Crises, What Crises?

1. Crises, What Crises? Nauro F. Campos Brunel University, CEPR (London) and WDI - University of Michigan Cheng Hsiao Department of Economics University of Southern California Jeffrey B. Nugent Department of Economics University of Southern California ICE-TEA 2006 Turkish Economic Association Ankara, Turkey

2. Reform literature: studies show that crises beget economic reforms, but largely silent on the question of which crises matter most Our Questions: • Which types of crises matter most? • Do the effects differ from one type of reform to another (trade and labor market reforms)? • Do the effects of the economic crises on reform differ from region to region? • Are the reforms interrelated? • Are the answers to these questions sensitive to: a. the relations between the different kinds of reform, b. the relations between the different types of crises c. institutional andother conditions?

3. To answer these questions, we 1.Put together a unique data set covering more than 100 developed and developing countries for 5-year periods from 1950 to 2000. 2. Develop measures of two types of crises – economic and political – and two types of reform. 3. Estimate the determinants of these two reform indexes (LMR and TL). 4. Determine the sensitivity of the results to different measures of each type of crisis, interrelationships between the crises and reforms.

4. I.Introduction: On Reform: Theory and Empirical Evidence Even though there is gradual convergence in some kinds of policy reforms, such as in fiscal and monetary policy reforms, in other areas of reform, there is little or no convergence, with major countries remaining unreformed and others even reversing their earlier reforms, often as the benefits of thsee reforms appear not to be as strong as they had been anticipated. While theoretical literature quite developed, empirical literature has lagged. What there is has been of the case study type or for short periods of time or cross-sectional.

5. Reform Theory: Alesina and Drazen (1991) Drazen and Grilli (1993) While reform (like financial reforms) with virtually no losers is easy, that with losers (structural reforms) may be more difficult (Rodrik 1996) Key hypothesis: • Structural reforms require agreements among the contending groups. • War of attrition: Each party has an incentive to hold out until the other party or group decides to make a concession. • Existence of a crisis can shorten the delay, forcing compromise and concessions earlier Examples and anecdotal evidence offered usually focuses on economic crises but we suggest political crises also.

6. Existing Empirical Evidence • Bruno and Easterly (1996): effect of hyperinflation on stabilization policy • Drazen and Easterly (2001): Effects of economic crises on subsequent economic performance: Mixed results • Alesina, Ardagna and Trebbi (2006) Stabilization likely to occur noy only following crisis but also in “honeymoon period” of a new government in presidential systems • Tornell (1998) Trade reform more likely when both economic crisis and political crises occur • However, Lora (1998), for LA only, shows only economic crises to have effect

7. II. Measuring Trade Liberalization, Labor Market Reform and Crises * Trade liberalization measure • Follow Sachs and Warner (1995) dichotomous measure “OPEN” as updated and corrected by Wacziarg and Welch(2003) for 114 countries, 1970s and 1980s • We extend this back wherever possible to the 1950s (with other data from Gwartney, Lawson and Damira (2000), Penn World Tables and Index of Economic Freedom • A country was classified as Closed, i.e., OPEN=0, if any one or more of the following dummy variables was positive: (1) an average tariff rate of 40 per cent or more, (2) non-tariff barriers covering 40 per cent or more of trade, (3) a black market exchange premium of at least 20%, (4) a state marketing agency or board for major exports, and (5) a socialist economic system (as defined by Kornai 1992).

8. Indexes of Labor Market Reform (LMR) These are all based on indexes of labor market rigidities or restrictions For OECD countries: Blanchard and Wolfers (2000) (BW), index of Employment Protection 1960-2000 for 5 year periods only For LAC countries: Heckman and Pages (2000) from late 1980s to late 1990s. Computed as the present value of costs of dismissing a worker in formal sector according to job security regulation to the firm at time worker is hired (exclusive of court costs) For other regions: Botero, Djankov, La Porta, Lopez-de-Silanes and Shleifer (2003) and extended by World Bank (2004) for other regions. This is a “Rigidity of Employment Laws Index based on three major subindices (difficulty of hiring, regidity of hours and difficulty of firing indexes), each of which is based on a number of more detailed indicators. This index is limited to the years beginning only in 1995 BW’s starting point is Index of Employment Protection (OECD 1999), OECD “late 1980s” and “late 1990s,” (based on inter alia ILO conventions, eg discrimination, child labor and fair dismissal), which they then extend by filling in in-between values by linear interpolation and then going back to 1960 on the basis of Lazear’s data and notice requirements and severance pay via backcasting

9. Further Steps for LMR Indexes: What did we do? For LAC and other non-OECD countries: we backcasted and sidecasted these indexes for recent years backwards in time using variables like the following: NEWEP = F (Dummy variables for Legal origins (French, English, German) Time-Varying data on adoption of ILO Conventions (chldlb, forclb, abolfl, eqlrem, discrm) Share of agriculture (and share squared) Quality of institutions index (property rights) Regional dummies Key Data: Forteza and Rama (2001, World Bank) Number of obs = 148; R-squared = 0.8139; Adj R-squared = 0.7928; Root MSE = 0.563 Used these coefficients and actual data to backcast and sidecast missing values.

