In January 1982, in his Newsweek column, Milton Friedman hailed Chile as an “economic miracle.” A decade earlier, Chile had turned to policies—the pursuit of free (“liberalized”) markets, a smaller role for the state, and globalization—that have since been widely emulated across the globe.
Figure 4.1 illustrates the global pivot to these policies in the 1980s. There is a strong upward trend in the extent to which countries introduced competition in various spheres of economic activity. Along with the shift to free markets, the size of the state—measured by government spending as a share of GDP—shrank. This smaller role for the state has been achieved through privatization and limits on the ability of governments to run fiscal deficits and accumulate debt. There has also been a steady move toward globalization, most notably in increased freedom for capital to move across national borders. Chile was ahead of the median country in all respects except in capital mobility: it maintained tighter restrictions than others through the 1990s but liberalized more actively later.
FIGURE 4.1: Trends in Economic Liberalization, Global versus Chile
Globally there was a strong upward trend beginning in the early 1980s toward adopting policies of deregulation, limiting the role of the state, and financial and trade openness.
Note: Composite index of policies to increase competition and to deregulate. Index takes values between 0 and 1. The median value across countries is shown. The index is smoothed using a five-year moving average.
Source: Ostry, Loungani, and Furceri (2018).
Note: Government expenditures as a share of GDP (including health and education). The median value across countries is shown. Data are smoothed using a five-year moving average.
Source: Ostry, Loungani, and Furceri (2018).
Note: The Konjunkturforschungsstelle (KOF) globalization index measures the extent that a country is globalized in three dimensions: economic, social, and political. The index ranges from 0 to 100; larger values indicate more globalization.
Source: Gygli, Haelg, and Sturm (2018) and Dreher (2006).
Note: Chinn-Ito index for period 1970–2014. The index takes values between −1.89 (most restrictive) and 2.39 (most open). The mean value across countries is shown. Chile right scale, data on Chile prior to 2001 are an average of the period 1970–2000.
Source: Chinn and Ito (2006).
With this chapter, we begin our analysis of the impacts of these policies on average incomes and on income inequality. We first study the impacts of various structural policies (or “reforms” as proponents of these policies tend to call them). While the reform index shown in the upper left panel of figure 4.1 is a composite of various policies, in this chapter we will look at the impact of each of the underlying policies separately. We then devote chapter 5 to a further and more detailed analysis of one of these policies—financial openness or capital account liberalization, illustrated in the bottom panels of figure 4.1. Chapter 6 looks at the impact of austerity—the shrinking of the size of the state, shown in the top right panel of Figure 4.1.
We assemble a comprehensive dataset of seven reform indices, covering both the financial and nonfinancial sectors of the economy (economists tend to refer to the nonfinancial sector as the “real” sector of the economy): domestic finance, tariffs, current account (or trade), capital (or financial) account, network industries, collective bargaining, and law and order.
Each of these indices attempts to measure the extent to which the sectors were deregulated, competition was strengthened, and institutions were improved. To take an example, the index for financial sector reforms—the first item in the list above—is based on the extent of interest rates and credit controls in place (the more controls in place, the more regulated the sector), the number of banks and their market shares (a sector controlled by a few large banks is less competitive), and various aspects of the extent of development of financial markets (such as, how extensive are local or municipal securities markets). Another financial sector index—the fourth item in the list—measures how open a country is to flows of foreign capital. This is based on measuring the restrictions placed on financial transactions between residents and nonresidents.
Similarly, the real or nonfinancial sector indices measure the degree of deregulation and competition in trade, network industries, and labor markets. How open countries are to trade is measured with two indices; one looks at the tariffs imposed—higher tariffs translate into less openness to trade—while the other captures nontariff barriers such as restrictions on the use of proceeds from trade (e.g., surrender requirements) and licensing requirements for carrying out imports and exports. The network reforms index measures the extent of competition and deregulations in the electricity and telecommunications sectors—these are often considered to be sectors critical to the performance of other sectors of the economy.
For labor market reforms, we use an index that captures the extent of collective bargaining. This index tries to capture the view that higher levels of collective bargaining can hamper the performance of labor markets if they allow workers to enjoy salaries far above the value of what they produce.
One final index is intended to capture the impact of the overall institutional setting of a country on growth and inequality. This index assesses the impartiality of the legal system and the popular observance of the law. We interpret this index to capture the effect of broad legal reforms that potentially increase economic freedoms and the enforceability of property rights.
Each of these indicators has shortcomings as far as its ability to measure fully the competition and deregulation in that sector. For instance, competition in labor markets depends not just on collective bargaining but also on restrictions on hiring and firing, among other features. For the cross-country analysis of the type we are undertaking, however, these indices represent the best option available; and they are the very same data used by the IMF and other researchers in earlier studies of the growth effects of structural reforms.
