Debate among economists about the $700 billion Paulson plan reveals a deep divide between realists and fundamentalists. If economists and policy makers pay attention to how the tension between these two positions plays out in this particular debate, it will help us know how to deal with it in other areas, including development.
The formal, model-based approach of the fundamentalists has contributed much to progress in economic analysis. At key junctures, it has also made important contributions to policy. The challenge is to maintain an intellectual environment that leaves space for a conversation with realists as well. In complicated policy contexts where models don't yet capture key forces, the realists have much to offer both policy makers and fundamentalist modelers. By giving voice to observations that strike realists as obvious but that are not accepted in conversations dominated by fundamentalists, the report by the Commission on Growth and Development could encourage a richer, more open debate about the policy options for poor countries.
Realists and Fundamentalists
The financial crisis provoked three open letters to policy makers. Fundamentalists opposed the plan (here.) Realists supported the plan (here) or supported more discretionary powers for dealing with the crisis without endorsing any specific plan (here.)
A quick look through the lists of economists who signed the various letters shows that the camps do not separate cleanly along the familiar lines of left-versus-right or active-versus-limited government. The key difference lies in the relative weight each side gives to formal models as opposed to judgment.
Fundamentalists have an unswerving faith in models. Policies should always be derived from the best available model. Data should be filtered through a model. If an observation does not fit within the context of a model, it should be excluded from consideration.
Realists are more conscious of the limits of models and more comfortable with a division of labor between the researcher who improves the models and the clinician who makes policy decisions. They recognize that the power of models comes precisely from a commitment to abstraction that filters out potentially important complexity. They believe that useful evidence can accumulate with direct experience as well as through the research process of testing and refining models. They believe that researchers should consider the possibility that the fault lies with the model when its predictions diverge from clinical judgment and that policies should draw on both sources of evidence.
Many times, the confidence fundamentalists have had in abstract models turned out to be well founded and the objections raised by realists who were more focused on details were misplaced. The fundamentalists were right that an airline industry could still function even if airlines could set their own fares; that people could still talk to each other even if they purchased phone service from different companies. The realists pointed to all the complicated details that arise in such markets, details that simple models could not capture. Fundamentalists, correctly, ignored the detail and pushed prescriptions based on the textbook model of competition.
Other times, the models are missing something that is too important. In the study of macroeconomic fluctuations, real business cycle theorists and their descendants, the dynamic stochastic general equilibrium modelers, are the quintessential fundamentalists. Their models are a useful way to make research progress, but in macroeconomic policy making, the great depression, which these models cannot explain, is a decisive data point warning us that the models are incomplete and have to be supplemented by clinical judgment.
The Financial Crisis
In the current crisis, the astonishing and unexpected consequences of the Lehman Brothers bankruptcy should serve as a similarly decisive data point. On the Thursday and Friday before Lehman filed for protection, I was at a conference on the financial crisis. Everyone there expected them to file on Monday. We repeated for each other all the fundamentalist arguments: "Everyone had been given time to prepare." "The courts handle bankruptcies all the time." None of us expected that putting Lehman through a court managed bankruptcy would be much different from arranging a forced sale of Bear Stearns.
We were all wrong. Within days, AIG was insolvent. Runs were developing on Goldman Sachs, Morgan Stanley, and the entire money market fund industry. Banks had stopped lending to each other in the Fed Fund market. Rates on Treasuries approached zero.
In response, the Treasury, Fed, and market regulators took drastic steps that the fundamentalists would surely have opposed had there been time for debate. Together, the Fed, Treasury, and the SEC arranged an emergency capital injection into AIG, guaranteed all the liabilities of money market funds, banned short sales of stock in financial firms, and injected massive amounts of liquidity into the banking system. Looking back, it appears that they had enough sand bags to hold back the flood and stop the panic, but perhaps just barely enough.
This is not a data point that can be dismissed as an outlier. It is the kind of observation that should make the fundamentalists just a bit less confident in their models and a bit more willing to listen to the realists who are willing to defer to the policy makers on the front lines.
