Is there a “reform fatigue” in the euro area?

Economic Modelling 26 (2009) 767–777

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Economic Modelling j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / e c o n b a s e

Is there a “reform fatigue” in the euro area?☆ Athanasios Vamvakidis ⁎ International Monetary Fund, 700 19th Street N.W., 20431, Washington DC, United States

a r t i c l e

i n f o

JEL classification: F41 O38 O52 Keywords: Economic reform Monetary union Euro area

a b s t r a c t The absence of monetary policy within a currency union increases the need for structural reforms that make the participating economies more flexible. However, the absence of exchange rate risk with respect to the other members of the union may reduce the urgency for such reforms. A number of other considerations also suggest that theory is ambiguous about the impact of participating in a currency union on progress in structural reforms. This paper addresses this issue empirically for the euro area. The results suggest that reforms in the euro area seem to have decelerated following the introduction of the euro, but from a fast pace. The paper discusses a number of possible explanations, including “reform fatigue,” the absence of “market punishment,” and “good-times” complacency. Estimates from an empirical growth model suggest that the slowing of reforms may slow down annual output growth by up to 0.2%. However, the results are preliminary and depend on the area of reform considered. Furthermore, the reform dynamics may change with the euro area starting slowing at the end of 2007. © 2008 Elsevier B.V. All rights reserved.

1. Introduction Although the euro is approaching its first decade, it is still early to draw strong conclusions about its impact on economic performance. Indeed, as seen in Fig. 1, the euro area's economic performance has been mixed: improving in recent years, but after a rocky start in Germany and in France, and with Portugal and Italy stagnating. Moreover, the area started slowing at the end of 2007, following the financial market turmoil that originated in the U.S. subprime mortgage market. The short time since the introduction of the euro does not allow any meaningful econometric tests of its impact on the economies of the euro area and calls for cautious interpretation of any preliminary empirical results. Other forces, particularly the strong global cycle in recent years, the slowdown that followed the financial market turmoil at the end of 2007, and a European integration process that goes beyond the euro area are also active and do not allow one to differentiate the impact of the euro. Although the euro area has been growing at a healthy rate in recent years, so does the rest of the EU and the rest of Europe.1 Therefore, it is early to know if the euro area's economic performance is because of the euro or despite of it. Furthermore, the theory is ambiguous about the impact of the euro on economic growth. Although the common currency has most likely contributed to macroeconomic stability across the euro area, has ☆ The views expressed in the paper are those of the author and do not necessarily represent those of the International Monetary Fund. ⁎ Tel.: +1 202 6235405. E-mail address: [email protected]. 1

See International Monetary Fund (2007a).

0264-9993/$ – see front matter © 2008 Elsevier B.V. All rights reserved. doi:10.1016/j.econmod.2008.07.010

reduced transaction costs and increased trade flows, all of which should accelerate economic growth, the absence of exchange rate flexibility and independent monetary policy may result in slower growth, particularly in the presence of asymmetric economic shocks. This discussion assumes structural reforms to be exogenous, but this may not be the case. On the one hand, the economies within a common currency area have to be more flexible than otherwise, to compensate for the absence of monetary policy, particularly during asymmetric economic shocks. On the other hand, they are not subject to the market discipline provided by exchange rates. While the first calls for faster progress in structural reforms, the second allows a slower pace. This paper attempts to have a first look at the impact of the euro on the euro area's economic performance by examining the progress of structural reforms since the introduction of the common currency. Since theory suggests that joining a common currency area may create incentives that accelerate or decelerate structural reforms, this is an empirical question. The answer could clarify some aspects of the economic impact of the euro on its member countries, particularly through the channel of the incentives for structural reforms. The results suggest that reforms in the euro area seem to have decelerated following the introduction of the euro, but from a fast pace. Namely, euro area countries reformed their economies faster than the rest of the world before introducing the euro, but as fast as the rest of the world, although slower than the noneuro EU countries, afterwards. Possible explanations include “reform fatigue,” the absence of “market punishment,” and “good-times” complacency. The slowdown of structural reforms, assuming it is not reversed, is expected to lead to slower long-run growth in the euro area. Estimates

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Fig. 1. Real GDP growth in the euro area, 1995–2007.

from an empirical growth model suggest that the euro area will grow slower by up to 0.2% annually because of the slower pace of structural reforms, keeping everything else constant. Since the euro area is now reforming as fast as the rest of the world, this deceleration of growth is not enough to leave the euro area countries behind. It only suggests that if the relatively fast pace of reform before the introduction of the euro had continued, the euro area's relative position in the world economy would have been improved, keeping everything else constant. However, these results are only preliminary and indeed may change direction in the future. The reform dynamics may change if “good-times” complacency is replaced by “bad times” urgency in case of economic shocks and their asymmetric impact across the euro area. The recent financial market turmoil is an example. Concerns about vulnerabilities from large external imbalances in emerging Europe and the extent to which each euro area member could be exposed are another. Such shocks may prove the importance of being flexible within a currency union and provide incentives to accelerate reforms. It is hard to persuade the public for the need to reform in the presence of benign economic conditions such as fast world growth, historically low interest rates and risk spreads, and ample global liquidity, which described the global economy during most of the euro's life so far.2 The case for reforms becomes much stronger during a slowdown, or even more so during an economic crisis.3 The paper proceeds as follows: Section 2 discusses theoretical arguments on the expected impact of introducing the euro on the incentives for structural reforms; Section 3 discusses the data set and presents some simple correlations and stylized facts; Section 4 tests econometrically whether the euro area countries reformed faster or slower than the rest of the world before and after introducing the euro; Section 5 discusses progress in macroeconomic reforms and looks at the relative position of the euro area countries in terms of implementation of structural reforms compared with the rest of the world; Section 6 uses an empirical growth model to forecast the impact of these results on the euro area's long-run economic growth; and Section 7 concludes with caveats and policy implications. 2. Theory This section discusses theoretical arguments for the impact of membership in a currency union on the pace of structural reform. The discussion suggests that this impact can go either way, depending on

