The State of Economics, the State of the World

Preface

Kaushik Basu, David Rosenblatt, and Claudia Sepúlveda

Origin

We live in troubled times. Over the past decade, the world economy has been wracked by financial crises, sovereign debt problems, backlash from political conflict and migrant crises, and, recently, a rise in xenophobia and protectionism. These issues raise major questions about the state of the world and also about the ability of economics to take on such challenges. Are these many economic and political crises and flare-ups symptoms of some deeper, underlying issues? Is economics as a discipline failing us at this time of soul searching? These are the questions that many are asking and that prompted the conference at the World Bank on which this book is based. We decided to bring in some of the finest minds in the profession—economists who have shaped modern economics—to ponder the state of the field and the state of the world in a series of papers. The conference consisted of 2 days of deliberation: The papers were presented, a distinguished group of economists commented on the presentations, and a large audience engaged with them in conversation and debate. This book is the outcome of these 2 days of deliberation.

In the 1950s through the 1970s, neoclassical economics reached a reasonable consensus in the economics profession, at least in the West. The United States and Western Europe experienced postwar rapid economic growth. Asia was still a sleeping giant in economic terms, the Soviet Union—with its particular economic system—was very much intact, and African countries were only beginning a wave of independence from colonial rule. Development economics focused on structural transformation along the lines laid out by Sir Arthur Lewis, and dependency theories also emerged that asserted that the global capitalist system was essentially rigged against the developing world. Despite the neoclassical consensus, some economists believed that advanced mathematical and engineering techniques could allow social planners to optimally set the path of economic growth and development.

Fast forward in history and one sees a very different evolution of the global economy over the past 25 years. The latest wave of globalization has led to the intensification of global value chains. Asia is now home to some of the most advanced economies on earth. It began with Japan, which was soon followed by Singapore, South Korea, Taiwan, and Hong Kong. By the mid-1980s, China was a growth leader, and in recent times, India and Vietnam are growing at exemplary rates. The Soviet Union no longer exists. Many middle-income countries—including those in Latin America—have achieved social progress, but dramatic income inequality persists, as do challenges to compete in the new global context. Africa has emerged from debt relief to achieve growth and reduced poverty rates, albeit at a variable and erratic pace. Rapid technological change provides both opportunities for technological leapfrogging as well as challenges to adapt.

As we see in this volume, the economics profession has adapted to the changing state of the world by learning from practical experience, challenging traditional assumptions, and developing new techniques and the use of big data. A predominant view in Western universities in the 1980s was that all economies were alike and that all developing countries needed to do was to get prices right. Development economics languished as a field of study. Since then, as developing economies have gained more prominence on the global stage, development economics has become one of the most dynamic fields in economics—particularly in terms of new statistical techniques and the ability to blend economic theory with empirical methods.

Despite all these changes and adaptations, the financial crisis that started in 2008 and caused a protracted recession has left scars on the world economy that linger even today. These scars show that the economics profession still faces major intellectual and research challenges. Addressing such challenges was one of the motivations for our conference.

With time, the societal goals of economics and the normative presumptions underlying the profession have also shifted. From a narrow focus on gross domestic product, economists have come to recognize the need for a broader conception of human welfare and capability. Even the World Bank decided to broaden its mission goals from development and poverty reduction to a more direct targeting of inequality mitigation, which it refers to as the promotion of shared prosperity. This book is an assessment of our discipline at the crossroad of all these changes.

We regret that Kenneth Arrow did not live to see the publication of this book. Kenneth Arrow was one of the greatest minds of our time, an economist who straddled like a colossus the second half of the past century and the opening years of this one, and who opened the conference with a presentation of enormous sweep. Ken Arrow passed away at the age of 95 on February 21, 2017, while he was working on completing his paper for this volume. He was in touch with us in our capacity as the volume editors until the last weeks of his life. After some deliberation, we decided to include his paper, despite it being an unfinished work. We did not want to put words into his mouth, nor leave out this final statement from him. We are grateful to Larry Summers for helping us edit the paper lightly; we also worked on it to make obvious corrections but took care not to change any of the original meanings. As a result, some parts of the paper are obviously incomplete. We hope that this chapter from an economist who helped shape so much of modern economics will be of value to all readers. Indeed, we believe that part I of this book—the three sweeping essays by Kenneth Arrow, Amartya Sen, and Joseph Stiglitz—will be viewed as a short summary of the theoretical foundations of modern economics.

Road Map

The Introduction that follows this Preface recounts the intellectual underpinnings that preceded the neoclassical consensus of the mid-twentieth century. This historical perspective reminds us of the role of theory and intuition in guiding our understanding of economics—even in the current age of more abundant data and more evolved statistical analysis. The Introduction makes the case that both theory and empirics are essential to closing key knowledge gaps and crafting policy that can enhance human well-being.

Thereafter, the book is organized in three parts. Part I deals with Foundations. Twentieth-century economic theory—or neoclassical economics—reached a pinnacle in the middle of the past century based on two pillars: general equilibrium theory and welfare economics. Part I includes chapters by three Nobel laureates. Ken Arrow and Amartya Sen each provide a recounting of the two pillars of equilibrium and welfare. Chapter 1, Professor Arrow’s contribution, is poignant, being published posthumously. It takes us through the origins of some of the key ideas of economic theory, going back to John Stuart Mill and Augustin Cournot and to the birth of the demand curve, which would be such a central idea for so much of economics. Professor Arrow tells the history of economic thought that led to the formal characterization of general equilibrium and to a proof of existence and its optimality properties, which are enshrined in the two fundamental theorems of welfare economics. It was a monumental breakthrough for economics when he and Gerard Debreu published their 1954 paper in Econometrica.¹ In chapter 1 in this book, Ken Arrow points out how we need to be careful when jumping from these abstract ideas to policy decisions. He reminds us that economics is different from a science like astronomy: In economics, we are ourselves participants in the system that we are trying to understand. Thus, we are too close to the subject of our analysis. As a consequence, we might not see the whole picture, or our views might be biased.

