Rigidities in Greece’s product and labor markets leading to economic imbalances and the significance of reforms to these markets are played out in the first paper. The second paper describes the problems, progress to date, and agenda for work in Greece’s revenue administration and how this effort has been achieved primarily by raising tax rates to high levels and reducing wages, pensions, and other spending. The third paper is on the need for designing and implementing debt restructuring frameworks as well as improving banks’ loan resolution practices so that Greece’s banks are positioned to support the economic recovery.

Abstract

Rigidities in Greece’s product and labor markets leading to economic imbalances and the significance of reforms to these markets are played out in the first paper. The second paper describes the problems, progress to date, and agenda for work in Greece’s revenue administration and how this effort has been achieved primarily by raising tax rates to high levels and reducing wages, pensions, and other spending. The third paper is on the need for designing and implementing debt restructuring frameworks as well as improving banks’ loan resolution practices so that Greece’s banks are positioned to support the economic recovery.

Restoring Growth1

Rigidities in Greece’s product and labor markets have increased the cost of adjustment to large pre-crisis economic imbalances. Simulations from a calibrated model of the Greek economy confirm that reforms to these markets can play a significant role in stemming output losses and supporting the recovery. In particular, with important labor market reforms having been implemented recently, steadfast implementation of product market reforms is key to reinvigorating growth.

A. What Explains Greece’s Adjustment Pattern?

1. Greece has made headway in restoring competitiveness via internal devaluation, but adjustment costs have been high. The improvement in the trade balance by 9 percentage points since 2009 was achieved by contracting output by 22 percent—a much worse trade-off than in other economies. Despite initially encouraging performance, export growth has done little to cushion the impact of domestic demand collapse on the economy. By contrast, other crisis countries (Spain, Portugal, Ireland) have had relatively more success in stimulating exports and avoiding a deep output collapse. The difference can be explained in part by Greece’s larger initial imbalances (e.g., the CGER-estimated REER misalignment was higher for Greece than for Spain and Portugal), and hence by the need for a greater reallocation of resources. Such reallocation is inevitably costly in the shortrun. Even so, the loss of output has been proportionately higher in Greece.

A01ufig01

Large Domestic Demand Contractions in OECD and EMs

Citation: IMF Staff Country Reports 2013, 155; 10.5089/9781484363683.002.A001

Source: IMF, World Economic Outlook; and IMF staff estimate.

2. To account for the high adjustment costs, we conduct an empirical analysis of growth during large adjustment episodes. Our econometric analysis follows a large literature on growth performance in current account adjustment episodes (e.g., Milesi-Ferretti and Razin, 1998), with two important distinctions. First, we choose a sample based on large domestic demand contractions rather than large current account adjustments. This focuses the analysis on adjustments to negative shocks and eliminates externally-driven current account improvements. Second, we add structural indicators to test for the potential effect of labor and product market rigidities on growth during the adjustment episodes. Adjustment episodes are defined by two criteria: (i) negative domestic demand growth; and (ii) a contraction in the average domestic-absorption-to-GDP ratio by more than 3 percentage points between two consecutive three-year periods. To avoid excess heterogeneity, the sample is restricted to OECD and emerging market economies. In this exercise, the variables used to explain cumulative growth are as follows:

  • Institutional indicators. Product and labor market rigidities raise adjustment costs by hindering the reallocation of resources. In our empirical analysis, we include labor and product market regulations at the start of an adjustment episode as proxied, respectively, by the “Labor market regulations” index and the “Freedom to trade internationally” index, both from Economic Freedom of the World Annual Report (Gwartney et al., 2012). Note that, while better indicators of product market regulations are available (e.g., OECD indices of product market regulations), their coverage of countries and of time samples is narrower. We use country rankings in both cases—a higher value indicates more regulated product and labor markets.

  • Exchange rate regime. Fixed regimes limit or eliminate the nominal exchange rate adjustment channel, potentially increasing costs. We use a dummy for fixed exchange rate regimes based on the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER, 2012). Pegged regimes are defined as belonging to three AREAER categories: no separate legal tender, currency board, and conventional pegs. Members of currency unions are also classified as operating under fixed exchange rate.

