By Vytautas Kuokštis and Ringailė Kuokštytė
How can we explain the very uneven economic outcomes in EU member countries during the COVID-19 pandemic, especially considering that the shock was largely symmetric?
In our article for the Journal of Common Market Studies, we analyse quarterly data on economic growth and show that institutional quality, measured using the World Bank Governance Indicators and the Fraser Institute’s Economic Freedom Index, helped to moderate the economic shock, thus contributing to the divergence among EU countries.
Theoretically, the role of institutions may be expected to matter through a few important channels. Higher-quality institutions are likely to contribute to better policy decisions and their superior implementation. In the case of the pandemic, one would expect such institutions to be associated with more appropriate responses regarding the timing of both healthcare and economic measures, as well as the scale and efficacy of these measures. Besides, higher-quality institutions are more trustworthy, which may have encouraged businesses not to curb their investment during the pandemic; similarly, they may have led citizens to more fully comply with regulations, as a consequence of which less stringent measures may have been needed. Uncertainty was less of an issue in this institutional scenario.
Furthermore, institutional quality in terms of economic freedom facilitates a faster and more effective reallocation of resources in the realm of activity by economic actors. The mechanism of market prices, with its inherent ‘profit and loss signals’, in lieu of information distributed by a centralised authority, provides better guidance as to viable economic options in a given disaster-like context.
Taking advantage of an extended period of the COVID-19 pandemic and therefore its several waves, our analysis employs these theoretical expectations by focusing on the possibility that institutions mattered more when the shock of the pandemic was more severe.
We find that the importance of institutional quality waned over time as the pandemic shock became less severe. In 2020, the shock was more substantial, given the newness of the virus. Extreme uncertainty that ensued and the lack of vaccines only exacerbated this shock. As revealed in Figure 1, the influence of higher-quality institutions was substantial and significant in 2020, but not in 2021.
Furthermore, the role of institutional quality was particularly significant when the virus spread reached its highest levels. Figure 2 shows that, at low levels of institutional quality measured, here, in terms of the Economic Freedom Index, increasing deaths had a statistically significant and substantially important negative effect on economic growth. However, this effect weakened at higher levels of institutional quality. In fact, at the highest institutional quality levels, increasing deaths had no statistically significant adverse effect on growth. We observe the same patterns using the World Bank governance predictor.
Furthermore, the institutional perspective helps to shed some light on EU countries’ individual experiences. Figure 3 shows country-based average residuals (unexplained positive and negative deviations) in economic growth for EU members in 2020. The dark-shaded bars depict the unexplained growth estimated based on the regression model that only adjusts for the extent of the virus spread, economic structure, and forecast GDP growth. The light-shaded bars are based on the model that additionally adjusts for institutional quality.
The institutional perspective is helpful in better explaining the growth experience of both the largest over- and under-performers. In particular, a relatively bad performance of countries such as Romania, Hungary, Slovakia, and Greece is less surprising given their low level of institutional quality, whereas the opposite is true for countries such as Ireland, Sweden, Denmark, and Estonia. That is, their good economic results during the pandemic are not as startling when one considers the quality of their institutions.
The article contributes to offering additional evidence that institutional quality matters in dealing with shocks. Practically speaking, the COVID-19 pandemic yet again exposed the underlying institutional heterogeneity within the euro area and the EU more generally. Without closing gaps in institutional quality, it is hard to expect substantial convergence among EU members in the future. This should also inform EU financial assistance, as a special emphasis should be placed on improving institutional quality, especially given that aid effects are also likely to be conditional on the institutional environment. The potential of the EU’s most recent financial instrument, the Recovery and Resilience Facility, to transform EU economies and narrow down developmental gaps is also contingent on the institutional quality of particular member states. Institutional reforms would not only enhance member states’ long-run growth prospects but also help bolster their resilience to shocks.
Vytautas is an associate professor at Vilnius University, Institute of International Relations and Political Science. His research interests focus on comparative and international political economy.
Ringailė is a researcher at General Jonas Žemaitis Military Academy of Lithuania. Her research interests include EU politics, international cooperation, and defence policy.
Link to academic profile.