Wed, Jan 05, 2005 - Page 9 News List

All talk and no action kills confidence in economic reforms

By Alberto Alesina and Francesco Giavazzi

Reform, when long discussed but never implemented, can do far more harm than good. Anticipation of a reform -- say, of pension rules, the health system, or unemployment benefits -- worries everyone who might feel the impact. In response, people cut consumption and save more, expecting that sooner or later they will have to start paying for some of the services they had been used to getting free or at subsidized rates.

But because reform in Europe is usually discussed rather than implemented, the benefits fail to materialize: people work harder only when they are sure that tax rates are actually cut, and in financial markets the positive effects of lower government spending do not come before any reform is approved. In the meantime, as politicians debate and do nothing, consumer confidence falls, economic performance worsens, and the consensus needed to get reforms approved in the first place vanishes. Still the talk does not stop, nor does the fall in consumer confidence.

Germany's recent experience provides a worrying example of this vicious circle. Reform of Germany's generous social system has claimed the front pages for German papers for more than 10 years. Some timid measures have been implemented, but the general feeling among Germans is best described by the following answer to a survey conducted two months ago by the newspaper Die Welt: "47 percent of those interviewed plan to cut consumption due to the uncertainty about pensions and health reform."

The result has been a sharp fall in consumer confidence: the German index of consumer sentiment was small but positive in November 2000; it has since fallen to minus 20, the sharpest decline in the euro zone.

Out on the street, pessimism runs rampant. For two years now, the growth rate of private consumption (measured at constant prices) has been negative: minus 1 percent in 2002 and minus 0.5 percent in 2003. Similar declines in real consumption are rare in industrial countries, because in bad years consumers typically draw on their savings to keep their consumption relatively constant. In the case of Germany, one has to go back to the early 1980s to see similar negative numbers in consumption growth. As a result, rather than falling, the household saving rate has increased, rising from 9.7 percent of disposable income in 2000 to 11.8 percent last year.

Depressed consumption and higher savings have affected all age groups, but the relatively old have been more prone to the trend than the relatively young. The only positive signs in consumption are seen among the youngest households, those headed by people in their early 20s, who evidently hope that sooner or later the reforms will be approved and their tax burden reduced. But the saving rate even in households in their 30s has risen along with concern about reforms.

Not surprisingly, elderly people cut consumption more. With retirement, they have lost almost all options: they can no longer work more, nor can they sign up for private health plans -- the insurance premiums at their age are too high. So they are forced to rely on their savings, and virtually stop consuming. Put this in the context of a rapidly aging population, and the effects on overall consumption are dramatic.

Interestingly, France is the only large Euro-zone country where consumer confidence is growing (from minus 24 a year ago to minus 13 today). The reason is simple: as next year's elections approach, reforms have been shifted off the political agenda.

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