The fact that broad-ranging, fundamental economic reform is difficult is attested to by the simple observation that it is quite rare. Much of what one observes in the economic history of OECD looks more like “coping” – often belatedly – with problems; or taking one step forward and one step back.
I argue that significant reform requires a confluence of two factors that do not often come together: a broad-based popular sentiment that “things have to change”, and a leadership that is able to translate this broad dissatisfaction into a concrete programme that crystallises the issues and points to their solution. Most of the time, democratic politics turns out to be quite conservative. Mandates for real change are rarely extended to governments.
To see why this is so, it is necessary to figure out what economic reform actually is. How can you spot a true economic reform, as opposed to an arbitrary change in policy? I am not aware of any agreed answer to this question, and the one I offer is no doubt incomplete: the best definition I can come up with is that economic reform is policy change directed at improving the static or dynamic efficiency of resource allocation in the economy. But, at its essence, this involves taking away rents that have built up in the economic system or, to broaden the concept somewhat, to reduce or modify acquired rights. Of course any political programme might involve a redistribution of rents – in favour of those who support the government, perhaps at the cost of those who do not. So reform, as opposed to redistribution, involves reducing rents in the economy as a whole – including rents that accrue to the “natural constituencies” of the party in power.
A few examples can serve to clarify the point.
A strengthening of competition policy, broadly defined, is perhaps the most obvious example. Such a move is generally accepted to improve market functioning, but the immediate target is the rents that accrue to companies with market power, and probably also for the workers who share in these rents. It is thus not only the capitalists, but also the workers who are likely to feel threatened.
Likewise, a tax reform to broaden bases and lower rates is clearly an efficiency-improving move. But tax distortions create rents in favour of those who are in a position to exploit them, and it is these rents that are targeted by the reform. The more outrageous the tax loophole, the greater the likelihood that someone is vitally dependent on it for survival.
Perhaps the most provocative economic reform issue to try to fit into this “rent reduction” framework concerns social policy. On the face of it, it would be antediluvian on my part to argue that social benefits – social assistance, extended unemployment benefits, housing benefits, child allowances, etc. – that most of our societies provide to cushion the impact of adverse fortune on those least able to cope with it, constitute “rents”. Politically, most OECD countries have opted to enshrine such redistribution as basic rights for the population, and in most countries there is at least acceptance that such redistribution is part of the fundamental social contract. Furthermore, even on narrower efficiency considerations, there is substantial evidence of dynamic positive spill-overs from adequate social support to overall economic performance – in particular as regards the safeguarding of economic opportunity for children.
Nonetheless, it has to be recognised that social policy involves a double burden: on society at large via higher (and thus inevitably more distorting) taxes; and also on the supply-side, by creating rent-seeking opportunities for potential beneficiaries – a phenomenon summed-up in the economists’ jargon of “poverty traps” and “unemployment traps”. The solutions here are complex, but most economic reform programmes have recognised the importance of transforming unqualified “rights” to social benefits into a much more conditional “contract” between donors and recipients based on one form or other of mutual obligation and – in the end – only a contingent right. Reform of disability pension schemes is perhaps the most visible current example.
If reducing rents in the interest of greater efficiency is a task that can be counted on to evoke the opposition of those whose rents are at risk, it would be hard enough. But the problem goes deeper, because of the general tendency for rents to be capitalised out of the economic system.
Housing subsidies, for instance. When introduced (perhaps for apparently compelling social reasons), such subsidies constitute a rent to those who can now afford more housing than otherwise. But over time, the subsidy gets built into the price of houses. This is a capital gain to those who happen to own a house, but for new entrants into the market there is really no benefit. The value of the subsidy is just offset by the higher price they have to pay for the house. The point is, while it might make sense to scrap the subsidy, it is very difficult to do because the current crop of house owners (assuming the subsidy has been around for a while) did not benefit from the subsidy, but do bear the cost if the subsidy is stopped. This could be seen – with considerable justice – as a very unfair policy.
