Can structural reforms boost growth? (Study)

Summary:

• Structural reforms increase potential growth and long-term employment;

• Deregulation has focused more on goods and services markets than on labor markets in OECD countries;

• Their short-term effectiveness is uncertain: depending on the economic situation, some policies may be recessionary.

Policies aimed at reforming labor and goods and services markets are being promoted as tools to boost growth in advanced countries, particularly in Europe. By acting on the supply side, such structural reforms have positive effects on long-term growth and employment by allowing for a better allocation of production factors. However, their short-term effects are more uncertain and may even be recessionary under certain conditions.

Why carry out structural reforms?

This type of reform refers to reforms that transform the structure of labor and goods and services markets. In the case of labor markets, they may involve changing the legislative framework governing how companies hire and fire workers, or the unemployment insurance system. In the case of goods and services markets, an example of structural reform is the deregulation of a sector such as retail or network industries.

These policies are therefore positive supply shocks, which combat distortions such as the emergence of rents in an oligopolistic market (telecommunications), or which change the way existing institutions operate (such as unemployment insurance).

The decline in potential growth and productivity in developed economies makes this type of action particularly relevant, especially since this phenomenon is attributable to structural rather than cyclical causes. Although exacerbated by the 2008 crisis, this slowdown in productivity began in the 2000s^. Peripheral European countries were a good illustration of this trend, with characteristics symptomatic of structural weaknesses: real exchange rate appreciation, rising current account deficits, and increasing prices for non-tradable goods. These included losses in price competitiveness and the emergence of rents and rigidities in the private and public sectors, which contributed to these countries being hit very hard by the debt crisis (2009-2012). This is why structural reforms are being promoted, particularly by the OECD and the IMF, as a significant lever for reviving growth.

What do they consist of?

For reforms targeting goods and services markets, the aim is, for example, to facilitate access for new companies compared to those already in place, while at the same time ensuring that the least productive firms leave the market. By improving competition, these reforms should reduce the cost paid by consumers. Similarly, efforts can be made to reduce the administrative costs of businesses and investors in order to increase foreign direct investment (FDI) and trade. By promoting investment and innovation, these reforms increase productivity and long-term growth.

Most advanced economies have already adopted deregulation reforms aimed at increasing competition, but not for all sectors. While network industries (rail, electricity, telecommunications, postal services, etc.) have been massively deregulated, reforms for retail trade and services have stagnated (Figure 1).

Figure 1 Regulation of the goods and services market

Composite indicator from 0 to 6, with scores close to 6 indicating strong regulation and scores close to 0 indicating no regulation. Median value for OECD countries.

Sources: IMF, OECD, BSI-Economics

By definition, structural reforms in the labor market aim to reduce structural unemployment. For example, reducing the duration and level of unemployment insurance and supporting active employment spending^[iii]are examples of policies that seek to reduce long-term unemployment by facilitating a return to work and encouraging job search. Efforts can also be made to facilitate dismissal procedures by capping labor court compensation or relaxing the framework for economic dismissal, a measure included in the El Khomri law in France, for example. The logic behind this reduction in employment protection is that by reducing the uncertainty surrounding dismissal, companies would gain flexibility to adjust their payroll in times of crisis and would therefore be more inclined to hire. Regulation in the labor market is much more constant than in the goods and services markets, as institutions are stable and difficult to reform (Figure 2). This rigidity can be attributed to societal preferences that change little over time, giving rise to different models of wage bargaining between countries, for example.

Figure 2 Labor market regulation

Employment protection (left axis): Composite indicator from 0 to 6, with scores close to 6 indicating strong regulation and scores close to 0 indicating no regulation. Median value forOECDcountries.

Active employment expenditure (right axis): as a percentage of GDP, median value for OECD countries.

Sources : IMF, OECD, BSI-Economics

Uncertain short-term effects

What is the economic science saying about the short- and long-term impact of such reforms? For long-term effects, the overall assessment is positive: a structural overhaul of the goods and services markets and the labor market would lead to an average GDP gain of nearly 10% for OECD countries over a 10-year horizon.

But when we look at the short-term effects, the picture is more mixed (Table 1). This is particularly true for reforms targeting the labor market, whose immediate impact depends on the economic situation and the policy mix in place (fiscal and monetary policy choices). In particular, reforms that facilitate layoffs or promote competitiveness can have recessionary effects in the short term: while layoffs, restructuring, and market exits by companies are immediate (triggered at the time of the reform), hiring and market entries are only gradual. The sequencing of structural reforms therefore appears to be key, as discussed below.

Interest in this type of reform has given rise to a body of theoretical literature that simulates their impact on the economy under different scenarios. For example, the work of Cacciatore et al. is based on a general equilibrium model in which different types of reforms are implemented:[v]

1. a pro-competitive reform of the goods market (reducing barriers to entry);

2. a relaxation of employment protection (reduction in dismissal costs);

3. a reduction in unemployment benefits;

4. an increase in active employment spending (making the labor market more efficient).

The model is calibrated to simulate the behavior of the eurozone economy, and three scenarios are considered:

A. a « normal » macroeconomic baseline scenario

B. a crisis situation where monetary policy is functioning normally

A. a crisis situation where monetary policy is not functioning (with a liquidity trap where the nominal interest rate is 0)

Table 1 Impact of reforms

Sources: IMF, OECD, BSI-Economics

A + sign indicates a positive effect on growth and/or employment. A – sign indicates a negative effect, a -/- sign indicates a negative or even very negative effect, depending on the source.

