On making policy in a second-best world:
[W]e're always in a second-best world. We're always forced to think about reform strategies that will work in the world as we find it, not in the world we would like to have. Suppose you're in a setting where the rule of law and contract enforcement are really weak. And you realize that they don't change overnight. Are you better off promoting the set of policies that presume that rule of law and contract enforcement will take care of themselves, or are you better off recommending a strategy that optimizes against the background of a weak rule of law? And I say that the evidence is that you do much better when you do the second.
The best example is China. Its growth experience is full of these second-best strategies, which take into account that they have, in many areas, weak institutions and a weak judicial system, and therefore they couldn't move directly to the kinds of property rights we have in Europe and the United States. And yet they've managed to provide incentives and generate export-orientation in ways that are very different from how we would have said they ought to have done it, which would have been to simply open up their economy or privatize their enterprises. There, second-best strategies have been very effective. The same can be said of Vietnam, say, or farther afield, a country like Mauritius. ...
The point about second-best outcomes is just a warning that you better do your homework and make sure that the second-best interactions are the wind behind you rather than the wind that'll be slowing you down.
I can give you examples where I think the standard recipe worked very well. Poland in 1990 did the most amazing cold turkey reforms. It opened up its economy, removed its subsidies, and removed price controls, all virtually overnight. And they did rather well, but there were a number of things that were specific to the Polish context that supported that — it had membership in the European Union as a carrot, and it received a stabilization fund to underpin the zloty. When Russia tried to do the same, it didn't work, because there were many things that were missing in that context compared to the Polish.
On nation-states in a global economy
Now, one can envisage a world economy where those institutions are provided not by the nation-state but by some global institutions. Conceptually, there is no reason why we can't have those, in which case the nation-state might become no more important than the state governments of Kansas or Nebraska are to the U.S. economy. But unless we have something like that, all we have is the nation-state. So it's very important for the health of markets – national and global — that the nation-state be healthy, that it be able to provide those functions. That necessarily means that economic globalization is something we can push only so far, because if we push it so far that you weaken the nation-state, it cannot provide these functions anymore — in fact you are undermining the stability and function of markets as well.
I think the financial crisis has made us see this a little bit better at least in the context of financial regulation, which is moving in a much more robust way into the national domain. But the lesson extends beyond financial regulation to many of the market-supporting functions of the nation-state.On how economic science works and the role of models
The root of it is the problem that the profession has more or less the wrong idea about how economics as a science works. If you ask most economists, "What kind of a science is economics?," they will give a response that approximates natural sciences like physics, which is that we develop hypotheses and then we test them, we throw away those that are rejected, we keep those that cannot be rejected, and then we refine our hypotheses and move in their direction.
This is not how economics works — with newer and better models succeeding models that are older and worse in the sense of being empirically less relevant. The way we actually increase our understanding of the world is by expanding our collection of models. We don't throw out models, we add to them; the library of models expands. Social reality is very different from natural reality in that it is not fixed; it varies across time and place. The way that an economy works in the Congo is very different from the way that it works in the United States. So the best that we can do as economists is try to understand social reality one model at a time. Each model identifies one particular salient causal mechanism, and that salient effect might be very strong in the Congo but it may be very weak at any point in time in the United States, where we may need to apply a different model.
If you look at the progress of economics all the way from perfect competition to imperfect competition, from incomplete information to behavioral economics, at every step we have said, "Here are some additional realities for which we need newer models." Behavioral economics doesn't mean that we want to ignore models in which people are rational. There are plenty of settings where presuming people are behaving rationally is still the right way to go.
When you look at economics in that way, as a collection of models, then what does it mean to say that economics knows something about the world? Economists know how to think about various causal mechanisms that operate as part of social reality, but what they're very bad at in practice is navigating among the models describing them. How exactly do I pick the right model for a given setting? This is a craft because the evidence never settles it in real time. We have these periods of fads where we say the New Keynesian or the Neoclassical model explains everything. We lose sight of the fact that models are highly context-specific and we need to be syncretic, simultaneously carrying many models in our mind.