1. Econometric models to study the macroeconomic effects of structural reforms Christian Dreger German Institute for Economic Research (DIW Berlin)

2. Rationale of structural reforms Overly restrictive regulation can worsen the economic performance –Information asymmetries, rent seeking of special interest groups, management and incentive problems Output and employment are stimulated in competitive and deregulated environment Flexible markets contribute to a smoother transmission of shocks, shorter periods of unemployment

3. Areas of structural reforms Reforms affect the general framework on how the economy operates Improve functioning of product, labour and financal markets Financial markets highly deregulated, while product and labour markets are not Reforms act on the supply side of the economy, try to reinforce market-based adjustment

4. Product market reforms Increase in competition can foster output, employment and productivity growth Static efficiency gains due to lower mark ups, internal restructuring of firms etc, lead to one time productivity change Higher incentives to research and innovate provide dynamic efficiency gains Dynamic effects can boost productivity over longer periods of time

5. Labour market reforms Perspectives of workers improve, notably by creating new jobs Labour reallocates faster in response to shocks, labour demand more in line with economic conditions Higher incentives of households to work encourage labour supply Unemployment traps for low productivity workers become less important

6. Financial market reforms Abolition of credit and interest rate controls Compared to product and labour markets, financial markets already deregulated, see Fraser index Private consumption does not depend only on permanent, but also on current income Households faced by liquidity constraints, in particular in economic downturns

7. Ambiguous effects of reforms Reforms might imply long term gains, but short term losses, as adjustment to the new conditions might take a while Costly reallocation of resources, decline of inefficient firms, unemployment can increase over a transition period Reforms affect distribution of income Losses concentrated, gains widely dispersed with only limited benefit for each individual

8. Appropriate econometric framework Models have to analyse the long run, but also medium and short run effects Models should be suited to investigate single and comprehensive reform strategies Interactions between different areas of reforms. Sequence of reforms important for political acceptance Past reforms provide insights into the effects of future reforms, only if agents behaviour is unchanged

9. Institutional databases OECD, Fraser, LABREF, etc, describe institutional conditions on product, labour and financial markets Often missing values, variables interpolated to match frequency of macroeconomic data, merging required Definition of indicators not unique. Indicators often rank-scaled: only the direction, but not size of impact can be examined Useful for international comparisons, robustness analysis, inclusion in satellite models

10. Typology of econometric methods Variety of models available to examine impact of structural reforms –Microsimulation models if heterogeneities have to be taken into account –Macroeconometric techniques rely on representative agent framework: single equations (panels), partial and general equilibrium models, macroeconometric models and DSGEs Models have their individual pros and cons –Data requirements –Use for policy consulting (ex ante vs ex post analysis) –Reform packages and adjustment processes

11. Basic building principles Models based on empirical fit –Single equations (reduced form regressions) and macroeconometric models are data driven –Equations estimated, in sample measures of fit –Might not be fully consistent with economic theory –Risk of structural breaks in out-of sample period Models based on theoretical consistency –CGEs and DSGEs microfounded, i.e. based on optimizing households and firms –Consistent with economic theory –More liberal on data issues, parameters often calibrated

12. Ex post vs ex ante analysis Past reforms provide insights into effects of future reforms, only if behaviour of agents is unchanged Data driven methods subject to Lucas critique, structural breaks invalidate policy conclusions, only ex post analysis –Single equations, macroeconometric models Models based on optimizing agents are more robust to changing parameters, ex ante analysis –CGEs and DSGEs Check relevance of Lucas critique in advance. Impact of regulation indicators on crucial elasticities must be 0

13. Single equations Easy and fast to implement, standard software packages (Eviews) Direct and indirect effects of reforms, only the latter are interpretable Tests for nonlinear effects Useful as satellite models from the perspective of more elaborated models Can provide linkages to regulation indicators Ad hoc specification of the equation Due to policy dependent parameters, risk of structural breaks Ex ante analysis not recommended

14. Computable general equilibrium models (CGEs) Rely on optimizing agents, micro-macro consistency (social accounting matrices) Data limitations not important. Distributional effects can be included (sectors, segments of labour markets etc) Lack of empirical underpinning, results driven by model assumptions –Calibration to a base year, where long run equilibrium is achieved by assumption –Parameters derived conditional on that assumption –No measures of uncertainty Only static analysis, adjustment process, sequence of reforms cannot be discussed Even not immune to structural change

