Crises, What Crises? New Evidence on the Relative Roles of Political and Economic Crises in Begetting Reforms

Abstract

Crises beget reforms is a powerful hypothesis. But which type of crises – economic or political – are the main drivers of structural reforms? To answer this question, we construct measures of labour market and trade liberalisation and the two types of crises for a panel of about 100 developed and developing countries between 1960 and 2000. We find that political crises are more important determinants of structural reforms than economic crises. This finding is robust to the inclusion of interdependencies between crises, feedbacks between reforms, different estimators and various alternative measures of crises.

Acknowledgements

We thank Ari Aisen, Mustapha Nabli, seminar participants at the Annual Congress of the International Economic Association (Marrakech), the Pacific Development Conference (San Francisco), and the Eighth Conference of the International Society for the New Institutional Economics (ISNIE), the Editor (Oliver Morrissey), and two anonymous referees for valuable comments. Kannika Damrongplasit, Ladan Masoudie and Parul Srivastava provided excellent research assistance. All remaining errors are our own.

Notes

1. Drazen and Grilli (1993) develop the normative implications of the Alesina and Drazen (1991) war-of-attrition model. See also Labán and Sturzenegger (1994), Acemoglu and Robinson (2001), Acemoglu et al. (2003), Persson (2002) and Giavazzi and Tabellini (2005).

2. In their words, ‘crises and emergencies may be welfare-enhancing and hence desirable. When ongoing social conflict implies that an economy has settled in a Pareto-inferior equilibrium, radical changes are often needed to break the stalemate and put the economy on a welfare-superior path. The necessary introduction of drastic measures … is usually unpopular and forcibly resisted because of distributional concerns … The extreme welfare loss that each agent suffers in a crisis dwarfs the loss he may associate with an unfavorable distribution of the burden of a major policy change’ (Drazen and Grilli, 1993: 598.)

3. Drazen notes that ‘it is useful to distinguish those reforms which are expected to be of general benefit (for example, macroeconomic stabilisation) from those for which there are clearly defined losers ex ante (for instance, breaking up a monopoly). … The former, associated with the launching of reform programs, have more immediate payoffs and widely distributed political costs; from an economic and political point of view, they are easier to implement. The latter are associated with the consolidation of a reform program and generally concern deeper structural reforms. Their benefits accrue only over the longer term and require the elimination of advantages of some special interests; from both a technical and a political point of view, they are more difficult’ (Drazen, 2000: 405).

4. Another advantage of this hypothesis is that it somewhat mitigates Rodrik's critique that the relationship is tautological: ‘There is a strong element of tautology in the association of reform with crisis. Reform naturally becomes an issue only when current policies are perceived to be not working. A crisis is just an extreme instance of policy failure. That policy reform should follow crisis, then, is no more surprising than smoke following fire’ (Rodrik, 1996: 26–27).

5. There is also an emerging literature on the broader economic effects of democratic transitions examining, inter alia, whether or not changes in the political regime (from dictatorship to democracy) generate economic crises. Notably, Rodrik and Wacziarg (2005) provide evidence suggesting that democratic transitions do not produce such crises. This is an important result for our argument as it suggests that the possibility of endogeneity of economic crises vis-à-vis political crises is remote, a proposition that we test with our data but found little support for.

6. In other words, the year attributed to the trade liberalisation may not correspond to the year of maximum severity of crisis or maximum implementation of the reform in question.

7. Tornell's treatment does not allow for the facts that: (1) trade liberalisation takes time to be fully implemented, and (2) governments (a) often adopt only partial reforms, and (b) may decide to reverse the reforms.

8. Huang and Temple (2005) is one of the first papers to look at this issue empirically, while Giavazzi and Tabellini (2005) is one of the first to study the relationship between political reforms and economic liberalisation (the latter using an index similar to ours). On the implications for economic performance see: Forteza and Rama (2006) for labour market reform, Winters (2004) for trade liberalisation, and Lin and Nugent (1995) for institutions.

9. Drazen and Grilli (1993: 606) recognise that this is an important assumption: ‘If the policymaker is biased in favor of one of the two groups, he could use distortionary taxes not just to induce agreement, but also to produce an outcome in favor of its constituency. The social desirability of crises in this case becomes questionable’. Note that in this case crises refer exclusively to economic (not political) crises.

10. Loayza and Soto (2004) provide a thorough discussion of reform measurement issues.

11. More specifically, these authors defined a country as closed (i.e. open=0) if it had any one of the following: (1) an average tariff rate of 40 per cent or more, (2) non-tariff barriers covering 40 per cent or more of trade, (3) a black market exchange rate that is depreciated by 20 per cent or more relative to the official rate, (4) a state marketing agency or board for major exports, and (5) a socialist economic system (as defined by Kornai, 1992).

