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Credibility and Institutional Reform Reversibility
This original version of this post is co-authored with Emilio Ocampo.
As highlighted in my book with Emilio Ocampo and as I mentioned in this blog, credibility is the linchpin for any stabilization plan’s success. Credibility essentially encompasses the widespread belief that the government will steadfastly adhere to its economic policy, ensuring the plan’s durability. This, in turn, hinges on two crucial factors: 1) the political viability of the implementing government and 2) the alignment of its micro and macroeconomic approaches. The former relies on garnering support from a majority of voters, contingent upon the plan’s capacity to yield positive outcomes—curbing inflation without inducing a recession—in the short term. The latter necessitates a high degree of confidence in a) the government’s ability to execute a series of structural reforms encompassing substantial cuts in public expenditure, trade liberalization, tax system streamlining, banking restructuring, and economic deregulation, and b) the non-reversal of these reforms by subsequent administrations.
In essence, the degree of credibility is directly proportional to the likelihood of successful implementation of structural reforms and the prolonged sustenance of these changes. Stated differently, reforms that are more irreversible inherently command greater credibility. Various factors influence the reversibility of institutional reforms. Firstly, cultural norms play a pivotal role. In democracies characterized by respect for institutional standards and a clear separation of powers, legislatively enacted reforms are rarely overturned. Conversely, in democracies grappling with chronic institutional instability, laws lack credibility as the Executive Branch capriciously disregards or alters them. Argentina’s recent history confirms this phenomenon, exemplified by the “Intangibility of Deposits” and “Zero Deficit” laws from 2001, showcasing the deep institutional instability in the nation.
A second factor diminishing the likelihood of reform reversal is the associated cost, be it economic or electoral, of said reversal. For instance, Correa refrained from de-dollarization in Ecuador due to the currency’s greater popularity among Ecuadorians than himself.
Furthermore, a third factor hindering reform reversal is the logistical challenge or time required, potentially diluting the intended impacts of such a reversal. For instance, in an environment of unrestricted capital movement, even a hint of potential currency conversion could prompt depositors to transfer funds to more secure offshore locations.
Lastly, the probability of reform reversal is diminished if the reform necessitates approval from an international entity. For instance, in a democracy grappling with institutional instability, undoing a local regulation or congressional action is comparably simpler and less costly than reversing a multinational free trade agreement involving another jurisdiction’s legislative branch.
In democracies characterized by a robust separation of powers and adherence to legal norms, reforms within domestic purview possess the same degree of permanence as international accords. However, this isn’t the case in Argentina, where institutional instability renders domestic laws more susceptible to change than any international pact.
Should dollarization be pursued, a judicious sequencing of the requisite reforms (labor, tax, social security, banking, etc.) becomes pivotal in reversing the nation’s decline. To ensure the successful execution of these reforms, it’s advisable for them to be contingent upon previously implemented, hard-to-reverse changes. For instance, adopting multilateral free trade agreements under the Mercosur umbrella should precede labor reform, as these would be demanding and costly to undo, compelling the political system to advance with them.
An additional aspect to consider is that for a reform to flourish, it must attain a baseline level of credibility contingent upon the likelihood of its reversal. A lower probability of reversal engenders greater credibility. This relationship is depicted in the graph below. The requisite minimum credibility, denoted as C*, demands a corresponding probability of reversal, PR*.
The conundrum lies in Argentina’s institutional instability, preventing the attainment of C* under its jurisdiction. This concept is graphically illustrated below.
In sum, in democracies marred by institutional instability, the probability of reform reversal is mitigated when: 1) the economic and electoral cost of a reversal is steep, 2) the reform necessitates the approval of a supranational entity (thereby subject to a secure jurisdiction, either partially or entirely), and 3) the logistical complexities or temporal demands negate the intended outcomes.
Three reforms meet one or more of these conditions: 1) dollarization with central bank dissolution, 2) comprehensive banking reform fostering unrestricted competition and capital mobility, and 3) engagement in free trade agreements with other regions or blocks.
These three reforms create a “trap” for political power, streamlining the implementation of reforms initially considered relatively easy to reverse.
In a nation like Argentina, where institutional instability prevails, the sequence in which reform programs are enacted is a pivotal determinant of their success. Associating reversible reforms with harder-to-reverse measures bolsters their credibility. Conversely, starting with reforms that are easy to reverse risks truncating the plan. Reversing these reforms could impede progress toward more resilient ones.
The original post in Spanish can be found here.
Next: Why dollarization.
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