The reform club

By Paul Donovan
April 15, 2014

(Any opinions expressed here are those of the author and not of Thomson Reuters)

That custodian of the English language, the Oxford English Dictionary, describes a bubble as “anything fragile, unsubstantial, empty or worthless; a deceptive show”. Could this description apply to the current frenzy for “reform” that is seemingly sweeping the global economy? The answer is “yes, in part”. While there are some genuine attempts at reform, market expectations for reform will inevitably be disappointed in some parts of the world.

The global financial crisis has prompted politicians to advocate economic reform in two ways. First, the crisis demonstrated that the status quo needed to be changed — and in many cases that change required sizeable structural change. Second, as the structure of the world economy has changed (lower global capital flows, slower global trade, etc.) so economies have had to adapt the way that their economies are structured.

The inevitable reaction to this is that politicians are scrambling over each other to advocate reform. Reform is seen as a break with the past, and helps governments avoid being tainted with past errors. Advocating reform is a way of containing popular anger about historical mistakes. Looking at the focal points of fiscal, labour market and financial system structures, almost three quarters of the world economy as measured by GDP is assessed as needing some kind of reform in one or another of these areas.

In some cases, the need for reform is seen as being very broad based. Japan’s need for fiscal and labour market reform is at least recognised (though perhaps not put into practice) by Abenomics. The Euro area’s need for a credible change in its banking system structure has been acknowledged by giving the central bank the power to regulate banks, though this is still seen as incomplete.

Moreover, the bigger need for reform of the monetary union (to make it work) is seen by economists as a critical medium-term goal. Chinese reform was considered sufficiently important as to merit an entire plenary session last year (accompanied by an ambitious and lengthy document detailing change).

Fiscal reform in the United States seems to be the goal of every incoming president, and the increase in the deficit wrought by the global financial crisis along with the brinkmanship of government shutdowns has only emphasized the need for change.

Investors have become hooked on the reform hype. Almost every discussion on global economics will dedicate some time to reform and structural change. However, structural change is never pleasant (as anyone who lived through the upheavals of the Anglo Saxon economies of thirty years ago or the Asian economic changes of fifteen years ago can testify). As a result, the political willingness to talk about reform is rarely matched by political action. It normally takes a very significant economic threat to spur a government into embracing major reform.

Expectations of reform are therefore unlikely to be matched by reality. Where reform is believed to be needed, meaningful and comprehensive reform is expected in only around a third of cases. Reform hopes are likely to disappoint two thirds of the time, which is quite a lot of disappointment for investors to bear. In some cases the attempt to match reform expectations with reform reality may compromise on a gradualist approach.

China’s reform agenda is a good instance of this; the initial reforms are the “easy” reforms – changes that are unlikely to produce any near-term problems for economic growth or perhaps more importantly for social stability. More serious reforms that may entail a degree of social change (and therefore economic risk) are being delayed until some future date.

So how should investors approach the outpouring of promises of reform? ‘With caution’ would seem to be the best advice. Some economies are undertaking change, it is true, but from a global level the amount of structural change is likely to disappoint reformist aspirations. In some cases reform will just not take place, in other cases it will be less comprehensive than had been hoped. A healthy cynicism on reform will probably yield good results.

In one sense, the fact that ambitious global reforms are likely to be more modest in reality is to be welcomed. Anything that changes the normal way of doing things is very disruptive to an economy – people do not tend to adjust that quickly. Labour reform in particular can therefore come with considerable short-term pain.

The most successful reforms tend to be those reforms that are undertaken against a backdrop of economic growth elsewhere in the world. If three-quarters of the world were to try and reform all at once, there would be no external growth left to ease the pain of adjustment.

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