Amartya Sen has done pioneering work on individual choice and social welfare, with fundamental research that lies at the intersection of economics and philosophy, a pointed example being his celebrated liberty paradox, which has spawned a large literature in both disciplines. In chapter 2 of this book, Sen provides a history of the theory of rational decision-making and social welfare. He notes that the early theorists of the late eighteenth century were preoccupied with two concerns: avoiding authoritarianism and avoiding arbitrariness. Sen’s chapter is a natural sequel to chapter 1 by Arrow. Just as Professor Arrow was a key figure in general equilibrium theory, he also provided the initial impetus for social choice theory, with his famous impossibility theorem. Professor Sen, arguably the leading social choice theorist in the world, relates the work of Arrow to research going back to the work of John Stuart Mill in the nineteenth century. Turning to welfare economics, Sen starts with Pigou’s classic 1920 book on the subject.² Unlike social choice theory, welfare economics’ philosophical origin lies in Bentham’s utilitarian approach, and consequently, it focuses on the sum of the utilities of the individuals in the community. Sen notes that the disregard for the distribution of those utilities reflects a partial blindness of considerable ethical and political import and goes on to elaborate on how this neglect can be remedied. This major recounting of rational choice and welfare economics will be useful both for students of economics and philosophy, and for researchers trying to break new ground.

In chapter 3, Joseph Stiglitz summarizes the evolution of the economics of information and the role of information asymmetry in market failures, fields in which he himself has made seminal contributions. Much of early economics was based on the assumption of perfect information. The consumer knew what kind of good she was buying, the creditor knew exactly what the risks of lending to a person or a firm were, and the employer knew how good a worker he was hiring and also had full information on what the worker was doing when on the job. All these assumptions are of course wrong. But economists persisted with them, often in the belief that they were innocuous assumptions that made it easier to build models and make progress, but at times out of cussedness. In a series of papers, Joe Stiglitz showed that, first, the assumptions were not innocuous—they led to serious policy mistakes—and second, with patience and ingenuity, we could make room for imperfect and asymmetric information and still build formal models of analysis.

Some critical features of traditional economics (such as wage rigidities, excess supply of labor, and excess demand for credit), which in the works of Keynes and Arthur Lewis were assumptions, could now be explained endogenously. Thanks to Professor Stiglitz’s early publications, this work is now part of the mainstream, and chapter 3 of this book provides a bird’s-eye view of the background for this field.

Part II of the book consists of three chapters that deal with macroeconomic stabilization and growth. Developing countries have suffered multiple macroeconomic crises over the past three-quarters of a century. But the 2008–2009 global financial crisis that started in the United States, pummeled many rich countries, and then swept through developing economies has resulted in some deep soul searching in the profession of economics. One issue that has become clear to the economics profession, based on experience, is the close link between macroeconomic policies and the regulation and evolution of the financial system. In part II, Guillermo Calvo (chapter 4) and Hyun Song Shin (chapter 5) discuss new thinking on inflation and financial stability, respectively. Moving from short-run stabilization to long-run growth, theory has evolved beyond the original Solow model to endogenize Solow’s careful accounting of the role of total factor productivity. Part II closes with chapter 6 by Philippe Aghion, which brings the reader up on the latest thinking on endogenous growth theory.

Guillermo Calvo’s focus in chapter 4 is on more chronic but equally compelling matters. His concern is with two key macroeconomic phenomena that have occurred since the middle of the past century: chronic inflation and more recently, chronic deflation. From the perspective of the history of economic thought, Calvo draws on the role of rational expectations in macroeconomic theory and its role in helping us understand these phenomena. Although some rich countries experienced unusually high inflation in the 1970s, emerging markets suffered much more severe inflationary episodes, accompanied by debt crises. Macroeconomists initially attributed the emerging market crises purely to policy mistakes that affected the fundamentals for investing in those markets. However, the persistence and systemic nature of these crises led economists to think about the role of expectations in generating sudden stops of access to foreign capital. Guillermo Calvo, who pioneered this literature, is clearly in a special position to review it. In keeping with a recurring theme of this book, Calvo points to intellectual inertia, triggered by traditional models working well to explain macroeconomic performance in high-income countries, as a probable cause of some our discipline’s failings.

More than ever, financial market developments—including exchange rate movements—are impacting the real economy. As Hyun Song Shin puts it in Global Liquidity and Procyclicality (chapter 5), the financial tail appears to be wagging the real economy dog. More specifically, exchange rates do not seem to adjust in the required direction to help eliminate external imbalances in key economies. Global financial markets have become highly integrated, implying that policy makers everywhere are focused on the next move of the US Federal Reserve Board. Anomalies in interest rates across currencies, the rise of the dollar in global transactions, and cyclical instabilities have been a focus of a lot of our attention, especially since the 2008−2009 financial crisis. Shin, a world authority on international finance, dissects and analyzes these concerns in a chapter that is of special interest in today’s world, especially since the financial sector crisis of a decade ago.

