The Governance Threat to Development

For several decades, markets and market incentives were the main drivers of economic trends and policies. No longer. We have entered an age of political economy, in which the actions of governments and the possibility of drastic policy shifts have become the main determinants of economic performance.

Until recently, global supply chains were based almost entirely on efficiency and comparative advantage. Trade agreements were negotiated and expanded to remove restrictions on the free flow of goods, capital, technology, and, to some extent, people. With the advent of digital connectivity, trade in services began proliferating. In Europe, the creation of the Eurozone led to the dismantling and privatization of many state-owned enterprises (SOEs) and monopolies.

Governance, both at the domestic and international levels, remained relatively stable, albeit not homogeneous. Across much of the world, governments were relegated to a secondary role. If policymakers support markets and grease the wheels of global capitalism, the thinking went, prosperity and progress would follow.

To be sure, not all significant economies followed this prescription. The Chinese government, for example, has maintained its prominent role in the economy. Public-sector investment in infrastructure, human capital, and technology remains consistently large, with the government holding on to controlling stakes in SOEs even after they are listed on stock exchanges. These SOEs represent a substantial and growing share of the Chinese economy’s supply side. The state also continues to influence the private sector through the presence of Communist Party officials on corporate boards.

Latin American countries are an exception to this general pattern of stability. Over the past few decades, many have oscillated between reasonably extreme forms of market dominance and equally intense versions of populism and state intervention in pursuit of distributional objectives, frequently at the expense of growth.

While the general approaches to economic management varied, they were generally stable, with significant positive effects. Cross-border investment skyrocketed, fueling growth and prosperity in emerging markets. And global trade, characterized by widespread adherence to clear rules, experienced few disruptions.

But this historical pattern has broken down. Former US President Donald Trump’s administration departed from its predecessors’ trade policies, imposed tariffs on imports from China, and marginalized the multilateral institutions responsible for regulating the global economy. China, in response, has adopted an increasingly assertive stance, openly flouting international economic rules.

Technological advances have partly driven this shift. With its “great firewall,” China has essentially walled off the internet within its borders. Most major US tech companies have been either banned from entering the Chinese market or compelled to exit after refusing to comply with the government’s stringent data and censorship requirements.

Meanwhile, the United States has re-embraced industrial policy to build resilience, win the strategic technology race with China, address domestic inequality, and promote sustainability. While achieving these goals will require elevated levels of public and private investment that may take years, if not decades, to pay off, the new industrial policies will likely have a significant effect on the level and quality of US growth – unless, of course, a future administration reverses them.

As a critical driver of GDP growth, the private sector has long played a crucial role in China’s “socialist market economy.” But that has changed over the past few years, as President Xi Jinping’s administration has clamped down on competing centres of power and influence. The aggressiveness and personal nature of the regulatory crackdown on the Chinese tech sector have fueled uncertainty regarding the private sector’s position, resulting in reduced investment.

While it is well known that both policies and incentives drive investment, macroeconomic stability has also been widely recognized as a prerequisite for growth and development. There are generally two sources of stability: competent management and continuity in a country’s economic model, regardless of its specific characteristics.

However, such stability and the reasonable assurance of continuity have become increasingly rare in recent years. While economic policymaking inevitably spurs disagreement in any political system, fewer disputes mean fewer abrupt policy reversals, enabling incremental, less disruptive changes in response to evolving conditions. But debates about economic policy and the role of government have become increasingly polarized, raising the risk of drastic shifts. The expectation of policy instability has a dampening effect on investment and, thus, on sustainable growth and long-term prosperity.

This trend can be observed in both developed and developing economies. Foreign investment in China has declined, particularly in sectors most likely disrupted by strategic competition. In the US, investors’ and policymakers’ growing embrace of environmental, social, and governance (ESG) goals has given rise to a counter-movement seeking to ban sustainability guidelines.

But policy stability can be more resilient than it seems at first glance. India, for example, has made impressive progress over the past 30-plus years, both under Indian Prime Minister Narendra Modi’s Bharatiya Janata Party (BJP) and the opposition Congress Party. Initiatives such as the biometric identification system Aadhaar and the Unified Payments Interface – developed and operated by the National Payments Corporation of India, a joint project of the Reserve Bank of India and the Indian Banks’ Association – have transformed the country’s economy. India’s remarkably inclusive digital transformation, also enabled by Reliance Jio’s low-cost mobile data revolution, has inspired some to suggest that the US Federal Reserve consider taking better advantage of its instant-payment system, FedNow.

Modi is likely to lose a national election sometime soon. But even if he did, the chances that his successors would dismantle the country’s burgeoning digital infrastructure are virtually zero. Any government that tried would probably not last very long.

The lesson is clear: maintaining policy stability is crucial for long-term investment and economic performance.

This stability can be achieved by identifying shared interests and perspectives that transcend ideological and partisan divides. Policymakers would do well to seek and nurture these areas of common ground rather than devoting their efforts to exploiting political and social divisions for short-term gain.

11th Year • July 2023 • No. 119 EBR