Economic uncertainty flows from overly-optimistic political promises

PEOPLE like to live and operate in stable and peaceful environments where property rights are enforced and the legal system - including taxation and regulation - is predictable. This institutional stability allows agents to make plans and improve their reactions to unforeseen circumstances, writes World Review expert Professor Enrico Colombatto. But the real world is different. Here, policymakers have considerable discretionary power, and are encouraged to use it. They are, for example, encouraged to intervene whenever economic performance drops below expectations. And when intervention undermines stability and predictability, more intervention is often called for, to make good the previous mismanagement. The outcome is an abnormal loop, in which economic policymaking follows expectations; and expectations tend to focus more on what the policymakers will do next, rather than on the actual features of the economic system. Questionable regulation and over-optimistic promises of high growth eventually led to disappointment about economic performance in a number of European countries prior to 2007. The authorities responded by increasing public spending and indebtedness, ultimately leading to a crisis. But once mired in the crisis, people hesitated in reacting. They declined to accept the losses and shied away from investing in new business. Instead, they preferred to wait for a new wave of government intervention. Government action in the realm of economics in the United States tends to concentrate on monetary policy, which is driven by the data on GDP growth. As the data is subject to significant variability, however, monetary policy remains vague and markets become skittish. Similar comments apply to a number of developing countries where governments hardly resist the temptation to offset business fluctuations and external events, or to take action to meet expectations boosted by overly optimistic promises. A typical case is the Chinese commitment to stick to a 10 per cent annual growth target. It averaged 9.06 per cent from 1989 to 2015 with an all-time high of 14 per cent. Deviations from this target were initially counteracted by massive public spending and easy banking credit. Today, China is grappling with relatively low growth - by its standards - of seven per cent in the first quarter of 2015, a weakened banking sector and fragile public-finance. However, many agents are speculating about Beijing’s next moves with regard to banking and public spending, rather than worrying about the financial failings per se. Common to these patterns is the notion that the desirable rate of growth can be achieved through appropriate policies, that deviations from such desirable targets are the result of bad government choices, and that more - and hopefully better- decisions are required. Much depends on how one conceives the anticipated rate of growth within this context, a definition which plays a major role in assessing the deviations from expectations and the reactions of policymakers. For example, the Spanish government has announced that GDP growth in 2015 will be above 2.5 per cent. This would be barely acceptable in the US, and would persuade the central bank, the Federal Reserve, to keep interest rates low. It would be a disaster in China, where the authorities would probably react with huge public-investment projects. But such Spanish growth rates would be welcome as an unparalleled success in France and Italy, where the governments would probably respond by launching new social policies and redistribution. So, to engage in informed reasoning about what the future might hold, observers must consider the interaction between three sets of variables - how individuals form their expectations about economic performance, the possibility that temporary or systematic deviations from such targets occur, and the likely reaction of the authorities to any deviations. Some economists estimate that the long-run figure for this variable is around two per cent annually. This means that undeveloped economies could grow much faster than two per cent a year, as they have a lot of catching-up to do. By contrast, advanced economies are likely to grow at a slower pace, especially if their labour force has less motivation or works fewer hours, investments slow down or regulation intensifies. Most Europeans would be satisfied with an average two per cent growth rate. Regrettably, it will take time before public opinion accepts that under the present circumstances a growth rate close to stagnation is a more realistic target. It is only then that policymakers will dare to make realistic promises, and abstain from engaging in vain efforts to jump-start the economy without introducing structural reforms. The temptation to honour overly-optimistic political promises through short-sighted intervention tends to be irresistible - with erratic results. This is likely to be the true source of economic instability over the next few years, adding to the uncertainty which always characterises economic contexts. For a more in-depth look at this subject with scenarios looking to future outcomes, go to our sister site: Geopolitical Information Service. Sign in for 3 Free Reports or Subscribe.

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