the reforms, the economic cycle, and the rules within the currency union, among other factors. It also suggests that the impact may change over time. The bottom line is that structural reforms are even more important within a currency union, but easier to postpone. What countries that are members of a currency union, including the euro area, actually do is ultimately an empirical question. Economic flexibility is a must within a currency union and therefore, reforms that increase it are of key importance. According to the seminal contribution by Mundell (1961) and the huge literature that followed it, the members of a currency union should ensure that their economies are more flexible than if they had their own currency, to compensate for the absence of a response by monetary policy when the union is hit by asymmetric shocks. They need free labor mobility within the union, openness to capital flows, and price and wage flexibility, to ensure that the factors of production move where the union's economy needs them the most, and prices, for goods, labor and capital, adjust to equilibrate demand with supply. Such flexibility helps a member of a currency union to adjust to a negative asymmetric shock, for example, by allowing labor and capital to move to countries that were not hit by the shock, while prices and wages adjust to bring the economy back to full employment. Otherwise, the production factors will be unemployed or underutilized and prices above the full employment level, which would magnify the impact and the duration of the shock, as the central bank cannot respond by loosening monetary policy. Therefore, structural reforms that facilitate the movement of factors across sectors and regions and the adjustment of prices and wages are key for reducing the vulnerability of a currency union's members to economic shocks and therefore, increasing potential growth. This suggests that progress in structural reforms should be faster in currency unions. Furthermore, structural reform is one of the few tools that a member of a currency union has to increase its competitiveness.4 As there is no local currency, price competitiveness cannot improve by a devaluation. Reforms such as liberalization of product and labor markets, simplification of business regulation, and facilitating the establishment of new businesses are some of the limited tools to keep prices in line with the ones in competitors and attract investment. Therefore, countries in currency unions may have to reform faster than otherwise in order to be competitive. However, the absence of exchange rate risk may allow countries in a currency union to postpone reforms.5 Focusing on the euro area, by “outsourcing” monetary policy to the European Central Bank (ECB), the country members benefit from low interest rates, much

2

See Vamvakidis (2007). Reforms often follow shocks and crises (see Rodrik, 1996). The discussion on financial sector reform that followed the financial turbulence from the collapse of the U.S. subprime mortgage market is an example. 3

4

See Schadler et al. (2005). See Tommasi and Velasco (1996) for a discussion of the literature on crisis-driven reforms. 5

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Fig. 2. CPI inflation in euro area countries, 1990–2007.

lower in most of them than when they had their own monetary policy, relatively low inflation and macroeconomic stability (see Figs. 2 and 3). The result has been faster economic growth, particularly in the first years after joining the euro area and for countries that used to have considerably higher interest rates. This growth “windfall” may have reduced the urgency of economic reform. Moreover, the lack of market punishment for “bad policies” makes the postponement of otherwise necessary reforms easier. Financial markets cannot “punish” a euro area country for not implementing economic reforms, or even for steps backwards in reforms, by selling its currency and forcing a devaluation. Therefore, less market discipline in the euro area, and in any other currency union, may lead to a slower reform pace, which, as explained above, would be more detrimental than outside a currency union. There are a number of other reasons why euro area members may be reforming slower after introducing the euro. The need to meet the Maastricht criteria may have led to an acceleration of reforms before joining the euro area. However, policy makers and the public may have felt that reforms did not have to progress at the same pace after the criteria were met and the countries were qualified to join the area. Although the Maastricht criteria are of macroeconomic nature, structural reforms do affect some of the targets: product market reforms can reduce the inflation rate; privatization can reduce the fiscal deficit; and most structural reforms improve market confidence on an economy and its currency. The reform progress may have moved back to its previous trend, or to an even slower pace if the efforts to join the euro area have caused a “reform fatigue”. In this case, the public may not be willing to support further reform for some time after “making it to the euro”. Preparing for the euro was a target that focused the public's minds and a vehicle for the authorities to push for reforms, but may have created a public perception that reform efforts could be relaxed afterwards. Looking forward, these arguments are even more valid for the new EU members, since in addition to preparing for joining the euro, they have recently gone though the EU harmonization process, which includes deep reforms in a large range of areas, especially for transition economies.6 6 EU candidate countries have to harmonize their regulation with the EU's acquis communautaire, which is the total body of EU law, before joining the EU. The so called acquis includes 31 chapters of regulations, including: free movement of goods, free movement of persons, freedom to provide services, free movement of capital, company law, competition policy, agriculture, fisheries, transport policy, taxation, economic and monetary union, statistics, social policy and employment, energy, industrial policy, small and medium-sized enterprises, science and research, education and training, telecommunication and information technologies, culture and audio-visual policy, regional policy and coordination of structural instruments, environment, consumers and health protection, cooperation in the field of Justice and Home Affairs, customs union, external relations, common foreign and security policy, financial control, financial and budgetary provisions, institutions and other areas.

In addition to these theoretical considerations, the strong economic cycle up to the mid-2007 may have led to “good-times” complacency in the euro area. With fast growth in the global economy, historically low interest rates and risk spreads, and ample liquidity, the euro area benefited from a high tide during its first years of life. It is difficult to make the case for reforms when the economy is growing fast without them. This is particularly the case for the smaller and less developed euro area countries, in which monetary conditions may be too loose.7 Namely, the ECB's monetary policy is primarily determined by the macroeconomic conditions of the larger members, which suggests that it will be too loose for the converging euro area economies, leading to growth faster than potential in the short-term. In the medium term, nontradable prices will increase, competitiveness will deteriorate and growth will slow down, but in the meantime, an illusion of economic success may obstruct the need for structural reforms. Limits on changes in macroeconomic policy within a currency union may also make some structural reforms difficult to sell. Fiscal limits, such as the 3% of GDP general government deficit limit in the euro area, may not allow fiscal policy to compensate population groups who may temporarily loose from some structural reforms. This would increase the political cost of such reforms. A similar argument holds for monetary policy. Some structural reforms, such as product market reforms, may lead to lower inflation for some time. This would allow loosening of monetary policy, which would also make the reforms easier to implement.8 However, the links between fiscal and monetary policies on the one hand and structural reforms on the other can also work the other way. As mentioned above, some structural reforms, such as privatization, could reduce the budget deficit, which would then leave room to compensate those who loose from these reforms—for example, through active labor market policies for redundant workers. Moreover, structural reforms are usually more effective in terms of higher investment and faster growth in an economy that guarantees low inflation, exchange rate stability and fiscal sustainability by joining a currency union, which would, again, make the reforms easier to accept and implement. Given the theoretical ambiguity, the drive for structural reforms within a currency union, and in the euro area more specifically, is an empirical question, which is what the next section turns into. However, and as emphasized above, empirical results will not provide the final answer given the short time series. The results are

