SEAN INNIS. Economic thinking has driven policy making in the past, but will it in the future? Part 2

Mar 20, 2020

As discussed yesterday, the changing policy environment affects the role of economic thinking in policy determination. Against that background, Part 2 today discusses the key challenges that economic thinking needs to resolve to retain its policy relevance.

Today’s policy environment creates clear challenges for economic thinking. Far from being the go to tool for policymakers, policymakers are turning away from an economic thinking to other frameworks to guide the development of policy.

Part 1 of this article examined four dynamics influencing the environment face by policymakers today. Changing expectations of government, falling confidence in government’s ability to deliver, changes in the focus of policy and delivery mechanisms, and the impact of globalisation on national and local decision making have created a different policy environment to that faced by policymakers in the past.

A key question is whether and how economic thinking needs to adjust to these dynamics and the policy environment they create. Without seeking to be comprehensive, five challenges spring immediately to mind. None of the challenges are new. But unless economic thinking can evolve to provide more compelling response to these five areas, it is likely that the influence of economic thinking will continue to decline as a policy force.

Five challenges for economic thinking

 Challenge 1: What is progress anyway?

Economists have long understood GDP to be a useful but imperfect measure of societal progress. But even as an imperfect measure it is tiring badly. Societal expectations are increasing beyond the things GDP measures well (production and income) to the things it measures poorly or not at all (a clean environment and high-quality care). This shifting emphasis means that a core tool for defining societal progress is becoming less resonant and less useful.

GDP remains an important and valid measure. After 30 years of sustained growth, we must be careful not to underplay the importance economic growth plays in our society. It is easy to undervalue something you have always had. But it is also clear that we are in a phase of policy making where many people are happy to trade GDP growth potential for other objectives. To put this down solely to a misreading of the value of growth would be a mistake. It is a deep and conscious setting of priorities that are different to the past.

This creates a challenge for economic thinkers. Economic thinking needs to define and embrace measures of progress that better reflect the genuine aspirations society. Unless economic thinking can do this in a way that better explains how economic growth and policy advice contributes to that broader concept of progress, the power of economic advice will continue to lessen.

Challenge 2: Whatever happened to a win-win world?

Dialogue around globalisation has shifted dramatically from a prevailing assumption that free trade and investment delivers win-win outcomes for all nations to an emerging view in some quarters of a zero-sum game. This dynamic has shaken one of the strongest foundations of policy making in the 80s and 90s – that free trade and global engagement is at the heart of delivering economic prosperity and national security.

Many reasons exist for this shift. Changes in geopolitical power, particularly with the rise of China and relative decline of the US, have seen great power contest and increased bilateralism. Longstanding weaknesses in the global rules-based architecture have emerged as key sticking points in international cooperation. Technology changes which have underpinned a more globalised world, have also created new risks to national security. The uneven distribution of benefits across and within economies has created domestic disquiet in a number of key trading nations. And to this we must now add the reality, rather than merely the threat of, a global pandemic.

These changes have seen national sovereignty being reasserted by some nations at the expense of global growth potential. The traditional economic view that increased interdependence delivers greater national security has also lost influence, being replaced with one of closer national control. In saying this, it is important not to overstate what is happening. These changes have not (as yet) resulted in a wholesale retreat from a generally open world. But it has given some pause to a long-held general view that further globalisation is good – and this is before the full impact of COVID 19 plays out.

This is the second challenge for economic thinking. A better intellectual reconciliation is needed between the desirability of enhancing global (and national) growth potential via increased globalisation and the opportunity cost of that globalisation. This reconciliation needs to consider whether current high levels of global openness mean that at least some nations face diminished marginal gains from further globalisation.

Challenge 3: Markets work, but…

Economic thinking has played a major role in the promotion of using market mechanisms to achieve societal objectives. This has seen a proliferation of markets created and supported by government. These markets have been used, amongst other things, to pursue a range of environmental (such as water) and social policy objectives (such as disability and aged care).

The theoretical benefits of competitive markets are attractive – by facilitating choice competitive markets optimise consumer benefit and the use of constrained resources. In essence, using markets are good for the consumer and good for the economy. And, where markets are truly competitive and work well, this is true.

A mature reflection on the use of markets as a policy tool over the last 30 or so years suggests that the promise of the market has always not been delivered in practice. There is little doubt that some of this failure reflects bad implementation of good ideas, but this is not a full answer. It is also clear that advice based on economic thinking did not anticipate and respond to some of the core challenges posed in using markets to achieve policy ends.