Philippe Aghion has contributed to many areas of economic theory. One of his works that attracted an enormous amount of attention with an abundance of follow-up research is the Schumpeterian theory of economic growth. Although nations strive to fulfill many different objectives, growth is a central concern of development economics, if for no other reason than as an enabler of some of our other aims and objectives. In chapter 6, Aghion starts from the Solow model, the true template in growth economics, and goes on to use the Schumpeterian growth paradigm to shed light on a host of topics of contemporary interest. Thus, his chapter analyzes the relationship between competition and innovation-led growth; the possible causes of secular stagnation; and the recent rise in inequality, especially the gap between the super-rich and the rest.

Part III of the book is a set of four chapters brought together under the heading New Areas of Research and Inquiry. These four chapters represent branches of economics that are relatively new. They are based largely on challenging the traditional assumptions of neoclassical economic theory and traditional approaches to empirical economics, as well as on the application of economics to emerging global concerns.

Chapter 7 is based on the lecture at the conference given by Nick Stern, the world’s leading authority on environmental economics and the economics of climate change. The chapter provides an overview of the economics of climate change—perhaps the most pressing—and the most fractious—issue of our times, concerning all nations. Written jointly with Sam Fankhauser, chapter 7 provides a thorough overview of the unique threat to global prosperity that is posed by climate change. The authors review the history of environmental and natural resource economics. They then make the case for a radical deepening of economics analysis to accommodate sustainability concerns and guide the policy response to climate change. It is unfortunate that development policy traditionally did not focus on environmental issues, despite work on environment and natural resources dating back to the eighteenth and nineteenth centuries. The risks posed by climate change are staggering, and the options that we have are laid out with care in this chapter.

No stocktaking of modern economics is complete without an account of behavioral economics. Cass Sunstein is a leading authority on law and economics and on behavioral economics, with original works in both these fields. In chapter 8, Professor Sunstein provides an overview of behavioral economics, where the traditional approach of a rational Homo economicus is challenged by our understanding of human psychology and human behavior in the real world. It seems natural to presume that a nation’s economic well-being depends on economic policy. It therefore took time for us to realize that many drivers of an economy lie outside economics, in social norms, cultural mores, and psychology. Behavioral economics, the subject of a recent World Development Report of the World Bank,³ sensitized economists to these important influences that lie outside the discipline but are key determinants of development. Behavioral economics, including important contributions by Cass Sunstein, alert us to the fact that human beings are often irrational, and more importantly, that these irrationalities are often systematic. Understanding them can enable us to promote development more effectively.

Professor Sunstein’s chapter is followed by another one dealing with a relatively new field of inquiry, the evolutionary prospects of economies and societies. Although the origins of evolutionary game theory go back to the early 1970s, the entry of this discipline into mainstream economics is more recent. One of the most prominent contributors to this field of research is Jorgen Weibull. In chapter 9, he and Ingela Alger discuss the role of morality and the evolutionary foundations of human motivation, showing that unqualified selfishness may be good for the individual in an immediate sense, but if acquired by all in a society, it sets that society on a course toward extinction. Morality, in the sense of Kant, is evolutionarily stable. That is, if all of us are prepared to forgo a little bit of our self-interest to uphold some of our collective interests in the Kantian sense, our society will be more robust in terms of surviving natural selection. Even apart from this reasoning, the ideas of evolution, once a preserve of biology, have now come into economics in a big way. Chapter 9 summarizes some of the most important ideas in this discipline for the wider community of economists and students of social science.

One of the most important advances in modern development economics is the use of randomized control trials (RCTs) to get at causal explanations of various policy interventions and alternative economic outcomes. Did the election of women as leaders of village councils play a role in the better provision of local public goods in India? Did deworming help schoolchildren in Kenya attend school more regularly and do better in their studies? By bringing the method of RCTs from epidemiology to development economics, we can now hope to answer such questions with a clarity that we did not have earlier. The RCT has been a source of celebration, criticism, and controversy, but as a method in the toolkit of development economics, its value is undeniable. Chapter 10, which closes the book, is by Esther Duflo, written jointly with Abhijit Banerjee and Michael Kremer. Duflo’s own research and publications played a critical role in the development of this field of research. She gives a detailed account of the rise of the field, its achievements, and some of its pitfalls.

Acknowledgments

We as editors thank a large group of individuals who helped carry out this megaproject, including the organization of the conference on June 8–9, 2016, at World Bank headquarters. Over and above the authors of the chapters, who presented papers at the conference and whose work we commented on above, there was a stellar cast of discussants, who read and commented on those papers and whose comments are included in this volume. Here is the list of discussants, in alphabetical order (to minimize discontent) to whom we are extremely grateful: Larry Blume, Francesco Caselli, Shanta Devarajan, James Foster, Varun Gauri, Xavier Gine, Gäel Giraud, Gita Gopinath, Robert Hockett, Karla Hoff, Ravi Kanbur, Aart Kraay, Aslı Demirgüç-Kunt, David McKenzie, Célestin Monga, Maurice Obstfeld, Hamid Rashid, Martin Ravallion, Luis Servén, and Mike Toman.

The chairs of the conference sessions were Augusto Lopez Claros, Makhtar Diop, Felipe Jaramillo, Ayhan Kose, Bill Maloney, Kyle Peters, Martin Rama, Ana Revenga, and Augusto de la Torre. We are grateful to them for conducting the sessions and also for their comments and ideas during the session.

