Speech

Convinced By Commonsense -- Or Why We Need Economics, Keynote Address by Anne O. Krueger, First Deputy Managing Director, IMF

October 7, 2005

Good morning. I am very pleased to be able to join you today. Economic education is important—crucially important. That is why so many of you are here at this conference. And it is why I was so keen to be here. The NCEE and its affiliated organizations have a vital role in fostering the teaching of economics in our schools. And this conference, and other events like it, are important in encouraging that.

This morning I want say something about why economics is important and why, in consequence, economics education is vital.

The challenges facing economics teachers are daunting. There was some good news from the recent survey of what Americans know about economics which was conducted for the NCEE: nine out of ten Americans believe an understanding of economics is important. There was also some evidence that on some issues, understanding among both adults and students had improved when compared with the survey undertaken for the NCEE in 1999. Any progress is welcome, of course.

But the latest study underscored the extent to which many people still lack an appreciation of factors that directly affect them and their families. There is a widespread failure to realize the importance of a college education to future salary expectations, for example. Only two in ten adults and students fully understood what a difference to earning potential a college degree would bring. And only half of all adults—and even fewer students—know that savings kept under the mattress—or anywhere else at home—are at the greatest risk of losing value through inflation.

So the NCEE's Campaign for Economic Literacy is both worthy and worthwhile. Economic literacy—or the lack of it—has far-reaching implications both for the personal well-being of a country's citizens and for that of a country's economic policymakers as they seek to act in the best interests of society as a whole.

At the personal level, the more people understand about savings, income potential and other economic issues, the better they can look after themselves and their families; the better they are able to manage the earning and spending sides of their lives; and the better able they are to prepare for retirement. People need to understand the trade-offs they are making—between leaving school and starting to earn money in their teens and going to college in the expectation of a higher income in later life, for example. They need to understand how best to save money in a way that finds the right balance between risk and return for them so that they will have an adequate income in retirement—an increasingly important factor as people live longer and as our population ages.

But—and this is equally important—the more the population at large understands about economic issues, the more sensible and informed will be the discussion about economic policy issues affecting the national economy; and the better will be the policy decisions that are taken. Fewer than half of students—according to the NCEE survey—know what a budget deficit is. Only a quarter of students and fewer than half of all adults know what we mean by Gross Domestic Product. When such concepts elude many citizens, it is difficult for policymakers and political leaders to set out their arguments for specific economic policies in a way that offers a balanced assessment of the costs and benefits of a particular policy option. Instead, the economic policy discussion tends to be selective and unduly simplistic, often focusing on the short-term, and perhaps even erroneous, implications of a course of action.

Providing school students with a solid grounding in economics is, therefore, a vital public service. As individuals acquire a better understanding of the issues that can affect their own welfare, they will be better placed to make sensible decisions about their jobs, savings and pensions. And as those individuals acquire a better understanding of the role of incentives and trade-offs in the functioning of the economy, so they will be able to make a more informed assessment when confronted with competing public policy choices.

We can all agree that citizens—here in America but around the world as well—should have a better grasp of how the economy functions. But as all of us here know, setting an objective is one thing: achieving it quite another. Economics deals with the big issues which ought to make it easy to engage students.

About three months ago, a new Research assistant joined my small team at the Fund. Naturally, I asked him how he came to be interested in economics. This is a question that some stumble over, but he was quick to answer: and he was surprisingly clear about his reasons. He told me that while in his teens he had lived in China with a host family. He had witnessed at first hand the impact on everyday life of that country's rapid economic growth. Over a short period he had been able to witness people around him escape from a life of poverty. He had seen people acquire material goods, seen them become dramatically better off, find jobs, have enough money to eat. He wanted to study economics because he wanted to understand how the benefits now being enjoyed by a growing number of Chinese citizens could be spread around the world to those countries where the authorities have thus far not put in place policies conducive to rapid and sustained economic growth. Experience shows that without economic growth, significant progress in reducing poverty is not possible.

My young colleague got right to the heart of what we economists are about. Yes, we want to understand how the world works; how people behave; and how resources are allocated. But we want to do that because we want to understand how the rules, or laws or whatever we choose to call them, can be applied for the benefit of everyone. We want to raise living standards and reduce poverty -and as we have seen on our television screens in recent weeks, this remains a challenge even in some parts of a rich country like the United States.

