Econ Focus

Third Quarter 2014

Interview

Dani Rodrik

PHOTO BY DAN KOMODA

Dani Rodrik

Curiosity about what makes nations grow and develop is as old as the economics profession itself, having motivated Adam Smith's 1776 The Wealth of Nations. Development economics as a distinct field, however, is relatively young.

Its progress has come in fits and starts. Widespread support for state-directed investment after World War II was met by backlash with growing awareness of communism's weaknesses and with the Latin American debt crisis of the 1980s. The Asian miracle then convinced the world that free trade and open markets would solve poor nations' ills, and aid to such countries was conditioned on their efforts to liberalize. Liberalization without attention to context, too, is now seen as a failure.

The work of economist Dani Rodrik suggests that policymakers may have been asking the wrong questions. He argues that development is not a "one size fits all" proposition: The individual circumstances of countries determine the success or failure of aid, liberalization, and other efforts to prod development. Moreover, his work has contributed to the modern idea that institutions matter as much as any single policy, natural endowment, or economic structure.

That is not the only area in which Rodrik, a native of Turkey, has questioned convention. Few topics unite economists like the virtues of free trade, so it was notable when Rodrik made a case for the limits of globalization in the 1997 book Has Globalization Gone too Far? In it, he argued that globalization in the extreme can harm social stability by threatening the institutions that underpin it.

Rodrik has also taken a critical look at the economics profession, and in particular, how economists can best provide practicable guidance to policymakers. As his views on development suggest, one theme is that economists should be wary of hubris — and should be clear to policymakers about the limits of the profession's knowledge.

Rodrik is currently at the Institute for Advanced Study, but he will be returning to Harvard University in mid-2015. He is the author of several books, as well as the forthcoming Economics Rules: The Rights and Wrongs of the Dismal Science. Aaron Steelman interviewed Rodrik at his office in Princeton, N.J., in late 2014. Renee Haltom contributed to the interview.


EF: What are the problems, as you see it, with what you describe as the "orthodox" thinking in development economics? I have in mind your critique of "the Washington consensus," the philosophy developed around the late 1980s.

Rodrik: I think it's a classic case of mistaking a model for the model. The Washington consensus presumed that all countries would benefit from a rather similar recipe. The three planks of it were to stabilize, to liberalize, and to privatize; in principle these are good things, but they leave out many important details that might result in that model backfiring.

One thing they leave out is the economics of second best. When you're working in a context where there aren't many other failures in the system, getting some things right doesn't guarantee that you're going to end up right. A classic example is what often happened with privatization: If we didn't have the institutions of contract enforcement or rule of law, or an antitrust policy, privatization could easily turn into a means of providing monopoly rents to the government's cronies instead of generating efficiency gains.

Similarly, trade liberalization on the face of it is a good thing, but if you do it in countries where the exchange rate is overvalued and labor markets and capital markets aren't working well, opening up to trade quickly will result in the collapse of many industries without new, more efficient ones rising up in their place.

I think the profession learned from the experience of the 1990s, and now we're at a very different point. Development agencies are getting used to thinking in a more contextual manner and developing solutions specific to setting.  It has made the task harder since you can no longer advocate ready-made reforms, but that's as it should be.

Another area where we made a similar mistake was in macroeconomists' advocacy of financial globalization in emerging markets in the mid-1990s. The notion there was that allowing developing countries to access capital markets globally would increase their investment and enable them to grow more rapidly. This view was informed by a saving-constrained model of economic growth. We forgot that other models went in other directions — models, for example, suggesting that when financial regulations are weak, capital coming into your economy could be dangerous, or that when investment is constrained by inadequate protection of property rights, more foreign capital boosts consumption rather than saving. The actual experience with financial globalization suggested those other models may have been more relevant. As firms and governments borrowed from abroad, we got more frequent and deeper financial crises and little benefit in terms of aggregate investment or growth.

