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Global macro & geopolitics from a small economy perspective

Taking context seriously

David Skilling
14 October 2011

This is the latest edition of an email series containing reflections on globalisation, policy, and public sector issues. Despite the events of the past few years many commentators continue to offer sweeping, universal economic policy recommendations (the ‘hedgehog problem’ I have discussed before). But all countries are different in some way, and these differences should be taken seriously in designing economic policy. So this week’s Observer contains some reflections on the importance of national context for policy design, with specific reference to the policy implications of the size of countries.

Context trumps universality
The cross-country evidence shows that there is only a relatively weak relationship between specific policies and economic outcomes. Differences in geography, the location of competitive advantage, preferences, history, culture, and institutions, and a myriad of other factors, mean that there is no clean mapping of policy settings onto outcomes. Dani Rodrik observes that there is “one economics” but “many recipes” in terms of designing policy; there are enduring principles of good policy but many ways to give effect to these principles. There is a substantial element of art to economic policy-making as well as science.

This resonates with me. More than 15 years of working in or alongside governments has taught me that context trumps universal policy principles. In my observation, successful, sustainable policy-making takes context seriously and is humble in the application of policy principles. Very few policies work at all times and in all places; a country’s situation and circumstances matter enormously for the effectiveness of policy. In New Zealand, for example, the impact of implementing orthodox policy settings was significantly altered by the forces of economic geography and the impact of globalisation on a small, remote economy. The late Speaker of the US House of Representatives, Tip O’Neill, famously observed that “All politics is local”. Much the same can be said for the design of economic policy.

Small countries are not scaled-down large countries
As one example of the importance of context, consider how country size can affect policy-making. Small countries are different from large countries in many respects. To name a few: small countries tend to be less diversified, to have fewer areas of critical mass, to have a greater exposure to the global economy in terms of trade and investment flows (in both directions), are more likely to be volatile, and are more exposed to the agglomeration effect in which people, capital, and companies tend to be attracted to larger economic centres. So economies do not scale in a linear way; New Zealand is not just a 1% version of the US economy, nor Singapore a 10% version of the UK economy, and economic policy needs to be approached differently. Just as in the physical sciences (e.g. phase transitions in networks, emergent properties of systems) the scale of the economic system matters.

Clearly there are some elements of policy best practice that can be sensibly applied across countries, large and small, but policy settings need to deal with context seriously. Indeed, the policy debates in small countries feel different and focus on different issues than those on the radar screen of G20 policy-makers. In terms of fiscal policy, for example, small countries are more likely to emphasise prudence and resilience because of their greater exposure to market sentiment than large countries that have more degrees of fiscal freedom (reserve currency status makes it easier for the US to borrow). And economic policy in small countries commonly has a more deliberate feel to it, reflecting an attempt to position their economies to compete successfully; for example, through R&D spending, tax policy, support for key sectors, and so on, in addition to the macro policy foundations. This does not necessarily mean bigger government (e.g. Singapore, Hong Kong), but in general it does mean a more deliberate, strategic government. These policy differences reflect the different realities that small countries confront. [As an aside, I am frequently struck that the policy debates in state and city governments of large countries are more reminiscent of those in small countries than those in their national capitals].

Beware homogeneity
At one level, pointing to the importance of local context is not particularly controversial. And indeed, many governments are very thoughtful in this regard. But strong pressures towards policy homogeneity remain, and governments need to be vigilant to resist these various pressures. First, the pressure to ‘chase the median’: there are any number of rankings that compare countries on multiple measures in order to better understand their strengths and weaknesses. This can be useful, but the response should be more than simply making sure that countries benchmark well against their peers on all dimensions; countries should tailor their efforts to a national strategy. Second, the pressure to pursue the conventional policy wisdom, which is often developed in larger countries. Conventional wisdom on fiscal policy and industrial policy (as discussed above) may not be well-suited to small countries for example. At the least, the conventional wisdom needs to be tested. And third, the pressure to consider only the domestic environment in designing a policy approach. Ironically perhaps, local context becomes more important when the challenge is to position an economy in a globalising world. In autarky, it may be that there is a more uniform set of policy prescriptions; this is much less the case when a country is globally exposed, and countries need to develop strategies that position them for success in the global economy.

The existence of these choices places substantial demands on the capacity of decision-makers. Implementing a menu of first best policies may be politically challenging but it is not particularly intellectually taxing. In contrast, country-specific policy requires a deep understanding of both policy principles and local context. Not only is this hard work, it also requires innovation, creativity, and risk tolerance –and an acceptance of differences. And because the world is not static, ongoing investment in this process will be required as a country’s circumstances change. But the upside from this investment is a substantially improved likelihood of achieving peak performance.