7 8

See IMF (2008). See The Economist (February 17, 2007), “Economics focus: the art of the possible.”

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Fig. 3. Lending interest rates in the euro area countries, 1990–2006.

only preliminary and strictly backward looking. Some conclusions on the impact of past reforms on future growth could be drawn, but caution is also needed as future reforms may change the growth dynamics. 3. A first look at the data Following a number of other studies, we measure structural reform using the Index of Economic Freedom compiled by the Fraser Institute.9 This is a broad index, compiled based on a large number of economic variables and survey data, taking values from 1 to 10 and increasing as an economy reforms. It is the average of five sub-indexes, measuring: the size of the government, legal system and property rights, sound monetary policy, freedom to trade, and regulation (see Annex I). What follows reports results for the general index and for the five subindices. Some of the subindices are more closely linked to structural reforms than the rest. A change in these indices is used to measure the progress in reforms over time. Although there are a number of other indices measuring progress in structural reforms, such as, for example, the World Bank Doing Business index or the OECD product market and labor market indicators, the index of economic freedom captures more aspects of structural and broader economic reform, and is available for a longer period.10 The progress in structural reforms is assessed for two five-year periods, before and after the introduction of the euro. The available data allows us to take the first period to be from 1995 to 2000 and the second from 2000 to 2005. Although the euro area came to life in 1999, the economic freedom index is not available for this year.11 Taking the year 2000 as the break should not be a problem, since structural reforms take time to be implemented and perceptions may take even longer to change and be reflected in some of the survey data that are used to compile such indices. Looking at the broad index, lagging economies in terms of structural reforms seem to have narrowed their gap with the rest of the euro area before joining the area. Fig. 4 shows a very strong

negative correlation between the value of the index in 1995 and its change during the period 1995–2000. The correlation between the two is equal to −0.88. This implies that countries with the lowest index reformed faster, which is what one should expect as these countries tried to meet the Maastricht criteria, achieve real converge, gain market confidence and improve their competitiveness before introducing the euro.12 Although the direction of this trend remains the same after the euro, the trend itself is much smoother. Fig. 5 continues showing a negative correlation between the starting position in 2000 and the change during the period 2000–2005, but it is has now fallen to − 0.21. Moreover, while the index increased in all but in one of the euro area members before the introduction of the euro, it increased in only three of the euro area members after the introduction of the euro, while it stayed the same in three of them (including in Germany and France, the largest members of the area) and declined in the other three. The very small number of observations does not allow any formal statistical tests in these two graphs, but the change of the correlation is economically significant. Lagging countries seem to be less determined to catch up in reforms after the introduction of the euro. Comparisons with reforms in the rest of the world lead to similar conclusions. Fig. 6 shows that taking the starting position as given, the euro area reformed faster than the rest of the world before introducing the euro. Most of the euro area countries are above the trend line in the rest of the world during this period, which suggests that they reformed faster than countries outside the euro area that were starting at a similar stage of market reform. However, the opposite seems to be the case in the years following the introduction of the euro. According to Fig. 7, most euro area countries are below the trend line in the rest of the world during this period, which suggests that they reformed slower than the rest of the world given the starting position. Taking a first look at the subindices, the picture is mixed. Fig. 8 shows a negative correlation between the change before the euro and the change after the euro for the subindices of legal system and property rights and size of government. However, the correlations are positive for the subindices of sound monetary policy, freedom to trade

9

For more details see http://www.freetheworld.com/. The World Bank Doing Business index is available only for the period 2005–2006, while the OECD product market and labor market indicators are available only for selective years up to 2003 (1988, 1998 and 2003). 11 The index of economic freedom is available every five years starting in 1970 and annually after 2000. 10

12 The only country where the index fell during this period is Ireland. However, Ireland had the highest index in the euro area in 1995. Moreover, its index fell by only a negligible magnitude during 1995–2000.

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Fig. 4. Structural reforms in the euro area, 1995–2000.

Fig. 5. Structural reforms in the euro area, 2000–2005.

and regulation. Therefore, for the first two subindices there seems to be a “reform fatigue”, while for the other three a “reform momentum”. One has to interpret these correlations with caution. For example, the

positive correlation for the monetary policy index is driven by Greece, which is an outliner and was qualified for the euro only in 2001. Also the positive correlation of the regulation index is driven by the credit

Fig. 6. Structural reforms in the world economy, 1995–2000.

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Fig. 7. Structural reforms in the world economy, 2000–2005.

