EZ Original Sin? Nominal rather than institutional convergence

Elias Papaioannou 07 September 2015

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There is an inherent disconnect between modern economic reasoning on growth on one hand, and the convergence criteria set up by the Maastricht Treaty and the Stability and Growth Pact that set the foundations for the euro on the other hand.

  • The focus of economic policymaking across EU member countries during the transition period in the 1990s was on meeting a set of nominal criteria, low inflation, exchange rate stability, moderate public debt levels, and sound fiscal policies.

While there is nothing inherently wrong in having solid macro-economic performance, the problem with these goals is that they are outcomes, endogenous macro aggregates stemming from deep structural economic, political, and societal features.

Countries in Europe did not have different debt levels, budget positions, and inflation rates by luck, but because EU countries have developed different sets of political and contractual (legal) institutions. Differences in outcomes arose because EZ members regulate their product and labour markets differently and because the Eurozone nations differ greatly on the capacity to perform their core duties, enforce contracts, and collect taxes.

The generic problem with the design of the European monetary unification project was its focus on nominal targets and outcomes rather than on addressing the deeper underlying institutional features shaping economic policymaking, the structure and competitiveness of the economy, and economic efficiency. The focus was on symptoms rather than the causes.

Some theory: Transition and convergence

Since the path-breaking work of Bob Solow and Trevor Swan in the 1950s, macroeconomists have decomposed development and growth into a transitory component, stemming from the accumulation of the production factors (i.e., skilled and unskilled labour, infrastructure, ICT capital) and a more permanent stable component, that reflects the efficiency of a country to produce for a given level of (skilled and unskilled) labour and capital.

The key insight of neo-classical theories of growth is that countries can experience growth even in the absence of improvements in the efficiency of production (total-factor-productivity), as long as they implement some basic policies that spur investment (capital accumulation). Catch-up growth is feasible and profitable when capital is relatively scarce, since in this case the return on investment is high. Yet, once the economy accumulates (physical and human) capital, the return on investment falls and the economy reaches a (so-called) steady state where growth is driven solely by technical progress, i.e. improvements in production efficiency (total-factor-productivity).

As countries develop, they need to shift their growth paradigm from capital investment towards technological innovation, research and development, entrepreneurship in skill-intensive sectors, and high value-added activities. Moreover, countries need to differentiate their goods, perhaps upgrade their quality of production in order to gain global market shares and exploit some monopoly profits.

This framework is quite useful in understanding the fast growth in the European periphery in the 1990s and early 2000s (and in earlier decades). Greece, Portugal, Spain, Ireland and to a lesser extent Italy experienced fast growth during the 1990s as monetary stability (pegging local currencies to the ECU) and the associated drop in inflation unleased the power of capital accumulation and led to an increase in investment.

This process was bolstered by some reform in financial intermediation, banking in particular.1 During the 1990s these countries also gained some competitiveness thanks to privatisation of inefficient state enterprises and some limited reforms on product markets (that were initiated by the Single Market Plan in the 1980s). However, improvements in the efficiency of production were limited and many firms in the south found it hard to compete internationally. The increased global competition (stemming from the lowering of tariffs and other non-tariff-barriers, the rise of Chinese and Asian imports) made it very hard for the small, family-run, mismanaged, and focused on domestic markets firms in Greece, Portugal, Spain, and Italy to compete. So, the drop in interest rates and the stability of the single currency did not translate into an increased productivity in the south. Instead, these features contributed to the construction boom and the relocation of labour from agriculture and inefficient manufacturing into construction (see Garicano et al. 2013).

The leadership of the EU realised that catch-up growth had reached its limit and that advanced EU countries had to switch their growth model. The introduction of the euro was accompanied by the ambitious Lisbon Agenda in 2000 that aimed to make in just ten years the EU “the most competitive and dynamic knowledge-based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion". Yet, the Lisbon agenda has been a massive failure, as very little was done on structural reforms and human capital investments that are sine qua non requirements for modern growth.