But it is hard to teach young people about the concept of trade-offs and incentives, and the central importance of these concepts in shaping sound economic policies. Most young people are fortunate and grow up in homes where they do not perceive budget constraints; the opportunity cost of an alternative is not clear to them and it makes it difficult to teach a subject that starts with the proposition that "there is no free lunch".

The importance of economics

No aspect of life is untouched by economics—though it can be hard to convey its central importance in all our lives. Economics has things to say, and to teach us, about why some of us have enough to eat and why some of our fellow citizens go hungry, why some of us are gainfully employed and others cannot find a job. It teaches us about the importance of education, about taxation and government expenditures; about why some companies succeed and others go bust. It teaches us why some countries grow rapidly and others struggle to grow at all.

Economics provides the analytical framework to address the central issues that affect us all every day. It helps us to understand how scarce resources are allocated efficiently. It provides the tools to make rational judgments about trade-offs. Economics enables us to learn about public policy choices, sifting information and testing our conclusions in a scientific way. It allows us to make informed choices about how best we can achieve our objectives, whether those be concerned with our personal retirement pensions, our company's sales performance, our country's fiscal position, or the global effort to reduce poverty.

It is hard to overestimate the importance of—and the benefits that flow from—this analytical framework. Relying on commonsense or intuition will only get us so far. Economics helps us to identify truths that are counter-intuitive and beliefs that turn out to be wrong. Being able to marshal the relevant facts and analyze them is vital if we are to ensure that the choices we make, and the actions we take, are those that will best enable us to achieve our aims.

One area where we economists remain powerless is the weather. In recent weeks, we have witnessed the devastating impact of hurricanes in the southern United States—and I know that some teachers were unable to attend this conference because they were affected. As the New Year began, our television screens were full of pictures of the destruction causes by the Asian tsunami.

We may not be able to tame nature. But economics teaches us a great deal about the consequences of natural disasters—and what we can and cannot do to mitigate them. In the US and in Asia, the poor were the worst affected. They are least likely to be able to escape and they tend to live in the most vulnerable areas in the least well-constructed housing. The poor are most affected by the scarcity of resources: they cannot afford to take precautions against such disasters and yet they cannot afford to live elsewhere.

Being able to respond effectively to natural disasters such as these depends on being able to learn from previous experience. Evidence-based research and the tools of cost-benefit analysis enable us to make informed judgments about the best course of action. It's not just a question of marshalling the necessary resources to help those worst affected—it is a matter of ensuring those resources are used effectively to bring maximum benefit to those in need.

There is an understandable desire to respond rapidly when people lose their homes or their livelihoods, or both. Speed is certainly of the essence in the first phase of recovery when dealing with immediate humanitarian issues. Beyond that, though, it can often be a story of more haste, less speed: trying to do too much long term rebuilding too quickly can result in resources being wasted.

In January this year, shortly after the tsunami struck, I visited Sri Lanka and the Maldives, two of the worst-affected countries. The aim was to get a first-hand view of the scale of the disaster and assess what the IMF could do to help. We are not a recovery or development organization: our focus in such cases is in providing short-term financial assistance and advice on managing the recovery efforts in a way that does not conflict with broader economic objectives.

In the discussions I had during my Sri Lankan visit, the challenge of finding the most effective recovery strategy was highlighted. Part of the recovery plan then in its early stages—and later modified—called for rebuilding 80,000 houses in 2005. A laudable aim. But previously, only 5,000 new houses a year had been built in Sri Lanka in total. Trying to ramp up house building activity to this extent would have been eventually infeasible. It would have put enormous pressure on the supply of raw materials, thus pushing up prices. Trying to find sufficient workers would have driven wages up for construction workers. And that much construction could not have happened in such a short time.

When construction activity is intensified in this way, for whatever reason, shortages are inevitable. Experience has taught us that the consequence is that quite a chunk of the money set aside for this work would go not in more houses built—or roads repaired, or whatever it is we are looking at—but in rising costs as wages and raw materials prices inevitably rise to reflect the surge in demand and consequent supply shortages. However much we want to help in the wake of disasters, we need to bear in mind that there are capacity constraints: there is only so much that can be done in a short time. Economics provides the necessary context for recognizing this and ensuring that realistic and achievable goals are established, and alternatives are considered.

