STOCKHOLM UNIVERSITYDepartment of Economics

Master ProgrammeEC9901 Master Thesis

30 September 2011

Reform and Losers' Compensation

Greek crisis: short analysis and policy recommendations

Author:Michalis Zervos

Abstract

This thesis analyzes factors which a�ect losers' compensation andreform imposing. Another question addressed is the roll of the politicalsystem and electoral power. This theoretical research contributes byshedding light on the factors, which a�ect losers' compensation and theability to impose reforms. Finally using all available knowledge it alsorecommends policies, which, from my point of view, may help Greeceto impose necessary reforms and exit the severe crisis. The promotionof knowledge in this area limits the economic and social cost. Such asystematic analysis in this area does not exist to my knowledge.

Keywords: Losers' compensation; Reform imposing; overcompen-sation; Policy recommendations for Greece

Contact the author at: mzer.su@gmail.com

Contents

1 Introduction 2

1.1 Purposes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21.2 Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . 21.3 Previous Studies . . . . . . . . . . . . . . . . . . . . . . . . . 3

2 Imposing Reforms 7

2.1 Resistance to reforms . . . . . . . . . . . . . . . . . . . . . . . 72.2 Inaction & optimal waiting time . . . . . . . . . . . . . . . . . 8

3 A Simple Model 10

4 Losers' Compensation 16

4.1 Why to Compensate the losers? . . . . . . . . . . . . . . . . . 164.2 Factors a�ecting the reform imposing . . . . . . . . . . . . . . 184.3 Psychological Factors . . . . . . . . . . . . . . . . . . . . . . . 25

5 Successful Chinese reform 27

6 The Russian reforms' failure in 1990:s 28

7 Recent Greek crisis and the role of reforms 30

7.1 Comparing Greece with China and Russia . . . . . . . . . . . 32

8 Policy Recommendations for Greece 35

9 Concluding Remarks 36

Bibliography 37

A Political Power Determinants Assumptions 39

A.1 Median Voter Theorem Decomposition . . . . . . . . . . . . . 40A.2 Political Ideological Wind (PIW) . . . . . . . . . . . . . . . . 41

B Expectations - E�ect on the Business Cycle 42

C Democracy - High Level vs low Level 44

D Some Derivations and �gures 44

D.1 Status quo - New Reform . . . . . . . . . . . . . . . . . . . . . 44D.2 Information E�ect . . . . . . . . . . . . . . . . . . . . . . . . 45D.3 Austerity and Business Cycle . . . . . . . . . . . . . . . . . . 46

i

D.4 Strikes e�ect in a Low Business Cycle . . . . . . . . . . . . . . 49D.5 Prospect Theory Figure . . . . . . . . . . . . . . . . . . . . . 50D.6 Relative Income �gure . . . . . . . . . . . . . . . . . . . . . . 51

E Negative Factors in Greece 52

E.1 Permanent Over-employment in Public sector . . . . . . . . . 52E.2 Polarization E�ects . . . . . . . . . . . . . . . . . . . . . . . . 54E.3 Political Cost and Prisoners' Dilemma trap . . . . . . . . . . . 56E.4 High Bargaining Power . . . . . . . . . . . . . . . . . . . . . . 57E.5 Corruption and the Established Frequency of it . . . . . . . . 58E.6 The Game of the Communists . . . . . . . . . . . . . . . . . . 59

F Recovery Policy Recommendations for Greece 61

Acronyms

0MP Zero Marginal Productivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

LHS Left hand side . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

MVT Median-Voter Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

PIW Political Ideological Wind . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

HLD High Level Democracy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

LLD Low Level Democracy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

CCCP Soviet Union . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

HDE Hyperbolic Discounting E�ect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

vNMEF von Neumann Morgestern Expected Utility Function . . . . . . . . . . . 23

List of Figures

1 Losers' Compensation . . . . . . . . . . . . . . . . . . . . . . 10

2 Losers' Excess Demand/Compensation . . . . . . . . . . . . . 11

ii

3 Gainers and Losers among Job-Switchers . . . . . . . . . . . . 18

4 Relation between RAE and Business Cycle . . . . . . . . . . . 21

5 Three Median Voter lines . . . . . . . . . . . . . . . . . . . . . 41

6 Old Status Quo - New Reform e�ciency curves . . . . . . . . 45

7 Reform support CDF function . . . . . . . . . . . . . . . . . . 46

8 Austerity Level e�ect on Debt . . . . . . . . . . . . . . . . . . 49

9 Strikes Duration - Hicks paradox . . . . . . . . . . . . . . . . 49

10 The Prospect Theory . . . . . . . . . . . . . . . . . . . . . . . 51

11 Loretz Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

12 Greek Public Sector 0MP Over-employment . . . . . . . . . . 53

13 Polarization e�ects . . . . . . . . . . . . . . . . . . . . . . . . 55

14 A typical Prisoners' Dilemma in Greece . . . . . . . . . . . . . 56

15 Possible Greek total bargaining power . . . . . . . . . . . . . . 57

16 Corruption Multiple Equilibria: Good (B) and bad (A) . . . . 59

Acknowledgements

[1] I want to thank professors Mikael Priks and Mats Persson for valu-

able comments and suggestions.

[2] This paper was written according to the syllabus of Master Pro-

gram in Economics at Stockholm University. All ideas and opinions

expressed here and all mistakes and errors are those of the author and

do not re�ect others or the Stockholm University. Creative comments,

opinions, corrections and critics are welcome.

[3] whereas the words he, his and him are met in the paper, except

from the case they are nor referred to an explicitly speci�ed man,

it should be considered as representing even the feminine sex (he=

she/he, his=her/his, him=her/him). The reason is to avoid the dis-

crimination of the feminine gender.

1

1 Introduction

1.1 Purposes

The main objective of this paper is to analyze theoretically and describe the

factors which a�ect the reforms imposing, the losers' compensation demands

and the cost of the compensation. This knowledge may facilitate a more

e�ective reform imposing (implementing and enacting).

Another objective is to analyze shortly the ongoing Greek crisis where the

reforms' roll is present. Then it is compared with the Chinese success and

the Russian failure in 1990:s and use the conclusions and available knowledge

(theory, debate and own contribution) to recommend policies. Greece is

currently in focus because its heavy debt crisis consists a threaten for the

other European economies. Greece had experienced an increasing de�cit and

debt rate which led to a severe crisis which led even to a hard recession.

Government panic reactions and individuals resistance make the situation

very serious.

The topic is important because the growing democratization increases the

need of implementing of necessary reforms in pure democratic environment.

As these goals are more di�cult to achieve, compared with an autarchy or

dictatorship system, the knowledge in the area is important, but too little

yet. Persson-Tabellini (2000) [14], recommend a research on this relatively

dark area.

1.2 Methodology

First I present a review of earlier studies. The problem is explained in a

simple model. I discuss the factors which a�ect the easiness of imposing the

2

reform and the cost of the compensation. The Chinese success and Russian

failure (in 1990:s) are then discussed. I analyze shortly the Greek case and

compare it with these two countries. Finally I use the implications of the

paper to recommend policies that might succeed best, from my point of view.

This thesis is structured in the following sections:

• Section 1 presents the main objective of this study and reviews of previous

studies.

• Section 2 describes reform imposing di�culties.

• Section 3 presents a simple model which explains the optimization prob-

lems of the government and the losers.

• Section 4 discusses factors which a�ect reform imposing and compensation

costs.

• Section 5 summarizes the reasons why the Chinese reform has succeeded

with losers compensation.

• Section 6 summarizes the reasons why the Russian reform in 1990s has

failed.

• Section 7 describes the Greek crisis, the role of the reforms in it and com-

pares the Greek case with the Russian and Chinese ones.

• Section 8 recommends optimal policies for Greece, from my point of view.

• Section 9 summarizes my concluding remarks.

Appendices have informative material in case the reader needs more in-

formation about concepts and e�ects mentioned here.

• Determinants of the political power are discussed, explanations and deriva-tions which may facilitate the reader's understanding are presented and a part

of the negative background of the Greek failure is discussed.

1.3 Previous Studies

Traditionally economics used to calculate the gains and losses of reforms

and policies and focus on the algebraic result: social gain or social loss? In

3

the �rst case, we were satis�ed. Often the question of compensating the

losers was avoided, with the argument that we obviously have an increased

social welfare from the new reform. Why to compensate the losers? Clyde

Prestowitz1 (2002) writes that it is a problem of trade not to compensate the

losers. Although there are more winners than losers, the losers exist. Why

should we allow the lack of compensation and the overcompensation for other

groups?

Although the above �ndings were originally written for the trade sector, it

is obvious that they are valid even in reforms in other sectors. The problems

of the insu�cient compensation are:

(i) In the worst case it may block the implementation of reforms.

(ii) Unfair with social consequences.

(iii) Newer research shows even economical consequences. Researchers �nd

bene�ts both for the society and the economy when losers are relatively

satis�ed.

Few authors have written in this area. Two of the most interesting studies

are of Roland (2001) �The Political Economy of Transition�[8] and the second

of Roland et. al. (2001) �Reform without losers - China�[9]. In the �rst study

he analyses how it might be possible to have e�ective reforms in transition

economies, which minimize the loss for the losers: Roland mentions four

available strategies for eliminating political constraints2, so that political

reforms can be enacted3:

1President of the Economic Strategy Institute in Los Angeles Times: 2002-04-05. Part

3, Page 3,�President Pushes Lawmakers to Expand Trade Legislation: Bush seeks �fast-

track� authority. Democrats want help for U.S. workers hurt by foreign competition.�2pp 32-353Recommendation b however did not work in Russia in 1990:s and in Greece 2010.

Recommendation d is relevant nowadays in Greece now because of the crisis, easier for

reforms, as the demand for compensation is at lowest level. More countries try to use this

chance to impose reforms

4

� a) building reform packages that give compensating transfers

to losers from reforms

b) making reforms only partial to reduce opposition;

c) creating institutions that make credible a commitment to

compensating transfers; or

d) wait for a deterioration of the status quo to make the reform

more attractive.�

In the second study Roland et. al. (2001)[9] describe the advanced and

successful system in China4. It succeeds with the reform to achieve Pareto-

improving and still preserve Pareto e�ciency. The logic behind this reform

is to achieve e�ciency without leaving the losers uncompensated.

� This approach liberalizes the market gradually, depending on

the needs of the industrialization, while the existing old forms

continue to exist in simply words it implicitly transfers neces-

sary compensations to potential losers.�

A survey by Drazen & Easterly (2001)[7] sheds light the area about if

and how crises induce reforms. They describe the impact of the crises to

implementing reforms. The crisis may decrease the opportunity cost of the

reforms5.

Also Shleifer-Treisman(2001)[17] describe how Russia failed to impose

successful and well planned reforms in 1990's because of lack of knowledge

and planning. The lack of experience and many other factors, among which

weak democracy with strong opposition controlling the Parliament (Duma)

and ignorance to compensate important key players made the things di�cult.

