Finding the right economic reform strategy for Europe

Together with fiscal consolidation, structural reform is the new European mantra. International organizations and European Union bodies regard such reform as a prerequisite of economic recovery, growth, and alleviation of the unemployment plague.

Indeed, the agreement reached between the Greek government and the “troika” (the International Monetary Fund, the European Central Bank, and the European Commission) includes a 48-page list of detailed reforms. Not all countries are given such a long to-do list, but, since new EU legislation was adopted in 2010, specific recommendations are addressed to all. For example, the brief addressed to Italy includes recommendations on the efficiency of public administration, the fight against corruption, corporate governance in the banking sector, the labor market, schools, taxation, opening up the services sector, and infrastructure.

To be sure, European countries urgently need to implement deep reforms. Poor productivity growth and stubborn unemployment are evidence that their economies require comprehensive transformation. But if this observation provides the rationale for reform, it does not provide a firm enough basis for drawing up effective economic-revival plans.

The design of a reform strategy requires solving two problems. The first is one of purpose. Successful societies are a diverse lot. Some are unequal, and others are egalitarian. Some cherish large welfare states, and others starve them. Some rely on extensive collective agreements, and others exclude them altogether. Some are based on arm’s-length transactions, and others rely on recurring relationships. Scholars refer to “varieties of capitalism” to highlight the absence of a single template for success.

But if there are different models, what should the priorities for reform be? International organizations generally point out – rightly – that in most cases a country can improve economic efficiency without changing its economic model. For example, there is often ample room for achieving the same income redistribution at lower budgetary cost, or for ensuring that collective wage agreements take into account the interests of those without a job. So national models can be reformed while retaining arrangements that meet social preferences.

This answer, however, is somewhat facile. Countries are not only inefficient; often, they are also inconsistent. For example, they pretend to become global hubs but do not welcome foreigners, which is what prevented Japan’s emergence as a world financial center in the 1990’s; or they hope to develop as knowledge-based economies but dislike academic freedom; or they aim to nurture innovation but do not want innovators to become rich.

Such inconsistency is often a major impediment to development. By contrast, the success of the United States as an innovation powerhouse relies on a high degree of consistency across fields ranging from education and immigration to taxation and the labor market.

So pro-growth reform not only requires substituting efficient arrangements for inefficient ones; it also demands confronting hard choices, which is, at bottom, a political endeavor. For this reason, it is not something that any international organization can even suggest in lieu of a country’s voters.

The second problem in designing structural reform is one of strategy. As the economist Dani Rodrik has pointed out, standard analysis generally results in a laundry list of desirable reforms that does not tell governments where to begin. Apprehensive leaders start with the most politically expedient items, while bold leaders start with the most challenging prescriptions; but there is no guarantee that either of these approaches will deliver the expected result. Even a seemingly rational strategy of correcting the largest inefficiencies first is not necessarily the appropriate one.

One reason is that the effectiveness of reform may depend on conditions prevailing in other sectors: good universities, for example, cannot remedy the consequences of poor secondary education. Moreover, eliminating one distortion may be ineffective or even counterproductive: in an economy plagued with rents, partial reform may simply result in shifting them across sectors and agents, rather than reducing them to the benefit of consumers.

As a result, considerable political energy may be consumed in pushing through measures that deliver very little. Instead, reform should start with the most binding constraint to performance (which one that is depends on the whole set of hindrances that confront the economy).

In addition, outcomes may depend on cyclical conditions. Advocates of structural reform generally claim that they aim to increase output and welfare in the medium term, and that the short term does not matter. But, while some reforms – for example, those improving access to credit or eliminating rents that harm consumers – can indeed help to boost growth during a demand shortfall like the one that Europe is now experiencing, others can have the opposite effect. For example, labor-market reforms that make it easier for companies to reduce staff may weaken demand further, underscoring the importance of considering reforms’ short-term effects.

What all of this suggests is that an economic-reform agenda cannot result from a mechanical exercise. At some point, hard choices about priorities and sequencing must be made. This is not to say that international organizations and the EU are of no help. On the contrary, these bodies can be very valuable insofar as they carry out international comparisons and point out deficiencies. But there is a line in the sand beyond which only governments can set priorities and act. That, after all, is what voters elect them to do.

The opinions expressed here are those of the author, not necessarily those of the World Economic Forum. Published in collaboration with Project Syndicate.

Author: Jean Pisani-Ferry is Professor of Economics at Université Paris-Dauphine and currently serves as Director of Economic Policy Planning for the Prime Minister of France.

Image: A large European Union flag is seen in Romania REUTERS/Bogden Cristel.