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Shock or gradualism?

May 18, 2015
in Blog

Big economic crises or situations of economic distress usually put pressure on policy makers to embark upon economic reforms. If the situation is troubled enough, then whether the reforms should all be done at once (shock) or step-by-step over time (gradualism) becomes a heated question. Some Latin American countries, like Argentina, have experienced this dilemma more than once. A present presidential candidate in Argentina claims that he needs a full term of four years to reduce inflation from around 30% to one digit; not to the 1-2% range, but just one digit, suggesting that after four years he would consider an inflation rate of 9% to be a success.

What’s the typical trade-off present in the shock versus gradualism debate? The advocates of gradualism argue that a shock policy reform would impose unnecessary social and economic costs to society. For instance, to cut down spending and stop inflation all of a sudden can produce a fall in output and a rise in unemployment. On the other hand, the advocates of shocks argue that the route of gradualism goes through the unnecessary risk of leaving reforms incomplete because the political power and influence does not last long enough. Incomplete and inconsistent reforms, while an apparent improvement in the short-run, can prove to be problematic in the medium and long-run. The critics of gradual reform point to social and economic costs, but usually overlook that a shock policy reform should have a transition plan that makes gradualism an unnecessary risk.

Let me use an analogy to illustrate this idea. If you have toothache, your tooth is removed on the spot by your dentists (shock policy); not a several visits (gradualism). There are two ways to do this however, the butcher way, or the surgical way. The butcher way is to just remove the tooth that is inflicting pain on the patient. The surgical way is to devise a transition plan, which in this example consists of applying anesthesia so that there is no pain between the removal of the tooth and the healing process. Policy makers behave like butchers when they cannot delay a policy reforms and implement plans without considering transition strategies. A policy maker behaves like a surgeon when there is a properly implemented and consistent plan. This, however, is different from gradualism, where the required reforms are implemented step-by-step as they yield results.

Shock policies are inspired in the German Miracle, where Ludwig Erhard played a central role. After administrative failures by the allies over the German economy, Erhard puts forward a monetary reform to replace the Reichmark with the German Mark. The same day this policy was announced, price controls were removed and rationing programs were relaxed, contrary to the recommendation of the United States and the Allies. These reforms started the German Miracle and by the time the Marshall Plan was put in place, Germany’s economy was already recovering.

There are other contemporary examples, most notably Chile (1975) and Bolivia (1985). Chile opened its economy to foreign investors and put the domestic entrepreneurs in the need to compete in equal standing with foreign entrepreneurs. Even though these reforms were implemented during Pinochet’s de facto government, the short-term result was to stabilize the economy and a higher growth rate than their neighbors in the medium and long-term. In Bolivia a shock reform put an end to hyperinflation. This reform was implemented in a period of 100 days by Gonzalo Sánchez de Lozada. Among other reforms, exchange rate was liberalized, price controls and subsidies to public companies were removed, reduction of two-thirds of employment in public companies, and a debt swap was negotiated with the IMF. In a few months hyperinflation rates dropped to 15% yearly. Even though a rise in the unemployment rate can be observed, this was already the trend in the Bolivian economy before the reform was implemented.

A more ambiguous case is that of Poland (1989) after the Soviet Union fell. Regulations and price controls were eliminated, but there was no decisive movement towards privatization of public companies, certainly a key issue in a former satellite of soviet Russia. Still, in the medium and long-term Poland significantly improved its economic performance.

These cases show that policy reforms were not done in isolation, but that they were part of a plan. A reform, for instance, that just aims to remove capital controls is not a “reform plan”, and it unlikely by itself to solve economic imbalances if price controls remain in place, market regulations remain to be oppressive, fiscal deficit remains out of control and so inflation rates.

A counter example, more in favor of gradualism, could be the case of China where reforms have been done gradually. Despite undeniable results, it still the case the a large portion of China’s population remains alien to economic improvement because the reforms are extended gradually to the rest of the country.

The problem is not the shock policy itself. The problem is the economic and social costs already present that call for reform in the first place and an inconsistent and incomplete implementation of the required reforms. In other words, if your dentist has enough vision as to apply anesthesia, why remove the troubled teeth gradually rather than in one visit?