Why Are Structural Reforms So Difficult?

• Author: Raghuram Rajan
• Position: Economic Counsellor and Director of the IMF's Research Department
• Pages: 56-57

The benefits of structural reforms aren't always as obvious as the smaller, short-term costs

Page 56

Many economic problems are due to problems in the working of markets, rather than, say, to resource shortages or an excess or deficiency of overall demand. To most economists, the need for structural reforms-measures that change the institutional and regulatory framework governing market behavior-then seems obvious. Such reforms can impose costs on a few in the short run but will potentially make many more better off in the long run. Economists believe that the opposition of these few can be overcome through compensation from the government. But this rarely happens. Why?

Reforms are hard to sell

The first problem is that the gains from reform are never as clear to the wider public as they are to economists, often because they are indirect. Consider the removal of interest rate ceilings on loans. The public is likely to view such a reform as a license for lenders to charge extortionate rates.

In truth, if interest rate ceilings are removed in a competitive financial system, the prices of loans will reflect risk accurately, and loans will be allocated more efficiently. The kind of distortion that ceilings introduce depends on the kind of lenders present in the system. If the lenders are private banks that aim to maximize profits, they will simply not lend to projects requiring a break-even rate above the ceiling. So risky projects will be shut out, even if they are worthwhile.

But if lenders don't care about profits or can't evaluate risks, they will be inundated with loan applications from high-risk borrowers with financially unviable projects. Because lenders can't charge a rate that exceeds the ceiling, they may use some other way of choosing among applicants willing to pay a higher rate-for example, the ones who pay the largest bribe. Applicants who have the most to gain from bribing will be those with the most unviable projects because they will get the largest interest subsidy. Thus, lenders (often state-owned) will not only succumb to corruption but will also make very risky loans.

When interest rate ceilings are in place, regardless of whether lenders maximize profits, loan allocations aren't optimal: the economy assumes either too little or too much risk. Moreover, lenders can't make a large enough return from lending to pay savers a high...