The euro area needs structural reforms but they can cause damage when economies are weak
THROUGHOUT the euro crisis, policymakers have been desperate to buy time so that the therapies prescribed for troubled European economies can be administered. The European Central Bank’s new bond-purchasing strategy has ushered in another period of respite, which with luck will last longer than previous ones. There are two main courses of treatment for peripheral economies. One is austerity, to get public finances under control. The other is structural reform, to boost growth.
Structural reform comes in many guises. It can mean opening up product markets to more competition (Italy is starting to loosen the strict licensing system that has long shielded pharmacists from competition). Or it can involve making labour markets more flexible (Spain is trying to narrow the divide between well-protected permanent staff and lightly protected temporary ones). Such reforms are less controversial than austerity. But are they the right remedy in bad times?
Over the long term, higher productivity growth and better-functioning labour markets are vital if economies in southern Europe are to regain the competitive ground they lost in the first decade of monetary union, when their unit labour costs soared relative to those in northern countries like Germany. Unable to devalue against their euro-zone partners, they must restore competitiveness the hard way, by lowering domestic costs. Structural reforms are worthwhile elsewhere in the euro area, too. The IMF estimates that eliminating half of the gaps between euro-zone countries and what the OECD considers best practice in the rich world in pensions, labour and product markets, together with tax reform, could raise euro-area output by 4.5% over five years.
That is a lot, given that conventional wisdom holds that reforms take a long time to bear fruit. Change is disruptive: workers and businesses must adjust to new incentives and working practices before the benefits show through. Margaret Thatcher shook up Britain’s sclerotic, union-dominated labour market in the 1980s, but the unemployment rate still exceeded 10% in the recession of the early 1990s. It was only during the subsequent job-rich recovery that the effects of curbs on union power and sharper incentives to work materialised. A German overhaul of its labour market a decade ago has had a swifter impact, but lengthy pay-off periods are commonly held to explain why so many politicians are reluctant to take on vested interests.
The OECD, an inter-governmental think-tank, has investigated big structural reforms in 30 rich economies over the three decades before the crisis. In a working paper published earlier this year, its researchers focused on shake-ups in labour and product markets, as well as tax reforms like reducing the share of direct taxes (on income) in the total tax take. They found that the full pay-off from reform usually took five years to materialise, but that some gains appear sooner.
Take cuts in unemployment benefit, which spur the jobless to find work. A big reduction in benefits typically raised the employment rate by a percentage point over five years, with a fifth of that gain coming in the first year. Dual labour markets, a particular problem in southern Europe, provide another example. Without reform, employers respond to a fall in demand for their products by getting rid of their temporary workers but find it difficult to resist pressure from “insiders” on permanent contracts for higher pay. The OECD study suggests that past initiatives to reduce job protection for regular staff have quickly cut unemployment, especially among women and young people. (Further weakening the position of temporary workers actually hurts employment, both initially and in the long term.) Revenue-neutral tax reforms that shift the burden away from direct taxation also get more women into the workforce quickly as it becomes more advantageous to have a second family income.
The OECD’s research tells a broadly reassuring story about structural reforms. The moral is that governments should just get on and do them. But there is an important proviso: the state of the economy can affect the reforms’ short-run impact. When economies are depressed, sweeping labour-market changes tend to bring down employment rather than raise it. Lowering unemployment benefits may sharpen the incentive to find work but if there is no work available the jobless will simply have less money to spend. Similarly, weakening job-protection measures will make it easier for firms to get rid of excess staff but they will make no offsetting hires.
Structural reforms could do with a bit of structuring themselves, in other words. First, when economies are already in dire straits, as in southern Europe, policymakers should focus initially on shaking up product markets, whose efficacy is less sensitive than labour-market reforms to the state of the economy and which can themselves help get more people into work. The OECD’s research finds that promoting competition in network industries such as telecommunications, transport and electricity raises labour-market participation. Second, since product-market reforms typically encourage new firms to enter markets and these firms depend upon the flow of finance, it is vital that banks are lending normally. Finally, if governments do decide to press ahead with reforms across the board, there is a strong case for easing the pace of fiscal retrenchment to give them a fair wind.
Structural reforms work best in good economic times. Because tough measures are, perhaps wrongly, seen as tough politics they are more often introduced in bad times. But better design can help make change more palatable.