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The Good Times Might Never Come

In a BBC interview last week Paul Krugman said: “a full employment economy is by far the best environment in which to make structural adjustment; you can see that historically”.

It’s a claim that fails the tests of theory and evidence.

In the lexicon of international organizations the term structural adjustment describes a mix of regulatory and economic reforms intended to restore the sustainability of market-oriented economic growth after onset of crisis. Adjustment includes measures to restore balance of payments, promote exports, macroeconomic stabilization, public debt and budget deficit reduction, elimination of wage and price distortions, privatization, and the relevant institutional reforms of law and regulation (the sequence is disputed).

I want to discuss the reasons for the flaw in the implied ideal Krugman sequence: Economic recovery (or just jobs) first, structural adjustment second. Countries can and should delay difficult reforms at least until exit from crisis is well underway.

The prestigious “window of opportunity” alternative to Krugman:

The Nobel Laureate economist historian Douglass North finds that though the best kinds of historical change are seen in retrospect to have been slow and incremental (as culture and norms evolve) economic and political crises repeatedly supplied the discontinuous “windows of opportunity” for the emergence and transformation of formal organizations.

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The political scientist Francis Fukuyama similarly notes that the “demand for institutional change… is usually the product of crisis or extraordinary circumstances that create no more than a brief window for reform”. Fukuyama observes that during the Latin American debt crises of the 1980s countries being rescued by international organizations:

“were advised to move as rapidly as possible toward [structural adjustment] on the grounds that the political window for engagement in this kind of reform would close quickly and that it was better to get the pain of adjustment over with all at once”

Two classic views of the function of crisis in change:

The foremost American sociologist of the twentieth century, Talcott Parsons, had no doubt that change relates to the disequilibrium in causal ways: “Strain always sets up re-equilibrating processes”. Changes in a society’s destiny “have often been attended with severe dislocations of the previous social organisation”. Again: “the increase of strains in one strategic area of social structure are finally resolved by a structural reorganisation of the system”. Parsons explained change partly in terms of the struggles between vested interests which are inevitable when a system is reorganized.

The economist most frequently mentioned in this blog, Joseph Schumpeter, could not conceive of economic progress in the absence of crisis. Recurrence of crisis is integral to cycles of innovation and growth: “Stabilized capitalism is a contradiction in terms”. He “stresses discontinuity” and the “kind of economic change that is likely to break up the existing patterns… creating new positions of power, civilisations, valuations, beliefs, and policies”. Sometimes politics is the external disturbance to which the economy must adapt. Much more common, however, is “institutional lag”, the tendency for the economy to run ahead of institutional capacity. Societies prosper only if their institutions catch-up with the economic dynamic. Almost always crisis is the signal for this to happen urgently.

Late twentieth-century structural adjustments:

A well-regarded comparative study of structural adjustment reforms in Asia, Africa, and Latin America by Merilee Grindle and John Thomas found that if there is no crisis the stakes will be low, the consequences of failing to implement reforms will not be severe, and policymakers lean towards incremental or marginal change. During politics-as-usual decisions typically revolve on organisational issues, bureaucratic politics, and building coalitions. Policy elites may be preoccupied with satisfying interest groups or networks.

The authors find that during a crisis policy elites come under pressure to reform with urgency. They are more innovative and take bigger risks. Major issues of legitimacy and social stability come to the fore. Reformers are more likely to undertake radical change. In fact, reformers might manufacture the perception of crisis to get policies onto the political agenda. In crises policy elites can be expected to have more autonomy to set agendas. In crises politicians and citizens are more willing to allow technocrats wide-ranging powers that insulate them from political pressure. Crises at the same time often disorganize and weaken interest groups that would otherwise resist reforms.

In different parts of the world since the 1980s the combination of statist or populist policy failures and international shocks produced economic chaos, recession, hyperinflation, and debt crises. According to Stephan Haggard and Robert R. Kaufman the response to crisis was consequently usually “a profound shift in development strategy, away from state-led, inward-oriented models of growth toward emphasis on the market, private ownership, and greater openness to trade and foreign investment”. In general they find that crises were often decisive in a change of political regime for “overcoming policy stalemates”.

In an important comparative study of twenty-one developing countries, Deepak Lal and Hla Myint argue that neoliberal economic reforms attempt to restore order to economies and political systems that were made unmanageable by populist and statist economic policies, when “only a crisis” can resolve the “resulting paralysis of the polity and economy”.

Stephan Haggard’s analysis of the Asian financial crisis 1997-8 offers other examples of reform driven by exigencies of crisis. The IMF and governments such as Indonesia “saw in the crisis an opportunity to press forward with reforms they had sought for some time”. Taiwan, for example, “seized the opportunity to strengthen the regulatory framework”.

