– the IMF needs to draw the right conclusions
This blog draws two lessons from the failed Greek programme. Olivier Blanchard is right that the fiscal adjustment of the last 5 years was unavoidable. An earlier debt restructuring could hardly have prevented it. (1) However, an earlier debt restructuring would have allowed significantly lower primary surpluses from now on and it would have made the programme more credible. Higher confidence in Greece would have provided more political and financial stability, essential ingredients for growth. Financial contagion was probably an incorrect argument for delaying debt restructuring. Even if it had been right though, it did not change the underlying problem of debt unsustainability. (2) Equally important, the IMF failed to prioritise a strategy for Greece to regain competitiveness. The programme initially made a correct diagnosis of Greece’s major competitiveness problem. The problem was a result of the pre-crisis Ponzi scheme with ever-increasing deficits financing higher public salaries and rising pensions. However, conditionality on improving the business environment and product markets, augmenting competition and lowering wages through the abolition of the 13th month salary were weak or absent. This made a turn-around of the economy away from a bloated state sector towards a larger export sector impossible. Contrary to Portugal, exports hardly increased in Greece. Political economy considerations would have called for a frontloading of structural reforms for which the political energy in 2013/14 was clearly lacking – despite later IMF insistence on such reforms. These mistakes raise significant questions on the governance of the IMF. They also call for drawing the right lessons for the third programme.
The IMF’s chief economist, Olivier Blanchard, just came out with a robust defence of the IMF policy choices in Greece. His piece is clear and deserves careful reading and analysis. It is important to understand the key mistakes in the Greek programme and to draw the right conclusions.
Greece’s 30 June failure to meet a payment obligation to the International Monetary Fund starkly exposed the wider failure of the Greek financial assistance programme. It was the biggest missed payment in the IMF’s history and highlights the uncertain prospects of repayment of the €24 billion the IMF has outstanding to Greece. However, the IMF’s exposure is small compared to the exposure of the euro-area institutions, which amounts to more than €190 billion.
Five years after the start of the programme, what do we now know about the mistakes and what lessons should the Fund draw from the Greek failure? I would prioritise two points, which Olivier Blanchard does not sufficiently recognise:
Believe your numbers
Independent economists and IMF staff had doubts about Greek debt sustainability from the beginning of the programme. Instead of insisting on earlier and deep debt restructuring, the IMF agreed to change its internal rules to cater for financial stability concerns as a reason to overrule the sustainability doubts.
We now know that the financial stability concerns were overstated. We also know that they were not directly related to the Greek situation. Instead, the rising spreads elsewhere were largely a result of debt sustainability doubts in those territories. The absence of a proper lender of last resort was the other missing piece – until the European Central Bank stepped in with the Outright Monetary Transactions programme. The Irish and Portuguese programmes were bound to happen even without the crisis in Greece. As regards the banks in France and Germany, the direct exposure numbers were small compared to the overall size of the banking systems. They were also small compared to the bank rescue programmes enacted.
One has to concur though with Olivier Blanchard, that the policy system was genuinely worried about the debt restructuring. At the beginning of the programme, it was simply impossible to convince any policy maker that this was the right choice. However, the euro area lost substantial time until the decision to restructure was finally taken. The debt exchange happened only in March/April 2012, almost two years after the start of the programme. Moreover, the restructuring was executed in a way that made future debt restructuring more difficult as Zettelmeyer, Trebesch and Gulati point out. Pushing for an earlier debt restructuring and less generous terms for holdout creditors could have saved substantial resources to Greece.
In any case, even with financial stability concerns, the fact that Greece’s debt was from the outset unsustainable should have been recognised. Financial contagion risk cannot be an excuse for ignoring sustainability.
The IMF should have assumed responsibility for this mistake early on and accepted the postponement of debt repayment – as the Europeans did in November 2012. The European debt moratorium significantly reduced the Greek debt burden. If the IMF had accepted delayed debt repayments similar to the Europeans, it would have gone a long way in preventing the current escalation of the situation: no new programme would have been needed to fund an IMF rollover.
More importantly, however, an earlier and deeper debt restructuring would have given more fiscal space for later years.
Even with earlier restructuring, I doubt that a slower fiscal adjustment up to now would have been feasible. Even with a full debt restructuring, creditors’ appetite to fund huge deficits would have been limited. In any case, up to now more than 40% of GDP worth of deficits has been funded by the programme. Olivier Blanchard clearly accepts the fact that deficits had to come down, although he has typically argued for less austerity. More specifically, he argues that
“Fiscal austerity was not a choice, but a necessity. …. The deficit reduction was large because the initial deficit was large. ‘Less fiscal austerity,’ i.e., slower fiscal adjustment, would have required even more financing ….”
Indeed, the initial deficit of Greece was extremely high, at 15% of GDP, and the Greek financial assistance programme is by far the largest in recent history. Here Blanchard is aware of the limits of what can be done with such starting conditions: fiscal deficits were too high and had to be reduced.
One can make this point differently: high deficits were the root of Greece’s problem, not the solution. Greece lost market access in early 2010 because its economy was severely imbalanced. Since joining the Euro, Greek governments had been running a Ponzi scheme by increasing their government borrowing every year, paying higher public wages and making the pension system more generous. Greek public sector wages more than doubled between 1999 and 2009, while increasing by only 40 percent in the rest of the euro area. Other economists such as Ricardo Hausmann have highlighted explicitly that Greece’s problem did not come from austerity. I clearly agree with Blanchard that deficits had to come down – this was an inevitable reaction to the unsustainable pre-crisis policies. One can debate the speed of fiscal adjustment but even spread over 7 years, it would have both been painful for Greece and it would have required more IMF/EU funding.
