The euro area debt crisis was, for the most part, a crisis of the European periphery, in particular of the European south. Some Southern European countries (Greece, Portugal, and Cyprus) had to resort to bailout agreements, which entailed the implementation of comprehensive economic adjustment programmes; Spain negotiated a more limited and targeted financial package for its ailing financial sector. Even countries that did not enter a financing agreement, like Italy, came under intense pressure to adjust their economies. Fiscal consolidation and structural reforms were the two pillars of the euro area’s strategy for handling the crisis in exchange for bailout funds (Baldwin and Giavazzi 2015).
In a new book, Economic Crisis and Structural Reforms in Southern Europe: Policy Lessons, we bring together contributions from academic and applied economists that cover the recent experiences of Southern European countries in dealing with structural reforms while struggling with their worst recession period since WWII (Manasse and Katsikas 2018). The different chapters span a wide range of topics, from banking reforms in specific countries such as Cyprus and Spain, to labour market reforms in Spain and Portugal, to product market reforms in Greece. Other chapters take a comparative perspective, discussing the effects of structural reforms on the functioning of the labour market, the banking system, and the current account and political issues that arose during the reform effort.
While the basic ingredients of the policy prescriptions imposed by international institutions were quite similar across countries, they were introduced in heterogeneous economic, political, and institutional environments by governments with varying degrees of commitment and competence, and were implemented by administrations of different technical ability. Finally, they were met by different degrees of resistance in terms of public opinion and organised special interests. Despite this heterogeneity, success or failure in the implementation of reforms seems to revolve around the alchemy of a small number of ingredients: delay, ownership, external constraint, timing, sequencing, the balance of reforms, and fiscal consolidation. This column proceeds by considering each of these ingredients in turn.
Economic crises may occur overnight, but are typically the results of decades-long imbalances, which myopic policymakers have consistently ignored. Examples from Southern Europe abound: stagnant productivity growth in Portugal and Greece; obsolete labour market institutions in collective bargaining, hiring, and firing procedures in Portugal, Greece, and Spain; high entry barriers in product markets and bureaucratic obstacles for setting up new firms in Greece and Portugal; inefficient supervision, nepotistic corporate governance, and political interference in the banking sectors of Cyprus, Greece, and Spain; bloated government sectors with high political interference in Greece and Portugal. The longer the delay in reforms, the larger the imbalances become; the larger the imbalances, the larger the social cost associated with reforms, and the more difficult it becomes to share it among stakeholders, resulting in further delay.
Delay has an additional perverse ‘cultural’ implication – it often generates the illusion in the public opinion that, having endured for decades, obsolete institutions pose no threat, and, more importantly, they are not the culprit of the current hardships, but rather that it is reformers who are to blame. In fact, one of the explanations for the (relative) success of reforms in the Portuguese banking sector, and in the labour markets in Portugal and Spain, was that the governments and the public opinion in these countries were aware of the need for reform, and the countries had a history of partial reforms. In Greece, by contrast, political polarisation and instability prevented any consensus. In Cyprus, the conflict extended to political institutions, with the central bank and government openly disagreeing on measures to recapitalise the ailing banking sector. Finally, ownership turns out to be important not only for implementing reforms, but also for keeping them in place.
The ability of international institutions to enforce reforms upon recalcitrant governments is limited. International creditors can credibly threaten to withdraw or not renew credit lines and liquidity support, as the ECB, European Commission, and IMF did in Greece. The external scapegoat may relieve some of the domestic political pressure from reform-prone governments, as in the case of Portugal and, to some extent, Spain. However, the case of banking resolutions in Greece illustrates that there are limits to external interventions, particularly as concern the reform implementation phase. On the other hand, the cases of Cyprus and Spain provide illustrations of the detrimental effects of the absence of an external constraint. Initially, the Cypriot authorities explored alternative possibilities of funding (e.g. Russia), which they hoped would come with no strings or conditions attached. This only delayed the banking resolutions and made the required adjustment more painful. Similarly, in Spain, it was only when the European institutions forced a bailout of the financial sector that substantial restructuring took place.
