Guest author: U. Schuetz: Unintended Consequences

Unintended Consequences. Challenges for Portugal’s “Arranged Liberalization”
Ulrich Schuetz, University of Lucerne, Political Sciences (ulrich.schuetz@stud.unilu.ch)

Introduction
   After Ireland and Greece, Portugal was the third eurozone country to receive financial aid within the European Financial Stabilisation Mechanism (EFSM) framework of the so-called “troika”, composed of the European Union (EU), European Central Bank (ECB), and International Monetary Fund (IMF). In May 2011, the Portuguese socialist government, with support of the conservative opposition (which came to power one month later), accepted a reform plan conditional to the disbursement of financial assistance. The plan aims to improve Portugal’s economic competitiveness and performance through structural reforms towards a more liberal system. At the same time, it requires the state to substantially reduce public debt to regain fiscal solvency. Criticism of the reforms mostly reflects different macro-economic standpoints and comes mainly from economic observers. A frequent evaluation states that instead of fiscal austerity, expansionary monetary policy would lead the way out of the crisis (e.g. Krugman 2012). Because of the pro-cyclical nature of their conditions, past IMF programs were blamed for pushing countries into recession (Soros 2002:120). Missing from the debate on the effectiveness of the troika reform plan is the question if the reforms are embedded in an environment favorable for liberalization. A generalized “one size fits all” liberalization program might not produce the expected results, especially if non-economic factors are considered. Analyzing the separate aspects of the reform plan and trying to predict potential shortcomings in their application is necessary to be able to assess the chances of success. This essay is an attempt to do this by starting from the following assumption: If institutional complementarities and non-market relationships such as corruption and clientelism are ignored, the outcome of liberal reforms will be negatively affected.
   The first part of this paper provides a short overview of the troika reform plan. Subsequently, institutional complementarity and the Varieties of Capitalism approach are discussed regarding the Portuguese case. Finally, the impact of corruption and clientelism on a liberal reform process is addressed before summarizing the findings in a conclusion.

Troika Reform in Portugal
Details of the reform program were agreed on by both the old and new Portuguese government and troika. The agreed measures had broad political support as a result of a basic consensus on European issues between the country’s two biggest political parties, conservative Partido Social Democrata and socialist Partido Socialista (Fischer 2011). The two main pillars of the program relevant to this discourse are (1) increasing competitiveness and growth through liberal reforms and (2) regaining fiscal solvency through a substantial reduction of the public deficit (IMF 2012:4)1. Disbursement of financial assistance is subject to troika’s review of the implementation of the reforms. Portuguese authorities also committed to consult with troika on legislative changes that were not part of the agreement (European Commission 2011:1). As a consequence, the Portuguese government sends a quarterly letter of intent to the IMF and ECB with a review of the progress made so far and documenting the next steps, closing with a request to transfer the next installment. This is standard procedure for IMF-supported programs. The Fund itself argues that “conditionality can serve as a valuable commitment device that complements and enhances ownership of structural reforms” (IMF 2003:12).

   Failing to meet the reform plan’s targets would result in troika withholding funds and ultimately in Portugal defaulting on its debt. As a consequence, not implementing the reform plan is not a real option for the Portuguese government. Therefore, the term “arranged” is used here to describe the reform process.
   To increase competitiveness and growth, Portugal has to reform its Code of Civil Procedure and move towards arbitration to improve efficiency of the court system. Eliminating excessive rents and liberalized tariff-setting increases market pressure on the state-owned electricity company. A comprehensive reform of competition law and additional steps remove bureaucratic restraints on companies. Further measures of the Portuguese government include a reform of the labor market towards more flexibility, reducing the cost of dismissals, weakening collective bargaining mechanisms, and the elimination of two national holidays. To strengthen fiscal solvency, Portugal is taking measures such as restructuring and privatizing state-owned enterprises, cutting pensions and salaries in public administration, reducing the number of government employees, raising consumer taxes, and increasing personal income and corporate taxes (IMF 2012:83-121).
   With the possible exception of higher taxes, all measures that make part of the reform plan move control over the allocation of resources away from the state to market-based mechanisms. The result is what can be called an “arranged liberalization” of the Portuguese economy.

