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

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.)