Economic Crisis and Structural Reforms in Southern Europe

Policy Lessons

Paolo Manasse, Dimitris Katsikas, Paolo Manasse, Dimitris Katsikas

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351987349
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

In recent years the countries of southern Europe have undergone, with varying intensity, a serious and prolonged economic crisis. Most have had to implement comprehensive economic adjustment programmes, including a wide range of structural reforms. Economic Crisis and Structural Reforms in Southern Europe examines these reforms, drawing policy lessons from their successes and failures.

This book employs two basic strands of analysis: issues of policy design, and political economy considerations. It considers the choice of timing and sequencing of reforms, the choice of the appropriate policy instruments, the pressure of interest groups and the political calculations involved in reforms. Featuring chapters in which contributors explore both national cases of specific structural reforms, and a comparative approach in order to evaluate similar reforms across countries, this important and topical work explores ongoing issues within the economy.

Focusing on the challenges of designing and implementing structural reforms under conditions of crisis, this book will be of interest to policy makers and researchers from national and international organizations as well as academics and members of research institutes interested in the economics and politics of the Eurozone crisis.

1
Introduction

Dimitris Katsikas and Paolo Manasse

1.1 Southern Europe in crisis

The Eurozone debt crisis was, for the most part, a crisis of the European periphery and in particular of the European south. Southern European countries underwent, with varying intensity, a serious and prolonged economic crisis. Many of them (Greece, Portugal and Cyprus) had to resort to bailout agreements, which entailed the implementation of comprehensive economic adjustment programmes, while Spain negotiated a more limited and targeted financial package for its ailing financial sector, at the price of the latter’s comprehensive restructuring. Even countries that did not enter a financing agreement, like Italy, came under intense pressure to adjust their economies.

Most analysts would now agree that the principal direct causes of the crisis in these countries were sluggish productivity growth coupled with easy credit conditions. These translated into low international competitiveness and led to unsustainable current account deficits (see for example Baldwin and Giavazzi 2015). With the partial exception of Italy, which also suffered from low competitiveness, but where the major imbalance was the fiscal one, the other southern European countries exhibited very high current account imbalances during the years that preceded the crisis. These deficits, which mirrored high current account surpluses of northern European countries, were very persistent: the real exchange rate could only adjust via price movements, since these countries were members of the Eurozone. These imbalances did not raise particular concerns at the time, as it was thought that they reflected a positive and indeed, sought after, ‘catch-up’ process. According to this rationale, investors from the capital-rich North directed their funds to profitable investments in the relatively capital-poor South, increasing the latter’s growth potential and promoting convergence in the Eurozone. As it is now clear however, these capital flows did not fund productive investment that could foster convergence; they were instead directed towards the non-tradable sectors of these countries’ economies, raising wages and inflation, thereby undermining further their already weak international competitiveness, and boosting asset and real estate prices, thereby creating financial bubbles; in some countries, they were also used to fund mounting fiscal deficits. When, in the aftermath of the global financial crisis, there was a ‘sudden stop’ of the capital flows, these countries had to face the harsh adjustment of a credit crunch.

This narrative of mounting imbalances and sudden stops is a familiar one, as it describes a pattern often encountered in previous crises (Reinhart and Rogoff 2009). A key question then is, why weren’t these imbalances addressed before they led to crisis? After all, that these countries could end up in trouble was hardly surprising. Already before the euro came into being, some of these countries were considered EU’s economic weak links. Indeed, according to several studies, they should not have been part of the first wave of the Economic and Monetary Union (EMU); in theory at least, the potential for a successful monetary union was limited to the countries of the core (e.g. Bayoumi and Eichengreen 1993). However, the EMU was in essence a political project, and a variety of factors, beyond the scope of this volume, ultimately led to the decision to allow all countries to participate from the beginning.

The failure to prevent the crisis can be attributed to two main factors. First, it is not always easy to discern good from bad current account deficits (Eichengreen 2012). Experts can disagree for years over such issues, and at the time, it was not immediately clear what these deficits entailed. Still, given that a few years after the launch of the EMU, evidence was increasingly becoming available about the growing imbalances, this argument becomes increasingly tenuous as we move in time towards the crisis. A second factor that could explain inaction even in the face of mounting evidence of unsustainable imbalances, are the politics and institutional architecture of the EMU. It is commonly acknowledged by now that EMU’s architecture was seriously flawed; its monetary pillar was the only one with any real substance, built around the European Central Bank (ECB), with its clear institutional framework, strong policy mandate and statutory independence from political interference. The economic pillar on the other hand was very weak. The so-called ‘preventive arm’ of the Stability and Growth Pact (SGP) lacked enforcement powers, and more to the point, only regarded individual fiscal imbalances. There was no real supranational coordinating mechanism to tackle the EU-wide stance of fiscal policy and thus current account imbalances. Multilateral surveil-lance was supposed to be carried over at the Council, but its Broad Economic Policy Guidelines proved completely ineffective (Pisani-Ferry 2006). As a result, the EU lacked effective institutions with a clear mandate to prevent excessive imbalances. Finally, the ability of economic coordination to address growing international imbalances is limited in any case, because current account imbalances are not under the direct control of governments, so addressing them is not an easy task. With hindsight, it is not difficult to see that, lacking an international framework, domestic interests and politics dictated inaction in a situation where everybody was profiting: banks and other financial players from northern Europe enjoyed substantial profits from their investments, while governments, and the financial and construction sectors of the economy in particular, in southern European countries, were enjoying the benefits of easy money (Eichengreen 2012).