Similarly, economic analysis is an essential component of the fight against poverty—an issue much on the minds of finance ministers from the Fund's 184 member countries when they met in Washington a fortnight ago. Economic research has taught us a great deal about the causes of poverty and about the way to reduce it. By identifying the policies that have been proven to be effective in reducing poverty we can, in turn, encourage the adoption of appropriate policies in those countries where there has been little or no progress in reducing the number, or proportion of those living below the poverty line. Experience has repeatedly taught us that rapid and sustained economic growth has to be the basis of any successful poverty reduction effort. We know, too, that education has a vital role to play in helping people escape poverty and enjoy higher living standards; that measures to improve healthcare are also important. And, contrary to what we believed in the 1950s and 1960s, a stable macroeconomic environment—the charge of the IMF—is vital for attaining higher growth rates.

Globalization

Globalization has played a critical role in enabling rapid economic growth. Globalization is perhaps the most maligned economic issue of our times. The word itself evokes a visceral reaction. It seems to inspire anxiety in many people who regard the word as a synonym for lost jobs, falling living standards. The latest manifestation of this is the controversy over outsourcing: some critics of globalization would have us believe this amounts to the export of jobs from industrial countries to developing countries.

Economics helps us to see how globalization works and what its real as opposed to perceived consequences are.

The evidence of the benefits of globalization is overwhelming. It is not a new phenomenon, of course: even Marco Polo was following in a tradition of trade and economic interaction that stretched back thousands of years to the early Mediterranean traders. The nineteenth century saw the industrial economies grow rapidly as world trade grew and as economic relationships, especially among the industrializing economies, intensified. Britain—the first country to start the process of industrialization—continued to grow rapidly by the then historical standards. Between 1820 and 1900 real GDP grew on average by more than 2 per cent a year. The German economy grew even more rapidly-by 2.3 per cent a year. The U.S., where industrialization had started later, experienced average growth of more than 4 per cent a year over the same period. But population growth in these countries meant that real per capita GDP rose more slowly—by around 1.3% to 1.5% a year on average in all three countries.

The achievements of the nineteenth century pale in comparison with the rates of economic growth experienced in the second half of the twentieth century—achievements that owed much to the lessons learned from the disastrous beggar-thy-neighbor economic policies of the 1930s, which had contributed to the length and depth of the depression. As policymakers sought to resolve national economic problems, including widespread financial crises, they had done so without regard to the consequences inflicted on other countries by tight monetary policies, damping down domestic demand, and devaluation. Protectionist measures—including the Smoot-Hawley tariffs introduced in the US in 1930, and the British Imperial preference scheme—were aimed at protecting domestic economies from foreign imports, regardless of the damaging impact on world trade.

The founders of the postwar multilateral economic framework were determined to prevent a repetition of such mutually self-destructive policies. They recognized that sustained rapid economic growth was essential for reducing poverty and raising living standards for all, and that international financial stability and a multilateral trading system based on the principle of gradual liberalization were both pre-requisites for sustained growth. The Bretton Woods institutions—the IMF and the World Bank—along with the trading system established under the General Agreement on Tariffs and Trade—now the World Trade Organization—paved the way for a new era of global growth.

The multilateral framework with which we are now so familiar was successful beyond the dreams of its creators. The industrial countries achieved growth rates in the postwar period that surpassed anything seen in the nineteenth century. Between 1946 and 1973, for example, Japan experienced average real GDP growth of over 9 per cent a year. Yet even this seemed modest compared with the performance of some of the developing countries. From 1960, Korea experienced growth every decade that exceeded what Britain had achieved in the whole of the nineteenth century. For several decades, real Korean GDP grew by close to, or above 9 per cent a year on average. Between 1965 and 1990 real per capita GDP grew by an average of 7.1% a year—almost 5 times as fast as the main industrial economies managed in the nineteenth century.

Korea's achievement remains outstanding. But many other developing countries, especially some of those in Asia, achieved remarkable rates of growth. More recently we have seen India as well as China experience rapid growth over a sustained period.