The Commission's Report
As the report implies (read the overview here), there is a fundamentalist model of developing countries. It has an implied policy prescription captured in the familiar phrase "stabilize, liberalize, privatize."
There is an observation that should do for development what the great depression does for business cycle theory and what the panic in the days after the Lehman bankruptcy should do for finance. The report wisely leads with this fact. Some nations have grown for decades at historically unprecedented rates of growth. China is the extreme case in this set, as the largest economy and the one that has grown fastest, so it naturally attracts the most attention. It is not, however, the only one, and they cannot simply be dismissed as outliers.
The fundamentalist models that would justify the "stabilize, liberalize, privatize" prescription don't generate sustained growth at these rates. These models all emphasize accumulation of human and nonhuman capital, and stocks of inputs can't grow fast enough to generate growth at these rates. It could be, as the fundamentalists sometimes suggest, that these very fast growing economies are privatizing fast enough to get big temporary gains from steps like privatization that remove distortions, but in the cases that the commission point to, rapid growth lasts too long for this to be plausible.
Moreover, if we will listen, as the commission has done, policy makers will tell us what they think is going on. To cite one point taken up in the report, inflows of technology by foreign firms are crucial to rapid growth. With appropriate subsidies, countries can encourage this inflow. An exchange rate regime that makes the country an attractive base for manufacturing goods for export may be an important second-best subsidy that can achieve this goal. Directed credit or other forms of industrial policy may do so as well.
These are not deep points. They have been made before. Of course, they immediately suggest the standard point, which the report makes very clearly: good policy requires good governance. Little of this, however, has been taken seriously enough by mainstream fundamentalist academics. In these circles, discussions of industrial policy or structural exchange rate policies are still disreputable (or perhaps dangerous,) so the possibility that effective governance combined with activist policies can lead faster growth than passive policies is not given serious consideration.
By listening to the realists and taking what they say seriously, the report has the potential to change this equilibrium. Realists and fundamentalists will have much work to do before they agree about whether exchange rate policies or explicit forms of industrial policy work can be beneficial for growth, but at least they begin a conversation that is more productive than the "don't ask, don't tell" status quo.
models with unrealistic assumptions
There are so many economic models which discount the role of important variables (that matter much more in reality than those considered in assumptions) just because these variables complicate the standard models. Does this mean that a lot of economists have been spending time working on unrealistic models filled with unrealistic assumptions?Also, without models it is hard to decisively conclude or prescribe policies. Where can we draw the line between realism and fundamentalism in economics? I feel that models are as real as it can be until they are proved otherwise by unprecedented events like the current financial crisis or the Great Depression or the events in 1970s. But this aspect is hardly emphasized in the economics class we take in college. I wonder, why?
It is much too early to say who is who!
Absolutely all signatory are most probably convinced they are fundamentally realists, and it is much too early to know on what side of history any signatory is finally going to come out on. Though it has mostly been described as a bail-out plan, given that it is hard to envision anyone daring to carry an instrument on a balance sheet at a price much higher than that resulting from a government sponsored bail-out reverse auction, teh plan could just as well end up removing some shade of blissful ignorance and thereby result in the ultimate take-down plan. Was this to occurr I expect we would see a lot of reversals of roles.
Here's one test
In this case, the fundamentalists were ones who said that we can rely on standard measures like bankruptcy for Lehman. Realists were ones who said that given the unusual conditions that prevailed, it was too risky to let them go into bankruptcy. By these criteria, most of the people who signed the letter opposing the Paulson plan were probably fundamentalists. Remember, the realists were the ones who said that given the complexity of interconnection, a competitive market in telephony would never work. Fundamentalists were the ones who said that they didn't know precisely how, but they were sure that market competition would work just fine even there. So it is not true that everyone wants to be called a realist. Or that realists are always right or more sensible. My point was that fundamentalists should listen to realists and they should put more weight on what they say when predictions based on the fundamentalist models are turning out to be wrong.