  • Exchange rate misalignment. The extent of initial imbalances dictates the size and possibly the speed of the subsequent adjustment. We use the IMF’s CGER measure of exchange rate misalignment, and specifically the equilibrium real exchange rate method (Lee et al, 2008).

  • Financial conditions are potentially an important determinant of adjustment costs, determining both the degree of consumption smoothing and support for investments. Give the potential endogeneity of indicators of financial conditions, and given the focus of the analysis on large domestic demand contractions, we use a dummy indicating banking crisis episodes during or up to two years before the beginning of the adjustment episode (Laeven and Valencia, 2012) as a proxy for the tightening of financing conditions.

  • External shocks. External conditions are approximated by growth in partner countries (weighted by trade shares). This series, as well as cumulative GDP growth and national accounts data used to select the episodes, are from the IMF’s WEO database.

Explaining Cumulative Growth During Episodes of Large Domestic Demand Contractions 1/

Source: IMF staff estimates.

Standard errors in parentheses; *** p<0.01, ** p<0.05, * p<0.1.

Robust regression reestimates the baseline specification using robust regression, which downweights observations with larger absolute residuals using iterative weighted least squares (Andersen, 2008).

3. The econometric results show that adjustment costs are shaped both by initial conditions and macroeconomic shocks and by the degree of product and labor market flexibility (Table). Although based on a small sample of adjustment episodes, the results indicate that the degree of overvaluation, external demand growth, and the tightening of financial conditions in the aftermath of banking crises are strongly and significantly linked to adjustment costs. Product and labor market regulations also have a negative and significant impact on growth, and the estimates are fairly robust (as indicated by alternative estimation methods). Pegged regimes also seem to be negatively correlated with growth during the adjustment episode, as indicated by the high and negative coefficient of the peg dummy. To further test whether adjustments under fixed exchange rate regimes—potentially more relevant to draw lessons for Greece—differ from full sample results, the model is re-estimated based on a sample restricted to those episodes under fixed exchange rate regimes. The estimates are less precise—suggesting a wide range of outcomes under fixed exchange rate regimes in the sample—but values and signs of key coefficients remain close to the full sample estimation.

4. Greece’s low score in both product and labor market flexibility indicators suggests that structural rigidities have played an important role in making the adjustment more costly. While labor market reforms have advanced since the beginning of the crisis, there has been relatively little progress in addressing structural rigidities in product markets. Several factors played a role in restraining product and labor market flexibility:

  • Greece entered the crisis with an overburden of regulation. The key sources include: (i) important assets have been owned—or their use restricted—by the state, and they remain underutilized (e.g., because of land zoning restrictions) or subject to monopolies (network utilities); (ii) regulations have been excessive, with permitting, licensing and export-import requirements well inferior to EU best practice; and (iii) even beyond explicit requirements, outsiders have been discouraged from entry into new markets by implicit barriers, including excessive bureaucracy, corruption, and opaque tax and labor regulations. These barriers limited competition (including from FDI), keeping prices and margins well above the EU average level, and preserving an economic model based on small and inefficient enterprises.

  • Similarly, Greece’s labor market regulations were rigid and tended to protect insiders. The labor market has traditionally suffered from a closed and inflexible system of collective bargaining, very high firing costs (severance payments and redundancy notification periods), a high national minimum wage relative to competitors, and high non-wage labor costs. The reforms under the program have significantly reduced the rigidities, which facilitated wage adjustments and contributed to the reduction in unit labor costs (ULCs).

A01ufig02

Barriers to Entry

Citation: IMF Staff Country Reports 2013, 155; 10.5089/9781484363683.002.A001

Source: World Economic Forum, Global Competitiveness Indicators.
A01ufig03

Labor Market Indicators

Citation: IMF Staff Country Reports 2013, 155; 10.5089/9781484363683.002.A001

Source: World Economic Forum, Global Competitiveness Indicators.
A01ufig04

Changes in Unit Labor Costs

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2013, 155; 10.5089/9781484363683.002.A001

Sources: ECB; Haver; and IMF staff calculations.

