Do economic crises lead to policy reform?

By Nauro F Campos and Jeffrey B Nugent

If economic crises make the short-run pains of reforms easier to bear, then crises could yield considerable long-run benefits. But this column argues that the recent global financial crisis has been wasted thus far. It suggests that it is political crises – and not economic turmoil – that actually bring about reforms.

Hillary Clinton, the US Secretary of State, in a visit to the European Parliament in March 2009, famously said that “we should never waste a good crisis.” This is nothing new to economists. Indeed, that practitioners of the dismal science tend to see crises in a good light may surprise only the less attuned. Economists appreciate crises. We see crises as an opportunity to implement needed economic reforms. While welfare-enhancing and often technically sound, structural reforms are repeatedly challenged by special interest groups or politically powerful constituencies making the risk of partial or delayed implementation a potential factor preventing the success of the reform itself.

So, do crises induce reforms? In a seminal paper, Drazen and Grilli formalise the idea that “crises and emergencies may be welfare-enhancing and hence desirable” (1993, p. 598). This turned out, justifiably, to be a hugely influential insight: “that economic crises seem either to facilitate or outright cause economic reforms is part of the new conventional wisdom on reform” (Tommasi and Velasco 1996, p. 197).

From this point of view, the 2007 global economic crises has so far disappointed in that meaningful reforms have not yet been implemented. Although the initial policy response was better timed and more substantial than in previous crises (Eichengreen and O’Rourke 2010), the fact that the 2007 crisis still lingers is an obvious source of concern, with Greece and Europe an ever-present reminder that it may take more than an extremely severe economic crisis to actually implement needed structural reforms. This column explores why this crisis has so far been such a disappointing one. It revisits the intuition, reinterprets the theory, and re-assesses the evidence. It proposes that political crises beget reforms to a greater extent than economic ones.

Reinterpreting the theory

Drazen and Grilli (1993) develop the normative implications of Alesina and Drazen (1991) in a war-of-attrition setting in which social groups disagree on the implementation of a tax reform (or stabilisation.) Government expenditures are covered by either monetisation of the deficit or (non-distortionary) taxation. Monetisation arises because social groups do not agree on who will bear the costs of the tax reform. Delay in agreeing on the burden of reform propels inflation.

Here there are two groups that, until stabilisation occurs, share equally the distortionary burden. The one that concedes agrees to pay a larger share of the costs. Utilities increase with consumption and decrease with inflation and differ on the losses each group attaches to inflation. The war-of-attrition is driven by asymmetric information, i.e. each group only knows its own losses. The representative individual chooses a time path of consumption and a date on which to bear a larger share of the cost of reform (the optimal time to concede depending on the group-specific loss).

Drazen and Grilli’s model focuses on the optimal concession time. The solution supports the war-of-attrition interpretation of delays in adopting a welfare-enhancing change in policies (a “reform”). The group that benefits from reform tries to “wait the other group out” in the expectation that the other group would benefit even more from the reform. Put differently, one group tries to learn about the costs that the other group suffers (or believes it suffers) from the continuation of the distortions associated with the delay in implementing the reform. This ends when one of the groups agrees to bear a larger share of the cost. The greater the distortions in the economy or the larger the scope for reform, the larger will be the losses each group assigns to the perpetuation of the status quo and the faster one group will concede (by agreeing to pay a larger share of the costs). In a nutshell, a deterioration of the status quo (i.e., a crisis) shortens the delay in implementation. Drazen and Grilli show that crises can be welfare-enhancing because they accelerate agreement over the distribution of the cost burden of the reforms, thereby also speeding up the pace of reforms.

A crisis fosters reform because it “convinces” one specific group to bear a larger share of its cost. We suggest that a political crisis, or a realignment of the political power of the different groups in society, would serve the same end of “convincing” one of the groups to bear a disproportionate share of the costs. Although this would hold for any type of reform, we conjecture that such realignments would be especially conducive to structural reforms, such as trade and labour market liberalisation, and other difficult policy decisions (that need widespread agreement to succeed).

