Needed: A European institutional union

Elias Papaioannou 12 February 2016

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The recent crisis in Europe has revealed an institutional void at the EU and the Eurozone levels. For example, at the onset of the global financial crisis in 2007-2008, the EU and the currency union lacked a centralised institution for fiscal policy coordination. Transfer and risk sharing mechanisms were almost non-existent, as the EU budget is small – approximately 1% of EU GDP. In spite of some regulatory-legislative harmonisation policies in the 2000s, the supervision of banks and other financial intermediaries differed considerably across member states and the EU and the Eurozone were far from offering unified financial services to European citizens across the border. At the same time, core EU institutions, most notably the EU Commission, were not in a position to offer leadership and coordinate the policy response to a crisis that threatened the existence of the EU. The EU Council of Heads of State and Economics and Finance Ministers (the ECOFIN/EuroGroup) responded to market turmoil sluggishly without having coherent plans. If anything, EU politicians added risk to the system (Baldwin and Giavazzi 2015, Corsetti 2015). Given these flaws and the evident institutional void, the ECB took a central role, coordinating not only monetary policy, but also pushing for the banking union project, for the establishment of transfer mechanisms (the European Stability Mechanism, ESM), and even assisting in the design of policy reforms in product and labour markets. Some have argued that the ECB is even involved in fiscal policy.

The apparent institutional void has led to some modest reform, most notably the banking union project (with a single supervisory mechanism regulating large systemic European banks, common capital requirements, and a common bank resolution system) and the creation of the ESM, which can assist member states in crisis times. And there are many proposals in the direction of more centralisation, such as launching Eurobonds, the establishment of an EU centralised fiscal authority,1 and the empowerment of existing EU institutions, such as increasing the balance-sheet of the European Investment Bank (see Tabellini 2016). These proposals are in the right direction, though unfortunately – and in a very European manner – they move slowly and are filled with exemptions and loopholes.2

Institutional gaps at the National-level

At the same time, there is a non-negligible gap on EU-EZ countries’ national institutional capacities (quality of justice system, tax collection, administrative performance, control of corruption); this gap, which has not received much attention either from policymakers or from academics, is equally dangerous to the weak and dysfunctional pan-European institutions.

In the countries of the European core (e.g., Germany, Netherlands, Austria), legal institutions are well-functioning, adequately protecting investors from managerial fraud; property rights are well-defined; public bureaucracies are professional and public goods-provision is decent; red tape and corruption, while not absent, are not huge issues. While there is always room for improvement, the European countries of the core enjoy strong state capacity, being able to enforce their government’s legislated policies, collect taxes, and apply the rule of law. In contrast, in the European periphery (Greece, Italy, Portugal, and Spain), legal protection of shareholders and creditors is weak, both because laws are conflicting, ill-designed and not-well-thought-out, and because courts are slow, inefficient, and often produce conflicting rulings. Public administration and national bureaucracies are largely inefficient, characterised by political interference, graft, and lack of professionalism. And states’ fiscal capacity is not particularly strong, as tax evasion is sizable and it is challenging for the government to enforce its decisions (Besley and Persson 2011). Moreover the size of the unofficial economy is considerable with sizable costs for the state coffers and negative spillovers in the formal sector.3

Figure 1 below illustrates this gap using some proxies of national institutional quality from the World Bank’s Governance Matters Indicators Database (Kaufman et al 2011). The graph plots the mean values of three governance quality measures (rule of law, control of corruption, and government-bureaucratic effectiveness) for seven core EZ nations (Finland, France, Luxemburg, Germany, Netherlands, Austria, and Belgium), the seven EZ periphery countries (i.e., Greece, Malta, Cyprus, Ireland, Spain, Portugal, and Italy) and the five EZ member countries in Eastern Europe that transitioned from centrally-planned to market economies in the 1990s (Slovakia, Slovenia, Latvia, Estonia, and Lithuania). There is an evident gap between the core and other two sets of countries across all categories. And while these indicators are survey-based, proxies containing perhaps non-negligible noise, a similar picture emerges when considering other indicators that measure specific aspects of the institutional environment, such as legal quality, court efficiency, red tape in product markets, and easiness of registering property. In Figure 2 we tabulate the mean values of a proxy of court efficiency that measures the days needed to resolve a simple legal dispute in courts. There are sizable differences in court delays across the Eurozone with countries in the South (namely Greece, Italy, Portugal, Malta, and Cyprus) having formalistic and slow court systems. It takes roughly 800 days to resolve a simple commercial dispute in the countries of the European South, double the time needed in the EZ core. Data from the European Justice Scoreboard that provides a much more analytical overview of the performance of courts across Europe suggests that the problem of delays is even more pronounced when one focuses on cases pending in administrative courts; for example in Greece  it takes more than 3 years to resolve a straightforward dispute in Greece (Papaioannou and Karatza 2016).