EF: Is your argument that trying to create institutions like a rule of law in some of these countries is just too hard to do or would take too long, such that we're better off going for the second best to make people's lives better off now?

Rodrik: I think that's a false dichotomy in the sense that we're always in a second-best world. We're always forced to think about reform strategies that will work in the world as we find it, not in the world we would like to have.

Suppose you're in a setting where the rule of law and contract enforcement are really weak. And you realize that they don't change overnight. Are you better off promoting the set of policies that presume that rule of law and contract enforcement will take care of themselves, or are you better off recommending a strategy that optimizes against the background of a weak rule of law? And I say that the evidence is that you do much better when you do the second.

The best example is China. Its growth experience is full of these second-best strategies, which take into account that they have, in many areas, weak institutions and a weak judicial system, and therefore they couldn't move directly to the kinds of property rights we have in Europe and the United States. And yet they've managed to provide incentives and generate export-orientation in ways that are very different from how we would have said they ought to have done it, which would have been to simply open up their economy or privatize their enterprises. There, second-best strategies have been very effective. The same can be said of Vietnam, say, or farther afield, a country like Mauritius.

Of course, there's still a question with countries like China of whether this series of unorthodox reforms gets you some benefits for two or three decades but then gets you stuck. The answer is that we don't know.

EF: One could imagine a situation where the pursuit of second-best policies would lead to such a relative prosperity that it retards the incentive to do some of the first-best things.

Rodrik: Absolutely. That's something people are worried about, and rightly so. Whether these second-best strategies weaken your incentives to put in place the underlying institutions that you need to move it to a true market economy, such that you lock yourself into an intermediate regime. But do you really want to give up decades of rapid growth on the off chance that you will eventually get stuck?

The risk of second-best policies has to be traded off against another risk, which is that the surest way that you can discredit economists' favorite policies is by forcing them on countries where the short- to medium-term gains are going to be very weak or none. You end up discrediting those strategies because they end up underperforming and producing reform fatigue, or even worse, a backlash. That's the story of Bolivia or Argentina.

EF: Yet maybe it's possible that we could recognize place-specific examples where we believe we can actually get the ordering correct.

Rodrik: Yes, and it could be possible. The point about second-best outcomes is just a warning that you better do your homework and make sure that the second-best interactions are the wind behind you rather than the wind that'll be slowing you down.

I can give you examples where I think the standard recipe worked very well. Poland in 1990 did the most amazing cold turkey reforms. It opened up its economy, removed its subsidies, and removed price controls, all virtually overnight. And they did rather well, but there were a number of things that were specific to the Polish context that supported that — it had membership in the European Union as a carrot, and it received a stabilization fund to underpin the zloty. When Russia tried to do the same, it didn't work, because there were many things that were missing in that context compared to the Polish.

EF: Around the turn of the millennium, there was quite a bit of discussion in the popular press about the decreasing importance of place and traditional institutions of governance due to technological advances. Yet the nation-state hasn't proved to be as expendable or as unwieldy as many seem to have predicted. How do you think that view arose in the first place, and why was it mistaken?

Rodrik: I think it was a blind spot created by the apparent success of the global economy. When markets are working well, it's easy to miss the kinds of things that make them work well. I think what happened in the long period of expansion of the postwar global economy is that most advanced countries experienced relatively rapid growth, relative equity, and relative stability. And we forgot that, in fact, all of those were facilitated by institutions that were largely products of the nation-state. Institutions of macroeconomic stabilization, such as monetary and fiscal policy; institutions of social insurance such as transfers and safety nets; and various regulatory institutions in product, labor, and financial markets.

It's only when something goes wrong that we realize how important those things are. In a national crisis, you realize how important a central bank is that's going to pump liquidity into the system, or the fiscal system that provides your unemployment checks and stimulus or bails out companies whose failures would otherwise come at huge social costs. We forgot that good economic performance was underpinned by the institutions that markets require, which have been provided traditionally by the nation-state.