Varieties of Capitalism and Mediterranean Reality
In a nutshell, the Varieties of Capitalism approach as introduced by Hall and Soskice (2001) tries to answer the question how different models of capitalism shape economic performance. Different models of capitalism are identified through institutional characteristics and their effect on the behavior of companies. Hall and Soskice distinguished between two basic types, liberal market economies (LMEs) and coordinated market economies (CMEs). LMEs such as the United States, Great Britain and Canada comprise a market-oriented institutional structure with companies interacting mostly through anonymous market mechanisms. CMEs, on the other hand, show networks of corporate institutions and collective organizations through which coordinating problems of companies are resolved. Examples of CMEs include Germany, Japan, and Sweden. The Varieties of Capitalism approach suggests that institutions within an economy are complementary to each other and, therefore, reforms should always include all complementarity factors. Successful countries in terms of economic growth are those with an institutional framework that respects the complementarity of its parts (e.g. Hall and Gingerich 2009:50). These findings do not prefer one of the two basic types. Higher rates of growth can be achieved in either liberal or coordinated market economies. It is the countries “in the middle”, with institutions that evolved in a mismatched manner, that suffer from lower economic growth. The theory is not without its critics. Its core hypotheses that overall institutional coherence contributes to healthy macroeconomic performance has been challenged (e.g. Kenworthy 2005). Also, regarding how complementarity is considered in the political process, Deeg suggests that it “may be easily overestimated in its utility for explaining stability and change” (2005:22-23).
   With regards to Portugal, the approach of Hall and Soskice is not easily applicable. Initially simply leaving out “ambiguous” countries such as France, Italy, Spain, Portugal, Greece, and Turkey, later studies introduced mixed market economies (MMEs) as a cluster (Hall and Gingerich 2009:33). Other researchers identified more types of distinctive economic models. In the concept of Amable (2003), Portugal is labeled as “Southern European Capitalism”, an economic model characterized by price- rather than quality-based competition, relative high involvement of the state, little “non-price” coordination, high employment protection in large companies but flexible options for temporary work, and a moderate level of social protection with a structure towards poverty alleviation and pensions, again with a high involvement of the state. However, there are further institutional aspects relevant especially to Southern economies that are not fully implemented into those theories. Focusing on companies and their relationships downplays the centrality of the state in the domestic economy of these countries. Furthermore, other forms of non-market relationships such as clientelism and corruption as well as the effect of the EU’s economic programs on Southern European economies are neglected (Featherstone 2008:10).
   Notwithstanding the limitations of the general concept and its specific shortcomings with the case at hand, Varieties of Capitalism provides a useful framework to evaluate institutional reforms. Consequently, and assuming reforms need to respect institutional complementarity in order to be successful, the Southern European model of Capitalism provides a challenge. Amable concluded that “the difference of models within Europe should make the pursuit of a general liberal strategy more difficult” (2008:3). The impact of the same reforms may be very different according to the structural of institutional arrangements in different countries. Even reforms deemed “liberal” can be designed in a way to fit the corresponding institutional framework in LMEs and also CMEs (Hall and Thelen 2007:20-27). The situation in MMEs is more complicated. In a mixed market economy, it is not possible to simply enhance an existing system that is already coherent. Troika’s liberal reforms must either fundamentally transform the Portuguese economy into a LME or they will have no or very limited impact. Thus, the important question is if the reform program is able to initiate this transformation to a liberal market economy. The alternative scenario is a patchwork of individual measures that ignores complementarity and effectively continues the model of Southern European capitalism, although with a more liberal layout.

