The mirage of structural reform

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The mirage of structural reform

ATHENS - Every economic program imposed on Greece by its creditors since the financial crisis struck in 2009 has been held together by a central conceit: that structural reforms, conceived boldly and implemented without slippage, would bring about rapid economic recovery. The European Commission, European Central Bank and International Monetary Fund anticipated that fiscal austerity would be costly to incomes and employment - though they significantly underestimated just how costly. But they argued that long-delayed (and much-needed) pro-market reforms would result in a compensatory boost to the Greek economy.

Any serious assessment of the actual results produced by structural reforms around the world - particularly in Latin America and Eastern Europe since 1990 - would have poured cold water on such expectations. Privatization, deregulation and liberalization typically produce growth in the longer term at best, with short-run effects that are often negative.

It is not that governments cannot engineer quick growth takeoffs. In fact, such growth accelerations are quite common around the world. But they are associated with more targeted, selective removal of key obstacles, rather than broad liberalization and economy-wide reform efforts.

The theory behind structural reforms is simple: opening the economy to competition will increase the efficiency with which resources are allocated. Open up regulated professions - pharmacies, notaries and taxicabs, for example - and inefficient suppliers will be driven out by more productive firms. Privatize state enterprises, and the new management will rationalize production (and shed all the excess workers who owe their jobs to political patronage).

These changes do not directly induce economic growth, but they increase the economy’s potential - or long-run - income. Growth itself occurs as the economy begins to converge to this higher level of long-run income.

Many academic studies have found that the rate of convergence tends to be about 2 percent per year. That is, each year, an economy tends to close 2 percent of the gap between its actual and potential income levels.

This estimate helps us gauge the magnitude of growth we can expect from structural reform. Let’s be hyper-optimistic and suppose that structural reforms enable Greece to double its potential income over three years - pushing Greek per capita GDP significantly beyond the European Union average. Applying convergence math, this would produce an annual growth boost of only about 1.3 percent, on average, over the next three years. To place this number in perspective, remember that Greek GDP has shrunk by 25 percent since 2009.

So, if structural reforms have not paid off in Greece, it is not because Greek governments have slacked off. Greece’s record on implementation is actually pretty good. From 2010 to 2015, Greece climbed nearly 40 places in the World Banks’s business-environment rankings. Instead, the current disappointment arises from the very logic of structural reform: most of the benefits come much later, not when a country really needs them.

There is an alternative strategy that could produce significantly more rapid growth. A selective approach that targets the “binding constraints” - those areas where the growth returns are the greatest - would maximize early benefits. It would also ensure that the Greek authorities spend valuable political and human capital on the battles that really matter.

So, which binding constraints in the Greek economy should be targeted?

The biggest bang for the reform buck would be obtained from increasing the profitability of tradables - spurring investment and entrepreneurship in export activities, both existing and new. Of course, Greece lacks the most direct instrument for achieving this - currency depreciation - owing to its eurozone membership. But other countries’ experience provides a rich inventory of alternative tools for export promotion - from tax incentives to special zones to targeted infrastructure projects.

Most urgently, Greece needs to create an institution close to the prime minister that is tasked with fostering a dialogue with potential investors. The institution needs the authority to remove the obstacles it identifies, rather than having its proposals languish in various ministries. Such obstacles are typically highly specific - a zoning regulation here, a training program there - and are unlikely to be well targeted by broad structural reforms.

The absence to date of a single-minded focus on tradables has been costly. Different reforms have had conflicting effects on export competitiveness. For example, in manufacturing, the competitiveness benefits of wage cuts (“internal devaluation”) were offset by the increases in energy costs resulting from fiscal austerity measures and price adjustments by state enterprises. A more focused reform strategy could have protected exporting activities from such adverse effects.

Conventional structural reform tends to be biased toward “best practices” - policy remedies that are supposedly universally valid. But, as successful countries around the world have discovered, a best practice mindset does not help much in promoting new exports. Lacking its own currency, the Greek government will have to be especially creative and imaginative.

In particular, the experience of other countries suggests that a quick supply response is likely to require selective, discretionary policies in favor of exporters, rather than the “horizontal” policies that advocates of conventional structural reform prefer. Therein lies a paradox: The more orthodox Greece’s macro and fiscal strategy is, the more heterodox its growth strategy will have to be.

Copyright: Project Syndicate, 2015.

The author is professor of international political economy at Harvard’s John F. Kennedy School of Government.

by Dani Rodrik

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