Aug 18, 2014 03:51 PM

A Field Manual for Economic Reforms

Economic reforms are on the agenda in many countries. Europe comes to mind because of its dismal growth performance. In early August, the announcement of a GDP decline in Italy underlined the need for action and it prompted a call by Mario Draghi, president of the European Central Bank, for strengthening the EU oversight of national reforms (or the lack of them). But Europe is by no means the only place in the world where governments must consider ways to bolster economic performance. The same is true in India, where Narendra Modi, the new prime minister, has committed to pro-growth reforms. Brazil also has experienced an economic slowdown. Whoever wins the next presidential election will have to implement an array of reforms to foster development. Even fast-growing countries like China are making plans to improve their performance structurally, change the composition of growth and pay more attention to sustainability and income distribution.

The question in this context is: What is the right strategy for reforming? Should, for example, all key measures be introduced at once? Or is gradualism preferable? When fiscal adjustment is also needed, should it be regarded as a complement to structural reforms, or should it be delayed? A quarter of a century ago, these issues were hotly debated in the context of the transition to the market of the former communist countries. Poland exemplified the radical reform strategy, while China under Deng Xiaoping epitomized the gradualist approach. Both had staunch partisans. With hindsight however, it is clear that radicalism vs. gradualism was too simple a choice to make sense. Both Poland and China in fact reached their aims, having each adopted a strategy in line with their own economic and political situations.

From this experience, however, it does not follow that all reform strategies are equally effective. In too many cases, governments pick and choose from the list of potential reforms the ones they consider the most expedient politically. But what Dani Rodrik of Princeton University calls the "laundry list approach" is generally highly inefficient.

First, not all reforms are equally desirable. In any given case, only a few have the potential to lift critical obstacles to growth and employment. These are high-power reforms and they should be implemented first. This is where China got it famously right when it started with agricultural reform in the late 1970s. The productivity boom that resulted helped to lift real incomes and to build support for further transformations. Which are the critical reforms depends on each country's specific conditions.

Second, reforms may be complements to each other, in which case they must be designed in a mutually consistent way and be implemented jointly or in close sequence. This is often the case for labor and product market reforms, but the same may apply to measures regarding education and the labor market, or product markets and financial markets. The closer a country gets to the efficiency frontier – in short the more developed it is – the more important these complementarities are. When you are far away from the frontier, virtually any improvement helps. But if the economy is already quite close to the best economic performance globally, what brings real improvement is the building of a consistent ecosystem. Innovation policies are in this respect a case in point.

Third, partial reforms generally deliver much less than comprehensive ones. Governments are often under the impression that if political obstacles prevent them from carrying out a reform in full, they will get half of the result if they succeed in implementing half of the action plan. Again, this may be a correct approximation when starting from backwardness, but for relatively advanced economies, this is generally untrue. The reason is that reforms often aim at changing the rules of the economic and social game. Changing them partially risks creating more confusion than certainty. It may even create insecurity, when economic agents know that the measures implemented only pave the way for further ones that are yet to come.

Fourth, equity matters. A reform strategy may be economically optimal but too harmful socially to be viable, let alone desirable. Not everybody has the same time preference, in other terms not everybody can afford to wait until his or her own situation improves. As Ravi Kambur of Cornell University once observed, disagreements over the reform agenda often boil down to matters of distribution and time preferences.

Fifth, the macroeconomic context also matters. Here, views differ widely. Some claim that real reforms are only implemented in the absence of any other alternative. For this reason pro-growth reforms will be delayed as long as the government has an opportunity to stimulate the economy in a less painful way, be it through fiscal or monetary action. Others argue that governments rely on a limited political capital and may be forced to choose to invest it either in fiscal retrenchment or in structural reforms. History in fact offers examples of both situations. More precisely, complementarity is generally observed in situations of acute stress, such as when a country is forced to require assistance from the International Monetary Fund. However, there is more often substitutability in less extreme situations. Take for example Germany, which in the last decade implemented reforms and fiscal adjustment in sequence, not simultaneously.

The upshot is that the choice of an appropriate reform strategy matters considerably, but that adequacy to the terrain is of utmost importance. There is no such thing as an all-weather to-do list. For this reason, international organizations can play a precious role by collecting evidence from experience and by evaluating the lessons from successes and failures. For their advice to provide useful guidance, however, they must be adroit enough to resist the temptation of ready-made solutions and accept that ultimately, the choice of priorities has to rest with national governments.

Jean Pisani-Ferry teaches at the Hertie School of Governance in Berlin and serves as commissioner-general for Policy Planning in Paris. He is a former director of Bruegel, the Brussels-based economic think tank

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