Brookings: Experts - Domenico Lombardi

Turnaround: Third World Lessons for First World Growth

Fri, 15 Mar 2013 10:30:00 -0400

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March 15, 2013
10:30 AM - 12:00 PM EDT

Saul/Zilkha Rooms
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

In his new book, Turnaround: Third World Lessons for First World Growth (Basic Books, 2013), Brookings Nonresident Senior Fellow Peter Blair Henry, dean of the NYU Stern School of Business, explores how large developing countries—China, India and Brazil—and even smaller ones have broken free from previous periods of poverty and turned their economies into engines of growth, using policies often thrust upon them by advanced nations who now seem unwilling to heed their own recommendations. The book uses case studies to demonstrate how the policy pendulum in emerging economies now swings in the direction of prudence and self-control, and how with similar discipline, the First World may yet recover and create long-term prosperity for all its citizens.

On March 15, Global Economy and Development at Brookings hosted a discussion of Turnaround and whether advanced economies can learn lessons from the emerging world on how to spur economic growth. Henry gave a short presentation on his book, followed by a panel discussion. Panelists included Uri Dadush, director of the International Economics program at the Carnegie Endowment for International Peace, and Brookings Senior Fellow Domenico Lombardi. Lesley Wroughton, senior correspondent for Thomson Reuters, moderated the discussion.

Italy's Election and the Euro Crisis

Domenico Lombardi — Wed, 27 Feb 2013 00:00:00 -0500

Italy’s election on Monday left the country in political chaos with no clear solution for managing its crippling fiscal crisis. Center-left party leader Pier Luigi Bersani is claiming the top post but will lack majority control in Parliament. Without the legislative body’s full support, Bersani’s push for continued austerity measures could falter. Senior Fellow Domenico Lombardi say this uncertainty is deeply troubling for the EU leadership.

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Italy's Election and the Euro Crisis

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Domenico Lombardi

Mr. Tsipras Comes to Washington

William J. Antholis and Domenico Lombardi — Fri, 25 Jan 2013 09:45:00 -0500

Editor's Note: Greek opposition leader Alexis Tsipras spoke at Brookings on January 22 during his first trip to Washington. While at Brookings, Tsipras discussed Greece's austerity measures, its image in the international community, the country's relationship with the Euro zone, and its potential for economic growth.

The new head of Greece’s opposition party, Alexis Tsipras, came to Washington this week. Mr. Tsipras has become a key player in the Euro Crisis. His meteoric rise in the polls and close second-place finish in Greek elections last summer rattled global financial markets. His pre-election rhetoric raised the possibility of a Greek exit from the common currency, which could have led to a domino-like collapse of the Euro.

Mr. Tsipras's trip to Washington was his first, meeting with government officials, members of congress, policy analysts, Greek American groups and the public. He brought with him members of his SYRIZA party, which literally translates as the Coalition of the Radical Left. That name makes Americans nervous, since America has never had a viable socialist party. SYRIZA, for its part, outflanks the socialists to their left, so many Americans were doubly nervous.

Optimists and pessimists could both find what they were looking for in his visit. As one American with whom he met said privately, “We agreed on somewhere between 40% and 60% of what he said. So let’s call it 50-50.” That assessment is about right.

Mr. Tsipras delivered four core messages. He found a receptive audience for two, but less so on two others.

Tsipras Success. Tsipras has consistently argued that the austerity measures that Europe has forced on Greece will not create growth.

Many in Washington agree. If Europe had had an Obama-style stimulus plan and a Bernanke-style monetary policy, Greece would not have become the Achilles Heel of Europe. Instead, lack of fiscal and monetary support has lead to a shrinking economy, unemployment, fear and hopelessness in the Greek public.

In fact, continuing to focus on political sustainability is Mr. Tsipras’s most effective argument. Economic and political reforms must be "owned by the people" of Greece, or the country will not be able to heal itself. That means that both growth and sacrifice need to be shared fairly. He cited the recent U.S. fiscal cliff agreement that led to a slightly more equitable tax system, targeting the truly wealthy. And his own recommendations are not to nullify the current agreement between Greece and its European lenders, but instead to renegotiate a more gradual approach to a balanced budget. Public employees need to feel part of the agreement.

