Every time a country is financially troubled, those who have to reluctantly chip in for its rescue are quick to prescribe “structural reforms” as the cure to all ailments. The problem however is that neither can they spell out what these reforms consist of, beyond vague statements on tax or labour market reform, nor how they can be successfully implemented.
The difficulty of carrying out structural reforms often lies in their timing. Akin to what happens in the corporate world, restructuring in the short-term is usually associated with higher costs and lower revenues, which in a distressed situation requires additional funding; something reluctant lenders typically abhor. Another hurdle is the diminishing degrees of national freedom in an ever-intertwined world. This is most patent in the Eurozone. With a common currency that is de-facto alien to its members, monetary policy dictated by the ECB and fiscal finances constrained by the Fiscal Compact, the actual willingness to implement deep reforms lies on the lending syndicate and not on the ailing country itself.
The labour reforms in Germany and Spain serve well to illustrate the previous two issues. The much praised Hartz reform in Germany took place at a time when unemployment was close to 10%, the economy was enduring a very mild recession and at a time when Maastricht’s deficit rules were perceived as facultative only. The Spanish reform on the contrary was put through when the country’s unemployment was at 26%, experiencing a deep and prolonged recession, with public deficit skyrocketing beyond -10%. Whilst Germany’s reforms was on its own initiative, the Spanish one was partly imposed by the Eurogroup in exchange for bailing out the nation’s banks.
Financial constraints apart, many nations find themselves trapped in an economic straightjacket that considerably limits the scope of reform. When countries choose to belong to multi-lateral trade organizations – particularly the EU – they agree not to provide state aid to national industries. However, a restriction aimed at preventing trade to happen in uneconomic terms causes a side-effect in which nations end locked in their position within the global value chain. In the past, countries like France, Japan, Korea, or more recently China, have nurtured “infant industries” in sectors like defence, electronics, shipbuilding or steel, but this option is no longer available. This abstinence is to be welcomed if you are higher up in the chain, but is costly when you are at the bottom. The optionality to change your economic model has economic value, and writing it off means a greater loss for those countries that can gain the most from using it.
When it comes to structural reforms, the EU offers both the best parable, and the greatest of all ironies. Countries that have lost all degrees of financial and economic freedom are being compelled to make structural reforms they have little room for implementing. All this is requested by the very countries that are avoiding reform – think of France – partly thanks to the windfalls enjoyed from the status quo: mainly cheaper funding, a weaker though widely accepted currency and internal leading positions in industries with high capital barriers. It should not come as a surprise then that an economic literate country like the UK is seriously considering whether regaining degrees of economic freedom makes more sense than remaining glued to the pack.
Fernando de Frutos, MWM Chief Investment Officer
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