Triangle of Trust as a Condition for a Leap in Quality of Life

Reut believes that a development leap is based on the triangular relationship between investment in the future, stability, and government ability to plan and implement long range policy. At the heart of these three elements, is trust.

Executive Summary

This document identifies the shared traits of countries that experienced a leap in socio-economic development and quality of life as a result of government policy. We distinguish these countries from those that based their development on serendipity, like fossil fuel deposits.

This document is a component of the Top-15 project, the goal of which is to transform Israel into one the 15 most developed nations in terms of quality of life. Fulfilling the Top-15 vision requires a socio-economic leap in Israel.

Of the countries that experienced a development leap, three macroeconomic characteristics are apparent: (a) increase in domestic savings and investment, (b) openness to innovation, and (c) stability as defined by low and stable inflation and a low debt burden. These characteristics are necessary for growth, but not sufficient.

Despite these commonalities, in terms of regulation; legislation; and the specific uses of investment, savings, and trade policy, the paths taken by each of the countries that have significantly improved their quality of life have been tailored to domestic needs.

The countries that have made a leap all managed their public sector in a way that aligned the interests of the government, the workers, and the private sector. One of this document's conclusions is that the public sector in these countries shared three attributes:

  • A Central Brain with Carrying Capacity that can design, plan, and implement policy directives.
  • Tomorrow Before Today - A commitment to allocate resources for investment instead of consumption on the part of the government, private business, and households.
  • Stable Environment - A combination between policy that creates a stable environment and the ability to change course in response to unexpected developments.

These three traits are interconnected.

To develop and sustain these three traits, cooperation between the government, labor, and industry based on shared interests and trust is required.

Preface

Top-15 - This concept refers to the goal of transforming Israel into one of the 15 most developed countries in terms of its citizens' quality of life. The Top-15 Vision advances an agenda that seeks to generate a leap in Israel's growth and quality of life.

A development leap requires an Episode of growth - A definitive rise in Israel's quality of life relative to that of other developed nations requires a period of time (Episode) during which non-cyclical forces meaningfully raise the country's socio-economic status.

The Top-15 Agenda includes seven componenets - (a) a robust understanding of the future environment in which Israel will be one of the 15 most developed nations, (b) identification of the engines of growth in quality of life, (c) management of Israel's individual burdens and exploiting her unique assets, (d) design, implementation, and management through appropriate budgetary or regulatory policies, (e) reform of the public sector, (f) identification of relevant indices by which to measure Israel comparatively, (g) and the creation of a national conversation that is guided by the Top-15 Vision.

This document addresses the question: What is the common denominator between countries whose quality of life has leapt dramatically? Countries whose growth is due to serendipity like oil wealth are excluded.

Methodology

This document is based on a study of the shared characteristics of countries that have successfully managed a development leap. We concentrate on those countries that resembled Israel in some way during their stages of development. None is an exact match, but each provide worthwhile lessons. Among others, we studied Ireland, Finland, South Korea, Taiwan, and Singapore.1

Common Denominator: Management, Stability, Openness, and Investment

The conclusion of Reut's comparative study is:

a. Macroeconomic stability, exposure to foreign trade and knowledge, and investment are vital (but insufficient) - The most common attribute of those countries that managed a development leap are a) increasing investment as a proportion of GDP, b) openness to trade and ideas, and c) macroeconomic stability in terms of stable and low inflation, relatively little national debt, and decreased public expenditure. Nevertheless, these conditions are not sufficient for growth.2

b. We recognize no other similarity in policy components - The individual stories of growth differ vastly across the sample countries. Excluding the macroeconomic policies described earlier, fiscal policy and the division of resources varies. Examples exist of development based on manufacturing for export, free trade, protectionism, and more.3

c. Similarity in management of the public sector - One common denominator that seems to be shared by all countries that have made the leap is the way in which the public sector is managed in relation to the most influential actors in the economy, specifically labor and employers.

Core Issue: Government Conduct - While the contributions of macroeconomic stability, open trade, and investment policy are well accepted by development literature, the centrality of government management and the specific factors that improve its performance are new and important contributions to growth literature.

This paper concentrates on elucidating the form of public sector management that leads to a development leap and identifies the conditions necessary for its creation.

Triangle of Trust as a condition for Development Leap

Countries that achieved a development leap shared three traits during their episode of growth:

a. A "Central Brain" with Carrying Capacity that could design, plan, and implement policy directives.

b. Tomorrow Before Today - commitment to allocate resources to investment instead of consumption on the part of the government, private business, and households

c. Stable Environment - combination between policy that creates a stable environment and the ability to change course in response to unexpected developments

These three components are connected systemically upon a basis of aligned interests and trust between the key players in the economy, especially the government, labor, and business.