Second, at a personal level, Mr. Tsipras sought to shed the caricatures that have shaped the international image of the Greek left. In a country where leftists have historically been incendiary, prone to violence, and aggressively anti-American, Mr. Tsipras came across as genial, courteous, pragmatic, and eager to hear American views. While he certainly has strong ideological leanings, he showed himself to be someone genuinely interested in hearing suggestions and even criticisms. He spoke warmly about President Obama’s inaugural calls for social justice. And he held himself up as the last best hope of Greece falling into the hands of the neo-fascist Golden Dawn party.

In that regard, many noted his recent trip to Brazil, where he met with former President Lula da Silva. In the 1990s, Lula famously shed his militant image to become a beaming and gregarious icon for a globally integrated and competitive Brazil. Should Tsipras become prime minister some day, he seemed to say, he would be just such a leader.

Tsipras Trip-ups. Mr. Tsipras has a ways to go in convincing his skeptics on his third core argument: that the Euro zone needs Greece as much as Greece needs the Euro zone. He has repeatedly argued that Greece’s last two governments have too easily caved to the pressure of northern Europeans to accept austerity measures in exchange for new bailouts.

Some are still nervous about contagion from a Greek exit. By so brazenly playing the game of chicken with northern Europeans, Tsipras still keeps them up at night.

Many others, however, now believe that the European Central Bank and other Euro zone countries have defended themselves from the impact of a Greek default and return to the Drachma. Most Greek debt is now owed to the EU, ECB, and IMF, not private bondholders. That means that the contagion is less scary, and largely under control.

Ironically, Mr. Tsipras himself seemed a bit nervous when presented with the idea that Greece could or should leave the Euro zone. If that happened, it would take away his biggest bargaining chip.

Finally, Mr. Tsipras failed to convince people on a fourth point: that he has a positive vision for growing Greece’s economy. Whether Greece stays inside the Euro or reverts to the Drachma, it will still need to make major changes in its economy to attract foreign investment and boost its exports.

Tsipras avoided engaging on a concrete discussion of what would make Greece’s economy more competitive. He dismissed the idea that Greece was Europe's last communist economy -- saying that privatization had not happened because there really was nothing to privatize.

He also said that the focus on deregulating certain industries (pharmacies and hair salons) was a distraction to take away from the oligarchs' own complicity in crime and corruption. There was a lot of talk from him and his party about taking aim at “robber barons” and “wealth redistribution”. While many Americans would certainly support equitable taxation and real jail time for real criminals in Greece, redistribution for its own sake is likely to scare away many investors.

The small good news here is that Mr. Tsipras regularly referred to the need to attract foreign investment, and he was keen to meet with investors. He also made allusions to developing strategies for key industries such as tourism, export agriculture, or energy. Still, the details of that strategy have yet to be worked out.

In this regard, many were quite concerned about his political strategy in the coming weeks and months. The situation in Greece has just begun to calm down, and the country will soon prepare for the critical tourist season. When I asked Mr. Tsipras if SYRIZA would avoid strikes -- which have been so damaging to Greece's image in the world -- he said that each society had its own way of dealing with politics. “Politics is not tea and crumpets.” There is certainly a place for expressing dissent. But allowing a minority of Greeks to regularly shut down the economy is not democracy as Aristotle envisioned: the art of ruling and being ruled in turn.

There was an echo of the dark side of public employees in Athens this week. The head of the striking Athens metro worker’s union was asked if his union would follow orders to report to work or be fired. “Over my dead body.” Not tea and crumpets, indeed.

Over the coming months, Mr. Tsipras and SYRIZA will have ample opportunities to demonstrate that their definition of radical means not putting all of Greece out of work simply to win power. If, on the other hand, they can find a way to paint a positive vision for the future and an equitable role in the Euro zone, then the SYRIZA glass may become more than half full.

Authors

Image Source: © Charles Platiau / Reuters

Greece and the Economic Challenges Ahead: A Conversation with Greek Opposition Leader Alexis Tsipras

Tue, 22 Jan 2013 14:15:00 -0500

Event Information

January 22, 2013
2:15 PM - 3:45 PM EST

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

On January 22, Global Economy and Development at Brookings hosted Alexis Tsipras, the leader of the Greek opposition, for a conversation about Greece and the economic challenges ahead. Tsipras’ remarks touched on themes including: economic and social prospects for his own country; the relationship between Athens and the rest of Europe, including what reforms are needed in Greece and Europe to address the crisis; and what role, if any, the U.S. can play in assisting Greece and Europe tackle their current problems.