We also thank Gabriela Calderón for her help in organizing a superb conference and the Development Economics Communication team for their help with disseminating information about the conference. We are also grateful to Gabriela Calderón and Trang Huyen Hoang for preparing the manuscript for submission to the MIT Press, as well as our references police, Woori Lee and Ruth Llovet Montañes.

Finally, we take this opportunity to express our gratitude to our editor at the MIT Press, Emily Taber, for her help and cooperation at every stage and also her patience, as we crossed over some of our own deadlines in bringing this large project to a close.

References

Arrow, Kenneth J., and Gerard Debreu. 1954. Existence of an Equilibrium for a Competitive Economy. Econometrica 22 (3): 265–290.

Pigou, Arthur C. 1920. The Economics of Welfare. London: MacMillan.

World Bank. 2015. World Development Report 2015: Mind, Society, and Behavior. Washington DC: World Bank.

1. Arrow and Debreu (1954).

2. Pigou (1920).

3. World Bank (2015).

Introduction: The State of Economics, the State of the World

Kaushik Basu

1776 and 1860

For the discipline of economics, and for the world at large, these are unusual times. The shock and awe of the financial crisis that began in the United States in 2008 and the series of economic fault lines it ripped open—from the sovereign debt crisis in the European Union to the massive slowdown in several emerging economies that we are currently witnessing—have led to much soul searching.

The past nearly two and a half centuries, from Adam Smith’s The Wealth of Nations (1776) to the flourishing of empirical research and big data in current times, mark the astonishing rise of a discipline. From a broad, descriptive, and speculative subject, economics has come to acquire a common methodological foundation, mathematical structure, and a growing database. It has vastly enhanced our understanding of markets, exchange, money, finance, and the drivers of economic development.

How did this come to be? Where is economics headed? Will it be up to the diverse challenges of our times? Will global poverty be eradicated, or will it be exacerbated under the strain of a deteriorating environment? These are the questions we grappled with over the 2 days of the conference that is the basis of this book. The conference brought together some of the most prominent individuals who have, for better or for for worse (depending on your love or distaste for economics), played a role in making economics what it is today.

There have been achievements in economics from well before 1776 to now. But for me, the transformational period of the discipline was the 100-odd years, starting from the second half of the nineteenth century. If you like birthdays, I have a date to propose to mark the birth of modern economics: February 19, 1860.

Stanley Jevons wrote a celebrated letter to his brother on June 1, 1860, saying that he had made a stunning discovery in the past few months that explained the value of different goods and gave him insights into the true theory of Economy. He told his brother that so thoroughgoing and consistent was his theory that I cannot now read other books on the subject without indignation (Collison Black 1973, 410).

When exactly did he hit upon the idea? Historians of economic thought have drawn our attention¹ to a special entry in Jevons’s diary, on February 19, 1860: At home all day and working chiefly at Economy, arriving I suppose at a true comprehension of Value. Birthdays for scientific breakthroughs are always questionable. But if we can have Mother’s Day, Valentine’s Day, Administrative Professional’s Day, I see no reason we cannot have Modern Economics Day, and February 19 would be my pick.

Of course, thinkers were already laying the foundations for Jevons’s breakthrough. Gossen had worked out quite a lot of this a good one or two decades before Jevons. Cournot laid some of the substructure in 1838. And the law of diminishing marginal utility and its significance were described by Daniel Bernoulli as early as 1738, to solve the St. Petersburg paradox, which had been discovered in 1713 by Nicolaus Bernoulli. (And, yes, it was all in the family, Nicolaus being Daniel’s brother.)

It is also important to note that although Stanley Jevons (1871) was clearly on to the main ideas of general equilibrium and value, he never quite got all the way there. We needed Léon Walras (1877) to put up the main structure. And for the full general equilibrium project to be completed, with the existence of equilibrium proved and its welfare properties spelled out, we needed to wait another 75 years for the seminal contributions of Kenneth Arrow.

By the time John Hicks, Paul Samuelson, Ken Arrow, Gerard Debreu, Lionel McKenzie, and others were doing their work,² modern game theory had been born. Over the next decades, the combination of a fully worked-out general equilibrium system, game theory, and a little later, social choice, ideas of asymmetric information and adverse selection, endogenous price rigidities, theories of economic growth and development economics, and the first understandings of the rudiments of monetary policy would transform the landscape of economics.

Few activities in life are as innately joyous as the pursuit (and if one is lucky, the discovery) of new ideas, the unearthing of patterns in the abstract space of concepts and numbers or in the world of data and statistics. Frontline researchers must have the space, like artists and composers, to do what they do as an end in itself. The greatest benefits of research are usually a by-product of this freedom. But here at the World Bank, our preoccupation is much more down to earth and is driven by policy needs. Hence, what we wanted to take away from the conference was how we can draw on the best of economics to promote development and sustained, inclusive growth, and contribute to making the world a better place. The World Bank’s research and data analyses have been enormously influential, reaching the desktops of finance ministers and policymakers all over the world; indeed, a special responsibility comes with this influence.

At the time of this writing, I have been chief economist of the World Bank for nearly 4 years. This conference and the book are an opportunity to share some of my concerns and questions with the distinguished gathering at the conference and also with a wider readership. The hope is that the conference and its proceedings (to wit, the present book) will strengthen the World Bank’s mission of promoting development.

Because the World Bank’s engagement is primarily with development economics, it may be worthwhile to point out that development economics, like economic theory, has had its moments of epiphany. Arthur Lewis had been troubled by two problems. First, there was the age-old question of why industrial products, such as steel, were so much more expensive than agricultural products. Second, why were some countries persistently poor, while others were so rich?

