Column : Rescue or restructure

Written by Michael Walton | Michael Walton | Updated: May 8 2009, 07:43am hrs
What has the debate over bailout or bankruptcy of the US car industry got to do with Indias National Rural Employment Guarantee Scheme Both concern the relationship between protection, economic change and power. They share two design challenges: first, how to provide a cushion for those hurt by adverse shocks whilst encouraging the economic restructuring needed for long-term growth; and second, how to align policy and institutional design with politics, so that equitable and efficient choices are not subverted by the structure of power.

Lets put politics aside for a moment, and consider the social and economic goals in response to a shock. Loss of work or a bad harvest causes suffering in the short to medium term. We care more about this the greater the suffering and the more likely that it will have long-term effects. Unemployment in the United States can have severe effects when alternative work is scarce, and particularly when this also means loss of health insurance. Risk is even more pervasive in India, especially in rural areas and the urban informal sector. Adverse shocks can push households into deeper poverty, and lead to postponing health spending, cutting back on food and pulling kids out of school. The Self Employed Womens Association is finding that many of its members, most of whom are poor, are suffering large economic shocks, and having to make use of a range of such adjustment mechanisms, with big costs to their well-being.

Yet it is also in societys interest to encourage the economic change that will lead to higher growth and well-being in the future. It is true that a severe recession can sometimes destroy productive or organisational capital that is viable in the long term. That is the essence of the argument for government support of the US car industry. But it is unclear whether governments are much good at sorting this out, or whether industrial policy should be driven by economic conditions in a recession. There is a more robust case for public policy to concentrate on reducing aggregate decline, through contracyclical policy, and for industrial policy to focus on issues for the future, such as strengthening the research and development system in the country.

The first design challenge thus takes us to institutions that provide protection and support for adjustment of workers and households, but encourage flexibility of economic activities. Unemployment insurance, adjustment assistance and NREG are all aligned with this. The NREG does have design issuessuch as working out how to make the right to work mobile over spacebut the first-order effect is to provide a cushion that is supportive of, not in conflict with, rural change.

So, lets turn to the second design challenge: the link with politics. Once a crisis occurs, governments will be under pressure to help those with the greatest influence. This is clearly relevant to the US car industry. It is also an issue for the design of financial policy in the US. Bailouts are, unfortunatately, justified for the financial industry because of the systemic effects of financial implosion. However, there are real concerns over power distorting design: MIT economist Simon Johnsonex-chief economist of the International Monetary Fundis a leading proponent of the view that the US financial workout is unduly shaped by the power and influence of big banks. In an Indian context, loan waivers were highly politically popular and alleviated short-run suffering, but at the cost of setting back the objective of financial deepening that is central to rural economic change.

It is better to get buy-in to institutional mechanisms that have sound efficiency and equity objectives before a crisis occurs, and reduce the scope for government discretion. Bankruptcy was in part invented precisely to get more equitable and efficient loss allocation mechanisms when firms cannot meet their obligations, without leaving this to discretionary responses when the going gets tough. The US governments decision to let Chrysler go into bankruptcy was a good thing: it increased policy credibility, and set in train a process in which productive assets will be used, and losses distributed in a reasonably equitable fashion.

NREG can also be seen as an institution in which the automaticity that is essential to the right to work reduces discretion. Is it politically aligned Congress has counted it as an achievement of the current government, but it is in the interests of NREGs purpose that it be seen as an institution of the state rather than the policy of onepartyas is intrinsic to its legal design. Such substantive incorporation into state functioning is necessary for long-term success.

Managing adverse shocks should follow two principles: focusing on support to people not industries; and institutionalisation of loss allocation processes ex ante so that crisis choices are not shaped by those with greatest power. These apply with equal force to the US and India.

The author is at the Harvard Kennedy School, the Institute of Social & Economic Change and the Centre for Policy Research