Aug. 11 (Bloomberg) -- The crisis in the euro region is spreading to Italy and Spain, triggering emergency purchases of those countries’ bonds by the European Central Bank.
Further ECB support is likely to be conditional on progress by those nations in fulfilling pledges to accelerate fiscal consolidation and carry out structural reforms.
But can Italy and Spain succeed in overhauling their economies, and how should institutions such as the ECB and the European Union help catalyze change? Some answers can be found by examining the pitfalls exposed by the rescue of Greece, where the problems are the most acute.
The bailout plan adopted by the Athens government more than a year ago is failing to meet some of its central objectives. The country is grappling with a deeper-than-expected recession, which has been aggravated by a credit crunch due to banking-sector problems. Tax revenue, meanwhile, is below target, and progress on structural reforms has slowed. More worrisome, polls showed that an overwhelming majority of the population favored the plan initially, but support is now below 25 percent.
That public backing, which is a necessary condition for success, is vanishing for several reasons. The recession and austerity measures are perceived as evidence that the plan is failing. And the lack of progress in carrying out structural reforms is causing the rescue to be associated with the government cutbacks, which are primarily hitting the poorest. That adds to the existing feeling of injustice: High-profile corruption cases involving politicians and well-connected businessmen haven’t been prosecuted, and tax evasion is still pervasive and in plain sight.
A few weeks ago, the troika of the ECB, EU and International Monetary Fund decided to support Greece with a huge follow-up assistance plan.
Yet there are two prerequisites for that proposal to succeed that were missing from the initial blueprint: The government must persuade the public of the plan’s benefits; and it must move forward with deep institutional reforms. This includes changes specified in the initial plan, such as liberalizing labor and product markets, privatizing state-owned businesses, opening closed professions and strengthening tax collection.
The authorities now must go further by introducing accountability and incentives in the public sector, where tax collectors who are found to have accepted bribes are punished with a six-month salary freeze. The government should also overhaul the absurdly slow and inefficient justice system, which takes years to resolve even simple disputes or to prosecute corruption cases.
In addition, law enforcement should be enhanced, and strong corporate governance mechanisms to protect minority shareholders and creditors need to be put in place. Institutional reforms will have dramatic effects on growth by removing major obstacles to investment and entrepreneurship. Some of the benefits will accrue quickly, which will make it possible to relax austerity measures (particularly those affecting the low-income retirees who experienced tremendous cuts) and will increase the plan’s popularity.
These improvements will be popular as Greeks are increasingly aware that the status quo only protects minorities such as members of closed professions, corrupt public servants and government suppliers, who enjoy large benefits financed by high taxes.
Time and Resources
Giving momentum to these changes requires modifications both to the bailout plan’s design and its implementation. The troika should focus more on the reforms and less on fiscal targets, and give Greece the necessary time and resources to implement them.
This emphasis has been lacking. For example, the plan makes little reference to improving the justice system or corporate governance. Progress can be achieved with simple policies such as bringing the court system into the computer age, which will increase efficiency and transparency at a small cost. Applying restrictions on trial postponements (it isn’t uncommon for a case to be granted five postponements) will also produce large gains at no fiscal cost.
The plan also does too little to hasten institutional changes. The government was pushed to make up for fiscal shortfalls with new austerity measures, which deepened the recession. Yet in several instances where market liberalization was more limited than required -- such as opening up the pharmacist, notary and legal professions -- the troika didn’t apply sufficient pressure.
Likewise in the privatization debate, the troika myopically focuses on the short-term proceeds, without paying sufficient attention to the governance of the businesses that will be privatized and the competitive structure of the industries in which they will operate.
The institutional transformations must be extended to Greece’s public administration. The current system isn’t based on merit, lacks accountability and has misaligned incentives. This has created a dysfunctional bureaucracy that is largely unable to implement the enormous changes that are required. The recent wage cuts, salary caps for senior public officials and hiring freezes have demoralized existing employees and make it hard to recruit new talent at a time when it is most needed.
As a result, government agencies charged with important tasks such as tackling tax evasion, designing the privatization process, and executing product-market and financial-market reforms lack specialized personnel.
The troika should help remedy these deficiencies by providing technical expertise and financing for specific projects. The reforms, however, should be designed and implemented by Greeks, both within the country and from the thriving Diaspora.
That will enhance the legitimacy of the plan in the eyes of the public and bring much-needed human capital from abroad. Senior positions in public administration should be filled with talented technocrats, and pay should be increased. To minimize populist opposition and the appointment of party loyalists, selections could be approved by parliamentary committees.
Meaningful institutional change would clearly require additional resources from the troika. These costs are miniscule relative to the return that they will generate: a significantly increased chance of success for the bailout plan, and the backing of the Greek people, who desperately want their country to change.
Given the troika’s huge financial commitment to Greece, and the long timescale of the new plan, it would be disastrous to focus myopically on monthly tax revenue or privatization proceeds, rather than on the institutional framework that will drive the long-term growth of the Greek economy.
The assistance to Italy, Portugal and Spain should have the same focus. Even though the institutional deficiencies in these countries aren’t as severe as in Greece, they remain a major impediment to growth.
(Elias Papaioannou is assistant professor of economics at Dartmouth College and Harvard University. Dimitri Vayanos is professor of finance at the London School of Economics. The opinions expressed are their own.)
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