In an autobiographical essay, Lewis (1980, 4) writes about his eureka moment in 1952: Walking down the road in Bangkok, it came to me suddenly that both problems have the same solution. Throw away the neoclassical assumption that the quantity of labor is fixed. An unlimited supply of labor will keep wages down, producing cheap coffee in the first case and high profits in the second. The result is a dual national or world economy. This epiphany was the genesis of his classic paper on dual economies in the Manchester School (Lewis 1954), which would play a major role in his being awarded the Nobel Prize in 1979³ and in triggering research on development economics.

Intuition and Causality

I turn now, more specifically, to the subject of development policy. For the project of converting research to good policy, we need three ingredients: data (and evidence), theory (and deductive reasoning), and intuition (and common sense).

One of the great achievements of economics in recent decades has been in the area of empirical analysis. We have good reason to celebrate the rise of data and our ability to analyze data using different methods: from intelligent bar charts, through simple regression analysis and structural models, to randomized control trials. This recent success raises the hope of economics becoming a truly useful science (see Duflo and Kremer 2005; Banerjee and Duflo 2011).

There is, however, a propensity among some economists to dismiss all theory as esoteric.⁴ Among other dangers, we run the risk of making our discipline inefficient. Suppose we insisted that Pythagoras could only use empirical methods. Would he ever have gotten to his famous theorem? The answer is: He might have. If he had collected a large number of right-angled triangles and measured the squares on their sides, he might have hit on the conjecture of the two smaller squares adding up to the one on the hypotenuse. But this approach would be extremely inefficient. Moreover, there would be a lot of debating and dissent. Some would charge him with using a biased sample of right-angled triangles, all from the Mediterranean region. Would it work in the Arctic, in the Southern Hemisphere? they would query.

We must acknowledge that many truths can be discovered more efficiently and more compellingly using pure reason. Further, there is a great deal of sloppiness in the way we reason about the use of evidence. For instance, hard-headed practitioners will often tell you the following: If we do not have any evidence about whether some policy X works, we must not implement X. (I was told exactly this fairly recently, in response to a suggestion I made.)

Let me call this rule in quotes an axiom. To see that it is an unreasonable axiom, observe that if we do not have any evidence about whether X works, then we also do not have any evidence about whether not-X works. But because we have to do either X or not-X, the original axiom has to be flawed.

For good policy, we need facts and evidence, but we also need deduction and reasoning. We can go a step further and make a case for using mathematics. Although the use of mathematics can be overdone (as has happened in economics), the immense achievements of Cournot (1838) and Walras (1877), and of modern economics, would not have happened without it. This is because mathematics is a disciplining device, even though it is demanding and clearly not something that is applicable in all situations. As Krugman (2016, 23), not being able to make up his mind whether a particular argument of Mervyn King (2016) was right, observes, words alone can create an illusion of logical coherence that dissipates when you try to do the math.

The power of doing a model right, even if it is abstract and uses assumptions that may not be real, can be seen from general equilibrium. Take Gerard Debreu’s (1959) classic The Theory of Value. This book is of great beauty, as spare as poetry. In some ways, it is comparable to the work of Euclid, for it brings together in a systematic way an amazing range of ideas. Euclid may not have been as original as Pythagoras or Archimedes, but in bringing intellectual order to a scattered discipline, he had few peers, and he served an enormous role in the progress of knowledge. Likewise for Debreu’s slim book.

The pathbreaking general equilibrium model of Walras, Arrow, and Debreu provided a template that sparked off some of the most original works in microeconomic theory—notably those by Akerlof and Stiglitz—which have to do with modeling the functioning of markets under imperfect information.⁵ These works have greatly enhanced our understanding of micromarkets; why markets fail; and why prices are often endogenously rigid, resulting in credit markets with excess demand and labor markets with excess supply. This research also has hopes of improving our macroeconomic analysis, because, as we know, Keynesian macroeconomic analysis, like Arthur Lewis’s dual economy model, makes extensive use of price rigidities, and neither Keynes nor Lewis had an explanation for these rigidities. Thanks to the work of Stiglitz and a few others, we now have a formal understanding of open unemployment and credit markets that do not clear despite the absence of exogenous restrictions on interest rate movements.

Along with these positive theories, we have seen the rise of normative economics. Perched between analytical philosophy, mathematical logic, and the social sciences, this achievement was remarkable. Major contributions were also made by Samuelson (1947), Bergson (1938), and others, but the truly astonishing breakthrough was Ken Arrow’s (1951) slim book: Social Choice and Individual Values. Arrow’s impossibility theorem became the bedrock of an enormous research agenda. The leading figure here was Amartya Sen, whose work, straddling philosophy and economics, demonstrated that it is possible to bring the finest traditions of theory and mathematical logic to bear on age-old questions of ethics and normative principles (Sen 1970; see also Suzumura 1983). This work brought into the mainstream of rigorous analysis such concepts as rights, which were widely talked about but seldom subjected to careful scrutiny (Sen 1996). This body of work has been important for the World Bank, because its mission goals have foundations in such concepts (World Bank 2015b) and also in related country-specific research (Subramanian and Jayaraj 2016).

It is worth digressing for a moment to note that data and statistics belong to a larger domain of inquiry, which has to do with description. The term descriptive social science is often treated as a pejorative, which is unfortunate. As Amartya Sen (1980) points out in a powerful essay, developing a good description is not easy, and a huge amount of the progress of science depends on description. Description, be it in words or data, entails choice. Description is not regurgitating everything we see around us. We have to pick what is vital and make that available to others. How we describe and what we describe shape our understanding of the world. The describer is therefore a pivotal agent.

