BOP deficit declined has nothing to do with addressing these important variables.

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Economy still stuck in mess

Last week, the central bank came up with encouraging news that Balance of Payments (BoP) deficit declined from Rs 20 billion in the first quarter of 2009/10 to Rs 2.62 billion when the annual figures were compiled. Commentators were quick to extol stringent steps taken by the central bank to restrain imports of certain goods. The decline in BoP deficit has given some respite to policymakers, at least in the short term with regards to restoring market confidence that they can competently manage transactions between Nepal and the rest of the world.

Though this is welcoming news, it does not mean that other macroeconomic variables are also on the right track vis-à-vis existing monetary and fiscal policies. The core problems that led to BoP deficit beginning first quarter of last fiscal year have not been resolved yet. Worse, fresh indicators about the competitiveness of the economy show that the economy is still plagued by structural constraints, leading to alarming lending and consumption levels without reasonably proportional impact on growth and employment. We are still stuck in the same economic mess as before—widening trade deficit, high inflation, slow economic growth, low employment, and rigid non-economic constraints.

Our economy’s BoP is composed of three sections: Current account, capital account and financial account (there is ‘balancing item’ as well to account for statistical errors). Current account is the sum of balance of trade (exports minus imports of both merchandise goods and services), net factor income (such as interests and dividends), and net transfer payments (such as remittances, foreign aid, and pensions). This is the most important part of BoP with regards to its bearing on our economy’s growth, employment, exchange rate, and inflation. Despite the decline in BoP deficit, our current account is still in a very bad shape, implying that the main economic and non-economic issues are not resolved yet. Unless they are addressed, any fix on BoP accounts is of temporary, unsustainable nature.

Merchandise exports are down by 9.7 percent to Rs 61.13 billion in 2009/10. Last year, it was up by 14.2 percent reaching Rs 67.70 billion. Exports to both India and other countries declined. Meanwhile, merchandise imports have surged to Rs 378.80 billion, a growth of 33.2 percent. It grew by 28.2 percent, reaching Rs 284.47 billion in 2008/09. Imports from India and other countries grew by 34.2 percent and 31.8 percent, respectively. Consequently, trade deficit widened by 46.5 percent, reaching Rs 313.67 billion. In 2008/09, it rose by 33.3 percent and amounted Rs 216.77 billion. Trade deficit with India and other countries rose by 46.75 percent and 46.7 percent, respectively. This indicates an unfavorable balance of trade situation. It is simply unsustainable as we cannot forever import more than what we can afford to.

The reason why BoP was in surplus in previous years (Rs 44.66 billion in 2008/09) was because of high inflow of remittances, which checked current account from deteriorating amidst rising negative balance of trade. As growth rate of remittances inflows went down, thanks to declining demand of Nepali workers following the global economic crisis, current account went into the red, dragging overall BoP in its direction.

Current account deficit amounted to Rs 32.35 billion as against a surplus of Rs 41.44 billion in FY 2008/09. Capital account, which reflects a net change in national ownership of assets, surplus doubled this year to Rs 12.58 billion, up from Rs 6.23 billion in 2008/09. Financial account deficit was Rs 3.70 billion as against Rs 21.20 billion surplus in 2008/09. As a result, the overall BoP situation came down from a deficit of about Rs 20 billion in the first quarter to Rs 2.62 billion by the year’s end. The transfers and earnings from capital account are insufficient to negate widening trade deficit, which is dragging overall BoP in the negative terrain.

The decline in BoP deficit by the fourth quarter of 2009/10 looks like progress, isn’t it? Yes, but there is nothing to cheer about. There is no major change in indicators that will keep BoP accounts in a comfortable space in the coming years. Unless we find a way to narrow down the trade deficit – primarily by exporting more, and encouraging domestic production and consumption instead of imports of pretty much everything ranging from luxurious to non-luxurious goods and services – the problems associated with BoP deficit will not be adequately addressed. Continuing to bank on remittances and trade credit liabilities to even out BoP account is not a smart idea and policymaking.