Fig. 8. “Reform fatigue” and “reform momentum” in the euro area.

market subindex. The correlation is negative for the labor market and the business regulation subindices.13 4. Empirical results This section discusses estimates from a simple regression with the change in the broad index of economic freedom or the change in the five subindices as dependent variables. The list of explanatory variables includes: the initial level of the index to control for the starting position; the lagged change of the index to see if there is a reform momentum or a reform fatigue; and a euro area dummy variable. Some specifications also include a dummy variable for EU countries that are not in the euro area. We first estimate two cross-sections, one for the period before the introduction of the euro, 1995–2000, and one for the period after the introduction of the euro, 2000–2005, using OLS. The sample includes all countries in the world with available data, which comes to a total of 123 countries. Results for the period before the introduction of the euro suggest that the euro area countries reformed faster than the rest of the world during this period. According to the first regression in Table 1 for the broad index, the estimated coefficient of the initial level of the index is negative

13

These results are available from the author.

and statistically significant, suggesting that countries in the world that are behind in reforms are catching up. The estimated coefficient of the lagged change in the index is positive, but not significant, suggesting no clear trend of reform momentum or reform fatigue. The estimated coefficient of the euro area dummy is positive and statistically significant, although at the 10% level, which suggests that controlling for everything else, the euro area countries reformed faster than the rest of the world during this period. As discussed above, this is what one may expect to see as countries were trying to meet the Maastricht criteria and prepare for the common currency area. The explanatory power of the regression is small, with an adjusted R2 of only 0.23, but this is not unusual in cross-country regressions. Looking at the five subindices in the other regressions of Table 1, we see that two of them are driving the result related to the euro area dummy variable: the subindex measuring freedom to trade and the subindex measuring regulation. The estimates for the euro area dummy variable in these two regressions are positive and statistically significant. The estimate of the euro area dummy in the regression for sound money is also positive and equal in magnitude with the estimate in the regression for the freedom to trade, but is not statistically significant (it is significant only at the 15% level). The estimates in the regressions for the size of government and the legal system and property rights are negative and positive respectively, but not statistically significant. Therefore, it seems that euro area countries reformed faster than in

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Table 1 Structural reforms in the euro area before the euro compared with the rest of the world, 1995–2000.

Table 2 Structural reforms in the euro area after the euro compared with the rest of the world, 2000–2005.

OLS estimates

OLS estimates

Dependent variable: change in index before the euro

Dependent variable: change in index after the euro

Constant Initial level of index Earlier change in index Euro area Adjusted R2 Observations

Constant Initial level of index Earlier change in index Euro area Adjusted R2 Observations

Economic freedom

Size of government

Legal system and property rights

1.64⁎⁎⁎ (7.27) − 0.23⁎⁎⁎ (− 5.94) 0.08 (1.16) 0.26⁎ (1.80) 0.23 123

1.25⁎⁎⁎ (4.68) − 0.20⁎⁎⁎ (− 4.50) 0.04 (0.46) − 0.27 (− 1.20) 0.13 123

− 0.33 (− 1.29) 0.05 (1.17) − 0.08 (− 1.51) 0.07 (0.30) 0.01 123

Sound money

Freedom to trade

Regulation

4.69⁎⁎⁎ (12.13) − 0.56⁎⁎⁎ (− 9.58)⁎⁎⁎ 0.08 (1.30) 0.65 (1.58) 0.51 123

2.06⁎⁎⁎ (5.64) − 0.26⁎⁎⁎ (− 4.56) − 0.22⁎⁎⁎ (− 2.78) 0.65⁎⁎⁎ (2.73) 0.23 123

1.43⁎⁎⁎ (6.74) − 0.22⁎⁎⁎ (− 5.72) 0.05 (0.88) 0.37⁎⁎ (2.59) 0.23 123

Constant Initial level of index Earlier change in index Euro area Adjusted R2 Observations

Constant Initial level of index Earlier change in index Euro area Adjusted R2 Observations

Economic freedom

Size of government

Legal system and property rights

0.94⁎⁎⁎ (3.40) − 0.12⁎⁎⁎ (− 2.70) 0.08 (1.09) − 0.19 (− 1.22) 0.11 123

1.68⁎⁎⁎ (5.69) − 0.26⁎⁎⁎ (− 5.28) 0.09 (1.00) 0.25 (1.06) 0.21 123

0.83⁎⁎⁎ (2.99) − 0.11⁎⁎ (− 2.37) − 0.03 (− 0.26) − 0.28 (− 1.02) 0.08 123

Sound money

Freedom to trade

Regulation

3.72⁎⁎⁎ (9.46) − 0.44⁎⁎⁎ (− 8.64)⁎⁎⁎ 0.01 (0.27) 0.48 (1.53) 0.38 123

0.37 (1.19) − 0.09⁎ (− 1.90) − 0.24⁎⁎⁎ (− 2.06) − 0.51⁎⁎⁎ (− 2.71) 0.24 123

2.12⁎⁎⁎ (5.77) − 0.26⁎⁎⁎ (− 4.18) 0.03 (0.26) − 0.32 (− 1.46) 0.23 123

Heteroskedasticity consistent t-statistics in parentheses; ***, ** and * indicate statistical significance at the 1, 5 and 10 percent level, respectively.

Heteroskedasticity consistent t-statistics in parentheses; ***, ** and * indicate statistical significance at the 1, 5 and 10 percent level, respectively.

the rest of the world before introducing the euro in the areas measured by the index of freedom to trade, which includes a number of tariff and nontariff barriers, other transaction costs related to international trade, and capital market controls, and in the areas measured by the regulation index, which includes credit, labor and business regulations. In contrast, one sees no clear difference between reform progress in the euro area and the rest of the world after the introduction of the euro. According to the results in Table 2, the starting position still matters, with countries starting with a low index reforming faster, but there is no clear correlation between reform progress and lagged reform progress, except for trade, where there seems to be some “reform fatigue” in the world economy. The euro area dummy variable has an estimate that is statistically insignificant, except for the trade subindex, where it has a negative and statistically significant estimate. The results suggest that, on average, the euro area seems to have reformed as fast as the rest of the world after introducing the common currency, compared with faster in the period before. Again, caution is in order, since the results for the period before are driven only by two from the five subindices, while the results for the period after suggest slower reform that in the rest of the world in one of the five subindices. Furthermore, even if reform progress did slow down after the introduction of the euro, it seems that it returned to the world trend, which is not necessarily a reason to be concerned. The results for the period after the introduction of the euro are confirmed by estimation using panel data.14 The index of economic freedom is available annually only for the period after 2000. Therefore, we can estimate a panel regression using annual data only for the second period of our sample. The estimate of the euro area dummy variable for these regression is insignificant for both the general index and all subindices of economic freedom, which confirms that the euro area countries reformed as fast as the rest of the world after introducing the euro. However, the index is not available annually for the period before the introducing the euro, and therefore, we cannot estimate the same panel for this period, this is not a complete robustness test of our results.