Figure 1. Institutional gap across the Eurozone

Figure 2. Court inefficiencies across the Eurozone

Institutional divergence

The institutional gap across EU-EZ member states is not news and by no means a recent phenomenon. Due to historical, cultural, geographical and other deep-seated reasons, EU and EZ member countries have followed heterogeneous economic and institutional development paths.4 Yet two aspects have not received much attention.

The First-Phase: Economic convergence without institutional convergence

During the transition period in the 1990s and during the initial years of the single currency (roughly 2000-2007), the economic convergence in the European periphery was not accompanied by any noticeable improvement in national institutions; corruption remained relatively high across most countries in the European south, legal quality even deteriorated in Italy and in Greece, tax evasion remained high, and the performance of public administration and local bureaucracies remained at low levels. So while institutional and economic development usually goes in tandem (as in the case of former communist countries), this is not what we observed during 1993-2007 in the initial EZ member countries. If anything, there was a slight deterioration in institutional capacity of most countries in the periphery and across many dimensions. Figure 3 shows the evolution of the World Bank’s control of corruption index in Spain, Italy, Portugal, and Greece from 1996 till 2014. After some improvement in the late 1990s, there is clear deterioration. A similar pattern emerges when one examines the evolution of the rule of law index that captures the quality of property rights and contractual institutions and the index of government effectiveness. By contrast, the control of corruption, rule of law, and government effectiveness indicators are quite stable in the countries of the core.

Figure 3. Evolution of control of corruption in the European south

Institutional persistence can explain part of the continuation of the institutional gap across the EU; yet EU and EZ policies did not help. There were at least four policy mistakes:

  1. To start with, the Maastricht Treaty and the Stability and Growth Pact criteria and rules that set the stage for the currency union in the 1990s focused myopically and exclusively on outcomes (e.g., inflation rates, fiscal targets) rather than on improving the associated institutional environment of members states (Papaioannou 2015). The targets were purely fiscal and monetary and there were no specific goals to improve the institutional environment of conducting business. And while in the 1990s the countries of the periphery did implement some reforms, mostly on product markets, to meet the Maastricht Treaty targets, the reform effort tuned down and eventually got abandoned when countries joined the Eurozone (see also Fernandez-Villaverde et al 2013).
  2. There was not much effort by EU-EZ bodies (Commission, ECB, the European Parliament, and the Council) to improve dysfunctional institutions, even though administrative red tape, corruption, and slow courts were interacting with EU policies. For example many member-states in the South and in Eastern Europe could not fully absorb EU structural funds aiming to improve infrastructure and welfare states due to slow, inefficient, and corrupt local bureaucracies. So not only did the EU fail to set up specific institutional targets, but it did not seem to bother much, even when ineffective national institutions were impeding EU policies.
  3. While institutional reform was part of the Lisbon Agenda of 2000 that aimed to make 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”, these reforms and ideals were abandoned. The Lisbon Agenda as it stands is arguably one of the biggest EU failures.    
  4. At the national level, the fall in interest rates in the periphery led to capital flow bonanzas, investment spikes (mostly in non-tradeable sectors), and an associated decline in unemployment; thus the local political establishment did not prioritise institutional reform. Thus, unfortunately, the countries of the EZ periphery are forced to undertake institutional reform amidst deep recessions, something quite challenging for the political establishment.   