A planning body with the ability to govern - A development leap occurs when the government acquires the ability to design, plan, and implement policy. We identify two components to this ability:

a. Central Brain - A group of people that has the ability to develop, design, and influence policy decisions and management of the public sector. It need not be formal, nor need it be officially within the government, but it must have the ability to approach challenges and opportunities from the perspective of the national interest. In most cases, the decisions and recommendations of this body are accepted and implemented by policy makers. Ireland and Singapore are two relevant examples.4

b. Carrying Capacity - The ability of a political element to make and implement decisions. It is built upon the following components:

  • Material - Availability of human, financial or other physical resources.
  • Legitimacy - Public agreement to grant the leaders authority to make decisions that alter the socio-economic reality.
  • Political - Capacity of the top executive to stay in power and forge coalitions to pass decisions and required legislation in the relevant executive and legislative bodies.
  • Legislative/Judicial - Capacity to codify executive decisions legislatively and uphold them judicially.
  • Institutional - Capacity of branches of government to "get stuff done", i.e. to sustain cross-agency cooperation in planning and decision-making, as well as in the implementation of policies.

c. Vision is not a requirement - The existence of a shared national vision is not necessary for growth. It is possible to create the momentum for development without the need for a centrally planned vision of tomorrow.5

Nevertheless it is necessary to create an environment in which the interests of various influential sectors of the economy are aligned for the period of time during which the economy makes its development leap.

Tomorrow before Today - Growth for the future is based upon investment today. For example, all countries that succeeded invested heavily in their infrastructure. This is reflective of a readiness to allocate resources from consumption to investment in the public sector, the business sector, and in the household:

  • The government reallocates resources to seeds of growth such as infrastructure, R&D, and education instead of allocating it to transfer payments, subsidies, and government consumption.
  • The business sector invests in R&D and worker training instead of reaping profits.
  • The labor force shows willingness to delay pay increases to the future. This sacrifice is built upon the understanding that a piece of a larger future pie is worth more than an immediate pay raise today.6

Stable environment with the ability to change policy - A stable environment encourages long term planning. Conversely, the absence of stability forces the market to concentrate on short term planning, inhibits hiring workers and making capital investments7, and increases the costs of risk management. 8

A stable environment results from the following trends:

  • Stable macroeconomic indicators - A stable macroeconomic framework is identified by stable and low inflation, a small national debt burden, and efforts to decrease the public sector's share of the GDP.9 National investment tends to be high in this framework as well.10 The countries that developed quickly shared this trait.
  • Stable policy indicates the government's ability to uphold its decisions in the face of political opposition.
  • The ability to change direction recognizes the need to alter policy in response to unexpected challenges without falling victim to political opposition.
  • Conflict resolution - A stable environment rests on the ability of the leading and competing sectors of the economy agreeing to pursue mutual interests instead of bickering over individual interests. This is necessary if labor unrest, political squabbling, and judicial intervention are to be avoided. 11
  • Long and stable government tenure - In most of the comparison countries, governments enjoyed long and stable tenures. Importantly, adherence to growth policies was maintained even during transitions. 12

Triangular Relationship - Between the three traits, Central Planning Body and Carrying Capacity ('Carrying Capacity'), Tomorrow before Today ('Investment'), and Stable Environment ('Stability'), exist systematic connections.

  • Carrying Capacity permits Stability - The ability to govern, especially in the ability to legislate and implement laws in an organized fashion based upon an established platform, creates stability in the economic sphere.
  • Stability permits Investment - A stable environment permits economic actors to invest resources in growth instead of risk management.
  • Carrying Capacity permits Investment - Business and personal investment flow from the environment created by the government. A strong and legitimate government increases incentives for private sector investment. Additionally, Carrying Capacity encourages labor and business to enter into longer term agreements on the understanding that the government will act as a guarantor for their implementation.
  • Investment permits Carrying Capacity and encourages Stability - As more investment flows into the market, all parties develop incentives to maintain stability. Forces that maintain the political and policy status quo are strengthened.

Trust at the Center of the Triangle - An episode of cooperation between employers, employees, and the government promoted by aligned interests ('trust') is the basis for the triangle that permits growth and is necessary for its existence. In the absence of trust, no episode can be long-lived. Actors will hesitate to trust each other's promises and the national conversation will degenerate to division of the pie instead of making it larger.13

The foundation of an Episode of trust is long tenures and stable policy - frequent power transitions and changes in policy direction diminish confidence in the private sector. They are characteristic of the absence of long term planning and describe an environment in which parties vie over division of the national pie. Conversely, stable policy and long tenures develop trust and permit cooperation for growth.

End.



1 When many of these countries began their development, they were significantly less developed than Israel. Likewise, not one country is a perfect copy of Israel's economy.

2 The World Competitiveness Report 2006-2007 of the World Economic Forum states: "In fact, there is overwhelming evidence that in the absence of a solid foundation of macroeconomic stability, growth will be anemic-viz. Argentina-or, at best, volatile-viz.Turkey." (Part 1, p.4).

3 Ireland's growth is based primarily on Foreign Direct Investment (FDI) through the operations of multi-national firms on Irish soil; a cheap, educated, English-speaking labor force; the IDA's promotion of Irish business; and low corporate taxes. (Walsh, 2000)

Japan and Germany played catch-up to US Total Factor Productivity and regained their positions as world leaders in manufacturing and exports. Gilchrist S., Williams J.C., "Transition dynamics in vintage capital models: explaining the postwar catch-up of Germany and Japan," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S) 2001.