The delay in the reforms bereaved the government the ability to impose the

reforms e�ciently. A segmented reform with partial compensation of some

4pp 120-1425Again this analysis is relevant nowadays in Greece now because of the crisis, easier for

reforms, as the demand for compensation is at lowest level. Moreover more countries take

the chance from the Greek adventure to impose reforms, as I mention later.

5

losers made them reluctant to accept the completion of the reforms and they

undermined it. When the popularity of the president fell o�, president and

government lost the control.

Also Shleifer-Treisman (2001) state that the plan to enact and implement

reform is like going through a mountain-chain without a map. There is not

a recipe about how to solve a speci�c problem. Even if one has succeeded to

go through Pyrenees, this is not a guarantee that he is able to do it in Alpes.

One has to plan by calculating and testing and in many cases go ahead by

�test and error�. To this successful paradigm I should contribute with more

assumptions which make the paradigm more alive. Assume also that there

are aboriginal people in these areas, which oppose your way through. Then

you may partly compensate some of them or have to either expropriate or

coopt them in order to go ahead.

Besides, they underline the necessity of using a combination of expropri-

ating and coopting reform resistants, they recommend pursuing one reform

and then the other, which may o�er a higher expected value that doing both

simultaneously. This is quite opposite to Roland's advice and the evidence

in Russia and Greece support their opinion.

Toshihiro's (2003)[11] analyses the compensation of losers in job re-allocation

and new job choice. This is interesting as it might be related to the reform

compensation, because a reform often causes job reallocation. Gainers and

losers are created from the movement . It is obvious that mostly losers are

created without the possibility to choose freely. The level of income plays

important role in the compensation demands , because the lowest income

persons need urgent compensation.

6

2 Imposing Reforms

A reform is de�ned here a superior economic system or even policy, whether

a minor or major one. In a autarchy6 or even more in a dictatorship it

is obviously easier to impose reforms than in a democracy, at least at the

�rst period. In a representative democracy it is more complicated. Trans-

parency and freedom of the opinions require negotiations between parts and

the potential losers (often key-players with veto rights) need to be persuaded

and/or compensated. When there is a real need for reforms, the problem of

persuading the losers to accept the reform arises.

Why should we impose reforms? Can we plan the future perfectly in a

way that no new reforms are needed? The answer is that even if we plan

the economy perfectly, the condition may change with time and when new

information comes we will need to reform our plan. Status quo in the econ-

omy often is driven to diminishing performance (returns per unit of time),

like technology does. The social planner plans the new reform to improve

performance. The imposing has costs (political, switching and compensation

of losers)7.

2.1 Resistance to reforms

The interaction between inertia and evolution is eternal. Many scholars have

recognized that new techniques emerge in a manner that many times depends

on the relation between the new techniques and the old ones (status-quo).

The choice of techniques may be considered either as a natural selection8

6Autarchy is de�ned in this study as the regime which is more or less authoritarian in

comparison to the democracy. I avoid the term monarchy as there are democracies which

o�cially are called even monarchies, e.g. Sweden or United Kingdom.7See in the Appendix 6 on page 45 an informative graph8�natural selection is really a metaphor for an impersonal process, where nature decides

about the selecting�

7

or by conscious individuals making deliberate choices. Resistance to reform

may be considered increasing the loss from non-reform (it increases the loss

from the di�erence of the new reform performance minus the old status).

The Systemic Resistance is a phenomenon that requires some exogenously

de�ned minimum time duration of the system. There are even other reasons

why societies might resist (subjectively pro�table) innovation. It has to do

with a kind of change aversion, especially when changes happen relatively

often. As we understand, all evolutionary systems have some source of resis-

tance to change or else they might collapse by too many and too unnecessary

changes leading to insecure situations. Kau�man (1993) describes this as

his �supracritical region�. This e�ect tends to delay the reform. Drazen,

A(2000)[6] states that people in power often avoid reform.

2.2 Inaction & optimal waiting time

Drazen(2000)[6] describes how several factors may lead to inaction9.

Intuition: Inaction is expected to increase the social loss from the dete-

riorating performance of the status quo. It decreases the easiness to impose

reforms. Drazen (2000)[6] presents the stopping problem, by supposing the

social cost for enacting the social policy and a reservation utility which de-

termines the outcome of enacting - not enacting the reform. It may be the

need of capital accumulation, lack of human resources, political instability,

con�icts etc. Or just reluctance. The important aspect for this study is

that inaction increases the loss in the economy and this probably may a�ect

the compensation ability of the social planner. However, this e�ects may

trade-o� with the easier acceptance of the reform by the losers because of

the decreasing opportunity cost.

Increasing the waiting time may facilitate the announced reform. The

reformer trades o� the loss from waiting with the easiness achieved by wait-

9As inaction we mean the delay in acting to do something

8

ing. Glazer (1991) argues that � a policy may be politically unpopular if

implemented immediately, but may attract support later if its implementa-

tion was expected, so that individuals adjust their behavior accordingly and

would su�er losses where the policy not implemented. Political leaders may

therefore announce an intention to implement a policy later, rather than

pushing for its immediate adoption, thereby building a constituency for a

policy change�. From the individual perspective it may help when the pro-

posed reform matures, so that they become gradually used to it, impose some

changes-improvements and appreciate the advantages more positively.

If we delay in order to decrease the reform opposition according to Drazen

(2001)[7] the expected cost is increasing. The di�erence between the new

chosen time and the earlier optimal chosen may be considered as the cost of

imposing the reform. In case the economy is already in a crisis (recession),

a delay to intervene in order to facilitate reforms imposing may trade a

relatively early intervention with some cost in terms of loss by the recession.

In case of relatively late intervention time this cost is lower as by assumption

we accept that it is easier to impose the reforms.

Roland (2001) refers to this explicitly as �wait for a deterioration of the

status quo to make the reform more attractive� (p 35). One thing we need to

take into advance is that after the reform is imposed we should do our best for

a quick recovery. A long recession may set our successfully reform in danger

because may reinforce a vicious circle which will produce social discontent

against the reform, which will be considered as failed. As mentioned earlier

on page 20, the recovery needs to be quick for the reform to succeed ex post.

It is also important that we distinguish between reform of general bene-

�t like macroeconomic stabilization and some reform that obviously creates

losers and gainers. The latter case is more di�cult for the reformer because

it generates harder resistance and higher compensation demands.

9

3 A Simple Model

Below I present a simple model which contributes to an easier understanding

of the problem. We assume that the reform increases social welfare Sw. Non-

losers want the reform. Social welfare increases in two ways: the reform

increases the performance of the economy in a higher level than the current

status quo and moreover the current status quo is deteriorating. In case

losers have demands higher than z they are able to block the reform, so

that there is an additional loss (as the time derivative of Sw is negative.

Sw = ∂Sw

∂t< 0). Reforms create losers. The main actors are the government

and the individuals.

Figure 1: Losers' Compensation

In Figure 1 above we make a few simple assumptions to facilitate un-

derstanding. There is perfect information, both government and losers are

honest. All n individuals are homogeneous losers. The government calculates

the the total losers' loss K and sets the supply of compensation at z = Kn.

Loser i has a utility sWi from the reform where

s∗Wi = s∗Wi(ci, z) =

S̄W if ci = z

R < s∗Wi< S̄W if 0 < ci < z

R if ci = 0

10

s.t. sWi = ci − ki + S̄W where ci is the compensation, ki the loss from the

reform and sWi the utility from the reform. Let AS̄W in Figure 1a be the

loss ki. The individual will get the compensation ci and both losers and non-

losers get the same utility S̄W . There is no excess demand for compensation.

• More complications: the government does not to give all the compensation

(e.g. does not have enough resources). Then the losers will demand more

and either they will block the reform or the reform will be implemented

and the losers will have a loss. This is gain shared equally among, the

non-losers. Theoretically the stopping rule Eq.(1) is still valid but the losers

because of many reasons (strategic behavior, imperfect information etc) have

the possibility to press the governmnet and a�ect z = z(ci) and get more

compensation, or block the reform. When the losers get more than the budget

constraint, this leads to a government de�cit. The social loss is considered

small for the losers. E.g. the losers may consist 20% of the society. If they

get 1 million too much, only 20% of the loss will a�ect them. And because

the �tragedy of the commons� ( Garrett Hardin10 (1968) they have incentive

to demand more.

Figure 2: Losers' Excess Demand/Compensation

In Figure 2 above we see deviations from the optimal solution. In 2b

10http://en.wikipedia.org/wiki/Tragedy_of_the_commons

11

demand in H may cause an increased compensation EE∗HG which is gain

for the losers but loss for the rest of the society (non-losers). The opposite is

valid with EE∗LG where losers have loss and non-losers gain. Interpretation:

For ci > c∗ there is over-compensation which causes social resources loss. For

ci < c∗ there is utility loss for the losers. For ci = c∗ we have an optimal fair

solution.

• In (2(b)) the fair solution is where the reform compensation equals the real

reform loss ci = ki. It is straightforward that

cEi = ci − ki → cEi = 0

A increase in cEi over zero increases the utility of the loser i at the cost of the

rest of the society. The opposite happens when cEi is negative: the utility of

the loser i decreases and the rest of the society shares the gain. Both cases

are unfair. For reasons that I explain in this thesis the bias we observe in

real life (in democratic regimes) is often to the direction of cEi > 0 rather,

than the opposite. When then we apply symmetry this means a large loss of

social resources.

• The model use ci either as the compensation the loser gets or as the loser

compensation demands. The importance with the over-compensation de-

mands is that even if they go down to the fair compensation level, they may

block the reform for a long time, causing social loss.

Let p the share of the losers in the society. When the losers get over-

compensation, it spreads over all the society and the losers' loss in social

resources is much smaller, than their over-compensation, e.g if the losers are

20% in the society and they get 1 million too much, the social resources

RC will decrease for them by only 0.2 × 1 million. So for example if losers

are 100 (n = 100) they get ncE extra compensation and the decrease in

social resources is for them only 0.2× ncE that is their net gain is (1− p)cE.Therefore they have an incentive to demand more and press the government

12

to increase z. But the high demands besides can also lead to a delay in the

reform and the deteriorating status quo decreases the social resources SSQ.

The probability α of the reform is a function of the losers' compensation

demands ci and the compensation o�er z of the government to the losers .