It should be realized that in terms of productive capacity of the economy, prospect of future growth and employment scenarios, we are still very much deep in the same mess we were at the beginning of this year when BoP deficit was record high. In fact, we are actually going deeper into the mess. The ratio of exports to imports has declined from 23.8 to 16.1. Economic growth rate plunged from 3.9 percent to 3.5 percent. Inflation is still double-digit. Worse, amidst supply side constraints, cartelling and increasing money supply, inflation will probably creep up and stagnate at high level. Additionally, consumption has increased by 0.3 percentage points to 90.6 percent of GDP, and domestic savings is worryingly low at 9.4 percent of GDP.

The message is clear: We are still deep into economic mess, and the way BoP deficit declined by the fourth quarter of 2009/10 has not and will not contribute to us getting out of low growth, low employment, high prices and remittances-fueled impact-less investment cycles. This is further substantiated by the latest Global Competitiveness Report which ranks Nepal as the least competitive nation in South Asia. Globally, Nepal is 125th (out of 139 countries) most competitive nation!

[Published in Republica, September 16, 2010, pp.7]

South Asia (and Nepal) in 2012

What would South Asia look like two years from now? The World Bank’s GEP has forecast for some of the South Asian countries. Nepal is expected to grow at 4.2 percent in 2012. Its current account balance is expected to be the second best, albeit negative, in 2012. Bangladesh is the only country in South Asia whose current account is expected to be positive in 2012. Also, in 2012 Bangladesh is expected to be the second highest growing economy (at 6.1 percent), following India, which is expected to grow at 8.2 percent in 2012.

Source: GEP, 2010-09-16

In 2012, Nepal will be around US$ 20 billion economy, (nominal GDP) with imports higher than exports. With population of 31 million, its per capita GDP is expected to be US$ 579.

Source: GEP, 2010-09-16

Poverty in Nepal

Different measures have different estimates. The NLSS I and NLSS II have the following estimates.

Meanwhile, MPI and the WB have the following estimates:

Additionally, the ADB has its own estimate of poverty and draws a poverty line at $1.35 a day. For Nepal, with the new ADB estimates, the percentage of population living in poverty is higher than under $1.25 a day. Under $1.35 a day estimate 59.5% of the population live in poverty, while under the WB’s estimate 24.7% live below the $1.25 a day line and under $2 a day 64.3% of the population live in poverty.

Lord Keynes and President Roosevelt, 1938/02/01

To Franklin Delano Roosevelt, 1 February 1938

Private and personal

Dear Mr. President,

You received me kindly when I visited you some three years ago that I make bold to send you some bird’s eye impressions which I have formed as to the business position in the United States. You will appreciate that I write from a distance, that I have not revisited the United States since you saw me, and that I have access to few more sources of information than those publicly available. But sometimes in some respects there may be advantages in these limitations! At any rate, those things which I think I see, I see very clearly.

(1) I should agree that the present recession is partly due to an ‘error of optimism’ which led to an overestimation of future demand, when orders were being placed in the first half of this year. If this were all, there would not be too much to worry about. It would only need time to effect a readjustment;—though, even so, the recovery would only be up to the point required to take care of the revised estimate of current demand, which might fall appreciably short of the prosperity reached last spring.

(2) But I am quite sure that this is not all. The recovery was mainly due to the following factors:—

1. the solution of the credit and insolvency problems, and the establishment of easy short-term money;
2. the creation of an adequate system of relief for the unemployed;
3. the public works and other investments aided by Government funds or guarantees;
4. investment in the instrumental goods required to supply the increased demand for consumption goods;
5. the momentum of the recovery thus initiated.

