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Structural Reforms in the Euro Zone: an IMF Perspective
October 18, 2017
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IMF Communications Department
MEDIA RELATIONS
Phone: +1 202 623-7100Email: MEDIA@IMF.org
Good afternoon ladies and gentlemen. It is a pleasure to be here. Thank you to the ECB for the invitation.
Among the primary economic reasons for the creation of the common currency was clearly the notion that a common nominal straitjacket would harden budget constraints in all member states, not least those with deep-seated structural problems, catalyzing reforms and allowing them to gradually catch-up with the better performing economies.
This has not happened on anywhere close to the hoped-for scale. Take the experience of the twelve original members of the Euro zone including Greece. Before they adopted the common currency, there was steady convergence in GDP per capita, reflecting robust growth in the less prosperous countries. However, following the adoption of the common currency, this convergence largely stopped, and—since the crisis—we have actually seen divergence.
We have found that the lack of convergence mainly reflects persistent gaps in productivity growth across countries. Countries with higher levels of labor productivity at the time of euro introduction have continued to see a rise in productivity since then. In contrast, labor productivity has stagnated in countries that had low productivity in 1999. As a result, the gaps in real per capita income levels have widened rather than narrowed. You can find our detailed analysis in our report on the 2017 Article IV consultation for the Euro Area from July.
Thus, the focus of this conference on structural reforms is highly relevant. We are discussing critical, some might say existential, issues.
That structural reforms can help improve productivity is obvious. But what our analysis shows is that not only do they boost productivity, the boost is larger in countries with lower levels of productivity.
As part of the 2017 Euro Area Article IV, we looked at 20 advanced European countries over 1980 to 2014. What we found is that the less productive a country is, the bigger are the productivity gains from structural reforms.
This is good news. It confirms that even if all countries pursue structural reforms this helps close the productivity gap between countries with lower per capita incomes and those with higher per capita incomes. In other words, structural reforms foster convergence.
Unfortunately, however, reform efforts in euro zone countries have fallen short of what is required for such catch up. We have collected a dataset of all the major structural reforms in euro zone countries over the past three decades. We find that the strongest reform momentum was in the years running up to euro adoption, when several countries implemented comprehensive reforms. The shared objective of ensuring successful euro adoption created ownership and determination to overcame resistance from vested interests. But after the euro’s introduction, reform efforts weakened.
The metrics for monitoring structural reforms developed by the Commission shows a similar picture for the more recent period. As mentioned, this was not supposed to have happened—on the contrary.
There are several reasons for this. Let me briefly mention two:
First, there is the question of institutional weaknesses. While sentiment based indicators should be handled with caution, it is striking that both the World Bank’s governance indicator and the World Economic Forum’s Global Competitiveness Index indicator for public institutions show a strong positive correlation between the quality of institutions and productivity levels among Euro area member countries. While this is not the place to discuss the direction of causation—it probably goes both ways—our findings—as I will explain—suggest that weaker institutions make it easier for vested interests to block reform efforts.
Second, the reform momentum might also have been stifled by the large easing of financial conditions associated with Euro accession in some of the structurally weaker countries. Here too it is striking how lower real rates and capital inflows boosted employment and GDP growth, while failing to promote a catch-up in productivity. We need to be mindful of this when we discuss how policies at the central level can support reforms in individual countries.
But this is not the focus of my remarks. I will focus primarily on the experience of the IMF in helping to foster structural reforms in the context of IMF supported programs—inside and outside the Euro zone—and on the lessons in this regard that—in my view—are relevant for the Euro Area. I will be drawing in large part on two comprehensive crisis program reviews published in 2009 and 2015, and on very detailed and independent ex-post evaluations of our recent programs.
As you may know, the Fund streamlined its approach to structural program conditionality after the Asian crisis in the 90s. There were several reasons. One of them was clearly that we were seen as being guilty of mission creep.
As a result, in the crisis programs in the wake of the Global Financial crisis, the number of conditions was substantially scaled down compared to past programs and refocused on core macro-economic and financial issues. For instance, our arrangement with Iceland in 2008 had not a single structural reform outside the fiscal and financial sector.
Thus, by the time the IMF got involved in programs in the euro zone, we had largely withdrawn from structural conditionality. However, with no recourse to devaluation and facing deep competitiveness problems, our Euro zone programs—not surprisingly—returned to the inclusion of structural conditionality. The majority of conditions still aimed to address financial and fiscal issues, but we again ventured beyond these sectors.
So, what are our lessons about program implementation? If we look at reform implementation overall—that means including conditions for reform of the financial and fiscal sectors, as well as structural reforms—the 2015 Crisis Program Review finds that, across all programs, 70 percent of benchmarks were met without delays. The implementation rates for Ireland and Portugal are at or above this level, while the programs in Cyprus and Greece in 2010 and 2012 are below.
Furthermore, we see a difference in implementation between conditions in the financial and fiscal area, on the one hand, and broader structural reforms, such as labor and product market reforms, on the other hand. Broader structural reforms were much more likely to be delayed, only partially implemented, or not implemented at all, than measures in the financial or fiscal area. We found that implementation delays on structural reform conditionality were about 20 percent longer, on average, then for financial and fiscal conditionality.
Countries seem to have a harder time implementing structural reforms. Why is this the case?
I want to highlight three lessons that we have learned from our experience, drawing in particular on an in-depth analysis from 2015 on the relationship between structural reforms and macroeconomic performance in the context of our surveillance role. Hence, these three lessons are broadly applicable to all countries, not just programs.
