How to get rich without knowing how: the paradox of development economics

1. How to get rich without knowing how:the paradox of development economics NYU College of Arts and Sciences Scholars’ Lecture October 6, 2009 William Easterly (Economics)

2. The paradox of development economics • Development does NOT require any one person (Expert, Leader, or Aid Official) to have a comprehensive understanding of how to achieve Development… • (sort of like how evolution happened on its own before Darwin) • …we development economists must accept this paradox to say useful BOTTOM-UP things; refusal to accept it leads to wrong TOP-DOWN advice.

3. Growth Ignorance

4. The Paradox meets the Political • THE PARADOX: 2 decades of growth research has failed to identify robust determinants of growth • The POLITICAL: Yet we economists are required to advise leaders how to achieve increases in growth for all countries. • Out of this contradiction comes the tragedy of misguided development economics.

5. Temporary high or low growth, moves back towards world average Change in growth from 1986-95 to 1996-2005 Previous growth rate (1986-95)

6. Why so ignorant about growth? • Temporary spurts of growth are bad news when most explanations of growth involve permanent factors. • 145 different variables found to “determine growth” (with approx. 100 observations). None were robust to sensitivity testing or new data.

7. Failure of specific attempts to raise growth • The “Big Push” of foreign aid to raise growth rates (50s through 70s) • Structural adjustment to raise growth (80s and 90s) • Shock therapy to reach high growth in ex-Communist economies (90s)

8. Predicted path of income of intensive-aid countries under top-down planning approach

9. Actual outcome of top down planning in aid-intensive countries

10. Everyone confesses ignorance • Barcelona Development Agenda (2004) -- Blanchard, Fischer, Krugman, Rodrik, Sachs, Stiglitz : “there is no single set of policies … to ignite sustained growth.” • “experience …frustrated the expectations …{that} we had a good fix on the policies that promote growth.” (Rodrik 2007) • “in real life it is very hard to move the permanent growth rate; and when it happens… the source can be a bit mysterious even after the fact.” (Robert Solow, 2007)

11. Spence Growth Commission (World Bank) 2008 • Had $4 million budget. And the answer is: • “It is hard to know how the economy will respond to a policy, and the right answer in the present moment may not apply in the future.”

12. Why so unable to explain growth?

13. Some predicted the unpredictability of growth • Friedrich Hayek: “The growth of reason is based on existence of differences. . . .{between} individuals, possessing different knowledge and different views. [I]ts results cannot be predicted . . . . [W]e cannot know which views will assist this growth and which will not.” • Development is BOTTOM-UP outcome of lots of unpredictable individual successes and failures.

14. Growth is innovation! • Cannot predict innovations or they wouldn’t be innovations! • Innovations behave a lot like random shocks, like coin flips! • Unpredictability of growth is a testable hypothesis just like unpredictability of the stock market. We have already seen from nearly 100% mean reversion that we cannot predict future growth from past growth.

15. Growth as innovation: it is surprising where growth will come from • Who would have predicted cut flowers in Kenya (40% of European market), • or women’s cotton suits in Fiji (42% of the US market)? • Or that Egypt gets 30 percent of its manufacturing exports from bathroom ceramics, of which 93% goes to Italy? • Public goods (health) also draw on individual innovation, like (accidental) invention of penicillin • Social entrepreneurs in aid: discovery of oral rehydration therapy to prevent infant deaths from diarrhea; microcredit.

16. If innovations are unpredictable, why do we think we know more than we do? • Biases about randomness: • Explanations bias • Leader bias • Success bias • All of these biases favor TOP DOWN rather than BOTTOM UP

17. Kahneman-Tversky biases about how we treat randomness • The myth of the “hot hand” • interpret hot streaks as better performance even when they are really random • “growth miracles” defined by a hot streak • We spuriously EXPLAIN them with “great leadership” or some policy

18. Related Kahneman-Tversky bias • “Law of small numbers” • Making too much of too few years for “secret to success”, when a small sample will have a HUGE random component. • Example: After one good harvest, Malawi confirms wisdom of fertilizer subsidies! • Example: a few years of high growth: Mozambique miracle – Great President Chissano • It’s too easy to find “small numbers” cases to “prove” or “disprove” a case for your favorite policy X, or for a leader.