The noneuro EU countries offer an alternative control group, which may be more similar with the euro area members than the rest of the world. Since one of their main differences is the introduction of the euro, comparisons of the speed of reforms in these two groups is an

14

These results are available from the author.

Table 3 Structural reforms in the euro area before the euro compared with the rest of the world and noneuro area EU countries (including new EU members), 1995–2000. OLS estimates Dependent variable: change in index before the euro

Constant Initial level of index Earlier change in index Euro area Non-euro EU Adjusted R2 Observations

Constant Initial level of index Earlier change in index Euro area Noneuro EU Adjusted R2 Observations

Economic freedom

Size of government

Legal system and property rights

1.64⁎⁎⁎ (7.24) − 0.23⁎⁎⁎ (− 5.96) 0.08 (1.15) 0.28⁎ (1.88) 0.13 (0.86) 0.23 123

1.24⁎⁎⁎ (4.20) − 0.19⁎⁎⁎ (− 4.13) 0.03 (0.44) − 0.26 (− 1.13) 0.05 (0.21) 0.12 123

− 0.34 (− 1.26) 0.05 (1.12) − 0.08 (− 1.49) 0.06 (0.25) − 0.03 (− 0.10) 0.00 123

Sound money

Freedom to trade

Regulation

4.64⁎⁎⁎ (11.92) − 0.56⁎⁎⁎ (− 9.60)⁎⁎⁎ 0.10 (1.49) 0.69⁎ (1.67) 0.43 (1.13) 0.51 123

2.09⁎⁎⁎ (5.71) − 0.26⁎⁎⁎ (− 4.66) − 0.22⁎⁎⁎ (− 2.87) 0.69⁎⁎⁎ (2.85) 0.27 (1.04) 0.26 123

1.28⁎⁎⁎ (6.22) − 0.20⁎⁎⁎ (− 5.27) − 0.04 (− 0.61) 0.42⁎⁎⁎ (3.07) 0.51⁎⁎⁎ (3.46) 0.30 123

Heteroskedasticity consistent t-statistics in parentheses; *** and * indicate statistical significance at the 1 and 10 percent level, respectively.

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Table 4 Structural reforms in the euro area after the euro compared with the rest of the world and noneuro area EU countries (including new EU members), 2000–2005. OLS estimates Dependent variable: change in index before the euro

Constant Initial level of index Earlier change in index Euro area Non-euro EU Adjusted R2 Observations

Constant Initial level of index Earlier change in index Euro area Non-euro EU Adjusted R2 Observations

Economic freedom

Size of government

Legal system and property rights

1.02⁎⁎⁎ (4.08) − 0.14⁎⁎⁎ (− 3.54) 0.00 (0.02) − 0.08 (− 0.59) 0.64⁎⁎⁎ (5.16) 0.25 123

1.34⁎⁎⁎ (4.23) − 0.21⁎⁎⁎ (− 4.14) 0.02 (0.17) 0.40⁎ (1.65) 0.60⁎⁎ (2.59) 0.25 123

0.89⁎⁎⁎ (3.14) − 0.13⁎⁎ (− 2.56) − 0.01 (− 0.08) − 0.21 (− 0.72) 0.23 (0.97) 0.08 123

Sound money

Freedom to trade

Regulation

3.58⁎⁎⁎ (10.33) − 0.44⁎⁎⁎ (− 9.83)⁎⁎⁎ − 0.03 (− 0.62) 0.62⁎⁎ (2.26) 1.40⁎⁎⁎ (5.99) 0.52 123

0.54⁎ (1.74) − 0.12⁎⁎⁎ (− 2.63) − 0.22⁎⁎⁎ (3.36) − 0.39⁎⁎ (− 2.07) 0.43⁎⁎⁎ (2.79) 0.28 123

2.20⁎⁎⁎ (6.03) − 0.28⁎⁎⁎ (− 4.51) − 0.05 (− 0.43) − 0.23 (− 1.05) 0.43⁎⁎ (2.08) 0.17 123

Heteroskedasticity consistent t-statistics in parentheses; ***, ** and * indicate statistical significance at the 1, 5 and 10 percent level, respectively.

interesting exercise. The specifications in Tables 3 and 4 include a dummy variable for the noneuro EU countries, for the periods before and after the introduction of the euro respectively. The results suggest that the euro area countries reformed faster than the noneuro EU countries before the introduction of the euro. The estimate of the euro area dummy variable in the specifications before the introduction of the euro (Table 3) is positive and statistically significant at the 10% level for the general index and the subindex of sound money and at the 1% level for the subindices of freedom to trade and regulation. In contrast, the estimate of the

Fig. 9. General government structural balance in percent of potential GDP, 1991–2007.

Fig. 10. CPI inflation rate, 1992–2006.