The evidence as it stands

What does the existing evidence tell us? Bruno and Easterly (1996) show that high inflation is a more successful driver of macroeconomic stabilisation than, say, indexation mechanisms. Drazen and Easterly (2001) use panel data for more than 150 countries and find only mixed evidence for the “crises beget reforms” hypothesis. Specifically, they find that although episodes of extremely high inflation or black market premia are indeed followed by periods of more significant reform measures, similar results do not obtain for high current account deficits, large budget deficits or negative rates of per capita growth. Pitlik and Wirth (2003) report econometric evidence suggesting that deep economic crises foster structural reforms. They study the role of political factors (but not crises) and suggest that democratic regimes with fractionalised governments are more conducive to reforms.¹

The evidence revisited

In recent research with Cheng Hsiao (Campos et al. 2010), we reinterpret the Drazen and Grilli model and set out to test the hypothesis that political crises are a more powerful driver of structural reforms than economic crises. Our approach differs in a number of aspects. With respect to measurement, we use continuous variables instead of dummies to measure both reforms and crises. Instead of focusing on a single relatively “easy” reform, we focus on two more “difficult” structural reforms, namely trade and labour-market liberalisation (and the interactions between the two). With respect to the political environment, we consider democratic governance, a wide variety of political crisis indicators, and various institutional dimensions. Our data, moreover, cover a large sample of countries for a longer period of time than most existing studies (a panel of about 100 developed and developing countries between 1960 and 2000).

Exploring the existence of cross-regional differences, we find that, with a couple of minor exceptions of specific measures in one region or another, the effects of economic crises on the two structural reforms are either weak and insignificant or more frequently perverse, i.e., they inhibit rather than trigger reform. In the case of political crises, these effects on reform also vary. They are often strong and positive in the case of trade reforms but frequently negative and significant in the case of the labour-market liberalisation. Similarly, in most regions the levels of economic and political development (the latter represented by democracy) have positive influences on trade reform indicators but rarely on labour- market reform indicators. With a few minor exceptions, the results hold for a substantial number of sensitivity checks, including the use of alternative measures of economic and political crises and institutional constraints, different estimations methods and the use of lagged as well as simultaneous feedback effects (by the latter we mean that they account for the possibility that political crises breed economic crises, and vice-versa). In previous research, Lin and Nugent (1995) conclude that political crises systematically translate into important institutional changes and are found to be a more important driver of structural reforms than economic crises.

To Brussels, Beirut, and beyond

The main conclusion we offer here is that economic crises may not be as powerful a force for change as some think. Instead, we suggest that by shaking up existing coalitions, political crises can serve as a more important driver of reforms. Reforms need political support and, more often than not, this can be better engineered through accountable and capable political leadership (Jones and Olken 2005). Although the policy implications we can draw may be of relatively limited practical importance, this nevertheless helps to throw fresh light on various recent events. Two of these are the crisis in Europe and in the Middle East. With respect to the former, these results strongly support the lucid analysis from Wyplosz (2011) that “the real surprise has been the woeful mismanagement of the crisis.” For the latter, they raise a warning to the leaders now emerging from the so-called Arab Spring, that partial and easily reversible reforms will buy time in the short run but will have large and undesirable consequences in the long haul.

References

Alesina, Alberto and Allan Drazen (1991). “Why are stabilizations delayed?”, American Economic Review,81(5):1170-1189.

Alesina, Alberto, Ardagna, Silvia, and Francesco Trebbi (2006), “Who adjusts and when? On the political economy of reforms”, IMF Staff Papers, 53:1-29.

Campos, Nauro, Cheng Hsiao, and Jeffrey Nugent (2010), “Crises, what crises? New evidence on the relative roles of political and economic crises in begetting reforms”. Journal of Development Studies, 46(10):1670-1691

Bruno, Michael and William Easterly (1996). “Inflation’s children: Tales of crises that beget reforms”, American Economic Review Papers and Proceedings, 86(2):213-217

Drazen, Allan and Vitorio Grilli (1993), “The benefit of crises for economic reforms”, American Economic Review, 83(3):598-607.

Drazen, Allan and William Easterly (2001). “Do crises induce reform? Simple empirical tests of conventional wisdom”.Economics and Politics, 13(2):129-158.

Eichengreen, Barry and Kevin O’Rourke (2010). “A tale of two depressions: What do the new data tell us?”, VoxEU.org, 8 March.

Jones, Benjamin and Benjamin Olken (2005), “Do leaders matter? National leadership and growth since World War II”,Quarterly Journal of Economics,120 (3), 835-864.

Lin, Justin and Jeffrey Nugent (1995). “Institutions and economic development”, in J Behrman and TN Srinivasan (eds.),Handbook of Development Economics: Vol. 3, Elsevier.

Pitlik, Hans and Steffen Wirth (2003), “Do crises promote the extent of economic liberalization? An empirical test”, European Journal of Political Economy, 19(3):565–581.

Tommasi, Mariano and Andres Velasco (1996), “Where are we in the political economy of reform?”, Journal of Policy Reform,1(2):187-238.

Tornell, Aaron (1998), “Reform from within”, Department of Economics, UCLA, mimeo.

Wyplosz, Charles (2011), “Happy 2011?”, VoxEU.org, 5 January.

Notes

1. Other very important contributions are Tornell (1998) and Alesina et al. (2006).

This article originally appeared at VoxEU.