Shrink, baby shrink

High growth rates are the most important driver of economic prosperity, aren’t they? Well, think again. Fascinating new research shows that the absence of economic crises in fact is much more significant. This has stunning implications for economic policy.

No student of economics can get around it. Neoclassical growth theory belongs to the core curriculum of any Economics faculty in the world. In these courses you have to chew through complex mathematical models which economists use for analysing why some countries are rich and others are poor. You’ll learn that the capital stock is very important for high economic growth, as well as human capital and the right level of capital investment. The rate of technical progress, of course, also matters.

One question, however, is rarely addressed in those classes: Is high economic growth really the most important driver of economic prosperity? At first sight, this question might look barmy. “What else?”, you might be tempted to answer.

In fact, however, things are a bit more intricate, as a new paper by John Joseph Wallis reveals. According to Wallis, an economic historian with the University of Maryland, high growth in good times is not as important for high living standards as economists usually tend to think. How often a country is hit by economic downturns is what matters most, as well as how severe these crises are. “Rich countries are not rich because they grow faster when they grow, but because they have fewer episodes of negative growth and shrink more slowly in times of crisis,” asserts Wallis.

There are some figures supporting his point. When poor countries are growing, they are doing this at a faster pace than rich ones. However, they are also much more likely to experience severe recessions. In times of economic upswings, in rich countries the economic output grew by 3.9 percent between 1950 and 2004. In poor countries the growth rate was 5.4 percent. However, the industrial countries enjoyed economic expansion in 45 of those 54 years. In developing countries, however, this was only true in 35 years. Conversely, rich counties had to endure only nine years of recession; in poor countries there were more than twice as many. Additionally, these crises were accompanied by much bigger output losses.

A similar pattern emerges in the U.S. economy with regard to the periods of 1840 to 1949 compared with 1950 to 2009. Prior to World War II, growth rates were much bigger than afterwards. Simultaneously, however, the U.S. economy experienced additional and much more severe downturns in the first period.

Those trends cannot be explained by arcane models of traditional neoclassical growth theory. Hence, Wallis has developed his own hypothesis: a “theory of shrinking,” as he quipped recently on a conference of the Economic History Society in London. It does not resemble a new quantitative model but abstract considerations about the political economy.

The starting point of the new theory is the general observation that economic crises often imply a dilemma. Actions which are perfectly reasonable from the perspective of a single person tend to make matters worse when they are pursued by everyone. Banking panics are a case in point. If doubts on the stability of banks spread, it makes sense for you to get your money out of the bank before it’s too late. However, if every customer tries to do this, then even the most solid bank falls apart immediately. Hence, society faces a coordination problem. If we manage to synchronise our behaviour we are able to avoid a downward spiral that harms everybody.

According to Wallis, this fundamental dilemma is the basic cause of economic and political instability. As long as co-operation is associated with a significant risk of being short-changed, there is there no way of fixing this problem. After the Great Depression, however, the industrial countries managed to come to grips with that. According to Wallis, Roosevelt’s “New Deal” was the first important step. Interestingly, the direct consequences of this gigantic economic and social program on employment and growth were not what mattered most. The decisive thing was the establishment of a guarantee that every single person was treated equally by the state – for example, if one lost their job or savings.

Wallis calls this “the principle of impersonality.” The new deal ushered in a new era of “impersonal” government policies which curtailed governmental discretion, not only between the government and individual citizen bus also with regard to the relationship between the federal government and the states. For example, thanks to the “New Deal” Americans are relying upon public deposit insurance. They know that their savings are safe even if their bank collapses and therefore do not need to rush to clear their accounts if a banking crisis is imminent.

In Wallis’s own words:

“One of the biggest obstacles to public support for government action is the rational fear that the government will use its powers to benefit some and harm others. In times of crisis, the ability of governments to coordinate individual behaviour can be hampered by fears of unequal treatment. The process of expanding a government’s ability to solve (or mitigate) coordination problems must involve ways to ensure that government treatment of individuals and subordinate governments mitigates the fear of selective treatment that favours some groups, regions, industries or interests over others.”

Wallis is convinced that the impersonal governmental institutions which have been established since the “New Deal” have enhanced economic and political stability since World War II. They have imbued single actors with a feeling of trust to be treated fairly if things get tough. This was a precondition that made co-operation possible. And this enhanced co-operation helped to prevent or mitigate crises.

If this theory holds, it has tremendous implications for economic policy. It would be wrong to judge policy decisions only by their direct implications for economic growth, as it is currently done. Much more important would be a completely different question: Does the policy measures makes the economy more stable? If policies that help to prevent crises also slow down economic growth a little, that would not be such a big deal, after all.

(c) Olaf Storbeck, 2010. All rights reserverd.

A German version of this text is available on Handelsblatt.com