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Are economists in love with tough love?

Aug 09,2021 - Last updated at Aug 09,2021

CAMBRIDGE — Mark Twain purportedly said that “History never repeats itself, but it rhymes”. Typically, however, what rhymes is not the underlying historical facts but the narratives we construct around them. The stories we tell about the world repeat some basic ideas that may not necessarily be true. But we like to believe that they are because they make the world more intelligible and morally certain.

The standard education of economists is a case in point. Beyond individual theories, the profession possesses a long list of rhymes. We recognise their metre and can guess when and how they end, because we know the previous stanzas and also know that the next phrase needs to rhyme with them.

Consider Adam Smith’s invisible hand, according to which we get our dinner from the butcher and the brewer because of their self-interest, not their generosity. The market can turn their private vices into public virtue. So, greed may not always be bad.

Conversely, good intentions may sometimes pave the way to hell, which is why many economists argue the world needs the kind of tough love that people dislike in the short run but is good for them in the longer term. Specifically, competition allows the more able to triumph over the less able, thus “freeing resources” that the winners can put to better use. On this view, any attempt to prevent competition from doing its thing — such as a garment industry fighting cheaper Chinese products, farmers opposing food imports, or taxi drivers protesting against Uber, will inevitably make people poorer.

For example, attempting to ensure that everybody has a minimum amount of land to live on would inevitably be inefficient. Not all farmers have the same ability, and the world will be better off if the more successful ones get more land and the less productive find other jobs. Likewise, economists commonly regard the plethora of small businesses in much of the developing world as a consequence of, you guessed it, insufficient competition. If competition was tougher, all these small, inefficient firms would fold, and their owners or employees would get jobs with better, larger companies.

The reason why this does not happen automatically, through the market’s invisible hand, is that some people are up to no good. They seek protection instead of competition, rents rather than productivity, and privilege rather than a level playing field. Economists are called on to confront these interest groups for the purpose of protecting the common good. After all, there is nothing like a bit of moral certitude to underpin righteousness and strengthen the ethical spine of tough lovers.

This, in short, is the story told by, among others, the Nobel laureate economist Edward Prescott and Stephen Parente, as well as many of their students. The narratives are repeated so frequently that many economists simply sing along to the rhyme, even though life may be somewhat more complicated.

At the core of many of these narratives is the assumption that people and firms are heterogeneous: some are more capable than others. But this heterogeneity is taken to be exogenous, or somehow determined outside the story. The invisible hand’s task is thus to improve the allocation of resources by putting more of them. including land, labour and capital, under the control of the more capable. That way, resources will go to those able to generate the biggest return, and the world will be richer as a result.

It is easy to see how a slight change to the story may introduce dissonance and break the rhyme and moral certitude. First, what if heterogeneity was not so exogenous? Maybe some people are more capable today because they have had access to better education, acquired more experience, or benefitted from higher-quality infrastructure.

Providing laggards with the same opportunities may improve their performance, too, and make countries better off as a result of higher and broader-based productivity. But this would require investment in backward regions, enough time for people to become more productive through experience, and possibly even assistance in adopting and adapting technology. In short, it would require love that is tender, not tough.

Second, what if capital and labour are not so mobile? Maybe the capital that needs to be reallocated is tied up in land or factories, and cannot be moved. Or maybe people in the area speak a different language, which they value, and are embedded in a complex web of local social relations that makes it difficult for them to move.

Wiping them out of the market through competition, far from improving resource allocation, may actually worsen it. Farmers, for example, would lose their sunk investments and become unemployed, wasting both capital and labour. A better policy would help improve these people’s access to technology and markets. But this, too, calls for tenderness, not tough love.

East Asia’s successful agrarian reforms did not simply permit resources to flow a priori to more capable people, but instead empowered farmers with land, credit, and infrastructure, as well as access to inputs, markets, and extension services. And as digitisation efforts such as Colombia’s Fábricas de Productividad have shown, helping firms in other sectors adopt and adapt technology can enhance their prospects.

Tough economic love definitely has a place in today’s world. But economists may currently be overusing this default rhyme, attributing to a lack of discipline outcomes that may instead result from insufficient solidarity and concern. If they are not careful, their unconditional love for tough love will often end in useless and avoidable tears.

 

Ricardo Hausmann, a former minister of planning of Venezuela and former chief economist at the Inter-American Development Bank, is a professor at Harvard University’s John F. Kennedy School of Government and director of the Harvard Growth Lab. Copyright: Project Syndicate, 2021. www.project-syndicate.org

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