Monday, October 8, 2012

How Fast Is Too Fast?

When it comes to economic reforms, how fast is too fast? The question of the practical pace of reforms comes up after this statement from U.K. finance minister George Osborne (as quote at Reuters):

We’re reducing the size of government from almost 50 percent of our national income to just 40 percent in just five years. I just don’t think it’s realistic to cut a great deal faster than that.

On the surface, it would appear that the Conservative Party government is already making cuts faster than the economy can absorb them. A healthy Western economy can keep up with exogenous large-scale institutional changes to the extent of about 1 percent of GDP per year. The rate is higher in a good year and in good circumstances, or lower when there are other stresses, but the 1 percent rate works as a rule of thumb. Based on that, Osborne’s plan can be expected to cause unemployment to increase by about 4 percent in 5 years. A slower approach would cause less disruption and therefore could reach the same goals faster.

In theory, transitions can happen several times faster with narrowly chosen short-term central economic planning. Given the degree of institutional corruption across major economies, though, no one should expect this approach to work consistently. China and Argentina serve as current examples of the high costs of large-format reforms sponsored by corrupt central governments. India and Russia, by contrast, have at least the same level of corruption, but have managed to steer clear of the worst economic disruptions by enacting reforms on a much more timid scale. Brazil is an interesting case where, in spite of obvious problems with corruption, faster reforms have taken hold successfully, not just right now, but more often than not since the 1990s. How do they do it?