Now, one can envisage a world economy where those institutions are provided not by the nation-state but by some global institutions. Conceptually, there is no reason why we can't have those, in which case the nation-state might become no more important than the state governments of Kansas or Nebraska are to the U.S. economy. But unless we have something like that, all we have is the nation-state. So it's very important for the health of markets – national and global — that the nation-state be healthy, that it be able to provide those functions. That necessarily means that economic globalization is something we can push only so far, because if we push it so far that you weaken the nation-state, it cannot provide these functions anymore — in fact you are undermining the stability and function of markets as well.

I think the financial crisis has made us see this a little bit better at least in the context of financial regulation, which is moving in a much more robust way into the national domain. But the lesson extends beyond financial regulation to many of the market-supporting functions of the nation-state.

EF: In your opinion, is it possible to have a healthy nation-state without a good measure of social insurance and redistribution? Or are those part and parcel to having a society that will accept some of these other institutions?

Rodrik: The Great Depression produced rising protectionism in global trade, with global trade basically collapsing and in turn significantly aggravating the economic crisis. This time around we didn't have that. Historically, recessions are prone to producing protection because people want shelter from imports when jobs get scarce. It's really remarkable how little a rise in protectionism we got during the most recent financial crisis.

I think the social insurance functions of the state were in part responsible for that. Unemployment benefits and other transfers, along with automatic stabilizers, alleviated the social cost of the crisis. The takeaway, I think, is that social insurance and safety nets are important for maintaining the legitimacy of the market. In some earlier research, for example, I showed that the welfare state was the flip side of the open economy: The more a country exposed itself to risks originating from the world economy, the more extensive was its welfare state.

EF: This issue in good measure goes beyond economics and into social science more broadly. Do you think the widespread interest in Thomas Piketty's book Capital in the Twenty-First Century signals parts of the economics profession to get back to such big-picture questions?

Rodrik: Of course, economics has a very long tradition of speaking to the big issues. The classical economists — Adam Smith, Karl Marx, David Ricardo, John Stuart Mill — were public intellectuals as well as path-breaking economists. Some of that tradition was lost as the discipline became more mathematical and conceptual, working with abstract frameworks rather than the issues of today.

As economics became more empirical in the last 20-30 years, we as a profession started to look for the keys where the light was rather than where they were more likely to be. So a lot of the empirical work of the last 20 years captivates the public but not in quite the same way: It's interesting but not necessarily speaking to the big issues of today.

My guess is that we are probably moving toward greater engagement with the big issues. I'd like to believe that Piketty's book is telling in that respect, although I think its reception had to do much more with the social and political interest in Piketty's topic of inequality.

So I don't necessarily expect that there is going to be a huge change in the nature of the profession. I think what keeps most economists from becoming public intellectuals is that it would push them beyond their comfort zone, which is in talking about the issues that they really feel they can pin down. That's a natural source of reserve, which I hope is to be respected; often, in fact, the profession has gotten into trouble precisely when economists have overreached beyond their expertise and have used very specific models to make very broad conclusions. You take the efficient market hypothesis too far, for example, and you create the conditions for a global financial crisis. That nuance often gets lost on the other side, the audience. And that's something we need to work on.

EF: That theme seems to run through your work — that economists have an inherent obligation to be of use in helping to guide policy, conflicted with the danger that the public thinks economists know more than they do. How should we think about dealing with that tension?

Rodrik: The root of it is the problem that the profession has more or less the wrong idea about how economics as a science works. If you ask most economists, "What kind of a science is economics?," they will give a response that approximates natural sciences like physics, which is that we develop hypotheses and then we test them, we throw away those that are rejected, we keep those that cannot be rejected, and then we refine our hypotheses and move in their direction.