The importance of the economic climate

The four types of reforms improve production and employment in the long term: over a 10-year horizon, when implemented together, they deliver a gain of around 2.5% in GDP and a 2% reduction in unemployment. However, they only bear fruit gradually, and some have negative effects in the short term.

The reform of the goods market (1) has a positive short-term effect (within two years of the reform) on growth and employment. Similarly, reform 4 (active spending on employment) enables the unemployed to return to work more quickly and thus leads to a better economic recovery. It is even more effective in crisis scenarios (B or C).

However, reforms aimed at reducing employment protection and unemployment insurance have a negative impact on employment and growth in the short term in scenarios B and C. Implementing these types of reforms when the economic situation is poor weakens demand and delays recovery. In reform 2, layoffs are immediate but are only offset in the long term by rehiring once the recovery begins. Thus, layoffs occur at the wrong time, during the recession. In reform 3, the reduction in benefits is supposed to encourage a return to work. However, this only happens when companies start hiring again, i.e., once the crisis is over. In the meantime, the loss of income associated with the reduction in benefits is immediate, further contracting aggregate demand, which is already depressed, as was the case in Spain in the early 2000s.

The sequencing of structural reforms is therefore particularly important. In times of crisis (scenarios B and C), reform of the goods market and active labor market policies should be prioritized (policies 1 and 4). In « normal » situations (scenario A), it is time to reform unemployment insurance and employment protection (policies 2 and 3). These theoretical results should be put into perspective: for example, the Hartz reforms carried out in Germany in the 2000s (which included a reduction in unemployment insurance and protection against dismissal) were implemented at a time when the national economic situation was severely deteriorated. However, these reforms were facilitated by a favorable international economic climate. Similarly, structural reforms are more likely to be effective quickly if neighboring countries do not implement them at the same time, reducing undesirable symmetrical effects.

The importance of monetary policy

The results of Cacciatore et al. are not very sensitive to the functioning of monetary policy, i.e., the difference between scenarios B and C. Eggertsson et al. qualify this finding. In a similar model, they consider the impact of a structural reform that has short-term recessionary effects similar to those of policies 2 and 3 presented above. They show that when monetary policy is functional (outside the liquidity trap), the central bank can lower interest rates and thus mitigate the deflationary effects of the reform in the short term. But when monetary policy is no longer functional, it cannot combat such recessionary effects. Thus, in addition to the importance of macroeconomic conditions, the functioning of monetary policy and its transmission to the real economy are important criteria to consider when implementing structural reform.

The role of announcements

On the other hand, both articles agree on the importance of government credibility and the effects of announcements. For example, as stated above, making it easier to lay off workers in times of crisis leads to a situation where companies can lay off workers without too many constraints and rehire them when the economy recovers. The effect is procyclical and exacerbates the recession. If, on the other hand, it is credibly announced that such a reform will be implemented in the medium term, once the crisis is over, then companies can proactively rehire because they know that they will be able to terminate these contracts more easily once the reform is in place. Even if, in France at least, the potential cost of future layoffs is not the only criterion taken into account by companies when considering hiring.

Reform in a monetary union?

A recent theoretical study by Gali et al. also questions the effectiveness of reforms that promote wage flexibility for countries in a monetary union. Wage flexibility is traditionally seen as a way to regain competitiveness in the event of a negative shock. Lower wages allow for lower prices and thus real depreciation, which would boost the economy. This is particularly useful in a monetary union where the exchange rate cannot be used. Structural reforms that reduce wage rigidity would therefore be relevant in this context, which explains why they have been implemented in adjustment programs (Greece, Portugal, Spain, etc.). However, Gali et al. show that this mechanism has been very ineffective in the eurozone: with monetary policy being centralized and with a mandate focused solely on price stability in the zone as a whole, price adjustments have been moderate in these countries. Losses in purchasing power linked to wage reductions have occurred, but gains in competitiveness have not.

What are the empirical analyses?

Empirical work on structural reforms generally confirms these theoretical results. The IMF, based on OECD data, lists the structural policies implemented in advanced economies since 1970 and assesses their quantitative impact on major macroeconomic variables (employment, production, inflation, etc.)[x]. In particular, the aim here is to establish which reforms are statistically significant in explaining an economic recovery or an increase in employment, for example. In the analysis, reforms of goods and services markets, such as the deregulation of German network industries in 1998, have a positive impact in the medium term, even when implemented during a crisis. However, policies aimed at facilitating layoffs (such as those implemented in Spain in 1990) have no (statistical) impact, or even a negative impact when unfavorable macroeconomic conditions are taken into account. Finally, the study shows that reducing the generosity of unemployment insurance has a positive effect on long-term employment (especially when combined with active policies), at the cost of a negative effect on short-term growth.

Conclusion

International organizations are calling for structural reforms to remedy deflation and sluggish growth, particularly in Europe. Some policies are effective, such as those concerning goods markets. But others, such as those affecting the labor market, only pay off gradually or even have a negative effect in the short term. Their effectiveness depends on good macroeconomic conditions and a functional monetary policy. Thus, an effective complement would be a demand-side stimulus, such as a fiscal stimulus. This is a policy now desired by these same international organizations.