Agricultural subsidies are very similar. Their value is capitalised in the value of land; but it is extremely difficult to know who has actually benefited. Current farmers are not the most likely beneficiaries; but they are the ones likely to be wiped out if the subsidy is halted.
A final somewhat more complex illustration is provided by the difficulty of reforming pay-go pension systems. Following the Samuelson consumption-loan model, the initial generation essentially gets a free ride. The one-time gain in going from a system where you provide for your own pension to one where your kids provide it for you is capitalised out of the system. But then, even under stable demographics, future generations earn a much lower return on their contributions than their parents did; and in an ageing society this return becomes small or even negative. In these conditions a funded system would look far more attractive, but to achieve it requires putting back the capital that was taken out by the first generation of this example – a burden on the “transition generation” that most societies are not prepared to face.
So, to summarise the argument, economic reform is about reducing rents. It will be opposed by those whose rents are at risk – and they know who they are. The beneficiaries from the efficiency gains brought about by reform are much less aware of the benefits, which in any case tend to be dynamic rather than static. Thus, if competition policy or regulatory reform creates new market opportunities, one can predict that these opportunities will be exploited; but one cannot identify ex ante who it is that will exploit them (they may not know themselves at the time of the reform!). On top of that, in many cases the rent reductions that are the consequence of the reform may be seen, and indeed felt, as unfair in that it is not the beneficiaries of the rent who bear the cost of its reduction. It is, in my view, this nexus that makes reform so difficult.
In view of this difficulty, it is perhaps amazing that reform nonetheless happens. The upshot is, that with very few exceptions, broad-based reform seems to require, as a necessary condition, a perception of crisis – acute crisis as in the case of Scandinavia at the start of the 1990s; or at least a sense of chronic deterioration, as in New Zealand prior to the 1980s reform and in the Netherlands in the mid-1980s, or the United Kingdom under Thatcher. The hallmark of such crisis situation – not surprisingly if you think about it – is an out-of-control budget. I guess the point is that real reform only becomes possible once the possibilities of throwing money at a problem are foreclosed.
One supposes that crisis conditions may also, in the end, prove a sufficient condition for reform, at least in mature democracies where one imagines that good sense will prevail in the end. But it is clear that the timing of reform depends on political leadership – in the first instance leadership to make clear that there is a crisis. The last decade in Japan following the collapse of the bubble economy, indicates how – even when international observers have no difficulty in identifying crisis conditions, popular perception may not coalesce into something solid enough to permit a fundamental departure from “politics as usual”, forcing the government to move cautiously and step-by-step for a very long time.
I recognise that this thinking seems to have led me into a somewhat nihilistic corner, to the point of saying that the most realistic reform scenario is to wait for things to get so bad that there is no other option. I have to confess that, as regards “core Europe”, my sense is that in this sense the pre-conditions for fundamental reform have not yet been met. But this should not imply passivity. Surely there is much that governments can do to promote reform even when lacking a clear mandate for wide-ranging action: to move ahead in areas where the ground for reform has been best prepared; and to lay the groundwork for further reform by setting out to shape, or reshape, popular understanding of the issues. Various techniques – advisory “expert” commissions, budget sustainability exercises, even tripartite consultations (if not allowed to become a kind of second government outside electoral validation) can play a very useful role. And indeed, in this domain, effective international support for reform via institutions such as the EU or the OECD can play a significant supporting – or indeed at times initiating – role.
*The views expressed in this note are strictly the personal reflections of the author, based on his own experience of “watching” economic developments in the OECD over a quarter of a century, and do not necessarily reflect the views of the OECD or its member governments.
The article is extracted from comments originally presented to the international conference on Economic Reforms for Europe: Growth Opportunities in an Enlarged European Union. Bratislava, Slovakia, 18 March 2004.
©OECD Observer No 243, May 2004