Economic Science, Economic Policy, and Economic Advice

1. Economic Science, Economic Policy, and Economic Advice Joseph E. Stiglitz The World Bank Institute for Advanced Studies, Berlin October 15, 1998

2. The role of knowledge • 1998 World Development Report, on Knowledge for Development, has two major themes: • Developed and developing countries are separated by a knowledge gap, not just gaps in physical and human capital • Information imperfections impede the workings of markets, and policy choices must take this into account

3. The scientific approach • Knowledge revolution is based on modern science and technology, and especially on scientific thinking • Shift to scientific thinking is a crucial part of a country’s development transformation: • Beliefs should be based on evidence • Scientific thinking accepts constant change • Science recognizes its own knowledge limitations • But even developed countries fall short of ideal

4. Scientific knowledge in economics • Economics is a social science; therefore experimentation has only a limited role, and making inferences is not easy • We’ve learned enough to resolve many of the big questions • But important questions remain, and they have profound effects on tens of millions of people

5. Scientific knowledge in economics: Applications • Three important applications: • Causes of and responses to the East Asian crisis • Financial market liberalization • Privatization • In all these cases, economic analysis must exceed the standards of journalism • We must use the scientific approach: good analytical arguments and empirical evidence

6. Application #1: The East Asian crisis • Analyses of the causes of crisis have identified culprits without doing careful analysis; e.g., • Lack of transparency • Weak financial systems • Political cronyism • Recommended responses have included high interest rates, despite the lack of analysis or empirical evidence supporting this approach

7. Application #2:Financial Market Liberalization • Advocates equate financial market liberalization with trade liberalization • But neither theory nor empirical evidence supports this equation • Ideology focuses on gains from liberalization; science weighs losses and gains

8. Application #3:Privatization • Private property is sacred to the ideology of capitalism • That ideology has been reinforced by the many experiences with inefficient state firms • But science seeks to understand why state firms are so often inefficient, and thus find out when privatization works well • Analysis shows that privatization without competition will not yield the desired benefits

9. Policy advice and economic science • Rigorous analysis is crucial; but in economics, we will always suffer from uncertainty • Economic science -- as opposed to economic ideology -- explicitly acknowledges that uncertainty when giving policy advice • Once advice & uncertainties are clear, policy choices should be left to the democratic process ==> greater effectiveness, more local capacity

10. Incentives of policy advisers • We can bring the scientific approach to bear in thinking about incentives of advisers • Incentive problems has been widely recognized in medicine: • Information imperfections mean that both fee-for-service and HMOs have incentive problems • Doctors won’t always reveal their uncertainty • Modern medicine recognizes, tries to address these problems through greater openness

11. Incentives of policy advisers • Similar incentive problems affect economic policy advisers: • “Patient” doesn’t necessarily know how effective a given treatment might be • Therefore policy “doctors” often fail to acknowledge their uncertainty . . . • . . . and if the patient’s health worsens, doctor can blame patient for not following his advice

12. Incentives of policy advisers • To assess incentives, we need to ask: • To whom are advisers accountable? • Who pays them? • What is the governance structure? • Advisers have incentives to hide mistakes, reduce competition, hoard information

13. Incentives of policy advisers • This mix of incentives affects both: • Outside advisers • Advisers within governments, such as: • Staff of independent regulatory agencies • Finance ministry and central bank staff • Secrecy often compounds the problem; it creates rents, encourages special interests • One remedy: make more information available

14. How to improve our advice • Demand internal consistency • Work to improve predictive ability, rather than engaging in ex post rationalization • Investigate rigorously the issue of secrecy: does open discussion really cause economic harm? • Explore the incentives of advisers

15. Concluding remarks • Science differs from ideology in key respects: • It encourages questioning • It recognizes uncertainties • It values openness and democracy • It evaluates arguments on their own merits