The root problem: Economic policies and identity politics

By Andres Velasco, Daniel Brieba

NEW YORK: What kinds of economic policies should centrist reformers pursue? The standard answer is that they should target innovation-driven economic growth and a fair distribution of income. Achieving these goals simultaneously would be difficult under normal circumstances. Nowadays, the clash of identities threatening to tear apart many democratic societies makes it even harder.

According to conventional wisdom, a fairer distribution of income is the best way to defang identity politics. In fact, the opposite is true: unless we address the identity clash head-on, politics will become so nasty and intractable that spurring innovation and reducing economic inequality, let alone improving public services and curbing climate change, could become impossible.

Part of the answer is candidate choice: elitist, aloof leaders will be perceived that way by voters. Policies also can play a role, but not just any policies. The key is to transmit one fundamental message to voters: government is working for you, not for elites of some kind or for friends in the party establishment.

Several policies potentially fit that bill. One is revamped social insurance. Whoever finds no helping hand when they become ill or lose their job is likely to become skeptical of mainstream politicians and potential fodder for populists and demagogues. But many risks are not insurable. In circumstances like the 2007-09 global financial crisis or the COVID-19 pandemic, insurance markets break down. That is why the London School of Economics’ Ricardo Reis and one of us (Velasco) argue in a recent paper that government should also be the insurer of last resort.

Think of the United Kingdom’s furlough scheme, which allowed businesses to survive the pandemic downturn while shedding relatively few jobs. During the 2022 energy crisis triggered by Russia’s invasion of Ukraine, the new approach was evident in novel transfer programs targeted at the neediest households. Insurance-driven fiscal activism comes with a caveat: to spend more in bad times, government needs to retain access to credit at reasonable interest rates. That means spending less or taxing more in good times. Insurance-driven fiscal activism is not synonymous with fiscal profligacy.

The golden age of trust in democratic institutions in Western Europe and North America after World War II was also an age of strong employment creation, with good jobs at good wages. Similarly, the wave of democratisation in East Asia and Latin America in the 1990s and early 2000s was underpinned by job growth.

The years since have been very different. Most advanced economies have experienced lower job stability, growing underemployment, and a declining labor share of national income. In emerging and developing countries, the Asian miracle, which was based on the growth of manufactured exports, looks increasingly hard to replicate. And in all countries, rich and poor, the specter of job destruction from automation and artificial intelligence haunts workers.

As Harvard’s Dani Rodrik and Stefanie Stantcheva write, “One of the fundamental problems of contemporary capitalism is its failure to produce adequate numbers of good jobs to sustain a prosperous and growing middle class.” A possible way out is the “active” labor market policy pioneered in Scandinavia and adopted elsewhere in Europe. It includes skills re-training, pro-employment subsidies, and helping with job search. The goal is to increase the chances that everyone – including people with few skills and little experience – can land a decent job.

If the goal is to increase social cohesion and lower the temperature on identity issues, creating good jobs is much better than handing out a universal basic income. Good jobs can provide links to the community, a sense of self-worth, and hope for the future; sitting at home checking social media while waiting for a government handout cannot.

Not long ago, if a country had pockets of prosperity alongside de-industrialised regions with shuttered businesses and high unemployment, the standard advice to the unemployed was to move to where the jobs are. Today, we understand that people wish to live where their community, family, and friends are. When young and enterprising people do move away, it is bad news for the communities they no longer call home. Social bonds break down and local productivity declines even further. Citizens who feel left behind are easy prey for populists.

Italy and the UK, countries with deep regional income disparities, have shown that helping lagging regions is tricky. But that should not keep reformers from trying. The key is to move away from only transfers and income support and toward a “big push” that expands both the supply of goods that can be sold elsewhere and creates demand for services that can be sold only locally. Helping retrain workers, cooperating with local firms to identify public goods and services they need, and easing assimilation of knowledge are all components of a successful strategy.

There are good reasons for wanting people and ideas to move across national borders. Communities that are open to the world are likely to be more creative, more productive, and freer. But it would be naive to ignore the potentially deleterious political impact of mass immigration. The economic costs and benefits of immigration are unequally distributed across workers. Not everyone who worries about the impact of migration on the fabric of local communities is a racist or a xenophobe. The right migration policies will vary by country. But to avoid becoming fodder for the populist monster, they must make intuitive sense to voters.

An analogy may help. Having children often involves sleepovers. If each child invites a couple of friends, they can all camp out on the living-room rug. But the kids often have such a good time that they push to invite more and more friends, even though there is no room for them all to sleep on one floor. Sleepovers must be regulated; so must immigration.

Such policies convey to the average voter that they have a government they can identify with – and that identifies with them. Unless voters receive that message, they will be susceptible to nativist populism and the identity politics on which it thrives.