noneuro EU dummy variable is insignificant in all regressions, but in the one for regulation, where it is positive and statistically not different from the estimate of the dummy variable for the euro area. However, the noneuro EU countries reformed faster than the euro area countries after the introduction of the euro. The estimate of the noneuro EU countries dummy variable in the specifications after the introduction of the euro (Table 4) is all positive and statistically significant for the general index and for all subindices, but the subindex for legal system and property rights, where it is positive but not significant. In contrast, the estimate of the euro area dummy variable is insignificant for the general index and has a negative sign. Although it is positive and significant for the subindex of government size (at the 10% level) and for sound money, it is negative and significant for the subindex of freedom to trade and insignificant for all other regressions. The positive estimates for the subindices of the government size and sound money this specification suggest that although the euro area countries reformed slower in these two areas than the noneuro EU countries, they reformed faster than the rest of the world. This may explain why these estimates are not significant, although they are positive, in the specification in which the rest of the world includes the noneuro EU countries (second and fourth columns in Table 2). Therefore, for these two areas, the results may not be driven by reform fatigue in the euro area countries, but by relatively strong reforms in the noneuro EU countries. The estimates suggest that the noneuro EU countries have reformed faster during the second period not only than the euro area but also than the rest of the world. This may be driven by reforms in the new EU member countries during the EU harmonization process. Indeed, out of the fifteen countries in the group of noneuro EU countries, twelve are new EU members. Moreover, ten of the new EU members are transition economies, which may suggest that they needed bolder reforms during the EU harmonization process in order to meet the requirements of the EU's acquis, given their lower starting position. Indeed, a specification with separate dummy variables for transition noneuro EU economies and other noneuro EU countries shows that the above results are primarily driven by the first group.15 Summarizing, the regressions find some preliminary results implying that euro area countries reformed faster than the rest of the world, including the noneuro EU countries, before introducing the euro, but as fast as the rest of the world and slower than the noneuro EU countries after introducing the euro. However, although these results hold for the broad index measuring reform progress, the picture is more mixed, although not very different, for some of the components of this index.

15

These results are available from the author.

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5. Other empirical considerations

Table 5 World ranking of the euro area in structural reforms.

5.1. Macroeconomic reforms The theoretical arguments on the impact of joining a common currency area on economic reforms also apply for macroeconomic reforms. Euro area countries may want to avoid large fiscal deficits to have fiscal room for stabilization policies since monetary policy is not an option. On the other hand, the market cannot discipline them by selling their currency in the case of unsustainable fiscal policies. In addition, the Maastricht criteria of 3% of GDP for the general government deficit and 60% of GDP for the general government debt may lead to deep fiscal reforms in countries with high fiscal deficits before joining the euro area and a slowing of reforms afterwards. Indeed, one sees an improvement in fiscal balances in the euro area before the euro, followed by a deterioration afterwards. Fig. 9 shows unweighted averages for the general government structural balances— balances adjusted for the business cycle—in the euro area and in the noneuro EU countries excluding new EU member countries (therefore, this group includes only Denmark, Sweden and the U.K.).16 The euro area countries improved their fiscal balances considerably before introducing the euro, but took a U-turn right after. More recently, fiscal consolidation has resumed, forced by the EU's Excessive Deficit Procedures in some countries. Almost all euro area countries followed these trends.17 However, it is not clear whether these fluctuations are fully explained by the introduction of the euro. Indeed, a very similar trend is seen in the noneuro EU countries during the same period. The improvement in fiscal positions before the euro is actually stronger for noneuro countries, suggesting that euro area countries may have stopped when they reached a deficit safely below the 3% target. The fiscal balances deteriorated in both groups, by more or less the same magnitude, early in the current decade, and started improving again more recently, with the noneuro countries keeping their balances consistently above the levels seen in the euro area. A very similar trend can be seen for inflation rates. Although euro area countries do not control their inflation through monetary policy, they do affect it through their wage policy and structural reforms that liberalize prices and labor and product markets. Fig. 10 shows that inflation fell considerably in the euro area before the introduction of the euro, as countries had to meet the Maastricht inflation criterion, but increased afterwards. Although noneuro area countries followed the same trend, their inflation was higher than in the euro area at the time of the introduction of the euro, suggesting more progress in the latter group. However, their inflation has been consistently below inflation in the euro area after the introduction of the euro. 5.2. Is there room for more reforms in the Euro area? Although we have controlled for the starting position of a country, if the euro area has already achieved progress in structural reforms that puts the region at the top of the rest of the world, the estimates may simply suggest that there is not much room to move upwards. Although in practice there is always room for more reform, this may not be accounted for when a country has a high value in the indices measuring progress in reform. However, this does not seem to be the case in the euro area. Table 5 looks at the latest available ranking of the index of economic freedom (2005) and the World Bank doing business index (2006) for the euro area countries (excluding Slovenia). Both indices suggest that although most euro area countries are relative advanced in terms of structural reforms, they still have a long way to go to reach top

Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain

Economic freedom, ranking 2005

World Bank doing business index, ranking 2006

18 38 11 52 18 56 9 52 11 15 38 44

30 20 14 35 21 109 10 82 . 22 40 39

rankings. The average ranking is 30 for the index of economic freedom and 38 for the World Bank index of doing business. According to both indices, the most advanced country is Ireland, while the less advanced is Greece. Clearly, there is still large room for structural reforms in almost all euro area countries. The IMF country staff reports are a good source for information on the areas in need of reform in the euro area.18 According to recent reports, although country-specific shocks have been reduced in recent years and area-wide shocks increasingly explain economic fluctuations, the first kind of shocks remains a concern. To address this concern would require labor and product market reforms to strengthen the economy, wage flexibility to rapidly adjust competitiveness when needed, and further financial integration to help consumption smoothing. Particular attention should be given to the synergies between labor and product market reforms and hence on the benefits from eliminating remaining barriers to the full integration of goods and services markets, including obstacles to foreign entry. Planned reforms in the reinvigorated Lisbon Agenda, the EU's Services Directive, and the EU's Financial Services Action Plan recognize the need for such reforms and envision important steps in this direction.19 6. Implications for economic growth This section uses econometric estimates from a growth model to estimate the possible impact of the slowdown in structural reforms in the euro area after the introduction of the common currency on the economic growth of the region. The estimates use a sample of a 109 developed and developing economies over the period 1996–2005, to coincide with the period of the above results.20 The estimated coefficients are used to estimate the growth of the euro area's real per capita GDP if structural reforms had progressed after the introduction of the euro as fast as before the introduction of the euro. The data are from the IMF's World Economic Outlook database, except when indicated otherwise. The empirical specification is the following: ðReal GDP per capita growthÞi = c + βXi + u;

for country i = 1; N ; n:

The dependent variable is the average per capita real GDP growth rate for each country i; c is the constant term; β is the matrix of

18

See http://www.imf.org and International Monetary Fund (2007b). The Lisbon Agenda is the EU's development plan, which was set out by the European Council in Lisbon on March 2000. The Services Directive aims to create a free market for services within the EU. The Financial Services Action envisions a single market in financial services. 20 The sample size is determined by data availability. 19

16 The data are estimates from the IMF's World Economic Outlook database, which does not provide estimates of structural balances for emerging economies. 17 The results by country are available from the author.