The crisis and institutional divergence

The crisis uncovered the institutional deficiencies of the European periphery that somehow were hidden by the robust foreign-capital-driven growth of Greece, Ireland, Spain, and Portugal in the period 2000-2007. As the crisis intensified and countries demanded huge external financial support packages, attention shifted to growth prospects, as this is a crucial element in any debt sustainability analysis. The market’s focus was on tax evasion and the size of the shadow economy, as they matter crucially for debt sustainability.5 EU and national policymakers started delving into the institutional details as it became apparent that tackling corruption, improving public administration, reforming legal protection of investors, and speeding-up the judicial process were necessary conditions for a recovery.

Figure 4a shows the sizable differences in courts’ delays at the beginning of the crisis between core countries (in blue bars) and periphery countries (in red bars). There are massive delays in Italy and Greece, with Portugal, Spain, and Ireland following. Yet, as Figure 4b that plots the data in 2014 illustrates, things have not improved. Actually the situation in Greece has deteriorated sharply due to the interactive effects of the deep recession that increased incoming cases and troika’s policy to lowered courts’ funding and cut judges’ compensation. The same applies when one looks at courts’ ability to deal with bankruptcy and insolvency. World Bank’s Doing Business around the World Statistics show that the time spent in bankruptcy in Greece has increased from roughly 2 years (in 2008) to 3.5 years (in 2014), while mean recovery rates have fallen from 46% to 34%.

Figure 4a-b. Courts’ inefficiencies before and after the crisis

This pattern of institutional deterioration in the European South over the crisis years applies when one looks at other indicators capturing distinct (though related) aspects of local institutional capacity. For example, Figures 5a-5b tabulate the mean values of the control of corruption and rule of law indicators in 2007 and in 2014 for the three EZ group countries – core, periphery, and former transition.

Figure 5a-b. Control of corruption and rule of law before and after the crisis

Arkolakis et al (2016) provide further evidence of a deterioration of the institutional environment in Greece and other countries of the European periphery during the crisis. For example the ranking of Greece in the rankings of the Global Competitiveness Indicators of the World Economic Forum has fallen from 67 (out of 134 countries) in 2008-2009 to 91 (out of 148 countries) in 2013-2014. The drop is especially pronounced in the ‘institutions’ subcategory were Greece’s rank fell from 58 to 103.

Consequences of institutional gap and divergence

The apparent and growing institutional gap between the core and periphery (and also the former communist countries) has important implications for the functioning of the EU and the Eurozone for at least two reasons.

First, the institutional gap maps into non-negligible differences in output, productivity, labour utilisation, and unemployment, between the core and periphery. A voluminous theoretical and empirical literature provides ample evidence that institutional quality – namely sound investor’s protection, efficient judicial processes and courts, absence of red tape, control of corruption, and state capacity to enforce contracts and collect taxes – matter crucially for productivity (see for an overview Acemoglu et al 2005, Acemoglu and Robinson 2012, Besley and Persson 2012, La Porta et al 1997, 1998, Djankov et al 2003). The resulting gap in economic performance has contributed to the large European balance of payment imbalances (trade deficits in the periphery financed with capital from banks in the core), which have been a key driving force of the crisis (Baldwin and Giavazzi 2015).6 One should stress here that research shows that institutions are crucial for total factor productivity (‘new growth-style’) growth, as they are disproportionally more important for exports, entrepreneurship, innovation, and the process of creative destruction. It is no coincidence that the severity of the crisis and length of the economic downturn map almost one-to-one to institutional deficiencies and the associated current account deficits in the beginning of the crisis (see also Micossi 2016).

Second, malfunctioning national institutions in many EU-EZ countries and the resulting institutional heterogeneity impede the conduct of EU-EZ policies, as their implementation depends on local institutional structures and member countries’ state capacity. For example, the enforcement of EU legislation (EU Directives and EU Regulations) on a variety of issues, related to product markets, financial intermediation, industrial policy, depends on national courts, parliamentary acts, and administrative actions. Another example of how failing national institutions block EU-EZ reforms comes from the Economic Adjustment Programs (EAP) that Greece, Ireland, and Portugal had to undertake as well as the strict EU policy guidelines in Italy and Spain. Many provisions and policies detailed in the EAPs on strengthening tax collection mechanisms, reducing red tape for businesses and entrepreneurs depend crucially on local public administration, courts, and state ability to convert wills and laws into action. So the partial – at best – success of those programs should not be surprising, as they initially just set some fiscal and economic targets without delving into the institutional frictions. Greece’s initial EAP in the spring of 2010 is perhaps the most illustrative example of a program based on nominal targets that would be met with salary and pension cuts, tax hikes, and public expenditure freezes that ignored the malfunctioning Greek courts and inefficient public administration. As the IMF (2013) acknowledged in its self-assessment of the Greek program, a key policy mistake was to underestimate the country’s state capacity to enforce legislation.