This is not how economics works — with newer and better models succeeding models that are older and worse in the sense of being empirically less relevant. The way we actually increase our understanding of the world is by expanding our collection of models. We don't throw out models, we add to them; the library of models expands. Social reality is very different from natural reality in that it is not fixed; it varies across time and place. The way that an economy works in the Congo is very different from the way that it works in the United States. So the best that we can do as economists is try to understand social reality one model at a time. Each model identifies one particular salient causal mechanism, and that salient effect might be very strong in the Congo but it may be very weak at any point in time in the United States, where we may need to apply a different model.

If you look at the progress of economics all the way from perfect competition to imperfect competition, from incomplete information to behavioral economics, at every step we have said, "Here are some additional realities for which we need newer models." Behavioral economics doesn't mean that we want to ignore models in which people are rational. There are plenty of settings where presuming people are behaving rationally is still the right way to go.

When you look at economics in that way, as a collection of models, then what does it mean to say that economics knows something about the world? Economists know how to think about various causal mechanisms that operate as part of social reality, but what they're very bad at in practice is navigating among the models describing them. How exactly do I pick the right model for a given setting? This is a craft because the evidence never settles it in real time. We have these periods of fads where we say the New Keynesian or the Neoclassical model explains everything. We lose sight of the fact that models are highly context-specific and we need to be syncretic, simultaneously carrying many models in our mind.

Certainly, there are things in economics that can be said to be fairly universal; many of those are actually quite innocuous, such as the assertion that "incentives matter." I think we can often also agree after the fact: We can say that the Soviet system was economically inefficient, or that the 2009 stimulus package of President Obama reduced unemployment. These are things on which there is a fair amount of consensus, and rightly so, because the evidence is more or less in. But the vast range of propositions over which economists agree in public don't have that kind of support, and that's where I think we often get into trouble.

EF: So when you start thinking about, for instance, the Congo, how do you know that you have enough place-specific evidence of what's going on to select the right model?

Rodrik: The answer is: not very well and only imperfectly.

What you do is apply a number of strategies. One is to look at whether the critical assumptions of a model seem to track the context well. The emphasis here is on critical assumptions, because every model, and therefore every explanation, is necessarily a simplified version of reality, so there will always be assumptions that don't make sense. A critical assumption is one that if you were to relax it in the direction of greater realism, it would change the result significantly. Should I apply a model with imperfect competition or perfect competition — the question there is going to be, will it change significantly the result of the question that I am asking?

Another strategy is seeing whether the comparative static properties of the model are borne out beyond the specifics that you're interested in. So in the case of the Congo, you might say, "The problem is that the private sector is investing so little. Is it because they don't have access to finance, or is it because they are in a poor investment climate?" Those are two different models of growth, if you will. One would be based on low savings, the other would be based on, let's say, poor institutions or poor property rights. One of the comparative static implications of these two models would be that when foreign aid comes in, or there are remittances, does it go into consumption or does it go into investment? If it's a saving constraint model, it would go into investment. If it's a return constraint model, it's going to consumption. The way these economies actually behave tells you something about what the underlying model might be.

These are diagnostic techniques that can help us navigate among alternative models, but above all it requires judgment.

EF: In development economics, do you have to actually have a person on the ground in that place to do model selection successfully? Your observation of the channels through which things work might be better.

Rodrik: You need both local and global perspectives. One of the things I find most useful when I'm asking these questions in different settings is talking to businesspeople. You will learn things that data from the national statistics agency will not reveal to you.

But you could also make the mistake of thinking that that's all you need. Often what you miss when you don't have the global comparative dimension is the dog that didn't bark. You forget to ask questions that you ought to have asked, because another country under apparently similar settings appeared to overcome certain constraints. You have to ask, why is it that those strategies aren't being followed in this particular context? That's one of the ways in which economics works best; models are like case studies that give you a sense of the possibilities. If something that ought to have happened isn't happening, then you have to dig deeper and figure out which assumption of the model is being violated.

A mistake that I think the very empirical end of the profession makes is thinking that we can simply run the right experiment to determine causality, and then we can do this model-free. In fact, nothing is model-free. Anytime you are thinking about a causal relationship, you have some model in the back of your mind, and that model has a bunch of explicit and implicit assumptions that are hidden into it. And you better recognize what those are.