5. Would the elimination of existing distortions limit output losses during the recession and contribute to the recovery? While econometric estimates give a broad-brush picture of the correlation between structural rigidities and growth performance during the adjustment, they are not sufficient to analyze the effects of removing the distortions: the data sample is limited and proxies for potential explanatory factors are imperfect. Given the limited data, the model does not directly capture the response of growth to reforms reducing structural rigidities (correlating it instead only with a level). Neither does it consider the sequencing of policies (e.g., labor and product market reforms) that could potentially affect adjustment costs in different ways. To explore these questions, we use a calibrated model of the Greek economy in the next section.

B. Can Structural Reforms Reinvigorate and Sustain Growth?

6. What economic effects can realistically be expected from the implementation of structural reforms? While the initial program for Greece relied heavily on productivity gains (driven by structural reforms) to deliver a quick rebound in growth, the strategy has been subsequently revised to allow for deeper wage and price adjustment, more fully taking into account the authorities’ implementation capacity and the transmission channels of reforms. This section addresses two questions: what can structural reforms deliver in terms of growth and improvement in competitiveness, and how fast? We review how structural reforms affect economic performance in theory and previous empirical studies, before turning to Greece-specific simulations.

Theoretical channels and results from previous empirical studies

7. Theoretical results point to benefits from structural reforms, but indicate that they may not materialize immediately:

  • The main theoretical channel through which structural reforms affect economic performance is through a reduction in rents (Blanchard and Giavazzi, 2001). Removing barriers to entry—which are defined broadly, including excess bureaucracy and other deficiencies in business environment—enhances competition and reduces rents. This brings prices more in line with marginal costs, encouraging managers and workers to operate more efficiently.

  • The process of improving efficiency of the economy is not frictionless. It involves improving allocative efficiency (moving resources to more productive uses) and productive efficiency (organizing work more effectively, trimming fat and reducing slack). In the process, low-productivity firms exit, releasing resources to be absorbed by more productive firms (who are also better able to compete abroad). Transition costs can be high, particularly when market imperfections in the credit market constrain investments of productive firms, or uncertainty about economic prospects weigh on investments directly.

  • Different forces play a role in increasing long-term productivity growth. The process of improving allocative and productive efficiency ultimately comes to a stop when the economy reaches the production frontier, and innovation and the introduction of new goods and processes drive growth thereafter.

8. Empirical results are in line with the theory, indicating that the effects of structural reforms build up gradually:

  • In the long run, product and labor market reforms can have positive effects on growth, employment, and productivity (e.g., Bouis and Duval, 2011; Barnes et al; 2011; OECD, 2012; Hobza and Mourre, 2010);

  • In the short run, the impact is smaller because of adjustment costs, especially in the case of labor market reforms (Cacciatore et al, 2012), and particularly when these are undertaken during recessions (Bouis et al, 2012);

  • There are complementarities between product and labor market reforms: a broad reform package would be more beneficial than individual reforms as the former could help lower transitional costs (Cacciatore et al, 2012). They would also improve the distributional consequences that might otherwise arise if wage declines are not matched with proportional price declines.

9. Greece-specific empirical results point to potentially sizeable positive effects of structural reforms on GDP and productivity. In particular, using a calibrated model, Zonzilos (2010) finds that product and labor market reforms could boost GDP level by about 10 percent in the steady state, and also help restore price competitiveness. This is in line with previous empirical studies.

Model setup and simulation

10. The impact of product and labor market reforms in Greece is simulated using the IMF’s Global Integrated Monetary and Fiscal model (GIMF). This DSGE model (see Box 1) can help illuminate transmission channels and analyze the sequencing of reforms. Given the presence of monopolistic competition in both firms and labor markets, the GIMF is well suited to analyze the effects of structural reforms reducing price and wage markups (because, as discussed above, structural reforms are usually framed in terms of making the markets more competitive, for example, through reducing entry barriers). Our simulation framework is similar to Lusinyan and Muir (2012).