However, an earlier debt restructuring would have allowed for lower primary surpluses as of 2015. In our computations, a one percentage point lower primary surplus per year during 2015-2030 amounts to some 10% difference in the debt to GDP ratio by 2030. An earlier debt restructuring could have easily brought 10 or even 20% of GDP less debt, allowing for substantially lower primary surpluses going forward. Concessionary financing, as Olivier Blanchard argues, has helped. However, it was clearly not enough to restore debt sustainability.
In short, the IMF bears responsibility for not insisting earlier that the debt is not sustainable and asking for earlier and deeper debt restructuring. This would have allowed running a much lower and more realistic primary surplus target. Instead, the IMF accepted to structure the programme in a way that put all hope on higher future primary surpluses. The historical evidence, however, is rather clear that such high primary surpluses are extremely unlikely – and quite bad for economic growth especially when paid to external creditors. In contrast, contagion risk was probably overstated. Fiscal numbers that did not add up were also undermining confidence in Greece. With fiscal sustainability, there would be no Grexit debate now.
When you enter a programme, address all serious imbalances upfront
Greece had lost a huge amount of competitiveness relative to its partners. It was running current account deficits of well above 10 percent in the five years preceding the programme. This loss of competitiveness was driven by the bloated state sector but it extended to the entire economy. The programme should have prioritised restoring the competitiveness of the Greek economy. For this, an elimination of the 13th month salary in the private sector or a similar measure was inevitable. Yet, the IMF did not insist on this crucial point, despite discussing that it would actually be advisable (see point 43 in the staff agreement). Delaying it meant delaying the competitiveness adjustment. The result was a deeper recession as unemployment increased instead of wages.
In the public sector as well reforms were initially rather timid or inconsistent. The bloated state sector was tackled partly by reducing the number of public employees. However, early retirement schemes for public sector employees were put in place and these now cause significant problems in the pension system. This was not really a lasting solution.
In an upcoming Bruegel paper, Alessio Terzi shows how little emphasis was put on product market and business reforms in the first programme. Yet, the programme should also have prioritised product market reforms and productivity enhancing investment. It should have addressed vested interests as manifested in oligopolistic structures. Yet competition policy was hardly touched. With the second programme issues such as business environment finally became more important in the conditionality (see our blog here). However, during 2013/14, it became more and more difficult to enact any meaningful reforms in Greece. Conditionality on reforms thus came too late.
Yet, regaining competitiveness earlier would have allowed the export sector to pick up some of the slack in the economy. In Portugal, the cut in domestic demand was partly offset by a significant increase in exports of more than €10 billion since 2008. In contrast, exports in Greece have barely increased since 2008. Clearly, the programme did not do enough to achieve a turn-around in the export sector in Greece.
Political economy provides us with the simple insight that when a crisis occurs, there is only a short window of opportunity for deep reform. In the Greek case, the IMF failed to seize the opportunity of frontloading tough conditionality on structural reforms that would have boosted the export sector. Professor Blanchard only mentions that Greece did not comply with structural reform demands:
“Only 5 of 12 planned IMF reviews under the current program were completed, and only one has been completed since mid-2013, because of the failure to implement reforms”
This should come as no surprise. Since mid-2013, compliance with conditionality weakened as th economy weakened and interest groups had time to organise themselves. Political economy teaches us that resistance to reform will be fiercer the later the reform comes.
A combination of many factors is responsible for the failure of the Greek programme. We have argued that fiscal policy, lacking confidence, corrupt elites, a lack of competitiveness and weak productive structures combine to explain Greece’s miserable performance. Professor Blanchard shares this view: “But fiscal consolidation explains only a fraction of the output decline. Output above potential to start, political crises, inconsistent policies, insufficient reforms, Grexit fears, low business confidence, weak banks, all contributed to the outcome”. Generations of empirical economists will struggle to assign percentages to the different mistakes.
Yet, the IMF spectacularly failed on two fronts: earlier debt restructuring and substantial and early reforms to restore the competitiveness of Greece. The former would have allowed running lower primary surpluses in the future. It would have made the programme more credible allowing confidence to be restored; the latter would have been the best way of minimising the unavoidable shrinkage of the Greek pre-crisis bubble by boosting exports.
One can debate whether the IMF is the main institution responsible for the failures in the design of the programme. Certainly, the EU institutions played a major role. However, the IMF participated in the programme to be an independent and experienced institution. If it made those mistakes because the European institutions overruled it, it should draw the right lessons for its governance and its participation in financial assistance programmes as a junior partner.
Going forward, the IMF should indeed be the impartial voice of reason on Greece and resist political pressure. Numbers are merciless and politics can ultimately not overrule them. The following things are central:
– The IMF should insist on lower primary surpluses going forward. Achieving a primary surplus of 3.5% would trigger a further substantial shrinkage of the Greek economy. Entering a third programme with these numbers and only later organizing debt relief is counterproductive. Fear of Grexit does not make a programme sustainable.
– The IMF should seize the opportunity of new programme discussions to insist on structural reforms that matter for growth. Political ownership of reforms is crucial.
– Finally, the IMF should review its governance and its participation in financial assistance programmes as a junior partner.
The Europeans needed the independent outside view of the IMF to start their first programme. Five years on, the IMF is still needed as a voice of reason. It should learn from its mistakes.