THE EFFECTIVENESS OF
IMF ECONOMIC REFORM PROGRAMS
Lucia Riscado Cordas
6064892
BACHELOR OF SCIENCE
February 2, 2016
Supervisor: D.H.J. Chen
Number of Credits: 12
Abstract Some say that the financial crisis of 2008 has been good to the IMF, as it has rescued the institution from its growing irrelevance by reestablishing its central place as first responder to financial distress. With more than 35 new country arrangements put into place since 2010 — of which most are remarkably with developed European countries — IMF’s capacity and scope to carry out deep and lasting structural changes make it one of the principal financial institutions of this time. Standard economic wisdom says the policy of the IMF is right; even though IMF’s loan conditions imply very tough cuts, this will ultimately lead to economic recovery and growth. However, some of the world’s most authoritative economists on macroeconomic matters argue strongly that the reform policies of the IMF are being misapplied and are killing the patients they were intended to save. This paper consists of a literature case study investigating the effectiveness of IMF reform programs from 2010-2014. Examined will be to what extent the three leading arguments in academic literature against IMF economic reform policy are justified in the case of Greece, Ireland and Portugal.
Statement of Originality
This document is written by Student Lucia Riscado Cordas who declares to take full
responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that
no sources other than those mentioned in the text and its references have been
used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of
completion of the work, not for the contents.
Table of contents
Introduction
1. The IMF
1.1. Historical Background
1.2. Mandate, policy basis and conditionality
1.3. Definitions
2. Country specifics
2.1. Greece
2.2. Ireland
2.3. Portugal
3. Three leading points of critique
3.1. Self-defeating austerity
3.2. Moral hazard
3.3. “One size fits all” approach
4. Method
5. Literary case study
5.1. Self-defeating austerity
5.1.1. Literature in opposition to IMF policy 5.1.2. Literature in support of IMF policy5.2. Moral hazard
5.2.2. Literature in support of IMF policy5.3. One-size-fits-all approach
5.3.1. Literature in opposition to IMF policy 5.3.2. Literature in support of IMF policyConclusion
Introduction
Some say that the financial crisis of 2008 has been good to the International Monetary Fund (IMF), as it has rescued the institution from its growing irrelevance (Grabel, 2011). The Fund has largely contributed to emergency lending following the financial crisis, and has developed and monitored the economic reform programs for several developed European countries in close cooperation with the European Commission (EC) and the European Central Bank (ECB) (Seitz and Jost, 2012). With more than 35 new country arrangements put into place since 2010 — including substantial loans to several developed European economies — its capacity and scope to carry out deep and lasting structural changes make the IMF one of the principal financial institutions of this time, capable of designing much of the global economic landscape ahead (Vernengo and Ford, 2014).
The reform programs of the IMF are well known for their stringent conditionality: when a country borrows from the IMF, its government agrees to adjust economic policies to overcome the economic problems it faces (IMF, 2015). Standard economic wisdom says the policy of the IMF is right; even though the loan conditions imply very tough cuts, it will ultimately lead to economic growth (Janssen 2010). However, eight years after the start of the current financial crisis, some European economies still find themselves with shockingly fragile economies and financial sectors. Over the past five years, thousands of individuals across the Eurozone have participated in public demonstrations against the IMF (Casper, 2015). To many citizens, the austerity measures of the IMF seem fruitless as well as endless.
Not only citizens pose objections towards IMF policy, also academics and some of the world’s most authoritative economists on fiscal matters argue strongly that IMF’s reform programs are not leading to desired outcomes of decreased public debt and economic recovery (Corsetti et al., 2012). For example, Eggertsson and Krugman (2012) argue that the pro-cyclical measures implemented by the IMF have helped push European countries further into recession, and have been impeding the recovery. Additionally, one leading criticism on the IMF is that the reform programs have remained rigid and “one size fits all” since the 1990s, rather than being more country specific (Bird, 2007). Li, Sy and McMurray (2015) argue that the effectiveness of the IMF’s austerity programs is questionable because the design of the programs overlooks the recipient country's unique economic fundamentals and shape of fiscal policy. Furthermore, the moral hazard problem is seen as a major drawback in the public and academic debate regarding IMF reform programs (Franklin et al., 2015). Critics claim that the IMF’s large-scale financial support programs, induces investors and governments to treat this financial support as a form of insurance, which in its turn leads to risky behavior (Lee and Shin, 2008; Jorra, 2012).