α = α(ci, z), α =

1 if ci ≤ z

0 if ci > z(1)

For many reason presented in this thesis the losers can require an excess

compensation ci > ki, ci > z (larger than their real loss and than the

government o�er) and press the government to increase z. The government

calculates:

K =n∑

1=1

ki i ∈ [1, n] = C =n∑

1=1

ci , i ∈ [1, n], z =K

n

Where K is the total losers' loss, C is the total compensation amount and z

the o�er to each loser (we assume here that all individuals are losers). Loser

i optimizes:

maxci

Ui = α(ciE + S̄W ) + (1− α)(−SSQ) (2)

where ciE is the deviation from the optimal compensation, often higher than

this (cEi = zE > z∗), S̄W is the standard utility from the reform, which

everybody takes and −SSQ is the loss from the status quo deterioration

because of the reform delay (when ci > z). The �rst-order condition is:

α(cE′

i + (1− α)(−S ′SQ) = 0

which becomes:α

(1− α)=

(SSQ)

cE′

i

(3)

Interpretation: Left hand side (LHS) represents the relative probability of

the reform and when SSQ increases, α also needs to increase for the Equation

(3) to hold. One more factor which makes things more di�cult is the lag in

13

the e�ect of SSQ, which permits high ci (demands).

Intuition: the loser is myopic and undervalues the e�ect decrease in the social

resources as much smaller. He knows that the government cares about its

re-election, which depends on the loser-voter.

The government optimizes social welfare and plans reform to enhance so-

cial welfare. The deteriorating status quo causes social loss and utility loss in

terms of electoral power. Imposing reforms can lead to political cost and thus

electoral cost. Too high compensation increases utility among losers but de-

creases government's utility among the non-losers. So the government needs

to �nd the optimal compensation which maximizes its utility. The latter

depends on the aggregate social welfare, the amount of the social resources

and the government's re-election probability. It optimizes:

maxzE

Ug = α((zE + S̄W ) + (1− α)(−SSQ) (4)

where zE is the excess compensation supply to the losers. In a similar way

as the losers maximization problem the government faces the problem from

the increase of zE. The �st-order condition gives:

α

(1− α)=

(SSQ)

(zE + S̄W )(5)

where zE is the deviation from the optimal supply to the losers, z = z∗ = Kn.

We notice that the government has lower incentive to increase zE than losers

do with cE. E.g. if zE = cE and the losers get 1 million over-compensation,

the social resources decrease by same amount so the net utility (increased

compensation-decreased social resources) for the government is zero. How-

ever, the delay of the reform is costly and the government may compromise

with the losers and give more compensation. The government has incentive

to o�er a compensation higher than the fair one. It expects an increase in

social welfare with the reforms and thus increased utility. In some cases the

political cost can lead them in many cases to postpone the reform, but a

14

long delay decreases the social welfare and thus the government utility. A

trade-o� is obvious: The cost of the excess compensation decreases the social

resources and therefore the government's utility. On the other hand the delay

of the reform creates loss, pressing for agreement with the losers.

• Duality : Given the reform the losers maximize compensation utility and

the government minimizes compensation cost.

• In case of no reform (ci > z), there is a loss for the society. As α = α(ci, z),

government and losers press each other. The government has three options:

i)To try to persuade individuals to lower their requirements to match z

ii) To conduct key players in an advanced way and either expropriate or coopt

important key players which oppose the reform (Shleifer-Treisman(2001)[17]).

iii)To increase the z to match ci

• Most of factors lead to a bias of both ci and z to the same direction, namely

to over-compensation.

• We also can further assume compensating discrimination11. Then the ac-

ceptance of the reform can be expressed by by the cumulative distribution

function H(.) (we see an example of this in Figure 7 on page 46). Then the

government may use H(.) to calculate the needed threshold for achieving a

required support to imply the reform.

With this model the e�ects on reform imposing, i.e. on ci and z, are

easily understood. In a more extended model each e�ect may be analyzed

deeper. Finally, by building a synthesis with all the e�ects, we solve the

model (probably a task for a book, not for this thesis, because of the limited

space).

11A term similar to the pricing discrimination in order to facilitate understanding.

15

4 Losers' Compensation

The trend is to transform autarchies to democracies is strong. This a�ects

indirectly negatively the easiness of imposing reforms. In pure democratic

environment it is more di�cult to impose reform. The social planner needs to

be aware of the occasionally limited resources and use all available knowledge

to achieve the highest possible e�ciency.

Giavazzi-Tabellini (2005) argue that [10] �Countries that �rst liberalize

the economy and then become democracies do much better than countries that

pursue the opposite sequence, in almost all dimensions.� According to them

the sequence matters, i.e. �rst must we liberalize the economy and then

the democracy, to obtain good performance.12. A high level Democracy13

may be more e�ective than a dictatorship, but it is not necessary that any

Democracy is better than a �average� dictatorship14.

4.1 Why to Compensate the losers?

Compensation may be socially bene�cial, therefore necessary. Reforms cre-

ate losers, systematically redistribute income and it leads to accumulated

income, inequality and discontent. As Alesina, A and Perotti, R (1995)[2]

state, the income inequality and the discontentment a�ect negatively invest-

ments and demand, creating a vicious circle. Besides, discontent losers may

behave socially negatively, attach themselves to some discontent party that

undermines the system etc.

12In Development economics there is a great support to the factor of Democracy as

promoting growth and development, however we should comment that this is not always

the case, the quality of Democracy matters (see Section E.5 on page 58)13See section C on page 4414We should compare only with cases where the dictator is relatively consistent to focus

in the public interest

16

I do not assume here disasters or actions (taked or not taken by individu-

als) or state as (Scanlon, J, 1988).[16] but usual behaviors. Here a distinction

should be made between short-run losers and long-run losers. Short-run losers

may be after all long-run gainers. It is important to be clari�ed for the losers

that claiming too high compensation or blocking the reform is not socially

optimal and it may even damage themselves later.

Many governments experiment in order to �nd some successful techniques

in imposing reforms. By thinking inductively rather than deductively, they

try to provide the possibility or impossibility of certain reform, observing

which technique has succeeded and which has failed. However, as Shleifer-

Treisman (2001)[17] state there is no guarantee of success in such applications

of policies: each case may be unique and we need to �nd own solutions.

Democracies face a harder resistance to reforms than autarchies and dic-

tatorships. The losers are expected to react. Theoretically one simple way

could be to take from those that gain most and give to those that lose most.

But how to implement this in practice?

In case individuals are forced to change job, they will be either gainers

or losers. Even the long run gainers may face some loss in the short-run.

In Figure 3 from Toshihiro (2003)[11], we see graphically how gainers and

losers are represented.15 We assume two sectors, Y and X. We consider here

that 0S0S1 represents movers from X sector to Y sector. South part of the

�gure denotes low income, while north part high incomes. The dotted line

shows an indi�erence curve between gainers and losers. Toshihiro (2003)[11]

underlines the trade-o� of the social planner between Pareto improving and

overcompensation.

15In the original the job switching is determined by the wage and prices and it was

originally for trade. In the case of reform individuals are pressed to move and they require

compensation

17

Figure 3: Gainers and Losers among Job-Switchers

Source: Toshihiro (2003) (edited)

The weight of the compensations will be more on the low incomes losers

movers (in the graph the triangle 0DA represents the losers and low income

movers). The magnitude of the compensation is a problem. In addition

of this trade-o� Toshihiro states another trade-o�, this one being between

overcompensation and size of aggregate production gains. That is, the com-

pensation's utility function follows a non-monotone curve, with slope being

negative after some point.

4.2 Factors a�ecting the reform imposing

• Political Electoral Power Politicians compete to win the elections and get

the government16 by investing personal ability, �nancial/media support by

interest groups and the use of the Political Ideological Wind (PIW)17. The

16Appendix A on page 3917For PIW see Appendix A.2

18

help from the �nancing sponsors has some constraints, as these will require

some bene�ts later in case the politician wins the elections. This makes the

marginal bene�t positive but declining (f ′ > 0, f ′′ < 0) as the sponsors

increase and the politician unavoidably he will end up with the optimal

number of sponsors. Because of the large total expenditures, the optimal

number of candidates is two (see Appendix A on page 39). But relaxing

the assumption of symmetry will cause di�erences in the personality, ability,

intelligence to select optimal amount of �nancial support. The most e�ective

politician wins the elections and gets the rents, while the concurrent one fails

and has a loss and even the �nancing sponsors have a loss in their investment

on him.

Intelligent and charismatic politicians may foresee and use the political

trend, which I model more detailed in Appendix A.2 on page 41 as PIW

but also they take into advance psychological rules in order to increase their

political power. Considering how it depends on the political game may be a

complicated model, where we need to model several trade-o�s and possibili-

ties and the outcome maybe a function of MRS:s of the several trade-o�s.

As expected the existence of the political cost in imposing reforms makes

the process sensitive to the political cycle. Therefore the prospect of fu-

ture elections may a�ect the strategies of incumbent politicians reformers

(Aghion, Bolton, Persson). Also Bonglioliy, A and Gancia, G (2010) [4] �nd

that the electoral cost leads to a less e�cient outcome for the society because

of the politicians interest to be re-elected. Considering the model we can un-

derstand that the government with more electoral margin has more ability

to survive easier the cost of a reform.

• Political Economic complementarity Saint-Paul(1999) [15] states that in

some cases the imposing of a speci�c reform may hinder the political accep-

tance of imposing other reforms. Also economic complementarity exists for

analogous reasons. In some cases it may even facilitate some other reforms,

19

but the problem is in the �rst case. If the relation is only to one direction,

then the solution is of course to avoid the problematic sequence.

Particularly in transition economies the e�ect of the recent reform a�ects

reform later in the nearer future. Shleifer-Treisman(2001) write: �the terrain

is reformed continually�. This seems to be the case both in Russia and Greece

when many reforms had to be imposed within a short time.

Besides Russia we experience this even in Greece now when many reforms

are to be imposed within a short time. We may see it as some case of time

complementarity. We may call it a �reform fatigue� and if interacting with

other factors it may make reform implementing more di�cult.

In case the government plans to impose many reforms simultaneously this

will be much more di�cult than to impose one after the other: For example:

suppose the government attempts to impose �ve reforms simultaneously for

the simplicity each of them having 20% losers. Objectively the gainers are

80%. It is clear that 80% of the society are winners from the reforms and

the government maximizes social welfare. But the losers maximize their own

(individual) utility rather than the social welfare. Therefore it is expected

that even with perfect information the anti-reform front will be much much

higher than 20%, depending on how much the events are dependent. In the

worst case of a corner solution where theoretically we assume that the events

are mutually exclusive or disjoint the losers will be as many as 80%, which

makes the reforms impossible.

• The Business Cycle e�ect. Roland (2001)[8] explains that case of a

high growth economy, it is expected to be easier for the losers to accept the

reform18

Also Drazen and Easterly (2001) [7] elaborate the theory that crises in-

18See also Akerlof et. al. (2002)[1] the case where a decrease in wage is accepted easier

through an in�ation increase rather than nominal wage decrease (framing and anchoring

e�ects).

