Complexity in economics and the effectiveness of different policies

Those on the right and left of the political spectrum frequently engage in debates over economic policies which they are seemingly unable to resolve, even with reference to ‘evidence’. This may be because the differing outcomes of various policies are determined by variables not included in the model they are considering. In such debates, the participants need to consider more complex models which include variables outside those they have included. Thus policies which increase the redistributive effects of taxation in a particular national economy may in some cases affect the rate of economic growth negatively and in others have no effect or even increase it. Those on the right would argue that such policies will always have negative effects on growth, and point to the case of the UK in the 1970s in which very high marginal rates of tax apparently discouraged incentives for ‘enterprise’, in contrast to the lower rates brought in under the Thatcher government and the subsequent improved performance. Those on the left might in turn argue that the 1960s saw relatively high rates of tax in many countries combined with rapid growth and low unemployment, much lower in fact than the rates which have prevailed in the ‘neo-liberal’ era which has been in place since the late 1970s. How can both sides be right?

I would argue that both sides can be right, but in different contexts and under different economic conditions not considered by either. From a Marxist point of view, one of the keys to economic performance is the average rate of profit in the economy. A high or rising rate of profit should lead to greater rates of investment, rising productivity, employment and wages, and a decent rate of economic growth. A low or falling rate of profit will precipitate falling investment and employment and poor rates of economic growth. It will ultimately require a reorganisation of the economy with the elimination or liquidation of weaker firms and a reallocation of funds needed for investment to stronger firms. Eventually the rate of profit can start to rise again, and economic performance can improve.

If we bring the idea of the average rate of profit into the debate over rates of taxation, we can suggest that an economy with a high and rising rate of profit can absorb increases in taxation, which may slow the rate at which the profit rate is rising, but not affect it unduly, and an improvement in economic performance can continue. If the rate of profit is low or falling, an increase in tax rates can lead to an even lower rate of profit, preventing economic recovery from taking place. In this case, lower tax rates may raise the profit rate, encouraging an increase in investment, output and employment. Thus a more complex economic model can better explain the different outcomes of the examples used by those on the left and right of the debate to make their case.

A similar argument can be made in the debates over industrial policy effectiveness in developing countries. As I have argued in earlier blog posts, here and here, and as maintained by the economist Mushtaq Khan, the success or failure of industrial policy can be explained by examining the compatibility of different policies for promoting technological catch-up with the political settlement or balance of power in a particular country. Some developing (and now rich) countries, such as Taiwan, South Korea, and Japan used industrial policy with great success for a significant period, while others, such as India, Pakistan and countries in Latin America, had less success, although there were narrower positive achievements in particular sectors. Khan argues that a rapid catch-up in levels of technology and productivity by developing countries to those of the already rich countries may require industrial policy, but that simply being ‘behind’ with the potential to catch up is no guarantee of success. The successful industrial policy states were those that had a particular balance of political power or political settlement in society which enabled states to enforce conditional protections and support for sectors with rapid growth potential. Firms or sectors that did not perform well had their support withdrawn, which minimised the welfare losses from industrial policies. States with less successful outcomes were in many cases unable to enforce such conditions, and as a result, firms and sectors did not ‘grow up’ to become internationally competitive. In this way, political factors can be seen to be vital to a model which explains the outcomes, successful or otherwise, of industrial policies for rapid development.

Thus the two examples above show that fairly mainstream debates in economics can be resolved by reference to factors not considered by either side in the argument. While simple models in economics can sometimes be useful, introducing more complex factors may often be necessary to inform a richer analysis and better explain outcomes.

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One thought on “Complexity in economics and the effectiveness of different policies

  1. Pingback: ‘Pick the right time and flourish, miss the wrong time and perish’ | The Political Economy of Development

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