Reforms: Love them for the long term

István Székely, Melanie Ward-Warmedinger 23 February 2019

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With global convergence at its fastest rate ever, getting ahead via well designed and growth enhancing reforms is paramount. Still, faced with complex or politically costly reforms, countries may drag their feet. Worse, there is a growing number of reform reversals, where countries have backtracked on even fundamental reforms. 

Reversals have involved ‘best-practice’ institutions, already in place for over 20 years. Substantial fiscal (or other) benefits have apparently outweighed the high costs of reversal, which fall on later governments. Reversal episodes have shown that legislations can be re-written (‘formal’ reversals), or that the way institutions operate within the existing rules can be changed (‘behavioural reversals’), unaccompanied by democratic debate. The economic consequences of reversals may be hard to assess, may go unnoticed in the short term, or may occur in opaque policy areas. The reactions of market participants, households and firms have not been strong enough to condition national policymakers’ actions.

We argue that in order to endure, reforms have to be accompanied by and keep pace with social learning. In other words, they have to be cherished and nurtured by a society which ultimately understands and values their benefits. This social learning needs to be sufficiently strong to outweigh the opportunistic behaviour of politicians seeking windfalls and increased powers. 

Social learning as a quality assurance

Self-enforcing social norms are important in driving society’s acceptances and aversions, which in turn help to ensure that institutions gradually evolve towards more perfect institutions, in a sort of experimental way (Roland 2001). Thus, some flexibility in the national design of institutions is important. 

Social norms emerge bottom up via social learning (Rotter 1954, Young 2015), shaped by reinforcement effects. The likelihood of reinforcement, multiplied by its positive or negative value to an individual or group, determines the likelihood that a particular behaviour is performed. Through this process, a social norm emerges and effectively guides societal behaviour. 

More complex is the concept of parallel social norms and social learning processes. Here, two communities with different characteristics may assess the same objective situation differently. Research on artificial intelligence has shown that if the intensity of interaction between two communities declines below a critical level, parallel norms can emerge and become stable (Sen and Airiau 2007). Regional concentrations of foreign direct investment, tourism, or immigrant populations may reinforce such an effect. Market forces can produce strong agglomeration effects, supporting particular migration routes and bringing global forces much closer to societies. Development funds may promote development, but also expose isolated communities where market forces were less prevalent to external norms and learning.      

Economists tend to assume that policies are optimal and fully credible. So, once reforms are introduced, self-enforcing social norms and social learning should catch up with the new reality fast enough to create domestic anchors for them. The reversals we have studied show things to be very different. In many cases, social learning has been slow and most institutions remained fragile, vulnerable to the attempts of special interest groups to capture them. For the same reason, laws and institutions created to promote good policies could fulfil this role only to some degree. Furthermore, the design of some reforms or institutions were less than perfect, causing unforeseen negative side effects that were not carefully monitored and addressed at the implementation stage.

Documenting reversals in former transition countries

While there is a huge literature on the political economy of reforms (Abiad and Mody 2005, Campos and Coricelli 2009, Iancu and Ungureanu 2013), little attention has been paid to reform reversals. In a recent study (Székely and Ward-Warmedinger 2018), we find strong evidence of both formal and behavioural reversals in former transition countries that joined the EU after 2004. 

Reversals are not unique to former transition countries, nor to countries within the EU, but these experiences offer important lessons because the former transition countries implemented reforms that were unprecedented in terms of their depth and scope within just one generation. For many, the desire for a higher standard of living, to be anchored to the West and to enter the EU, spurred major reform waves and led to the very rapid introduction of institutions that had evolved as a best practice in highly developed countries. 

Although social learning accompanied this process, in many former transition countries it was not fast enough to keep pace with the rapid reforms, leaving new best-practice institutions with social norms that were not sufficiently strong to maintain them (e.g., the fiscal systems in Romania or Poland, banking supervision in Bulgaria or Slovenia). As a result, wide-spread reform reversals emerged in the region. 

It was frequently the interaction of reversals in different sectors (fiscal, pension, financial) that created a full-blown reform reversal episode. Partial and opportunistic reversals took place where governments were weak and the economic implications were not felt immediately (such as pension reforms in Hungary, Romania or Poland). In contrast, major and multifaceted reversals required strong and stable governments. While the crisis undoubtedly made countries more prone to reversals, even fundamental reform reversals occurred when a country had weathered the crisis well and where inequalities had declined (e.g., Poland). 

The banking sector seemed particularly prone to behavioural reversals, both in public and private institutions. Again, the interplay of behavioural reversals in different areas (banking supervision, private and state-owned banks, non-bank corporations) led to full-blown reversal episodes. The rather low level of transparency and public scrutiny (e.g., the restricted access to decision making in banking supervision, central banking or state-owned banks in these countries) may have provided a convenient veil for forces seeking reversals in financial institutions. Public scrutiny of private banks was perhaps even weaker and the degree of transparency lower. Behavioural reversals were also, by nature, more difficult to detect, sometimes remaining latent for a long time before a major event (such as the collapse of a large bank). This lack of transparency may also explain why social norms could not prevent reversals that turned out to be so costly for society, and why vested interests, for which the sizable direct gain could overrule norms, could drive reform reversals so far.  