15. Partial equilibrium models Advantages and disadvantages similar to CGE approach Specific sectors or markets considered in very high detail, used in network liberalization Spillovers to other parts of the economy ignored Policy measures investigated only in directly affected markets Reliable results, only if linkages to other markets can be neglected. Otherwise, policy conclusions would be biased Easier to maintain than CGEs. Quick adaption to study new policy relevant questions

16. Macroeconometric models Based on national accounts data Long and short run separated, equations specified in error correction form Wage and price rigidities, long run determined by supply, short run by demand side Satellite models bridge the gap between frequency of regulation indicators and macroeconomic data Designed for simulation and forecasting, models might be subject to Lucas critique Long run ex ante analysis questionable, but models are suited to study short run impact of reforms

17. Dynamic stochastic general equilibrium models (DSGEs) Microfoundation of macroeconomeric models Consistent with economic theory, as for CGEs, Lucas critique less relevant Ex ante analysis of reforms Impact of reforms studied in terms of the change in welfare Dynamic specification allows to examine sequence of reforms and adjustment processes Deficits in short run analysis, macroeconometric models might still be useful Even not immune to structural change

18. Satellite models extend simulation capabilities of the core model, improve maintainance Satellite models constructed for certain transmission channels of structural reforms –Identification of transmission variables like TFP, markups, reservation wage Reforms have to be proxied by institutional variables, preferably on a quantitative scale Once institutional impact has been determined, the change in the transmission variable is passed to core model –Change in transmission variable affects core variables. Effects studied by counterfactual exercise Implementation of structural reforms in CGEs and DSGEs

19. Product market reforms should try to improve the level of competition and innovation Satellite models focus on the link of reforms on the mark up of prices over marginal costs, the TFP rate and the degree of the administrative burden Transmission variables available on a quantitative scale, while some institutional regressors like PMR or MICREF indicators are not If possible, quantitative proxies should be used –Involvement of the state in the economy, number of days necessary to establish a business, working time needed to fulfill bureaucratic requirements etc Quality of approximation can be examined by rank correlation analysis Product market reforms

20. Reforms include employment protection, wage bargaining, taxes and transfers and active labour market policies Main transmission channels are labour income taxes, reservation wage and the wage mark up Taxes and transfers, bargaining power and active labour market policies available on a quantitative scale Other indicators rank scaled, proxied by quantitative indicators –Long term unemployment for overall degree of regulation –Employment protection: Severance pay, length of notice periods, maximum duration allowed for fixed term working contracts etc Common factor of quantitative proxies might be appropriate Labour market reforms

21. R&D investments or policies to stimulate innovation work through an increase in efficiency, translates into a TFP shock Satellites include the link between TFP and R&D investments and R&D and its basic determinants –Number of scientists and engineers, patents, level of tertiary education, research in public sector etc Core models can also be modified to consider directly the role of R&D or different skills of labour Augmentation of the production function to include human capital stock, transformation of unskilled to skilled labour Knowledge based economy

22. Decision tree for model selection Models have their individual pros and cons, no method superior in general Most accurate tool depends on specific topic of research Steps in model decision process involve –Direct or indirect effects of structural reforms –Stability of the relationship: ex post or ex ante analysis –Partial or entire economy analysis –Static or dynamic analysis –Relevance of distributional issues: heterogeneous or homogeneous agents

23. Social security in Germany Social contributions to health, pensions, unemployment insurance, nursing care Contributions are paid by employees and employers, by equal amounts Funds used to finance extra insurance benefits of public interest –East German workers did not contribute, but receive pensions –Maternity benefits, health insurance for parental leave System increases costs of labour, worsens employment perspectives –Social contribution rate exceeds 40 percent of the wage bill Reforms in the financial structure could improve the employment record

24. Social security in Germany (II) Effects studied in a macroeconometric model for German economy Benefits of public interest. Financing by the public, not only by workers Contribution rates cut by 1 percentage point financed by higher government debt or increase in VAT rate Debt financing more expansive. Employment rises by 70Tsd workers 2 years after the shock, increase in GDP growth by 0.2 points Tax increase might be beneficial in the long run from a regulatory policy perspective