In Europe, the word “reform” is as misleading as it is ubiquitous. You heard it during the Italian election campaign, when politicians – such as Mario Monti, the country’s outgoing prime minister – were classified as pro-reform. Others, the rest of Italy’s political class, have been deemed anti-reform. It is as though reform has become an issue of religious dogma. You are either in or you are out.
In or out of exactly what, one may ask? What, exactly, is reform?
Growing up in Germany in the 1960s and 1970s, I recall Willy Brandt,
West Germany’s chancellor during some of those years, talking endlessly
about reforms. For him, the word meant more workers’ rights and an
increase in welfare payments. This has always been the meaning I first
think of when I hear it.
decade later, in the UK under Margaret (now Lady) Thatcher, reform
became synonymous with privatisation and deregulation, and a reduction
in the rights of trade unions. This is closer to the meaning that it
holds for most people today.
There is certainly a clear, positive – though often overstated – case
for structural changes such as the liberalisation of services, changes
to labour markets to help younger workers and pension reforms to ensure
long-term fiscal solvency. These reforms would probably increase the
gross domestic product of several countries by a non-trivial but unknown
A former editor of The
Economist used to advise young reporters to “simplify, then
exaggerate”. This is exactly what happened to the debate on reform in
Europe. You might want to add “distort” as a third element. The
simplification consisted of the notion that there is a link between some
vague idea of reform and economic success, as measured in GDP per
capita. No such link exists.
The richest countries in the world include those with both liberal
and regulated labour markets. Per capita GDP in the highly regulated
French economy has been higher than in the deregulated UK. The
relatively solid performance of a largely unreformed France does not
obviate the need for reforms. But it shows that the relationship is much
more subtle than the dogmatists acknowledge.
The exaggeration consists of overstating the actual impact of reforms
when they take place. Has financial liberalisation really increased
long-run economic growth, or may it merely have given us a housing
bubble? Has German labour market reform really increased long-term
productivity or were other factors at work?
This distortion has become even worse recently, as reform has been conflated with austerity.
Whenever you hear a European official applauding Mr Monti’s “reforms”,
what they are really praising is his fiscal consolidation. In other
words, they applaud the many of his policies that reduced economic
growth, and not the few that might have a chance to increase it one day.
and reform are the opposite of each other. If you are serious about
structural reform, it will cost you upfront money. If you want to open
your labour market to a hire-and-fire rule, you will need policies to
deal with those who are laid off. These costs may outweigh the financial
benefits of reforms in the short term but the reforms may still pay off
in the long run. Structural reforms, properly done, are not suited to
the task of delivering austerity.
By contrast, austerity – higher taxes and cuts in public sector
investments – weaken the economy’s capacity in the short run, and
possibly also in the long run. If you have youth unemployment of more
than 50 per cent for a sustained period, as is now the case in Greece,
Italy and Spain, many of those people will never find good jobs in their
lives. Economists speak of a so-called “hysteresis” effect – permanent
economic damage that will not be repaired even if there is a full
recovery. Austerity could well leave an economic and social scar across
Italy and Spain would have been a lot better off to come up with a
list of front-loaded targeted structural reforms and backloaded fiscal
consolidation. When you do it the other way round, cutting investment
and raising taxes in a recession, you never get out of the hole, and you
waste your political capital on austerity, leaving none for reforms.
By putting fiscal consolidation first, the political establishment
also took a big gamble against what we know from history. A senior
Italian official told me a while back that they had the situation under
control. There would be a slight bump but the economy would take off
afterwards. He was wrong. As last week’s European Commission forecasts
confirm, the southern European economies are behaving as was predicted
by those who thought austerity would sap growth and using monetary
policy to offset it would be ineffective.
I am not surprised that European electorates are rejecting these
policies, and the politicians who delivered them. On Monday we will know
how Italy has voted. My hunch is that it is not going to be a good
evening for the “Austerians”.
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