775

776

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Table 6 Estimates from a cross-country growth regression, 1995–2005. OLS estimates Dependent variable: average annual real per capita GDP growth Independent variables Constant

0.98 (0.62) Dummy for transition economies 1.88 (2.71) Initial real GDP per capita − 0.49 (− 3.62) Population growth − 0.43 (− 1.78) Investment/GDP 0.14 (3.58) Inflation rate − 0.02 (− 2.29) Credit to private sector/GDP 0.001 (3.18) Index of economic freedom 0.43 (2.30) Cost of business start-up procedures (% of GNI per − 0.03 capita) (− 3.85) Euro area dummy

1.00 (0.64) 1.98 (2.67) − 0.51 (− 3.84) − 0.40 (− 1.51) 0.14 (3.60) − 0.02 (− 2.20) 0.001 (1.61) 0.43 (2.31) − 0.03 (− 4.00) 0.43 (0.76)

Euro area dummy ⁎ index of economic freedom Number of observations Adjusted R2

109 0.52

109 0.52

1.54 (1.04) 1.91 (2.61) − 0.50 (− 3.68) − 0.43 (− 1.67) 0.14 (3.57) − 0.02 (− 2.31) 0.001 (2.62) 0.34 (1.90) − 0.03 (− 3.90) − 16.23 (− 1.57) 2.24 (1.58) 109 0.54

Heteroskedasticity consistent t-statistics in parentheses.

parameters to be estimated; Xi is the matrix of independent variables; and u is the error term. Each country has one observation, which is either the average over 10 years or the initial value in 1996, depending on the variable. Focusing on the last ten years has a number of additional advantages: the sample includes more economies; some cross-country indices are not available for earlier years; and overall data quality has improved compared to previous years. Causality can be difficult to determine in growth regressions.21 Even though the literature has found estimation with instrumental variables to confirm the robustness of most of the growth determinants in this specification, one has to be cautious and interpret the estimates as broad correlations, which indicate an interaction with growth that may be going both ways.22 The preferred specification in the first column of Table 6 captures the most important, but not all, determinants of growth in the literature.23 It is selected by including only variables that turned out to be statistically significant and robust to changes in the specification. This does not imply that the omitted variables do not affect growth, since almost all of these variables were statistically significant in some empirical specifications.24 Since some of these variables are alternative measures of similar aspects of the economy and are highly correlated, one has to choose those that seem to explain growth the most. The results suggest that, keeping everything else constant, countries with a relatively low income level, a low population growth rate, a high investment share, a low inflation rate, and a relatively developed financial sector (measured by the ratio of private sector credit to GDP) grow faster. Both macroeconomic and structural policies affect economic growth. The index of economic freedom, which measures a number of different aspects of macroeconomic and structural policies and reforms, has a positive and statistically significant estimate. Moreover, countries

21

See for example Temple (2000). For a detailed discussion of the use of instrumental variables in growth regressions see Barro and Sala-í-Martin (2004). 23 The model is taken from Moore and Vamvakidis (2007). See this paper for a detailed discussion of the model and the variables on the right hand side. 24 These results are available from the author. 22

with high costs for starting new businesses grow more slowly.25 The second regression in Table 6 includes a dummy variable for the euro area, while the third regression adds an interaction term of the euro area dummy variable with the index of economic freedom. None of these variables turns out with statistically significant estimates. This suggests that the other independent variables in the regression already explain the growth differences between the euro area countries and the rest of the world and that structural reforms, as measured by the index of economic freedom, have the same impact on the euro area as in the rest of the world. These estimates and the estimates in Tables 1 and 2 can provide a rough idea for the growth impact of the slowdown in structural reforms in the euro area after introducing the euro. This is done by multiplying the estimate of 0.43, which is the impact of an increase in the index of economic freedom by 1 on real GDP per capita growth, with 0.26, which is the increase in the index of economic freedom in the euro area above the rest of the world before the euro, plus 0.19, which is the decline (or slower increase) of the index of economic freedom in the euro area below the rest of the world after the euro. In other words, had the euro area's structural reforms continued progressing after the euro as fast as before, the area would have increased its index of economic freedom by 0.45 (out of 10) from the rest of the world. Multiplying this by 0.43 gives an annual growth impact of 0.2—falling to 0.15 if we use the third regression in Table 6. Therefore, this simulation implies that annual growth in the euro area's per capita output may be slower by up to 0.2% after the introduction of the euro, simply because structural reforms were slower. This estimate does not imply that the euro area countries will grow slower than their peers, since both groups implement reforms by a similar pace according to the estimates in Table 2. It only suggests that had the relatively fast pace of reform before the introduction of the euro continued, the euro area's relative position in the world economy would have been improved, keeping everything else constant. Caution is in order in using these estimates. This simulation gives some idea of what the estimates in this paper imply in terms of growth. However, given that the results are very sensitive on the subindex used, the short time series, and the causality concerns for the growth regression, these estimates should be treated as very preliminary.26 Moreover, since structural reforms may take time to be implemented and to affect growth, the above simulation suggests that annual growth may slow down by 0.2% in the future, unless reform implementation accelerates back to the pace before the introduction of the euro. 7. Conclusions The absence of independent monetary policy and country exchange rate in a common currency area such as the euro area affects the incentives for economic reforms. From the one hand, reforms that increase economic flexibility and improve competitiveness are more important 25 The regression also includes a separate constant term for transition economies. We tried a number of country dummies, but this was the only one which turned out statistically significant. Dummy variables for Africa and for East Asia, although statistically significant in growth regressions for earlier decades, with negative and positive estimates respectively, do not turn out significant in this specification. The significance of the dummy variable for the transition economies suggests that they have been growing faster than what would have been expected based on the growth determinants in this model—by 1.9% in terms of per capita GDP. Most of these economies collapsed in the beginning of their transition during the early 1990s, while some experienced social unrest, or even war. However, this was followed by a strong economic recovery after the mid-1990s, as peace prevailed, the transition process moved forward, and the region's economies opened up to the rest of the world. The result may have been a growth “bonus”, which, however, may not continue in the future, at least not to the same extent. 26 There are no good instruments for the index of economic freedom. Using lagged values of the index does not result in statistically significant estimates (these results are available from the author). This may be explained by the fact that the index is available only in five year periods before 2000 and the lagged values used as an instrument are from 1990. However, the results remain when we use lagged values of the other independent variables in the regression as instruments.

