Economic Uncertainty and Structural Reforms

Barcelona GSE Focus

This research was a candidate for the Vanguard of Science Prize, organized by La Vanguardia newspaper.


Can economic uncertainty make it easier for politicians to implement painful but beneficial reforms? In Barcelona GSE Working Paper (No. 847), “Economic Uncertainty and Structural Reforms,” Alessandra Bonfiglioli and Gino Gancia find evidence that indeed this is the case. Combining data on structural reforms and economic volatility into a panel data set covering 56 countries and stretching back decades, the authors find a robust positive relationship between the level of economic volatility, independently of the presence or absence of an economic crisis, and the average size of liberalizing reforms.

Why are reforms, even those which are widely viewed as necessary and beneficial, often so difficult to enact? In the case of reforms which have short-run costs and long-run benefits, the desire of politicians to be re-elected may be an important part of the story. Luxembourgish politician Jean-Claude Juncker once said “We all know what to do, but we don’t know how to get reelected once we have done it.” There are a variety of reasons why voters may blame politicians for the short-run pain inflicted by reforms, which in turn forces politicians to be overly cautious.

In spite of the general atmosphere of caution, there do seem to be some conditions which make bold change easier to implement. A crisis, for example, by raising the cost of inaction, may force politicians to make reforms they would have neglected in normal times–hence the phrase “never let a good crisis go to waste”. Bonfiglioli and Gancia propose another facilitating condition which, though related to crisis, is distinct–the level of economic uncertainty.

Uncertainty and reforms

The basic idea is that if the future performance of the economy is uncertain, voters won’t know whether a bad short-run outcome is the result of political actions or mere economic fundamentals, making it easier for politicians to escape blame for the costs of reform. This helps politicians overcome their myopia, and makes them willing to implement larger reforms.

In addition to the positive effect that uncertainty may have on the chances of reform, it is also possible to identify some ways in which the effect might be negative. If the distribution of the costs and benefits of reform is uncertain, for example, voters may prefer to avoid the risk of making a big change, leading to status quo bias. Also, if the size of the benefits and costs of reforms are not known beforehand, voters and politicians may prefer to make reforms more slowly, adopting a gradualist, “wait and see” approach. There is no way theoretically to determine whether the positive or negative effects of uncertainty will dominate in shaping the reform environment, meaning that in order to know the direction of the overall effect it is necessary to look at the data.

Data and empirics

In order to measure the impact of uncertainty on economic reform, the authors construct a panel data set including 56 countries with yearly data from 1973 to 2006. To measure reforms, they compute the annual changes in indices capturing the level of liberalization (or legal restriction) in six key sectors: the domestic financial sector, external capital accounts, trade, the current account, product markets and agriculture. The measure of economic uncertainty used by the authors is the volatility of stock market returns. The authors also use data on the incidence of natural disasters, political shocks such as coups-de-etat, terrorist attacks with the goal of identifying the causal effect of exogenous variation in economic uncertainty, narrowly defined as the variability of investors’ expectations about firms’ future sales, as much as possible. The authors also control for political variables such as the extent of democracy and the left/right orientation of the current government, for economic and financial crises, as well as indicators of the level of development such as the level of Gross Domestic Product (GDP) per capita and membership in the Organization for Economic Cooperation and Development (OECD) and European Union (EU), also with the goal of holding these factors constant and isolating the effect of the variable of interest.

The authors find, finally, a positive and significant effect of economic uncertainty on the average size of liberalizing reforms which persists under a wide variety of estimation methods and combinations of control variables. Specifically, they find that, depending on the specific method used to estimate the effect, a one standard deviation increase in the volatility of stock returns in a particular country is associated with an increase in the average size of reforms of anywhere from 4 to 33 percent.

Don’t let it go to waste

In other words, after examining the data, it appears that the positive effects of economic uncertainty on the reform environment outweigh the negative. This suggests that, even though stock markets remain volatile worldwide in the aftermath of the 2008 financial crisis, this uncertainty may have a silver lining and that, just like a “good crisis,” politicians should not let it go to waste.