In light of the above discussion, this research seeks to examine the effectiveness of IMF’s economic reform programs from 2010-2014. In order to give a constructive answer to this research question, examined will be to what extent the three leading arguments against IMF’s policy hold water in the case of Greece, Ireland and Portugal:
• Assumption 1: IMF’s priority on pro-cyclical measures (tax increases and spending cuts) lead to a prolonged recession and self-defeating austerity measures
• Assumption 2: IMF loan programs lead to debtor and investor moral hazard: The IMF loans work as an insurance for recipient countries and investors, encouraging irresponsible and risky behavior
• Assumption 3: The IMF uses a one-size-fits-all approach with designing the economic reform programs, which leads to a less effective and constructive reform policy
Addressing this research question is of particular importance from the perspective of policy makers, as the stakes for reform programs are high. In advanced European countries, with an aging population and rising healthcare costs, the high increase of debt due to the
financial crisis is an unwelcome addition to the fiscal burden (Corsetti 2012). A convincing policy response is therefore of particular importance. In addition, a prolonged commitment to ineffective measures could perhaps lead to a subversion of social consensus towards the common currency and thereby jeopardize progress towards European integration. The included literature review of this research will provide a comprehensive representation concerning the debate surrounding IMF’s reform policy.
The methodology used in this thesis consists of a literary case study on Greece, Ireland and Portugal. Following the financial crisis of 2008, the governments of Greece, Ireland and Portugal have been dealing with severe economic downturns. All three countries have implemented IMF guided reforms in exchange for a loan during the years 2010-2014. The evolution of these economies along with the implementation of IMF reform programs in all three countries presents a notable case for study. To give a constructive answer to the research question, the three leading arguments in academic literature against IMF policy are being tested on each country. This thesis is structured as follows. Chapter 1 gives an explanation on the role of the IMF and provides insight about the underlying basis and policy of IMF’s economic reform programs. Chapter 2 will give some background information on the economies of Greece, Ireland and Portugal and the content of the assistance they received from the IMF. The third chapter of this thesis will present a review of the debate surrounding the three leading arguments against IMF policy. Chapter 4 describes the methodology used in this thesis. The literary case study will be presented in chapter 5. Based on the debate in Chapter 3, I will examine to what extent the three arguments are likely to hold water in the case of Greece, Ireland and Portugal. Finally, this thesis will end with a conclusion.
Chapter 1
- The IMF
This chapter will first present a short piece of background information on the historical and current status of the IMF. Secondly, some definitions that will be used throughout this thesis are explained. Furthermore the policy mandate and conditionality of the IMF will be looked at in detail. 1.1. Background information The International Monetary Fund was created in 1944 to act as a global lender of last resort and help European countries recover after World War Two (Bird, 2007). However, the IMF quickly moved to solely helping developing nations around the world. Its typical lenders were small, emerging economies needing loans as they implement structural changes. The 1997–8 Asian financial crisis put a halt on the international power of the IMF, as the Fund was faced with a lot of criticism on their work, mainly on their broadened structural conditionality (Broome, 2015). In the fiscal year of 2005, just six countries had stand-by arrangements (SBAs) with the Fund, the lowest number since 1975. The 2008 financial crisis lead to an increase in power and shift of focus for the IMF, as the Fund started dealing with sovereign default situations in a number of developed European countries (Ban and Gallagher, 2015).