Figure 4.2 plots the average level of the reform indicators by country group over time. All indicators take values between 0 and 1. Higher values of the index imply more liberalized economies. There has been a broad trend since the mid-1980s toward liberalizing domestic finance, trade, capital accounts, and network industries. The advanced economies have almost completely reformed along the domestic finance, trade, capital account, and law and order dimensions with almost all advanced countries having an index greater than 0.8. Low-income countries (LICs) and middle-income countries (MICs) lag behind advanced economies in these reform areas and the gap between advanced economies and MICs and LICs has been maintained through the years.
FIGURE 4.2: Reform Indices Over Time by Income Level
There has been a broad trend toward liberalizing domestic finance, trade, capital accounts and network industries. Advanced economies have almost completely reformed along the domestic finance, trade, capital account, and law and order dimensions. Middle- and low-income countries continue to lag.
1/ Telecom and electricity
Note: All indices rescaled to lie between 0 and 1. Plots the average level of each reform index for each year for the group of advanced countries, MICs, and LICs. Country coverage changes over time as more data become available. Higher values indicate more liberalization.
Source: Ostry, Berg, and Kothari (2018).
For network industries and labor market reforms, the picture is blurrier. For the collective bargaining index, there is no clear difference between advanced economies and MICs and LICs. In fact, there is large variation in the index within advanced economies, reflecting the fact that different advanced economies follow very different labor market models. Nordic countries, for example, have relatively high levels of collective bargaining (low values of the index) whereas Anglo-Saxon countries have low levels of collective bargaining (high values of the index). The average value of the index for MICs is actually higher than for advanced economies (MICs have less collective bargaining on average than advanced economies). Similarly, for network reforms, there is considerable overlap in the distribution of the index between advanced countries and the other two groups.
We use standard statistical approaches (regression models) to assess the effect of reforms on growth and inequality—see the Technical Appendix. Figure 4.3 portrays our results in graphical form for all the reform indices. It shows the long-run change in per capita GDP (in percent) and the Gini coefficient (in percentage points) following structural reforms, thus showing the trade-offs between equity and efficiency that these reforms entail in the medium-to-long term. In this figure, we consider the impacts of moving the reform indicator from its median value to its seventy-fifth percentile value. What are our conclusions?
FIGURE 4.3: Growth and Inequality Effects of Structural Reforms
Structural reforms raise both long-run incomes and inequality, posing trade-offs between equity and efficiency.
Note: Each panel plots the effect on the level of income and the level of inequality of moving the reform variable from the median to the seventy-fifth percentile. The first bar in each panel (and left scale) plots the percent change in per capita GDP over fifty years arising from a reform. The second column in every panel (and the right scale) plots the change in the Gini coefficient over fifty years arising from a similar reform episode. Statistical significance is indicated by asterisks above the bar: *** p < 0.01, ** p < 0.05, * p < 0.1
Source: Ostry, Berg, and Kothari (2018).
First, consider reforms to the domestic financial system. The long-run effect (over several decades) on per capita GDP of moving the reform indicator from the median to the seventy-fifth percentile would be an increase in average incomes by 25 percent and an increase in inequality by 2 percentage points. In theory, the effect of domestic financial reforms on inequality is ambiguous. On the one hand, reforms could reduce credit constraints, lead to greater financial inclusion, and thus reduce inequality (Galor and Zeira, 1993). On the other hand, if the rich have better access to the formal financial sector, further financial deepening could benefit them disproportionately (Greenwood and Jovanovic, 1990). Our empirical evidence suggests that the latter effect dominates.
Financial globalization (or capital account liberalization) confers output benefits when the full sample of countries is considered but comes with a big increase in inequality. We explore this more fully in the next chapter.
Lowering tariffs results in a long-run increase in per capita GDP of 15 percent (again over several decades)—consistent with the positive effect of trade liberalization on growth documented in Sachs and Warner (1995) and Frankel and Romer (1999)—without having a significant impact on inequality. However, with the other measure of trade liberalization—the current account liberalization index, which considers nontariff barriers—there is an impact not just on output but also an increase in inequality. An increase in the reform index from the median to the seventy-fifth percentile (Honduras or Trinidad and Tobago in 2005 compared to the United States) results in a long-run increase in per capita GDP of 12 percent and an increase in the Gini of 2.8 percentage points.