20

duce reforms, although they failed to �nd enough support for the hypothesis

empirically. The recent Greek crisis seems to support the hypothesis. With

high de�cit, large debt and negative per capita growth Greece succeeds to

impose necessary reforms that for more than 20-25 years were impossible, as

the demand for compensation is now at lowest level (the opportunity cost of

the reform). The e�ect seems to be even �experted� to other EU countries

which try to avoid a crisis by imposing reforms.

Figure 4: Relation between RAE and Business Cycle

The intuition is consistent with the theory: Individuals' reservation com-

pensation level varies over the business cycle. I summarize the two theo-

ries by depicting the predictions in the Figure 4 below I depict a possible

relation between the business cycle (Low=recession, Normal=growth 2%-

3%, High=growth >4%) and the impact on the Reform Acceptance Easiness

(RAE)19, so that it will be consistent with the theories above.

The Chinese case seems to support this theory. China succeeded with

the reform imposing, as it has very high growth rates for a long time. If

wages and bene�ts are indexed to the BNP changes, than they may absorb

a part of the loss, therefore the compensation claims will be lower than they

19The aim of the graph is to facilitate understanding the e�ects. The curvature and the

slope may be vary in every unique case and the author has no intention to argue for the

speci�c ones shown in the graph

21

should be. Concerning reforms imposed in a recession, we need to take into

advance that after the reform is imposed we should do our best for a quick

recovery. Long recessions may threaten the imposed reform in danger by

causing discontent against the reform).

• The relative income level of the losers. If losers have loss in the short

run but they are gainers in the long-run, a lower compensation in the short

run (while they have loss) might possibly be accepted, or even no compensa-

tion, under the condition that they are not of relatively very low income. But

what happens when individuals cannot absorb some of the short-run loss?

The income of the losers a�ects positively the increase of compensation

demand the nearer their income is to the poverty line. We see this even in

Figure 3 on page 18 (represented by the triangle 0DA.

Calmfors, L and Holmlund, B (2000)[5] state that income distribution

con�icts may act as a constraint in employment policy, because often policies

that reduce unemployment re-distribute income in large groups, which turn

to be losers.

• The role of the real interest rate. Intuition: high real interest rate

makes compensation at present value more di�cult if the government needs to

�nance the compensation by loan. Therefore a low real interest rate facilitates

the easiness in compensation and results easier acceptance of the reform. The

discounted present value of the future compensation x in

Vu =1

1 + rx

is decreasing when the real interest rate r goes up, ∂Vu∂r

< 0. This leads to

present bias preferences. The present value of X in time t for individual i

for su�ciently large number of n time periods it tends to give the relation

PV (X) ≈ 1

rX ti

Also a high in�ation causes loss as it eats up the compensation of the losers,

decreases the pro�ts for those who have lent the government. In�ation also

22

is related to the real interest rate 1 + r = 1+i1+π

or r ≈ i − π and a high

in�ation triggers a higher interest rate by Central Banks, which makes the

governments loans more di�cult. So a best solution is a real interest rate

with an in�ation near the in�ation target.

Even if the real interest rate is not high but the economy is not stable

(high in�ation volatility) and there are in�ation expectations, this is enough

for making the losers suspicious and increase the unwillingness to accept the

reform. According to the principle of ambiguity aversion20 (Verplanken &

Orbell,2003)[18] & Nelson et al., (2001, pp. 168-174)

• Uncertainty. Uncertainty about if the individual gains or loses from the

reform is often a problem, but also a battle �eld for the social planner and the

anti-reform group. Calmfors, L, Holmlund, B(2001) [5] �nd that uncertainty

leads to a status-quo bias. This is expected to decrease the acceptance of the

labour market reform.

Often we assign subjective probabilities to the states and build the von

Neumann Morgestern Expected Utility Function (vNMEF).

EUi = p(x) + (1− p)y , y < 0 < x

An example: assume two groups A gainers 70% of the population with payo�

4 and a losers group 30% with payo� -5. With certainty the majority 60%

supports the reform and the expected social outcome is

EU = 0.70× (4) + (1− 0.70)× (−5) = 2.8− 1.5 = 1.3

But in case the anti-reform group creates uncertainty in the half of the A

20People usually choose alternatives whose probabilities of events and outcomes are less

ambiguous. This consists a possible break with expected utility maximization and Bayes's

Rule.

23

group then we have

EU =

(+)35%︷ ︸︸ ︷

0.70

2× (4) +

(−)35%︷ ︸︸ ︷

0.70

2× (0.5× 4 + 0.5× (−5)) +

(−)30%︷ ︸︸ ︷

(1− 0.70)× (−5) =

= 1.4 + (−1.75) + (−1.5) = −1.76

This shows that 65% of the population is now against the reform and the

expected social loss is -1.76. In the model it means that individuals raise

their ci much

Uncertainly is a function of information and the latter is a �eld on

which a �ght is held between the pro-reform front and the anti-reform front.

• E�cient Information e�ect. The social planner's persuading ability with

e�cient arguments is important for accepting the reform and limiting un-

certainty. It is not enough to rely on the objectively majority of gainers.

It is important therefore that the government will not lose the information

battle. If the opposition wins the information war, the resulted increased

uncertainty increases the number of the people which subjectively are feeling

losers21.

In the study of Russia and Greece the governments obviously lack ability

to have informational advantage and in many cases the reform is blocked.

• Unemployment. A high rate of unemployment yields lower opportunity

cost of the reform for many reasons. The unemployed face low job switching

costs, lower costs of being educated for a new job and higher uncertainty

about employment.

But although the unemployed may be more positive to reforms, unions

support the insiders' interests, which may be quite di�erent. Calmfors, L,

Holmlund, B(2001)[5] commend in the political economy of unemployment.

One of the explanations of persistent unemployment refer to this as explained

by political mechanisms that prevent labour-market reforms. In such cases

21See an explaining graph in Appendix D.2 on page 45.

24

reforms are blocked by unions and insiders which may feel losers.

• Advanced Gaming with Key Players. As Shleifer-Treisman(2001)[17] state

in case of restrictions in resources ability in playing e�ectively with the stake-

holders is valuable. The e�ective combination of expropriating and coopting

is a powerful tool giving the possibly maximum payo�s with respect to the

available resources.

4.3 Psychological Factors

Often individuals do not behave consistently to maximization of expected

utility provided by vNMEF function but they deviate from it. Behind the

deviations are psychological phenomena which explain much of the devia-

tions, as Amos Tversky Daniel Kahneman22 (1986)(p.252 & pp. 273-275)

describe why we need to take into advance psychology23 when we want to

analyze, understand and partly predict behaviors and thus avoid e�ciency

loss in policies.

According to Tversky & Kahneman (1986) with the Prospect Theory (Fig-

ure 10)24 individuals show a bias to the gains and avoid equal losses (loss

aversion). The strange with this bias is that individuals behave like risk-

averses in gains, while risk-lovers in losses. This is an obvious violation to

the vNMEF. Loss aversion rule increases the reform opposing for losers as it

is easily understood by intuition.

Individuals will have a bias in their preferences to the direction of the

gains which means a bias to status quo which is overvalued. In Figure 10 on

22�We argue that the deviations of actual behavior from the normative model are too

widespread to be ignored, too systematic to be dismissed as random error, and too funda-

mental to be accommodated by relaxing the normative system�23Lennart Erixon, Lectures in Economic Psychology, Stockholm University 201024Departure from a status quo, gains more important than equal losses and loss aversion,

which produce behaviors that are risk neutrals in the gain area, while risk neutrals in the

loss area.

25

page 10 we consider status quo to the right of 0 and the reform to the left.

This means that they will show a status quo bias, which also implies that

they will oppose the reform as they will demand a higher certainty equivalent.

Many other phenomena (which we often do not include in our models) a�ect

economic behaviors and reform imposing:

• Ideology: Either political, religious or nationalistic, ideology is a strong

feeling causing long-run oriented behaviors. In contrast to most psycholog-

ical phenomena which lead to short-run bias behaviors ideology often may

lead to long-run bias.

• The high aspiration level of income25 creates great expectations, high com-

pensation claims and decreases the acceptance of the reform. The individuals

utility level is therefore in a great degree a function of their aspiration income

level. The anti-reform group tries to raise the aspiration level of income in

the society.

• Hyperbolic Discounting E�ect (HDE)26 This e�ect may make normally thereforms more di�cult as it causes a status quo bias. 27 Negative e�ect on

the reform imposing.

• Con�rmatory bias and overcon�dence28 and Anchoring29: in these cases it

is crucial for the two blocks to create initial believes that will resist a change.

• Regret theory (regret aversion)30 is present and people are reluctant to takedecisions that may lead them to regret. Related to uncertainty, negative ef-

25Aspiration level of income is the reference level which determines if we are satis�ed

with our actual wage or we demand a higher one26A present bias in preferences: the near future is valued as more important.27People over-evaluate the loss in the near future relatively to the better times in the

later future.28People collect, treat and interpret information in a way that is consistent with the

initial hypothesis (belief)29when an individual has formed an hypothesis, he stops taking in new information

objectively30People tend to prefer options minimizing regrets (at the cost of utility...)

26

fect on reform imposing easiness.

• Ambiguity aversion creates a status-quo bias and has the analogous e�ects

as in the case of uncertainty, we mentioned before. Related to uncertainty,

negative e�ect on the reform imposing.

• The Peak-End Rule31 may have negative e�ect when reforms imposed in a

crisis are not followed by a quick recover and growth.

• Individuals' myopia. Intuition: myopic (short-run biased behaviors) indi-

viduals understand more di�cult the long-run advantages of the reform.

• The quality of the society (social discipline etc) may a�ect predispositions

and to some degree the easiness of imposing reforms.

• In low stability societies applying reforms is di�cult as the losers require

too much and they do everything to stop the reform.

Such phenomena may lead to situations where it happens that �the most

forceful resistance not from losers but from winners� (Hellman, 1998) All

these phenomena with the exception of ideology drive ci up (negative e�ect

on the reform imposing).

5 Successful Chinese reform

China has imposed successful reforms during the transition to the free market

since 1979. The country has achieved an impressively high growth rate for

a long time. Recent analyst calculations suggest that China will go over the

USA economy and become world's �rst economy in some time between 2020

and 2027, if the current situation and China's high growth holds.

It is a brilliant case of successful implementing of reforms with an almost

military discipline and sophisticated mechanisms, which provide the com-

pensation of the losers. Roland et. al. (2001) �Reform without losers�[9]

, analyze the Chinese system with success in the compensation question.

31people are putting more weight on recent and exceptional experiences

27

China uses a system with a �dual track� (plan track and market track). The

success of this system requires the imposing of di�erent prices for the two

tracks. By buying and selling freely the losers get compensated, therefore

Roland is allowed to talk about reform without losers.

It is shown that this successes to both achieve Pareto improving in the

�rst stage, while it succeeds to preserve Pareto e�ciency in the second stage.

