By MARIANA MAZZUCATO & SIMON SHARPE*

How to make better economic policy choices

The UK is entering its deepest recession in 300 years. Millions of jobs are at risk and the national debt has exceeded 100% of GDP. Isn't it time to explore the conceptual foundations of economic theory?

Indeed, as governments everywhere are borrowing, spending and regulating on an unprecedented scale, a deeper understanding of economic decision-making is essential to speed recovery and avoid long-term risks. This is why the UK Treasury's new guidance on decision-making for transformational change is so welcome, and why ministries of finance everywhere must follow suit.

In a recent study for the Better Regulation Executive from the UK, we found that while public policy organizations are increasingly diversifying their approaches to decision-making, many remain overly reliant on static tools such as cost-benefit analysis. These tools are inadequate to understand, predict and drive innovation and structural changes in the economy.

In the UK, critics of cost-benefit analysis argue that the practice has contributed to worsening regional inequality. If infrastructure investments in areas of higher productivity are valued as more valuable, these wealthier regions will receive the lion's share of new investment, further increasing their productivity. this cycle of feedback reinforcement will naturally cause a widening gap between the haves and the have-nots. Static cost-benefit analysis does not recognize these Feedback dynamic.

Prevailing economic policy structures have also hampered the global response to climate change. Static analysis suggests that replacing coal with gas would be the cheapest way to reduce emissions. But the theory totally ignored the Feedback dynamics that would lead renewable energy to become the cheapest form of electricity generation quickly.

These are not market failures, they are failures in our understanding of how markets work.

When we worked together on the UK Industrial Strategy in 2017, we found that many economists had highly restrictive views on the role of the state. Some advocated government support only for sectors that were already relatively competitive exporters. Others said anything beyond fixing market failures was too much. For still others, the best industrial strategy was not to adopt an industrial strategy.

And yet, it was state investment that led to the internet and smartphones – investments aimed not at correcting market failures, but at developing new opportunities. If South Korea had focused on sectors where it had a proven comparative advantage during the post-World War II years, it would have doubled down on rice exports rather than become the world's most innovative economy.

The UK Treasury's new guidance is revolutionary in recognizing that the economy is a complex system, shaped by Feedback dynamic and constantly changing. This new understanding, based on the concepts and mathematics of evolution rather than those of Newtonian mechanics, can go beyond allocating scarce resources to create new ones. He recognizes that innovation, growth and transformation are happening all the time, it is up to the State to stimulate them in a direction of change that is advantageous for society.

Targeting choices matter, because seemingly small developments can have huge and lasting consequences. The innovations that gave internal combustion engines an edge over electric vehicles in the early 1900s had profound effects – on the oil industry, urban planning, global geopolitics and the planet – that we still struggle with today.

Path dependence arises because markets are deeply social, embedded in institutions, norms and routines, and because technologies benefit from increasing returns. As a result, markets can get stuck in less than ideal conditions and economies can get stuck in competitive positions whether they like it or not. For decades, Germany was the world leader in machine tools and the United States in information and communication technologies.

Today, the world is moving towards a clean energy economy. But the form it takes, the pace at which it develops, and the competitive positions of countries within it depend on the economic policy decisions that governments make now. Governments that try to stimulate their economies by building new coal plants will create lost assets and increase the future risk of job losses. Those who invest strategically in clean technologies, by contrast, will claim top positions in the economy of the future.

After setting a direction, governments need to identify the most effective policies to drive progress. In complex systems, cause and effect are often disproportionate. To ensure large gains with small inputs, and not vice versa, we must find leverage points.

Many economists have recommended a single carbon price, applied equally across the economy, as the most efficient approach to reducing greenhouse gas emissions. But apart from a few exceptions, where targeted carbon pricing has helped trigger tipping points, new investment, not through carbon taxation, has so far driven nearly all of the world's progress in low-carbon transitions.

This shouldn't come as a surprise. Imagine the current fossil fuel economy as a large building that needs to be demolished. Should we drive a bulldozer and push hard against the side, spreading the pressure evenly throughout the building, or should we focus that same energy into a controlled explosion at a critical point in the structure?

Identifying these hot spots requires a better understanding of the Feedback in the economy, as we argued in 2018. Policy choices also benefit from considering dynamic spillover effects – where change in one sector catalyzes further changes in others. For example, the industry from software it emerged as a spin-off from NASA's Apollo program. Had the program been evaluated on the basis of a cost-benefit analysis, it would never have started.

In a new working paper, we suggest how the traditional cost-benefit analysis can be extended to become a “risk-opportunity analysis”, in which the mapping and manipulation of Feedback are central. By dealing with the economy in all its messy and ever-changing complexity, this approach is better able to ensure that our investments are not wasted, our recovery is not delayed, and the new world economy we create is more prosperous, equal and sustainable.

*Mariana Mazzucato is professor of economics at the University of Sussex (USA). She is the author, among other books, of the entrepreneurial state (Company of Letters).

*Simon Sharpe is a visiting policy researcher at the Institute of Innovation and Public Purpose of University College London (UCL).

Translation: Stefanni Mota

Originally published on the portal Project syndicate.