Don’t Panic

Crises don’t get a lot of positive buzz these days. In fact, I recently became aware that the current economic and financial crisis is sometimes referred to as “The Panic of 2008.” The term crisis is apparently a bit too vague and mundane: it is routinely applied to a rather broad range of occurrences, from crises of confidence to mid-life crises. Panic, on the other hand, has a nice ring to it. Crucially, it clearly suggests that the event bearing such an accolade is extraordinary in some sense.

Crises, depressions and panics, however, are not necessarily all bad. Crises are generally caused by unsound and unsustainable policies. Monetary policy is too lax. Credit is too easily available. Government spending is out of control. Trade unions are too greedy and make excessive demands in wage negotiations with employers and/or government. Or, as was largely the case with the present crisis, all of the above apply. Crises help highlight the unsustainable nature of such policies. And, with a bit of luck, they put a stop to them.

It is not easy to abandon unsustainable policies, even when everyone agrees that they are indeed unsustainable. We may all agree that the budget deficit is excessive. How do we cut it then? Should we cut spending on national defence, health care, welfare benefits, civil-servant salaries, or pensions? Should we raise the income tax across the board or only for the highest or the lowest tax bracket? Or raise the VAT instead? Greece is a case in point. The country has been teetering on the brink of default and bankruptcy for at least the last six months. Yet every couple of weeks, it is paralyzed by a massive strike by those who stand to lose out as a result of the proposed austerity measures. Civil servants don’t want to accept lower salaries. Truck drivers are angry that the excise tax on fuels has gone up. Pensioners and students alike are furious that the government is going to be less generous to them. And virtually everyone is seething because some Germans had the audacity to suggest that Greeks should sell some of their islands or, god forbid, the Acropolis.

Of course, I am not the first to make this observation. Alberto Alesina and Allan Drazen made this argument at the beginning of the 1990s (“Why are stabilizations delayed?” American Economic Review 81 (5), 1170-1188, 1991). Back then, their arguments build primarily on the experience of Latin American countries, several of which experienced episodes of fiscal recklessness and/or run-away inflation in the preceding years. Alesina and Drazen argue that stabilizations are delayed because of disagreement over who should bear the cost of the required adjustment. In such cases, a war of attrition ensues and the crisis continues unabated until one of the groups affected by the stabilization throws in the towel and agrees to bear a disproportionate share of the cost. This will happen when that group is better off accepting the adjustment rather than allowing the crisis to continue. For instance, the civil servants may decide that it is better for them if they receive a 20% salary cut rather than risk that the government goes bankrupt and is unable to pay their salaries at all. Or employers may agree to pay higher taxes rather than face the uncertainty associated with run-away inflation.

Crisis, in other words, begets reform. Things have to get really bad before they can get better. Or, put differently, unless things get really bad, people won’t be prepared to accept short-term costs in return for the promise of a long-term improvement in the future.

So far so good, but does Alesina and Drazen’s argument hold water in real life? Their article is theoretical and therefore we need to turn to empirical analysis to test its predictions. Allan Drazen and William Easterly found some supporting evidence (“Do crisis induce reform? Simple empirical test of conventional wisdom,” Economics and politics 13, 129-157, 2001). Specifically, they found that countries with extremely high inflation tend to report lower subsequent inflation rate than countries that experienced moderate inflation. Similarly, countries with very high black-market premiums manage to stabilize their currency markets more effectively than countries with moderate premiums. However, they found no evidence that crises improve economic growth or other aspects of economic performance.

In a joint paper with Ariane Tichit of University of Auvergne (entitled “How I Learned to Stop Worrying and Love the Crisis”), we pursue the effect of crises further. Since crises and reforms are relatively rare occurrences, we focus on a sample of crises that experienced both in sufficient measure – the post-communist countries in Eastern Europe. During the 1990s, these countries underwent crises of varying severity and, at roughly the same time, attempted economic reforms with varying success. Our measure of the crisis severity is the depth of the economic contraction between 1989 and the trough of the output trajectory. We find, reassuringly, that the depth of the output fall translates into more rigorous subsequent reform and faster economic growth. Crises also affect institutional development but here the pattern is more complex: institutional quality declines at first, in proportion to the severity of the crisis, but the crisis then translates into an institutional improvement later on.

For the time being, Greece appears off the hook, thanks to the solidarity and generosity of the other Eurozone countries. This may have stopped the crises from spreading to the remaining PIGS (Portugal, Ireland, Greece and Spain). This short-term gain, however, may come at the cost of allowing Greece to avoid undertaking a fundamental reform of its economic policies and especially public finances.