Don’t stop believing
The IMF suggests some sweeteners to help the medicine go down
ASK a Greek government official what is ailing the economies of the European periphery, and he will almost certainly mention weak demand, before launching a tirade against austerity-obsessed politicians from northern Europe. Ask a German official, however, and the answer will be very different. In March, as the European Central Bank prepared a new salvo of stimulative measures, Jens Weidmann, the president of the Bundesbank, expressed his disapproval. Stimulus is no panacea, he warned, and “can’t replace urgently needed reforms.”
Structural reform is like exercise: nearly everyone could use a bit more of it. This newspaper has been known to recommend it to governments from time to time. Yet the extent to which economies stuck in a mire of low growth and low inflation should focus on structural reform, rather than stimulating demand, is a tricky question. Few economists would argue that Italy’s economy is a model of efficiency. Yet some economists reckon that making it easier to sack workers and cut prices is risky when a country is already facing high unemployment and deflation.
In its latest “World Economic Outlook”, the International Monetary Fund devotes a chapter to the debate. It affirms that structural reforms help raise an economy’s long-run growth prospects. Productivity stagnates when it is difficult to start new firms or expand healthy ones, or when labour cannot easily be shifted from moribund sectors to more efficient ones. Advanced economies still have plenty of room for reform, the IMF reckons.
However, some reforms, the IMF points out, take effect faster than others, and with a less painful adjustment. Reform of “product markets” aims to boost competition among firms, through privatisation, deregulation, the liberalisation of trade and by making it easier to start a business or attract investment. Such reforms generate bigger benefits in the long run than in the short run, but can nonetheless boost output almost immediately. Deregulation of the energy sector, for example, can reduce costs and boost profits in other industries, and open new investment opportunities. These benefits begin to accrue almost at once, even in weak economic conditions (though the IMF does caution that short-run gains may be limited when credit markets are malfunctioning, a common feature of economic crises).
The short-run payoff to reform of labour markets is much more dependent on the state of the economy. Reforms which make it easier to hire and fire workers contribute to rapid growth in output and employment when an economy is already running on all cylinders (see chart). At times of economic weakness, however, firms respond by doing far more firing than hiring, deepening the downturn.
Cuts to unemployment benefits designed to encourage the jobless to seek work follow a similar pattern: in bad times, the benefits in terms of increased interest in work are outweighed by the squeeze such reforms place on spending. An exception to the pattern are reforms that peel away inefficient taxes on labour. This delivers the greatest bang when economies are weak. A one-percentage-point cut in overall taxes on labour during a slump boosts output by 0.7% in the year of the reform, the IMF finds, but yields no benefit at all during booms.
Governments presiding over weak economies could enact changes in ways that minimise nasty short-run effects, the IMF suggests. They could prioritise product-market reforms, and adopt labour-market reforms that would only take effect after a lag, to allow time for economic recovery. Reforms could also be coupled with fiscal stimulus, the IMF reckons, which could then be unwound as growth improves.
The big debts carried by the governments of the euro-area periphery will be difficult to sustain if the prospects for growth do not brighten in the long run. A short burst of deficit-financed stimulus might therefore prove a small price to pay for a much-needed dose of structural reform. In contrast, by adopting structural reforms at the same time as slashing spending, European politicians may be creating an association in voters’ minds between reform and economic hardship—a reflex that would not bode well for the health of Europe’s economy or for the survival of the euro. Stimulus is no substitute for urgently needed changes. It might prove an indispensable complement, however.