It is important to be aware that description can take many forms. What the anthropologist describes often does not take the form of numbers and data. But the description of what he or she has seen and, more importantly, experienced is vital for our understanding of the world. The concept of thick description—which we owe to Gilbert Ryle (1968) and Clifford Geertz (1973) and used by umpteen anthropologists—has vastly enhanced our understanding of traditional and remote societies. It has enabled us to intervene more effectively. At times this intervention has been for the wrong reasons (for instance, to enable colonial domination), but it has also helped carry the development agenda further by extending the reach of modern medicine and education.

Historically, we have learned of the motivation and purpose of other lives, which are distant from ours, by the ardor and work of anthropologists. These topics are very difficult to learn and comprehend by data and statistics alone. Living with the subject and acquiring an intuitive understanding are often necessities. This knowledge has been put to good and bad uses, to help the poor living in distant lands and in traditional societies, and also to exploit people and spread imperialism and colonial control. For good or for bad, the knowledge has been useful.

The absence of such knowledge can create major handicaps. Consider terrorism. Because of the dangers associated with observers interacting with terrorist groups, we do not have studies of the kind anthropologists have provided for remote societies, resulting in an insurmountable knowledge gap.

The skeptics, from Pyrrho to David Hume and Bertrand Russell, were right: Neither fact nor deduction can take you all the way to the best policy to implement. The reason is that causality, regardless of whether it is present, can never be demonstrated. In the end, causality lies in the eyes of the beholder. For me, the most thought-provoking observation on this comes from a tribesman from Nepal. The famous National Geographic photographer, Eric Valli, seeing the tall trees these tribesmen climbed to gather honey, asked one of them whether they ever fell out of those trees. The answer he received was: Yes, you fall when your life is over.⁶

Given the impossibility of discovering causality, for good policy, it is not enough to have the facts; it is not enough to combine facts with theory. I am convinced we need one more ingredient: common sense and what I have elsewhere called reasoned intuition (Basu 2014).

Researchers refuse to admit it, but it is true that there is no escape from the use of intuition, and the bulk of what we call knowledge that we acquire through life occurs casually, mainly by using common sense. It would be a mistake to insist that all knowledge has to be rooted in scientific method, such as controlled experiments. It is quite staggering to consider the number of things a child learns through nonscientific methods.

As to why such knowledge, acquired through intuition and common sense, may have value, we have to recognize that our intuitions are what they are because of evolution. These methods have survived natural selection, and so their power must not be dismissed out of hand. Evolution has shaped a lot of what we see in our economic life; this is widely acknowledged, but our understanding of the interface between evolution and economics, for which some foundations were laid by Maynard Smith and Price quite some time ago (see Maynard Smith and Price 1973; Weibull 1995) remains rudimentary. There is a foray into this topic in this book (see chapter 9) in the context of morality and its origins (see also Alger and Weibull 2013). But it is arguable that such innate knowledge acquision applies to many other domains. The way people commonly acquire knowledge may not meet the test of scientific standards, but it cannot be dismissed out of hand. At the same time, casual empiricism can lead to superstitions, which we have to guard against. I have argued elsewhere (Basu 2014) that what we need is reasoned intuition, that is, the use of intuition vetted by reasoning. This is not a surefire method, but it is the best we can do.

Data, theory, and intuition are the three ingredients for human knowledge and progress. But even with all three in place, skepticism, as philosophers through the ages have reminded us and as Keynes (1936) did in chapter 12 of General Theory, must be a part of the thinking person’s mindset. One problem with scientists who lash out against superstition but do not question scientific knowledge is the double standard. They fail to recognize that, when it comes to certainty about the future, scientific wisdom is as much open to question as many other forms of knowledge.

Knowledge and Caveats

We are heading into uncharted territory and struggling with the world’s economic problems. Recent problems include United Kingdom’s vote in favor of exiting the European Union (I suspect this important issue will persist for some time) and the decline in commodity prices (especially that of oil), which is creating a lot of stress in commodity exporting nations and in corporations that have invested in this sector. Questions are being raised about the readiness of the discipline of economics to address such issues. The first thing to recognize, however, is not that economists misread or underestimated these crises, but how these problems show that there is still a lot about the economy that we do not know.

Experts in any discipline suffer from the disadvantage of not knowing exactly what it is they do not know. Take, for instance, medicine. Given how little we know about the human body and brain, when we consult a doctor with health problems, in most cases the right answer for the doctor to give is: I have no idea. But we seldom hear this. Doctors almost invariably tell you what your problem is. What should warn you that when doctors say they know what your ailment is, they in fact often do not is that, even in the eighteenth century, well before the arrival of modern medicine, doctors seldom said they had no idea what ailed the patient. This is because doctors in the eighteenth century did not know—and doctors now do not know—what they did not and do not know. It is much the same with economists.

