Friedrich Heinemann

1
Explaining reform deadlocks

• Friedrich Heinemann
• ZEW Mannheim
• E-Mail heinemann_at_zew.de
• Workshop Economics Meets Psychology
• Frankfurt, Deutsche Bundesbank, 14 July 2004

2

• Explanations for slow reforms
• Macro-approach based on EFW indicator
• Descriptive insights
• Probit regressions
• First conclusions
• Outline of planned research project

3
Starting point

• Long lags between problem identification and
  institutional change
• Particularly relevant for large Euro countries
• High economic costs of institutional stickiness
• Reform policies unpopular
• Why do voters hurt themselves?

4
Rational explanations

• Distributive effects of reforms coupled with
  interest group power
• J-curve effects and short time horizons of
  certain lobbies (ageing society)
• Uncertainty of outcomes and risk aversion
• Coordination problems (Alesina and Drazen (1991)
  war of attrition)

5
Doubts about solely rational explanations

• Status quo brings about uncertainty (e.g.
  pensions).
• Structural stickiness affects large shares of
  population and interest groups.
• Strong incentives for reform winners to
  compensate losers.

6
The case for behavioural economic policy

• Irrationality should be more relevant at the
  ballot box compared to financial markets
• Irrational voting is costless from an individual
  point of view.
• Caplan (2001) treats irrationality as a standard
  good where demand depends on price.
• Rational irrationality vs. rational ignorance.

7
Transferring behavioural finance insights

• Status quo bias preference for one option only
  because it happens to be the status quo
• Endowment effect preferences depend on whether a
  certain good is possessed or not
• Loss aversion utility function non-continuous in
  reference point which is the status quo
• All these anomalies benefit the status quo and
  hint to irrational psychological barriers to
  change.

8
Empirics of reforms a macro approach

• Country panel
• Definition of a reform indicator
• Comparing properties of reform and no reform
  countries
• Searching for causal links
• Reminder No single approach is capable of
  testing whole universe of potential factors

9
Quantifying reforms

• Challenge quantifying reforms
• Suggestion A reform event is defined as a
  significant change in the Economic Freedom of the
  World (EFW) index
• Characteristics of EFW index
• available since 1970 in 5 year intervals,
• for 123 countries,
• 38 variables in current version,
• scale 0 (completely unfree) to 10 (free),
• grouped into government, legal system, money,
  freedom to exchange, regulation,
• Aggregate index as unweighted mean of five
  sub-components.

10
Advantages EFW as reform indicator

• Data availability (e.g. compared to Heritage
  Foundation),
• availability of sub-indices,
• clearly established link with growth the index
  indeed measures changes relevant for growth
  potential,
• lack of alternatives.

11
Frequency of reform events (in of period
observations)
A reform event is defined as a change in the EFW
aggregate indicator by at least 0.5/0.75/1.0
points.
12
Explanatory variables objective need for reforms

• unemployment (level and change),
• growth (level and change)
• openness export ratios, extent of capital flows
• change real effective exchange rate
• country size measured by population
• starting value of EFW index

13
Explanatory variables political economic factors

• age structure such as population share above 65
  (-)
• dependency ratio (-)
• life expectancy ()

14
Explanatory variables rational ignorance and
limited rationality

• school enrolment (),
• availability of media information (?)
• financial development as proxy for economic
  education ()
• Note hard to differentiate between rational
  ignorance and limited rationality in macro
  approaches.

15
Test for differences in mean for reform/no reform
events (number of observations in brackets) - I
16
Test for differences in mean for reform/no reform
events (number of observations in brackets) - II
17
Probit regressions

• Specification
• dependent variable 1/0 reform/no reform within
  five-year-window
• reversed causation problem explanatory variables
  prior to five-year-window
• inclusion of time and income group dummies to
  account for country heterogeneity and reform
  moods
• Data availability leads to elimination of
• unemployment ratio, GDP p.c., real exchange rates
• Elimination of variables due to general
  insignificance
• dependency ratio, newspapers, TV-sets, population
  size, bank credits

18
Probit regression reform determinants,EFW total
Time and income group dummies not reported p
values in parentheses, // significant at
10/5/1.
19
Probit regression reform determinants,EFW
sub-indices
not reported time and income group dummies,
growth and life expectation (both always
insignificant) p values in parentheses,
// significant at 10/5/1.
20
Conclusions from this first macro-approach

• Objective need for reforms variables perform
  well.
• Changing fashions in reform moods.
• Hint to political-economic factors probability
  of reform decreases with increasing age of
  population.
• Level of education relevant for government sector
  reforms.
• But Macro-approach only of limited use for
  assessing degree of (ir)rationality.