Why Investors Shouldn’t Expect Much Euro Zone Reform

Deregulation of labor markets may be the wrong move in the short run, both politically and economically.


Like a pious father saying grace before every meal, Mario Draghi, president of the European Central Bank (ECB), once more repeated his standard plea for comprehensive deregulation of euro zone economies at his regular monthly press conference on Thursday. In his opening statement, he prayed for “further measures to enhance labor market flexibility and labor mobility.” Draghi did not, on this occasion, ask for parallel liberalization in product markets — though he did last month and in all probability will next month.

Draghi can be thankful that although the currency union is still far from his happy vision of a highly free-market economy, many member states are at least moving further towards his ideal. Euro zone politicians in the troubled periphery may not be listening to his prayer with reverence — some are unenthusiastic revolutionaries, muttering complaints about the reform agenda under their breath as they ponder how to get their electorates to agree to it. They are, however, listening to him carefully. This is because Draghi holds the purse strings — and the euro zone purse has some very tight strings attached.

Draghi’s home country, Italy, has outlined one of the most ambitious programs of deregulation. This was spurred initially by a letter to the prime minister, Silvio Berlusconi, penned jointly in August 2011 by Draghi and Jean-Claude Trichet on the eve of Trichet’s retirement to make way for Draghi. The missive demanded spending cuts and extensive reforms in return for the emergency buying of Italian government bonds — with strikingly specific suggestions for changes to the labor market, including the liberalization of closed professions and cuts to public-sector wages.

It was Berlusconi’s unwillingness to adhere to these changes that ultimately forced his resignation two months later — ushering in a new government under Mario Monti whose reform agenda has, in the words of Credit Suisse, succeeded in “ticking all the boxes recommended by international institutions, such as the European Commission and IMF.” New rules, such as the removal of an employee’s right to be reinstated after a redundancy made for commercial reasons, aim to make it easier to hire and fire workers.

The three other countries in which reform has been most radical are all in the reluctant club of nations whose bond markets have been saved by emergency assistance from the ECB: Italy, Spain, Portugal and Greece. In Spain, for example, redundancy payments for permanent workers have been cut savagely. Draghi has again rammed home the conditional nature of aid — politicians must reform markets as well as trimming fiscal deficits, and in return he will keep their national bond markets on life support — when outlining the terms of the Outright Monetary Transactions program, the ECB’s latest emergency bond-buying initiative, in August this year.

In the eyes of the ECB, deregulation is probably most urgent in labor markets. Even before the credit crunch put employees out of work, rigid rules in these countries depressed employment rates, limiting output growth.

Most economists think deregulation is, in the long term, good for these countries’ economies, and hence for the sustainability of their sovereign debt markets. The economic case for pressing ahead with liberalization is strong. Can institutional investors therefore look forward to a fast pace of growth across the entire euro zone, boosted by deregulation?

The answer is “no,” for several reasons.

Experience shows that politicians will continue pressing ahead with reform only if the markets take them by the heels to dangle them over the precipice — and keep them suspended there. A sudden leap in French bond yields late last year suggested that the country might be joining the peripheral countries shunned by institutional investors — and Nicolas Sarkozy, the then-president, responded with a flurry of measures. However, the momentum for change dissipated with the return of yields to safe-haven levels. There is, as Credit Suisse wryly observes, “nothing like a crisis to put plans into practice and focus minds and efforts.”

Moreover, even if the euro zone succeeds in running fast down the road of reform, it will only be running to stand still.

The European Commission has predicted that, unless there are major changes to economic policies, the currency union will see a notable long-term decline in the growth of “potential output” — the pace at which it can advance before shortages of labor and capital start to hamper economic expansion. This is because the euro zone’s working-age population, the number of people from their late teens to early sixties, is set soon to decline. As a result, the commission projects growth in potential output — which over the economic cycle as a whole equates to growth in actual output — of only about 1.25 percent between 2015 and 2020. This is much lower than the commission’s estimated rate for potential output growth of 1.9 percent in the years before the credit crunch. The ECB has used this sobering projection to call for employment deregulation — arguing, in a 2011 paper on potential output, that “real and nominal rigidities in labor markets may hinder the reallocation of labor resources and limit the adjustment of wages, leading to weak labor demand and a persistent pattern of lower employment growth.”

A further problem is that reform can, temporarily, reduce rather than increase output. Over the course of an economic cycle, rules that make it easier to hire and fire will probably encourage the former more than the latter. However, during the sort of slump that much of the euro zone is facing now, it may well encourage the latter more than the former. Moreover, the experiences of Spain and Greece in particular show that it is much harder to persuade the populace, during downturns, to accept such reforms: They look to disgruntled voters like panic measures to soothe international capital markets rather than rational adjustments.

The euro zone peripheral states are, in other words, implementing good reforms at the worst possible time — and this suggests that deregulation could dig a bumpy road for sovereign bonds.