Case in Point: Severance Pay
The reduction of severance pay as one measure of the reform plan is analyzed here to exemplify the discussed challenges. The labor market reform of 2011 and its planned continuation aim to bring more flexibility to companies by lowering job protection. Workers with contracts signed before November 2011 have the right to a severance pay (indemnização por despedimento) of 30 days’ worth of salary for every year with the same employer. For newer contracts, severance pay was cut to 20 days with a maximum relative to the minimum wage. It is planned to be further reduced to EU average levels of between six and ten days. In addition, companies have to establish funds to finance these payments (Público 2012). The economic argument behind the measure is that lowering job protection allows companies to hire and fire workers more easily. Thus, restraints on hiring are lifted because firms have less risk of large severance payments once workers are no longer needed. Overall, this should be beneficial to levels of employment. It is also a first step to reduce a strong insider/outsider problem. Under the old regime workers with regular contracts (mostly in big companies) enjoyed high job protection while the rest of the workforce and especially younger people had to settle for temporary contracts without any of these benefits. In addition, limited welfare provisions increase the attachment to job security and amplify the insider/outsider problem with regard to the unemployed.
   On the face of it, lowering job protection is beneficial for companies and economic activities. Combining it with measures limiting the renewal of temporary work contracts, in theory, also diminishes the insider/outsider problematic mentioned above. However, institutional complementarity goes beyond labor reform. Because of the pressure on Portugal’s finances, the country’s already limited welfare provisions for “outsiders” are further reduced, increasing workers dependency on their employment. The welfare “deficit” has to be made up by families. This has direct implications on the job market because it undermines job mobility and flexibility (Featherstone 2008:20). Additionally, the cut in severance pay even generates a new insider/outsider situation because it is only applicable for new contracts. Existing employees within a company enjoy benefits not available to their colleagues. It can also be argued that this measure has very limited impact outside large companies. Because the level of severance pay remains relatively high, smaller companies have little incentive to hire new staff. So far, they were able to circumvent those restraints by hiring workers on temporary contracts. Without this possibility, small companies might actually hire less or move to the informal sector (shadow economy) as an unintended consequence of the reform.
   The privatization of state-owned enterprises (SOEs) is also related to the issue of company size and severance pay. Portugal committed to restructure and privatize most of its 98 SOEs, including some of the country’s largest companies representing 4.6% of GDP and 3.6% of the workforce (IMF 2012:19). The sale of the state’s energy companies is relatively straightforward as some are already semi-private. Other companies are restructured and downsized first to be “fit for the market”. Those include a train company, two airlines, the national airport operator, a water company, the national postal service, and a television channel. Downsizing staff in these firms, however, will diminish the effect of the cuts in severance pay. SOEs in Portugal are mainly large companies, so they are among the few that could actually benefit from a more flexible system of severance pay but because they are forced to downsize their staff they will not contribute to job creation. As a result, no positive effect on unemployment can be expected of the changes in severance pay.
   Generally, Varieties of Capitalism identifies firms as key actors in a “bottom up” process of institutional change. However, Hall and Thelen admit that mixed market economies such as Portugal provide a “hard case” for this proposition because the state has a more dominant role (2007:27). The reforms initiated by troika even emphasize this weakness of the theoretical argument. Because troika can be viewed as an outside actor and the reform measures are unilaterally pursued by the government, this is clearly a “top down” process. To what extend a pure top down process is able to fundamentally change a nation’s institutional environment cannot be answered here but seems highly doubtful.

Clientelism and the Shadow Economy
In addition to institutional coherence and the challenges it poses to reform, non-market relationships such as corruption and clientelism offer even more basic complications. How can liberal reforms, or reforms of any nature, be effective if the regulation they are based on is bypassed by a significant part of actors in the economy? Interestingly, this question is not raised by troika and informality and rule of law as general factors are largely ignored in the reform program even though there is emphasis on making the judicial system more effective.
   Shadow economy is defined for this discourse as the combined activities of underground and informal production. The former includes activities to deliberately avoid taxes or circumvent law provisions concerning minimum wages, working hours, safety, etc. while the latter includes small economic actors with little or no division between work and capital, mostly pursuing occasional jobs, e.g. craftsmen, farm workers, and small merchants (Dell’Anno 2007:255-256). Illegal production is ignored here as it is not relevant to the subject. Any attempt to measure the shadow economy can only be estimation. One way of approximation is calculating it indirectly with the MIMIC model (Multiple Indicators and Multiple Causes). MIMIC factors in government employment in labor force, tax burden, subsidies, social benefits, self-employment, and unemployment rate2. Schneider et al. estimate the average size of Portugal’s shadow economy between 1999-2007 at 23% of official GDP (2010:456). This is the third highest percentage for European Union founding members (EU15) after Greece and Italy and much higher that the EU15 average of 17.9%.
   The troika reform plan addresses the informal sector. However, it is limited to generalized fiscal policy measures such as increasing efforts to fight tax evasion, fraud and informality. The government increases means available for audits, higher penalties for the most serious tax crimes and introducing electronically-transmitted invoices (IMF 2012:88). So far, the reform process does not fundamentally tackle reasons identified by economists why people engage in the shadow economy, namely taxation, regulation and a generally high level of informality. To reduce the size of the Portuguese shadow economy, Dell’Anno recommends reforms of unemployment benefits, improvements to efficiency of the public sector together with an increase of economic freedom, and reforming tax regulation for the self-employed (2007:270). Compared with the troika reforms, only measures improving efficiency in the public sector and increasing economic freedom meet these criteria.
   Reducing the size of shadow economy activities and reintegrating them into the official economy should be a top priority for Portugal. One important measure to achieve this is lowering the level of informality, a change process that probably requires more than “top down” regulation. Developing policy tools that go beyond isolated economic measures to do so would make for a viable field of further study.
   Closely related to the effectiveness of reforms that are enforced “top down” is government effectiveness. Reforms can only achieve their policy goals if they are carried out by a reliable government body and state administration. In this respect, it is important to notice that Portugal suffers from relatively poor government effectiveness, with a ranking of 81.8 out of 100 in the corresponding World Bank index of 2010 (World Bank 2012). While day-to-day corruption in dealings with the administration is rare in Portugal, there are numerous cases of politicians’ corrupt transactions especially in connection with infrastructure projects that are not effectively prevented by the legal system (Guerreiro 2011). Moreover, the country shows a high level of clientelism. Clientelism is not limited to the political system where party politicians distribute public jobs or special favors in a patrimonial way but also in the private sector. Like in the public sector, job distribution in private companies is predominantly arranged in informal ways through personal connections. While clientelism has moderated somehow due to the European integration process, it is still a predominant factor in Portuguese economy and politics (Magone 2003).
   As with the shadow economy, there is a lack of available policy tools dealing with clientelism. There are no direct measures in troikas reform plan to challenge clientelism in Portugal. It can be argued that clientelism will be reduced through the increased efficiency of the judicial system and the development of the country’s economy towards more market based mechanisms. This would result in a virtuous cycle, following the logic that “as productivity grows, as private sector economy develops, a more materialistic preferences develop, and as inequality falls, the extent of clientelism falls, and the efficiency of government policies improves” (Robinson and Verdier 2003). However, if the liberal reforms do not deliver beneficial economic outcomes, the result could be just the opposite with clientelism increasing due to fewer legal constraints on companies.