10. Next Step on LMR Indices Convert TL and LMR indexes into the same 0-1 range and same direction (higher values reflecting Trade Liberalisation and Labor Market Reform as in Lora (1998) Subtract each value from the series maximum and divide this by the series range (maximum minus minimum value). Once all the variables are collected, they are aggregated and transformed into a 0 to 1 scale (with 1 indicating maximum reform over countries and years

11. Measures of Crises • Political (3) • Political Instability: Principal components index of revolutions, coups, political assassinations during each 5 yr period (Banks 2005) • Inverse measure: Regime Durability (Polity IV) • Civil War Intensity (Correlates of War Project) • Economic (4) • Max fall in GDP • No. of years in currency or debt crises • Inverse Measure: Current Account Balance (CAB)

12. Measures of Political Institutions • Party Fractionalization Index • Political Constraints Index (Henisz 2000)

19. Panel Data Estimation • Each Reform Index = F( Economic Crises, Political Crises, Institutions) • Test for Pooling across Regions: Homogeneity across regions rejected • Sensitivity Analyses • Alternative Measures of Crises • Allowing feedbacks between the two types of reforms both contemporary and with lags

20. Initial Model with No Feedback between Reform Types • Ritc = α +β1Ptc + β2 Etc + β3Xtc + ε where Ritc is reform index i at time t in country c P = Intensity of Political Crises E = Intensity of Economic Crises X = Institutional and Other Controls

21. Table 1 Effects on Trade Lib.

22. Table 2 Labor Market Liberalization

23. Next Step: Sensitivity Analysis • Use alternative measures of both Economic and Political Crises • Debt Crises (Economic) • Civil War Intensity (Political) • Repeat Tables 1, 2 substituting these alternative measures for Currency Crises and Regime Durability • These results given in Tables 3, 4

24. Table 3 Trade Liberalization

25. Table 4 Labor Market Reform • Neither Debt Crises nor Civil War Intensity has a significant effect in any region • While effects of Max Fall GDP no longer significant , those of CAB and Political Instability have very similar effects as in Table 2

26. Next Step: Allow for lagged effects across Reforms • Trade Lib affected by Lagged LMR • Ritc= α0+α1Rjt-1c+β1Ptc+β2Etc+β3Xtc+ ε • LMR affected by Lagged Trade Liberalization • Tables 5, 6 repeat the specifications of Tables 1, 2, respectively, with this added variable in each case

27. Table 5 for Trade Liberalization • Lagged Labor Market Reform Variable has significant negative effects in Africa, LAC • The Max Fall GDP still has positive effect only in LAC • Currency Crisis still has negative effects in All, DEV, Africa and LAC • CAB still has positive effects in All, Africa • Regime Durability still has positive effects in DEV, negative effects in All, Africa • Political Instability still has positive effects in All, DEV, LAC and MENA

28. Table 6 for LMR • Lagged Trade Liberalization hassignificant positive effects on LMR in All, Africa, and Asia • Effects of Max Fall GDP remain Negative and Significant in All, Asia and Transition • Effects of CAB remain Positive and Significant in All, DEV and Africa • Effects of Political Instability remain negative in All, Africa • Effects of Regime Durability Remain Positive in All, DEV, Asia, MENA

29. Final Step: Allow for Simultaneous Interaction between the Two Reform Variables: 2SLS Estimates • Ritc= α0+α1Rjtc+β1Ptc+β2Etc+β3Xtc+ ε • Difficulty of Identifying Good Instruments. Can no longer have identical specifications. We exclude Max Fall GDP from Trade Lib, Currency Crises and CAB from LMR • Multicollnearity also present • Results in Table 7 for Trade Lib. weaker, with fewer significant determinants. • But in No case is there a sign reversal. No support for Econ. Crisis Begets Reform (Curr Crisis, CAB) have opposite sign • Support for Political Crisis remains: Regime Durability negative, significant,in Africa, Pol Instability positive, though not statistically significant • For no region and for each reform is there evidence of simultaneous feedback between the reforms.

30. Table 8 for LMR • No Simultaneous feedback in Reforms • For DEV only is there a positive, significant effect of Economic Crisis on LMR • Political Instability Hinders LMR • Because of multicollinearity and identification problems, cannot reject possibility of feedbacks between the two reforms, but certainly does not support this.

31. CONCLUSIONS • Robustness checks of Tables 3-8 generally find very similar results as in Tables 1, 2 • Political Crises seem to be more important determinants of reform than Economic Crises • For political crises the effects differ in sign between the two reforms: • Negative of LMR • Positive on trade liberalization • Heterogeneity in results across regions: should not pool • Other determinants: • Level of GDP, Institutions (Party Fractionalization) • Both Positive for TL and negative for LMR

32. Future Research • Instead of determining only levels of TL and LMR in each country and period, should also determine Speeds of implementation • Conduct detailed case studies to determine why the effects of political crises vary across regions as well as types of reform • Investigate the determinants of other reforms (financial sector reform, privatization, etc.