Incremental Structural Reforms are Structurally Incremental

Last week, Ameya Naik and I were explaining government decision-making to our GCP class using Putnam’s two-level games framework. We used the 1991 Indian economic reforms to illustrate how external pressure at the Level 1 (between the Indian government and World Bank negotiators) was deployed as a mechanism to water down opposition in Level II (between the Indian government and its domestic stakeholders).

Back came a very interesting question: does it mean that no economic reform can happen without a crisis in India? That’s an important and widely discussed question. To establish otherwise, we need one instance of an economic reform in India that was undertaken without an immediate, external macroeconomic crisis at hand.

My colleague Narayan Ramachandran writes in Mint lists two reforms that in his opinion are the ‘biggest legislative accomplishments’ of the current government: the GST reform and the Insolvency and Bankruptcy Code (IBC). Taking a step back, I realised that both these reforms are examples where policy reform happened even without an immediate, escalatory, external crisis that would otherwise have allowed the government to use a ‘tied-hands approach’ to push long-pending reforms.

Even if we assume that these two reforms disprove the crises hypothesis, we need to confront the question: are these ‘big bang’ reforms? Are they ‘turning points’ in economic policy the same way that the 1991 economic reforms were? They clearly aren’t at least on one metric: the 1991 reforms were wholesale reforms and had a direct impact on every aspect of economic policy – taxation, licensing, trade, etc. So, we are back to the initial question (with a twist): can big bang reforms happen only when there is a macroeconomic crisis?

Based on the Republic of India’s experience, it can be said thus:

1. we haven’t yet had a big bang economic reform without a macroeconomic crisis.

2. we did have macroeconomic crises in the past that didn’t lead to big bang reforms either. For example, India’s BOP account deficit in 1981-82 was more than in 1990-91 and yet there were no reforms in 1981-82.

Clearly, there are more drivers even for big bang reforms apart from a macroeconomic crisis. But it is unlikely that a big bang reform will happen without a crisis. Leave the big bang reforms, the Indian experience shows that even the smaller, successful reforms such as GST have needed a 20-year turnaround cycle from ideation to implementation. And yet it is still at best a work in progress.

What insights can we then derive as advocates of economic policy reform?

1. Incremental structural reforms are structurally incremental. So policy advocacy is required even after the legislation comes into effect. If we lose steam by then, we will see a change in outlay but not the desired improvements in outcomes.

2. A corollary of 1 is that we cannot wait for high-quality institutions to be in place. The GST case is again illustrative. In the long run, it is better to get GST legislation off the ground with five rates rather than waiting for perfecting the institution.

3. A corollary of 2 is to separate the criticism of tardy institutional setup from the criticism of the reform itself. If conflated, even the incremental reform will cease to be durable.

4. We still need to keep making the case for big bang reforms. However improbable they might be, trying to move the Overton Window towards big bang reforms will at least create a political resultant in the direction of incremental structural reforms. In contrast, if policy advocacy lowers its expectations for incremental reforms in the first place, the opposing status-quo forces will ensure a political resultant that will slow down even the most incremental reform.

So the path to incremental structural reforms is through an ask for big bang reforms.

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Bonus: this excellent paper The Political Economy of Policy Reform: Insights from South East Asia cautiously lists a few drivers for economic reform:

1. ideas are needed to drive an intellectual agenda, sometimes well formulated in advance, but on other occasions developed in response to specific circumstances. From this “ideas factory,” there also needs to be a group of individuals willing to assume public office, interact closely with political leaders, and work together as a united team.

2. political leadership is essential, generally featuring a key individual or group of leaders who understand the case for reform and are prepared to actively promote it.

3. major negative exogenous shocks, economic crises, the imminent cessation of external support, and a dawning realisation that “the system is broken” have all played a role.

4. reforms are durable only if they deliver and thereby win over a constituency of support. This requires that they be reasonably comprehensive so that they are not sabotaged by “unreformed” sectors of the economy.

5. reform is not a linear progression, and thus long time horizons are needed.

6. the rules of the game change, sometimes dramatically, in the transition from authoritarian to democratic systems where voice, accountability, and public persuasion become important arbiters of reform success.

7. institutions in some broad sense are critical, but it is not necessary to have “high-quality” institutions to reform.

8. the Southeast Asian experience suggests that it is easier to implement relatively prudent macroeconomic policies and broadly open commercial policy than it is to undertake microeconomic reform.

9. there does not seem to be any clear association between the propensity to reform and the level of corruption. Corrupt regimes that are also growth-oriented frequently display a capacity for partial reform on the presumption that growth offers greater opportunities for both political longevity and rent-seeking.