However, this model is applied in a partly dictatorship-like environment with

central planning. China has many advantages (but also many disadvantages)

compared with western economies. In some areas it looks like a free liberal-

ized market but in other important �elds it is operating like a dictatorship

and this besides the drawbacks gives China certain advantages, which should

be di�cult if not too di�cult in a western free market democracy. One of

the advantages is the easiness to impose reforms.

With respect to the special character of the economy in China, the ques-

tion that arises therefore is if and how the dual track system could be imple-

mented in western free-market economies, or a similar system for achieving

an e�cient compensation of losers.

6 The Russian reforms' failure in 1990:s

The young Russian Democracy failed to impose e�cient reforms during

1990:s and �nally got a severe �nancial crisis. Russia had already had some

negative factors, like the poor national integration and the federal structure,

but also the economy was concentrated sectorally and geographically. Al-

though many economists warned them to stabilize the economy �rst and then

privatize the economy, they did the opposite. Such mistakes in combination

with the delay, which caused a decreasing popularity of the president and

increasing discontent, led therefore to a decrease of the reform acceptance.

28

President and government were late to impose the tax-system reforms.

The fall in popularity increased the reform opposing. Many mistakes made

the situation worse. As Shleifer et al. (2001) state, a better strategy with

advanced gaming (using combinations of expropriating and coopting losers)

could have given better results.

Attempts for reform in 1991 and 1997 failed as the important changes

were either blocked in the enactment or were not implemented. As the gov-

ernment did not have the ability to fully compensate the losers, the only

way to implement the reform was to persuade them. But the communists

in the opposition were more e�ective. The government failed to isolate the

losers and failed to pass legislation ( in the Tax Code or the Budget Code).

Incentive problems interacted to reduce revenues and �nally, the government

failed. The key tactics should be to isolate the opponents of the reforms

but they did not have knowledge about how to do this. The failure of the

tax reform after 1995 re�ected the reformers' inability (and unwillingness) to

e�ectively handle the situation. Banks had pro�ts from the high in�ation in

the beginning. The Central Bank was delayed in eliminating it but gradually

banks moved from the pro-in�ation to the anti-in�ation group.

The government should coopt 32 both the two important stakeholders

(federal governors and big businesses) or at least isolate the one of them

by making coalitions against them. The parliament (Duma) was under a

strong in�uence of the communists, which did not like the reform and tried

to undermine it. As a consequence, they tried to persuade the losers to

require much higher compensation, which in practice led to rejecting the

reform.

Another mistake was that they tried to impose the reforms in a frag-

32Shleifer (2001):�Cooptation implies not dealing the stakeholders out of the game, but

dealing them new cards�, i.e. they are persuaded not to exercise their veto rights against

the reform

29

mented way, instead for imposing them at once. Although Roland (2001)

recommends �making reforms only partial to reduce opposition,� this does

not work in any case and did not work in Russia of 1990:s. This made inter-

mediate compensated losers reluctant to support the reform program fearing

that they will lose their relative bene�ts and requiring new much higher

compensations.

Comparing with the Chinese practice, we may say that they did not

have the knowledge and the time to go gradually as they democratized the

society �rst; then they tried to privatize the economy, that is, in the oppo-

site sequence that Tabellini recommends, namely to stabilize, liberalize and

develop the economy �rst and then the democracy. It might work much bet-

ter, as using the dictatorship power they should implement and enact the

reforms quite easier and more e�ectively. But the sudden collapse of the

Soviet Union (CCCP) did not permit a careful transition. The quick democ-

ratization gave to the anti-reform block the power to block the reforms.

7 Recent Greek crisis and the role of reforms

Greece had a dictatorship 1967-1974, during which the country experienced

relatively high economic development (average growth over 7% with public

debt under 17% of GDP). The dictators did not open up the economy fully

and did not achieve very high GDP per capita.

Then the democratic liberalization took place without a complete eco-

nomic liberalization and development, something that Giavazzi-Tabellini (2005)[10]

do not recommend. The Democracy Level (see Appendix C on page 44), was

higher after the dictatorship than before, consistent to their prediction but

the level then sank. Governments became weak, the unions' bargaining power

became extremely high, corruption and tax evasion increased, polarization

e�ects and prisoners' dilemma traps increased de�cit and debt.

30

• Two large parties competing for the government. Both were cor-

rupted33. Each party believes that it is the other party that it is (most)

corrupted.

• A third important party, the Communist party has as goal the tran-

sition of the economy to communistic and undermines both attempts to de-

velop the economy and reforms.

From the 1980:s de�cit and accumulated debt increased. Imposing nec-

essary and important reforms was di�cult, ine�cient or even impossible

because the governments were in a �political cost trap34.�

Richard D. Wol� (2011)35 in one of his online lectures36 �nds similarities

between the US and Greece de�cit and debt building causes: politicians

tax the rich and individuals less than needed and then they borrow, from

the rich (and from abroad). The accumulated debt causes a crisis. Then

the government tries to decrease de�cit by strict austerity which leads to a

recession and leads to a vicious circle. What is interesting for this thesis is

that politicians try to consume low cost popularity by postponing reforms

and therefore the creation of losers. This can lead to a socially ine�cient

and unfair situation increasing the inequality. Some factors which worsen

the economy performance (and reform imposing) in Greece are:

• Corruption and established frequency37 of it [13] (see Appendix E.5 on

page 58)

• Polarization e�ects38.

33According to Greek press, surveys and the opposite party of each of them34Chicago School theory predicts the voters should isolate the corrupted party and �x

the problem with competition.35Professor in University of Massachusetts, known as marxist36http://www.youtube.com/watch?v=AG0zL1ZIw08feature=playerdetailpage37Corruption's accumulation accelerates on environment where it is already established.38a process where people gradually overvalue their good points, undervalue their bad

points, while they do a similar process but the other way around for the others. This en-

hances negative e�ects like corruption, and may operative negatively on reform acceptance.

31

• The communists and radical left consist a major problem for the re-

forms just like in the case of Russia in 1990:s. In order to develop a tech-

nique to overcome this problem successfully an analysis is helpful in providing

knowledge. See Appendix E.6 on page 59.

• The arming rivalry between Greece and Turkey: It eats up more than

5% of GDP of Greece and plays a heavy role on increasing de�cit and debt.

• The demographical problem increases the debts of the Social insurance

services and a�ects the state de�cit and debt. See Appendix F on page 61

for a description of this problem and how it is related to the immigration

problem.

7.1 Comparing Greece with China and Russia

China is very di�erent from Greece. At �rst, it is an almost dictatorial

regime with strong self-disciplined social planner, while Greece is a weak

Democracy. China does not face any serious resistance to reform imposing.

Although o�cially is called a communistic regime the communists are helping

the fast development, while in Greece the communists dream a communistic

society and economy, undermining the government attempts. In combination

with other interest groups this makes the reforms di�cult in Greece, while

in many cases even when a reform is imposed and enacted, there have been

so many compromises and exceptions that take the reform far from being

optimal.

In China the opportunity cost of the reform is kept very low with many

decisions, e.g. authorities keep the wages of the Agricultural sector low. Also

the cost of the reform is kept down with restrictions, like the prohibition of

moving to the industrial areas if one does not already have a job o�er, which

keeps the unemployment low. China uses an intelligent system to compensate

losers by using the Dual track system. In Greece, although the compensation

See Appendix E.2 on page 54

32

may be high, it is often considered by the losers incomplete because of the

high claims (because of too high expectations and aspiration levels).

China without opposition problems follows disciplined the growth models

of Harrod-Domar and Lewis, but also is favored by the issue, which Giavazzi,

F, Tabellini, G (2005)[10] have explained, it is good to liberalize and develop

�rst the economy and then (probably) the democracy. In Greece the strong

opposition and the high political cost often prevent creative plans.

Public sector in Greece is huge and many economists estimate over-

numbered employed to about 400.000. In China they decrease gradually the

Zero Marginal Productivity (0MP) Agricultural workers, making them more

productive in the high pro�t industrial sector, while in Greece since 1980:s

the opposite seems to be the case. They accumulate more and more 0MP

employees in the Public sector, as we see in the Figure 12 on page 53. An-

other important detail is that in China 0MP employed have very low wages,

while in Greece 0MP ones have very high ones. The Table below shows the

main similarities and di�erences between Greece, China and Russia:

33

Comparison of China and Russia (1990:s) with GreeceGreece

- Similarities Di�erencesChina • Both: Pool of 0MP workers • China: the pool of 0MP is decreasing

• China: high corruption, high penalty; giving workers high productivity.Greece: very high corruption very • Greece: Increasing 0MP employedlow penalties • Greece in EU and EMU

• China: half-dictatorship, Greece a LLDemocracy. (In China no reform resistance,

in Greece very high resistance)• China the pool decreases giving high MP;Greece the pool increases• China has a very high growth rate;Greece has a high recession• Greece has too high permanent over-employment with public sector• China: complete reforms; Greece imposespartly and not e�cient reforms• China: bossy regime solves the problemof myopic behaviours, Greece the opposite(blocked or non-e�cient reforms)• Greece has very high bargaining powerof unions; China not so much• In Greece high austerity leads torecession and discontent and the longduration threatens the imposed reforms

Russia • Both after dictatorship • Greece in EU and EMU• Both high corruption • Greece has much larger debt and• Both high tax-evasion de�cit which gives the lenders the right• Both high uncertainty to dictate policies• Both low ability to impose reforms• Both Low Level Democracy• In both communists oppose reformsstrongly• Both lands face in�ation problem• Both try to liberalize withouthaving stabilized �rst• Both partly imposed reforms withlow performance• Both fear of the political cost• Large income inequalities -many with low income 34

8 Policy Recommendations for Greece

• Build a National Government as a tool against political cost tramp.

Such a coalition should experience large co-ordination costs, but may remedy

even partly the great problem of the political cost tramp and solve e�ciently

the prisoners' dilemma problem.

• Improve Information delivery to citizens - potential losers. The anti-

reform group invests much in this �eld because the winner will have an ad-

vantage. Any dark areas in the information increases uncertainty, which

strengthens the anti-reform group.

• Expropriate or coopt the reform opponents. As Shleifer-Treisman (2001)[17]

write it is important to use proper and e�cient strategy when the resources

are limited in order to get the reforms implemented and enacted.

• Plan pilot programs to evaluate future reform imposed locally may be

helpful because they decrease the opportunity cost of the reform. They meet

limited resistance locally which facilitates success and the acceptance by the

whole society later facing lower opportunity cost because of the interaction

of local success and delay (see Drazen(2000))[6].

• Avoid partly imposing of reforms. As Shleifer-Treisman(2001)[17] un-

derline intermediate gainers will oppose the complete imposing of the reform.

Trade-o� with the recommendation of Roland (2001)[8] where making re-

forms only partial reduces opposition. From my point of you, in the cases of

Russia and Greece the �rst recommendation is stronger, as in case of many

reforms to be imposed it avoids even a heavier �reform fatigue�.

