Regulation adds “clutter” to an economy, sort of akin to creating an obstacle course that workers and businesses have to navigate in order to be productive.
In other words, red tape makes it harder to be profitable. And that reduces incentives to invest.
Today’s column will look at how deregulation could reverse some of the damage from red tape.
Here’s a chart from a new study from the European Central Bank. It shows that labor market reforms and product market reforms in recent decades have boosted investment.
The authors, Christos Mavrogiannis, Nico Zorell, and Christoph Zwick, explain their methodology and findings.
Using data from 26 OECD countries over the period 1975 to 2020 and state-of-the-art empirical methods, we analyse how major labour and product market reforms affect private investment over time. Our findings indicate that both labour and product market reforms can significantly boost private investment. A major labour market reform typically increases the level of real private investment by 5% cumulatively within six years, while a major product market reform yields an impact of 3%. Product market reforms thus tend to have smaller positive effects, possibly because they are often focused on specific network industries while labour market reforms are more likely to affect the wider economy. For both types of reform the benefits build up gradually and take around three years to become statistically significant. …These results carry important policy implications. ..our estimates underscore the potential of well-designed labour and product market reforms to revive private investment and enhance long-term growth prospects in advanced economies.
The previous excerpts explain the economic benefits of deregulation and are a good follow-up to another ECB study from 2018.
If you want to understand why, here are some passages explaining why economies produce more without excessive red tap.
Economic theory provides different channels through which structural reforms may stimulate private investment. Product market reforms, for instance, can encourage investment by lowering entry barriers, reducing markups and decreasing administrative costs associated with firm entry and expansion…. This is because in less competitive markets, firms may limit investment in additional capacity in order to preserve monopoly rents on existing production. Moreover, barriers to entry and expansion may discourage investment and firm creation, while stronger competition may encourage incumbent firms—particularly those close to the technological frontier—to invest and innovate in order to maintain their competitive advantage… Labour market reforms may likewise support investment by reducing labour adjustment costs and increasing wage flexibility, thereby lowering the expected costs and risks associated with expanding production capacity. More broadly, labour market institutions can influence human capital accumulation, technological adoption and the reallocation of resources across firms, all of which can raise the marginal product of capital and thus encourage investment.
Here’s an interesting chart (at least to me) showing the pace of deregulation in recent decades.
Product market deregulation was especially prevalent during the era of “the Washington Consensus.”
By the way, there also were examples in the dataset of added regulation.
The authors also studied what happened when politicians expanded red tape.
The narrative dataset used in this paper allows us to examine the plausibility of our baseline results by looking at the impact of counter reforms, i.e. episodes in which major structural reforms were rolled back. Intuitively, the impulse responses of counter reforms should be a mirror image of our baseline results. …counter reforms are indeed estimated to have a negative impact on private and total investment over longer horizons in contrast with the positive effects obtained in the deregulation case. …The results are thus consistent with our baseline estimation for major structural reforms.