About that competitive market in telephony
I'm an amateur in this field, with an engineering perspective. I'd like to suggest a reason why a competitive market in telephony ultimately worked (and there were hiccups). The reason is that there were tight feedback loops involving millions of customers with very clear service expectations, and a carefully engineered infrastructure that had a solid track record, maintained by thousands of experienced and knowledgeable engineers who knew the difference between marketing hype and a working product.
The trouble with the current situation is that there has been so much smoke and mirrors and leverage involved. Things had to get pretty bad before people woke up and the lies wouldn't fly any more. For quite a few years there was lots of running room for self-deception, complacency, and fraud.
(That said, even network-based technology industries are being pressed by these kinds of forces. Just look at the foolishness in the late stages of the DotCom boom, what happened to WorldCom, the blizzard of spam and malware on the Internet, etc.)
It is worth reading Malcolm Gladwell's New Yorker piece (The Talent Myth) of a few years ago about Enron and the importance (or lack thereof) of sheer "talent" in prospective managers. An excerpt:
The broader failing of McKinsey and its acolytes at Enron is their assumption that an organization's intelligence is simply a function of the intelligence of its employees. They believe in stars, because they don't believe in systems. In a way, that's understandable, because our lives are so obviously enriched by individual brilliance. Groups don't write great novels, and a committee didn't come up with the theory of relativity. But companies work by different rules. They don't just create; they execute and compete and coördinate the efforts of many different people, and the organizations that are most successful at that task are the ones where the system is the star.
As Gladwell makes clear, an essential component of managerial systems that work and keep working is healthy and tight feedback on results and risks. It seems that the emphasis in the credit derivatives market has been on the putative protection from risk offered by these instruments. To the extent that their availability helps people delude themselves as to the risks they are in fact running, and undermines traditional discipline in monitoring risk, there is guaranteed to be trouble down the line. That is what we are facing now.
Free market fundamentalists will say that markets correct themselves. Well, sure, if you settle for a sufficiently brutal definition of "correct". The same could be said of overpopulation; sooner or later it will "correct" itself. A democratic society has a right to ask for, and get, more than fatalistic acceptance of massive failure, collapse, and promises of eventual recovery or reconstruction of its vital underpinnings.
Fundamentalists, Realists, and Skeptics
There is a great deal of truth to the division of economists into fundamentalist and realist camps. And this distinction undeniably has some explanatory power for the lists of economists who have signed dueling letters to Congress about the Paulson plan. But I place myself very strongly in the realist camp, and yet I signed the initial letter. Maybe I am just a stochastic error in Paul's model, but I have an alternative explanation: I think of myself as a skeptic first and foremost. I am deeply skeptical of DSGE models (which fundamentalists worship). But I am also skeptical of handing over such enormous power to one person with very little accountability, ESPECIALLY if the plan for spending that money does not make any kind of sense to me. I think you will find that there are a good many signers of the original letter who would resist being lumped into the fundamentalist camp. So I think you need at least one more explanatory variable.
Not persuaded
Chris, I see your point, but think that it is a useful exercise to stick to a one factor model but let people switch sides. It is possible for someone to be a realist about the great depression but a fundamentalist about bankruptcy and moral hazard. Before the Lehman bankruptcy the test I outlined in response to Per implies that you and I were both fundamentalists. Or perhaps I should say that we both adopted the fundamentalist position when we contemplated the Lehman bankruptcy. We weren't alone. As I indicated, every academic economist I spoke to was adopting this position. A Lehman bankruptcy, we thought, would not cause big problems and was preferable to an arrangement that the ones used Bear Stearns or Fannie and Freddie that required more explicit government intervention. Personally, I switched sides when I saw how much damage the Lehman bankruptcy did and how quickly the damage was accumulating. If my prediction was so wrong, it seemed to me that the time had come to place less trust in the models and to listen more carefully to people closer to the front lines who were raising alarms. I switched to support for giving Bernanke and Paulson all the firepower they asked for because I thought the increased risk of a financial panic that we would run if we didn't far outweighed any risks from spending the resources in the wrong way or from giving Paulson too much discretion.