• Select which kind of reforms to be imposed. When many reforms

need to be imposed in a short time (e.g. during a crisis) sort the necessary

35

reforms to ascending order according to the relative average expected cost of

compensation and begin with the less. This way we avoid increasing side-

e�ects on the aggregate cost. The other way around is expected to have

much higher total cost.

Besides pure reform imposing policies, proposed here, even development

measures and policies are proposed in the Appendix F on page 61.

9 Concluding Remarks

The main objective of this paper was to analyze theoretically the factors

which a�ect the imposing of reforms with compensation of the losers. A case

study speci�c to Greece was carried out. To facilitate comparisons, China

and Russia also were discussed in the thesis. I �nally used the accumulated

knowledge and own contribution in order to recommend policies for Greece.

The contribution of the study is it addresses the issue of reforms, gives an-

swers to questions about the reform imposing and shows how to facilitate

it.

The contribution of this paper includes even a simple but very explaining

model with several informative �gures39, which summarize available knowl-

edge combined with own theoretical contribution and give to the reader better

understanding of the arguments expressed here.

Many factors a�ect the losers' compensation. It is important to take into

advance all the available knowledge when we try to �nd solutions in imposing

reforms as there are no recipes. Each case may be unique and requires own

planning and experiment. Individuals optimize often myopically in the short-

run and try to get too high compensation. The dependence of the government

on the losers-voters leads to a bias to over-compensation or to delay in reforms

39Figures 1-6, 10, 11, 13, 15.

36

causing a resources loss.

Also in the Appendix there is material which facilitates understanding

for the reader which requires a deeper understanding of the ideas and princi-

ples presented in the thesis. The author attempts to improve understanding

by introducing new concepts like the decomposition of the Median Voter

Theorem40, and the de�nition of the Political Ideological Wind (PIW)41.

The analysis has some limitations, such as the nature of the behaviors

in the society, the quality of the democracy, the degree of social discipline

and trust to the government and the interaction of psychological phenomena

a�ect reform imposing. Many factors can not be measured easily. It is still

much we don't know and this makes the research interesting.

Further research and analyses are needed for an improved knowledge

in this area. This thesis makes a step forward and challenges the debate

so that the interaction with the triggered antitheses may hopefully pro-

duce a superior synthesis, which is the ultimate objective of this thesis.

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[1] G.A. Akerlof. �Behavioral Macroeconomics and Macroeconomic Behav-

ior �. The American Economic Review, 92(3):411�433, 2002. 20

[2] A Alesina and R Perotti. Income Distribution, Political Instability and

Investment, volume 40. European Economic Review, 1996. 16

[3] Jens Chr. Andvig and Karl Ove Moene. How corruption may corrupt.

Journal of Economic Behavior Organization, 13(1):63�76, 1990. 58

40This makes the theorem more �exible and operative, see Appendix A.141Important to explain motions of the political ideas leading to redistribution of the

political power, see Appendix A.2

37

[4] A Bonglioli and G Gancia. Politicians, Uncertainty and Reforms. Insti-

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[5] Holmlund B Calmfors, L. Unemployment and economic growth: a partial

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[6] A Drazen. Political Economy in Macroeconomics, Inaction, Delay and

crisis. Princeton, 2000. 8, 35

[7] A Drazen and W Easterly. Do Crises Induce Reforms? Simple Empirical

Tests of Conventional Wisdom. 2001. 5, 9, 20

[8] Roland et. al. The Political Economy of Transition. Journal of Economic

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20, 35

[9] Roland et. al. Reform without losers - China. The Journal of Political

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[10] F. Giavazzi and G. Tabellini. Economic and Political Liberalizations.

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[16] J Scanlon. Winners and Losers: some thought about the Political Ec-

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[17] Treisman D Shleifer, A. Without a Map - Political Tactics and Economic

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[18] Orbell S Verplanken, B. Re�ections on past behavior: A self-report index

of habit strength. Journal of Applied Social Psychology, 2003. 23

Appendices

A Political Power Determinants Assumptions

Political electoral power is one of the factors, which a�ects the ability to im-

pose reforms. The mechanism of achieving political power in a representative

democracy is the majority voting system. Politicians have some endowment

in ability (personality42, to attract voters, relevant education etc) and invest

xi for claiming the government. The amounts for the campaign are huge

and the politicians need external �nancing by sponsors. Even when some

politicians are relatively more popular/superior in endowment, the fact that

the other politicians use external �nancing, forces them to do so. I assume

that the marginal utility of the external �nancing is diminishing (there are

constraints in the number of sponsors and the size of the help). An im-

portant distinction is needed to be made to the Media groups which o�er a

stronger support to the politician (political party) and therefore contribute

more heavily to the building of political power. In some cases even media

owners may be politicians and win the elections, (e.g. Silvio Berlusconi).

42actors, media-men and other known people may be relevant for providing support for

the party leader

39

In some cases a politician even owns media �rms (TV, Newspapers, web-

newspapers etc) which a�ect power creation and therefore contribute more

heavily to the building of political power, which then is re-inforced by exter-

nalities, e.g. the case of Berlusconi in Italy.

Here I assume that in the basic model from Political Economy of rent-

seeking politicians and I replace the delegating lawyers with the sponsors

�nancing the politicians and two things are straightforward:

• The optimal number of candidates is two, in order to minimize total expe-

diture and maximize utility.

• With the help of the sponsors they increase their possibility to win but

there is a stopping rule because of the increasing marginal cost of the spon-

sors. Intuition: in case of inability for a su�cient compensation the political

cost for the government is less harmful when a large power margin exists.

The reform success is therefore in that case a function of political power mar-

gin. The losers reactions may be a�ected by their relative electoral power.

Later we may impose more complexity: In the reality the election process is

a more complicated problem. When we relax the assumption of the symme-

try, politicians may di�er and this a�ects their probabilities. The psychology

plays a crucial roll. More trade-o�s are built and �nally the decision out-

come and the subjectively optimal solution is a function of the MRS:s of the

several trade-o�s.

A.1 Median Voter Theorem Decomposition

In real life the electorate may be clustered in more than one clusters without

symmetry in preferences. In this cases Median-Voter Theorem (MVT)43 this

is not e�ciently valid.

43The MVT: If preferences are single-peaked, then majority voting will yield the out-

come preferred by the Median Voter. This becomes the preferable policy.

40

Figure 5: Three Median Voter lines

Therefore I assume that politicians derive the Median Voter in each clus-

ter and weight them by the relative electoral power (Figure 5 above). Then

they optimize by attracting the Median Voters according to the weights of

their electoral power. Then if the policy question is a single-choice (�yes or

no�) the strongest median voter gets satis�ed. In more complex situations

with more questions this principle gives more �exible solutions satisfying

more Median Voters accordingly to their weights. Factors like ideology, im-

perfect information, polarization and psychological factors may make possible

allotment to other than the strongest cluster. Often the elected politician

interacts with the supporters by being bene�cial to them in reforms or poli-

cies.

A.2 Political Ideological Wind (PIW)

Tullock (1980) states that rent-seeking is costly. It is shown that the optimal

number of candidates for the government is two, number which minimizes

the total expenditure and also that by delegating process politicians increase

their probabilities to win. Here I assume campaign �nancing sponsors instead

of lawyers, as I see it from my point of view.

Voters are not quite stationary in their preferences and even in their

ideology. Each party has in�ows and out�ows and the net in�ow changes

continuously. I introduce here a new concept, the PIW44, the trend of which

the politician may realize and use in order to transform them to votes for

44As political wind I de�ne more or less massive voter preference movements (not nec-

essarily on some particular political parties, but rather from and to major political areas)

because of events partially exogenous

41

him. By calculating or even by forecasting the PIW they maximize political

power and dominate in the political game. The ability of imposing radical

reforms is facilitated for politicians with strong electoral power.

PIW transfers political preferences/ideology either to the right or to the

left like an invisible wind eternally45. E.g. example in 60's and begin-

ning of 70's the increased living standards in many west countries created

a left/socialistic wind, while the fall of CCCP in 1990 created a right wind.

Although di�cult to a�ect this wind substantially, an experienced politician

should foresee and take into advance its trend. Besides exogenous factors

even charismatic leaders 46.

The politician tries to maximize his utility from the electoral power using

personal ability, support by �nancing sponsors etc. Besides there is some

group in the electorate, which tries to maximize utility by trying to support

the winner47 (the one they subjectively believe he will win the elections).

They increase the cost of the campaign, as the main candidates need to

impress, ensure and persuade them about their victory.

B Expectations - E�ect on the Business Cycle

The capitalistic system is built on expectations, which is well-known. How-

ever their e�ect is not constant over time/situations. They may fall down

quite easily, quickly and sometimes they may be catastrophic (e.g. in a cri-

sis or recession period), but in the recovering process they are slower and

carefully rising. This is natural and in accordance to the Laws of Nature.

Factors like Consumption (C), Investment (I) and Savings (S) can be then

45The society is in an eternal movement obeying in the axiom of Heraclitus (580BC)

�TA PANTA REI�:Everything is changing eternally.46E.g. two known cases, Olof Palme in Sweden and Andreas Papandreou in Greece had

successfully identi�ed and used PIW.47In some countries (e.g. Greece) analyzers estimate this opportunistic group to around

10% of the voter body and they are called opportunists, as they are supposed to lack

ideology.

42

expressed as functions of the expectations.

For the simplicity and in order to avoid building a complicated model, I

de�ne the expectations ex e�ect in a simple way:

∂C

∂ex> 0,

∂I

∂ex> 0,

∂S

∂ex< 0

where ex stands for the expectations about the economy evolution. Even if

S seems to increase, there is severe problem because the increase in it is not

healthy, are not investment oriented because of the overvalued risk. So S

which a�ects the investment in the reality declines, I declines. People just

withdraw money in secret places damaging investments and liquidity.

∂C

∂ex> 0,

∂S

∂ex< 0

Moreover I assume that in quiet periods the e�ect of the expectations is

quite small, not dramatic and therefore not so important: I call them neutral

expectations, assuming for the simplicity that the e�ect on I, C and S is

substantially smaller, practically zero: individuals accept the current level

of the economy as the default (no expectations for higher or lower levels).

By lower expectations I mean that individuals expect that a lower level is

coming (cycle nearer to recession)

Also a delay in intervention may operate like amultiplier in expanding the

signal of the crisis/recession, the core of the crash in the expectations. The

Press operates like a catalyst in this process, because of its nature: Press

maximizes utility (and revenues) when spreading news, which are terrible

and besides belong to some certain categories (unexpected, brutal, sexual,

absurd, etc). We should not expect that it will show response avoiding news

that may cause panics, because Press has a myopic (short-run) view of the

future. The response is a job of the politicians/economists.

