In which two smart economists talk past each other

This back and forth between Brad Delong and Dani Rodrik makes me think economists are ill equipped to talk about the second best world in which we live.

Dani says that bad constitutions prevent the necessary flows of factors (labor and capital) to make free trade policy effective in getting us to the first best world (where market outcomes are efficient and we dance naked in the streets singing songs of praise to Milton Friedman):

The two situations are alike only in the limiting (and counterfactual) case where government-imposed tariffs are the only transaction costs blocking economic exchange across international borders. In reality, national borders demarcate political and legal jurisdictions, which means that there remain plenty of transaction costs which block economic convergence. Capital flows are hindered by sovereign risk and the absence of international regulation and lender-of-last resort functions, which create the kind of syndromes that I often discuss in this blog. Labor mobility is severely restricted. And differences in regulatory regimes impose severe transaction costs (estimated by Jim Anderson and Eric van Wincoop to be of the order of 40% in tariff equivalents) on international trade. In the presence of these transaction costs, free trade in goods (in the sense of zero import tariffs) is in general incapable of achieving rapid economic growth and economic convergence in poorer nations of the world. If you do not believe this, just ask the Mexicans.

Within this U.S., economic convergence is achieved because there is a common constitution, a federal judiciary, nation-wide financial regulation, and free flow of labor.

Rodrik concludes we’re stuck in a second best world where it makes sense to have restrictions on trade, via “industrial policy” (read: government control of the markets) in the developing countries.

Delong responds by quoting Lant Pritchett “there is nothing as catastrophic as state-led development led by an anti-developmental state” and adds:

Any argument to commit a government to an active protectionist industrial policy must be accompanied by arguments about why the government will be capable and effective in this role when it has not been capable and effective in its primary roles of establishing property rights, providing tolerable administration of justice, building infrastructure, and providing education.

Rodrik counters:

Brad DeLong does not express my views accurately… In the absence of these [free flow of factors], trade liberalization does not get you there. You are in a second-best world and you need to think appropriately. The idea that developing countries cannot employ industrial policy in such a world to good effect is downright silly…. Here is a thought experiment: does anyone really believe that China would have grown as fast as it did if it had removed all its tariffs and trade restrictions in 1978, instead of liberalizing strategically and sequentially–first in agriculture, than in industry, then on the export side, and only later in the 1990s on the import liberalization side? There are many reasons why the Chinese strategy worked, but one of them is that it protected employment while industrial capabilities were being built up.

Finally, Delong responds with a nice, long post about the immediate post-Mao economic policy of China. He describes the second best policies China put into place to jump start its amazing, so far, track record of economic growth.

Its important to point out that Delong isn’t conceding the point. He’s merely pointing out China is the exception that proves the rule. “Any argument to commit a government to an active protectionist industrial policy must be accompanied by arguments about why the government will be capable and effective in this role.” Delong has Deng Xiaoping as the hero that saved China from disastrous Mao era policy and made the Chinese government a credible force for development thus justifying its second best policies.

I think my Professor Woo would disagree (pdf). 72% of the work force was employed in unsubsidized agriculture when Deng instituted market reforms. These reforms, creating a non-state non-agricultural sector, unleashed normal economic development as peasants streamed into these new and profitable industries. Any pain from those reforms was masked by great increases in productivity.

Woo argues that growth occurred in China despite gradual reforms. Gradualism wasn’t a series of second-best policies, but it was a result of the political reality in China. Gradual reform was the compromise between old statists and the people that recognized communism wasn’t working. Perhaps growth, and the structural transition inherit in it, would have come faster with faster reforms.

Plus, with only 19% of the population in subsidized industries, there was no credible threat of “riots and revolution as the now-unemployed urban manufacturing workers overthrew the government.” The only credible political force was the millions of peasants (and their pitchforks). The Soviet Union, with 93% of its population in subsidized heavy industry, was a different story.

Deng may be a hero, but its not because he orchestrated some great path of reform. Rather, he had the “courage” to take the pebble out of the dam holding China’s economy back; holding the peasants in the countryside*.

China isn’t an example of a credible pro-development government being entrusted with an “industrial policy” filled with second best policies. It, like Japan’s recovery after world war 2, is an example of the power of millions of people freed to do their business as they see fit in an economy running much below its potential.

*Ok, with TVEs peasants didn’t really leave the countryside. But if you can’t bring the peasant to the city, bring the industry to the peasant, I always say.

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