19. Experiment: rats and humans shown a light that randomly flashed either red or green, red twice as often; asked to guess what will flash next Rats followed optimal strategy of always guessing red. Humans thought they saw “hot streaks” of green so sometimes guessed green. “Our desire to see patterns in randomness allows us to be outsmarted by a rat.” Mlodinow Do Rats understand Growth better than Economists?

20. Attributing intentional skill to random outcomes • Experimental subjects watched two people who were rigged to perform the same. • The subjects know one of the two gets a payment, which one is determined by coin flip. • After payment, despite the subjects’ knowledge that the payment was random, they gave better grade to the one who received the payment. • We do the same with Leaders and growth rates.

21. The leadership bias in growth analysis • The Spence Commission after all the studies were done: “Growth at such a quick pace… requires strong political leadership.” • “Framework” prepared before the Studies said: “Economic growth requires: Leadership.”

22. The “success” bias • Drivers of Lamborghinis at 150 miles an hour on I-95 from NY to DC arrive in DC from NY in less than 2 hours • In DC, observing only these “successes” leaves out the majority of Lamborghinis who crashed in flames along the way. • performance of hockey moms driving minivans from NY to DC is better.

23. Example: Dani Rodrik on industrial policy • Dani Rodrik:“the countries that have produced steady, long-term growth during the last six decades are those that promoted diversification into manufactured … goods” • So Dani concludes, developing countries should have “real industrial policies.”

24. The problem is mixing up our probabilities (very common bias) • Dani is calculating wrong probability (If successful/Then you have industrial policy)! • Correct Probability (If have industrial policy/Then successful). Low with failures in Africa, Latin America, Middle East, $6 billion Nigerian Ajaokuta steel mill that never produced a bar of steel. • Analogous to : Probability(If you win big in Vegas/You Bet Large Sums at Long Odds) is HIGH – casino owners want you to focus on this probability. • Correct Probability (If You Bet Large Sums at Long Odds/ you win big) is LOW, so don’t bet your life savings! • Industrial policy may be disastrous on average but a few successes at long odds

25. How explaining growth despite growth ignorance led us to wrong approach to development

26. The question that always comes up in discussions of world poverty: What must we do to end world poverty?

27. Answer: that question only makes sense in an approach to poverty that will not end poverty • First, who is “we”? “We” must have power to implement “the answer”, so “we” must be authoritarian leaders (AUTHORITARIANISM) • Second, “we” could not allow poor people to choose their own paths, because “we” already know the “right answer” for THEM. (PATERNALISM) • So this question only makes sense in authoritarian paternalismapproach to development, which we have seen didn’t work

28. The myth of the “man in charge” • We act in our “growth advice” like there is somebody all-powerful in charge (reinforced by leader bias) • But there is nobody in charge of a complex economy, leaders have only a limited, partial, often unintentional effect. • The only effect of our “man in charge” myth is to improve the reputation of dictators.

29. Legacy of the Depression: Development Economics refused to accept Bottom-Up, preached Top-Down • Depression led to view: “economic development not spontaneous, as in the classical capitalist pattern, but consciously achieved through state planning.” (UN History) • Nobel Laureate Gunnar Myrdal (1956): “the alternative to making the heroic attempt is acquiescence in economic stagnation which is politically impossible …this is why [planning] is unanimously endorsed by experts in the advanced countries.”

30. Reliance on “invisible hand” a small minority viewpoint in birth of development economics • South African economist Herbert Frankel (1951): “development depends NOT on the goals and enforced decisions of planners, but on the piecemeal adaptation of individuals to goals which emerge but slowly … as they themselves become aware, in the process of doing, of what can and ought to be done next.” • TOP DOWN Myrdal got the Nobel Prize, BOTTOM UP Frankel was completely forgotten.

