Scott Sumner  

Policy affects levels, not growth rates (except in transition)

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Paul Krugman has a post that contrasts the economic performance of Japan, the US and France:

What's striking here is how similar the three look. Japan lagged in the late 1990s and early 2000s, but recovered. France has lagged since 2010, largely thanks to the eurozone crisis and its misguided austerity policies. But given how much rhetoric there is about structural problems here and there, what's striking is how little divergence there has been among advanced countries.

What this tells you, I think, isn't just that international competition is far less important than legend has it. It also suggests that economic growth is pretty insensitive to policy: France and the US are at the extremes of advanced-country regimes, yet there's not much difference in their long-term performance.


I mostly agree with this. International "competitiveness" is a completely bogus idea, not even worth discussing. Paul Krugman's own "Pop Internationalism" is perhaps the most effective demolition of the idea. I also think that long run economic growth is relatively insensitive to policy. If the global economy were growing at 1% per year in per capita real GDP, then I'd expect both Switzerland and North Korea to grow at about that rate, in the long run. At least assuming no policy changes. (Elsewhere I've predicted that North Korea will experience the world's fastest growth over the next 50 years, precisely because I expect them to engage in the largest amount of policy reforms.)

Perhaps this concept is easiest to explain with an example. Both Japan and France were much poorer than the US after WWII. Both engaged in "catch-up growth" until about 1990, at which point their per capita GDPs (PPP) had risen to about 70% of US levels. At that point they stopped gaining on the US. I would argue that this 30% gap is caused by policy differences, although I can imagine there might be other minor factors as well, such as land constraints in Japan. In any case, the US had a policy regime capable of producing modestly higher per capita GDP. But there is no reason for that gap to widen, unless the policy gap widens.

To take the simplest case, suppose that France's tax and transfer policies reduced hours worked by 30%. That alone could explain the GDP gap. But unless that policy gap got wider, both countries would grow at the same rate from that point forward. In fact, I do believe that much of the gap between the US and France is due to hours worked, although not all of it. The hours worked gap shows up in France having higher unemployment (bad) and lower hours per year for the employed (bad in theory, although often viewed favorably.)

France's productivity numbers look similar to the US, although they actually should be a bit higher, when you factor in things like their 10% structural unemployment. Japan's case is different, with hours worked being close to US levels (last time I looked) but much lower productivity. That may be because unlike France, Japan has relatively low average tax rates, similar to US levels. Instead their regulatory structure seems to create lots of inefficiencies.

To summarize, I worry that when people read Krugman say (correctly) that economic reform won't affect growth, they may get the wrong idea, and assume it doesn't affect the level of output. It most certainly does. And if you change the policy regime then growth changes during the adjustment period. For instance, today Britain is almost exactly as rich (and populous) as France, but went from growing slower than France prior to 1980 to growing faster since. That's because pre-Thatcher Britain had a worse economic model, and now it's about the same. (Or more likely in my view, Britain now has a better model, but France has more land and more human capital.)


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COMMENTS (19 to date)
John writes:

Hi Scott,

This is off-topic for this specific post, but I'm struggling with finding a way to reach you - both blogs seem to have no contact links for you.

Your principle: never reason from a price change - I'm trying to embrace it, but I'm struggling. Specifically in the case of raising the minimum wage and the impact on restaurant prices - Kevin Drum says "it won't matter, since all the restaurants are in the same boat". Megan McArdle points out that people can also choose to eat out less in response to rising restaurant prices.

Megan's response resonates with me as completely obvious and true, but it seems like it falls into the "Reasoning from a price change" error.

What am I missing?

[John: You can reach our bloggers any time by emailing them at our email address at webmaster@econlib.org.--Econlib Ed.]

Jeremy writes:

Japan has recovered?

Scott Sumner writes:

John, Good point, I meant never reason from an equilibrium price change. It is OK to reason from price controls. And as for the argument that "everyone is in the same boat,"
McArdle is clearly right. That's a pretty weak argument. Even if Drum is right about the minimum wage, he's definitely not right for that reason, as all consumers are always in the "same boat" when prices rises. And yet demand curves slope downward.

Jeremy, Their unemployment rate is down sharply, to 3.4%. I'm not saying they are fully recovered, but they are probably as close to being recovered as we are, and maybe more so than France.

Michael Byrnes writes:

@John,

I think that what Scott means by that saying is that it is important to reason from the underlying cause of the price change rather than from the price change itself.

If oil prices rise does that fact, in and of itself, mean that people are buying less oil (since it is more expensive to buy)? No. A rise in oil prices could mean that that there is more global demand for oil (ie, oil sales are actually higher) or it could mean that there has been a negative supply shock (ie, oil sales are falling because there is less oil to sell). Knowing only that the price rose you cannot conclude whether sales have risen or fallen.

One could envision a scenario where restaurant owners start voluntarily paying their wait staff at least $15 per hour. Or one could envision a $15 minimum wage, so restaurant owners pay their wait staff at least $15 per hour because they cannot legally do otherwise. The price change is the same, but the cause is different. When people criticize the $15 minimum wage, they are really criticizing the imposition of a price floor.

Dustin writes:

How does this rationale square with the divergent performance of states in the U.S.? Surely states have divergent policies, but these don't seem to explain performance.

E. Harding writes:

"I'd expect both Switzerland and North Korea to grow at about that rate, in the long run. At least assuming no policy changes."
-Then riddle me Madagascar and Niger. Has there been a continuous deterioration of policy in these countries? And Mexico (whose GDP/worker hour hasn't significantly grown since 1980, despite no deterioration in policy).