Network reforms do not appear to increase growth. But the effect of these reforms on growth differs markedly across countries and depends on the level of corruption, especially for the sample of LICs and MICs. It is likely that in many countries with high levels of corruption, network reforms lead to the creation of monopolies in extractive industries that enrich some people in society but do not deliver broad gains in growth. Furthermore, network reforms seem to be associated with higher inequality. Moving the reform indicator from the median to the seventy-fifth percentile (India in 2005 compared to Australia) increases inequality by over 2 points. As with network reforms, the collective bargaining index has little impact on growth but raises inequality.
Improving the quality of the legal system is very beneficial for growth. An increase in the reform index from the median to the seventy-fifth percentile (Vietnam in 2005 compared to Portugal or Japan) results in an increase in long-run per capita GDP by 39 percent. Furthermore, reforming the legal system seems to have fairly small effects on inequality, and the effects are not significant. Overall, legal sector reforms thus seem to generate no trade-offs, with reforms being good for growth but at the same time not increasing inequality. These reforms probably improve the enforceability of property rights while at the same time creating a level playing field for all, thus increasing growth without contributing to adverse distributional effects. From a policy perspective, some caution is nonetheless warranted: ours is a de facto measure—that is, a subjective survey-based measure of perception of rule of law—and its connection to specific reforms is not obvious.
Figure 4.4 is a similar figure but restricted to our results for LICs and MICs. What stands out for this group of countries? Domestic finance reforms yield a smaller bang for output but lead to a bigger increase in inequality compared to the full set of countries. Tariff liberalization and the current account liberalization index continue to deliver somewhat different results: the use of the former generates more favorable outcomes than the latter; that is, higher income effects and lower inequality effects.
FIGURE 4.4: Growth and Inequality Effects of Structural Reforms in MICs and LICs
Structural reforms in MICs and LICs also pose equity-efficiency trade-offs.
Note: Each panel plots the effect on the level of income and the level of inequality of moving the reform variable from the median to the seventy-fifth percentile. The left bar and scale in each panel plots the percent change in per capita GDP over fifty years arising from a reform. The right bar and scale in every panel plots the change in the Gini coefficient over fifty years arising from a similar reform episode. Statistical significance is indicated by asterisks above the bar: *** p<0.01, ** p<0.05, * p<0.1.
Source: Ostry, Berg, and Kothari (2018).
An important finding is that for this restricted sample of LICs and MICs there is no growth benefit from liberalizing capital account restrictions, but there is an increase in inequality. In these countries, moving the index from the median to the seventy-fifth percentile (Kenya or Philippines in 2005 compared to the United States) increases inequality by 2.6 points. The effect of external financial liberalization on growth depends crucially on the mix of capital flows (Blanchard, Ostry, Ghosh, and Chamon, 2016, 2017) and it is likely that the impact on inequality does as well. Foreign direct investment is more likely to boost growth, but can also increase inequality by raising skill premiums. Short-term debt flows, on the other hand, may increase the chances of sudden stops and financial crises, potentially harming growth on average while also perhaps raising inequality. Our empirical evidence shows that capital account liberalization poses a sharp trade-off between growth and equity, with such liberalization having weak effects on growth but leading to a strong increase in inequality.
There is some evidence of labor reforms increasing inequality in LICs and MICs. While less centralized systems may deliver more employment, they are likely to increase wage inequality, with the latter effect seemingly dominating in the macro data; reduced bargaining power of labor in a more decentralized system may also induce greater inequality.
To summarize, we find that many reforms increase inequality as well as growth. Our finding in chapter 3 that higher levels of inequality may reduce growth raises the question: What is the total effect of reforms on growth? That is, after considering the higher inequality following reforms, how much lower is the effect of reforms on growth (and is it even positive)? To answer this question, we carry out some simple calculations by combining results from the separate analyses of growth and inequality.
Figure 4.5 reports results for this calculation. In the case of domestic finance reforms, there is a large positive direct impact on average incomes; the dampening effect of inequality on growth only subtracts a little bit off the direct effect, leaving a sizable positive total effect. In the case of current account liberalization, the direct effect and the indirect effect almost cancel each other out. Capital account liberalization also has a positive total effect on average incomes for the full sample of countries; again, we stress that a similar calculation done for LICs and MICs would show a negative total effect as the direct effect on incomes is elusive while the impact on inequality is large.
FIGURE 4.5: Direct and Indirect Effect of Reforms on Level of Per Capita GDP
The total effect of reforms on incomes depends not only on the direct effect but on the extent to which the resulting increase in inequality subtracts from growth—the indirect effect.
Note: Each panel plots the long-run direct effect, indirect effect (through increase in inequality), and total effect (sum of direct and indirect effects) of reforms on per capita GDP. In the growth regression, we include investment and education as controls. As market inequality is used as the dependent variable in the inequality regressions, we use market inequality as the control variable in the growth regressions when doing this exercise. This ensures consistency when combining the growth and inequality regression results.
