Time to reform institutions

Posted by on 9 May 2012

Europe needs to move on beyond austerity and stimulus, and focus on reforming its institutional system that will address the misplaced incentives and the dependency mentality, and restore proper market signalization that will enable new patterns of specialization and increase productivity. 

There has been too much backlash between proponents of austerity and proponents of a fiscal stimulus. In a wide array of evidence from either sides of the debate (Alesina and Giavazzi
 leading the argument on one side and DeLong on the other in the VoxEU debate), they all certainly have merit, but they seem to miss an important point.

The debate needs an approach from another side of the political economy spectrum – the new institutional and free-market perspective calling for institutional reforms. Reforms that will address misplaced incentives in the labour market, the dependency mentality, and the non-functioning of basic state institutions. By doing so they could be able to restore proper market signalization that will enable new patterns of specialization and increase productivity.

Structural reforms are being called for by both sides of the argument, but no one really puts too much emphasis on them. They are pictured as a natural outcome of the respective policy in place, whether austerity or expansion. Alesina, for example, calls for “spending-based consolidation accompanied by the right policies”. These right policies include “easy money policy, liberalization of goods and labour markets, and other structural reforms”. On the other hand, DeLong emphasises the importance of “credible plans for long-run fiscal balance, structural reforms to free-up enterprise and increase opportunity, along with reforms of the social-insurance state”, all to come as a consequence of consolidation after the economy gets injected with more funds and the state supports its growth.

But so far, no one has been precise in how to achieve these structural reforms. They won’t follow automatically after austerity or fiscal expansion; they must be initiated by “market-augmenting governments” (Olson, 2000).


Where to start from? Political stability.


In their newest book, “Why Nations Fail”, Acemoglu and Robinson devise an entire framework that explains the success and failure of nations through the prism of politics. They make a strong and robust claim that the inclusiveness (as opposed to extractiveness) of political institutions will enable inclusive economic institutions and hence form a road to prosperity.

Peripheral Eurozone nations created a strong shift towards extractive political institutions in the past decade. The main goal of those in power was to preserve this position via populist redistributive policies. As a result they created misplaced incentives among both businesses and the population. They created a ‘dependency mentality’ leading to severe loss of competitiveness in the labour market, primarily through the loss of productivity. Businesses on the other hand received incentives that would guide them towards competing for political favours instead of competing for customers in the marketplace. Economic institutions were set up to support those with political power.

More research would need to be done in order to prove the potential causality between a set of extractive political (and economic) institutions and the sovereign debt crisis in which the peripheral Eurozone economies found themselves in. Even though existing instabilities in the labour market and the fiscal profligacy did put the system in potential danger of outside contagion, CA deficits caused by the common currency played a big role as well. It was a vicious combination of these followed by outside contagion that (additionally) worsened fiscal balances of the periphery.


Political stability will be harder to achieve in some countries (particularly with the rising sense of injustice among the people who will more and more opt for radicalization and a nationalist agenda). What the government can really do in this case is to restore the belief in the system by maintaining a stronger grip on the rule of law. It must act as an enforcer of contracts in order to signal greater stability to both foreign and domestic investors. The inefficiency of the state (particularly in collecting revenue) should be the primer goal of austere governments. If cuts would imply better efficiency, so be it.

The next step building on the public sector reform is the aforementioned liberalization of the labour market. The emphasis should be on creating favourable incentives to businesses by making the labour market rules much less rigid.

But where the government should restrain itself is from any attempt of trying to steer the economy, either through picking winners, guiding investment incentives or controlling the prices of loans. Signals for new specialization, trade and production should be left to the market to comply with in a slow, yet necessary restructuring process, supported by the new institutional setting. This is the only way to enable a productive resource allocation, removed from any distortion signals and able to attract capital. The banking system will follow upon the positive signs of confidence and stability in the economy, reducing capital flight and gradually improving their balance sheets and preparing more money to foster economic activity. 

All other attempts of internal or external devaluation won’t do any good since the problem isn’t in relative prices or wages but productivity. Neither will any counter-cyclical fiscal or monetary policy aimed at closing the nominal GDP gap, since it will only restore the pre-crisis status quo. Austerity on the other hand is failing in its basic premise of restoring confidence. As for the option of dissolving the euro and with it the entire Union, this will undermine the basic assumption of political stability in order for the reforms to kick in. It would take Europe much longer to consolidate after that.

Europe should turn to pro-market institutional reforms that will reduce distortive signals in the economy and create space for market led specialization and investment. This path is applicable to any country that found itself constrained by extractive political institutions that supported an unsustainable welfare state model of debt accumulation, high CA deficits used to finance consumption instead of production, fiscal profligacy, corruption and high levels of state intervention. 



Acemoglu, D. and Robinson, J. (2012) Why Nations Fail: The Origins of Power, Prosperity, and Poverty. New York: Crown Publishing

Alesina, A. and Giavazzi, F. (2012) "How is as important as how much", VoxEU.org, 3 April

DeLong, J. Bradford (2012) "Spending cuts to improve confidence? No, the arithmetic goes the wrong way", VoxEU.org, 6 April

Kling, A. (2012) "Patterns of Sustainable Specialization and Trade. A Smith-Ricardo Theory of Macroeconomics" Adam Smith Institute report, London

Olson, M. (2000) Power and Prosperity. Outgrowing Communist and Capitalist Dictatorships. New York: Basic Books


The views in this article are those of the author alone, and are not necessarily shared by any of his employers or affiliations. 

Vuk Vukovic