Saturday, May 03, 2008

Economists' Disagreements, Part II

Here's another view on why economists disagree, this one from Dani Rodrick:

Non-economists are often baffled by the disagreements among professional economists on the issues of the day--from international trade to the minimum wage, from economic development to health policy.

I think the best way to understand the source of these disagreements is to recognize that there are two genres of economists. I call them "first-best economists" and "second-best economists." Here is my guide to them.

You can tell what kind of an economist someone is by the nature of the response s/he offers when confronted with a policy issue. The gut instinct of the members of the first group is to apply a simple supply-demand framework to the question at hand. In this world, every tax has an economic deadweight loss, every restriction on individual behavior reduces the size of the economic pie, distribution and efficiency can be neatly separated, market failures are presumed non-existent unless proved otherwise (and to be addressed only by the appropriate Pigovian tax or subsidy), people are rational and forward-looking to the first order of approximation, demand curves always slope down (and supply curves up), and general-equilibrium interactions do not overturn partial-equilibrium logic. The First Fundamental Theorem of Welfare Economics is proof that unfettered markets work best. No matter how technical, complex, and full of surprises these economists' own research might be, their take on the issues of the day are driven by a straightforward, almost knee-jerk logic.

Those in the second group are inclined to see all kinds of complications, which make the textbook answers inappropriate. In their world, the economy is full of market imperfections (going well beyond environmental spillovers), distribution and efficiency cannot be neatly separated, people do not always behave rationally and they over-discount the future, some otherwise undesirable policy interventions can generate positive outcomes, and general-equilibrium complications render partial-equilibrium reasoning suspect. The First Fundamental Theorem of Welfare Economics is proof, in view of its long list of prerequisites, that market outcome can be improved by well-designed interventions. Since they have given up on the textbook model, members of this group have an almost-infinite variety of "models" to choose from as they think of public-policy issues.

The first group's instinct is always to apply the first-best reasoning to the case, ignoring market imperfections in related markets, while the second group almost always presumes some market imperfections in the system. I am over-simplifying a bit, but not a whole lot.

Among commentators in the blogosphere, I think Gary Becker, Tyler Cowen, Greg Mankiw, and Brad De Long (more often than not) are first-best economists. In is commentary on globalization, Jagdish Bhagwati is an unadulterated first-best economist, even though his best scholarly work is solidly cast in the second-best mold. Meanwhile, the undisputed king of second-best economists is Joe Stiglitz. He is joined by George Akerlof, Bob Shiller, Alan Blinder (recently) and Paul Krugman (especially when he writes on deregulation and health policy, and increasingly, but not always, on trade). I am definitely in the second-best camp as well.

When first-best economists are taken to task for ignoring real world complications--i.e., second-best interactions--they provide a range of answers. One is to downplay the significance of these issues by arguing that they are not convinced of the presence of the market imperfections in question. Sure enough, empirical evidence is hardly ever strong enough to move prevailing priors.

A second argument is that the presence of additional market imperfections does not change the first-best logic; it simply calls for each market imperfection to be treated with its own first-best solution. This allows each expert in a field to propose first-best solutions in that field, leaving complications elsewhere to be dealt with by others. Larry Summers had a nice point to make about this approach in his comments on a paper on banking reform in China (Brookings Papers on Economic Activity, 2006:2):

Like experts in many fields who give policy advice, the authors show a preference for first-best, textbook approaches to the problems in their field, while leaving other messy objectives acknowledged but assigned to others. In this way, they are much like those public finance economists who oppose tax expenditures on principle, because they prefer direct expenditure programs, but do not really analyze the various difficulties with such programs; or like trade economists who know that the losers from trade surges need to be protected but regard this as not a problem for trade policy.

(Come to think of it, is Larry Summers a first-best economist or a second-best economist?)

A third argument is that the government could never get complicated interventions right, so we are better off sticking with simple solutions. I have discussed this type of argument in an earlier post.

So at the end of the day, these disagreements are often grounded not in economics per se, but in strongly held prior views about the world in which we live in. Which is why non-economists are right to get exasperated with us.

Here's Tyler Cowen's response.

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