Now of these (i) was a prior condition of recovery, since it is no use creating a demand for credit, if there is no supply. But an increased supply will not of itself generate an adequate demand. The influence of (ii) evaporates as employment increases, so that there is a dead point beyond which this factor cannot carry the economic system. Recourse to (iii) has been greatly curtailed in the past year. (iv) and (v) are functions of the upward movement and cease—indeed (v) is reversed—as soon as the position fails to improve further. The benefit from the momentum of recovery as such is at the same time the most important and the most dangerous factor in the upward movement. It requires for its continuance, not merely the maintenance of recovery, but always further recovery. Thus it always flatters the early stages and steps from under just when support is most needed. It was largely, I think, a failure to allow for this which caused the ‘error of optimism’ last year.

Unless, therefore, the above factors were supplemented by others in due course, the present slump could have been predicted with absolute certainty. It is true that the existing policies will prevent the slump from proceeding to such a disastrous degree as last time. But they will not by themselves—at any rate, not without a large-scale recourse to (iii)—maintain prosperity at a reasonable level.

(3) Now one had hoped that the needed supplementary factors would be organized in time. It was obvious what these were—namely increased investment in durable goods such as housing, public utilities, and transport. One was optimistic about this because in the United States at the present time the opportunities, indeed the necessities, for such developments were unexampled. Can your Administration escape criticism for the failure of these factors to mature?

Take housing. When I was with you three and a half years ago the necessity for effective new measures was evident. I remember vividly my conversations with Riefler at that time. But what happened? Next to nothing. The handling of the housing problem has been really wicked. I hope that the new measures recently taken will be more successful. I have not the knowledge to say. But they will take time, and I would urge the great importance of expediting and yet further aiding them. Housing is by far the best aid to recovery because of the large and continuing scale of potential demand; because of the wide geographical distribution of this demand; and because the sources of its finance are largely independent of the stock exchanges. I should advise putting most of your eggs in this basket, caring about this more than about anything, and making absolutely sure that they are being hatched without delay. In this country we partly depended for many years on direct subsidies. There are few more proper objects for such than working-class houses. If a direct subsidy is required to get a move on (we gave our subsidies through the local authorities), it should be given without delay or hesitation.

Next utilities. There seems to be a deadlock. Neither your policy nor anybody else’s is able to take effect. I think that the litigation by the utilities is senseless and ill-advised. But a great deal of what is alleged against the wickedness of holding companies is surely wide of the mark. It does not draw the right line of division between what should be kept and what discarded. It arises too much out of what is dead and gone. The real criminals have cleared out long ago. I should doubt if the controls existing today are of much personal value to anyone. No one has suggested a procedure by which the eggs can be unscrambled. Why not tackle the problem by insisting that the voting power should belong to the real owners of the equity, and leave the existing organizations undisturbed, so long as the voting power is so rearranged (e.g. by bringing in preferred stockholders) that it cannot be controlled by the holders of a minority of the equity?

Is it not for you to decide either to make a real peace or to be much more drastic the other way? Personally I think there is a great deal to be said for the ownership of all the utilities by publicly owned boards. But if public opinion is not yet ripe for this, what is the object of chasing the utilities around the lot every other week? If I was in your place, I should buy out the utilities at a fair price in every district where the situation was ripe for doing so, and announce that the ultimate ideal was to make this policy nation-wide. But elsewhere I would make peace on liberal terms, guaranteeing fair earnings on new investments and a fair basis of valuation in the event of the public taking them over hereafter. The process of evolution will take at least a generation. Meantime a policy of competing plants with losses all round is ramshackle notion.

Finally, the railroads. The position there seems to be exactly what it was three or four years ago. They remain, as they were then, potential sources of substantial demand for new capital expenditure, Whether hereafter they are publicly owned or remain in private hands, it is a matter of national importance that they should be made solvent. Nationalise them if the time is ripe. If not, take pity on the overwhelming problems of the present managements, And here too let the dead bury their dead. (To an Englishman, you Americans, like the Irish, are so terribly historically minded!)

I am afraid I am going beyond my province. But the upshot is this. A convincing policy, whatever its details may be, for promoting large-scale investment under the above heads is an urgent necessity. These things take time. Far too much precious time has passed.

