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Politics-Proof Economies?

by Michael Spence
March 18, 2014

Federal workers demonstrate for an end to the U.S. government shutdown on the west front of the U.S. Capitol in Washington, October 13, 2013 (Jonathan Ernst/Courtesy Reuters). Federal workers demonstrate for an end to the U.S. government shutdown on the west front of the U.S. Capitol in Washington, October 13, 2013 (Jonathan Ernst/Courtesy Reuters).

This post was co-authored with David Brady, Deputy Director and Senior Fellow at the Hoover Institution and Professor of Political Science at Stanford University.

MILAN–Governments’ inability to act decisively to address their economies’ growth, employment, and distributional challenges has emerged as a major source of concern almost everywhere. In the United States, in particular, political polarization, congressional gridlock, and irresponsible grandstanding have garnered much attention, with many worried about the economic consequences.

But, as a recent analysis has shown, there is little correlation between a country’s relative economic performance in several dimensions and how “functional” its government is. In fact, in the six years since the global financial crisis erupted, the United States has outperformed advanced countries in terms of growth, unemployment, productivity, and unit labor costs, despite a record-high level of political polarization at the national level.

Of course, one should not paint with too broad a brush. Unemployment is lower in Germany, Canada, and Japan. And the U.S. income distribution is more unequal than in most advanced countries–and is trending the wrong way. Still, in terms of overall relative economic performance, the United States clearly is not paying a high price for political dysfunction.

Without dismissing the potential value of more decisive policymaking, it seems clear that other factors must be at work. Examining them holds important lessons for a wide range of countries.

Our premise is that the global integration and economic growth of a wide range of developing countries has triggered a multi-decade process of profound change. These countries’ presence in the tradable sector of the global economy is affecting relative prices of goods and factors of production, including both labor and capital. At the same time, declining semi-conductor costs have encouraged the proliferation of information and communication technologies that are replacing labor, dis-intermediating supply chains, and reducing routine jobs and lower-value-added jobs on the tradable side in advanced economies.

These are secular trends that call for forward-looking assessments and long-term responses. Relatively myopic policy frameworks may have worked reasonably well in the early postwar period, when the United States was dominant, and when a group of structurally similar advanced countries accounted for the vast majority of global output. But they cease working well when sustaining growth requires behavioral and structural adaptation to rapid changes in comparative advantage and the value of various types of human capital.

What, then, accounts for the U.S. economy’s relatively good performance in the post-crisis period?

The main factor is the U.S. economy’s underlying structural flexibility. Deleveraging has occurred faster than in other countries and, more important, resources and output have quickly shifted to the tradable sector to fill the gap created by persistently weak domestic demand.

This suggests that, whatever the merit of government action, what governments do not do is also important. Many countries have policies that protect sectors or jobs, thereby introducing structural rigidities. The cost of such policies rises with the need for structural change to sustain growth and employment (and to recover from unbalanced growth patterns and shocks).

No country is frictionless in this regard, but there are substantial differences. Relatively speaking, Germany, northern Europe, the United Kingdom, Canada, Australian, New Zealand, and the United States are relatively free of structural rigidities. Japan intends to get there. Southern Europe has a substantial agenda of flexibility-enhancing reform ahead of it.

Removing structural rigidities is easier said than done. Some stem from social-protection mechanisms, focused on jobs and sectors rather than individuals and families. Others reflect policies that simply protect sectors from competition and generate rents and vested interests. In short, resistance to reform can be substantial precisely because the results have distributional effects.

Such reform is not market fundamentalism. The goal is not to privatize everything or to uphold the mistaken belief that unregulated markets are self-regulating. On the contrary, government has a significant role in structural transitions. But it must also get out of the way.

Relative to the United States, Europe has two sets of problems. One is the need, especially in several southern European countries, to enhance structural flexibility and boost productivity. In the euro’s first decade, the southern economies’ unit labor costs diverged from those in Germany and the north, with growth sustained either by excess public debt and the government component of domestic aggregate demand, or, in the case of Spain, by a leveraged housing bubble. In the absence of the exchange-rate mechanism, resetting the system to allow the tradable sectors to generate growth involves painful relative deflation, a process that takes longer in a low-inflation environment.

Second, the eurozone permits these divergences because policies that affect growth are decentralized. The common currency and monetary policy are in constant tension with decentralized policymaking on taxation, public-sector investment, and social policies–all of which affect countries’ structural flexibility. Moreover, the single market is relatively complete in goods but not in services.

This is not a stable situation. Europe eventually must gravitate either toward deeper political, fiscal, and policy integration, or toward a structure that includes adjustment mechanisms–for example, greater labor mobility–to accommodate divergences in productivity.

Many countries, not only in Europe, must undergo structural adjustment in order to achieve sustainable growth patterns. All advanced economies’ structures and portfolios of employment opportunities are facing similar competitive and technological forces, and all are tending to shift income toward the upper end of the distribution and toward owners of capital.

The cross-country differences in performance partly reflect past policy choices affecting the speed of adjustment. Initial conditions matter, and in this respect America’s policy framework seems to have ensured the U.S. economy’s relatively higher resilience not only to the global crisis, but also to domestic political volatility.

Structural flexibility is not the whole answer; higher levels of public-sector investment would also help to generate sustainable recovery, especially in the advanced countries. But, with severe fiscal constraints in many countries likely to delay that element of the policy response, flexibility-enhancing reforms are the right place to start.

This article originally appeared on project-syndicate.org.

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