Keeping Institutional Reforms in Step

Senior Fellow, RIETI

Economic growth strategies have become a hotly-debated topic, but what can be said of Japan's current economic policies from the perspective of economic growth theory? This question will be examined below.

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The endogenous economic growth theory saw considerable development from the latter half of the 1980s. This theory holds that new technologies spillover (proliferate) in various forms through education and economic activities and that technological progress thus continues in a self-propagating fashion.

The major policy implication of this theory is that private-sector investment in education and R&D is not enough. Public investment in education and R&D will accelerate technological progress and enhance economic growth. In that sense, the education policies put forth by the new administration, including offering child care allowances and waiving high school tuition fees, can be regarded as important growth strategies to advance the formation of human capital for the next generation. At the same time, however, the government's science and technology budget is also essential for growth over the long term, and the downtrend in funding for science and technology apparent in the budget screening process and elsewhere has raised concerns.

The new administration is seeking growth with a greater emphasis on the demand side (e.g., consumers) than on the supply side (e.g., corporations). However, economic growth theory has produced few demand-driven growth models in recent years. There are models explaining the changes in industrial structure from primary industries to tertiary industries as well as "Big Push" models from development economics contending that public demand for new technology created through increased public spending promotes industrialization, but these do not fit with current economic conditions in Japan.

One demand-driven model that has not received much attention in recent years is the principle of the division of labor - the extent of the market (size of demand) limits the division of labor - proposed by Adam Smith in The Wealth of Nations. An extensive market (high demand) encourages a greater division of labor among producers, which in turn dramatically improves productivity and generates economic growth. Adam Smith suggested that the existence of a large market (demand) itself leads to economic growth. Indeed, this author also once advocated an endogenous growth theory model in which expansions in demand deepen the division of labor, the improved productivity resulting from the division of labor increases people's income, and demand expands still further. Professor Boyan Jovanovic of New York University asserts that higher demand increases corporate investment in R&D and spurs technological innovation and economic growth.

From either viewpoint, the linkage between expanded demand and technological progress at companies through the division of labor is a condition spurring economic growth. When considering policies, it is important not to regard consumers and companies as rivals but rather to employ a combination of policies such as R&D tax cuts to ensure that expanded demand leads to technological innovation at corporations. It is aggregate demand, i.e., both domestic and foreign demand, which drives technological progress and economic growth. Policies to stimulate foreign demand in emerging markets and elsewhere as well as domestic demand will thus be key to a demand-side growth strategy.

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In contrast to these efforts to elucidate the structure by which market mechanisms bring about growth, research examining the relationship between institutions/government and economic growth (the political economics of growth) has developed rapidly over the past 10 years. The connections between differences in the political influence of special interest groups, differences in political format (democracy, developmental dictatorship, etc.), and differences in the origins of laws on the one hand and economic growth on the other continue to become evident. Research in this field offers numerous suggestions for the future course of Japan's structural reforms.

Rapid market-oriented economic reforms following a "Big Bang" pattern were pursued in the former Communist bloc after the end of the Cold War, and economic growth fell off sharply for a time (see diagram). Professor Gerard Roland of the University of California at Berkeley and others assert that this economic downturn was caused by the sudden institutional changes. By contrast, Professor Sota Kato of the International University of Japan has posited the hypothesis that reforming multiple institutions at different speeds causes a temporary collapse in the mutual complementarity between these institutions, markedly weakening economic performance. Professor Kato and this author are pursuing joint research at the Tokyo Foundation to validate this hypothesis.

Post-Cold War Real GDP in Former Communist Bloc Countries

For example, institutions pertaining to the degree of freedom in the labor market may be mutually complementary with the size of the employment safety net (unemployment insurance, etc.). If there is only a small degree of freedom in the labor market, e.g., the movement of labor is restricted and companies are confronted with internal unemployment, then concerns about the future do not arise among workers even if the public safety net is small.

On the other hand, the combination of a largely free labor market and an extensive public safety net reduces concerns about the future because, although workers may more easily lose their jobs, there is a strong safety net in place to catch them. Consequently, consumption remains firm despite fears about possible unemployment, and economic performance is not adversely impacted to a significant degree. There exists a complementarity between institutions that cannot be ascertained in the simplistic and conventional "big government vs. small government" argument.

Given such a relationship, the economy's performance could be expected to worsen should liberalization of the labor market surge ahead and establishment of a safety net lag behind. In other words, liberalization of the labor market will improve corporate competitiveness but will also increase the possibility of workers losing their jobs. If the possibility of unemployment rises while the safety net remains fragile, consumers will reduce consumption out of concern about the future and the economy as a whole will stagnate.

At the time of reforming multiple mutually complementary institutions, this problem is exacerbated when the speeds of institutional change are not carefully coordinated. In the example of the former Communist bloc countries shown in the diagram, their economies temporarily declined as a result of comprehensive institutional reforms carried out in a "Big Bang" pattern but thereafter gradually recovered. This pattern can also be partly explained as the failure to coordinate the speeds at which institutions were changed.

A group comprising Professor Kato, this author, and others verified this hypothesis via regression analysis using country-specific data on economic freedom (FY 2008) provided by the Fraser Institute of Canada. Examining individual countries, the group determined that mismatches in the speed of change between institutions had an adverse impact on their economies. The data indexed the degree of freedom in various economy-related institutions (property rights and other legal structures, the financial environment, trade restrictions, market regulations, etc.) in 65 countries around the world. Because the changes over time in each of these indices from 1980 onward were made available, the speed of change in each institution could be determined through the speed of change in the indices.

Regression analysis using this data revealed that a significant difference in the speed of liberalization between two institutions in a given country has the effect of temporarily reducing the gross domestic product (GDP) of that country. For instance, if the disparity in the speed of the liberalization of trade restrictions and that of the liberalization of market regulations grows by 1%, the consequence will be a 2% drop in that country's GDP. The authors are now using this model to examine Japan's structural reforms since 1990.

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The lessons that can be drawn from the authors' research on Japan's economy at present are as follows: (1) market competitiveness, the size of safety nets, and numerous other institutions mutually complement each other, and it is crucial that their speed of change be coordinated when carrying out institutional reform; (2) past structural reforms have failed in coordinating these speeds. For example, a rise in market competitiveness while establishment of a safety net lagged caused increased anxiety about the future, stagnant consumption, wider disparities and other difficulties, and economic performance did not improve as much as expected; and (3) what is required now is that the government not halt structural reforms across the board but rather take steps to accelerate the establishment of safety nets to keep pace with market liberalization in order to synchronize the speeds of change among various institutions and quicken the improvement of economic performance.

Effective coordination of speeds between institutions requires that the ministries/agencies in charge of these institutions not carry out institutional reforms separately but instead that the government (prime minister's office) put forth a vision for reform and endeavor somewhat like an orchestra conductor to coordinate speeds at these ministries/agencies. Essential in that process is careful analysis of the institutions that mutually complement each other. Once this has been accomplished, ministries/agencies can carry out the institutional reforms under their purviews in accordance with the speeds indicated by the government. This is a division of roles between the government and the civil service bureaucracy likely necessary for "government-directed" economic policies.

As discussed above, economic growth theory has of late given increasing importance both to the workings of market competition and to the roles of each country's institutions, history and politics. The results of this cutting-edge research will likely provide valuable suggestions when drafting actual policy, whether considering growth strategies or pursuing budget screening.

>> Original text in Japanese

* Translated by RIETI.

February 15, 2010 Nihon Keizai Shimbun

April 26, 2010

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