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than outside a common currency area because monetary policy cannot adjust during the economic cycle. From the other hand, market discipline and punishment for bad economic policies is limited since investors cannot sell the currencies of the countries of the area. A number of other considerations in this paper also suggested an ambiguous impact of joining a common currency area on the drive for reforms. Empirical evidence in this paper suggest that euro area countries reformed faster than the rest of the world before introducing the euro, but as fast as the rest of the world afterwards. In contrast, noneuro area EU countries reformed faster than the euro area and the rest of the world in the second period. Although the results hold for an aggregate index of economic reform, individual indices by area of reform provide a somewhat mixed picture. However, they suggest that the slowing of reforms in the euro area took place primarily in the areas of international transactions (trade and capital transactions) and regulation (credit, labor and business regulations). Moreover, the rankings of the euro area countries show that there is significant room for further reform in the future. Using estimates from a growth model suggests that this slowdown of reform in the euro area back to the world trend may lead to slower annual growth than otherwise by up to 0.2%, keeping everything else constant. However, this does not suggest that the euro area will lag behind, since this slowing of reforms was from a relatively fast pace. The paper has emphasized that these results should be treated as preliminary. The period considers is relatively short, the indices used to measure reform progress may be subject to measurement errors, the explanatory power of the regressions is relatively small, and the reform drive of the euro area may change again in the future—the results are strictly backward looking. However, the results do suggest that to the extent that the euro area economies reformed slower after introducing the euro, they will also growth slower, unless they reform faster in the future. Although theory is ambiguous about what will happen to the reform drive of an economy after it joins a common currency area, there is no ambiguity on what should happen. The euro area's structural rigidities remain its Achilles' heel, inhibiting growth and making adjustment to shocks protracted and difficult. Structural reforms have progressed during recent years, but gaps with the rest of the world remain large for most countries. The strong economic cycle up to mid-2007 helped hide some of these rigidities, but they may emerge as growth slows down following the financial market turmoil at the end of 2007 and early 2008. Addressing them in advance is the clear policy implication from both the theoretical arguments and the empirical results in this paper. Annex I. Definition of index of economic freedom Economic freedom index Size of government General government consumption as share of total consumption Transfers and subsidies as a share of GDP Government enterprises and investment as a share of gross investment Top marginal tax rate Top marginal income tax rate Top marginal income and payroll tax rate Legal system and property rights Judiciary independence Impartial courts Protection of intellectual property Military in politics Law and order Sound money Avg. growth of money (last 5 yr) minus growth of real GDP (last 10 yr) Standard deviation of annual inflation (last 5 yr)

777

Annual inflation (most recent yr) Freedom of citizens to own foreign currency bank accounts (dom. and abroad) Freedom to trade internationally Tariffs International trade tax revenues (in percent of trade sector) Mean tariff rate Standard deviation of tariff rates Regulatory trade barriers Hidden import barriers Costs of importing Actual vs. expected size of trade sector Difference between official and black market exchange rates International capital market controls Foreign ownership restrictions Index of capital controls among 13 IMF categories Regulation Credit market regulation Ownership of banks Competition in domestic banking Extension of credit Interest rate regulations (leading to neg. rates) Interest rate controls Labor market regulations Impact of minimum wage Hiring and firing practices Labor force share with wages set by centralized collective bargaining Unemployment insurance Use of conscripts Business regulations Price controls Burden of regulations Time with government bureaucracy Starting a new business Irregular payments References Barro, Robert, Sala-í-Martin, Xavier, 2004. Economic Growth, second edition. McGraw Hill, New York. International Monetary Fund, 2007a. Regional economic outlook, Europe: strengthening financial systems. World Economic and Financial Surveys (November). Washington DC. International Monetary Fund, 2007b. Euro Area Policies: 2007 Article IV Consultation — Staff Report. Washington DC (July), http://www.imf.org/external/pubs/cat/longres.cfm?sk=21223.0. International Monetary Fund, 2008. Regional economic outlook, Europe: reassessing risks. World Economic and Financial Surveys (April). Washington DC. Moore, David, Vamvakidis, Athanasios, 2007. Economic growth in Croatia: potential and constraints. Financial Theory and Practice 32 (1). Mundell, Robert A., 1961. A theory of optimum currency areas. The American Economic Review LI (4), 509–517. Rodrik, Dani, 1996. Understanding economic policy reform. Journal of Economic Literature 34 (1), 9–41. Schadler, Susan, Drummond, Paulo Flavio Nacif, Kuijs, Louis, Murgasova, Zuzana, van Elkan, Rachel, 2005. Adopting the Euro in Central Europe: challenges of the next step in European integration. IMF Occasional Paper No. 234. International Monetary Fund, Washington. Temple, J., 2000. Growth regressions and what the textbooks don't tell you. Bulletin of Economic Research 52 (3), 181–205. Tommasi, Mariano, Velasco, Andres, 1996. Where are we in the political economy of reform? Journal of Policy Reform 1 (2), 187–238. Vamvakidis, Athanasios, 2007. External debt and economic reform: does a pain reliever delay the necessary treatment? IMF Working Paper/07/50. International Monetary Fund, Washington.