The bumpy road to structural reform
The world economy seems to have entered a rebalancing phase, with Europe in particular showing signs of firmer growth just as the US economy is decelerating. This would seem to make it as good a time for reform as ever, and several large and small OECD countries are in fact moving ahead. While all countries should continually adjust to new global circumstances, for some the need to reform is particularly pressing. The road ahead will be challenging, but there may be lessons for policymakers to help them smooth over some of the bumps.
OECD countries have made considerable progress in structural reform in the past two decades. From lowering barriers to international trade and foreign direct investment to financial market liberalisation, many have come a long way since the early 1980s.But looked at more closely, it seems that while product market reforms to free up various sectors have moved forward, less progress has been achieved on the labour front. Some countries such as France, Germany and Japan have reduced employer costs for low-skilled workers and introduced more flexible temporary job contracts, ostensibly to boost employment or improve competitiveness. However, the effectiveness of these reforms has frequently been blunted by other policies, such as overly strict hiring and firing rules for permanent contracts. The upshot has been a dual labour market, in which some groups enjoy highly protected jobs with good incomes, but in which others, notably younger workers and women, are denied decent career prospects.Even in product market reform, the depth and pace has varied from country to country and sector to sector. The US and the UK, together with a few others, undertook such reforms in telecoms, road freight and airlines in the 1980s and 1990s. France made its first forays into privatisation in the latter half of the 1980s, but the opening up of continental Europe’s major network sectors did not get fully under way before the 1990s. Moreover, instilling more competition into energy, postal services and railways has proved trickier.The reasons for such mixed progress are several. Vested interests, worried staff, or deep-rooted institutional arrangements that are hard to budge can clutter the road to reform.Then, technological developments matter: advances in communications technology probably made it easier to open up telecoms markets, all the more so as competition in turn spurred further technological progress.Different starting points can also influence the pace of reform and it naturally helps if popular opinion agrees there is a problem to fix in the first place. Electricity blackouts and “winters of discontent” set the public mood in favour of reform in the UK in the 1970s and 1980s. Railway reform is also influenced by public opinion. In France, for instance, the railway’s reputation for timeliness and technical prowess makes it hard to argue too loudly for deregulation, whatever the balance sheet might say. Nor would such an argument be helped along by some other examples of rail privatisation which, though carried out with public support, have struggled to deliver the promised improvements.In the end, economics rarely clinches the reform battle, whereas politics holds the key. This is because reform challenges the status quo. It brings into play notions of fairness, job security and dependability on the likes of medical cover or unemployment benefits. Though reforms tend to exact costs on particular groups, they may find allies in the wider community.Designing strategies to win over such opposition is what the political economy of reform is about. Thanks to good design, a number of OECD countries have managed to reduce unemployment and stimulate output growth, despite diverse circumstances and different reform paths. In common was a determination to adopt workable combinations of fiscal adjustment and labour and sectoral reforms, and where possible, to build some element of public consensus among stakeholders as well.Context matters a lot when devising strategies to grease the wheels for change. For instance, demographics have a bearing on reform. Ageing generations wary of their retirement may support changes in financial services and healthcare, and it may be easier to make labour markets more flexible in countries with relatively large young populations or active immigration, such as in Ireland.Getting the sequence right with consistent, mutually reinforcing policies is key. Experience shows that liberalising product markets is a good precursor to labour market reforms. This is because more competition reduces the ability of firms to earn excess profits by squeezing their price-cost margins, and obliging workers to alter their demands too. Also, because product market reform can boost demand, this raises employment and wages, facilitating further reform.In the political economy of reform, judgement and timing are vital. For instance, changes to income support are more likely to work during upswings when public momentum is upbeat. People will swing behind reforms as their beneficial effects become more apparent, as has generally happened regarding telecoms.In short, steady, persistent and coherent change is better than no change at all. And not reforming causes fractiousness, a loss of confidence and weaker economic performance. It can also end in a crisis.Major crises are no comfort to policymakers, but they nevertheless drive change. Indeed, OECD research suggests that an output gap (the shortfall between actual and potential output) of 4% increases the probability of a major structural reform in product and labour markets by almost a third.It was a crisis, with recession, spiralling wages and wide deficits that forced change in the Netherlands in the 1980s, and in Canada and Finland in the early 1990s with public finances to the wall. A morose economy eventually forced Japan’s hand on reform too.
Europe is an instructive case. Countries that pushed reforms long and hard, such as Denmark, Ireland, the Netherlands and the UK, show how important crises were in garnering support and setting reforms in motion. In fact, reforms were stepped up as economic circumstances improved and potential opposition fell into line. Policymakers applied consistent and mutually reinforcing labour supply and fiscal policies. Deal-making helped secure the co-operation of diverse interest groups: wage moderation in exchange for tax cuts in Ireland and the Netherlands, and sharpening active labour market policies while shortening unemployment benefit duration in Denmark, for instance.When it comes to reforms, each country should naturally devise its own strategies based on its own circumstances, but there are some general lessons for policymakers to bear in mind.First, reforms work better with proper sequencing and co-ordination within and between policies, even though in practice this may be a luxury. Also, co-operation between countries may yield benefits, whether in building a fair and open international trade regime, as with the Doha round, or a services market for suppliers and consumers, as in the EU.Second, promote supportive macroeconomic policies. If these keep aggregate demand close to potential output, they will oil the reform process by minimising the fear factor associated with structural change. In this context, whereas fiscal laxity may entail painful corrective action later on, sound public finances can create the wherewithal required for the introduction of reforms by providing confidence and room for manoeuvre.And third, always be transparent about the costs and benefits of reform, and be ready to communicate in the face of well-drilled opposition. Outside expertise has been shown to be useful here, as policymakers embark along the bumpy road of reform.Given the difficulties, political leaders understandably worry about losing popularity, or votes. However, as experience demonstrates, by marshalling the political economy of reform, (very different) governments can make decisive breaks with the past, and still look forward to winning the next election as well. RJC
Note: Effective international support for reform can play a significant role in helping to improve policy design and advancing the political economy of reform. Under the responsibility of Deputy Secretary-General Aart de Geus, the OECD aims to make a major contribution in that direction
©OECD Observer No. 261, May 2007
- OECD (2007), Going for Growth; Economic Policy Reforms, Paris. Available at www.oecdbookshop.org
- Duval, Romain and Jorgen Elmeskov (2005), “The Effects of EMU on Structural Reform in Labour and Product Markets”, OECD Economics Department Working Paper No. 438.
- Visit www.oecd.org/economics