Getting to Denmark

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American political scientist Francis Fukuyama is best known for his book on the end of history. This captured the US zeitgeist in the 1990s, but has not aged well.  It is Fukuyama’s more recent writings on social trust and political institutions that are more relevant to understanding the world today.  In ‘Political Order and Political Decay’ he described the way in which political institutions support economic and social progress and warned on the potential for institutional decay.  He identified political accountability, a strong, effective state, and the rule of law, as institutions that were critical in ‘getting to Denmark’; his lodestar of a prosperous, well-governed society.

The centrality of institutions in supporting economic development is well-established, particularly in emerging markets where weak political institutions have often led to poor economic and social outcomes and a higher risk profile. But increasingly it is advanced economies that are moving away from Denmark – exhibiting behaviours more commonly associated with emerging markets.  This has direct implications for the economic and market outlook in advanced economies.

From the US to Europe, exchange rates and stock prices are gyrating in response to tweets, executive orders, referenda results, and charged political debates. This week’s Economist cover story is of a molotov cocktail-throwing Donald Trump acting as an insurgent in the White House.  And in the febrile environment of the UK, Supreme Court justices were branded as ‘enemies of the people’ by some media after a recent Brexit judgment. Over time, these challenges to institutions will lead to increased political risk being priced into these countries – although equity market valuations remain elevated, suggesting that a collision between markets and new political realities is still to come.    

The weakening of independent checks and balances and a clean political process also poses a structural economic risk.  Strong political institutions act as the invisible architecture that supports economic performance. These institutions are often taken for granted, but can unravel.  History is full of examples of countries whose political institutions weakened to the extent that they were unable to respond appropriately to challenges.  Argentina is a classic example: from one of the 10 richest countries in the world in 1914 to a middle income country today, a fall largely attributed to poor governance and political institutions.  

These dynamics extend beyond the usual suspects. Consider Australia, the ‘lucky country’, blessed with resources, proximity to Asia, and historically strong political institutions.  But the experience of the past decade suggests risks ahead: there have been five Prime Ministers since 2010, with three changes due to internal leadership challenges. This combative political culture is compromising the ability to set coherent, long-term policy (to the extent that Australia increasingly – and unusually – refers approvingly to New Zealand, with its record of political stability).

In addition to the risks to these high-level political institutions, a more challenging political environment in advanced economies is also weakening the policy making machinery in government.  The weakening of Fukuyama’s ‘strong, effective state’ increases the likelihood of poor quality decision-making, disruptive lurches in policy, and greater difficulty in responding effectively to shocks.  Indeed, many governments around the world are struggling to respond appropriately to the need for change.  The difficulty in making coherent policy decisions has direct implications for the economic and market outlook for advanced economies, which extend beyond the political risks associated with specific election results.

And the quality of policy decision-making will matter more as countries face increasingly intense economic challenges. The prevailing policy consensus of the past few decades is changing, and strong policy decision-making capability will be required to respond effectively and creatively to deliver new policy approaches.  

Although public sector capability may not have been a particularly prominent source of competitive advantage over the past 25 years of strong global growth and globalisation, it will become much more so in a more challenging international context in which the margin for policy error is much reduced.  The quality of the political and policy-making machinery will become a major driver of country performance, particularly as governments place more weight on discretionary policy-making (as I noted a couple of weeks ago).  As such, variation in public sector capability will be a more central factor in driving cross-country variation in economic performance. 

I am positive on the outlook for countries that have strong governance and high quality political institutions; more so than for countries with weaker institutions even if they have decent economic characteristics (for example, I’m not sure that the dynamism of the US economy can offset the dysfunction of Washington DC).  It is countries with strong public sector capability that are most likely to be able to navigate a more challenging, complex environment, and to generate good economic and social outcomes on a sustained basis. 

Small advanced economies – countries from the Nordics to New Zealand, and from Switzerland to Singapore – tend to have the highest rankings in terms of institutional and governance quality.  These countries have high quality political systems, high levels of social capital and trust, as well as effective governance and policy-making capability.  This enables them to set strong policy, and to adapt policy quickly and responsively to emerging challenges and opportunities. Indeed, many small countries have consistently been in the vanguard of policy innovation and were also able to respond effectively to the global financial crisis.

These small countries have performed strongly over the past few decades because they were able to set policies in such a way as to benefit disproportionately from the process of intense globalisation.  Even though small countries are deeply exposed to a more challenging international environment, small countries with strong institutions and governance are well-placed to respond and to sustain ongoing strong performance.  But ongoing work will be required – even in Denmark.

David Skilling