Half-a-loaf reforms not enough to achieve economic stability

The key to a successful growth strategy is to ensure that policies reinforce and enhance one another, writes Michael Spence

AT A time of lacklustre economic growth, countries around the world are attempting to devise and implement strategies to spur and sustain recovery. The key word is strategy: To succeed, policymakers must ensure measures to open the economy, boost public investment, enhance macroeconomic stability, and increase reliance on markets and incentives for resource allocation are implemented in reasonably complete packages. Pursuing only some of these objectives produces distinctly inferior results.

China provides a telling example. Before Deng Xiaoping launched the policy of “reform and opening up” in 1978, the country had relatively high levels of public-sector investment. But the centrally planned economy lacked market incentives and was largely closed to the global economy’s major markets for goods, investment, and technology. As a result, returns on public investment were modest, and China’s economic performance was mediocre.

China’s economic transformation began with the introduction in the 1980s of market incentives in the agricultural sector. These reforms were followed by a gradual opening to the global economy, a process that accelerated in the early 1990s. Economic growth surged ahead, and returns on public investment soared, reaching an annual growth rate above 9% of GDP, shortly after the reforms were implemented.

The key to a successful growth strategy is to ensure that policies reinforce and enhance one another. For example, boosting returns on public investment — critical to any growth plan — demands complementary policies and conditions, in areas ranging from resource allocation to the institutional environment. In terms of effectiveness, the policy package is more than the sum of its parts.

Of course, the specific portfolio of policies varies depending on the stage of a country’s development; early-stage growth dynamics are distinctly different from those in middle-income and advanced countries. But the imperative is the same. Just as a developing China achieved rapid growth only when a comprehensive policy package was implemented, the advanced countries struggling to restore sustainable growth patterns today have found that incomplete policy packages produce slow recoveries and below-potential growth and job creation.

Consider the post-crisis performance of the European Union and the United States. Though both have had their share of problems, the US is performing somewhat better (though it still faces major challenges in generating middle-income employment).

The difference is not that the US launched a large fiscal stimulus focused on public-sector investment; no such stimulus was implemented, though many economists, including me, believe it would have generated a faster recovery and stronger long-term growth. Nor is the difference greater political effectiveness; few would say that the US government is functioning well nowadays, given rising partisanship and sharp disagreement about its proper role.

The US economy has benefited from two factors: its greater structural flexibility and dynamism relative to Europe, and the broader mandate of the US Federal Reserve, which has pursued a far more aggressive monetary policy than has the European Central Bank. Though analysts differ on the relative importance of these two factors — and, indeed, it is difficult to weigh them — it is safe to say that both played a role in facilitating the US recovery.

Europe is now placing a large bet on an increase in public-sector investment, using a combination of EU-level funding and national investment programmes, perhaps augmented by a modification of the EU’s fiscal rules. Given that public-sector under-investment is a common cause of subpar growth, this is a step in the right direction.

But public investment is not enough. Without complementary structural reforms that encourage private investment and innovation — and thus enable economies to adapt and compete in a global, technology-driven economy — a public-investment programme will have a disappointingly weak impact on growth. Instead, debt-financed public investment will produce a short-run stimulus, at the cost of longer-term fiscal stability.

The problem is that structural reforms are notoriously difficult to implement. For starters, they face political resistance from short-run losers, including the companies and sectors that existing rigidities protect. Moreover, in order to ensure such reforms ultimately benefit everyone, there must be a strong culture of trust and a determination to prevent more flexible arrangements from leading to abuses.

Finally, structural reforms require time to take effect. This is particularly true in the eurozone, whose members abandoned a crucial tool for accelerating the process — exchange-rate adjustments to account for different economies’ productivity levels — when they adopted the common currency.

ECB president Mario Draghi recently argued that, because individual EU countries’ growth-retarding policies have negative external effects, perhaps they should not have unimpeded control in certain policy areas. Though member countries’ financial supervisory authority is already being limited through centralisation of bank regulation and resolution mechanisms, Draghi’s suggestion is more far-reaching.

One wonders if Draghi’s proposal is politically feasible in the EU context. Even if it were, would it be necessary? All economies have sub-units across which economic productivity, growth, and dynamism vary considerably. Indeed, differentials in the quality of governance and policies seem persistent, even in economies that perform pretty well overall.

Perhaps part of the answer is to prevent sub-units — in the EU’s case, member countries — from falling short on reforms. But centralisation carries its own costs.

Given the risk inherent in betting on policy convergence, labour mobility — which enables highly valuable human capital, especially well-educated young people, to leave lagging regions for those that offer more and better employment opportunities — could prove to be a critical tool for adjustment.

As it stands, labour mobility is imperfect in the EU. But, with language training and the implementation of something like the Lisbon strategy for growth and jobs (which aimed to create an innovative “learning economy,” underpinned by inclusive social and environmental policies), mobility could be enhanced.

But more fluid labour mobility is no panacea. As with every other element of a growth strategy, mutually reinforcing efforts are the only way to achieve success. Half a loaf may be better than none, but half the ingredients do not translate into half of the hoped-for results.

Michael Spence, a Nobel laureate in economics, is professor of economics at New York University’s Stern School of Business and senior fellow at the Hoover Institution. Copyright: Project Syndicate, 2015.


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