(4) I must not encumber this letter with technical suggestions for reviving the capital market. This is important. But not so important as the revival of sources of demand. If demand and confidence reappear, the problems of the capital market will not seem so difficult as they do today. Moreover it is a highly technical problem.

(5) Businessmen have a different set of delusions from politicians, and need, therefore, different handling. They are, however, much milder than politicians, at the same time allured and terrified by the glare of publicity, easily persuaded to be ‘patriots’, perplexed, bemused, indeed terrified, yet only too anxious to take a cheerful view, vain perhaps but very unsure of themselves, pathetically responsive to a kind word. You cold do anything you liked with them, if you would treat them (even the big ones), not as wolves or tigers, but as domestic animals by nature, even though they have been badly brought up and not trained as you would wish. It is a mistake to think that they are more immoral than politicians. If you work them into the surly, obstinate, terrified mood, of which domestic animals, wrongly handled, are so capable, the nation’s burdens will not get carried to market; and in the end public opinion will veer their way. Perhaps you will rejoin that I have got quite a wrong idea of what all the back-chat amounts to. Nevertheless I record accurately how it strikes observers here.

(6) Forgive the candour of these remarks. They come from an enthusiastic well-wisher of you and your policies. I accept the view that durable investment must come increasingly under state direction. I sympathise with Mr Wallace’s agricultural policies. I believe that the SEC is doing splendid work. I regard the growth of collective bargaining as essential. I approve minimum wage and hours regulation. I was altogether on your side the other day, when you deprecated a policy of general wage reductions as useless in present circumstances. But I am terrified lest progressive causes in all the democratic countries should suffer injury, because you have taken too lightly the risk to their prestige which would result from a failure measured in terms of immediate prosperity. There need be no failure. But the maintenance of prosperity in the modern world is extremely difficult; and it is so easy to lose precious time

I am, Mr President

Yours with great respect and faithfulness,

J.M. Keynes

References

John Maynard Keynes (1938), “Letter of February 1 to Franklin Delano Roosevelt,” in Collected Works XXI: Activities 1931-1939 (London: Macmillan).

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Source: Brad DeLong

23 untold things about capitalism

Here is Ha-Joon Chang's list from his new book ’23 things they don’t tell you about capitalism’ (book review here). It will surprise you! I am looking forward to reading this book very soon. Chang has been an outspoken critic of free market and advocates greater government role and industrial policy.

23 Things they don’t tell you about Capitalism

Thing One. There is really no such thing as a free market.

Thing Two. Companies should not be run in the interest of their owners.

Thing Three. Most people in rich countries get paid more than they should.

Thing Four. The washing machine has changed the world more than the internet.

Thing Five. Assume the worst about people, and you get the worst.

Thing Six. Greater macroeconomic stability has not made the world economy more stable.

Thing Seven. Free-market policies rarely make poor countries richer.

Thing Eight. Capital has a nationality.

Thing Nine. We do not live in a post-industrial age.

Thing Ten. The US does not have the highest living standard in the world.

Thing Eleven. Africa is not destined for under-development.

Thing Twelve. Government can pick winners.

Thing Thirteen. Making rich people richer doesn’t make the rest of us richer.

Thing Fourteen. US managers are over-priced.

Thing Fifteen. People in poor countries are more entrepreneurial than people in rich countries.

Thing Sixteen. We are not smart enough to leave things to the market.

Thing Seventeen. More education in itself is not going to make a country richer.

Thing Eighteen. What is good for the General Motors is not necessarily good for the United States.

Thing Nineteen. Despite the fall of Communism, we are still living in planned economies.

Thing Twenty. Equality of opportunities is unequal.

Thing Twenty-one. Big government makes people more, not less, open to changes.

Thing Twenty-two. Financial markets need to become less, not more, efficient.

Thing Twenty-three. Good economic policy does not require good economists.