Among the areas of darkness that hamper development policy is our inability to link the micro and the macro. Suppose a government undertakes some intervention X in a thousand villages. X can be a conditional cash transfer, an employment creation program, or provision of a fertilizer subsidy. How do we evaluate the success of the program in reducing poverty? Typically, we do this by collecting data on the well-being of the people in these villages. If we are fussy, we may use all kinds of controls, including proper randomization. Suppose, through such a study, it is found that poverty has indeed gone down in the villages where X was implemented. Does this mean X is a good intervention? Not necessarily. Suppose the intervention X in a village has the following effect. It raises food prices a little and raises wages more. This will indeed lead to lower poverty in the village. But because a rise in food prices typically cascades across the whole economy, this intervention could mean that in other villages, which will only feel the full rise in food prices and a negligible effect on wages, poverty will rise. So it is entirely possible that the nationwide effect of the intervention will be no effect on poverty or even an increase in poverty, though poverty falls in the villages in which the interventions occurs.

These links between micro interventions and macro effects are poorly understood. We need to invest much more in this kind of research if we are to succeed in battling nationwide and even global poverty and to combat inequality.

In other micro-theoretic areas, such as finance and the psychological foundations of human behavior, economics has made great strides, as discussed in this book.⁷ But open questions still exist. In finance, it is increasingly recognized that there is no such thing as an ideal regulation. This is because financial products are amenable to endless innovation. Banks and financial organizations will keep developing new products, just as the pharmaceutical industry keeps discovering new drugs. And with each such financial innovation, we may need to modify and make our regulatory regime more sophisticated. Hence, this is one area where we have to reject the language of optimal regulation, which has a static connotation, and to create regulatory bodies that are flexible and ready themselves to innovate. This effort is complicated by the fact that when selecting financial products, people are often not rational and instead give into emotions, hyperbolic discounting, and framing delusions, as pointed out repeatedly in the recent behavioral economics literature.

One possibility is to label certain financial products as prescription goods and create the equivalent of doctors in finance, who have to sign off before a person is allowed to buy a financial product. We could, for instance, decide to allow balloon mortgages, but before a consumer can commit to one, he or she has to get a finance doctor to sign off on the financial viability of taking on such a contract. This cannot be done by mechanically following practices in medicine, but a case can be made for giving serious thought to such an architecture.

The interface between economics and psychology, and, more specifically, behavioral economics, has witnessed great strides; and we at the World Bank have tried recently to bring this progress to bear on the agenda of development policy with our World Development Report on Mind, Society, and Behavior (see World Bank 2015a). By drawing on evidence from laboratory experiments and field observations from around the world, behavioral economics teaches us a lot about how and where we should intervene.⁸ However, this discipline might risk becoming a catalog of findings. I call this a risk because of a propensity to think of the findings as set in stone, not realizing that they may be true in some societies at certain stages of development and might differ with place and time.

What is also needed is an effort to marry these findings more effectively with the concept of equilibrium (Akerlof and Shiller 2015). Then we would be able to leverage these findings to get much more out of them and also be able to predict better how the findings are likely to change from one society to another and to evolve over time. To my mind, one of the great contributions of traditional economics is the idea of equilibrium, which has many manifestations, from the general competitive equilibrium to Nash. We need to broaden the description of individuals from the narrow Homo economicus to that of more realistic individuals (with quirks, irrationalities, and social norms) and to use the idea of equilibrium in conjunction with this more realistic description.⁹ What makes this effort intellectually challenging is that for most real phenomena, which seemingly rely on human irrationality or adherence to social norms, it is possible, with analytical ingenuity, to accurately model the same behavior using perfectly rational individuals.¹⁰ In the end, better modeling calls for the use of judgement and intuition when deciding what assumptions we should rely on.

The World Bank has been increasingly engaged in this difficult area. Given the current drift of global concerns, we do not have a choice. These concerns naturally lead to another related field beyond the narrow confines of economics, that is, institutions and governance.¹¹ Our World Development Report on Governance and the Law (see World Bank 2017) takes on this challenging task.¹² One important area of policy making is the control of corruption, a big task faced by those at the helm of policy. Traditional economics treated an act of corruption (e.g., whether to pay a bribe to get an illegal electricity connection) on par with any other purchasing decision (e.g., whether to buy an apple)—that is, as an exercise in narrow cost-benefit analysis (see Bardhan 1997; Mishra 2006). It is not surprising that we have been so singularly unsuccessful in controlling corruption. To understand this phenomenon, it is important to bring in psychology and political institutions. Development policy cannot be built on economics alone.¹³

Finally, one area in which we have knowledge gaps but not as much as conservative commentators make out, is the connection between climate change and development. If we proceed the way we have done thus far, it is a journey headlong into disaster. This is unfortunate, because awareness of the connection between environmental resources and economic development came early, as evidenced in the works of Thomas Malthus, David Ricardo, Knut Wicksell, and others, even though we have been tardy in terms of action and policy. In recent times, the importance of this connection has been stressed by several authors, notably by Stern (2007, 2015). Now with the Paris Agreement of 2015, there is a platform to relate what we know on the subject with action on the ground, which is not easy, because it entails some cross-country coordination. It is worth stressing here that this engagement should be viewed very much as part of shared prosperity, because it entails intergenerational sharing of resources and well-being.