A01ufig05

Estimates of Price Markups

Citation: IMF Staff Country Reports 2013, 155; 10.5089/9781484363683.002.A001

Sources: Bottini and Molnár (2010); Christopoulou and Vermeulen (2012); and Hoekman, et al.(2001).

11. The standard calibration of GIMF is augmented with Greek-specific information. To reflect the negative impact of the crisis on the financial system, it is assumed that liquidity constrained households make up 50 percent of all households (compared to 25 percent for the euro area). The markups are calibrated to be consistent with empirical studies and previous results in the literature: the non-tradable sector price markup is 60 percent versus 35 percent for the rest of the euro area; and 20 percent—against 15 percent in the euro area—for the tradable sector. For the wage markup, we follow the assumption in Forni et al. (2010) and use the same values as for the non-tradable sector price markup. Steady state ratios are calibrated to 2011 values, with some modifications. In particular, the persistently high current account deficit is assumed to be eliminated in the steady state through higher exports and the debt-to-GDP ratio is assumed to decline to the euro area level in the steady state.

GIMF Model

GIMF is a multi-country Dynamic Stochastic General Equilibrium (DSGE) model with optimizing behavior by households and firms, and intertemporal stock-flow accounting (Kumhof et al., 2010):

  • Frictions in the form of sticky prices and wages, real adjustment costs, liquidity-constrained households, and finite-planning horizons of households imply an important role for monetary and fiscal policy in economic stabilization (the assumption of finite horizons separates GIMF from standard monetary DSGE models and allows it to have well-defined steady states where countries can be long-run debtors or creditors).

  • The non-Ricardian features of the model provide non-neutrality in both spending-based and revenue-based fiscal measures, which makes the model particularly suitable to analyze fiscal policy questions (fiscal policy can affect the level of economic activity in the short run).

  • Government debt is only held domestically, as nominal, non-contingent, one-period bonds denominated in domestic currency. The only assets traded internationally are nominal, non-contingent, one-period bonds denominated in U.S. dollars that can be issued by the U.S. government and by private agents in any region.

  • Firms employ capital and labor to produce tradable and nontradable intermediate goods. They are owned domestically (equity is not traded in domestic financial markets; instead, households receive lump-sum dividend payments).

  • A financial sector a la Bernanke, Gertler, and Gilchrist (1999) incorporates a procyclical financial accelerator, with the cost of external finance of firms rising with their indebtedness.

  • The version of GIMF used in this paper comprises 3 regions: Greece, the euro area, and the rest of the world.

12. Several simulations are analyzed. In a baseline simulation, there are no structural reforms. In a second simulation, only labor market reforms only are analyzed. A third simulation adds to the second simulation by analyzing product market reforms as well, albeit with hesitant and delayed implementation of these reforms. A final simulation looks at the effect of credible, upfront implementation of both labor and product market reforms.

13. In line with theoretical results and previous studies, the reforms are modeled as a reduction in rents. We assume that increased competition in the product and labor markets brings margins down. The key assumption here is the extent to which specific reforms could translate into markups. While a one-to-one mapping of specific reforms to reduction in rents is difficult to achieve, cross-country econometric results point to significant effects of reforms on markups. For instance, Griffiths and Harrison (2004) find that reductions in costs of doing business, regulatory trade barriers, labor market regulations, and government bureaucracy significantly reduce price markups in a sample of OECD countries. E.g., the 1995-2000 reforms in Germany to reduce costs of starting a business are estimated to have reduced the markup by 2 percentage points. The effects of wage markups are more difficult to establish empirically, but Stewart (1990) for instance presents evidence that markups are higher in unionized establishments facing less competition. Theoretical results also suggest that reforms to reduce the difficulty of hiring and firing, a lower wage replacement ratio, and increasing competition in product markets contribute to lower wage markups.