The principal reason for IMF’s re-empowerment is that, at the time that the European sovereign debt crisis erupted in 2008, the IMF still held a monopoly position when it came to experience in responding to financial crises (Grabel 2011). The European Commission (EC) possessed of much less credibility and experience in handling severe national fiscal problems in comparison to the IMF. Together with the EC and the European Central Bank (ECB) the IMF formed the so-called Troika, responsible for negotiating and monitoring the economic adjustment programs for Greece, Ireland and Portugal (Seitz and Jost, 2012). The cooperation with the other Troika-members was also essential for the IMF, as the Fund would not have been able to raise the lending funds by itself due to the large size of these loans. The IMF did however attain a highly influential position within the Troika. By contributing around 33% to the loan packages, the IMF received a maximum 100% influence in the program design and surveillance procedures, and also the approval of loan provision ultimately depends on the decisions of the IMF executive board (Seitz and Jost, 2012). In addition, as an international organization, the IMF enjoys a preferred creditor status in that IMF loans will be repaid prior to all other creditors.
2.2. Mandate, policy basis and conditionality
The IMF's purpose is to ensure the stability of the international monetary system (IMF 2015). In short, the IMF’s mandate consists of three tasks: to promote international monetary collaboration, giving policy advice and technical support and to help resolve crises by providing loans and/or assistance with economic reform. The focus of this thesis lies on the latter task of the IMF.
Throughout the 1980s and 1990s, IMF’s policy basis for its loan programs became synonymous with a market liberalization policy paradigm called the “Washington consensus” (Broome, 2015). Named in 1990 by the American economist John Williamson, the Washington Consensus originally referred to what he saw as a widely accepted 10 policy reforms for countries to implement when they find themselves in a financial crisis (Williamson 1990). For Williamson, the immediate target of these policy reforms was the crisis in Latin America. However, soon these 10 policy reforms were globally expanded and enforced by Washington-based agencies, which lead to the Washington Consensus to become viewed as the best institutional approach to economic reform, also by the World Bank and the IMF.
The economic reform programs of the IMF are famous for their conditions (Dreher et al., 2015). When a country borrows from the IMF, its government agrees to adjust its economic policies to overcome the problems that led it to seek financial support in the first place (IMF, 2015). Conditionality in its broad sense covers both the design of IMF loan programs and the specific tools used to monitor progress toward the goals set out by the IMF. The aim of IMF’s conditionality is helping countries towards a stable economy without resorting to measures that are harmful to national or international welfare. The loan conditions also serve to ensure that the country will be able to repay the IMF so that the Fund’s resources can be made available to other members in need.
2.3 Definitions
The IMF makes policy recommendations to European countries through its Article IV consultations and resulting papers (Islam et al. 2012). These consultations provide recommendations on a broad range of issues including fiscal, monetary, and exchange rate policy, labor market policy, health care and pensions and several other policy issues.
During an economic crisis, countries sometimes need financial support to help them overcome their balance of payments problems (IMF, 2015). The Stand-By Arrangement is created in June 1952, and is seen as IMF’s main lending instrument for emerging and developed countries.
When a country faces serious medium-term balance of payments problems because of structural weaknesses, these problems need more time to address. The Extended Fund Facility (EFF) can assist with this prolonged reform process, which is provided under the Stand-By Arrangement. Compared to the Stand-by Arrangement, assistance under an extended arrangement features longer program engagement to help countries implement medium-term structural reforms and extend a longer repayment period.
Chapter 2
– Country specifics
Since 2008, Greece, Ireland and Portugal have experienced an unforeseen reversal of fortune as their high economic achievements turned into great modern economic tragedies (Dreher et al. 2015). The reasons for the poor performance of these countries are varied: In Ireland, the core of the crisis is centered on banking system; Portugal’s crisis is mainly due to a fall in external competitiveness and a high degree of public debt, while the Greek crisis is mostly due to excessive and persisting imbalances (Martins, 2012). Despite their differences, the outcome was the same: the situation became unsustainable and IMF intervention was required (see table 1 for an overview of the program details). Despite their different natures, the economic downturn of these countries is a consequence of the same financial crisis. In this context, the three cases reveal themselves as an exceptional case study to compare the approach of the IMF. The evolution of these economies along with effectiveness of the IMF reform programs will be analyzed in this thesis. This chapter will give some background information on the content of the assistance these countries received from the IMF.