Alexis Tsipras is the leader of the SYRIZA coalition. Both Mr. Tsipras and the SYRIZA coalition have been vocal opponents of European austerity measures in response to the euro crisis. Those positions have led to a surge in public support for both the SYRIZA coalition and for Mr. Tsipras personally, placing either at, or near, the top in various Greek opinion surveys in recent months. Mr. Tsipras is the youngest person ever to lead the official-opposition party in the Greek Parliament.

Brookings Managing Director William Antholis provided introductory remarks and, with Brookings Senior Fellow Domenico Lombardi, moderated the discussion with Alexis Tsipras, including questions from the audience.

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Greece and the Economic Challenges Ahead: A Conversation with Greek Opposition Leader Alexis Tsipras

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20130122_tsipras_transcript

IMF Concerned With the Pace of France’s Economic Reform

Domenico Lombardi — Tue, 08 Jan 2013 11:51:00 -0500

Editor's Note: This piece is translated and adapted from the piece "La pigrizia riformista di Hollande preoccupa il Fmi," which appeared in the Italian daily Il Foglio.

In an empty Washington, where holiday vacations had already begun, the International Monetary Fund published the annual surveillance report on France the Friday afternoon before the Christmas holiday. Breaking from its usual practice, the IMF did not give the press an advance copy of the report on embargo although it did organize a conference call to discuss the report. However, the conference call was held on December 26, a holiday in France. Why did this happen? The answer lies in the report itself.

Let’s start with fiscal policy. France’s budget deficit is much higher compared to other European countries hit by the crisis. In 2009, it was equal to 7.5 percent of GDP. By comparison, in Italy it was 5.4. By the end of 2012, the French deficit decreased to 4.5 percent and should reach 3.5 percent by the end of 2013, at which point the Italian budget is expected to be balanced. What’s more, French authorities have said that they require five more years, till the end of 2017, to balance their budget. The IMF prefers more neutral terminology, such as “medium-term,” so as to even eliminate any hint of a deadline. Certainly, France does not have the large public debt like Italy has. However, the trajectory over the last few years is perhaps more worrying. For the period 2009-14, the IMF projects an increase of more than 12 percentage points in France’s debt-to-GDP ratio.

Admittedly, the gradual fiscal consolidation may be more a strength than a weakness of President Hollande’s strategy, in that it protects the French economy from harsh measures that are, at least for now, unnecessary. The IMF has acknowledged as much, and goes even further when it notes that “a more measured pace of fiscal adjustment would be appropriate, but European and market imperatives have reduced fiscal space at this juncture”.

Halfway into the report, we finally find the two lines that represent the crux of the fund’s position and provide the metric by which it evaluates the current developments of the French response to the crisis: "With the risks of an imminent break up [of the euro] largely averted, policy priorities have shifted to the process of forging stronger financial and fiscal integration in the euro area and to domestic structural reforms to improve competitiveness and raise potential growth".

It is precisely on this point that the France of François Hollande is in grave difficulty. The sustained decline in the competitiveness of the French economy has translated into a reduction in the country’s degree of international openness of 9 percentage points compared to the eurozone average in the period 2000-10, as the report notes at the very outset. In other words, since France entered the eurozone, instead of benefitting from the greater trade opportunities, it has become more closed off—a true paradox that highlights the sustainability of the single currency in the absence of drastic reforms. It is not a coincidence, the fund duly notes, that the correlation between the French GDP and the global economy has weakened. In this context, it further adds, French multinationals have managed to maintain a competitive price level abroad, but at the cost of reducing profit margins, thereby compromising their respective capacities for investment.

While the IMF had hoped for a “competitiveness shock” reform package, Paris has responded with selective and incremental measures to be put in place gradually. On the whole, the Hollande presidency has yet to put forward a convincing reform agenda. And yet, experience teaches us that the first months of government are the most fruitful in terms of reform.

In 2012, France ranked 34 in the annual ranking of the ease of doing business compiled by the World Bank. This was a drop of two spots compared to the previous year. Though France ranked higher that Spain (44) and much higher than Italy (73), the country is quite a few places behind other eurozone countries such as Finland (11), Ireland (15), Germany (20), Estonia (21), Austria (29), Portugal (30), Netherlands (31), and Belgium (33).