Deeper analyses of twentieth-century adjustments:

One of the pioneers of development economics, Albert Hirschman, had a theory that development practitioners learn the arts of policy making and become effective by coping with disequilibria and embracing “disproportionalities” in messy processes. Decision makers develop competency for understanding and modifying the means and ends of policy better when they work in a pressured hothouse environment forcing them to cope with tensions, bottlenecks, shortages, and instability. Societies move forward, said Hirschman, by “sailing against the wind”. A perturbation of status quo induces disequilibrium learning.

We like to think political leaders should undertake comprehensive reforms without the turbulence, uncertainty, and forced experimentation that arises as a survival mechanism during economic crisis. In fact, crises can eliminate political obstacles and provide the pressured cognitive environment conducive to better understanding of problems and solutions. A crisis is the legitimate incentive for decisiveness in the short run. It can make all the difference between incremental politics-as-usual and radical discontinuous reform.

Good political leadership is vital. Arnold Harberger, a Chicago economist who advised several Latin American governments during the 1980s debt crises, pointed out the catalytic role of “a handful of heroes”. But for the efforts of educated energetic technocrats with will, vision, and power to break the historical mould positive “policy would in all likelihood have failed or never got started”. The intensity of crisis was the factor determining the contribution of these leaders and the levels of risk they were prepared to run.

“It [was] no accident that waves of modernisation and liberalisation in Argentina, Bolivia, Brazil, Chile, Peru and many other countries were concentrated in periods of crisis. Later, when the crisis was past, additional steps in the reform process came slower and with more difficulty, in the face of popular indifference, bureaucratic inertia and political resistance and manoeuvring”

Some related considerations:

As Paul Krugman well knows, it helps to have an ideology lying around ready to put into action at moments of crisis when disequilibriating forces create strong incentives for change. On the eve of the explosion of the debt crises of the 1980s Milton Friedman offered a timely and categorical observation on the interplay of crisis, change and ideas:

“There is enormous inertia – a tyranny of the status quo – in private and especially governmental arrangements. Only a crisis – actual or perceived – produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around. That, I believe, is our basic function: to develop alternatives to existing policies, to keep them alive and available until the politically impossible becomes politically inevitable”

A similar point was made in a different way by Max Weber one hundred years ago. His emphasis was on the legal reforms that need to occur periodically for capitalism to regain momentum. Scholars may know them in theory. They may already have been “invented”. But they don’t get realized and implemented until economic conditions call out for them.

“Like the technological methods of industry, the rational patterns of legal technique must first be ‘invented’ before they can serve an existing economic interest. Hence the specific type of techniques used in a legal system are of far greater significance for the likelihood that a certain legal institution will be invented in its context than is ordinarily believed. Economic situations do not automatically give birth to new legal forms; they merely provide the opportunity for the actual spread of a legal technique if it is invented”

Today we are in a time characterized by debt crises in the advanced economies. Causes of twenty-first century advanced country crises are similar to the causes of late twentieth century crises in developing countries. The over-arching problem of several advanced countries is their massive debt overhang. Reducing the overhang is going to be painful. It means readjusting the mix of economic and institutional structure so as to restore economic dynamism. Healthy systems respond to strain through adaptation. The quality of policy is conditioned by awareness of strain. Crises generate the atmosphere for policy innovations.

The takeaway:

Structural adjustment is highly unlikely to occur without a crisis. Furthermore, getting out of crisis almost certainly requires structural adjustment. Even if the economist’s simulation models can show monetary and fiscal policy might restore employment without structural adjustment, the probability of avoiding repeat crises in the near term will still be zero.

Delaying structural adjustment when the opportunity for it is given by the intensity of crisis is the sure recipe for repeating cycles of useless and debilitating crises.

In their book This Time is Different Carmen Reinhart and Kenneth Rogoff said: [The] most expensive investment advice ever given in the boom just before a financial crisis stems from the perception that this time is different … Each time, society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on sound fundamentals, structural reforms, technological innovation, good policy.”

The error is replicated during the crisis if belief takes hold that structural reform can be left until the economy has recovered its strength because this time is different. There are all kinds of tempting delusions. The evidence about past crises is reinterpreted in more optimistic form. The models of the multipliers are more accurate now. The country is fundamentally richer and can afford not to change. The new financial technologies are efficient. We trust this set of politicians to do the reforms once the emergency is over.

No. As always, the crisis will be the only opportunity for economic and institutional restructuring that is the precondition for a new pattern of growth.;

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