Economists study the world through the lens of incentives, and have developed a rich understanding of how market participants make decisions. But although incentives are important, developing countries must do more than institute the right ones.
You don’t have to be a neuroscientist to understand that your brain determines what you see at least as much as the objects of perception do. But if you are an economist, your mind has been trained to see the world through the additional layer of incentives.
Incentives are everywhere, and economics has developed a rich and subtle conceptual framework for understanding all the ways in which they might get distorted. We talk about moral hazard, adverse selection, common-pool problems, agency problems, externalities, rent-seeking, excludability, rivalry, and market power. With these concepts, economists can explain why someone might do too little of a good thing (like investing, working, or providing public goods), or too much of a bad thing (like taking reckless risks or polluting). Viewed this way, most problems in the world can be attributed to distorted incentives.
But an old proverb cautions against seeing every problem as a nail just because you are holding a hammer. Though economics can capture many of the subtleties of incentives, it has developed a relatively narrower palette with which to describe capabilities and how they grow. But capabilities clearly matter. If someone is not doing something that we as a society value, it might be because they can’t, not because they don’t want to. This weakness in economics has far-reaching implications for our understanding of economic growth and development, which is fundamentally about the social accumulation of productive capabilities.
Whereas incentives affect the choices one makes among the options one faces, capabilities determine which options are available. Economic growth and development are about the expansion of those options and hence depend fundamentally on policies that catalyze or facilitate the accumulation of capabilities. Yet, owing to the exclusive focus on incentives, economists and policymakers end up searching only for nails.
For example, when asked what can be done to boost a country’s exports, economists tend to look for disincentives to export. Perhaps trade protectionism is causing firms to prefer the profitable domestic market over more competitive and risky export markets. Perhaps import tariffs are raising input costs, making exports less profitable. Maybe cumbersome trade policies and customs procedures are adding transaction costs. Or maybe high transport costs have become a hindrance. Not surprisingly, all of these incentive-based factors are included in the World Bank’s Doing Business Index and in the World Economic Forum’s Trade Facilitation Index.1
Seldom do economists studying this question consider whether a country has the capabilities needed to produce the right products of the right quality. Would policies to lower trade protections and reduce transport costs enhance that capacity? Or would increased competition in the domestic market impede industrialization and weaken the ability to negotiate with foreign companies? Without a view on how such policies affect the accumulation of capabilities, they cannot even be properly assessed.
Similarly, when asked why so much of employment in emerging and developing countries is in micro-firms – that is, the informal sector – the obvious answer, as Santiago Levy of the Brookings Institution argues, is that the government, through taxes and subsidies, has made it advantageous to remain small. But can’t the problem also be explained by micro-firms’ lack of access to the capabilities needed to grow, or to large firms’ lack of access to distant workers?1
To expand their capabilities – and thus their options – countries and firms need to learn to do the things they don’t yet know how to do. And yet, one can’t learn to do the things one does not do simply by doing them. One cannot acquire experience doing things that one does not do.1
How can a country escape this conundrum? An obvious first step is to bring in people or firms that do know how to do these things. Many studies have shown that immigration, diasporas, foreign direct investment, and even business travel are important factors in the growth of domestic capabilities. Policymakers need to ask whether countries are doing things (or not doing things) that may be limiting (or enhancing) these potentially transformative channels.
Moreover, what matters is not only the diversity of individual skills but also the local availability of suppliers or customers, especially for inputs or products that cannot be easily shipped. Again, these factors depend on the structure of the existing business ecosystem that firms take as given. And that ecosystem, in turn, is a reflection of the previous accumulation of capabilities, including those acquired by the government and used to provide specific public goods and regulations. Markets alone will not lead a country to adopt electricity, high-speed rail, safe vaccines, and mobile banking; willing and able governments must step in to guide the process.
In sum, capabilities exist at different levels – from individuals and firms to value chains and whole ecosystems comprising educational, training, research, regulatory, and other entities. But capabilities cannot be coordinated only by markets, not least because many capabilities exist within non-market organizations.
The accumulation of capabilities must be at the center of any growth and development agenda, and governments must be willing to engage in national and regional discussions of appropriate goals and effective strategies. There are many instruments that might be used to develop capabilities. These include trade protection for infant industries; demand guarantees (such as the contracts to purchase COVID-19 vaccines before they are proven to work); state-owned enterprises (as in the postal system and public utilities); policies that push national conglomerates to diversify; national development corporations (such as Singapore’s Temasek and Malaysia’s Khazanah), moonshots (as proposed by Mariana Mazzucato); and national and regional innovation systems.
Economics’ signal contribution to the world has been to deepen our understanding of incentives. But lacking an equivalent understanding of capabilities can lead us not only to see every problem as a nail, but also to nail developing countries onto a cross of a false orthodoxy.