Economists have been systematically biased in our approach to public policy, focusing on one set of results from economic theory—on the power of markets—while ignoring that same theory on the conditions under which markets fail. Citizens have information relevant to those market failures that economists don’t. Just as markets were described by Adam Smith as institutions that could aggregate economic information dispersed across millions of actors, information about how well public policies are working for the public good is aggregated by political institutions in the political marketplace. Politics provides a market test for public policies from which economists need to learn.

Stuti Khemani Senior Economist, Development Research Group, World Bank

I came to these conclusions while working on a paper recently published in the Oxford Encyclopedia of Economics and Finance on the political economy of reform. In the business of international policy dialogue and advising governments, reforms typically mean liberalizing markets, relaxing regulations, and cutting subsidies. Poor performance of state agencies in delivering services and managing enterprises is used to advocate for privatization. Utilities whose revenues do not cover operating costs, and who cannot borrow in capital markets for long-term investments, are the evidence used to advocate for raising tariffs, and corporatizing utilities. Politics is viewed as an impediment to getting this sound, technical advice implemented as policy.

Politics provides a market test for public policies from which economists need to learn.

The technical solutions of privatization and liberalization offered by economists to obvious problems of state-run enterprises, utilities, and other public agencies can ultimately be traced to the so-called fundamental theorem of welfare economics. Put simply, the theorem says that forces of competition in markets will yield better incentives and outcomes than state control. Yet, in focusing on one powerful result, economists have ignored the conditions under which the result holds: the need for state institutions to establish and protect property rights and facilitate trust in contracts. Further, economists have paid too little attention to our own discipline’s arguments for the role of public policy to address market failures and ethical concerns over inequality. In the classic graduate textbook of public economics, Jean-Jacques Laffont concludes that the economist can only define optimal policies from the perspective of a particular social welfare function. Since social welfare functions are defined in political markets, the technical is political.

What is the social welfare function underpinning the traditional policy prescriptions described as the “Washington Consensus,” or some version thereof? Sustained economic growth that increases the size of the proverbial pie is at the heart of this function. Growth-enhancing policy reforms are argued to be along the lines of privatization of state-owned enterprises; deregulation of “over-regulated” industries; financial liberalization (reducing state ownership of banks, for example); trade liberalization and supporting exchange rate policies (to facilitate a globally connected market economy); fiscal reforms (to ensure debt sustainability); and shifting public spending away from “non-merit” subsidies (meaning, it seems, subsidized consumption of energy, water, etc.) to basic health and education for poor households. But how do policy advisers know what is “over-regulated,” what are meritorious versus non-merit subsidies? By running growth regressions and simulations for macro policies, and randomized control trials for micro ones? The more policy prescriptions are pinned on growth regressions and forecasts, and on randomized control trials of small interventions, the further removed they are from economics, let alone politics.

Citizens in poor countries—where international organizations wield significant influence over policy—have long been complaining about pro-market reforms that are not accompanied by sufficient consideration of market failures and inequality. The response of international organizations was to devise communication strategies to help citizens understand the economic arguments. Now, citizens are on the streets in rich countries as well, and there are calls for reforming capitalism and rebuilding trust in government. The time seems to be right to move beyond the market-versus-state debates of the past decades and toward finding common ground using the very same logic of economic theory that advocated for markets to advocate for strengthening state institutions.

The reform needs of the 21st century are institutional, to enable governments to support markets where they work, and to step in when they don’t.

It is not useful to approach the political economy of reform by identifying winners and losers from piecemeal liberalization reforms (remove this subsidy, privatize that utility), and then proceeding to find credible ways of compensating the losers or persuading them to not block the reform. This approach does not have a track record of success. Instead, political economy research should be used by policymakers and their advisers to pursue institutional reforms.

There is growing economic theory, and supporting evidence, on trust and institutions. The old principal-agent problems in the firm or corporation are being further developed in the context of public sector organizations. State institutions can be examined as complex principal-agent problems that have multiple equilibria, each underpinned by a different set of beliefs or expectations about how others are behaving. This is the theory that could help find solutions to urgent problems of the 21st century, such as managing scarce water resources, adapting to and preventing further catastrophic climate change, preventing the spread of disease in a globalized world, and reducing violent conflict and forced displacement of people. These are problems where markets either do not exist or fail. A blanket prescription to push for markets as solutions—as some view the case of privatization of water, for example—is neither helpful to governments nor faithful to economics.