Why Are Governments Talking About "Structural Reform"?

tress growing on coins with green graph / csr / sustainable development / economic growth / trees growing on stack of coins
tress growing on coins with green graph / csr / sustainable development / economic growth / trees growing on stack of coins

It is late 2016. All indicators point to a world economy that will remain weak next year and in the longer term, in advanced and developing countries alike. Governments are feeling the pressure from voters to deliver faster economic growth--and plenty of jobs. Discontent is spreading and is threatening globalization--the idea that the free movement of goods, people, and knowledge makes the world a better place. Urgent action is needed. But the truth is that policy-makers are trapped between two unprecedented realities. The first is that the monetary and fiscal tools they have to manage their way out of short-term slumps are no longer effective or available--interest rates are already at almost zero and can't be cut much more, and there is no political appetite to let politicians borrow more to spend more. The second reality has to do with economic growth itself: it is becoming less dependent on accumulating capital and labor, more connected across borders, more urban, more private, and more volatile--that is, more complex.

So the search is on for a way to deal with both the cyclical downturn and the new nature of growth. Enter "structural reform," a broad label for any change in laws, regulations, policies, institutions, and logistics that makes investing more attractive and more profitable--whatever the level of interest rates. This is the advice of mainstream economists, whether for China, Brazil, Europe, Japan, or South Africa. It is also a public commitment of the "G20", the forum which brings together the political leaders of the world's largest economies. And it is a loud and recurrent request at the World Economic Forum, the prime advocacy platform for the global business community.

The concept is not new. Structural reform, a.k.a. "structural adjustment", was en vogue in the late 1980s and early 1990s, as a means to rescue debt-burdened developing countries. It involved policies like privatization of public enterprises, the elimination of subsidies, the reduction of import tariffs, and widespread deregulation. This market-friendly mix became known as the "Washington Consensus", because it was the staple recommendation of the International Monetary Fund and the World Bank. Many countries had no choice but to take the recommendation. So it's got a bad rap. Interesting, almost three decades later, it is back in fashion.

But, what structural reforms should a government choose? It depends on the country. Think of the health of an economy as the health of a human being. You know what the marks of a healthy person are: a body mass index of 22, a resting heart rate of 50 beats per minute, a total cholesterol level under 200mg/dl, a blood sugar count at dawn of 100mg/dl or less, etc., etc. How you get to those marks depends on where you start from. If you are young, slim, and athletic, small adjustments to your lifestyle may do the trick. If you are an old, obese, sedentary, smoking, heavy-drinker, well, a major program of diet, exercise, behaviors, and medicines may be called for--at once! The same case-by-case specificity applies to economies and structural reforms. There is no blueprint. Still, experience suggests a few guiding principles.

The first of those principles is that the lower a country's income level, the more critical it is to get the basics right. Reforms that, say, let farmers in low-income countries profit from their crops or clearly own their land have a much larger impact on growth than making business or patent registration faster. For their part, highly industrialized economies might be held back by labor regulations, but these barely apply in places where employment through formal contracts is rare.

Second, how reforms are sequenced, how they are grouped, and at what moment of the business cycle they are implemented also matter. For instance, doing trade liberalization--letting imports in and exports out--before financial liberalization--letting people hold any currency they want--yields better growth outcomes. Similarly, more flexible rules for banks to engage in micro-credit work better if accompanied by cadastral registries that show who owns what--the two are complementary. In fact, undertaking reforms in several areas at the same time--"in waves"--can significantly amplify gains in productivity, compared to doing them in isolation. The differential impact is not small: the estimated uptick in the five-year average growth in total factor productivity--the best measure of how well a society uses its capital, its workers, and its technology--due to implementing reforms in waves rather than piecemeal is 2 percentage points among advanced and emerging countries, and more than 5 percent in low-income ones. And timing can make a difference too: opening an industry to private investors at the bottom of the business cycle--that is, when the economy is in real trouble--does more to boost economic activity than at the peak.

Third, cost is a key factor in choosing reforms--many of them don't come cheap. Lack of resources makes it less attractive for governments to launch reforms whose negative short-term effects call for compensatory expenditures (e.g., helping workers who are laid off because of changes in the labor laws), and it may favor reforms with no immediate fiscal cost (e.g., allowing new firms to enter a market). You may be thinking: structural reforms sound painful, will they work? Although the earlier research showed mixed results, recent empirical evidence has been uniformly positive. Studies have found that reforms in trade and finance significantly raise growth--when you let people buy and sell across borders, and make banks sounder and more accessible, your economy becomes more efficient and more attractive to foreign capital. There is also a positive correlation between faster economic expansion and legal and institutional reforms, particularly in the area of property rights. The less red-tape, the better. Breaking up monopolies and letting in new producers boosts total factor productivity. Other types of reform have been shown to carry potentially negative effects on growth in the short-term, but positive ones in the long-run--that is the case with, for example, changes in some of the rules that govern the labor market and the pension system.

The bottom line is this: structural reform is not easy or popular, but it works. And it may be the only way out when the economy is in a jam.