Table 1. IMF arrangements with Greece, Ireland and Portugal during 2008-2013 (millions of SDRs)
No. Country Facility Date of Arrangement Date of Expiration or Cancellation Amount Agreed Amount Drawn Amount Outstanding 1. Greece SBA May-10 Mar-12 26,432.9 8,891.1 17,541.8
EFF Mar-12 Mar-16 23,785.3 16,574.4 23,280.8
2. Ireland EFF Dec-10 Dec-13 19,465.8 18,205.4 18,205.4
3. Portugal EFF May-11 May-14 23,742.0 2,363.0 21,379.0
Source: IMF 2015
2.1. Greece The IMF set out the first economic reform program for Greece in May 2010 (Seitz and Jost, 2012). Combined with the financial support of the other two Troika members, the three-year program had a worth of €140 billion, of which the IMF contributed €30 billion in the form of an SBA. In March 2012, the IMF approved of another €28 billion in financial support for Greece under an extended arrangement to support the country’s prolonged economic reform. A repayment of about €1.5 billion was due to the IMF under the stand-by arrangement on June 30, 2015. That repayment was not made when due. This made Greece the first developed country ever to default on an IMF loan.
2.2. Ireland
In November 2010, Ireland had to ask the IMF for assistance in order to overcome its financial crisis (Seitz and Jost, 2012). A joint loan package of € 85 billion was determined in November 2010. The IMF contributed € 22.5 billion via its Extended Fund Facility.
Ireland’s debt crisis can be seen as different to that of Portugal and Greece, because Ireland’s fundamentals are stronger, and the country’s macro-economic figures were very respectable before the 2008 financial crisis (Hanley, 2015). The problem for Ireland was that huge private bank liabilities developed into an unsustainable situation. Faced with the prospect of the collapse of the three biggest Irish banks, the Irish government took on state
responsibility for this bank debt. The IMF, together with the Troika members, provided the Irish government with the funds to bailout the banks. Although Ireland is seen as a different case from Greece and Portugal, the country did accept an economic reform program on classic IMF terms.
2.3. Portugal
In May 2011, Portugal became the third Eurozone country to enter a three-year economic reform program supported by a € 78 billion financial loan package (Seitz and Jost, 2012). The IMF contributed € 26 billion under its EFF. Low economic growth, weak international competitiveness and high fiscal deficits of close to 10 % in relation to GDP in 2009 and 2010 20 led to an unbearable rise in government funding costs in Portugal.
Chapter 3
– Three leading points of critique
The IMF can be seen as lender of last resort: when a country has no possibility to get funding on the private market for reasonable prices, the IMF can provide crucial loans to stabilize the economy and prevent a collapse of confidence (Moschellau, 2014). Advocates of IMF policy argue that the Fund’s external assessments of country’s economies is very important, as it helps the governments to stay on track with economic policy. Furthermore, supporters of IMF policy also argue that the Fund has a very important role in implementing the necessary reforms to get an economy in crisis back on track. The general belief is that these policies may cause short-term recessionary effects, but are essential for preventing future crisis and securing long-term development. Yet, despite the potential benefits of having an international monetary fund, which can provide an effective support during a crisis, the role of the IMF has proved to be very controversial. Given the enormous financial and political importance of IMF economic reform programs, the impact of these programs has been the subject to a large academic and popular debate.Almost eight years have gone by since the financial crisis erupted in 2008, but some European countries still find themselves struggling with fragile economies and high levels of debt (see figure 1). This slow pace of recovery revived the debate in both popular and academic literature on the effectiveness of IMF economic reform programs. This chapter will present a review of the debate surrounding the three leading arguments against IMF policy.