Steady-state factors. Institutions, red tape, and state capacity

So which features affect total-factor-productivity, the efficiency of production? In which areas shall the EU and the Eurozone focus on, so as to bring much-needed growth and prosperity?

  • A burgeoning body of research on growth and political economy provides compelling evidence that the focus should be on institutional reform.2

Europe seems to be in need of an institutional convergence, as institutions, the rules of the game – in Douglass North’s terminology – differ widely across Europe and, crucially, affect economic efficiency.

To be fair, there is still a lot of debate on exactly which institutional traits matter the most and whether other-than-formal institutional features (related, for example, to trust, beliefs, and civic-social capital) matter as well. A voluminous body of empirical research nevertheless shows quite convincingly that institutions exert a first-order impact on development and are especially crucial for advanced economies that have exploited the gains of catch-up growth (convergence).  

In particular, research and common wisdom suggest that the focus should be (or should have been) on:

  • Investor protection, shareholders, and creditors’ rights, which are crucial for the development of efficient, deep, and liquid capital markets (La Porta et al. 1997, 1998).

Moreover, legal institutions are associated with a higher volume of bank credit and lower interest rates to the private sector, a higher degree of entrepreneurship and innovation – factors that contribute to total-factor-productivity (see Levine 2005, and Papaioannou 2008 for reviews on the link between finance and growth).

Shareholders and creditors’ rights differ widely across the EU. In Italy and Greece, investor protection against tunnelling, looting, and managerial entrenchment is very weak, while the Scandinavian countries, Germany and the Netherlands offer shareholders and creditors a secure legal framework for investment. For example, in 2008, on the composite 1-10 range index of shareholder protection (produced by World Bank’s Doing Business Project) Greece scored 3.0, ranking 158-165 out of 181 countries. For comparison, the world average was 4.87 and the Eurozone average, excluding Greece, was almost 6 (see Papaioannou and Karatza 2015).

  • Court efficiency and the quality of contract enforcement affect economic performance and total-factor-productivity in particular (Djankov et al. 2003).

An efficient judiciary is needed to attract foreign investment, especially in complex R&D intensive sectors. Differences on the time to resolve even simple disputes differ enormously across Eurozone member countries (see Papaioannou and Karatza 2015 for details). The World Bank estimates that the time needed to resolve via the court system a standard dispute regarding a commercial claim that equals 200% of per capita GDP is 820 days in Greece and 1000 days in Italy! This is more than twice the time needed in other EU countries (400-500 days), and is even more than the average in low-income countries (682 days).

  • Formalistic product market regulations and associated red tape constitute a significant impediment to firm creation, innovation, and entrepreneurship in many countries in Europe.

For example, the countries in the periphery, such as in Greece and Italy, place numerous administrative-bureaucratic barriers to firm entry and expansion. Red tape fuels corruption, which in turn lowers trust towards the entrepreneur and business, which in turn breeds more regulation (Aghion et al. 2010). Moreover, red tape and start-up barriers are particularly harmful for the process of creative destruction and the relocation of labour and capital from globally declining sectors to industries with growth potential (Ciccone and Papaioannou 2006).

  • State capacity on enforcing contracts and tax collection has also been linked to development and prosperity (Besley and Persson 2010).

There are significant differences across Eurozone countries on both aspects of state capacity. Tax evasion is rampant in Greece and also widespread in Italy and other parts of the south, where the size of the shadow and unofficial economy are considerable. An innovative recent study (Artavanis et al. 2015) that compares tax filings with bank loans estimates that the unreported income in Greece in 2008-2009 was at least €28 billion, and the foregone government revenues amount to 32% of the record deficit for 2009 (that exceeded 15% of GDP).

Summary

Somewhat paradoxically, the criteria for joining the euro did not touch upon key institutional issues related to state capacity (tax collection), property rights protection, investor rights, red tape, and administrative-bureaucratic quality. The high growth during the convergence period came mostly from increased investment and some limited reforms, mostly on banking and monetary policy stability. Yet, if Europe is to proceed with an even closer union, more is needed so as to bring the quite heterogeneous economies of the 19 member states closer. This entails deep and multi-dimensional structural reform and setting up institutional – rather than nominal targets.

