Monday, July 13, 2015

Micromanagement of European reforms

The agreement between Greece and its Euro partners is full of very detailed policies to be approved by the Greek government in the coming week. How did we end up in a situation where the domestic policies of a Euro country are decided by other countries? I recently wrote a paper on the European reform agenda where I had a discussion on the role of Europe in the reform process. Here are some of what I wrote in the paper which is very appropriate for what we just witnessed over the last 24 hours.

Historically Europe has served as a catalyst for reform in some of the least-advanced EU economies. Through the imposition of requirements to join certain European initiatives it has fostered enough social consensus around the need for compromises. As an example, it worked well to transform and standardize the macroeconomic institutions of European countries, especially when it comes to monetary policy and inflation.

But these dynamics are not always productive. Reform is ultimately a domestic political business where trade offs are being made between economic efficiency, social goals and the way power and income are distributed in a society. Having Europe always as the reason why reforms need to happen is likely to generate unhealthy dynamics. In addition, it is not always easy to link reforms to the benefits of European integration.

The only way to change these dynamics would be through a much more contractual and ex-ante approach to reforms. This was partly the spirit of regulations of the Maastricht Treaty that established rules of behavior to be a member of the Euro. But, as experience has shown, those were not enforceable rules. The rules only worked well as an entry condition but once the entry decisions were made the rules became very weak. Rules have been renegotiated, changed, and violated on numerous occasions. Why not make the entry conditions more binding? The reality is that if countries were asked to reform or adopt irreversible commitments before joining any process of European integration, there would be very few members of the European Union or the Euro area left.

We need to be realistic as well and Europe needs to find a way to deal with countries and governments that do not want to go along with the reform process or that they are unable to do so. At the end of the day the speed of reform remains the decision of individual countries. Its citizens are the ones that will suffer the consequences of no reforms and low growth. This is true for any country, advanced or emerging, and this is true for Europe.

The reason why the reform debate becomes more visible and relevant in the European context relative to other advanced economies that struggle with similar issues of performance is that the process of European integration might occasionally force countries to move together. When you share risk via the balance sheet of a central bank or when you design a program of transfers from rich to poor regions, the reform agenda becomes a supranational issue not anymore a pure national debate. Maybe Europe needs to find ways to separate the two. Either through a much more contractual approach to institutions that leaves no room for further negotiation (e.g. a true no bailout clause) or by changing the design of those institutions so that the links between countries and the shared risks are minimized ("less Europe"). This might be suboptimal as it might come at a cost of reducing the effectiveness of those institutions but it might be the only way to make the process of European integration and economic reforms compatible.

In summary, maybe "more Europe" is not always the solution to all the European economic problems.

Antonio Fatás

Friday, July 3, 2015

Did the IMF provide support to Syriza?

The IMF published yesterday a preliminary analysis on the debt sustainability of the Greek government. The timing of the publication, a couple of days ahead of the referendum, has triggered a variety of interpretations of the conclusions. The Greek government has quickly jumped to argue that the results confirm that government debt in Greece is not sustainable and a substantial haircut is needed.

Is the interpretation of the Greek government correct? Yes and no. The IMF analysis suggests that under reasonable assumptions on growth and interest rates for Greece, it is very difficult to imagine a path of primary budget surpluses that makes the current situation sustainable. This is what the Greek government says and in that sense it seems that the IMF is providing empirical support to their claims. However, the analysis is full of other subtleties that do not warrant this quick conclusion and that in some cases contradict the views of the Greek government.

First, the report makes it clear that since Syriza came to power the situation has deteriorated because of a combination of lower growth, lower privatization revenues and a worsening of budget balances. So here the IMF seems to support the German (and others) view that the situation would be better if the right policies were applied. The need for haircuts is partly the responsibility of the current Greek government.

Second, there is nothing new in the IMF analysis and almost everyone agrees to it, including the other Euro partners. The real issue and where there is possibly some disagreement is on how to deal with an unsustainable level of debt. Here is where the subtleties start.

Let's go back in history first. In 2012 it was also clear to most that Greek debt was on an unsustainable path. Because of this the Euro partners and bond holders agreed to a haircut on the face value, an extension of maturities as well as a reduction in interest rate that implicitly reduced the value of the Greek liabilities. How much that reduced debt is debatable but it is likely that it reduced it by about €100 Billion.

But that first restructuring was clearly not enough. What went wrong? Growth never returned, in fact, the economy continued on its path of collapsing changing all the assumptions made by the Troika at the time of the negotiation. Why did growth fail to live up to the assumptions? Because the Troika underestimated the effects of fiscal austerity (in Greece but also anywhere else) and possibly because some of the projected reforms in Greece either did not take place an they did not pay off as much and as fast as planned.

What about going forward? Can we be more realistic regarding Greek prospects of growth? That's what they IMF is doing now. It forecasts growth in Greece to be input 1.5% in the long term. This is what I would say a very pessimistic number (even if it might still be realistic). It assumes that a country that has a GDP per capita of less than 50% of the most advanced economies in the world will fail to converge to that level, in fact it is likely to get stuck at that level or even diverge.

And here is where the Greek government and the IMF projections might be at odds. The Greek government argument is that once debt is reduced and all the reforms are implemented, the Greek economy will take off and start finally growing. But if growth returns, is debt really unsustainable Greek debt is unsustainable because the Greek economy will not grow in the long run (and this is not just about austerity). But if the Greek government is right and the reduction in debt does indeed raise the potential growth of Greece then the current debt level might be closer to being sustainable than what the IMF says. In other words, the IMF tells the Greek government something that they want to hear (debt needs to be reduced) but in an scenario that the Greek government cannot accept (growth is going to be dismal for decades).

The way out of this inconsistency is to make default a function of GDP growth rates. This goes back to the old idea of indexing the value of the debt (or the interest rate) to economic growth (here is a very good description of its virtues from Paolo Mauro). If the Greek government is right and Greece growth prospects are very good, the debtors will get back most of what they are owed. But if the IMF is right and growth in Greece will remain low over the coming decades, the debtors will get a lot less, whatever the low growth prospects allow for.

Antonio Fatás