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In my inaugural “In the Margins" column in these pages (Narendra Modi going the Stephen Harper Way, 10 November), I argued that Canadian Prime Minister Stephen Harper’s gradualist approach to policy reform better fits what we are seeing from Prime Minister Narendra Modi in his early days in office, than the big bang or shock therapy reform model of, say, a Margaret Thatcher.

More broadly, with the reality sinking in that gradualism, not shock therapy, appears to be the way forward for policy reform in India, it seems opportune to revisit the academic debate on the subject. To do this, one has to rewind to the early 1990s, and the lively debate that arose at that time in the context of the transition to a market system of ex-Communist economies in Eastern Europe and the former Soviet Union.

The academic literature that followed in the wake of this policy debate spawned a new field—transition economics—which sought to study the particular problems of economies in transition from central planning to the market, whether in Eastern Europe or elsewhere. Olivier Blanchard, one of the pioneers of the field, provides a comprehensive and accessible review of the literature in his 1995 Clarendon lectures at Oxford, published as The Economics of Post-Communist Transition.

This new field intersected with a broader trend in economics, which was to integrate more fully a careful modelling of the policy-making process into economic models of policy reform. Known variously as positive political economy or positive policy theory—an area of study at the borders between economics, politics and public policy—this new research has immeasurably enriched economists’ understanding of why governments don’t necessarily always pursue policies that seem to make the best economic sense. (In a word: politics matters, something that might have come as a surprise to economists, if not to anyone else.)

As it happens, some of my own doctoral research at Columbia was centred on the shock therapy versus gradualism debate—published in the journal Economics & Politics in 2003—and I draw on this in what follows.

First things first. When we refer to the speed and sequencing of policy reform, what sort of reforms do economists have in mind? In much of the early work, including mine, these would take the form of government policies—such as tariffs or subsidies—that distort the structure of the economy and lead to the standard deadweight efficiency losses. Reform, then, involves the removal of these distorting government policies. If the distortions are removed in one fell swoop, that is termed shock therapy or big bang. By contrast, if they are removed slowly over time, such a reform trajectory is termed gradualism.

The first key proposition is that, as a matter of economics, a shock therapy reform is always best, assuming that the economy is otherwise undistorted—a result attributed to economist Michael Mussa, but which, in reality, follows immediately from the fundamental theorems of welfare economics—which say, roughly, that in the absence of distortions, a competitive market can reproduce the welfare optimum and vice-versa.

It follows immediately as a corollary that any case for gradualism must rest on second-best considerations. There are two important cases. First, it might be that other distortions in the economy which are somehow irremovable imply that shock therapy isn’t best, and gradualism might be a better reform policy.

A well-known paper by Raquel Fernandez and Dani Rodrik (Resistance to reform: status quo bias in the presence of individual-specific uncertainty, American Economic Review, 1991) provides one instance of this. In a world in which it is impossible to identify the winners and losers from reform beforehand, and in which this uncertainty is uninsurable, they show that a reform which turns out to be efficiency-enhancing after the fact—when the winners and losers are known—might not be implemented at all.

This status quo bias, due to uncertainty, could potentially be unlocked through a gradualist rolling out of the policy reform—allowing winners and losers to be identified over time, rather than throwing the dice on who will win and lose right at the outset.

The second case considers those situations where shock therapy would be the best policy purely as a matter of economics, but political considerations prevent it from being implemented. The follow-up question that then arises is, if shock therapy isn’t politically feasible, will gradualism work instead?

My own research, cited earlier, demonstrates just this possibility. In a standard trade model, I show that a gradualist dismantling of a distorting tariff or subsidy could win crucial support from those adversely affected by the reform in the first instance, such as, for example, workers laid off in the import-competing sector which is now losing its protectionist cover.

Gradualism tempers the initial adverse impact of reform, and this ensures that a reform which would have failed if proposed as a big bang can succeed if it is rolled out slowly and smoothly.

There are many real world examples which validate the political superiority of gradualism over shock therapy, in both advanced and emerging economy contexts.

The original Canada-US Free Trade Agreement of 1988—the precursor to the North American Free Trade Agreement—mandated a phased removal of tariffs between the two countries. The rationale was to allow workers in affected sectors sufficient time to retrain and relocate, rather than confront them with the shock of a zero protective tariff and likely widespread unemployment the moment that the agreement came into being.

In a similar vein, the failure of Yegor Gaidar (acting prime minister of Russia from 15 June 1992 to 14 December 1992)—under the tutelage of economist Jeffrey Sachs and others—to implement shock therapy reforms in Russia was due to the backlash from those affected. Victor Chernomyrdin, who replaced him in 1994 and who was advised, among others, by Padma Desai, pursued a gradualist track to reform, and was distinctly more successful than his predecessor. (Desai, a noted specialist on the Russian economy, also famously co-authored, with her husband Jagdish Bhagwati, a landmark 1970 study, India: Planning for Industrialization, which was one of the first systematic critiques of planning in India and pointed the way toward the 1991 reforms.)

In the 1990s, shock therapy proponents such as Sachs argued that you cannot cross a chasm in small steps but only in a single leap. Desai’s shrewd and witty reply was that, unless you are Indiana Jones, you are better served by dropping a bridge and then crossing in slow and measured steps. A foolhardy attempt to leap across will likely lead you to be dashed against the rocks.

Twenty years have passed since the early debates between proponents of shock therapy and gradualism, and transition economics has been absorbed into the larger field of development economics. Yet, the broader lessons coming out of those debates remain valid, and are borne out by the consensus in the academic literature.

Except in unusual circumstances in which there is widespread political support for radical economic reform, a gradualist approach to reform almost always works better. This is one of those situations—perhaps too rare—where the economic science is largely in accord with basic common sense!

Economics Express runs weekly, and features interesting reads from the world of economics and finance.

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