Before EMU, imbalances of such magnitude would not easily occur, as higher inflation rates in a country would lead to periodic exchange rate devaluations in order to restore competitiveness. In turn, expectations of a potential depreciation served to keep interest premia high and capital flows at moderate levels in inflation-prone countries. Once these countries joined the EMU, things changed: they lost national monetary policy and the privilege to issue money, the SGP constrained their fiscal policy, and devaluation was no longer an option. In this context, their tactic of using the exchange rate as a substitute for market-based productivity growth was not a viable option any more (Hall 2014). There was no easy alternative to a long and politically costly effort of major reforms. However, the incentive to undergo politically painful reforms was attenuated by the influx of capital after joining the EMU. Spreads declined to historically low levels and markets effectively dismissed national-specific risk, leading to the imbalances described above. The failure of Eurozone’s architecture was due to the fact that the external constraint did not bind: to the contrary, the pressure for reforms was weakened further.

Once the crisis hit, the discussion on reforms came back with a vengeance. Structural reforms formed the second pillar of Eurozone’s strategy to handling the crisis in countries receiving bailout funds, the first pillar being austerity, promoted through ambitious fiscal consolidation programmes. Fiscal discipline was also at the core of a new set of measures designed to reinforce the governance of Eurozone. A revised SGP and an intergovernmental treaty on fiscal discipline, the so-called Fiscal Compact, formed the core of the new fiscal regime. The design of both bailout programmes and governance reforms reflected an ‘individual responsibility’ approach to budget discipline: every country needs to get its house in order, with little consideration for the economic and social costs (Katsikas 2012). EU-wide growth-funding initiatives, such as the Compact for Growth and Jobs, were agreed at the European Council of June 2012, but were never implemented. This approach effectively resulted in an adjustment process, whose burden was entirely borne by the deficit countries.

Structural reforms were thought to be necessary to remedy some of the underlying drivers of the major imbalances that led to the crisis. In other words, fiscal consolidation and labour and product market reforms were considered complementary. As will be shown later in this volume however, the combination of structural reforms and fiscal consolidation may not be as harmonious as some believed. Although there is considerable consensus that structural reforms yield positive results in the long run, evidence is much more mixed in the short term, particularly when reforms are implemented in a negative economic environment. Since austerity policies are bound to lead to economic slowdown, the appropriateness of their combination with structural reforms is far from evident, and if decided upon, reforms should be designed carefully in order to avoid reinforcing the adverse effects of austerity.

Despite the lack of conclusive evidence, this policy mix was the dominant approach to handling the crisis. The reasons were mainly political. An individual responsibility approach did not require any burden-sharing mechanisms, such as requiring surplus countries to pursue expansionary policies in order to facilitate Eurozone’s recovery. Their reluctance to assume a more active role stemmed primarily from the primary domestic goal of keeping a balanced budget and from a ‘moral hazard’ preoccupation concerning deficit countries: facilitating the recovery of crisis-hit countries would ease the pressure for fiscal adjustment and reforms. Moreover, it was dictated by the politics of the time: bailing out crisis-hit countries that were depicted in the press as spendthrift and/or corrupt was not a particularly popular proposition, especially following the public bailouts of banks during the financial crisis only a couple of years earlier. The rationale of the austerity plus reforms approach was facilitated and domestically legitimated by the narrative of the first incident of the wider Eurozone crisis, the Greek crisis.

Greece was a country evidently in need of major economic reforms and guilty of unparalleled fiscal laxity. As the crisis spread and real estate bubbles started bursting elsewhere, it became evident that the other southern European countries also faced serious structural weaknesses. However, not all of them faced the same structural weaknesses and not all of these weaknesses were on a scale comparable to that of Greece. Moreover, not all of these countries faced fiscal problems. Spain for example, throughout the early 2000s recorded very low fiscal deficits and from 2004 ran fiscal surpluses until 2008, when, due to the financial crisis and the accompanying economic stimulus package, its budget balance turned negative. Likewise, in 2007, the Spanish public debt was only 36 percent of GDP. Spain’s performance in terms of debt and deficit was substantially better than that of Germany at the time. Similarly, the fiscal deficit in Cyprus from the mid – 2000s was well within SGP limits, recording a significant surplus in 2007, while the public debt to GDP ratio was on a downward trend reaching 45 percent of GDP in 2008.

