Why we're not even ready for the current recovery let alone the next crisis

The 2007 financial crisis will be remembered by scholars not only for the speed of the collapse but also for the length of the recovery. It has been extraordinarily protracted and particularly so in Europe. In addition, the recovery has been very uneven across the European core and the periphery (Baldwin and Giavazzi 2015).

All too often, the diagnostic has been that structural reforms are the key to unlocking the recovery and delivering a return to higher growth and productivity.

One would struggle to find an economist who has anything against structural reforms in principle. Eliminating distortions that facilitate trade and increase choice is an easy sell to a profession in which very few ideas command consensus. However, from an academic point of view, the issue of whether structural reforms lead to higher growth without detrimental income inequality effects remains grossly under-researched.

Structural reforms comprise the set of government policies that fundamentally alter the way the economy is organised. Such reforms include the opening up of the economy to trade, to competition and to foreign direct investment; the transfer of state assets to the private sector; product market deregulation; and measures aimed at making labour markets more flexible.

We often hear these days we are not ready for the next crisis. In this column, we argue we are not ready for the current recovery and will not be until we understand reforms. Structural reforms are too important to be left to politicians – we need to revisit their drivers and understand their impacts in order to deliver a comprehensive, critical, non-dogmatic, and urgently needed assessment of their costs, benefits, drivers, and dynamics.

Conceptual issues

There are two concerns over the role of structural reforms in the recovery in Europe. The first finds its origins in a Keynesian interpretation of the low growth experienced since 2008 (Eggertsson and Krugman 2012, Eggertsson et al. 2014, Fatás 2016, De Grauwe and Ji 2016). Policies that improve the supply side through structural reforms will not automatically lead to more demand and output. Structural reforms may even lead to reduced demand and thus to an even more depressed economy. In a new book, we provide evidence that this has happened in Europe (Campos et al. 2018). This includes evidence that public investment is a more powerful tool for boosting growth than most structural reform programs.

In this context, the timing of the implementation of these reforms is key (Eggertsson et al. 2014). Some reforms, if implemented during a recession, can exacerbate the recession and as a result can have the unintended consequence of breeding hostility towards free markets and weakening the political resolve to undertake further reforms. Thus, structural reforms should not be seen as instruments to fight a recession, as has been the case in the EU, but as a tool to increase people’s welfare.

The second critique of structural reform programmes emphasises the importance of identifying specific structural reforms that are necessary to boost a country’s economic capacity to provide for sustainable growth. Some structural reforms can make a fundamental contribution to improving economic performance. The focus on labour market and product market flexibilities may be neither desirable – due, for example, to its negative impact on inequality – nor sufficient to promote growth (Rodrik 1996, 2005).

Challenges

The overall aim of our book is to take stock of current frontier work and to identify the new research needed on key issues surrounding structural reforms. We are convinced that some structural reforms can make a fundamental contribution to improve economic performance across Europe as well as to promote European integration. Yet we believe that comprehensive, critical, and non-dogmatic assessments of the costs and benefits of different reform programmes are key in guiding future policies. This will allow us to identify the conditions under which structural reforms are beneficial. We believe that future research requires a substantial shift from evaluating generalised direct impacts of structural reforms on economic growth to a broader set of issues and research questions.

First, because of the emphasis on the direct effects of structural reforms, indirect effects have received relatively less attention. For example, consider that the effect of a particular reform on economic growth cannot be directly identified not because it has no effect but because it happens indirectly (i.e. through another variable) or because it depends on the effect of another reform (as in an interaction effect). Disregarding these indirect effects prevents a proper evaluation of the effects of structural reforms.

Second, the focus on the direct effects of structural reforms has also resulted in the study of the determinants of structural reforms (i.e. the political economy of reforms) being left relatively underdeveloped. Understanding how structural reforms come about is equally important as understanding their effects. For example, reforms imposed top-down by creditor nations (as was done in the cases of Greece and Portugal) are unlikely to have the same positive effects as reforms that are generated as a result of a social consensus about their benefits.

Third, the scope of the research should also include a more detailed study of the optimal timing of the reforms. We already know that structural reforms applied during a recession generally do not work as well as reforms implemented during boom periods. Similarly, reforms that work for emerging countries that start a new process of industrialisation may not work well when applied to mature economies that are experiencing a process of de-industrialisation. A related factor has to do with the sequencing of the reforms. There is a large literature on the optimal sequencing of the reform process suggesting that it matters – that is, the exact sequencing of the reforms is likely to have quite different short-term and long-term effects on economic growth.

Fourth, there is the institutional framework and the nature of the political system in which the reforms are implemented. Some political systems and institutions are based on consensus building leading to greater acceptance of reforms once they are agreed upon. Others are more adversarial leading to conflicts during the post-reform process and to reversals in their implementation. Many other differences in political systems and institutions may matter.

Take-away

We believe that comprehensive, critical, and non-dogmatic assessments of the costs and benefits of different reform programmes are key in guiding future policies. Reforms programs should not be the technical implementations of some hidden ideological agenda.