In my study I apply the factors C, I, and S as functions of expectations

in the economy and it is easily understood that expectations operate like a

multiplier (negative, neutral, or positive) and in the bad case they lead to a

vicious cycle and cause to a recession. For many reasons expectations a�ect

43

the economy much stronger downwards than upwards,e.g a panic may lead

an economy to a crisis and even to a recession quickly, but the recovering

process will take more time.

C Democracy - High Level vs low Level

By High Level Democracy (HLD) I mean a well performing Democracy with

high social ability to co-operate and relatively low corruption and social tur-

bulence. Lipset (1963)[12] calls it Health of Democracy, it is the same thing.

Reversely by Low Level Democracy (LLD) I mean the opposite (see Figure

16(a) on page 59). The opinions about the positive e�ect of Democracy on

growth are true, however this does not mean that Democracy is a magic tool

that automatically creates high growth. It is needed much work and e�ort in

order to create and retain well operating institutions and supporting behav-

iors. This is crucial and in the worst case we may experience a LLD which

may limit the development or even deter and block healthy processes, in a

severe case threatening the economic evolution.

D Some Derivations and �gures

D.1 Status quo - New Reform

In Figure 6 we see such a status quo established by a previous reform, showing

positive returns but decreasing with time. Returns and performance are

decreasing with time. f ′ref > 0, f ′′ref < 0 reminding technology.

44

Figure 6: Old Status Quo - New Reform e�ciency curves

We assume decreasing returns in the form of BNP and workers' wages-

bene�ts indexed to output (BNP), b = ky, per unit of time. At time tref the

government introduces a new reform. The performance begins now low and

successively recovers at time trec in point D. The area ADC is the switching

social loss. Workers possibly will require compensation at the level of A, i.e

ABC. We notice that the required ABD is not real cost but rather automated

psychological belief in cases of lack of knowledge or information (inability to

identify the real deteriorating curve). The government may avoid compen-

sating the unreal part of loss by informing individuals.

D.2 Information E�ect

Uncertainty is a�ected by new information either positively or negatively.

Polarization in the information may increase uncertainty.

The reservation utility for loser individuals and groups can di�er because

of di�erences in preferences, own calculations, situation etc, but for all there is

some reference point, where they are indi�erent to support the reform or not.

For the support of the reform it is needed that Bref > Cref , or equivalentlyBref

Cref> 1. The distribution of this point follows then a CDF! (CDF!). In

Figure 7 the government may calculate the needed compensation for getting

45

50% of the support. But new information may increase uncertainty and the

demand for higher compensation and from 1.9 the needed fraction will be 3.

Figure 7: Reform support CDF function

An informational advantage from the anti-reform block increases uncer-

tainty and shifts the curve to the right: individuals objectively winners now

feel losers (those having relative utility between 1 and U2) and now oppose

the reform. The government needs to give more compensation, e.g. in or-

der to keep 50% of the supporters instead of theBref

Cref= 0D needs to o�er

Bref

Cref= 0E.

D.3 Austerity and Business Cycle

Extravagance spending cuttings are helpful but cuttings which a�ect in-

vestments and demand may shrink growth and lead to recession. Many

economists have the latest time after the rescue packet to Greece in May

2010 criticize strict austerity: Stiglitz (2010), Pissarides (2011), Paul Kru-

gan (2010, 2011) and others. Paul Krugman (2010)

The decrease of the de�cit by austerity is limited, i.e. we cannot draw

de�cit to zero by only austerity. Moreover we cannot use all the e�ect of the

austerity as it is not increasing monotonically but has diminishing returns

which they turn to be negative after some point. As the austerity increases

46

further it a�ects the expectations, gives the signal of crisis and may create

panic with negative e�ects on demand and growth (may turn to recession)

and the outcome in some cases is a large loss. The Greek case is a bright

example. The consequences are on the one hand easier imposing of reforms,

but if the economy does not go out of the recession the reforms are in danger.

Discontent against the reform will increase and this practically means an

increase of the individuals feeling losers.

Intuition: The decrease of the de�cit D can be written as a function of

two variables, the limiting of government extravagance, and the austerity Au.

Moreover growth G is a function of the expectations which in their turn are

a�ected by strict austerity. The latter �nally a�ectsG negativelyG = G(Au).

EU has chosen the strict austerity as a tool to decrease quickly the heavy

debts in the Union. But what is the result of this choice? And what is the

impact on the reform process and losers compensation? In Greece it led to

a recession, consistently to the debate. Also it facilitated some reforms but

then Greece faced a �reform fatigue�, a kind of reform satiation, and di�culty

to recover to positive growth rates.

• Proposition 1. Given that a drastic decrease in D by increasing

revenues is not easy and possibly not immediately feasible, a decrease in Au

is considered necessary and thus positive in the beginning.

• Proposition 2. Intuition: a large increase in Au has a negative e�ect

on expectations about the economy and �nally on G and this e�ect becomes

stronger than the e�ect on D and thus it increases the de�cit.

Austerity e�ect on de�cit and debt is divided in two sub-e�ects one direct

and positive decreasing de�cit and thus debt. And one indirect on expec-

tations and then on demand and other economic behaviors a�ecting growth

negatively. The latter then, once the economy enters in recession, leads to

higher de�cit and debt despite the austerity, causing more austerity claims

and deeper recession (vicious circle). It is wise to determine the point of the

optimal austerity in order to avoid recession.

47

We model this to analyze the e�ects:

Dd(Au) =(−)

Dd(Au)

Dind(G,Θe, Au) = Dind(G(Θe(Au)))

Then the total e�ect on D is:

∂Dtot

∂Au=Dd(Au)

∂Au+Dind(G(Θe(Au)))

∂Au→

→(−)∂Dd

∂Au+

(−)∂D

∂G×

(+)

∂G

∂Θe

(−)

×∂Θe

∂Au

We optimize by minimizing D wrt Au

minAu

D = Dtot = Dd(Au) +Dind(G,Θe, Au)→

s.t.Θe =(−)

Θe(Au) , G =(+)

G(Θe) , Dind =(−)

Dind(G)

the �rst-order conditions are:

→(−)∂Dd

∂Au+

(−)∂Dind

∂G×

(+)

∂G

∂Θe

×(−)∂Θe

∂Au= 0

(−)∂Dd

∂Au= −

(−)∂Dind

∂G×

(+)

∂G

∂Θe

×(−)∂Θe

∂Au=

∣∣∣∣∣MRS (−)∂Dd∂Au

,

(+)∂Dind∂Au

∣∣∣∣∣We also have

∂Dtot

∂Au< 0 ,

∂ ∂Dtot

∂Au

∂Au> 0

that is diminishing marginal e�ect. This yields a trade-o�, where there is

some value of Au that is optimal and after that the net utility decreases. The

optimal point of choice is where the marginal e�ect of austerity on de�cit

equals zero

The �gure below is a proposed plot in order to show a possible curve for

Au. After Au increases to the right of the optimal point a�ects negatively

growth and causes an increase in debt.

48

Figure 8: Austerity Level e�ect on Debt

To the extend that high austerity leads to a recession is a�ecting reform

imposing positively temporarily but to the extend that it causes a lasting

recession it is threatening the reforms, even those already imposed.

D.4 Strikes e�ect in a Low Business Cycle

Strikes (or fears of strike) have positive e�ect when they redistribute pro�ts

and wages fairly. But in low business cycle they have a negative e�ect to the

economy decrease the social resources and the compensating ability. Figure

9(a) below shows clearly how a long strike may decrease output so that

instead of gains workers may face a loss.

Figure 9: Strikes Duration - Hicks paradox

Sources: (a): Borjas (2008), (b):Cohuc - Zylberg (2004)

49

In a recession and even more in a heavy recession, like in Greece now, it is

likely that there is no gain to bargain about and the strike will have only loss,

both direct (production loss, wages loss) and indirect (leading to a sustained

recession).

John Kennan (2002) �nds that strikes duration is countercyclical (al-

though they should not be) and the evidence showed that they have a U-

shape curve.48. Probably psychological phenomena explain these behaviors.

D.5 Prospect Theory Figure

According to Tversky & Kahneman (1986) with the Prospect Theory (Fig-

ure 10)49 individuals show a bias to the gains and avoid equal losses (loss

aversion). The strange with this bias is that individuals behave like risk-

averses in gains, while risk-lovers in losses. This is an obvious violation to

the vNMEF. Loss aversion rule increases the reform opposing for losers as it

is easily understood by intuition.

48John Kennan (2002) �The duration of contract strikes in U.S. manufacturing�, The

University of Iowa, Iowa City, IA 52242, USA49Departure from a status quo, gains more important than equal losses and loss aversion,

which produce behaviors that are risk neutrals in the gain area, while risk loving in the

loss area.

50

Figure 10: The Prospect Theory

Source: (Tversky & Kahneman (1986))

In the Figure 10 above the status quo lies to the right of zero (reference

point), while the reform to the left. An equal departure from 0 makes the

status quo more attractive and over-valuated. The bias in their preferences

to the direction of the gains means bias to status quo, which also implies

an increased opposing to the reform (as they will demand a higher certainty

equivalent).

D.6 Relative Income �gure

In the Figure 11 below we may consider the correlation of the losers' group

with the lowest income population (the lower shaded part) as important.

The larger the correlation, the higher the probability p that the losers will

not be able to absorb the short run loss of the reform.

51

Figure 11: Loretz Curve

This happens under the assumption that the society in the model has

relatively low y (GDP per capita). That is we have the relation

p = P (A|B),

where using probability theory we specify

P (A|B) =P (A ∩B)

P (B)

where A is the probability that the y is relative low and B the probability

that the individuals are losers.

E Negative Factors in Greece

E.1 Permanent Over-employment in Public sector

The political system's malfunction the latest two decades has accumulated a

huge number supernumerary permanently employed in the Public sector. As

we see in Figure 12 below after the optimal point L∗ the employed are 0MP

workers.

52

Figure 12: Greek Public Sector 0MP Over-employment

In �gure 12 the optimal employment for the public sector is in L∗, where

the marginal product of the last employee equals zero. For the employ-

ment over this level the marginal product is zero, while the government pays

whole wages to all of them. It is estimated that over-employment is over

100%. Comparing with China we notice that China on the contrary de-

creases gradually 0MP employment in agriculture by increasing employment

in the productive industrial sector.

Employment and permanent employment in the public sector are pro-

tected by law. Besides court decisions are used to increase the permanent

employment. Both governments and judges see the utility from the increase

in permanent employment in the public sector but not the larger negative

e�ects.

�ToVima Newspaper� (2010)50 refers to court decisions which force the

government to change limited time employment contracts to permanent em-

ployment, although this is harmful for the economy and worsens the huge

debt and de�cit. The principle of the �prejudice� may lead to large number

of similar cases with a tremendous additional cost. Although judges have a

frank will to promote the social welfare do not have the knowledge to analyze

the consequences of over-employment in public sector to the society.