Timing of reforms
Are economic crises catalysts for reforms? The answer to this long-standing question provided by the examples discussed in the book is ‘it depends’. When the economy has deteriorated substantially, achieving political and social consensus on – and not back-tracking from – reforms becomes virtually impossible. The case of Greece is a clear example. The international institutions’ failure to address the issue of debt restructuring early on, during the first adjustment plan, required a harsh fiscal consolidation programme, which eventually played into the hands of anti-reformers. To a large extent, the international institutions did not understand, or were unwilling to consider, the importance of the domestic political constraint, which limits the feasibility of fiscal consolidation as well of structural reforms. On the other hand, the examples of the labour market reforms introduced in Portugal and Spain suggest that an incoming crisis can, at an early stage, force a consensus on the need of change, particularly if there is a history of public debate on reforms (see the previous point on ‘ownership’), and provided the economy has not already deteriorated too much.
Balance and timing of fiscal consolidation and structural reforms
In the examples discussed in the book, the ghost of fiscal tightening always hovers over the effects of structural reforms. The empirical analysis shows that product market reforms in Greece had positive effects on employment and prices, but these took some time to manifest and were retrospectively swamped by the short-run recessionary effects of expenditure cuts and by the inflationary effects of tax hikes. Also, there is convincing evidence that improving the competitiveness of labour and product markets in the euro area has long-run benefits and short-run costs – more competitive labour markets are associated with lower unemployment persistence and a faster recovery in the long run, but more flexibility also implies that the rate of unemployment becomes more sensitive to output-shocks in the short run, so that job losses rise during a recession. Hence, fiscal consolidation should be phased in gradually to make sure that the positive effects of structural reforms are not compromised and that a political backlash is avoided.
Sequencing of reforms
A reasonable sequence of reforms must respect two domestic political constraints. The first one is that ‘political capital’ is a scarce resource for the government. It should be invested in a few crucial reforms that identify the more ‘stringent’ bottle-necks to economic growth (Rodrik 2016). Political capital is quickly dissipated if invested in across-the-board programmes, and when this happens, reforms back-track. The case of Portugal shows that the authorities successfully sequenced reforms by starting from those in the labour market, whose positive effects improved ‘ownership’ and their sustainability. By contrast, Greece gave priority to the reforms which apparently presented the least resistance, again those of the labour market, rather than starting from those in the product market, which were politically more difficult. This strategy eventually backfired. The second political constraint is that the sequence of economic reforms must minimise, and imply a ‘fair’ distribution of, the adjustment costs. In Greece, fiscal consolidation and labour market reforms took precedence over product market reforms and privatisations. As a result, the fall in aggregate demand was aggravated by the drop in nominal and real wages (Manasse 2015). Workers and credit-squeezed small enterprises born the entire cost of the adjustment, and then revolted by electing reform-averse parties. Similarly, reforms aimed at raising total factor productivity, for example by fostering lower barriers in the product market or by improving wage bargaining, are found to be very effective in improving current account imbalances, although their effects take time to manifest. Hence, they should be given priority.
In summary, the contributions in the book show that many of the design issues and political economy preoccupations that accompany structural reform programmes, particularly during a crisis, need to be calibrated for the distinct features of the individual countries’ economic, social, and political systems. Still, such issues and preoccupations are not unique to individual countries, but tend to manifest repeatedly across countries and time. They mainly involve different combinations of a small set of crucial ingredients, whose case-by-case importance is ultimately crucial for determining the reforms’ success or failure.
Baldwin, R E and F Giavazzi, eds, (2015), The Eurozone Crisis: A Consensus View of the Causes and a Few Possible Solutions, VoxEU.
Manasse, P (2015), “What went wrong in Greece and how to fix it”, VoxEU, 12 June.
Manasse, P and D Katsikas (eds) (2018), Economic Crisis and Structural Reforms in Southern Europe: Policy Lessons, Routledge
Rodrik, D (2016), “The elusive promise of structural reform: The trillion-euro misunderstanding”, Milken Institute Review 18(2): 26-35.