Source: Ostry, Berg, and Kothari (2018).
The previous subsections present findings that many reforms raise both growth and inequality. The evidence is based on aggregating over the experience of several countries. Though we have used state-of-the-art techniques, it is nevertheless the case that econometric analysis cannot fully sort out the direction of causality nor can one be confident that the full set of factors influencing growth and inequality is included in the regressions. Hence, it is useful to supplement the evidence with narrative histories of—and the political discourse surrounding—growth and inequality in particular countries.
To carry out this exercise, we grouped countries into three categories and then in each case picked two countries to analyze in detail: (1) countries where there was a broad-based reform effort in many areas—with Australia and Tanzania picked as case studies, (2) countries where there was a big push on domestic finance or trade—China and Indonesia, and (3) countries that have pushed ahead strongly on capital account liberalization or network reforms—Czech Republic and Argentina.
The reform dates are chosen based on combining information from the indices of structural reforms and the event studies. Figure 4.6 plots growth and inequality before and after the reforms for our country cases showing that, in most cases, both growth and inequality increased following the reforms. The growth impact from reforms has been studied extensively by other authors. What we see is that there was also an increase in inequality in the aftermath of reforms, as suggested by our panel regressions and event studies. We next discuss whether the narrative evidence gives a sense of the mechanisms discussed in the literature review.
FIGURE 4.6: Growth and Inequality Effects of Structural Reforms, Country Cases
Inequality before and after reforms for our country cases shows that, in most cases, both growth and inequality increased following the reforms.
Source: Ostry, Berg, and Kothari (2018).
Broad-Based Reforms
Australia: In the 1980s and 1990s, Australia implemented extensive domestic financial sector reforms, including removing interest rate controls and some bank lending restrictions, and taking steps to foster increased competition. There was also comprehensive trade liberalization from the late 1980s through the 1990s, including phased reductions in tariffs across sectors. Collective bargaining systems were overhauled to introduce more labor market flexibility. There was also a major domestic finance reform in 1991 and network reform in 1996.
That Australia experienced a growth payoff from these reforms is widely accepted: the country has enjoyed steady growth over the past two decades. Adhikari, Duval, Hu, and Loungani (2018) show that Australia’s post-reform output performance has been better than that of a peer group of countries that did not undertake similar reforms. What is noteworthy is that market inequality has also increased following this period of reform: market Gini rose from 42 in 1991 to 47 in 2005. Concerns about these distributional effects have been part of the political discourse in Australia (Conley 2004), but were muted by the strong growth performance and by extensive redistributive policies (Greenville et al. 2013).
Tanzania: The country has launched two major waves of reforms. The Economic Recovery Program in 1986 focused on trade and exchange rate liberalization and a second effort in the mid-1990s focused on financial and labor market reforms and on privatization. Reforms paid off in higher growth: Tanzania’s per capita GDP growth averaged almost 3 percent a year over the period 1985–2010, substantially higher than its past growth and higher than that of its peers.
However, contrary to the experience of many other countries that have conducted broad-based reforms, inequality declined over the period. The country’s success in diversifying into labor-intensive manufacturing is often mentioned as a possible reason, but a full explanation of the country’s favorable distributional outcomes is still being debated (Atkinson and Lugo 2014). There is also some concern about more recent distributional developments: Treichel (2005) notes that, despite strong macroeconomic performance between 2001 and 2007, “social and poverty indicators for the country as a whole have not improved substantially over the past decade,” with progress on these indicators limited to the commercial capital, Dar es Salaam.
In general, countries carrying out broad-based reforms have seen increases in both growth and inequality. Examples include India (following reform in the mid-1990s), Uganda (1990–1995), Costa Rica (1990s), Ghana (late 1980s), Mozambique (mid-1990s), and Rwanda (early 1990s).
Trade-Focused and/or Domestic Finance-Focused Reforms
China: Starting in the late 1980s, China embarked on trade liberalization and domestic financial sector reforms. The network reforms and opening up of the capital account came much later, in the 2000s. Our empirical evidence would suggest a large growth impact initially from the trade and financial sector reforms, perhaps with some moderation as the growth impact of the later reforms is muted according to our evidence; inequality should increase, with the impact likely rising over time as the later reforms have stronger distributional consequences. As is well known, China has enjoyed remarkable growth following the launch of its reforms and this has enabled the rescue of millions from abject poverty. At the same time, inequality has increased dramatically, with large rural-urban income differentials and divergence between coastal and interior provinces (Yang 1999; Tsui 1996). Our evidence suggests that as capital account liberalization proceeds, such distributional impacts will grow and steps will be needed, through redistribution and other means, to contain their adverse impacts, including on growth itself. Many other countries in Asia that have followed a similar export-oriented strategy have experienced a similar increase in inequality in recent decades.