Well-designed fiscal systems, national or European, are thought to be the best anchor for fiscal policy and an efficient way to limit myopic political intentions. However, if social norms are not sufficiently strong, such fiscal systems, even if they are close to best practice, may have limited impact. When fiscal rules and systems are sufficiently strong, but social norms are not, the intention to create more fiscal space may generate spillovers that lead to reform reversals in other areas. This has occurred most frequently in pension systems, but also in tax policy and in corporate governance and the control of state-owned enterprises (e.g., in Hungary or Poland). 

External actors

External actors played an important role in shaping transition (Figures 1 and 2). While the first wave of reform in the former transition countries was driven by the desire to join the West, the second wave was driven by the desire for EU membership. This entailed access to the largest market in the world, the free movement of capital and labour, and a massive, historically unprecedented, financial support to promote convergence (Keereman and Székely 2010). It also came with a number of obligations and mechanisms that monitored and enforced their fulfilment. This increased and made tangible the perceived cost of a policy reversal, which carried with it the risk of being left out of the EU enlargement process. The public viewed such a possible outcome as very negative. The EU also acted as a strong anchor that could prevent or reverse formal reform reversals in areas covered by EU law, but could play a much weaker role in stopping behavioural reversals.

Figure 1 Reform space filled by countries in the first wave of EU enlargement, 1989-2004   

         

Figure 2 Reform space filled by countries in the second wave of EU enlargement, 1989-2007

 

Note: The vertical axis shows the percentage share of reform space filled with measures, a multidimensional space spanned by the six individual subcomponents of the EBRD transition index. The space filled is the product of the individual indices, each measured as a percentage of the maximum progress in that area. The space is fully filled (=100) if all subcomponents reach the maximum value and remains zero as long as any of the subcomponents remains at the minimum value.  
Source: Authors' calculations based on EBRD Transition Index

The literature on institutional monocropping (Evans 2004) recognises problems in the adoption of institutions in less developed countries that have evolved in other social environments. Developments in the first phase of transition, when Washington institutions were the key external anchoring institutions, are well captured by this literature. In the second phase, while social learning about the new rules and institutions and their broader implications may have catalysed reversals, experiences suggest otherwise. Rather, there seems to have been a lack of sufficient social learning following EU accession. The rules and institutions emanating from the common EU law have apparently not yet shaped the identities and mentalities of a sufficiently large part of society in some of these countries. At the same time, opportunistic reversals in the Baltic countries were stopped or undone.   

Conclusions

Our analysis naturally leads to the conclusion that the ultimate solution to prevent reform reversals is to accelerate social learning processes, particularly among parallel communities. Experiences suggest that both the introduction of initial reforms and the duration of the reform process would benefit from stronger national debate to develop a sovereign national understanding and collective memory of the reasons for the optimally chosen design.  It is also important to focus on the quality and internal coherence of reforms and newly created institutions and to carefully monitor their functioning to detect behavioural reversals as early as possible. External anchors can stop or reverse certain types of reversals, but not replace such domestic anchors.  

In the meantime, those countries who turned their back on earlier reforms have seen some of the others in their peer group continue on the path and pull ahead economically.

References 

Abiad, A and A Mody (2005), “Financial reform: What shakes it? What shapes it?”, American Economic Review 95(1): 66-88.

Iancu, D C and M Ungureanu (2013), “Conditionality and reform reversal: The case of the Romanian civil service”,  Draft paper presented at the NISPAcee conference, Belgrade. 

Campos, N F and F Coricelli (2009), “Financial liberalization and democracy: The role of reform reversals”, IZA discussion paper 4338.

Evans, P (2004), “Development as institutional change: The pitfalls of monocropping and the potentials of deliberation”, Studies in Comparative International Development 38(4): 30-52.

Keereman, F and I P Székely (eds.) (2010), Five years of an enlarged EU: A positive sum game, New York: Springer. 

Roland, G (2001), “Ten years after... transition and economics”, IMF Staff Papers 48: 29-52.

Rotter, J B (1954), Social learning and clinical psychology, New York: Prentice-Hall.

Sen, S and S Airiau (2007), “Emergence of norms through social learning”, IJCAI'07 Proceedings of the 20th international joint conference on Artificial Intelligence 1507-1512

Székely, I P and M Ward-Warmedinger (2018), “Reform reversal in former transition economies (FTEs) of the European Union: Areas, circumstances and motivations”, IZA policy paper 142.

Young, H P (2015), “The evolution of social norms”, Annual Review of Economics 7: 359-387.

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Topics:  Development EU institutions Europe's nations and regions

Tags:  reform reversals, institutions, former transition countries, EU, social learning

Principal Advisor, DG ECFIN, European Commission and Honorary Professor, Corvinus University of Budapest

Policy Coordinator, DG-ECFIN, European Commission

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  • 17 - 18 August 2019 / Peking University, Beijing / Chinese University of Hong Kong – Tsinghua University Joint Research Center for Chinese Economy, the Institute for Emerging Market Studies at Hong Kong University of Science and Technology, the Guanghua School of Management at Peking University, the Stanford Center on Global Poverty and Development at Stanford University, the School of Economics and Management at Tsinghua University, BREAD, NBER and CEPR
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