This ‘individual’ responsibility approach to crisis management produced a number of problems. First, for some of the crisis-hit countries, the pursuit of harsh front-loaded fiscal consolidation and the emphasis on labour rather than product market measures resulted in deep recessions and very high unemployment, sparking a social crisis (see for example Manasse (2015) for the case of Greece); second, the economic crisis in these countries worsened their debt dynamics (not least because of the link between troubled banks and sovereign debt), and third, the social crisis that followed the recession undermined the popular support for the reforms and generated political instability. These developments kept uncertainty at high levels in sovereign bond markets for these countries. To make matters worse, core countries also underwent a fiscal tightening at the same time, in an effort to reduce increased fiscal deficits due to their own banking bailout and stimulus packages employed to address the effects of the global financial crisis in 2008. The combination of these policies led Eurozone to a double-dip recession in 2012 and an anaemic recovery for a number of years thereafter.

Despite these problems, many European and national officials from the surplus countries still consider the handling of the crisis as a success. The following account of the Managing Director of the European Stability Mechanism (ESM), Klaus Regling, summarizes this narrative (2016, p. 3):

Europe has shown a willingness to provide financial solidarity. But countries can only get ESM money on strict conditions. They have to go through a process of often painful economic reforms. It is not something any government takes lightly. But this bitter medicine works. Four countries have successfully exited their programmes and are now success stories.

On the other hand, this policy mix has received strong criticism from many economists (e.g. De Grauwe 2015; Eichengreen and Wyplosz 2016; Krugman 2015). However, even within the economics profession, views are often divergent, as to the appropriate design and duration of the necessary policy recipe. For example, in its annual report 2016/17, the German Council of Economic Experts, stress the importance of continuing the pace of ongoing structural reforms (2016, p. 2): ‘further structural reforms are needed that facilitate more flexible wage and price formation and increase labour mobility’.

All in all, it seems that consensus over the appropriate policy response to the crisis is still elusive.

1.2 Economic crises and structural reforms

The moral hazard argument is essentially an argument about the timing of structural reforms. A crisis is thought to be a good time to implement reforms because it exerts pressure on the governments to take measures that would otherwise be politically difficult to take. The idea is not new; the proposition that crises beget reforms has dominated academic research for many years. Already in the mid-1990s the role of economic crises as a significant trigger for reforms was accepted as common wisdom in the literature (Drazen and Grilli 1993; Tommasi and Velasco 1996). This should come as no surprise, since scholarly interest on the issue of reforms became particularly intense following the Latin American debt crisis and the collapse of the Soviet Union during the 1980s; these two events led many countries in Latin America and Eastern Europe to implement (or attempt to implement) a host of reforms to change their economies (Rodrik 1996). The origins of the scholarly interest for reforms notwithstanding, the link seems obvious; we would expect reforms to be pursued when things have gone bad (therefore, a crisis has occurred).¹ It is for this reason that Rodrik complained that this hypothesis is to a large degree tautological and therefore non-falsifiable, since failure to reform may be always attributed to the lack of a crisis ‘severe enough’ to justify it (1996, p. 27).

Irrespective of which side of the epistemological debate one is positioned,² empirical findings seem to somewhat contradict this intuition, as they have produced mixed results; some studies have found evidence of strong support for the hypothesis that economic crises produce reforms (e.g. Pitlik and Wirth 2003), others have found that economic crises do not result in reforms (e.g. Campos et al. 2010),³ while most studies have reproduced the finding that some types of crises and some types of reforms seem to be related (e.g. Abiad and Mody 2003; Lora and Olivera 2004; Galasso 2014). On the whole, the evidence seems to point to the existence of some sort of positive association between crises and reforms, which however is quite complicated and diverse.⁴

The reasons for this outcome are two-fold: (a) methodological difficulties of measuring and evaluating reforms, and (b) substantive issues that affect the implementation and impact of reforms. Simply put, the findings of the empirical literature could be the result of our inadequate methods to identify and measure reforms in the aftermath of a crisis, or could simply reflect the fact that reforms do not happen as often as we think, following a crisis.

Concerning methodology, despite the fact that a variety of techniques have been employed in the empirical literature, these are not always well suited to the study of reforms. For example, many researchers deduce the implementation of reforms by observed changes in macroeconomic variables (e.g. Drazen and East-erly 2001; Alesina et al. 2006) in the aftermath of a crisis. However, it is obvious that the improvement of macroeconomic indicators may be caused by factors other than the adoption of a reform programme by the government (such as macroeconomic policies, or exogenous positive shocks) and therefore such an approach cannot provide conclusive evidence that reforms were actually implemented and were successful. Other studies employ more direct measures for assessing the promotion of reforms, such as indices based on regul...

Table of contents

• Cover
• Title
• Copyright
• Dedication
• Contents
• List of contributors
• List of figures
• List of tables
• Preface and acknowledgements
• 1 Introduction
• PART I The economics and politics of structural reforms: Theoretical considerations and historical experience
• PART II Policy design: Getting structural reforms right
• PART III The political economy of structural reforms in southern Europe
• Index