References

Acemoglu, D, S Johnson, and J A Robinson (2005), "Institutions as the Fundamental Cause of Long-Run Growth" in The Handbook of Economic Growth, ed., P Aghion and S Durlauf, Amsterdam, Netherlands: North-Holland.

Acemoglu, D and J A Robinson (2012), Why Nations Fail? The Origins of Power, and Prosperity Crown, New York, NY.

Aghion, P, Y Algan, P Cahuc, and A Shleifer (2010), “Regulation and Distrust.” Quarterly Journal of Economics. 125(3): 1015-1049.

Artavanis, N, A Morse, and M Tsoutsoura (2015), “Tax Evasion Across Industries: Soft Credit Evidence from Greece.” Mimeo University of Chicago.

Besley, T and T Persson (2011), Pillars of Prosperity: The Political Economics of Development Clusters. Princeton University Press, Princeton, NJ.

Djankov, S, R La Porta, F Lopez-de-Silanes, and A Shleifer (2002), “The Regulation of Entry,” Quarterly Journal of Economics.

Djankov, S, R La Porta, F Lopez-de-Silanes, and A Shleifer (2003), “Courts: The Lex Mundi ProjectQuarterly Journal of Economics, 118(2): 453-517.

Garicano, L, J Fernadez-Villaverde and T Santos (2013), “Political Credit Cycles: The Case of the Eurozone,” Journal of Economic Perspectives, 27(3): 145-166.

Ciccone, A, and E Papaioannou (2007), “Red Tape and Delayed Entry”, Journal of the European Economic Association (Papers and Proceedings), 5(2-3): 444-458.

Kalemli-Ozcan, S, E Papaioannou and J Peydro (2010),

What Lies beneath the Euro’s Effect on Financial Integration? Currency Risk, Legal Harmonization, or Trade?.Journal of International Economics, May 2010, 81(1): 75-88.

La Porta, R, F Lopez-de-Silanes, A Shleifer, and R Vishny (1997), "Legal Determinants of External Finance." Journal of Finance, 53(1): 1131-1150.

La Porta, R, F Lopez-de-Silanes, A Shleifer, and R Vishny (1998), "Law and Finance." Journal of Political Economy, 106(6): 1113-1155.

Levine, R (2005), “Finance and Growth: Theory and Evidence" in The Handbook of Economic Growth, ed., P Aghion and S Durlauf, Amsterdam, Netherlands: North-Holland.

Papaioannou, E (2007), “Finance and Growth: A Macroeconomic Assessment of the Evidence from a European Angle.” Chapter 2 in Financial Institutions and Markets: A European Perspective. X. Freixas, P. Hartmann and C. Mayer (eds.), 2007, Oxford University Press, Oxford, UK.

Papaioannou, E and S Karatza (2015), “The Greek Justice System: Collapse and Reform.” In Reforming the Greek Economy. Editors C Meghir, C Pissarides, N Vettas, and D Vayanos, MIT Press, August 2015.

Footnotes

[1] The key liberalising policies were the incorporation (transposition) into the domestic legal order the first and the second banking directive. Since the late 1990s, legal-regulatory harmonisation policies in financial services was bolstered by the directives and regulations of the Financial Services Action Plan that aimed to integrate financial intermediation across the EU. Kalmeli-Ozcan et al. (2010) estimate that 25%-30% of euro’s large impact on cross-border banking activities is attributable to such financial-banking sector harmonization policies.

[2] See Acemoglu, Johnson, and Robinson (2005) for a review and Acemoglu and Robinson (2012) for a general exposition of the institutional thesis).

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Topics:  EU institutions

Tags:  EU institutions, convergence, institutional features, economic growth, productivity, efficiency of production

Professor of Economics, London Business School; CEPR Research Affiliate

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