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Global macro & geopolitics from a small economy perspective

Political economy is back

David Skilling
Singapore Straits Times, 6 October 2012

The current economic and social challenges facing advanced economies around the world are reminiscent of the challenges facing policy-makers in the 1930s/40s and again in the 1970s/80s when a changing world reduced the effectiveness of existing policy approaches.

Now, as then, many advanced economies face sluggish income growth, substantial fiscal imbalances, and worsening employment and income distribution outcomes. These poor economic and social outcomes are not simply due to an unusually deep business cycle, but to the impact of intense globalisation, technological change, and policy choices. These are structural challenges, and demand a structural response.

These historical experiences also provide guidance in terms of how to respond. In both historical cases, new economic and social models were developed to respond to the new conditions – a more active role for government (the Keynesian Consensus) in the first example, and a slimmed-down role for government in the second example (the Washington Consensus). We are now in the midst of another turn of the cycle, although there is little yet by way of an intellectual consensus on the way forward.

These historical experiences also remind us that responding to these challenges is fundamentally about politics. For one thing, the economic and social models that were developed, particularly in the 1940s, were based on a broadly-shared political consensus that lasted a few decades. And importantly, to get to this new approach, governments first needed to manage through a period of volatile and sluggish growth, high unemployment, and price instability. Countries with high quality political institutions and leadership – such as the US under FDR’s Administration in the 1930s and 1940s – performed better than those that had weaker political systems.

This experience has direct relevance to today’s debates. Resolving the Eurozone crisis, addressing structural fiscal issues in the US, or managing sustained austerity programmes are all political – as well as economic – issues. They necessarily involve political choices about allocating adjustment costs and create winners and losers. These choices are particularly difficult in times of slow, volatile growth and fiscal austerity, when social tensions are likely to be rising.

Making appropriate choices on these issues has an important bearing on the economic and social outcomes that will be generated. And so the quality of political institutions and debate is likely to be an important source of national competitive advantage.

The implication is that assessing the prospects for the economic performance of various countries needs to incorporate a judgement on the ability of their political institutions to make sensible policy decisions. The underlying economic fundamentals, such as labour force growth, productivity potential, and the natural resource endowment, all matter. But countries can easily under-shoot their potential if their political systems are dysfunctional.

It is common to consider the impact of the political environment on economic outcomes in emerging markets. But the scale of the challenge facing many advanced economies means that politics is also an increasingly important factor in the developed world.

The US, for example, has many well-known economic strengths – such as a vibrant technology sector, globally competitive large companies, and world-leading universities – but increasingly it is the nature of its political institutions that are influencing sentiment about its medium-term prospects. Surveys of business and investor confidence consistently identify uncertainty about the nature of policy decision-making about fiscal policy as a negative factor. This constrains the economic potential of the US, despite their many strengths and capabilities.

In Europe, there are serious challenges associated with resolving the issues arising from the Eurozone crisis. This is still work in progress, although it seems to be heading in the right direction – largely because of political resolve, individually and collectively.

And at a national level, it is striking that the European countries that have responded most effectively to the crisis are those countries with well-functioning political institutions and that have relatively high levels of social trust and shared purpose. Many of these are small countries, such as the Baltic countries, Ireland and Iceland, who were hit hard by the crisis – but which have taken hard decisions on fiscal consolidation and structural reform and are now heading in the right direction. In general, although there have been changes in government in Europe (such as France and Italy), the political centre is holding.

In contrast, the countries that are struggling, such as Greece, are those with weaker political institutions – as well as having serious economic issues. And the prospects for countries such as Spain and Portugal rest heavily on the ability of their political leadership to reach a consensus on the way forward.

Considering the quality of a country’s government, political institutions, and political debate provides a useful additional perspective source of guidance on a country’s likely performance. This perspective makes me more positive about Europe’s overall prospects and less positive about the outlook for the US. Europe, and many of the European countries, recognises that it has structural issues and is embarked on a difficult process to address its challenges – and, for the most, part is maintaining a political consensus. The US, in contrast, seems not to have achieved a common perspective on the nature of its challenges – outside fiscal policy – and it is not at all clear whether progress is possible in Washington.

Some may disagree with these assessments. But the point is that the quality of political debate and decision-making is an increasingly important driver of national competitive advantage. In the short-term some of the decisions can be out-sourced to central bankers and other technocrats, but ultimately it is the government that will need to make hard decisions.

This is, then, a demanding time to be in government. There is a substantial intellectual challenge in determining how best to adapt the economic and social models to the emerging environment. Simply following the policies that worked well in the previous environment will not be sufficient. But this is also an intensely political process. Countries and governments that can manage the current political pressures, as well as developing a consensus on how to respond to the changing world, are likely to generate stronger economic performance over the coming years.