And those growth rates have translated into improvements in the quality of life for people in nearly every country. In East Asia, for example, almost two hundred million people escaped poverty between 1987 and 1998. Worldwide, infant mortality fell from 127 deaths per 1,000 live births in 1960 to 55 deaths in 2002. But in developing countries, the improvement has been even more dramatic: from 142 deaths per 1,000 births in 1960, to 61 in 2002.

Life expectancy has greatly increased because of better nutrition, healthcare, and growth. In the early 1950s, life expectancy in the world as a whole was 46.5 years: today, it is about 65.4 years. In developed countries, life expectancy was already 65.6 years in the early 1950s, and is 74.8 years now. Yet developing countries have seen a much larger improvement: from 41.4 years in the early 1950s to 64.9 years now. In the early 1950s, people in industrial countries could expect to live about 24 years longer than those in developing countries. That gap has narrowed to about a decade.

These are impressive numbers. It is hard to see how people can argue that globalization has harmed people. The evidence clearly shows that the rapid integration of the world economy has dramatically improvement the lives of hundreds of millions of people around the globe.

Trade

Trade is a central to the process of globalization and is the subject of much misunderstanding. There is an enormous gulf between what many people believe and what the data tell us. We hear much talk—and always have—about the dangers of free trade and how it robs people of their jobs. Protectionists are always coming up with reasons why the government should stop Chinese textile imports, or Asian steel imports—you name it someone is against it. Firms seeking protection from foreign competition can easily marshal support by whipping up fears about job losses.

The strong feelings that trade arouses offer a good illustration of what I meant when I said that economics can bring clarity to issues where the answers are counter-intuitive. Opposition to free trade, and to lower trade barriers, derives from a combination of vested interests, fear, and from those who are well-intentioned but misguided about how economies function. As Adam Smith rightly said more than two centuries ago, firms want monopoly power. They don't want to have to compete if they don't have to. They want to preserve market share, and/or their profit margins. But firms may also genuinely believe they will be unable to compete and are anxious about their ability to survive in a more competitive environment.

Likewise, workers are often fearful for their or their neighbors' jobs. Foreign imports are often blamed for job losses. Buying foreign goods is sometimes portrayed as unpatriotic, even. Yet the truth is more complicated than might be obvious at first. Protectionists might claim that someone driving a Toyota or a BMW down the street is depriving an American car worker of a job. Leave aside for the moment that both Toyota and BMW have manufacturing plants in the US. Only 21.8% of Americans who work in the automotive industry actually work in the manufacturing sector. The rest work in the services side—garages, sales and so on. For almost four out of five car industry workers, then, the origin of the automobile is of little importance. And if foreign cars are cheaper, consumers can more easily afford more of them, and potentially this creates more jobs in the industry rather than fewer. Two and three car families are hardly a novelty these days, but were the ultimate sign of opulence fifty years ago.

Opposition to foreign competition derives from fear and uncertainty. Those who think they will be adversely affected are quick to articulate their concerns. Yet we know from long experience that as trade barriers fall, trade expands; new firms are created to meet export demand; and existing firms will also hire new workers as exports expand. What we don't know in advance is in where precisely these firms will start up, nor who their newly-hired workers will be. So the people who will gain don't know who they are in advance.

Experience also teaches us that the fears of firms and workers are often misplaced. In the 1970s, during a visit to Korea, I met one of the industrialists who had been a leading opponent of the remarkably successful economic reforms introduced from the late 1950s onwards. This gentleman's office occupied the whole of the top floor of his company's twelve-storey building. He explained to me that he had opposed the reforms because he feared that that his company would be unable to survive competition from imports. Protected by high trade barriers, in the 1950s he had been one of Seoul's most successful businessmen. In those days his twelve-storey headquarters had been the tallest building in the city.

He had been forced to adjust to competition from overseas, he admitted. A new cement factory had to be built that produced a higher quality and more competitive product. Korea by the time of my visit was a buoyant, booming economy. The businessman pointed out that a decade or more into the reforms his was no longer the tallest building—he was surrounded in every direction by buildings of 30 to 50 storeys. You could no longer see all of Seoul from his office windows. In relative terms, he wasn't as well off as he had been back in the 1950s—in the sense that there were now many other industrialists who were successful. But in absolute terms, he said, he was far, far better off than he had been in those days. His company and his income had grown much more rapidly than would have been possible without the economic reforms that Korea had experienced. He certainly thought that the reforms had been the right thing to do.

