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How to Be an Open Economy

MILAN – The word “openness” has two related but distinct connotations. It can mean that something is unrestricted, accessible, and possibly vulnerable; or it can mean that something, such as a person or institution, is transparent, as opposed to secretive.

The first meaning is often applied to trade, investment, and technology (though most definitions do not match opportunity with vulnerability), which have always driven structural economic changes, especially with respect to employment. Structural change can be simultaneously beneficial and disruptive. And policymakers have long had to strike a balance between the abstract principle of openness and concrete measures to limit the worst effects of change.

Fortunately, academic research and historical perspective can help policymakers respond to this challenge intelligently. Consider the experience of Northern Europe’s small developed countries, which tend to be open, and for good reason: if they were not, they would have to over-diversify the tradable parts of their economies to meet domestic demand. That would impose high costs, because the small size of the domestic market would prevent them from achieving economies of scale in technology, product development, and manufacturing.

But these countries’ openness has increased the economic and political salience of investments in human capital and a strong social safety net. Social-security policies are doubly important for small, specialized economies, because an external shock to one tradable sector can affect the entire economy.

It wasn’t always so. Small- and medium-size economies such as Canada, Australia, and New Zealand used to have protectionist policies that over-diversified their tradable sectors. But with increased international trade and specialization, the cost of domestically produced goods – such as cars – relative to imports became too high for consumers to bear. In the 1980s and 1990s, these three countries began to open up, and experienced difficult structural transitions that nonetheless boosted productivity and provided broad-based benefits to citizens and consumers.

Still, striking the right balance is never easy. Canada, Australia, and New Zealand are all resource-rich countries that are susceptible to the “Dutch disease” – when one strong, capital-intensive sector hurts other sectors by pushing up the value of the currency. This has given rise to continuing concerns about under-diversification, which would make them vulnerable to volatility in global commodity markets and pose challenges for employment.

We tend to associate structural adjustments with international trade and investment. But industrial activity changes within countries all the time, and creates local- and regional-level challenges. For example, US textile production, once heavily concentrated in New England, shifted mainly to the South (before relocating to Asia and other lower-cost locales).

In 1954, then-Senator John F. Kennedy wrote a long, fascinating article in The Atlantic in which he attributed this undesirable dislocation in New England to tax subsidies in southern states. Such practices, he argued, would lead to inefficiently high levels of industrial mobility, because corporations would pursue profits wherever they could, regardless of the impact on individual communities. To prevent this race to the bottom, Kennedy called not for free trade, but for regulations to make trade more fair and efficient.

Indeed, structural changes are necessary to improve dynamic efficiency. But so, too, are policies to ensure that investments and economic activities are based on real comparative advantages, and not on transitory “beggar thy neighbor” incentive structures. This is particularly important during periods of rapid structural change. Because supply-side adjustments are slow, painful, and costly, they should not be made unnecessarily.

But, like closed economies that miss out on the benefits of trade altogether, open economies with significant institutional or political obstacles to structural change will underperform. This explains why many open economies today are failing to adapt to new technologies and trade patterns. Too often, policymakers want to prevent change from occurring at all. But while blocking change can protect existing industries and jobs for a while, doing so dramatically deters investment, and eventually hurts growth and employment.

A country’s economic and social-security structure can also stand in the way of change. As former Greek Finance Minister Yanis Varoufakis observes, the promise of a long-term growth dividend from structural reform is not enough to allay people’s concerns about the immediate or near-term future, especially in a semi-stagnant economy. If you replace something with nothing, you have to expect significant political and social resistance.

If structural reforms are not accompanied by social-security reforms, they are likely to fail. The “Agenda 2010” reform program initiated by former German Chancellor Gerhard Schröder in 2003 is a good example of this multi-prong approach; but it proved to be politically perilous for Schröder, who was not re-elected in 2005.

How reforms are sequenced also matters. For example, incumbent workers will be much more concerned with social-security reforms in a poorly performing economy than in a booming economy. Political resistance to structural reforms – especially from older incumbent workers – will be stronger in a low-output, high-unemployment economy, because it is worse to be laid off in such conditions.

As a rule, a government should not introduce structural reforms until it has first gotten its economy moving with fiscal and investment-oriented policies. Proceeding in this order will reduce the political resistance to change. As it happens, Europe is currently experiencing a modest but significant surge in growth. But whether policymakers will take advantage of this opportunity to pursue needed reforms is anyone’s guess.

One final lesson to bear in mind is that structural change is not just an unfortunate side effect of growth and the creation of new jobs and sectors; rather, it is an integral part of these processes.

One can see this clearly in successful developing countries, where the recipes for growth include openness, modern sectors, trade, high levels of investment, and an expanding human-capital base. These countries are not spared from structural shifts and distributional challenges. But their transitions are faster and less painful, because investments run broadly across their public and private sectors, and across tangible and intangible assets.

Developed economies are not so different in this respect. A significant across-the-board increase in investment might not fix all of their distributional and adjustment problems. But it certainly would help to spur growth and reduce economic and political frictions in their structural adaptations.