Figure 1: Debt positions of the 6 top indebted Eurozone
Countries Source: Thomson Reuters
3.1. Self-defeating austerity
The legacy of the European sovereign debt crisis is that a number of countries are dealing with dangerously high levels of public debt and public debt to GDP-ratios (Lane, 2012). This may lead to a situation where the debt is of such magnitude that interest rates on the public market are rising to unaffordable amounts and a future recovery is unattainable without outside financial resources. The public debt of Greece, Ireland and Portugal lead to such a situation, which is why these countries enrolled an economic reform program guided by the IMF.Expansionary consolidation, also known as austere or pro-cyclical policy, forms the main dogma of the European policy today to fight these high levels of public debt (Demopoulos and Yannacopoulos, 2012). Within the IMF, there also seems to be a core belief that, in the long run, austerity measures are needed for public debt reduction and stimulating economic growth after a crisis (Vernengo and Ford, 2014). In general, IMF’s austere reform policy refers to the desired outcome of lower government deficits and public debt. In order to reach these outcomes, the IMF regularly uses lower spending and higher taxes as fiscal policy instruments (Vernengo and Ford 2014).
According to this view expansionary consolidation, an increase in taxes and cut in spending today will reduce the need for an increase in taxes and a cut in spending in the future. Furthermore, announcements of these austerity measures generally have a positive
short-run effect on market confidence, especially with a crisis such as the one in 2008, which has been highly associated with negative expectations. By raising the expected income of the private sector in the future, and thereby increasing investors’ confidence, this fiscal consolidation may stimulate private consumption, accelerate economic growth and lower sovereign risk premia. Thus, the stringent short-term effects of fiscal consolidation may be expansionary in the longer run. This view however contradicts the Keynesian prediction that tax increases lead to contractionary effects on aggregate demand due to the fiscal multiplier effect (Demopoulos and Yannacopoulos, 2012). Academic literature poses major concerns on this priority of austerity measures by the IMF, especially in times when a country already suffers from a weak economy and high debt ratios (Shin, 2015; Ritsatos, 2014). The fear posed by many academics is that a vicious circle could be set in motion: Spending cuts lead to a decrease in GDP, which reduces taxes; consumer prices increase due to taxation, which reduces consumption and tax revenues; this reduced consumption leads to a drop in profits of firms which in turn creates a wave of business closings. As is clear, academics argue that austerity measures might be self-defeating in recessionary and weak economies, constituting in a fiscal debt trap as described by Hanssgen and Papadimitriou (2012).
Nobel Prize winner Paul Krugman (2012) is seen as a leader in the anti-austerity debate, as he fears the long-term impact of reduced growth associated with austerity measures will not lead to economic recovery. Krugman advocates for expansionary spending instead of a contractionary policy. The rise in European sovereign debt since 2008 is used as — wrongly say Eggertsson and Krugman (2012)— a reason to dismiss calls for expansionary fiscal policy as a response to economic downturn. In their article ‘Debt, Deleveraging, And The Liquidity Trap’, Eggertsson and Krugman argue there is an abrupt revision of views going on about how much debt is safe for individual agents to have, and this revision of views forces highly indebted countries to reduce their spending sharply. Eggertsson and Krugman argue that austerity doesn’t play a beneficial role when it comes to the deleveraging process and can create major problems of macroeconomic management, namely a public debt trap.
