The Banking Executive Magazine - May 2021

Incentives VS Capabilities ISSUE 149 MAY 2021 the BANKING EXECUTIVE 19 Economists study the world through the lens of incentives, and have de- veloped a rich understanding of how market participants make decisions. But although incentives are impor- tant, developing countries must do more than institute the right ones. You don’t have to be a neuroscientist to understand that your brain deter- mines 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 incen- tives. Incentives are everywhere, and eco- nomics has developed a rich and subtle conceptual framework for un- derstanding all the ways in which they might get distorted. We talk about moral hazard, adverse selec- tion, common-pool problems, agency problems, externalities, rent- seeking, excludability, rivalry, and market power. With these concepts, economists can explain why some- one might do too little of a good thing (like investing, working, or pro- viding 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 attrib- uted 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 nar- rower palette with which to describe capabilities and how they grow. But capabilities clearly matter. If some- one is not doing something that we as a society value, it might be be- cause they can’t, not because they don’t want to. This weakness in eco- nomics has far-reaching implications for our understanding of economic growth and development, which is fundamentally about the social accu- mulation of productive capabilities. Whereas incentives affect the choices one makes among the op- tions one faces, capabilities deter- mine which options are available. Economic growth and development are about the expansion of those op- tions and hence depend fundamen- tally on policies that catalyze or fa- cilitate the accumulation of capabil- ities. 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 disincen- tives to export. Perhaps trade protec- tionism 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 proce- dures are adding transaction costs. Or maybe high transport costs have become a hindrance. Not surpris- ingly, 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. Seldom do economists studying this question consider whether a country has the capabilities needed to pro- duce the right products of the right