Political Instability Significantly Hampers Economic Growth

Vice Chairman & Vice President, RIETI

Presidential elections which take place every few years will be held this year in France, the United States, and Korea following Russia, and how their results will affect their policies is drawing much attention. Meanwhile, Japan has had five different cabinets (Abe, Fukuda, Aso, Hatoyama, Kan), all of which fell within about a year or earlier, following the end of the long run of the Koizumi cabinet in 2006. It now has been half a year since the Noda Cabinet took office last September. Frequent Japanese elections often influence the fate of a sitting cabinet. With the divided Diet, short-lived cabinets have struggled in policymaking for the budget, taxes, and general legislation. Recent empirical studies abroad show that political stability and frequency of government changes affect business activity and economic growth. This article is intended to introduce some of those studies and provide my view on the implications of political stability for the Japanese economy.

Cabinet changes and their negative effects

Political instability lowers the predictability of government policies for firms and households, thus making it harder for them to commit to aggressive plans for investments and consumption. Regarding consumption, it has been often pointed out that uncertainty over the sustainability of the social security system leads to an increase in precautionary savings and slumping consumption. Likewise, changes in policies related to eco-related subsidies and taxation also have significant impacts on the decision to purchase durable goods.

For companies, investments in equipment, R&D, and human resources—including hiring new permanent staff—are long term in nature. Thus, the predictabilities of institutions and policies have an effect on their management decisions for such investments. As greater policy uncertainty raises the value of waiting to invest and consume until it is resolved, they become more cautious and hold back on investments and consumption. Uncertainty over the various institutions including the labor market, environmental regulations, and the electricity market has similar effects on investments, which will greatly impact not only short-term business cycles but also long-term economic growth.

A number of growth regression analyses in many countries have been carried out since the 1970s regarding the relationship between political stability and economic growth. In the early 1990s, Robert J. Barro showed in his paper that variables to measure political instability such as the number of revolutions and political assassinations negatively influence economic growth and investments.

Recently, the International Monetary Fund (IMF) economists published a working paper analyzing the relationship between the frequency of cabinet changes and economic growth using panel data covering 169 countries. According to the estimates, after controlling for the ordinary determinants of economic growth—such as education level, population growth, and degree of openness to international trade—an additional cabinet change a year reduces the annual real GDP per capita growth by around two percentage points. By decomposing transmission channels of the total negative effects of frequent cabinet changes on GDP per capita growth, it is shown that the adverse effects on total factor productivity (TFP) growth account for around 60%, physical capital accumulation for about 20%, and the growth of human capital accounts for about 20% respectively.

A recent paper published by Brandon Julio and Youngsuk Yook analyzed the effects of national elections on corporate investments, matching firm-level data of 48 countries from 1980-1985 with data on elections and political systems. The analysis indicated that firms reduce investment expenditures by around 5% on average during election years relative to non-election years, controlling for growth opportunities and economic conditions, and such negative effect is larger for countries with less stable governments. In addition, elections in which the outcomes are close, as measured by voting results, have more influence on investments than those with more predictable outcomes, in which the victor wins by a large margin. By industry, those classified as politically sensitive such as pharmaceuticals, health care services, petroleum and natural gas, transportation, and communications, the influence on investments was pronounced. These results are consistent with the hypothesis that political uncertainty curbs corporate investments.

Nicholas Bloom and others developed a new index of policy-related economic uncertainty and estimated its dynamic relationship to the real economy. The index shows the level of uncertainty spikes near presidential elections and after major events such as the Gulf wars and the 9/11 attack (see Figure). Their estimates show that a drastic increase in policy uncertainty between 2006 and 2011 reduced industrial production by around 4%, real GDP by 3.2%, private investment by 16%, and aggregate employment by 2.3 million at their peaks, with a lag of about a few months to a year and a half.

Figure: Major events and presidential elections generate higher "policy uncertainties" Figure: Major events and presidential elections generate higher "policy uncertainties"

Although such research has not been conducted in Japan, according to a survey of more than 3,000 Japanese firms that I recently conducted at the Research Institute of Economy, Trade and Industry (RIETI), approximately one-third of those firms answered "governmental/policy stability" as a factor significantly affecting their management decisions.

It is generally difficult to boost economic growth through policy. The Trans-Pacific Partnership (TPP) agreement has now became an important policy agenda, and it is estimated to have a potential impact of raising GDP by three trillion yen. This number shows a "level effect" of the policy. If the effects of participation in the TPP were to be realized in 10 years, its positive effect in improving the annual GDP growth would be less than 0.1 percentage point on average. I think this is a rather modest estimate as, in reality, there should be "growth effects" such as the increased influx of knowledge and technologies from abroad as the Japanese economy opens further, but it at least provides a reference figure.

Cutting the corporate tax rate is also expected as a growth policy which will increase the growth rate over the long run. Yet, when estimating the impact of a 10% cut based on standard investment functions, the average annual rate would be under 0.1 percentage point in terms of quantitative effect to potential growth.

Promoting R&D is a key policy for economic growth in advanced countries that have passed the catch-up stage, and their governments have been implementing a number of policies to accelerate innovation. A one percentage point increase in the R&D investment to GDP ratio will raise the annual economic growth rate by approximately 0.3 percentage point based on the past estimates of numerous empirical research on the economic effects of R&D.

Political stability will contribute to economic growth

In comparison with the above effects of major growth policies, quantitative contribution of political stability to economic growth is significant. As mentioned earlier, recent Japanese cabinets remained in power for about a year. If a cabinet stays in power for two years, the annual GDP growth rate will improve by one percentage point. It is difficult to find economic policies that have a similar quantitative magnitude. Although it is necessary to recognize that the aforementioned regression analysis is merely a mean value among many countries and that the figure here is a back-of-the envelope calculation, it suggests that political stability can have a significant growth effect.

During the period between the high-growth era and the 1990s when Japan was still trying to catch up with the Western industrialized countries, the bottom-up economic growth policies that supported industries and redistributed the growth benefits functioned effectively without strong political leadership. As Japan has matured, it is now facing increasing political agendas which require big decisions with trade-offs—such as social security and tax policies— between growth policies and redistribution policies to tackle with a fall in the potential growth rate, the aging society, and the accumulated government debt. Thus, the top-down decision-making—or "political leadership,"—has increased in its relative importance. On the other hand, as I discussed, political instability increases uncertainty over policy decisions, which will curb positive behavior among firms and households.

There is a long list of political issues waiting for political consensus including the comprehensive reform of social security and tax along with a secure energy supply. I hope political stability in any form will function as growth policy which will contribute to the full-fledged recovery of the Japanese economy in the future.

* Translated by RIETI.

March 27, 2012 Weekly Economist (The Mainichi Newspapers)

April 20, 2012

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