Put differently, most economists think that they work in an exclusively deductive method, meaning they form a hypothesis and then test it. In fact, much of the best economics involves moving back and forth between the deductive and the inductive. They look at the world and find an irregularity — the inductive stage — and then formulate a model or a theory to explain it, the deductive stage. Of course, you cannot test that model on the observation you have just made because the model has been created for the purpose of explaining that thing. You use the model to generate additional implications you have not thought of before, and then you see whether those additional implications are borne out or instead how you need to modify the model to make those additional implications empirically verified. But very few papers you read in research journals will actually tell you that's the mold in which they were generated.

EF: An aspect of this is that economists seem reluctant to bring culture into economics.

Rodrik: I think culture had a bad name in economics for a very long time because it was used as a catch-all category. There developed a well-justified resistance to using culture as an ad hoc factor explaining what you couldn't explain through existing models.

Some people would say, for example, that some societies don't respond to incentives in quite the same way because they don't have that market-based culture. Or that in some societies, people will not work as hard to make money because their culture values other things more. Those statements were actually made about countries like, believe it or not, South Korea in the late 1950s before its economy took off. And we've seen how misleading they were because it turned out that it wasn't a matter of culture, it was a matter of the incentives not being there. And funnily enough, when countries like South Korea and Taiwan began to develop by leaps and bounds, the cultural argument was turned upside down to argue that it was due to Confucian culture, with its emphasis on thrift and education.

Economists have two ways of thinking about norms. One is thinking of them as the outcomes of repeated interaction in game forms; you can think about cooperation or punishment or helping others as norms that are strategies on the equilibrium path of the game. People cooperate because of the long-term benefits of cooperation given that if they cooperate, others also cooperate. If they defect, they only get the short-term benefits and lose out in the long term because others defect as well.

The other way is to think of norms as a preference, as part of the utility function of individuals. Economists typically take preferences as given, so there's not a lot of research on how preferences are formed. But you could apply the same kind of thinking that economists do to advertising, for example, in which economic incentives shape spending on advertising in order to shape consumers' preferences. That is the subject of some of my current research on the effect of ideas in political economy on people's sense of identity, meaning their preferences for the kind of person they are, and how that affects economic outcomes.

So, economists have the tools to think systematically about these issues, it's just that the way we work is to look at them one at a time in the context of simple, stylized models. The problem is that too often when we move from the seminar room, where there's this incredible diversity of models, to the public sphere, we retire back to our benchmark models where all of the interesting stuff has been left out.

EF: These are questions that are inherently interesting in and of themselves, but do you see potential policy implications from this work?

Rodrik: I think it's full of policy implications. But we need to do the model selection and diagnostics right — to figure out how we match the circumstances to the most relevant model. As I said earlier, it's going to remain a craft, not a science. Most of the good economists who step into the public sphere and comment on actual developments have developed good judgment, but even then you won't see externalizing the mental process of how they got there. Why does Bob Solow know that this is the right way to think about this context? That knowledge doesn't necessarily percolate down to the rest of the profession, and it would be good if it did.

EF: Getting back to the main topic of Piketty's book, why should we be worried about income inequality in relatively developed countries? Surely we should be more worried about absolute deprivation, and you don't see much of that in developed countries relative to deprivation in a country like any in sub-Saharan Africa.

Rodrik: You might worry about it for several reasons. First is from the standpoint of economic efficiency, the extent to which inequality deprives individuals at the lower end of the income distribution from opportunities they otherwise would have made good use of. When you don't have access to assets and the relevant personal networks, which are two things that being poor deprives you of, it might be very difficult to develop your skills and talents.

You can also look at it from a broader social and ethical perspective as something that, as a society, we're not willing to put up with, that people are deprived of opportunities through no other reason but the luck of being born into poor families.

