A Rorschach Test for Economists

per Dani Rodrik:

I was visited today by a cabinet minister from a medium-sized, middle income country (which shall remain nameless for the purposes of this post). He explained that, among other challenges, he faces the task of attracting foreign investors to his country. He related the story of how he has just induced a large IT multinational to make a big investment by providing it rent-free space for 10 years on a public site. In view of the subsidy, he had to bring the finance minister on board. But he said that had not been a problem. The finance minister was happy to approve the benefit.

When you hear this story, which one of these two responses comes closer to how you feel about it:

A. Great! Another government gleefully wasting the public's money. When will those developing countries learn that you do not get ahead by distorting market forces. If the multinational needed a subsidy to be persuaded to come in, the social value it produces must be less than the social cost of the resources it will gobble up. Plus in this instance, the subsidy goes straight to foreigners.

B. How wonderful! For once a finance minister who understands that sometime you may need to grease the wheels of market forces to get you the kind of investments that you need. It may cost the budget money, but these kinds of things are the tonic on which growth depends. Economic development requires structural change, which market forces do not adequately reward. If this enables the country to set up a new IT hub, the policy will achieve its purpose.

Econ 101 says "A". In fact, pretty much all of the neoclassical tradition says "A". In fact, most Keynesian/Neo-Keynesians would say "A".

But those theories, as elegant and intellectually engaging as they are, do not account for the fact that "A" simply does not reflect reality in all cases. China, for example, is "breaking the rules" of economic orthodoxy by holding down the value of the yuan to boost terms of trade, therefore generating export-biased growth. The rise of economies all over SE Asia, in fact, demonstrates that Import-Substituting Industrialization -- coupled with high tariffs -- can help jump-start industries in the short term. The continued malaise of Latin America shows that persistent ISI policies are detrimental in the long run, but the lesson should be clear: governments can use artificial means to improve markets, at least in the short term. That this should be followed by eventual liberalization is a no-brainer. But in the short-term, governments can direct economies in profitable ways. It pains the libertarian slice of my brain to say so; but the reality-based slice of my brain (which is much stronger, thank you), reminds me that I may not deny the empirical reality.

This doesn't have to be done through central planning. It can be incentivized through tax credits or government investment.