An example: Dealing with private debt

It has become apparent that the Eurozone has to deal with the large stock of private debt that increased considerably in the euphoria years before the crisis (CEPR 2014).7 Dealing with private sector’s debt (households, corporates) is crucial as many firms are faced with a debt overhang issue that drags investment. Moreover, European banks seem to hold large amounts of non-performing loans on the books and resolving this issue is desperately needed in some countries – most notably Greece (but also Italy) – where banks have stopped lending to new firms and entrepreneurs. There are now calls to EU-EZ institutions to design pan-European policies and plans to deal with private debt and promote restructuring-reprofiling. Yet what is well-understood is that the success of any European-wide plan and regulation dealing with private debt will depend not so much on the design but on its enforcement by EU-EZ member states’ insolvency and bankruptcy institutions. As Figure 6 shows there is massive heterogeneity on the performance of bankruptcy and insolvency practices across the EU and the Eurozone. In Greece dealing with bankruptcy takes more than 3.5 years and quite often more than 6 years (Papaioannou and Karatza 2016) and recovery rates are well below 40 cents on the euro. Time spent in bankruptcy is high and recovery rates are also low in Malta, France, and Luxemburg. The scatter-plot illustrates that with the exception of Ireland where the process is fast and the cost low, all countries of the EZ periphery (and all countries of the European South) are on the bottom-right of the figure with slow and inefficient processes. Moreover, in many countries, insolvency is dealt-with by professionals and specialised judges, while in other countries there are no specialised procedures. And in many nations, mostly in the North, the focus is on reorganisation and restructuring, while in most countries in the South the bankruptcy code is focused on liquidation. Given those large differences in bankruptcy and insolvency practices around the Eurozone, it is hard to see how a common policy can succeed across member states. If Europe is to deal with the perils of private debt, it needs to move beyond EU Directives and/or Regulations; it is vital to reform the anachronistic, formalistic, and in many cases absurdly slow legal institutions in the South (and also in France and Luxemburg).

Figure 6. Bankruptcy-insolvency practices across the Eurozone

The way forward

Institutional reform at the EU-EZ level and institutional convergence towards best-practices should be at the top of the priority list of European leaders and policymakers. Institutional change at both the EU and the national level is desperately needed, if Europe is to meet the growing challenges faced by globalisation (competition from industrial and emerging markets, migration), avoid destruction, and fulfil the needs and aspirations of its citizens. While institutional redesign and reform at the EU-EZ level are currently implemented and debated, there is not much discussion and action on designing a concrete, thorough, and ambitious plan of improving national institutions so as to close the persistent and, if anything, growing institutional gap across the EU and the EZ. This has to change. In this regard the EU-EZ should consider the following:

  • To begin with, the EU needs to set a clear, ambitious, and succinct program aiming to address the large institutional differences across the EU, focused on improving governance, promoting growth, and raising equity. 
  • Consider establishing a European-level Institute that will monitor institutional performance and state capacity across the EU and the Eurozone.8 This Institute should produce league tables and thorough statistics measuring institutional capacity and reforms in a wide range of areas, such as product markets, regulation, state administration, courts, etc. The European Justice Scoreboard can serve as a starting point, though the analysis has to be more far-reaching and in-depth. This Institute should produce annual reports that should be submitted to the European Parliament, National Parliaments, and the Council of Heads of State.
  • EU structural funds – and even subsidies in agriculture – should be linked to well-defined reforms of national institutions. The current system, where the EU finances infrastructure projects mostly in Southern and Eastern Europe (that are plagued by corruption) is a disgrace; and it contributes to the rising distrust of citizens towards Europe.
  • Likewise, any debt forgiveness and reprofiling (in Greece or elsewhere) should be linked to countries meeting well-defined targets on improving legal protection of shareholders and creditors, removing administrative barriers to entry, reducing legal formalism, and safeguarding the independence of public administration.
  • The EU should even consider altogether blocking transfers to member states when national governments do not safeguard basic EU liberties and values, such as interfering with the independence of the judiciary or other independent national agencies.
  • The EU should offer direct technical and financial assistance to member states in improving the functioning of public administration and courts. After identifying best-practices across the EU and with the assistance of the Institute, the EU could assist in the transfer of knowhow, covering all the expenses. 
  • Currently there is little – if any – coordination between the European and the National Parliaments, and the power is mostly in the hands of the executive branch of the EU, the Commission, and the Council. Perhaps the EU Parliament can get a more active role in promoting institutional reform across EU-EZ member states.