3.2. Moral Hazard
The concept of moral hazard in association with IMF reform programs has been introduced by Vaubel (1983), but later restated by authors such as Goldstein (2001) and Bird (2007). Generally speaking, the term ‘moral hazard’ refers to the situation where the provision of insurance leads to the insurant taking actions that increase the probability of an adverse outcome (Dreher, 2004). In this situation, a person or entity has less incentive to maintain the insured asset properly, which might increase the probability of undesirable results. The moral hazard problem associated with IMF loans arises when investors and governments treat the financial support of the IMF as a form of insurance against country and investment default, and therefore behave more risky.The moral hazard problem associated with IMF loan programs may be further divided into debtor moral hazard and creditor moral hazard (Franklin et al., 2015). Debtor moral hazard occurs when debtor countries receive IMF loans with interest rates that are much lower than the market rate, as the market rate also consists of a risk premium associated with sovereign risk. This cheap IMF lending might encourage the governments of these countries to undertake irresponsible policies. Creditor moral hazard suggests that the (recurring) financial support from the IMF induces investors to behave more risky in the financial market.
The moral hazard problem is seen as a major drawback in the public and academic debate on IMF loans, as it poses concern about the effectiveness of IMF economic reform programs (Franklin et al., 2015). In his paper on the effect of IMF lending on the probability
of sovereign debt crises, Jorra (2012) explores empirically to what extent the IMF programs affect sovereign risk over the medium term. Jorra finds that IMF programs turn out to be especially harmful to country fiscal solvency when the Fund lends to countries whose economic fundamentals are already weak. In these circumstances debtor moral hazard is most likely to occur, because weak debtor countries have the incentive to neglect necessary but very painful policy adjustments and rely on IMF’s lending facilities instead. His research shows that IMF programs significantly increase the probability of subsequent sovereign defaults by approximately 1.5–2 percentage points.
Lee and Shin (2008) argue, in their paper on IMF bailouts and moral hazard, that repeated financial support from the IMF encourages investors to lend excessive amounts to troubled countries with a low interest rate, which does not accurately reflect the underlying risks associated with those countries. In other words, financial support from the IMF actually indirectly encourages investors and governments to behave irresponsibly, which may lead to further future crises. In his book on The IMF and global financial crises (2013) Joyce confirms this argument. He explains that during the current financial crisis, the IMF effectively set out lending facilities at subsidized interest rates inducing potentially serious moral hazard.
3.3. “One size fits all” approach
During the 1990s, the IMF was widely criticized for using a one-size-fits-all approach when designing economic reform programs for countries in need of financial support (Broome, 2015). The IMF has however claimed that, in response to these critics, it has become more flexible in the design of its lending arrangements (Islam et al., 2012). Over the last ten years, the IMF intended to transform its loan program modalities and how the objectives of loan programs are framed. In contrast to the early 1990s, for example, the IMF now places a greater stress on the importance of country ownership, poverty reduction, and social protection.Within the process of designing its economic reform programs, the IMF assigns a central to macroeconomic stability as an essential factor for economic growth (Islam et al., 2012). The IMF assesses this macroeconomic stability in terms preferred nominal targets for countries related to debt, GDP and inflation. The underlying theory of the IMF is that the predictability of these key nominal targets will lead to market confidence, which will in turn boost investment, stimulate growth, increase the employment rate and reduce poverty. In principle, it is obvious that these nominal targets should be tailored to country-specific circumstances in order to run an effective policy (Li et al., 2015). Thus in practice the targets suggested by the IMF should differ if country characteristics are taken into account.
In spite of the attempts of the IMF to make its economic reform programs more flexible and country specific, several academics still argue that the Washington consensus policy paradigm from the 1990s remains largely intact within the IMF (Broome, 2015). Li, Sy and McMurray (2015) argue that the effectiveness of the IMF’s loan programs is questionable because this one size fits all design of the programs as it overlooks the recipient country's unique economic fundamentals and shape of fiscal policy. The content analysis undertaken in the paper of Islam et al. (2012) assessed the extent to which the consultations of the IMF reveal a pattern of a one-size-fits-all approach. The result of this content analysis shows that there has been little difference in the IMF’s policy advice to European countries. Islam et al. conclude that given the urgency and length of the present situation in some European countries, an in-house evaluation and review of IMF’s current policy might enable the Fund to play a more constructive and effective role in Europe’s recovery.
