Friday, August 22, 2014
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Learning Economic Dynamism

Why are some of the world's most advanced economies--France, Germany, Italy, and Japan--suffering stagnant growth and high unemployment? More fundamentally, why do these countries seemingly fail to exercise the kind of economic leadership and innovation that their histories lead us to expect, especially in the innovative high technology sectors that most define our future?

Weak economic performance in these countries is even more puzzling in view of the sharp drop in their birthrates decades ago. Their population pyramids are now skewed towards middle-aged people who are in their most productive years and relatively free from the burden of raising children. Their per capita living standards should thus be substantially higher than in the US, where swarms of kids must be attended to and where new investments must be made just to keep the capital stock growing in step with a swelling population.

Of course, what is advantageous today may be problematic tomorrow: Europe and Japan will face severe problems when their demographic pyramids tilt towards the elderly, eliminating the temporary demographic advantage they have relative to the US today. But this isn't what ails their economies now .

Edmund Phelps of Columbia University says that these slow-growing countries lack "dynamism," which he defines as a combination of entrepreneurial spirit and the financial institutions to channel it. Both spirit and the necessary financial institutions must be present to enable "creative destruction" - the force Joseph Schumpeter argued sixty years was the engine of capitalist prosperity - to be unleashed.

But is this an accurate description of slow-growing countries? It is often said that continental Europe and Japan lack the strong risk-taking tradition that exists in America or the UK. But it is actually difficult to see much of a difference in fundamental human values or preferences between these countries and the US.

A decade ago, Maxim Boycko of Russia, Vladimir Korobov of Ukraine, and I conducted a study of economic attitudes towards capitalism, comparing the US, Russia, Ukraine, Japan, East Germany, and West Germany. While some variation in attitudes towards markets and enterprise did exist, the biggest differences were situational, rather than attitudinal: people in some countries had lower expectations of success and thought that government regulations would stymie their activities.

This--the effects of government policies on incentives--rather than basic cultural differences or weak financial institutions, is at the root of the sluggish growth seen in some advanced economies. Indeed, financial institutions, at least in some of the countries surveyed, are now among the most advanced in the world.

The irrational exuberance of the late 1990's led to some setbacks in the development of new financial institutions. But only recently many slow growing countries were eager to develop venture capital markets and foster stock exchanges--France's Nouveau Marche, Germany's Neuer Markt, Italy's Nuovo Mercato, and Mothers in Japan--devoted to risky investments.

These new stock exchanges, modeled on America's NASDAQ, ended up listing a lot of flimsy companies, and the collapse of share prices since 2000 caught them in the downdraft. The Neuer Markt no longer exists; the others are weak, if not moribund. But setbacks in the process of improving risk-taking are to be expected; it is important not to overreact to mistakes. Surely, the inadequacy of financial institutions is not what really retards the growth of these countries.

So, what is the problem? A number of books have appeared in Europe this fall about the causes of Europe's weak economies. Of these, Hans-Werner Sinn's Ist Deutschland noch zu retten? (Can Germany Still Be Saved?) stands out for its cogent argument.

Sinn argues that German sluggishness is largely the result of government-induced bad incentives--a problem that goes far beyond Germany's notoriously rigid labor market--and that, so far, Schröder's reforms do not go far enough to eliminate them.

Sinn shows that the combined effects of the German tax and social welfare system virtually guarantee that no breadwinner in a family with two children can end up with less than €1,500 a month, even without working at all. This rate is well above, for example, the wage of unskilled labor in the iron and steel industry. In effect, Germany is telling its unskilled not to bother working.

The effects of the social welfare system are especially striking in Eastern Germany, where benefits are at Western German levels, despite lagging far behind in economic development. Sinn estimates that an East German family on welfare can collect four times the average income of a family in Poland and six times the income of a family in Hungary. With such a hurdle to hiring workers, no wonder industry is reluctant to locate in the East and the region is supported by subsidies equal to 45% of its gross product.

Because of these destructive incentives, Eastern Germany, Sinn argues, will remain a region of chronic unemployment, much like Italy's Mezzogiorno, which has been a drain on Italian finances for decades. Moreover, the draft European constitution will prohibit discrimination in social-welfare benefits against immigrants from other EU countries. If this provision is adopted, Sinn concludes, there will soon be "twenty Mezzogiornos in Europe."

Sinn's proposals--adjustments in tax rates and welfare benefits--are technical and would have no immediate or dramatic effect on people's behavior. In the longer run, a system of good incentives must be created to change people's expectations of economic success and increase their opportunities to "learn by doing." Young people will better understand from their own experiences that taking responsibility for their economic lives pays off, that submitting to hard work and short-run risks is often wise and rewarding. Wherever this spirit takes root, financial sectors--and dynamic growth--will follow.

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