Clearly, the IMF report will not go unnoticed among those German political circles already in dismay with what they perceive as a lack of commitment by France to a broad-ranging reform agenda. The “contract” that Germany implicitly undersigned with France (and with Italy)—so say some in Berlin—was for the former to give up its own monetary sovereignty in favor of the common currency and in exchange for the benefit of greater trade and economic opportunities in the reformed economies of the eurozone.

Instead, during the period 2000-12, the share of German exports in the countries of the eurozone diminished by more than 7 percentage points. That towards emerging economies (Brazil, Russia, India and China), on the other hand, increased by the same amount. According to Goldman Sachs, by the end of 2020, the shares of German exports in the eurozone economies will diminish by almost 12 percentage points, while those in emerging economies will increase by 20 points.

What to do? Some policymakers are asking in Berlin. A lot will depend on whether or not the shockwave imposed on Italy and Spain in the last year and a half continues to bear fruit in terms of reforms. If so, demands for Germany to retract the implicit “guarantee” that has so far spared market pressures on France may gain ground again in Berlin. If that happens, the near future could hold a new, unseen chapter for the euro crisis.

Authors

Domenico Lombardi

Image Source: © Philippe Wojazer / Reuters

Brookings Survey on Eurozone Progress

Justin Vaïsse, Douglas J. Elliott, Domenico Lombardi and Thomas Wright — Wed, 12 Dec 2012 13:26:00 -0500

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The Brookings Survey on Eurozone Progress

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President Obama Hits the Ground Running in Europe and China

Domenico Lombardi — Mon, 26 Nov 2012 16:31:00 -0500

Editor's Note: This article was originally published in the December 2012 edition of Longitude, a monthly Italian publication on world affairs.

As their enthusiasm following the reelection of Barack Obama to the White House settles down, his closest advisors have begun to zero in on the items that the president’s international economic agenda will have to focus on during his second term. These include Europe and China above all.

Those end goals are, in some ways, similar to those pursued during Obama’s first term in office, yet the White House’s level of urgency and assertiveness may shift as a result of the developments (or lack thereof ) in the domestic agenda.

The president is focusing his recently-acquired political capital on addressing the so-called “fiscal cliff,” a precipitous mix of tax increases and expenditure cuts that, failing any agreement with Congress, will automatically kick in as of January 2013. Their effect would be that of slashing the deficit by 4 percentage points, but in so doing, they would erode the economic recovery now finally gaining steam in the United States.

While this is the most urgent issue for Obama’s administration, it is not necessarily the most important one. This year, the U.S. government is running a 9% deficit, which the IMF projects will drop to 7% next year. Meanwhile, the debt-to-GDP ratio will have escalated from 67% in 2006 to an expected 112% next year. In absolute values, this is the fourth consecutive year that the U.S. is running a deficit of over a trillion dollars, with the public debt stock already surpassing the $16 trillion threshold.

In his first term, President Obama gave priority to the objective of short-term stabilization of the economy, with the aim to ensure a faster turn-around, not to mention avoid a generalized fall-out. But his administration focused little on securing a medium-term consolidation path, partly because it may have conflicted with the previous objective of encouraging a short-term pick-up in demand.

Looking forward, a medium-term strategy is likely to become the priority of the Obama administration in the second term – which will eventually shape the U.S. tactical position on a range of international issues, from the euro area crisis to the relationship with China. The aim is to first stabilize its largest exports market where Europe is concerned, and then to try and increase its penetration in China, given the potential to do so. This is needed so that a stable – and, ideally, a rising – foreign demand for U.S. products will, to the extent possible, shield the economy from the compression of domestic demand resulting from the inevitable fiscal consolidation.

In his first term, the president’s position on the eurozone crisis was analogous to his administration’s attitude towards China. He acknowledged, mostly in private, some differences with the Europeans, in particular with Germany, but carefully avoided stressing this difference in public, and, rather, worked incessantly behind closed doors to urge his counterparts towards a solution he could welcome.

For instance, he turned the G-8 Summit at Camp David last May into the culmination of a long-standing strategy to put pressure on the German Chancellor Angela Merkel to adopt a more balanced approach, one centered on fiscal consolidation but also on enhancing growth prospects.