In extending the time coverage backward before 1970, we took advantage of the temporary liberalisation periods, many of which dated back to the 1950s, of Appendix 2-B of Wacziarg and Welch (2008) and pushed forward in time from their Appendices 3-A and 4. In a few other cases, we found additional raw data allowing us to apply the S-W criteria to additional time periods. When the raw data on some of the components was incomplete, we also extended the time and country coverage on the basis of similar indexes from the Economic Freedom of the World surveys published by the Fraser Institute (Gwartney et al., 2000). Specifically, previously non-classified Bahrain, Iceland, Lebanon, Oman, Qatar and UAE are classified as ‘open’ for some years based on scores of 1 (‘Free’) or at most 2 (‘Mostly Free’), while Cambodia, Laos, Libya, Sudan and Suriname were classified as ‘closed’ based on scores of 5 (Repressed) on the same trade openness component of the index for some years.

13. This was used to show something that Wacziarg and Welch (2008) had already shown, namely that the positive relation between growth and open found by Sachs and Warner (1995) and others disappears when the lower threshold is used or when the period studied is post-1990.

14. This index reflects the costs of job security regulation and is computed as the expected discounted cost at the time a worker is hired of dismissing the worker at some time in the future based on existing labour law (but excluding the costs of court actions). It makes use of a common discount rate of 8 per cent, an assumed turnover rate of 12 per cent and cost (inclusive of those related to seniority) of dismissing a worker (for either justified or unjustified reasons).

15. This is an up-date version of the index used in Alesina and Perotti (1996), Campos and Nugent (2003) and Campos et al. (2001).

16. For a review, see Furman and Stiglitz (1998) and Ishihara (2005).

17. The ‘Currency Crisis Indicator’ is constructed from data on nominal official exchange rates against the US dollar as follows: first, moving averages and standard deviations on a basis of five years are calculated. Then standardised scores are calculated using these moving averages and standard deviations, where the standardised score is equal to the value of the nominal exchange rate in a given year minus the average over the last five years (up to the given year) divided by the standard deviation over the same period. The next step is that a threshold value for the crisis is chosen (2.0 by the IMF, 2003). Finally, a dummy variable is constructed taking the value of 1 when the standardised score exceeds the threshold and zero otherwise.

18. CAB is, of course, an inverse measure of crisis.

19. It is important to keep in mind that the main reason for this somewhat limiting choice is that most of the labour market reform data (e.g. Blanchard and Wolfers, 2000; Forteza and Rama, 2006) is available only averaged over five-year periods.

20. Lora (2001) finds support for the role of economic crises on various reforms using annual data for a sample of Latin American countries between 1985 and 2000. We re-estimated his specifications using our data with and without enlarging them with our measures of political crises. Although we do find some effect of economic crises on our reform indicators for Latin American countries using our data, these effects vanish once we introduce our measures of political crises (with the resulting coefficients on the latter highly statistically significant).

21. We have also studied whether the effects of differences in levels of political development (democracy) would be better captured by accounting for interactions between democracy and each of our three key political variables (political instability, fractionalisation and durability). Our findings are qualitatively the same once these interaction terms are introduced. These are available from the authors upon request.

22. In light of the Rodriguez and Rodrik (2001) critique of the available empirical measures of trade liberalisation, we constructed and tested a number of variants of our main index above. Notably, we collected additional primary data on the exchange rate black market premium and, following Rodriguez and Rodrik's suggestions, checked whether using this as our measure of trade liberalisation would change our results. We find it does not. We also investigate whether a categorical version of the black market premium series would be more successful. Again, we find it does not. Finally, we followed Rodriguez and Rodrik's suggestion and computed a trade reform index based solely on black market premium and existence of a marketing board (the two variables they claim to be the only components of openness with positive effects on growth). We find that our conclusions are qualitatively the same as those reported in this paper.

23. Because of the much smaller number of observations (which for instance does not allow us to estimate comparable results for the transition economies) and because the main results are almost identical, again in the interest of space, these results are not reported here (but are available from the authors upon request). The results also seem to suggest that future research would benefit from additional data of the type that would provide a more comprehensive understanding of the effects of the intensity of political crises.

24. In addition to these being the less frequently statistically significant explanatory variables, another basis for such an exclusion is that one expects that international policy variables reflected in the trade reform index would seem more likely to be affected by the international dimension of crises while labour reform indicators would seem more likely to be affected by domestic macroeconomic variables (mostly related to unemployment).

25. Godoy and Stiglitz (2006) discuss this issue in the specific context of transition economies.

26. For some applications to year by year changes in financial reform indicators and institutional factors see Calderon and Liu (2003) and Chong and Calderon (2000).