There's also the argument that inequality has very perverse effects on our political system. We know that the political system in the United States is much more sensitive to the preferences of the very rich than it is to the preferences of the median voter. And as that gap widens, the responsiveness of the political system to the vast majority of the population is significantly reduced. These are all serious problems.

Finally, equity at home and improved opportunities in the rest of the world might be mutually reinforcing. A highly unequal society will find it harder to maintain openness to trade and immigration. So I think one of the reasons to worry about inequality in advanced countries is precisely that it might make it more difficult to maintain in the future the kind of open economy that enabled other countries, like China, to do so well.

EF: What do you think are the big unanswered questions in international and development economics?

Rodrik: One big question is how best to use foreign aid. After tons of studies, we still don't have a very good handle on that. Another big question is whether industrialization will continue to drive growth in low-income countries the way it did in earlier generations of successful countries. In other words, will the future patterns of growth look the same as the older ones? And the third question, which I'm very concerned with, is the nature of the political regime and how it relates to economic development: whether we're moving decisively away from liberal democracy and what that's likely to do to economic performance.

EF: Are there particular regions of the world where you fear that this is happening?

Rodrik: I think many countries are looking to places like Russia and China as examples for the future. The Hungarian prime minister recently said that Turkey and Russia were his models. You have people coming out of China saying that Western-style democracy is unable to solve today's problems. That's worrisome. There is a lot of disaffection with the way liberal democracies have been functioning, and that's drawing people away from that political model. I worry that as we move into the decades ahead we're going to lose something that was gained in the Western world at a big cost, which is the creation of liberal democracies.

EF: How did you become interested in international development issues, and who were the most influential people in your development as an economist on these topics?

Rodrik: I became interested in international development because I came from another country and because that country is relatively poor. It was natural for me to be interested in that.

The people who've influenced me most are probably Carlos Diaz-Alejandro, the late economist from Yale and Columbia, because of the way he approached the problems of developing countries; Albert Hirschman, because of what he called "possibilism," the view that the world has many more outcomes than our deterministic theoretical perspectives might suggest; and also my dissertation adviser, Avinash Dixit, who is the best modeler and clearest mind I know, who has always been a model for me to emulate.

EF: How would you describe intellectual life at the Institute for Advanced Study relative to more traditional academic departments?

Rodrik: The main difference here, of course, is we don't have students. So that makes this place much quieter than the typical academic department. We compensate for that by having between 20-30 visitors every year in various stages of their academic careers, but across the entire spectrum of the social sciences, so it's a much more multidisciplinary environment. It can be very stimulating in its own way, but it's also isolating in that there aren't many economists around. In the end, I found it wasn't a very good intellectual fit for me, which is why I have decided to return to Harvard.


Dani Rodrik

Present Position
Albert O. Hirschman professor at the School of Social Science, Institute for Advanced Study
(Starting July 1, 2015: Ford Foundation Professor of International Political Economy, John F. Kennedy School of Government, Harvard University)

Other Positions Held
Rafiq Hariri Professor of International Political Economy, John F. Kennedy School of Government, Harvard University (1996-2013); Professor of Economics and International Affairs, Columbia University (1992-1996); Assistant (1985-1989) and Associate (1989-1992) Professor of Public Policy, John F. Kennedy School of Government, Harvard University

Education
Ph.D., Princeton University (1985); Master in Public Affairs (M.P.A.), Woodrow Wilson School of Public and International Affairs, Princeton University (1981); A.B., Harvard University (1979)

Selected Publications
Author of the books Economics Rules: The Rights and Wrongs of the Dismal Science (2015, forthcoming), The Globalization Paradox: Democracy and the Future of the World Economy (2011), One Economics, Many Recipes: Globalization, Institutions, and Economic Growth (2007), and Has Globalization Gone Too Far? (1997); articles have appeared in journals such as the Journal of Economic Perspectives, Quarterly Journal of Economics, and American Economic Review

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