Along similar lines, his administration has always looked with great concern at statements soliciting a Greek exit from the eurozone, worrying that an uncontrolled breach there would trigger a meltdown in larger, but highly vulnerable, countries like Italy and Spain.

It is emblematic that one of the first sentences of that Summit communiqué reads: “We agree on the importance of a strong and cohesive eurozone for global stability and recovery, and we affirm our interest in Greece remaining in the eurozone.”

From the U.S. standpoint, a Greek exit would immediately raise the stakes and broaden geopolitical implications. A disorderly exit from the eurozone might be the prelude to an exit from NATO, where Greece has never concealed the fact that it does not feel adequately protected from its Turkish neighbor. This would be even more likely if Russia were to turn up in the guise of White Knight to help Greece with its inevitably difficult transition. The mere possibility of Russia solidifying its presence in the heart of the Mediterranean Sea is a scenario that neither the US nor Western Europe would be keen to consider.

Thus, the soft approach that characterized Obama’s first term vis-à-vis the eurozone crisis may evolve and become more firm as domestic stakes increase. In this scenario, his administration will have to escalate pressures on Germany to support a stable resolution of the Greek crisis. At the same time, they will have to urge Germany to adopt a more constructive and balanced approach between austerity and growth.

With regard to China, the administration has geared efforts towards improving communication with counterparts in Beijing, while remaining aware of existing areas of disagreement. The 2010 White House National Security Strategy captures effectively the thrust of this position: “We will not agree on every issue, and we will be candid on our human rights concerns and areas where we differ. But disagreements should not prevent cooperation on issues of mutual interest, because a pragmatic and effective relationship between the United States and China is essential to address the major challenges of the 21st century.”

Only in 2011, total U.S.-China trade stood at $503 billion, with China ranking as the second largest trading partner of the U.S. (after Canada) and its third largest export market. With this in mind, on January 19, 2011, President Obama said at the official arrival ceremony during his state visit to China: “At a time when some doubt the benefits of cooperation between the United States and China, this visit is also a chance to demonstrate a simple truth. We have an enormous stake in each other’s success. In an interconnected world, in a global economy, nations – including our own – will be more prosperous and more secure when we work together.” This is exactly what the just-reconfirmed administration will do in its second term – only, this time, knowing full well that an effective relationship with China is more vital than ever.

Authors

Domenico Lombardi

Publication: Longitude

Image Source: © Jason Reed / Reuters

The IMF in Greece: Marking New Territory

Domenico Lombardi — Mon, 26 Nov 2012 10:09:00 -0500

Editor's Note: This piece is translated and adapted from Domenico Lombardi’s biweekly column “Pennsylvania Avenue” in the Italian daily Il Foglio.

Next week we will find out whether or not the growing political gap that has distanced the International Monetary Fund from its key European shareholders for months can be partially bridged.

The need to reach a common agreement for Greece—a major agenda item at the Eurogroup meeting in Brussels next Monday (December 3rd)—reflects the “joint” nature of the Greek assistance program. This implies that a veto by even one of the creditors, like the IMF, would make the disbursement of the subsequent tranches of the Greek bailout program technically impossible.

In fact, there has been significant tension for some time at the heart of the Troika. Their report on Greece, due this past summer, has still not been finalized, so as not to make public the stark differences between the IMF’s position and that of the European creditors. The apparent source of friction is the sustainability of the Greek public debt. The IMF maintains that debt should be on the order of 120 percent of GDP by the end of 2020, as previously agreed, and expects that further resources be mobilized, if necessary, for the credible attainment of this objective.

The Europeans, however, would like for the application of this threshold to be postponed to 2022, with the possibility that the threshold might even be increased by a few percentage points, all of which would considerably weaken the scope for another debt restructuring. In this scenario, then, a reduction in the interest rate, together with other marginal interventions politically acceptable for creditor countries, would make it possible to postpone the issue of a new debt restructuring.

Currently, the Greek public debt is being held in good part by official European creditors, including the European Financial Stability Facility, the European Central Bank and some national central banks. For the EFSF, the write-off of any credit claims to Greece would presumably trigger a parliamentary procedure in Germany (for the German share of the potential write-off), which appears to be out of the question before the German elections next September and probably afterward as well.

But not even this fully explains why the distance, above all analytical, between the macroeconomic projections of the European creditors and the more independent projections of the IMF, has evolved into a significant political distance the likes of which have never been seen during the eurozone crisis.