14. We assume that the reforms close roughly half the gap between the Greece and the rest of the euro area over a five-year period. The reforms to labor markets already underway and to product markets currently in the pipeline are similar to the set of reforms affecting the markups identified in the empirical literature. The advances made to date in labor market reforms give support to this assumption on timing and their implementation path is assumed to be known with certainty by economic agents. But, given slow progress on product market reforms, the simulations distinguish between product market reforms that are not entirely credible (which limits the upfront benefits from the reforms) from those that are implemented fully and upfront. In the former, economic agents regard already implemented changes as permanent, but view further reforms with uncertainty in the near term.

15. We also assume that structural reforms reduce wage and price rigidities. While increasing competition ultimately lowers prices and wages, the speed of change is affected by nominal rigidities. These are a function of the degree of competition itself, but also of institutional regulations, such as minimum wages or price regulations. Before the crisis, price rigidities in Greece appeared much higher than in the rest of the euro area, while wage rigidities were in line with other countries. However, with typically more constraints to deflation and cuts in nominal wages compared to just slowdowns in price and wage dynamics, the inability of real wages to adjust downward is more constraining in severe recessions. We assume that wage and price rigidities are reduced by about 30 percent as part of the reform process..

A01ufig06

Average Duration of Prices

(Months)

Citation: IMF Staff Country Reports 2013, 155; 10.5089/9781484363683.002.A001

Source: IMF staff estimats.
A01ufig07

Average Duration of Wages

(Months)

Citation: IMF Staff Country Reports 2013, 155; 10.5089/9781484363683.002.A001

16. Importantly, to mimic the recession dynamics observed in Greece, we add shocks to the model. The fiscal adjustment—modeled to match the dynamics of the cyclically-adjusted primary balance in the adjustment—primes the downturn. However, it does not generate sufficient persistence to model Greece’s recession. This suggests that key explanators for Greece’s growth performance during the crisis go well beyond fiscal multipliers to include the range of severe confidence shocks hitting the economy in 2011–12, affecting investments and consumption both directly and through a liquidity squeeze. To align model-simulated growth path with actual data, we thus add shocks to investment, consumption, and financing.

A01ufig08

Real GDP Growth

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2013, 155; 10.5089/9781484363683.002.A001

Source: IMF staff estimats.

C. Simulation Results

17. Labor market reforms bring modest benefits in terms of output, but significantly reduce current account deficits (Figure 1). Without greater competition in the product market, the increased flexibility in the labor market has only marginal effects on prices, which drop by about ¾ of a percentage point after 5 years and by 2 percent by 2030. Output increases are also modest (about half a percent after 5 years and 3 percent by 2030). Employment increases though, as lower wage markups induce a switch from capital to labor in inputs to production. There is a strong reduction in current account deficits, driven by both reductions in imports and a modest increase in exports (as initial real wage declines limit consumption and investment, while supporting demand for labor and domestic supply).

Figure 1.
Figure 1.

Simulation Results, 2013–20

Citation: IMF Staff Country Reports 2013, 155; 10.5089/9781484363683.002.A001

Source: IMF staff estimates.
Figure 1.
Figure 1.

Simulation Results, 2013–20 (concluded)

Citation: IMF Staff Country Reports 2013, 155; 10.5089/9781484363683.002.A001

Source: IMF staff estimates.

18. Product market reforms reduce prices and boost output. Lower barriers to entry encourage competition, reducing prices by 1¾ percent in the medium term and by over 6 percent by 2030. The reduction in prices and stronger demand for labor increase real incomes, boosting consumption. Investments increase in anticipation of the future stronger demand from the external sector and consumption. Output growth is strong, averaging about half a percentage point more than in the baseline without reforms, with the cumulative effects of over 3 and 6½ percentage points after five years and by 2030, respectively. Higher investments and consumption would initially lead to a deterioration of the current account, reversed when the new production capacity comes on stream. The latter would increase exports: initial gains would be modest—given capacity constraints—but would rise in the medium to long term, helped by strong competitiveness gains.