Two dynamics, in particular, warrant further attention by economic thinkers. The first relates to the time it takes for markets to form and adjust to competitive processes. The second relates to the ability of a market to meet widely differing population needs, circumstances and capacities.

Markets do not form out of thin air. New demand is not instantly met by new supply. Instead, the process of forming a mature market can take many years, as we are seeing with the National Disability Insurance Scheme. Even in a mature market, the process of competition does not work instantly. Competition works requires suppliers to offer different combinations of value and price, some of which will not appropriately meet demand. These “mistakes” allow the entry of competitors who better meet the needs of consumers. But this process also takes time. Feedback loops which reveal opportunities for improvements in supply can also take many years to fully work through depending on the sector.

The bottom line is that markets need time and space to adjust effectively. Yet in many created markets, governments are driven to retain a level of control over both price and quality – undermining the adjustment process. This drive often reflects reasonable concerns. Fiscal control does matter, especially in areas where costs are large. Quality also matters, and indeed is often the key variable. This is particularly true in care markets where the objective of government is to ensure a high standard of personalised care is delivered, consistently over time and across a population with widely varying needs, locations and circumstances. A challenge that many created markets have struggled to meet.

These dynamics mean that it is sometimes difficult for a created market to deliver the benefits economic thinking seeks. This is not to suggest that markets should not be used in the delivery of policy outcomes. Markets can be a powerful vehicle for delivering choice and efficiency. But it is to suggest that some past advice and decisions have not delved deeply enough into the dynamics of created markets.

This is economic thinking’s third challenge. Until economic thinkers are able to articulate more convincingly how the dynamics of created markets will work, and how to ensure these dynamics do not generate unintended consequences, those advocating market-based approaches will become less influential.

Challenge 4: Consumer choice is great, but…

Choice, and the freedom it brings, is a key tenant of policy making in Australia. Traditional economic thinking has reinforced this by favouring market-based approaches, minimal intervention and the promotion of both choice and personal responsibility. This thinking is influenced by assumptions of rationality and empowerment – that people can and do act in the own interests.

That people genuinely desire choice in our society is clear, but it is also clear that (as a population) people place some boundaries on that desire. While people want choice, they also want confidence in the quality of goods and services being offered and protection when things go wrong. Our growing understanding of cognitive biases in decision-making has also raised questions about the assumption of rationality that underpins much economic thinking. But even in the absence of these biases, diligent people sometimes lack the time and technical understanding to make the well-informed decisions economic theory assumes.

This reality leaves policy makers needing to design for a population whose decision-making capacity varies widely. Simple appeals to personal choice and responsibility are unlikely to be sufficient and may not deliver the efficient allocation of resources economic thinking rightly seeks. A more considered balance is needed between free choice, personal responsibility and protection.

This raises the fourth challenge for economic thinking. Policy makers need a finer sense of when and how to support decision making by consumers. Such thinking needs to incorporate our growing understanding of how individual decision making actually works, and what this means for the best balance between personal responsibility and government responsibility for protecting and promoting the interests of individual consumers.

Challenge 5: Location, location, location

The influence of economic thinking on national policy has traditionally had relatively little regard to local dynamics. The emphasis, reasonably, has been on ensuring that resources and people flow flexibly to where they are of greatest economic value. This focus has been important in building the international competitiveness of Australia’s economy, and should not be discarded.

But the growing demand for policy to focus more strongly on local issues is unlikely to change. Local differences in opportunity and outcomes have been a powerful disrupter to both politics and policy making in other nations. And while these dynamics are less pronounced in Australia, they exist and should not be ignored.

This creates a fifth challenge for economic thinking, which has two dimensions. The first is the need for policy makers to develop a more nuanced view on how best to manage Australia’s changing economic geography. This should not involve a reversion to protectionism but does require a more considered view on how to maximise economic opportunity, manage inevitable transitions, and ensure a fair distribution of benefits from our future prosperity. The second is to more clearly respond and account for the importance local issues play in the wellbeing of people when considering policy.

A final word

The discussion above (and that outlined in Part 1) does not, and is not intended to, provide a complete picture of either how the policy making environment has been changing or the future role to be played by economic thinking. Rather the intention is to provide a sense of the changing interplay between economic thinking and policy making; and encourage further discussion about the positive role economic thinking can play.

Economic thinking has clearly played an important role in the prosperity and position Australia enjoys today. For that role to continue into the future economic thinking needs to respond to the changing nature of our society, the challenges we are now seeing emerge, and deepen the understanding and advice it brings to the policy table.

Sean Innis is inaugural director of the Public Policy and Societal Impact Hub at the Australian National University. A version of this article was published in The Mandarin on 2 March 2020.

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