There are, in fact, at least two reasons behind the dynamics of this recent tension: one internal to the institution and one external. The IMF is marking its territory, delineating the perimeter of its own independence with unusual firmness because it has come to realize that the outcome of these negotiations will define the power relationships within the Troika when Spain, and possibly Italy, ask the ECB to intervene in the context of its new Outright Monetary Transactions program.

In exchange for the purchase of government bonds—potentially unlimited—that the ECB will agree to make, the requesting country will have to agree to a conditionality framework that the IMF itself could help formulate and monitor during implementation.

Thus, a non-compliance assessment by the IMF would compel the ECB to immediately suspend its program of bond purchases with consequences easily imaginable for the stability of the bond market, not just in the country in question but in the entire eurozone.

Considering what’s at stake, it could be tempting at the last minute to exercise undue pressure on the IMF to bend its assessment, making it “fit” better with the preferences of this or that government of the eurozone. But if the IMF bows to its European shareholders now, in the case of Greece, what would happen in the near future when the stakes are even higher? How would this affect Spain or Italy—countries at the very heart of the eurozone and its fate?

To be credible, the IMF’s more assertive position vis-à-vis its leading European shareholders needs an injection of political capital, which is coming just now from the reelection of Barack Obama. The aim of the reelected president, fresh from a new electoral mandate, is to force the Europeans to face the seriousness of the Greek situation and to redirect their political leverage and financial resources toward a credible strategy to stabilize the free-falling Greek economy (and society) and encourage much-needed growth prospects.

Building on these developments, there are some, in Athens, who are even wondering whether the Greek authorities shouldn’t refuse the next disbursement tranche altogether in order to precipitate an immediate and definitive face-off with European creditors on the fate of the country.

Authors

Domenico Lombardi

IMF + ECB = OMT

Domenico Lombardi — Thu, 25 Oct 2012 10:58:00 -0400

Editor's Note: This article was originally published in the November 2012 edition of Longitude, a monthly Italian publication on world affairs.

The International Monetary Fund has once again revised projections for the world economy downward: the advanced economies will grow by only 1.5% next year, down from an estimated 2% last April, while the emerging and developing economies will grow by only 5.6%, down from an April forecast of 6%. For this year, too, growth estimates have been downgraded: among the eurozone countries, Italy will contract by 2.3%, compared to an estimated minus 1.9% forecast in April.

What these numbers don’t say is that the uncertainty underpinning the projections has broadened: projections rest on the fundamental assumption that policy commitments will be implemented; however, policy slippages or even policy mishandling could indeed occur and, if so, would derail implementation of reforms needed to stabilize the crisis.

Clearly, the epicenter of such uncertainty remains in Europe. In early September, European Central Bank President Mario Draghi announced the Outright Monetary Transactions (OMT) program – a program that would enable the ECB to make potentially unlimited purchases of government bonds in the secondary market of countries under stress, if activated by request of the countries themselves.

There are still several aspects to be clarified and policymakers from all over the world gathering in Tokyo for the Annual Meetings of the IMF in October had plenty of questions to ask. The first question, of course, concerns the unprecedented role(s) of the IMF in the implementation of such unconventional eurozone monetary policy operations.

According to the basic layout of the OMT program, the IMF would join the newly established European Stability Mechanism and the ECB itself. But in what capacity? One can envisage a number of roles that the IMF could effectively fulfill. The most obvious one is to mobilize its staff expertise in designing, and monitoring compliance with, conditionality. The ECB has no skills in this area but, more importantly, it would be politically unacceptable for a central bank to dispense conditionality. It is much better to outsource it to a third-party, so as to create some distance between the ECB and its regional members.

In that respect, there has indeed been an evolution from the early attitude of the Eurotower vis-à-vis the IMF. Initially eager to put a distance between itself and the IMF regarding the eurozone crisis, viewing the latter as an “internal” matter, the ECB has increasingly engaged the IMF, now seen as a fundamental safeguard for the ECB’s own independence from European politicking. Indeed, the apex was when Mario Draghi expressly sought the IMF’s involvement in the OMT; an ocean away, it took Christine Lagarde only a few hours to reply favorably.