31. Planning Approach continues today in development aid • the World Bank today requires 70 poor country governments to submit “Poverty Reduction Strategy Papers” -- PRSPs. • “define medium- and long-term goals …capture disparities by social group, gender, and region. …. … take into account … the expected contribution of policy actions to the attainment of long-term goals and intermediate indicators. ….” (Sourcebook on World Bank PRSP web site today)

32. The expert alternative today in academic development • “We formulate … “growth diagnostics”: how can we discover the binding constraints on economic growth in a specific setting, and then how do we come up with policy solutions that are cognizant of local second-best interactions and political constraints.” (Dani Rodrik 2008)

33. Government in Bottom-Up View • Of course, governments are necessary to provide public goods like health and infrastructure. • But democracy means holding governments accountable from the Bottom Up for providing quality public goods

34. But don’t we need experts to design democracy & other institutions? • “The value of freedom consists mainly in the opportunity for the growth of the un-designed … freely grown institutions.” (Hayek) • Changes in institutions also emanate from the Bottom Up, e.g. William Lloyd Garrison, Frederick Douglass, Susan B. Anthony, Alice Paul, Martin Luther King Jr., all campaigning for more individual equality and rights. • One thing those who understand BOTTOM UP can do is campaign for IDEALS and PRACTICE of individual equality and rights.

35. Why economists can say something useful after all

36. Optimal response to “law of small numbers” • Get more numbers! • Research has shifted to explaining per capita income levels rather than growth rates • Log of per capita income is the sum of all previous percent growth rates – that takes us away from misleading “law of small numbers” to the true power of “law of large numbers.”

37. Free market institutions from values/norms Regulation supportive of Free Market Regulation hostile to Free Market Collectivist norms Value individual rights

38. Democratic institutions from values/norms More democratic Less democratic Collectivist norms Value individual rights

39. Development and values/norms More development Less development Collectivist norms Value individual rights

40. What about China? • Economics is not exact science – ONE counter-example does not disprove a hypothesis • Relative lack of individual freedoms in China correctly predicts low level of income today in China (less than 1/10th of US)— • --Because growth is so volatile, we cannot be confident that high Chinese growth will persist so as to overtake US under current Chinese system— • China may possibly show the effect of a positive CHANGE in individual freedoms on BIG CHANGE in per capita income (but it’s only one observation so this is really untestable)

41. Intuition for BOTTOM UP • If “growth experts” at the TOP don’t how to raise growth… • …then best system is BOTTOM UP where problems solved by INDIVIDUALS with local feedback and incentives to fix problems. • Individual rights…where any individual can seize any opportunity • Free markets … problems are profit opportunities that entrepreneurs will fix • Free, competitive politics … problems are opportunities for political advancement, which political entrepreneurs will fix.

42. Friedrich Hayek saying more poetically what I just said: • “It is because every individual knows so little and… because we rarely know which of us knows best that we trust the independent and competitive efforts of many to induce the emergence of what we shall want when we see it."

43. Everything you need to know you learned in kindergarten • Economics common sense stood the test of time: • “Invisible hand,” individual rights, comparative advantage, gains from trade, democratic accountability • These all lead to common sense recommendations: don’t interfere with markets or trade too much! Don’t expropriate private property! Find out what public good voters want and give it to them! • Also advice for all of you: find your own comparative advantage, exploit gains from specialization, fix very specific problems, let other individuals worry about other specific problems.

44. Bottom Up Hope! • Bottom Up Development is hopeful because instead of all depending on a few at the TOP, we all at the BOTTOM can contribute.. • …you could discover penicillin, or oral rehydration therapy, or microcredit …or the iPhone. • the up side can be (and has been) so large for entrepreneurs from the Bottom Up