50http://www.tovima.gr/society/article/?aid=353461

53

Intuition: We have two e�ects, one direct (the increase in employment in

public sector increases social welfare) and one indirect (an over-employment

in public sector leads to de�cit and loss in social welfare). We can model

this:

SWd = SW (LP ) =

(+)

∂SW∂LP

where SWd is the direct social welfare e�ect and LP the employment.

SWoe = SWoe(D,LP,OE, LP ) = SWoe(D(LP,OE

(, LP )))

where SWoe the over-employment social welfare e�ect, D the government

de�cit and LP,OE the over-employment in the public sector, for each new

employed with 0MP employee. Then the over-employment e�ect SWoe is:

SWoe(D(LP,OE(LP )))

∂LP=

(−)∂SW∂D×

(+)

∂D|D>0

∂LP,XL×

(+)

∂LP,OE|wMP (LP,OE) = 0

∂LP< 0

So totally the employment in the public sector is:

SWtot

∂LP=

(+)

∂SWd

∂LP+

(−) for 0MP LP

∂SWoe

∂LP

Interpretation: Two things are obvious.

• There is a trade-o� where the accumulation of 0MP employees trades the

direct e�ect and the weight depends on how we evaluate the direct e�ect to

the loss from the over-employment.

• The severity of the negative over-employment e�ect ampli�es now by the

dramatically low the business cycle and may be catastrophic.

E.2 Polarization E�ects

As polarization I de�ne here the systematic over-valuation of own advantages

and undervaluation of own weaknesses with the other order around for the

competitor's ones. Polarization increases negative situations like corruption.

54

In reform imposing they a�ect even the compensation levels between the

several interest groups and the relative aspiration levels. to higher and higher

levels, as it operates in several stages.

I assume only two groups (or parties), A and B. Let the two parties'

share the corruption level of the country for parties A and B is 51% and

49% respectively in time t0. It doesn't matter which party is A and which B

for the �nal e�ect. With perfect information and without polarization both

parties see Figure 13(a) (51% for A and 49% for B) initially. In Sub-Figure

Figure 13(b) each party sees the other party to be more and more corrupted

and this justi�es an increase to own level and still retain the relatively honest

party etc.

With polarization both parties see the corruption level of the opposite

party to increase relatively more than their own level. Each party increases

the own corruption level and after some stages the aggregate corruption level

increases to high levels.

Figure 13: Polarization e�ects

The increase in corruption seems to have diminishing marginal utility as

the corruption level increases, because the cost of corruption increases more

(Corr′ > 0, Corr′′ < 0). The decreasing marginal utility of the corruption

prevents the total corruption, but is not enough to hold the corruption level

55

low. Polarization is not the only mechanism explaining increase in corruption,

however one of the important ones. The e�ect has applications even in other

cases of negative behaviors (e.g. the competition of the parties in over-

employment in the public sector, the over-borrowing etc).

E.3 Political Cost and Prisoners' Dilemma trap

Prisoners' dilemma-like situations and the logic of the political cost are often

behind the politicians' short-run biased behaviors. They cause social losses in

political, economic and reform imposing questions in Greece. This dilemma

is behind the decadence in Greece.

Figure 14: A typical Prisoners' Dilemma in Greece

In the Figure 14 above we get an idea about the prisoners' game of the two

major political parties in Greece.

But each side knows (or suspects) that once it goes on accepting, the

opposition will accuse it as betrayers and get high pay o�s, while this will

have a large loss for the government. As a consequence, the Nash equilibrium,

which always wins is reject/reject which is harmful for both. Objectively it

is well-known that that their gains are short-run and disappear, but their

losses become larger and larger. A consensus should give higher bene�ts for

both and the society, but they are unable to achieve it without external help.

Prisoners' dilemmas produce myopic behaviors and hinder or hold up the

56

reform imposing.

E.4 High Bargaining Power

The bargaining power of unions and interest groups has increased much from

1980:s and achieved very high levels in Greece. The pure bargaining e�ect

began to be complemented by a new e�ect, which I call blackmail e�ect,

because it is just that. The strikers besides they strike, force even the others

to strike. Moreover, besides the strike and the traditional demonstration,

unions and workers in a sector use even to block central roads, railways, even

ports and airports. The damage for the other sectors, workers and the whole

economy becomes high and usually the government compromises and satis�es

their claims for higher bene�ts or even additional permanent employment in

the public sector.

Figure 15: Possible Greek total bargaining power

The only way to �nance them is then by external borrowing. In the

graph below it is shown some visual example about how it can be, in public

sector equilibrium gives very high wages and high employment (A), while in

private sector also high wages but not so high employment as in the public

57

sector. Also unemployment bene�ts and pensions are not so high in the

private sector.

E.5 Corruption and the Established Frequency of it

Andvig and Moene (1990)[3], mention the case where the corruption is a func-

tion of the established frequency of it, which a�ects with its turn positively

the probability of corruption. This is a usual case as we show later. Mauro

P (2004)[13] shows the existence of multiple equilibria in corruption. Both

equilibria have defending mechanisms, however the lower �bad� has much

stronger ones and it is much stabler. Although individuals understand that

B o�ers a higher utility, prisoners' like situations (see Figure 14, on page 56

prevent the transition to it. Acting individually and without cooperation-

consensus they end up with a lower utility.

As this is valid in other important behaviors we may see it as a measure

of the quality of the Democracy In Figure 16a . Countries that end up in

point in point B have a well operating Democracy, which helps development,

but those in A experience problems from this malfunction that a�ects the

economy negatively51. As the corruption curve has a negative slope in the

Utility-Corruption space in Figure 16b low corruption is in Point SB and

high corruption in point SA.

51A possible explanation about inconsistent results in regressions about the impact of

the Democracy in development: high levels Democracies show signi�cant results, but low

level ones may deviate

58

Figure 16: Corruption Multiple Equilibria: Good (B) and bad (A)

Unfortunately in many cases �big-�shes� are seldom punished strictly in

Greece, as often they have the chance to postpone the trials for many years,

until the interest about is is very low and end up with a low punishment

or without at all, something which re-inforces the incentives for corruption,

tax-evasion etc.

However, when corruption increases at high levels the corrupted (parties,

individuals) experience some easiness to act and hide their behavior (Intu-

ition: it is easier to be corrupted in a corrupted land, than in a Land with low

corruption level. A kind of corrupting externalities?). This e�ect is weaker

than the cost of the corruption, so that totally the corruption has diminishing

marginal utility.

E.6 The Game of the Communists

The communists (and radical left) consist a strong resistance to reform im-

posing. The reason behind this is their want a transition of the economy to

communistic as an improvement of the society and its welfare. Therefore the

deterioaration of the current system looks as a necessary condition to this.

Without support in a hostile environment such a transition does not look

realistic today, especially after the fall of CCCP as the PIW 52 blows to the

52see Appendix A.2 on page 41

59

right and is quite capitalistic.

A global transition to a communistic system should be required, and

many conditions should be needed. I take two of them in a single model, the

deterioration of the global status-quo system VY and the reliability of the

alternative solution RL. For the transition to be possible it is needed that

RL − VY ≤ z̄ (6)

where z̄ is the acceptance threshold needed by the society. E.g. before the

October revolution in Russia in 1917 RL was strong, VY was low and z̄ was

relatively low. Today RL is weak, VY is strong and z̄ was quite high.

But let's assume that in time t1 it will be possible. The dilemma for the

communists is: what they should in the meantime?

• if they cooperate, workers will have a higher welfare level but this is

expected to shrink their electoral power and it may prolong the systems du-

ration (higher opportunity cost of the transition).

• if they �ght and undermine the system a lower welfare level is likely,

this will obtain relatively strong election power but after many decades their

behavior may be revealed as harmful for the working class (large utility loss)

which may decrease their reliability RL. Intuition: There is a trade-o� be-

tween the workers welfare level and the GKP electoral power.

In Greece it seems that they have chosen the second solution. With strong

in�uence on the syndicalists they require more and more causing many strikes

53, creates uncertainty and undermines reforms imposing.These reasons have

made the party a discontent party with a negative attitude for reforms impos-

ing and the result is a rejection of consensus. The discontent party activity

creates even spillover e�ects even to many voters of other parties by increas-

53It is known that many strikes decrease the BNP and thus the welfare level, while the

strike's utility is decreasing by the time (see Appendix D.4 on page 49

60

ing their uncertainty, has a strong negative e�ect on reform acceptance and

leads to a status-quo bias.

F Recovery Policy Recommendations for Greece

• The government should avoid actions which decrease the growth (e.g.

panic and too strict austerity54).

• Tax-paying discipline, elimination of corruption, meritocracy, institute

the Personal (Identi�cation) Number56.

• Avoid cuttings which damage investments and shrink growth and ac-

tions and panic which may a�ect expectations negatively see Appendix B).

• Eliminate supernumerary �zero marginal productivity� employees 57or

redirect them to productive activities. Build Active Labour Market Programs

sta�ed by them, educate unemployed people and immigrants.

• Solve the problem of the social insurance system (increased pension

age, education of immigrants).

• Instruct judges by law not to increase over-employment and permanent

employment in Public sector (See E.1 on page 52).

• Enforce the Law in practice. The Law should not be negotiated with

blackmailers and interest groups.

• Limit drastically weapons orders.

54Paul Krugman55 (2010) wrote that austerity is self-defeating56e.g. like in Sweden in the form of yyyymmdd-xxxx, where yyyymmdd is the birthday

date and xxxx is the control number57Lewis (1954)

61

Index

Advanced gaming, 25

Aspiration Level of income, 26

Chinese Reform, 27

Corruption, 58

Development recommendations, 61

Economic Psychology, 26

Expectations E�ects, 42

Factors A�ecting the reform impos-

ing, 18

High Bargaining Power, 57

High Level Democracy, 44

Inaction, Delay and Crisis, 8

Income Inequality, 16

Low Level Democracy, 44

MVT Decomposition, 40

Optimal waiting time, 8

Over-employment, 61

Paul Krugman, 61

Pilot reform programs, 35

Pol. & Econ. complementarity, 19

Polarization e�ects, 54, 55

Political Electoral Power, 18

Political Ideological Wind, 41

Prisoners' Dilemmas in Greece, 56

Psychological Factors, 25

Real Interest Rate and Losers, 22

Reform, 7

Reform Acceptance Easiness, 21

Reform without losers, 27

Relative income level losers, 22

Resistance to reforms, 7

Roland

Reform without losers, 4, 5

Russian Reform in 1990:s, 28

The Business Cycle e�ect, 20

The Game Of The Communists, 59

The game of the communists, 59

The Loretz curve, 51

The Prospect Theory, 25, 50

The Recent Greek Crisis, 30

Uncertainty, 23

Uncertainty and reform, 23

Unemployment and reform, 24

Without a Map, 5, 15

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