Chapter 4
– Method
This thesis aims to give answer to the following research question: To what extent are the economic reform programs of the IMF effective? The methodology used in this thesis is a literary case study on Greece, Ireland and Portugal. During the last six years, the governments of Greece, Ireland and Portugal have been dealing with severe economic downturns after the financial crisis hit Europe in 2008. The evolution of these economies, along with the implementation of IMF economic reform programs in all three countries, presents a notable case for study.
To give a constructive answer to the research question, the three leading arguments in academic literature against IMF policy are being tested on each country. The following assumptions will be examined in the case of Greece, Ireland and Portugal:
• Assumption 1: IMF’s priority on pro-cyclical measures (tax increases and spending cuts) lead to a prolonged recession and self-defeating austerity measures
• Assumption 2: IMF loan programs lead to debtor and investor moral hazard: The IMF loans work as an insurance for recipient countries and investors, encouraging irresponsible and risky behavior
• Assumption 3: The IMF uses a one-size-fits-all approach with designing the economic reform programs, which leads to a less effective and constructive reform policy
Chapter 5
– Case study
This chapter will examine to what extent the three leading arguments against IMF’s policy hold water in the case of Greece, Ireland and Portugal.5.1. Debt trap
5.1.1. Literature opposing to IMF policy
One argument frequently used in support of austerity programs, is that they will eventually reduce government debt ratios, and have a positive impact on GDP (Vernengo and Ford, 2014) Holland and Portes (2012) used the National Institute Global Econometric Model to model the quantitative impact of the austerity policies of European governments in 2011-2013. Their model tried to capture the importance of taking the economic conjuncture of a country into account with implementing austerity measures. They begin by estimating fiscal multipliers in economically stable times. The fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. Generally, fiscal multipliers are less than one. However, with a depressed economy and interest rates at or near the zero lower bound, Holland and Portes argue one can expect the negative impact of fiscal consolidation on growth to be bigger than in times of economic stability. Fiscal policy became contractionary in all European countries in their sample in 2011, with the most austere measures introduced in Greece, Ireland and Portugal. In order to assess the impact of the planned consolidation programs on GDP, the deficit and the stock of government debt, Holland and Portes considered two alternative scenarios. In the first scenario, they implement the policy plans under the assumption that the economy is behaving as in economically stable times: with flexible interest and liquidity constraints in line with the long-run average. In the second scenario, they allowed for an impaired interest rate channel and heightened liquidity constraints: assumptions they considered more realistic under the depressed conditions of the EU-countries after the financial crisis of 2008. Table 2 reports the estimated impact of the planned consolidation programs in Europe on GDP under these two scenarios. Figure 2 shows the impact on debt-GDP ratios. Table 2. Impact of consolidation programs on GDP Source: Holland and Portes (2012)Figure 2. Impact of consolidation on government debt ratio, 2013
Source: Holland and Portes (2012)
The research of Holland and Portes show that the assumption of austerity leading to a reduction of government debt ratios and an increase of GDP is conditional to the economic conjuncture. As the results in table 2 show, in contrast to economies in economically stable times, austerity measures implemented during recessionary times lead to adverse effect of rising government debt ratios in every country (except Ireland) and decreased GDP. Holland and Portes thereby conclude that austerity measures are more prone to become self-defeating during recessionary times.
Furthermore, Weisbrot and Montecino (2010) argue that next to a county specific situation of recession, also a country with a weak governmental system is more prone to end up in a self-defeating debt trap. Hanssgen and Papadimitrio (2012) confirm this view in their ex-post evaluation of IMF policy effectiveness in Greece. Their evaluation shows that because the Greek government lacked substantial institutional strength, the governments were unable to set out the appropriate strategies for structural reforms and preserve IMF’s interests. Amaral and Lopes (2015) conclude in their ex-ante assessment of the forecast errors made by the IMF, that errors could be avoided if the country specific structure of the economy and institutional framework were taken into account to a greater extent. The main conclusion of their assessment illustrates the technical incompetence of Greece’s economic reform program and the huge economic and social costs it unnecessarily caused.
