Structural Reform Needed

For John, BLUF:  Corrupt capitalism hurts economies.  Nothing to see here; just move along.

The PIGS did it to themselves, according to this study found at the University of Pennsylvania web site, titled "Political Credit Cycles: The Case of the Euro Zone".♠ 

Before monetary union took place with the fixing of parities on January 1, 1999, the conventional wisdom was that it would cause its least productive members—particularly Greece, Portugal, Spain, and Ireland—to undertake structural reforms to modernize their economies and improve their institutions.  This paper argues that, due to the impact of the global financial bubble on the Euro peripheral countries, the result was the opposite: reforms were abandoned and institutions deteriorated.  Moreover, it argues that the abandonment of reforms and the institutional deterioration prolonged the credit bubble, delayed the response to the burst, and reduced the growth prospects of these countries.

The PIGS used to use currency devaluation to deal with economic crises.  Moving into the Euro stopped that.  Some nations, such as Germany, moved to structural reform to move their economies forward.  Not all Euro Zone nations did.  But, not just avoiding reforms, but also believing that everything is OK:

It affects the ability and willingness of principals to extract signals from the realized variables in a bubble, where everything suggests all is well. A sequence of good realizations of observed outcomes leads principals to increase their priors of the agents’ quality. When all banks are delivering great profits, all managers look competent; when all countries are delivering the public goods demanded by voters, all governments look efficient (this mechanism applies both to real estate bubbles, as in Ireland and Spain, and to sovereign debt bubbles, as in Portugal and Greece). This information problem has negative consequences for selection and incentives. Bad agents are not fired: incompetent managers keep their jobs and inefficient governments are reelected. The lack of selection has particularly negative consequences after the crisis hits. Moreover, incentives worsen and agents provide less effort.

Put another way, with the economy seeming to soar, even the worst manager appears to be doing a good job, and when the bubble bursts, there is no metric for saying, based on past performance, who is a really good manager and who is average.  This is a topic that has been tackled in Against the Gods:  The Remarkable Story of Risk, by Peter L. Bernstein, and in The Black Swan:  The Impact of the Highly Improbable, by Nassim Nicholas Taleb.  The authors of the paper use the term "signal extraction problem", which reminds us of the book by Nate Silver, The Signal and the Noise:  Why So Many Predictions Fail-but Some Don't.♥ 

So, structural reform, which isn't unique to these three authors.  There is the October 2012 Liikanen Report.  But the Cyprus problem had been growing from September 2011.  It does not seem that this is a problem that can be solved by increasing the number of regulations, but rather requires actual structural reform, to borrow that word again.

The thing is, when governments can avoid painful reforms, they do.  The three authors point to Alessandra Casella and Barry Eichengreen, who in 1996 showed that "...if these groups expect foreign aid, they will delay concessions and reforms."  They also cite Jakob Svensson, who in 1999 showed that "...in a game-theory model, ... any windfall (including aid) increases rent-seeking and reduces productive public spending."  Put another way, "a government that can easily borrow abroad may use such borrowing to postpone otherwise necessary reforms."

Then there is the ugly term, "debt overhang":

Third, the literature on financial frictions has argued that the recovery from financial crisis is inherently slow because agents suffer from a debt overhang:  they need to deleverage and rebuild their capital.

There is no free lunch.

And, this isn't an April Fools Day joke, as I wrote it last week for posting at this time and date.

Regards  —  Cliff

♠  Jesús Fernández-Villaverde, University of Pennsylvania, NBER, and CEPR; Luis Garicano, London School of Economics, Centre for Economic Performance, and CEPR; Tano Santos, Columbia University.
♥  Since this is Easter Monday, perhaps we can make a word play on a line from the 1959 movie, Ben-Hur:  A Tale of the Christ, "Read well and live".