One could clearly come up with additional proposals. Yet it is of utmost importance for Europe to address the institutional gap  – citizens are becoming quite distrustful towards the EU as well as local institutions, courts, political parties, and politicians. And this distrust is also quite heterogeneous, with much higher levels in the South than in the core.9

Conclusion

It is hard to imagine an ‘ever closer union’ in Europe with the currently large institutional gap in courts, public administration, red tape, corruption, and fiscal capacity. The asymmetries in national institutions across the Eurozone are destabilising both because they impede real economic convergence and because EU-EZ policies’ depend crucially on local institutional structures, disparities and imbalances.

Referring to the adjustment program of Greece and the slow progress in reforms, the German Finance Minister Wolfgang Schäuble recently (January 2016) said to the Greek Prime Minister “It is the implementation, stupid!” He and his colleagues should not be mistaken, though; policy implementation depends, more than anything else, on sound institutions. And Europe has done little to assist Greece and the other countries of the EZ periphery to reform their malfunctioning institutions. “It’s the institutions, stupid!”

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, Volume I, P Aghion and S S Durlauf, eds, Amsterdam, Netherlands: North-Holland.

Acemoglu, D and J A Robinson (2012) Why nations fail? The origins of power, and prosperity, Crown, New York and London.

Arkolakis, C, A Doxiades and M Galenianos (2016) “The challenge of trade adjustment in Greece”, in Reforming the Greek economy, MIT Press, C Meghir, C Pissarides, D Vayanos, N Vettas, eds, Forthcoming, May 2016.

Artavanis, M and Tsoutsoura (2016) “Measuring income tax evasion using bank credit: Evidence from Greece”, Quarterly Journal of Economics, forthcoming.

Baldwin, R and F Giavazzi (2015) “The Eurozone crisis: A consensus view of the causes and a few possible solutions”, Introduction in The Eurozone Crisis: A consensus view of the causes and a few possible solutions, by R Baldwin and F Giavazzi, VoxEU.org, September.

Baldwin, R, T Beck, A Bénassy-Quéré, O Blanchard, G Corsetti, P de Grauwe, W den Haan, F Giavazzi, D Gros, S Kalemli-Ozcan, S Micossi, E Papaioannou, P Pesenti, C Pissarides, G Tabellini and B Weder di Mauro (2015) Rebooting the Eurozone: Step 1 – Agreeing a crisis narrative, CEPR, Policy Insight No. 85.

Besley, T and T Persson (2010) Pillars of prosperity. Princeton Univesrity Press, Princeton, NJ. USA.

Buttiglione, L, P Lane, L Reichlin and V Reinhart (2014) “Deleveraging? What deleveraging?” Geneva Reports on the Global Economy, CEPR ad International Centre or Monetary and Banking Studies.

Corsetti, G (2015) “Roots of the EZ Crisis: Incomplete development and imperfect credibility of institutions”, in The Eurozone Crisis: A consensus view of the causes and a few possible solutions, by R Baldwin and F Giavazzi, VoxEU.org, September.

CEPR (2015) “A new start for the Eurozone: Dealing with debt”, Monitoring the Eurozone 1, by G Corsetti, L Feld, P Lane, L Reichlin, H Rey, D Vayanos, B Weder di Mauro, CEPR.