Conclusion
Portugal is in a difficult spot for several reasons. Constrained by high levels of public debt, the current government tries to accomplish structural reforms to set the country back on track in terms of economic growth. The reform process that is conditional to financial support by troika attempts to do this through a series of liberalization measures. In addition to a macroeconomic debate over the adeptness of these measures, it is uncertain if the measures themselves are able to solve the structural problems they are designed to do so. In this context, this essay addressed the issues of institutional complementarity and non-market relationships. Illustrating the difficulties of designing policies that take institutional coherence into account, it is expected that the outcome of many reform measures will be nullified or at least reduced because complementary factors are ignored or cannot be tackled due to lack of financial resources of the state. In addition, this paper showed that issues such as a relatively large shadow economy and allocation of resources through clientelism instead of market-based relationships is bound to negatively affect the outcome of the reform plan as it produces unintended consequences. By developing policy solutions specifically addressing clientelism and the shadow market, political science could provide a valuable contribution to this problem.

References
   Amable, Bruno (2003): “The Diversity of Modern Capitalism”. Oxford. Oxford University Press.
   Amable, Bruno (2008): “Structural reforms in Europe and the (in)coherence of institutions”. In: Documents de Travail du Centre d’Economie de la Sorbonne. 2008:63 July 2008. URL: http://hal.archives-ouvertes.fr/docs/00/34/04/17/PDF/ R08063.pdf (April 29, 2012)
   Deeg, Richard (2005): “Complementarity and Institutional Change: How Useful a Concept?”. In: Discussion Paper SP II Wissenschaftszentrum Berlin. 2005:21 December 2005. URL: http://bibliothek.wzb.eu/pdf/2005/ii05-21.pdf (April 29, 2012)
   Dell`Anno, Roberto (2007): „The Shadow Economy in Portugal: An Analysis with the MIMIC approach”. In: Journal of Applied Economics. X:2 November 2007. pp. 253-277.
   European Commission (2011): “Portugal - Memorandum of Understanding on Specific Economic Policy Conditionality”. URL: http://ec.europa.eu/economy_finance/eu_borrower/mou/2011-05-18-mou-portugal_en.pdf (April 16, 2012)
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   Fischer, Thomas (2011): Interview DRS 4 aktuell. November 10, 2011. URL: http://www.drs.ch/www/de/drs/sendungen/drs-4-aktuell/5728.sh10200305.html (April 29, 2012)
   Guerreiro, Caiado (2011): “Combate à Corrupção”. Interview Opinião Pública, SIC Notícias. December 9, 2011. URL: http://www.youtube.com/watch_popup?v= RNr1eOhA4qE (May 6, 2012)
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   Hall, Peter A. and Thelen, Kathleen (2007): “Institutional Change in Varieties of Capitalism”. In: Socio-Economic Review. 7:1 October 2008. pp 7-34. URL: http://dev.wcfia.harvard.edu/sites/default/files/Hall_Institutional.pdf (April 15, 2012)
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   1 The two remaining pillars of the program are (1) financial stability and orderly deleveraging which calls for adjustment in banks’ balance sheets and (2) budget financing, aiming to bring Portugal back to the capital markets for its refinancing (IMF 2012:4).
   2 see Dell’Anno (2007) and Schneider et al. (2010).