First, the country’s implementation capacity plays a big role in making reforms successful. Differences in capacity could be one of the reasons for the uneven implementation of program conditions. Weak implementation capacity can be partly mitigated by technical assistance, though it takes some time to build up.
But, more fundamentally, as a number of IMF research papers have found, countries’ ability to implement programs depends on the strength of their institutions and program conditionality cannot substitute for weak institutions.
Also, looking at a broad range of program cases, we found that the share of program conditions met without delay was negatively correlated with the number of conditions. This suggests that when there are a lot of conditions, implementation capacity may be overwhelmed. We have learned from this. If you take the standby arrangement recently approved for Greece—which coincided with the second review of the ESM program—we had 7 prior actions while our European partners had 140.
The second lesson is that the payoff from reforms also depends on the ability to sustain the reform momentum. Our analysis suggests that successful reforms were typically implemented in sequence, as part of a wave of reforms intended to reinforce and complement one another, and complemented by sound macroeconomic policies.
This is an important finding. But I will not dwell on it, as I want to get to the third and last conclusion, which in my view is by far the most important one.
The main conclusion from our various analyses is that domestic ownership is essential for reforms to be successful. By ownership I mean the extent to which country authorities, public opinion and the broader political establishment agree on what reforms are necessary and welcome them.
As mentioned before, the reform momentum in the run-up to the creation of the euro is an example of how a strong impetus for reform, based on a shared objective, helped policymakers to overcome vested interests.
However, when reforms are legislated mainly due to external pressure—such as in a program—and without strong domestic ownership, the reforms are less likely to be successful.
This is in contrast with program conditions directed toward stabilizing the financial system or reducing the fiscal deficit, where the programs seem to have helped push countries to take corrective actions.
Let me give you some concrete evidence of the importance of ownership for structural reforms from our Ex-Post Evaluations of large IMF programs. The IMF carries out Ex-Post Evaluations for all programs that have “exceptional access”—that is, access above the Fund’s normal financing limits. Since the crisis, we have completed 23 such Evaluations.
We find that nearly one-third of the programs went off track before they were completed. In every one of those cases, weak ownership is identified as a primary reason for this. Moreover, the failure to implement agreed structural reforms was identified in all these cases as a key sticking point.
In another fifth of the Ex-Post Evaluations we see notable delays in meeting key program conditions or less than full implementation of reforms. In most of these cases, ownership waned over time due to reform fatigue, as financial pressures weakened, or in the context of political elections.
For the remainder of the programs, which were generally completed, without major delays, strong ownership was cited as a key contributing factor to the program’s success.
This suggests that, at least in program cases, frontloading reforms can help to make progress when ownership and political will are strongest, and before reform fatigue sets in. But, it’s also important to try and keep reform packages relatively parsimonious and focused on the most important challenges to avoid diluting ownership across too many fronts and overloading a country’s implementation capacity.
I believe that a critical lesson in this regard pertains to domestic political support. Compare the programs for Greece and Portugal, both of which I was closely involved in negotiating.
As mentioned, implementation in the case of Portugal was notably stronger than in that of Greece.
Critical in this regard—I believe—was the fact that the Greek body politic never unified behind the program: the governing party found stiff resistance to key parts of conditionality from the mainstream opposition parties from the outset of the program.
In the case of Portugal on the other hand, we in effect had parallel discussions with the main opposition party—with the full knowledge of the government—making sure that the key policies had broad political support. As a result, when there was a change of government a few months into the program, program implementation continued seamlessly. Only once the situation had clearly stabilized and the acute sense of crisis had abated did the usual fault-lines in Portuguese politics reopen.
The crucial issue is whether a sense of critical national challenges manages to unify the body politic. The Hartz reforms in Germany, the 2011-12 reforms in Spain, and the current reforms in France come to mind.
So, what are the overall conclusions that I draw? There are some obvious ones: structural conditionality has to be very well focused and parsimonious; it has to be carefully sequenced; and it should be assumed that results can often take a long-time to show.
What can be done at the Euro Area level to facilitate reforms in member states? To help address the implementation capacity issue, EU level bodies (and the Fund) can provide technical assistance and advice. A euro area central fiscal capacity—with participation conditional on compliance with the fiscal rules and progress on structural reforms—could possibly provide incentives for reforms and make it politically easier to sell reforms domestically.
But the main conclusion—in my view—is that we need to recognize that there are significant limitations on what Brussels can do to speed up reforms in member states. The overarching lesson of the Fund’s work in this area is clearly that structural reforms will not stick unless there is a strong domestic ownership. The reform momentum will remain critically dependent on the political resolve of the domestic body politic. It cannot be imposed from outside. National policy makers should not be misled by the current discussions regarding the architecture into believing that this will in any significant way change the need to mobilize a domestic resolve to overcome resistance from vested interest.
The current strong cyclical recovery provides the best possible economic environment for domestic policymakers to undertake such reforms.
References
“Real Income Convergence in the Euro Area”, by Hanni Schölermann, IMF Country Report No. 17/236.
“Can Structural Reforms Foster Real Convergence in the Euro Area”, by Angana Banerji, Christian Ebeke, Ksenia Koloskova, Hanni Schölermann and Jesse Siminitz, IMF Country Report No. 17/236.
“ Review of Recent Crisis Programs”, IMF Policy Paper, 2009.
“ Crisis Program Review”, IMF Policy Paper, 2015.
“ Structural Reforms and Macroeconomic Performance: Initial Considerations for the Fund”, IMF Policy Papers, 2015.
“ Structural Reforms and Macroeconomic Performance: Country Cases”, IMF Policy Papers, 2015.
