No pain no gain

Actually, countries do make painful economic reforms without austerity

May 15, 2013
May 15, 2013

The case for austerity, the notion that steep budget cuts can spur economic growth, has taken a beating lately, for instance here and here. But austerity lovers are tweaking their argument: Austerity during crises doesn’t necessarily spur short-term growth. Instead, it sets the conditions for painful long-term reforms. In other words, as Paul Romer has said: “A crisis is a terrible thing to waste.”

It’s the economic equivalent of  “it became necessary to destroy the town to save it.” Forget Bernanke-style short-term stimulus and loose monetary policy followed by long-term fiscal cuts. In this scenario, tight money supply and tight budgets (imposed by central bankers, foreign lenders or debt-nervous lawmakers) gives feckless politicians no choice but to tackle structural reforms. Steve Pearlstein fleshes this argument out as follows:

[T]he idea that countries like Greece, Italy and even France could be relied on to do structural reforms once a stimulus-induced, deficit-driven recovery had been achieved is simply a political fantasy. There is no historical support for such a belief, and everything we know about the politics of these countries suggests otherwise. … In fact, everything we know about politics in the United States would also support such a conclusion.

The question is: What evidence is there to support this claim?

I did some digging and found a 2010 OECD study of 20 cases of structural reform. It agreed with previous studies that “the most promising time to reform is immediately after a recession.” During periods of fiscal contraction, the economies in the study were less likely to initiate reform, while those that did were less likely to succeed. Also, hasty reforms imposed during fiscal crises were shoddy and reversed when conditions improved. Overall, the study found that apt reforms have more to do with a country’s political conditions rather than its economic health.

Here are a few specific examples cited in the study:

The 1996 welfare reform law in the United States. This landmark reform imposed work requirements on recipients of public welfare. At the time of its drafting, the US economy was growing at a rate of 3.8%. Throughout the 90s, a period of relatively high-growth and low-unemployment, US lawmakers passed budget reforms that resulted in the first post-war surplus. These reforms were driven in part by the concerns over rising US debt, but there was no crisis, and accommodative monetary policy from US Federal Reserve chairman Alan Greenspan supported the legislature’s efforts.

The 2002-5 Hartz reforms in Germany. An iconic set of structural reforms in Europe, this series of laws named for their lead drafter, Volkswagen executive Peter Hartz, introduced more flexibility into the country’s labor market and cut unemployment payments. What inspired the reforms? Slow growth, not austerity. The laws were instituted starting in 2002, a time of 8.7% unemployment in the German economy.  Germany ran budget deficits throughout this period, peaking at 4% of GDP in 2004, and asked the European Central Banks to lower rates, which it did until the reforms were passed.

The 2003 French pension reforms. This effort to right the French pension system increased the retirement fund contributions of public sector workers and raised their retirement age by five years. Passed at a time of low growth and high budget deficits, it overcame union opposition.

There are many open questions about the right approach to fighting recessions, but the idea that austerity is a pre-condition for structural reform is just that, an idea. It shouldn’t be taken at face value. We’ll be watching Japan, where Prime Minister Shinzo Abe is combining structural reform with stimulus and opening up domestic markets. It could offer more evidence that stimulus and reform actually go hand in hand.

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