Indonesia: Faced with declining oil revenues and balance-of-payments problems, the Indonesian government moved toward greater market orientation. The financial system was deregulated in two stages, with abolition of most bank lending controls, and the abolition of ceilings on deposit rates at state banks in 1983 and changes in controls to bank borrowing and lending rates and a relaxation of banking entry norms in 1988. “The combination of the June 1983 and October 1988 packages took Indonesia’s banking system in just five years from state bank dominance and bureaucratic suffocation to being an effervescent, private sector-driven collection of institutions, remarkably free of government intervention,” according to McLeod (1994). Reforms led to increased financial deepening, with private sector credit as a percent of GDP increasing from about 10 percent in 1980 to almost 50 percent in 1990. However, progress on financial inclusion was a lot slower, and Indonesia continues to lag behind Asian peers on the inclusion dimension. Growth picked up in the aftermath of the reforms, so much so that Indonesia was hailed as a miracle performer in the decade between the 1988 reforms and the start of the Asian crisis. Over the same period, however, inequality increased, as described by Jayadev (2005): “In the new regime, rapid urban growth (financed by abundant credit) changed employment patterns by moving people from unpaid family labor and the agricultural sector toward urban centers and cities. At the same time, sectors which had provided employment for low skilled workers declined,” exacerbating wage differentials.
A Thrust Toward Open Capital Markets and/or Network Reforms
Czech Republic: Among the transition economies, the Czech Republic was a “pioneer … in achieving a high degree of liberalization of its capital account relatively early in the transition process” (Arvai 2005). Liberalization of inflows was faster than the removal of outflow restrictions. FDI was the first major item to be liberalized in the early 1990s; most capital transactions were de jure liberalized by September 1995; and the Organization for Economic Cooperation and Development (OECD) accession took place in December 1995. Growth and inequality increased as they did in other transition economies, but some observers note that the Czech Republic underperformed on growth and suffered worse distributional outcomes than other transition economies because it focused excessively on promarket reforms such as opening of the capital account but “grossly neglected the need to establish a functioning legal framework and corporate governance of firms and banks” (Svejnar 2002). In the Czech Republic, the Gini coefficient in the 2000s was 7.5 points higher than in the 1990s, three times more on average than for other Central European transition economies.
Argentina: In 1990, the country privatized the state-owned telecommunications company. This had an immediate macroeconomic impact due to massive job cuts, particularly affecting the least-skilled workers, who generally were unable to find new jobs. Though rates gradually fell after privatization, they fell much more quickly in the commercial and long-distance segments most used by the wealthy than in the local tariffs most heavily used by the poor (Galperin 2005). This case is typical of many in the developing world, particularly in Latin America: the end of state monopolies in transportation and telecommunications contributes to income inequality as a result of substantial job loss of low-skilled workers, price increases, and a decline in real output, but with substantial benefits for the powerful and wealthy (Auriol 2005; McKenzie and Mookherjee 2003). Though many factors contribute to high inequality in many Latin American countries, network reforms are considered to have played an important role.
As noted in the introduction to the book, economists have traditionally paid attention to the efficiency gains of policies but ignored their equity impacts. Our results suggest that, on average, measurable and significant distributional impacts have been associated with structural reforms. We call attention to this fact not to argue that policymakers should shy away from pursuing reform. On the contrary, our results show that many reforms have a positive impact on growth even taking into account the effects on inequality. Rather, we lend weight to the call for reforms that are designed with distributional consequences in mind.
Our results also suggest that the growth impact of reforms cannot always be taken for granted. The consensus policies of free markets, macroeconomic discipline, and globalization have broadly worked, but this does not mean that departures from them are bound to be costly. In fact, with the passage of time, how strictly Chile adhered to consensus policies is being reassessed. Many have come around to the view expressed by Joseph Stiglitz that Chile “is an example of a success of combining markets with appropriate regulation” (2002 interview). Stiglitz notes, in particular, that in the early years of its move to neoliberalism, Chile imposed “controls on the inflows of capital, so they wouldn’t be inundated in the way that Thailand was, which led to the [1997–98 Asian] crisis.” In later years, with its economy and its financial markets much more developed, Chile saw fit to lift these capital controls. Chile’s experience, and that of other countries, suggests that no fixed agenda delivers good outcomes for all countries for all times.
