Critique of Bruegel’s Evaluation of Financial Assistance in Euro Area

One of the most useful and timely documents to have been produced by any economic think-tank in the recent past is Bruegel’s “Financial Assistance in the Euro Area: An Early Assessment”. This gives a blow-by-blow account of the assistance programs of Greece, Ireland, and Portugal. (Spain is omitted because, while its banks received assistance, the sovereign did not; the document would have been even more useful had the terms of reference been less restrictive so that it had included Spain.) The detailed account of country programs is followed by a pioneering analysis of the role played by the various institutions that were involved.

It is natural that an evaluation (even if “early”) should offer judgments on the decisions reached. In listening to an oral presentation of the results, I concluded that they presented three main criticisms: that (with the benefit of hindsight) it is apparent that the austerity was overdone; that Ireland erred in bailing out the senior bondholders; and that Greece should have restructured sooner. On reading the report, I discovered that, while these criticisms are indeed discussed, the reasons for the actions are also presented and at the end of the day the report does not offer firm conclusions on these issues. Granted that they are reached with the benefit of hindsight, it seems natural to offer judgments, and their absence would seem excessively cautious. Others have suggested additional criticisms: notably that the “walk on the beach” in Deauville and the temporary appearance of acquiescence in the prospect of Greece being forced out of the Eurozone led to an unnecessary intensification of the worries of bondholders. It is a pity that the report remains silent on those topics.

But on the future role of the three institutions charged jointly with negotiating the adjustment programs—the IMF, the EC, and the ECB, which jointly form the Troika—the Report makes some very thoughtful suggestions. It recognizes that being a third of the Troika threatens IMF independence: too big to withdraw, too small to be sure of getting its way. The solution proposed is to retain an IMF role, because of its expertise, but to reduce its role to that of a “catalytic lender” responsible for perhaps 10% of the cash. It likewise recognizes the anomalous position of the EC as agent for the Eurogroup (i.e. the governments) rather than its normal role as guardian of the Community’s common interest. The solution proposed is to convert the ESM into a European Monetary Fund that would integrate design, negotiation, monitoring, and lending, and give it the responsibility. So far as the third element of the Troika, the ECB, is concerned, the Report notes that while it is a key player because of its powers the negotiations cover subjects that extend “far beyond the remit of a central bank”. It therefore proposes that the ECB should remain part of the Troika but be silent about programs. The solution proposed is not very elegant, but seems to be necessary.

On the country programs, the Report concludes that in every country growth and unemployment have fared worse than originally expected but the current account has fared better (primarily because of the depth of the recession). It is pessimistic about the future of Greece but moderately optimistic in that it expects Ireland and Portugal to be able to resume market access in the near future. This much is uncontroversial.

The Report is typical of economic reasoning during the crisis in ignoring the potential relevance of incomes policy. That incomes policy could have helped is evident from Fig. 1, which shows how unit labor costs rose everywhere in the European periphery relative to Germany. (The figure plots Italy and Spain as well as the three countries in the Bruegel analysis.) Anyone who believes that price competitiveness matters is bound to take the staggering loss of price competitiveness shown by the Figure as more or less ruling out the resumption of growth (other than by a new burst of credit expansion) until the restoration of competitiveness. The strategy pursued by the EU, which is not challenged by the Report, involves achieving internal devaluation by high unemployment.

The Figure is based on 1999 because the euro was founded in that year, and there is therefore some presumption that the guardians of the euro (or at least the
Bundesbank) took some care to make sure that real exchange rates were more or less in equilibrium at that time. Since then one can argue that Ireland, as a rapidly-growing country, would have experienced a trend appreciation in its equilibrium real exchange rate. There seems no strong reason to posit that any of the other countries would have experienced a change. Accordingly a return to an index of 100 seems a reasonable objective.

The latest figures from the EC give reason to hope. With the exception of Italy, all the “peripheral” countries—not just Ireland—have made good progress in restoring competitiveness. Indeed, if the rate of progress witnessed last year could be relied on for another year or two, it would be redundant to preach the virtues of achieving a once-over gain in competitiveness of 25% odd, which is what incomes policy ideally offers. Unfortunately it seems likely that the gains in competitiveness seen last year were one-off events that were achieved at enormous social cost rather than replicable results of high unemployment. There is still a long way to go in restoring competitiveness (except in Ireland) at the rate of progress achieved in previous years. And the problem of Italy remains even on the most optimistic interpretation.

The major weakness of the Bruegel Report (like most analyses of the European crisis) lies in the minimal emphasis given to the loss of competitiveness in the European periphery in the years that led up to the crisis, and the complete absence of any discussion of the potential relevance of incomes policy. Conversely, the striking restoration of competitiveness (outside Italy) revealed in Fig. 1 suggests that the German insistence on prompt adjustment has paid off. Austerity may be relaxed, not as a sop to expansionists, but as the reward for achieving a large measure of adjustment.

Bruegel

Source: Table 7.7 (nominal unit labor costs for total economy) for each peripheral country and Germany from ECFIN AMECO database at  http://ec.europa.eu/economy_finance/ameco/user/serie/SelectSerie.cfm

This entry was posted in EU. Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s