E. Harding writes:

Also, regarding France, its RGDP/worker has shown a similar falling behind the U.S. as in Japan, only to a lesser extent:
http://research.stlouisfed.org/fred2/graph/?g=1F80
Peak=1.000

Swami writes:

[Comment removed. Please consult our comment policies and check your email for explanation.--Econlib Ed.]

khodge writes:

I'm a bit confused by Prof. Krugman: How can he, in adjacent paragraphs, refer to "misguided austerity policies" followed by "economic growth is pretty insensitive to policy?" I cannot understand how you could quote those paragraphs together and still have room to make a salient point.

Floccina writes:

This is good news because it means that the poorer parts of the world will have growth even if without big reforms.

Roger McKinney writes:

The growth rates of the US, Japan and France are similar because their policies are very similar. France likes to think of itself as socialist and the US thinks it's capitalist, but the truth is that there is very little difference in the three. All follow Keynesian/socialists policies. The differences are greatly exaggerated.

Brandon Berg writes:

I think Drum is making an important point, albeit overreaching. Every individual business owner, reviewing the books, might, after reviewing his books, naively conclude that since his profits are less than the expected increase in labor costs, the minimum wage will ruin him.

Of course, that's not how it works. Since the competition also has increased labor costs, everybody can raise prices. Not enough to totally offset labor costs, so some marginal businesses will go under, but it's not the bloodbath a naive business owner might expect.

@John:
The reason you shouldn't reason from a price change is that a price change of a given sign and magnitude may be caused either by a supply shock or a demand shock. Without knowing which one it is, you can't predict whether it will be accompanied by an increase or decrease in sales.

Brandon Berg writes:

Forgot to add to my last comment: A minimum wage increase causes price increases via a supply shock. You're not reasoning from the price change, but from the supply shock.

Prakash writes:

Would India be a counter point?

With horrible policies, India was stuck in what was called the hindu growth rate for a really long time, despite its poverty and even now, the rate of growth is not that great especially in per-capita terms?

Another potential counter point

Are you assuming that globalization is going to literally destroy every niche in the world? if a culture remained niche and closed to outer influences, couldn't it keep a lower growth rate for longer than the long run you envisage?

Brandon Berg writes:

@Scott:
You didn't really explain your model for why this is the case. Is the idea that since we have a global capital market, and new technologies are also globally available, that any economy that falls too far behind will become an attractive destination for foreign investment, preventing it from falling even further behind?

Britain has generally better policies than France (on employment for example), but they screw up their housing laws so massively that it completely negates almost all the positive effects of the rest of the regulatory structure.

(Yes, France screwed up central Paris' real estate market too, but central Paris is not that big of a deal in terms of population.)

Jess Riedel writes:

Like Brandon Berg, I would also like some details on this model. I imagine Scott just means that it's hard to fall too far behind the pack so long as economies are sufficiently integrated. Bad-policy countries with the lowest per capita GDP benefit disproportionately from the innovation, cheap goods, and increasing demand from successful countries.

But I'd wager that isolated economies could certainly reduce growth rates through policy, and likewise that bad policies in countries bring down the *World's* overall long-term growth rate (in rough proportion to the country's size). So bad policies reduce growth rates, but only in a tradgedy-of-the-commons way, with no one getting left completely behind.

Scott Sumner writes:

Dustin, I do think that state level economic policies have some impact. For instance people tend to move toward states with no income tax, although we don't know if the effect is strong.

E. Harding. I don't know much about Niger, but Mexico is obviously considerably richer than in 1980. I travel there frequently and you can really see the changes. Perhaps there are some measurement error issues. BTW, there are also some statistics that show no rise in real wages in the US, which I also very much doubt.

As I recall both Japan and France have slightly underperformed the US in recent years, I was speaking in terms of broad stylized facts, or approximations.

khodge, I believe Krugman was distinguishing between short and long run effects. Austerity policies have a short run effect.

Brandon, That's not correct. Even if they fully raise prices to cover the extra costs, (which the evidence suggests they do) many will go out of business as the quantity demanded falls.

Prakash, India supports my point. The so-called Hindu rate of growth was about 3%. After the reforms India sped up during what is a transition period.

Brandon, I'm surprised that my claim is even controversial. It fits the evidence and as far as I know it fits in with most economic theory. And yes, I'm assuming that anti-growth policies in one country don't have much effect on the global invention of new products like cell phones, or even the adoption of cell phones in almost all countries. The fact that many poor peasants in Africa now have cell phones provides powerful support for my claim.

Luis, I agree.

Jess, There's some truth to the tragedy of the commons claim. See my answer to Brandon.

Brandon Berg writes:

@Scott:
Re: Minimum wage, that's what I said. The new equilibrium will have higher prices, but not enough to fully compensate for the higher wage costs, so marginal low-wage employers will likely go out of business. When I said Drum was overreaching, I was referring to his claim that this wouldn't happen.

But just reviewing the books of each business individually, one might naively conclude that all low-wage employers will go out of business, because, e.g., a business may be making $7,000 per month in profits and facing an $8,000 wage increase. My point, and the kernel of truth in Drum's argument, is that it's not quite as bad as this makes it look, because everyone will raise prices somewhat.

Regarding the OP, I'm not arguing with you, just looking for an elaboration for those of us who aren't professional economists.

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