Will Europe’s Reform Momentum Continue?

Making positive economic change is a bit like dropping a bad habit—it may take some kind of crisis to jolt the body politic into action.

Reforms that tilt the incentives in the economic system towards higher productivity, with the possible exception of labor market reform, generally take place when times are bad.

This means Britain’s decision to exit the European Union, while certainly fraught with challenges, also offers remaining EU states an opportunity for greater integration on more economically advantageous terms. It remains to be seen whether European leaders rise to the occasion.

Further reform momentum in Europe is endangered by three factors. The first is political fatigue; the second is the increasingly expansionary monetary policy of the European Central Bank; and the third is the increasing attention to security. After several difficult years, European leaders may want to take the foot off the pedal and enjoy economic recovery, however lackluster. The loose money coming from Frankfurt aids this attitude: Record-low interest rates make it easier for governments to borrow and finance budget deficits. The immigration waves of 2014 and 2015, and fears of rising insecurity, have shifted the focus away from productivity-enhancing reforms. It remains to be seen whether the shock of the June 2016 Brexit vote in the United Kingdom will jolt European countries to enhance their productivity.

The historical record confirms that the strongest reform momentum coincides with periods of economic crisis. In the European Union, the first big reform wave took place in mid-1970s, in the period following the breakdown of the Bretton Woods system and the oil price shocks. The second reform outburst occurred during the late 1980s and early 1990s after banking crises in the Nordic countries and the collapse of communism in Eastern Europe. Reform efforts gathered steam again during a third episode in the early 2010s, in the aftermath of the eurozone crisis.

Between 2010 and 2012, during the financial crisis, EU countries recorded 124 reforms to improve the environment for doing business, according to the World Bank. Of those, 61 were in eurozone countries. Lithuania and Slovenia had the most reforms, nine each; followed by Portugal with eight. Malta was the only country without a single reform (table 1). In 2013–15, in the aftermath of the financial crisis, the number of reforms in Europe was about the same, 116, with 57 in eurozone countries. The top reformers were again in Eastern Europe: Croatia with ten reforms and Latvia with nine. Luxembourg was the only nonreformer.

The wide variation in attempted reforms across countries shows the European Union is not, contrary to populist suggestions, a constraint on improving business regulation. Countries that wish to attract more private investment and create jobs can do so on their own accord. This is an argument that Brexit proponents and other pronationalist groups should internalize.

Economic reforms involve changing regulatory policies in product and service markets, labor markets, and capital markets and banking. For example, insolvency reforms aimed at speeding up the resolution of nonperforming loans remove impediments to new lending. Reform changes also address market failures, for instance, through increased emphasis on effective financial sector regulation since the eurozone crisis. Several studies find that the strengthening of legal protections increases economic growth through its influence on financial sector development (Djankov, McLiesh, and Shleifer 2007; Prati, Onorato, and Papageorgiou 2013; Christiansen, Schindler, and Tressel 2013). Either way, change rallies powerful lobbies against it and the pushback puts pressure on politicians to abandon or limit reforms.

The positive effects of business-friendly reforms can be large. Hobza and Mourre (2010) quantify the impact of various reforms envisaged in the Europe 2020 strategy. They find that the proposed changes could boost real GDP growth from 1.7 to 2.2 percent between 2010 and 2020, depending on the depth of the reforms, while employment gains range from 1 to 4.5 percent. Bordon, Ebeke, and Shirono (2016) use OECD regulatory reform data to show that the combination of product and labor market reforms in the aftermath of the eurozone crisis raised the employment rate by one percentage point over a five-year period.

References

Bordon, Anna Rose, Christian Ebeke, and Kazuko Shirono. 2016. When Do Structural Reforms Work? On the Role of the Business Cycle and Macroeconomic Policies. IMF Working paper 16/62 (March). Washington: International Monetary Fund.

Christiansen, Lone, Martin Schindler, and Thierry Tressel. 2013. Growth and Structural Reforms: A New Assessment. Journal of International Economics 89, no. 2: 347–56.

Djankov, Simeon, Caralee McLiesh, and Andrei Shleifer. 2007. Private Credit in 129 Countries. Journal of Financial Economics 12, no. 2: 77–99.

Hobza, Alexandr, and Gilles Mourre. 2010. Quantifying the Potential Macroeconomic Effects of the Europe 2020 Strategy: Stylized Scenarios. ECFIN Economic Papers 424 (September). European Commission.

Prati, Alessandro, Massimiliano Gaetano Onorato, and Chris Papageorgiou. 2013. Which Reforms Work and under What Institutional Environment? Evidence from a New Data Set on Structural Reforms. Review of Economics and Statistics 95, no. 3: 946–68.