Below is a short statement made in front of the European Parliament in a hearing about “Successes and failures in adjustment program countries”. I was specifically asked to make a few references to Greece, Portugal and Italy.
The objectives of adjustment countries are two-fold :
- In the short run, they need to reduce the financing needs of public administrations in order to restore fiscal sustainability
- In the long run, they need to raise the level of potential output through structural reforms.
The financial crisis has induced policy measures that address both issues. Yet, at present, these economies show little sign of improvement. Unemployment has reached critical levels in Portugal, Greece and Spain. Growth remains anemic and the outlook for public debt is unfavorable despite the painful efforts that have been consented.
The structural adjustment strategy operates under considerable political constraints:
- In the short run, to offset the contractionary effects of fiscal adjustment, aggregate demand should be reallocated toward exports, which implies a depreciation of the real exchange rate. Because of the Euro, this is not doable through a currency depreciation. The only alternative is more downward flexibility of nominal wages, which in some countries (Portugal) simply does not seem to be happening, while in others (Greece) is a protracted painful process replete with political risks.
- In the long run, to increase incentives to work one needs to reconsider the generosity of the welfare state. But this runs counter to the political platforms that most political parties had been selling to the electorate for decades. To increase competition one needs to remove barriers to entry in goods markets; but such barriers benefits some well organized interest groups that are likely to oppose deregulation.
These constraints reduce the margin of manoeuver of policy makers and make it all the more important to come up with the best possible structural adjustment package. To date, I believe the measures that have been implemented fall short of that objective, in particular because the consistency between the two objectives mentioned above has been ignored. For structural adjustment to be successful,
- We need to avoid policy measures that consolidate the accounts in the short-run but have adverse effects on competitiveness and productivity in the long run, and
- We need to avoid reforms that boost competitiveness and productivity in the long-run but have an immediate negative impact on economic activity and/or fiscal revenues.
The pitfall of ignoring those caveats is that the reform package may be unsuccessful overall, as different items in the package will have offsetting effects on both the short-term and the long-term performance of the economy.
Let me now discuss some aspects of structural reforms in program countries under the light of those principles. I will pick some items in the comprehensive reform packages of Portugal, Greece and Italy and discuss the extent to which there is some coherence between their long-run and their short-run effects.
- Regarding the short-run fiscal adjustment, priority should be given to expenditure-reduction measures as opposed to revenue-augmenting ones. The latter must be associated with a greater tax burden which as such has negative long-run distortionary effects on the economy. There is a unanimous consensus over the benefits of greater tax compliance, which is part of the reform package in all program countries. Indeed, in principle, a greater efficiency in tax collection should allow to collect the same amount with lower tax rates, thus reducing distortions. Yet it may also pave the way for future tax increases by opportunistic governments – by simply making such increases less costly, and expectations of such developments may be harmful for investment and growth.
- In Portugal, severance payments for workers with permanent contracts have been considerably reduced, bringing them in line with the European average. While this reform was long overdue, and will certainly raise productivity and reduce unemployment duration in the long run, I believe it should have been postponed. Its immediate impact is to trigger a wave of job destructions in the middle of the recession, which jeopardizes the country’s short-term macroeconomic objectives. Furthermore, it will have little impact on job creation because most new hires are under temporary contracts whose terms are not affected by that reform.
- Symmetrically, the attempt to tax temporary contracts in Italy (and France) may be viewed as a useful step toward a unified labor contract that would do away with the inefficiencies of the dual labor market system. But in the short-run it may critically reduce job creation and postpone recovery.
- On the other hand, the reform of collective bargaining in Portugal, which among other things limits the automatic extension of wage agreements to an entire sector, especially whenever those agreements are signed by unions representing a minority of workers, yields positive benefits both from a long-run and a short-run perspective (A somewhat similar reform in Italy tries to allow firms to bypass collective bargaining by resorting to individual bargaining). In the long-run, it will reduce the equilibrium rate of unemployment, in particular since intersectorial labor reallocation will proceed through wage differentials instead of unemployment spells . In the short-run, it makes it easier to obtain the necessary level of wage moderation in order to restore external balance and bring down unemployment back to acceptable levels. I should hasten to add that, in the case of Portugal, unfortunately this is likely to be insufficient, as the required adjustment in wages is probably around a 10-20 % reduction in nominal wages, which could only be obtained through a devaluation that the Euro precludes.
- Presumably in order to alleviate the immediate consequences of the crisis, in particular the very high unemployment rate, Greece is extending its social safety net. This includes relief jobs, vocational training, basic guaranteed income as well as an extension of health benefit coverage. These programs are being financed by European structural funds and by the World Bank. While these measures are understandable given the political context, they are unwise; relief jobs are inefficient and schemes like basic minimum income are very difficult to undo and will create poverty traps. Greece probably cannot afford a level of social protection on par with Scandinavian countries. I believe this illustrates how a poor macroeconomic situation may create political support for policies that have long-run adverse consequences for the economy.
- Deregulation of protected professions – that is part of the reform package in Greece and Italy – should have positive effects both in the long run and in the short run. In the long run, the allocation of labor is more efficient and the cost of services to consumers falls. In the short run, the unemployed may enter those professions which alleviates the unemployment problem.
The severe fiscal crisis has brought forward a “day of reckoning” which has led countries to implement a catch-all adjustment program including many structural reforms that had long been discussed under different macroeconomic contexts. I think the above examples illustrate that one should have been more discriminating in selecting those reforms given the specificities of the Euro sovereign debt crisis.