But what exactly would OMT conditionality look like? Obviously, monetary and exchange rate policies are formulated at the eurozone level, so they cannot be part of any country-specific adjustment program. Even fiscal policy is somewhat centralized given the current EU legal framework and, especially, the Fiscal Compact treaty that will go into effect shortly. In fact, it would be unthinkable to ask any eurozone country for more ambitious fiscal targets than those that they have already set.

Yet the IMF could focus on the composition and the implementation of fiscal policy, advising on how to attain the several sub-targets needed to accomplish fiscal balance. Besides fiscal policy, another important area of conditionality is structural and competitiveness policies. This is already a relevant focus in the stabilization programs being pursued by the peripheral economies and, in a sense, is an obvious area given that there is not much room to leverage on in the other policy domains.

Structural and competitiveness policy reforms are definitely needed to address the longer-term sources of imbalance in the eurozone and to improve the competitiveness of several Southern economies. Historically, though, these are exactly the conditions that have proven to be the most difficult to implement, and they have also created non-negligible tensions between country authorities and the Fund as they are at the heart of any country’s own political process.

Think for one moment about what would happen if a new labor market reform were to be requested of Italy after the one already approved, not without tensions, a few months ago by the Monti cabinet. Or, in Spain, think of the consequences that any plan to strengthen the central European government’s policymaking authority over the country’s own regions would have. Or for that matter, any policy measure that would carry highly uneven distributional effects across Spain’s regions.

This raises a fundamental point. Contrary to those who see the OMT as a purely stabilizing mechanism, it could actually open a Pandora’s box that would cause underlying tensions to explode. To give just another example, this year Spain missed its fiscal deficit target by some three percentage points of GDP. If this had happened under an OMT program, the ECB would have faced a dilemma: either to stop its bond purchases and, in so doing, to escalate the full-blown crisis it was aiming to prevent, or to continue the program but, in so doing, fundamentally alter its relationship with its own member countries.

These aspects illustrate that one should have realistic expectations about the next steps with regard to the eurozone crisis and that any further escalating pressure should not be ruled out. All the more so if market investors were to further downgrade the growth prospects of countries such as Spain and Italy and form pessimistic expectations about the time path of their debt-to-GDP ratios. In other words, the pessimism would not be triggered by the dynamics of the fiscal variables, which immediately act on the ratio’s numerator, but by expectations on the future dynamics of the denominator, the GDP, which could shrink further or go through a protracted period of flat growth.

It appears, in fact, that the fiscal multiplier – that is, how GDP reacts to fiscal consolidation – is much higher than initially foreseen. Based on a rule of thumb, the fiscal multiplier was typically assumed to be 0.5 in advanced economies; that is, for each percentage point of fiscal adjustment in proportion to GDP, GDP itself would go down by 0.5 percentage points. Based on the latest IMF research published in the World Economic Outlook, fiscal multipliers are much larger in advanced economies, ranging between 0.9 and 1.7. That is to say, if the fiscal multiplier were 1, then a 1-percentage point fiscal adjustment would negatively affect GDP by 1 percentage point; likewise, a 5-percentage-point fiscal adjustment would trigger a 5-percentage-point GDP contraction and so on and so forth.

This happens because, contrary to previous consolidation episodes, the current wave of fiscal adjustments is simultaneously taking effect throughout the eurozone. As such, all the main trading partners are cutting back domestic demand, thus reducing their ability to mitigate fiscal adjustment in their neighboring countries by absorbing more net exports from these countries. This underscores the potential mitigating role that those European economies with current account surpluses might have played, but haven’t.

Germany’s surplus has now become greater than China’s, both in absolute and in relative terms. Yet Germany is also consolidating despite its fundamentally sound fiscal position. Already this year, its fiscal balance is close to equilibrium and its public debt is the lowest, in proportion to GDP, among the systemically important economies of the eurozone.

Authors

Domenico Lombardi

Publication: Longitude

Spain’s Risky “Wait-and-See” Attitude and the Consequences for the Eurozone

Domenico Lombardi — Wed, 24 Oct 2012 11:34:00 -0400

Editor's Note: This piece is translated and adapted from Domenico Lombardi’s bimonthly column “Pennsylvania Avenue” in the Italian daily Il Foglio.