And this one businessman's success was mirrored across Korea. What had been one of the world's poorest countries in the 1950s had industrialized rapidly. Today it is one of the richest countries in Asia, a modern industrial economy. Open trade has brought huge benefits as every Korean will tell you.

I noted that opposition to free trade often comes from firms apprehensive about the impact of increased competition. But as Europe's trade policymakers have recently discovered, while some firms spend their time opposing more open trade instead of preparing for it, many companies have eagerly embraced globalization. As you may know, the European Union and China agreed on a voluntary system of controls for Chinese textile exports to Europe. China agreed to abide by strict numerical limits on what it could export to the EU countries.

What the policymakers failed to appreciate, however, was the extent to which European retailers had already placed orders with Chinese manufacturers. The result was an enormous and rapidly growing pile of textile goods at European ports, prevented from entering the supply chain. The retailers were furious—they faced the prospect of empty shelves in the run-up to the Christmas rush. The media quickly dubbed the row `Europe's bra wars' and there were red faces all round. The problem was solved temporarily by some juggling with the quota numbers, but there is a clear lesson here: globalization is with us and no amount of tinkering at the edges will stop it. Those who want to gain the most should embrace it rather than try to run away.

Unforeseen consequences

A good economist should refrain from ever saying: "I can hardly believe my eyes". A good economist never believes his [or her] eyes. A good economist is always suspicious of the obvious, and rightly so. There is often a significant gap between what people perceive to be the truth and what is actually the case. I've already mentioned car imports as one example. Another, equally topical, is how best to respond to rising oil prices. As we have seen the price of oil—and in turn the price of gas and domestic fuel—climb over the past year or two, what we learned from the oil price shocks in the 1970s has become relevant once again.

There are important differences between the situation now and then, most notably that in the 1970s, the principal problem was a supply shock: the rise in prices now is largely demand driven. Nevertheless, there are some important lessons from the 1970s that are worth bearing in mind.

We're already seeing pressure for energy conservation as the price of gas in particular climbs here in the US. But economics provides the analytical tools for ensuring that what seem like terrific energy-saving ideas actually are. Who now remembers the bright idea for making cars out of aluminum, for example? As gas prices surged in the 1970s, the idea of making cars out of a much lighter material was appealing: a lighter car would burn less fuel. Well yes: but making the aluminum in sufficient quantities would burn more energy than the lighter cars saved.

Considerable efforts went in to forcing manufacturers to make cars more energy efficient in other ways. Making catalytic converters compulsory on new cars seemed like a good idea. But by raising the price of new cars, more people were tempted to hold on to their older gas-guzzlers, casting doubt on the calculations about reduced gas consumption.

Similarly, in Athens and other cities, efforts were made to cut consumption and reduce pollution by restricting car usage: cars could only be used on alternate days according to the end number of their vehicle license plate. But circumventing that restriction was simple: people held on to older, less fuel-efficient cars when they bought a new car, so that they could drive every day.

Economic analysis enables us to assess such ideas and to learn from what experience tells us about the response to incentives.

In the 1970s, the conventional wisdom had it that demand for energy was relatively price inelastic—that no matter what the price, the demand would remain fairly constant. In the wake of the oil shock, many governments sought to keep prices artificially low and pursued accommodative policies generally, in order to reduce the burden on consumers. They were the countries that ultimately encountered the highest inflation, the most intractable fiscal problems, and energy consumption remained high.

In countries where governments let the market work relatively freely, it turned out that energy demand was very responsive to price. Energy efficiency rose most rapidly in these countries as individuals and firms adjusted their behavior to reflect the rise in oil prices. People bought more fuel-efficient cars, refrigerators, air conditioners and furnaces. They insulated homes and offices better. It now takes about one quarter as much energy as it did in the 1970s to produce a unit of GDP.