Singapore could never be an industrial power house like Japan or Germany. Instead, Singapore capitalized on its geography to dominate trade in its region and has since made itself a center of Financial Trading and technology development.

W.G. Huff , The Economic Growth of Singapore, Cambridge University Press, 1997.

Spain, like other later entrants to the EU found itself progressively integrated into first the EEC and then the EU. Much of its policy was decided in Brussels, and much of the money came from EU development aid.

4 In Ireland, the Irish Development Authority had "autonomy from the civil service, extensive resources, and effective insulation from the political process." It had sole responsibility for attracting international investment, and its recommendations for that goal were accepted by Parliament more-or-less without question:

The Irish Labor Market

Singapore relied heavily on its Economic Development Board. Edgar Schein explores its importance in his book strategic pragmatism. Schein,Edgar, Strategic Pragmatism, MIT Press, 1996.

5 Southern European growth did not flow from an internal vision. It was a matter of catch-up with northern neighbors in the EU community. Beyond Liberalization, Privatization, and Deregulation - as more-or-less mandated by EU directives - growth does not seem to be the result of a manifest vision. As an example Spanish growth can in large part be attributed to four factors totally beyond domestic control:

  • the continuing fall in oil prices;
  • increased tourism;
  • a sharp reduction in the exchange value of the United States dollar;
  • a massive upsurge in the inflow of foreign investment;
  • exposure to foreign competition in accordance with EC requirements.

Larre B. and Torres R., "Is Convergence a Spontaneous Process? The Experience of Spain, Portugal and Greece?" OECD Economic Studies, No. 16, Spring 1991.

6 Trade unions were willing to cap wages in return for price caps on key necessities. "organizations accept wage moderation today in return for higher incomes tomorrow."

(See: Makus Jantti, Juho Saari, Juhana Vartianinen, "Growth and Equity in Finland", United Nations University, July, 2006).

Irish Congress of Trade Unions and Irish Business and Employer's Confederation negotiated deals regularly. The foreign firms in the IBEC were happy to abide by the terms and reward excellent employees with non-wage benefits. Wage moderation did not stick in industries characterized by scarce talent.

"Choice, Chance, or Coincidence?", ISSC DISCUSSION PAPER SERIES, 2003.

Spain - The Moncloa Pact was Spain's first Tripartite agreements and paved the way for economic development in the post Franco years. They included an agreement for wage moderation.

The Moncloa Pact (Spanish)

7 Bolivia confounded development economists because of its apparent perfect adoption of Washington Consensus Policies and non-existent growth. It seems that while the finance ministry was dedicated to growth, and the attendant fiscal austerity, the rest of the government was not. Corruption, favoritism, and cronyism conspired to halt development of the private sector. Without secure contract rights and stable regulation, businesses could not invest.

"Sustained Macroeconomic Reforms, Tepid Growth: A governance puzzle in Bolivia" by Kaufmann, Mastruzzi, and Zavaleta in In Search of Prosperity, edited by Dani Rodrik.

8 Argentina's default on $100B debt sent the country's economy into freefall and investors withdrew everything they could. Jennifer Rich, New York Times, 2/2/02.

9 See #2

10 In their research, Levine and Renelt "find a positive and robust correlation between average growth rates and the average share of investment in GDP." Theirs is a cross-country regression analysis with a sample of 119 countries. The result is particularly significant because the paper's stated purpose is to disprove the robust correlation between many economic variables and growth. The fact that investment is the only variable show robust correlation to growth is extremely important.

Ross L., Renelt D., "A Sensitivity Analysis of Cross-Country Growth Regressions", American Economic Review, Vol. 82, No. 4, Sep., 1992, pp. 942-963.

11 Tripartite councils are common in Europe. Periodic negotiated agreements between the government, labor, and capital stymie labor unrest and political deadlock. They have been used to great success in Spain and Finland (see the #6), and the Baltic states.

"Europeanization of Employment Policy Making in the Baltic States", Kerstin Jacobsson and CharlotteWest Södertörn University College Stockholm, Sweden

Japan reduced friction in the economy through its Iron Triangle of Government, Business, and Bureaucracy. Labor was implicitly represented through the business community's guarantee of life-long work.

12 Alesina et.al. show a statistical correlation between political instability and weak growth across 113 countries in the Journal of Economic Growth. The dominance of Lee Kuan Yew in Singapore and the LDP's monopoly on control in Japan are anecdotal evidence of the converse.

Alesina Alberto et. al., "Political instability and economic growth", Journal of Economic Growth, Volume 1, Number 2, June, 1996, pp.189-211.

13 See the two papers that have formed the basis of trust research in growth:

Knack S., Keefer P., "Does Social Capital Have an Economic Payoff? A Cross-Country Investigation", Quarterly Journal of Economics, Vol. 112, No. 4, November 1997, pp. 1251-1288.

Bjornskov C., "How Does Social Trust Affect Economic Growth?", Aarhus School of Business, Department of Economics, (Working Paper 06-2), Denmark, 2006.