The failure of traditional macro-economics to predict and prevent the global economic crisis has led Europeans to fear that the Greek economy might collapse and cause a domino effect within the European Union. Correcting the economic course in Europe and the rest of the world will require a new focus on formality. Rather than stemming from traditional risks, such as market volatility or restricted liquidity, Elena Panaritis argued that the current economic crisis began because rules guiding market function failed to adequately control risk. Building institutions and limiting informality are at the root of the solution to the current crisis.

Economists traditionally have ignored institutions, preferring models in which markets operate in a "frictionless" environment where transaction costs are minimal, contracts are enforceable and property rights are clear. In the real world, however, these structures are extremely salient in determining how markets function, Panaritis argued. Argentina's collapsed in 2001 illustrates her point well, since the ways institutions functioned were the key to understanding that crisis.

Through her research, Panaritis found that as informality increases, a country's potential to grow sustainably decreases due to limited labor mobility, low investment and social and environmental disorder. She explained that institutions are "agreements and rules that create markets and structures." When market institutions do not function properly, or when people choose to operate outside of institutional constraints, the informal sector becomes more salient. Informality can cause market distortions—price fluctuation or asset fragil tremendous impact. By accounting for the informal sector, economists can identify the roots of the problem, enabling them to craft more effective responses to the crises. Transforming the informal sector is difficult, however, since it requires not only political will and vision, but a high degree of trust between political leaders and the society they are trying to transform.

In her assessment of the current crisis in Europe, Panaritis explained that the EU and the eurozone were not created with institutional economics in mind, but followed traditional economics. As a result, these institutions operate on the assumption that each member state has rules and regulations in place to govern markets and that those rules are strongly enforced. At the same time, EU members strongly supported the welfare state, and created an elaborate system of labor law reform, which reduced competitiveness. Productivity decreased over time. Though the inclusion of former Soviet-bloc countries in 2004 boosted Europe's productive capacity as a whole, it did not alter the depressed productivity of certain member states, such as Greece. When the international crisis began in 2008, Greece's large informal sector began to take its toll on the market there, with clear repercussions for the entire continent.

Panaritis urged the Greek government not to waste the opportunity offered by the crisis to reform market institutions, which is long overdue in the country. In order to emerge from the crisis, the Greek government must engage all the players in the market—state institutions, citizens, and private sector capital—to create market institutions that people will respect and the state can enforce. In this way, Greece and the other eurozone members would be able to increase their potential for growth and sustain it, which would be crucial in reversing the current economic trends.

By: Andri Peros
Christian Ostermann, Director, European Studies