Money and the Person of Influence

The previous section discussed some gaps in our knowledge. One big gap is in the area of monetary policy. Although economics has made some dramatic breakthroughs in some practical areas (such as how to design auctions and how to micromanage demand and supply in sectors), its grasp of the impact of macroeconomic and especially monetary policy interventions is rudimentary. It is true that we have learned to manage hyperinflation, and we can hope never to see again, at least in advanced economies with sophisticated central banks, the kind of runaway inflation seen in, for instance, Hungary in 1946 and Germany in 1923. But as the global financial and growth crisis that began in 2008 continues unabated, and governments and central banks flail at this with different policies, it is evident that large gaps exist in our understanding of the impact of macroeconomic policies, and the linkage between the financial and real worlds (Stiglitz 2011). This is something I learned by fire, during my nearly 3 years as a policy maker in India (from 2009 to 2012). Although monetary policy was not my charge, it became clear during this time that much of our interventions were based on imitating policies followed by central banks in advanced economies, unmindful of the fact that their contexts differed.¹⁴

One reason for this deficiency is that we do not understand the functioning and role of money in a market economy the way we understand, for instance, the Walrasian general equilibrium system for real goods and services. Money in general equilibrium was part of a big research agenda in the 1980s, but that agenda has remained incomplete. One reason is that it is mathematically a very hard problem. But it must not be abandoned for that reason. In the rush to solve the next morning’s problem, often these deep questions take a back seat. But as the world struggles to cope with the slowdown, and the widespread use of negative interest rates does not seem to work (and in fact has a negative backlash from which no country is able to individually break out of), it is important for economists to keep working on some of this fundamental research.¹⁵ If the full general equilibrium model took some 75 years—from Jevons and Walras to Arrow and Debreu—and the study of money in equilibrium started in earnest in the 1970s and 1980s, we have little reason to abandon the problem as unsolvable.

To see the mystifying nature of money, one can look at a very different problem—the power of peddlers of influence. With the US presidential election in the offing, there was a lot of writing about lobbying, influence peddling, and corruption. In my youth in India, I remember talk about persons of influence, referred to those days as men of influence. I recall being baffled by one particular person and wondered why he was so well off. He had no special skill, no resources. He was just the man of influence (let me call him M). In those days, it took a wait of 6 years to get a phone connection. If you needed it sooner, you could try calling M and requesting his help. He would call up the relevant person in government; and more often than not, the favor would be done. If someone needed to get a child into a good school, she could ask M, and if M agreed, he would request the school principal to make an exception and take in this kid out of turn. It struck me much later what he was doing and I wrote it up as a model of the man of influence (Basu 1986). M was a person with a mental ledger of favors done. If i needed something from j, whom she did not know, she could ask M to ask j. Then j would do the favor, not because j cared for i or ever expected to need a special favor from i, but because j knew that someday he would need a favor from k and would need M to make a request of k. It is M that no one wanted to offend, because M was a clearinghouse with a memory. This is what made M a man of influence. In some sense, a person of influence is like money or a blockchain. It is a record of information and works only because everybody thinks it will work.

This description and even the model is straightforward enough. But its integration into a full general equilibrium model is extremely hard and remains an open agenda, thereby handicapping policy makers greatly and forcing them to rely more on intuition and guesswork than hopefully will be necessary in the future.

Politics and Economics

When discussing development policy, I have been stressing the role of economic theory and empirical economics—in brief, input from professional, scientific analysis. The lack of this input dooms many a developing economy. But it is not always easy to marry scientific analysis with the ground realities of politics. Maybe because I moved so abruptly from academe to policy making, I cannot be unmindful of the importance of the role of how one engages with politics and politicians. When I moved from Cornell University to the Indian government at the end of 2009, I quickly became aware of the potential conflict between the prescription coming from theoretical economics and political compulsions. One quickly learned that when a politician tells an economist, You are so good at theory, it is meant to be a devastating criticism.

I have recounted in Basu (2015) how, at one of my first meetings in my new job with the prime minister and some of his advisers, I was discussing how to control food inflation, which was then at double digits. I spoke at some length on changing the manner in which food reserves are released in India to get the maximum dampening effect on prices. I basically drew some policy lessons from the logic of Cournot equilibrium. I was delighted that my suggestion was accepted, which, I now believe, owes as much to my not uttering the words Cournot or equilibrium as to Cournot’s excellent theorizing.

One gets a fascinating glimpse of the interface between the world of economic ideas and political compulsions in developing countries from Arthur Lewis’s experience as chief economic adviser to the Ghanaian government. He was invited to take this position by Kwame Nkrumah, the country’s first prime minister and president. The United Nations and the United States tried to block this appointment on the grounds that Lewis was not very sympathetic to the Bank [the International Bank for Reconstruction and Development, commonly referred to as the World Bank] (Tignor 2006, 147). There were also concerns, such as the one expressed by A. W. Snelling, an official in the British government, that Lewis is a socialist, but a moderate one (Tignor 2006, 148).

Lewis’s tenure began extremely well, with Nkrumah personally excited at the prospect of Lewis steering the Ghanaian economy to a takeoff. On taking office, Lewis plunged into work, especially related to the second Five-Year Plan, with widespread support from others in government. But soon Lewis’s idea of what constitutes good economics and Nkrumah’s insistence on political compulsions came into conflict. Seemingly small differences of opinion—for instance, whether to spray cocoa trees that had been attacked by capsid beetles (pardon me for having forgotten who took which side)—became the cover for deeper conflict: the professional economist’s insistence on good economics and the politician’s stubbornness about what is politically good.

Lewis left office at the end of 1958, with Nkrumah’s letter, gracious but recognizing that they could not work together, in his pocket: The advice you have given me, sound though it may be, is essentially from the economic point of view, and I have told you on many occasions, that I cannot always follow this advice as I am a politician and must gamble on the future.¹⁶

Interests and Ideas

Some months after I moved from academe to the Indian government, a reporter asked me: What was the one thing that I had learned in this transition? Unusually for a question of this kind, I had an answer. The reader may recall Keynes’s beautiful observation on the power of ideas, which ended with the following: "I am sure that