The recent election outcomes in the regions of the Basque country and Galicia once again put the limelight on Spain and the ability of Prime Minister Mariano Rajoy’s government to stabilize and reform the country’s economy. As expected, the Nationalist Party gained a relative majority of 27 seats out of 75 in the Basque country. The leader of the Basque Nationalist Party, Iñigo Urkullu, is expected to take the helm of the regional administration once he forms a coalition, which will likely include the Socialist Party and its 16 seats. In Galicia, on the other hand, the People’s Party of Rajoy further consolidated its absolute majority in the premier’s native region, taking 41 seats out of 75, three more than in the previous elections.

With the election deadline now past, some observers believe that a formal request for assistance under the European Central Bank’s new Outright Monetary Transactions program (OMT) is imminent. Through the program, the ECB would agree to potentially unlimited purchases of government bonds on the secondary market in order to stabilize bond prices and to improve market-access for sovereigns under stress. And yet, it may be precisely the introduction of the OMT that could lead the Spanish prime minister to continue with his wait-and-see approach, which seems benefitting him and his party in the recent elections. This approach by Spain is encouraged by the large amount of liquidity that is already being made available by the ECB—as well as the liquidity promised under the umbrella of the OMT. Moreover, the U.S. Federal Reserve and the Bank of Japan have also introduced nonconventional monetary policy tools, such as another round of quantitative easing. Altogether, these central banks have flooded markets with such huge amounts of liquidity to calm global investors and markets for the time being.

Moreover, regional policy in Spain does not seem to offer any short-term timeline that might facilitate a proactive reformist shift away from the almost daily balancing act of Rajoy’s government. In about one month’s time, the Spanish government will have to face new regional elections, this time called by the Parliament of Catalonia, the country’s richest region. The elections will revolve around the underlying secessionist agenda that will presumably be supported by two-thirds of the newly-elected parliament. Under the threat of a secessionist referendum that would be called no sooner than 2014 and would, in effect, overwhelm the political dynamic of the Rajoy mandate, further regional elections may be brought forward. While all the regions of Spain missed the deficit targets for 2011, a good eight of them so far have requested the intervention of the regional liquidity fund to plug their draining coffers, depleting the fund’s financial capability in the process.

The Risky Consequences for the Euro

It is exactly this regional dimension that remains the Achilles’ heel for Spain, which up to this point has dulled the impetus for reforms. In Spain, the regions manage about half of non-social security public expenditures. By contrast, their scope to manage revenues is limited as they have no authority over the value-added tax or income tax. The composition of regional expenditures—with education, health and public services accounting, on average, about 80-85 percent of the respective regional budgets—makes any attempt at rationalization highly politicized. Thus, there is a continual passing of the buck by Spain’s regional governments to its central government, which itself is reluctant to cut unemployment subsidies and infrastructures spending.

Therefore, despite Spain having missed the 2011 deficit target by a good three percentage points of GDP, the government still announced a decision to increase pensions to compensate for the erosion in purchasing power caused by inflation.

The uncertainty that all this engenders further exacerbates the problem, undermining debt sustainability because of a relentlessly contracting GDP. Accordingly, the build up of stably recessionary expectations for growth could trigger a new wave of escalating pressure on Spanish yields, when it becomes evident that Madrid is in no position to implement a medium-term stabilization strategy.

In this context, it may soon become obvious that the request to activate the OMT will open a new and uncertain chapter on the eurozone crisis rather than providing the region with the stabilizing framework, which many have hoped for. Faced with a possible failure by Spain to meet the gamut of conditions in order to activate the ECB bond-buying program, the ECB will find itself at a crossroads: one path could lead to the immediate suspension of the purchasing program with the consequence of setting off a financial tsunami; the other path could lead to European authorities requesting some direct, centralized powers to oversee the country’s public finances and reform agenda as a necessary condition for the continuation of the program.

The Precedent of Washington and New York

This last option would expose the ECB to an incalculable political risk that is greater even than any risk the Federal Reserve has taken in recent history. In the rescue of the city of New York in the 1960s and of Washington in the 1990s, the U.S. Congress authorized federal intervention on the condition that the two cities establish a “control board” nominated by Congress and charged with overseeing municipal finances. The Fed, despite enormous pressure, managed to stay out of the rescue. However, in Europe’s case with the absence of a full-fledged European government, the ECB could be called on once again to fill the institutional vacuum. As it goes, Spain is likely to provide the trigger that may redefine—for better or worse—the future setup of the eurozone’s governance arrangements.

Authors

Domenico Lombardi