The return of political economy: The Jakarta Post columnist

Skyscrapers in the downtown area of Jakarta, on June 18, 2016.
Skyscrapers in the downtown area of Jakarta, on June 18, 2016.PHOTO: AFP

Politics is back, and markets do not know what to do about it.

By Paul Donovan

Political risk faded from financial markets in the 1990s. Central bank independence seemed to remove economic policy from political influence. Markets did not care which Bush or Clinton was in the White House, so long as Alan Greenspan was at the Federal Reserve. The result was a reverence for central bank policy, an emphasis on mathematical economics, and a disregard for political concerns.

The years since the global financial crisis have seen the rise of political economics. Political economics is not concerned with predicting election outcomes or speculating on political events (that dark art is psephology). Political economics is concerned with understanding the way policy acts upon an economy, and how political issues like wealth distribution can shape economic outcomes. Political economics is also about how people start to anticipate policy and change their behaviour as a result.

A key catalyst for the rise of political economics has been the realization of the extent of income inequality in many societies. Income inequality has been growing for many years in the developed world (although globally income inequality has fallen considerably). However, this inequality was disguised by consumption equality. Credit allowed people to spend income they did not have. This gave an illusion of equality.

With the collapse in developed economy credit growth after 2008, the underlying reality of income inequality became more apparent. The abruptness with which the inequality was revealed made its effects even more powerful. This led to a frustration - what had been the economics of aspiration turned into the economics of envy. Consumers turned from desiring something and using credit to obtaining it, to anger and frustration that their hard work was not enough to achieve the lifestyle that their neighbors enjoyed.

This situation was then compounded by the fact that in many economies a significant part of the population was left behind by the economic recovery. This pattern is not that uncommon in times of structural change, nor is it especially uncommon in the aftermath of an economic downturn. What increased the potency was the combination of those two factors at the same time.

The sudden, dramatic realisation of the extent of inequality and the sense of being excluded from politicians' talk of economic recovery has encouraged "scapegoat economics". This occurs when a group looks for an identifiable group that can be pinpointed as the cause of their economic position. Different societies identify different groups as scapegoats - the blame is misdirected in every case, but it serves as a focus for the economic pain.

Scapegoat economics can lead to a political response. Politicians arise who indulge in prejudice politics or anti-politics. "Remove the influence of this minority from the economy, and everything will be wonderful for you."

Hence the rise of political economics. Policy is more interventionist than it has been for many years to try and address the awareness of inequality. But policy is also swayed by anti-politics, as the political center tries to address populist concerns.

The problem for investors is that while economics is global, politics is local. Political economics is shaped by culture and social norms. To try and understand political risk from a distance is extremely difficult - certainly more difficult than plugging numbers into a mathematical economic model and receiving a standardised result.

The world is now a harder place for investors to understand. The rise of political economics inclines investors to keeping money closer to home, rather than investing in markets where the political risk is not understood. Ultimately, political economics may create a less efficient, less predictable and a less stable world economy.

* The writer is senior global economist, UBS Investment Bank, London. His latest book The Truth About Inflation was published by Routledge in April 2015.