Djankov, S, R La Porta, F López-de-Silanes and A Shleifer (2003) "Courts", Quarterly Journal of Economics, 118(2): 453-517.

Djankov, S, C McLiesh and A Shleifer (2008) “Debt enforcement around the world”, Journal of Political Economy. 116(6): 1105-1149.

European Commission (2014) The European Justice Scoreboard.

Guiso, L, H Herrera and M Morelli (2016) “Cultural differences and institutional integration”, Journal of International Economics, forthcoming.

Guiso, L and M Morelli (2014) “Fixing Europe in the short and long run: the European Federal Institute”, VoxEU.org, 3 November.

Guiso, L, P Sapienza and L Zingales (2016) “Monnet’s error?”, Economic Policy, Forthcoming.

Fernadez-Villaverge, J, L Garicano and T Santos (2013) “Political credit cycles: The case of the Eurozone”, Journal of Economic Perspectives, 27(3): 146-166. 

International Monetary Fund (2013) Greece: Ex-post evaluation of exceptional access under the 2010 stand-by arrangement, IMF Country Report 13/156, June.

Liu, Y and C B Rosenberg (2013) “Dealing with private debt distress in the wake of the Euopean financial crisis”, IMF Working Paper, WP/13/44.

Kaufaman, D, A Kraay and M Mastruzzi (2010) “The worldwide governance indicators: A summary of methodology, data and analytical issues", World Bank, Policy Research Working Paper No  5430. 

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.

Markellos, R, D Psychoyios and F Schneider (2016) “Soverign debt markets in light of the shadow economy, European Journal of Operational Research, forthcoming.

Micossi, S (2016) “Flawed real adjustment mechanisms in the Eurozone”, in Rebooting the Eurozone, edited by Richard Baldwin and Francecso Giavazzi, VoxEU.org, February.

Nunn, N (2014) “Historical persistence”, in The Handbook of Economic Growth, Volume II, P Aghion and S S Durlauf, eds, Amsterdam, Netherlands: North-Holland.

Papaioannou, E (2013) “Trust(in) Europe?”, Centre for European Policy Studies Report. 

Papaioannou, E (2015) “Nominal rather than institutional convergence in the Eurozone”, in The Eurozone Crisis: A consensus view of the causes and a few possible solutions, by R Baldwin and F Giavazzi, VoxEU.org, September.

Papaioannou, E and S Karatza (2016) “The Greek justice system: Collapse and reform”, in Reforming the Greek economy, MIT Press, C Meghir, C Pissarides, D Vayanos, N Vettas, eds, Forthcoming, May.

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Footnotes

1 See Sapir and Wolf (2015) and Guiso and Morelli (2014) on the European Financial Institute proposal.

2 For example the key issue of a common deposit insurance scheme has been postponed and the ESM’s funds are quite small given the size of the countries in the ‘danger zone’ (Italy, Spain).

3 See the estimates in Schneider et al (2011). In a novel study that compares declared with estimated-by-banks income of professionals in Greece, Artavanis et al (2016) estimate that non-reported professionals’ income in Greece was around 28 billion euros in 2009. The foregone revenue is around a third of the record-high fiscal deficit of 2009 that exceeded 15% of GDP.

4 See Acemoglu et al (2005) and Nunn (2014) on institutional persistence and on the historical origins of contemporary development.

5 See Markellos et al (2016) for the role of the informal sector and the shadow economy on sovereign debt markets.

6 See Arkolakis et al (2016) for the link between economic institutions, trade deficits, and misallocation, focusing on Greece.

7 See Liu and Rosenberg (2013) and Buttiglione et al (2014) for an overview and some descriptive evidence.

8 In principle the EU Commission could undertake this responsibility, perhaps establishing a new Directorate. Yet currently the Commission lacks vision and necessary capacity to undertake this goal.

9 See Papaioannou (2014), Guiso et al (2016), and Guiso et al (2016) on the European trust crisis and the link between heterogeneity in beliefs and institutional divergence.

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Topics:  EU institutions EU policies Europe's nations and regions

Tags:  EU, EZ, eurozone, Greece, institutional gap, institutions, weak institutions, reform, Corruption, rule of law, core, periphery, court inefficiency

Professor of Economics, London Business School; CEPR Research Affiliate

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