19. The results of the two reforms are additive, producing significantly higher output and lower prices, while improving external current account with a lag. Output growth is as much as ½ percentage point per year higher than in the baseline without reforms, with the cumulative impact of over 10 percent by 2030. Prices drop by over 6 percent cumulatively during this period. As noted, the current account deteriorates initially, reflecting largely the effects of product market reforms on investment and consumption, only to improve when the new export capacity—encouraged by improved competitiveness—comes on stream.

20. The simulated effects of reforms are in line with developments in the Greek economy. While identifying the effects of reforms is made difficult by the number of adverse shocks affecting the economy and the dynamics of the recession occurring simultaneously, economic developments following the implementation of labor market reforms are in line with model predictions: it led to large reductions in wages combined with the improvement in the current account through import compression, without markedly stemming output declines. Given uneven and delayed implementation of product market reforms, it is not unexpected that output gains are not visible.

21. The results are also consistent with long-term projected growth under the program. While the effect of reforms on growth ultimately taper off, they are still significant well beyond 2020. The cumulative effect of combined reforms on output reaches about 10 percent after 2030. The gradual accumulation of gains from reforms supports the projected TFP growth under the program, which is consistent with previous empirical results indicating relatively long payoff periods from structural reforms (Barnes et al., 2011). The assumed medium-term productivity growth in Greece is also consistent with results reported in other countries undertaking structural reforms (e.g., ¾ percent per year in Germany and 1½ percent in Netherlands). The still high productivity gap to the core of Europe indicates that the potential for catch-up growth is high, and gains from reforms could even exceed estimates from the model.

22. Growth could be frontloaded with more credible reform implementation. Alternative simulations in which economic agents fully anticipate future reforms boost growth though expectations of future recovery. The effect is strong: growth in the first year of reform implementation (assuming that both labor and product market reforms are implemented simultaneously) would be 1 percentage point higher compared to the non-credible implementation of reforms in our baseline simulations (long-term effects would be close in both scenarios).

A01ufig09

GDP Growth Under Credible and Non-credible Implementation of Reforms

(Deviation from baseline in percentage points)

Citation: IMF Staff Country Reports 2013, 155; 10.5089/9781484363683.002.A001

Source: IMF staff calculations.

D. Conclusions

23. Greece’s high adjustment costs can be explained in part by structural rigidities. While a number of factors have played a role in accounting for Greece’s growth performance in the past few years, pervasive structural rigidities have raised the cost of adjustment. Their effect has been direct and indirect: they likely contributed to the significant imbalances before the crisis, which made the adjustment painful given the scale of imbalances that needed to be corrected. They also likely created disincentives for an efficient reallocation of resources (by preserving rents) and increasing price and wage rigidities (delaying the necessary nominal adjustment).

24. The impact of structural reforms on GDP can be sizeable. We confirm earlier findings from the literature using the IMF’s Global Integrated Monetary and Fiscal model (GIMF) showing that policies that would close roughly half the gap in product and labor markets with the rest of the euro area could raise real GDP by about 4 percent after 5 years and by 10 percent in the long run. This is a significant boost to the economy, especially beyond the projected cyclical upturn when the labor force begins to shrink. It is also in line with previous econometric studies. It is smaller, however, than gains expected at the initiation of the program in 2010, reflecting more realistic assumptions about both the pace of implementation and the transmission channels. With reforms currently in place, staff’s latest projections are in line with model-based simulations.

25. A decisive implementation of product market reforms would have a measurable impact on output dynamics, inflation, and competitiveness. The early implementation of reforms in the labor market led to sharp reductions in wages, stemmed employment losses, and reduced current account. But a broader set of product market reforms is needed to meaningfully reinvigorate growth. Such reforms would have a meaningful impact on the speed of recovery (as credible product market reforms encourage investments in anticipation of future gains and exports boosted by the new capacity and improvements in competitiveness) and also on growth beyond the cyclical rebound, as gains from structural reforms are projected to materialize gradually.

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1

Prepared by Wojciech Maliszewski.

Greece: Selected Issues
Author: International Monetary Fund. European Dept.