We are seeing policymakers confront similar challenges today. Faced with the rapidly rising—and unsustainable—costs of fuel subsidies, for example, the Indonesian government has recently announced significant rises in fuel prices to the consumer. The removal of subsidies is always unpopular, and it makes sense to use some of the budgetary resources to target aid directly at the poor. But it is not possible to shield people from market forces indefinitely: and there is plenty of evidence from a wide range of countries that government subsidies for whatever commodity always benefit the better off more than the poor. After all, the rich use much more oil, especially in poor countries.

Economic education

So economic education is vital. I used the word commonsense in the title of my talk quite deliberately. As you all know, I'm sure, everybody and his dog has a view on economic issues. As soon as you say what you do, people offer their opinions on everything from the price of gas to the level of unemployment. And these opinions are not tentative—they are proffered as obvious fact.

And they are often wrong, powerfully so. One of the things that the discipline of economics enables us to do is make balanced, and disinterested, assessments, based on the empirical data, as the discussion about globalization illustrates.

Good economics teaching, starting in schools, has a vital role to play in countering misunderstanding. The classroom is the one of the best chances we have to capture the imagination of students and to start to educate them about how the world economy works.

Economic policy in democracies cannot be imposed from above—it has to be done by consent, and rightly so. But that consent needs to be properly informed. People need access to the relevant facts and to have a framework for assessing them. They need a better understanding of the ways in which appearances can be deceptive.

The IMF has an important role to play in encouraging the adoption of sound economic policies that will result in more rapid, sustained growth and thus more rapid and sustained poverty reduction. Our very broad membership, along with our responsibility to examine the policies of our members on an annual basis, gives us a unique insight into which policies are most effective.

From our vantage point, we can also see how poor policies result in economic crises and weak growth. And we can see how opposition from powerful interest groups can thwart the good intentions of policymakers. We cannot instruct policymakers what to do, nor do we have many direct sanctions on those who do not heed our advice. But we can seek to persuade, and influence, based on what we have learned in other countries. And we can buttress the efforts of policymakers who confront opposition. The greater the understanding of economics and economic policy among the wider public the more policymakers will be inclined to listen to us.

There are some encouraging signs. We have seen, for example, a significant decline in inflation rates around the world and, in many countries, an accompanying rise in growth rates. Policymakers in many emerging market economies have taken steps to increase the potential rate of growth and to reduce vulnerability to external shocks. Even in Africa, the focus of so much concern about poverty and economic weakness, we have begun to see growth accelerate in countries where policy reforms have been introduced.

There is a long way to go before the further substantial reduction in poverty that we all want to see can be achieved in many of the world's poorer countries. But as the economics profession has learned more about what policies offer the best prospect of success, and as those lessons have been disseminated we can see where reform efforts have begun to bear fruit. The Fund is often regarded as principally engaged in the business of crisis resolution. But crisis prevention is a vital part of our work, and encouraging the adoption of sound policies is central to that.

Conclusion

Let me sum up briefly.

We live in an age of globalization: this presents huge opportunities and huge challenges. We know that sustained and rapid economic growth is the best, the only means of reducing poverty on a global basis. Globalization has made rapid economic growth attainable for those countries that embrace the benefits of closer economic integration and adopt appropriate policies.

The international community has an important role to play by encouraging the adoption of policies that will deliver more rapid and sustained growth, without which poverty reduction will not be possible. We in the IMF seek to provide support for countries undertaking reforms aimed at macroeconomic stability and more rapid growth. For its part, the World Bank provides development aid and support for reforms at the micro level. And the two institutions co-operate closely.

Critics of globalization seek to portray it as threatening living standards and undermining the fight against poverty—in spite of overwhelming and well-documented evidence to the contrary. By providing clear analysis of the issues, and making full use of the empirical evidence, the analytical framework of economics enables us to rebut the critics' arguments and highlight the benefits that globalization can offer all citizens in all countries.

But economics can only successfully achieve this if there is a greater understanding of economics issues among the wider public. This is why economics education is so vital. The NCEE has already highlighted the problem of economic illiteracy: it is a problem that can only be addressed in our schools and I commend the NCEE for the work it is doing in supporting teachers as they seek to improve economic understanding. We in the Fund are proud to be associated, in a small way, with the work you do and I wish you every success in the future.

Thank you.