The Portuguese economic reform program of the IMF consisted of three components: fiscal consolidation, financial sector stabilization and structural reforms. In their paper on the economic reform programs of the IMF, Amaral and Lopes (2015) assessed the program of Portugal. Instead of an ex-post comparison between the actual results and the proposed targets, an ex-ante assessment of the forecast errors was made. Amaral and Lopes show that from a macroeconomic point of view, the first and third components of the Portuguese economic reform program were translated by the IMF into very harsh fiscal austerity measures with the aim of increased tax revenues and reduced public expenditure. According to Amaral and Lopes, these austere measures imposed by the IMF generated a deep and prolonged recession and job destruction as the unemployment rate in Portugal peaked at 17.5% in early 2013. Amaral and Lopes conclude that the prolonged recessionary effect of the Portuguese reform program was clearly underrated, largely due to the ideological belief in the virtues of expansionary austerity. Reis (2015) also addresses that the austerity measures imposed by the IMF were far from decisive on generating large primary surpluses for Portugal. Public debt is still high, primary surpluses improved modestly, and
public spending barely fell. Reis argues that, behind the low interest rates and longer maturities, Portuguese public debt is 130% of GDP.
Shin (2015) researched the Greek economic crisis in a comparative analysis with the East Asian financial crisis. He finds that the Greek government has not only missed IMF’s yearly targets multiple times, but also has incurred an increasingly high public debt burden. Shin concludes that IMF’s harsh austerity measures were self-defeating and reinforced a recessionary downward spiral, making it almost impossible for the Greek economy to achieve any meaningful debt repayment through economic recovery. The outcome is a massive humanitarian crisis, a combination of prolonged real economic recession, rising unemployment rate, accompanied by an unabated debt payment burden.
5.1.2. Literature in support of IMF policy
In the paper on ‘Austerity: Too Much of a Good Thing?’ (Corsetti et al., 2012), leading economists did research on the extent to which spending cuts and tax increases in the short run are desirable and effective in reducing the possibility of sovereign risk crises. They investigate the workings of the fiscal multiplier in a situation when private markets charge a risk premium on government debt (which was the case with Greece, Portugal and Ireland during 2010-2014). They illustrate this in figure 5 and 6 below, which are produced based on a standard new-Keynesian model, extended to imbed the possibility that:
- Markets price sovereign risk based on expectations of future deficits and debt - Rising risk premia on sovereign debt in turn create institutional risk, leading to a
devaluation of the balance sheets of banks and corporates. This in turn leads to increased taxation, higher costs of products and services and thus ultimately to a falling internal demand. Because of these reasons, higher sovereign risk of default translates into higher borrowing costs for private agents.
- A large recessionary shock is assumed that causes the monetary authorities to bring policy rates to zero
Figure 5. Short term recession, austerity expansionary Source: Corsetti (2012) Figure 6. Long term recession, austerity self-defeating Source: Corsetti (2012)
These figures plot the responses of output (left graph) and the deficit-to-GDP ratio (right graph) to a spending cut by 1% of GDP, against two key features of the crisis: is the expected duration of the recession (right axis) and sovereign risk premium to expected deficits (left axis).
Corsetti et al. (2012) study the effect of immediate austerity measures (spending cuts and tax increase), which is expected to last for the entire duration of the ongoing recession, which is the case for Greece, Ireland and Portugal. They find that, if a country’s recession is not expected to last very long – 1 year or less – immediate austerity measures cause a modest fall in output, and end up reducing a government debt ratio in the long run (see figure 3). In this case, the contractionary impact of the fiscal multiplier is weakened by a positive effect of the consolidation on the interest rate on sovereign debt, which will be reflected by lowered private borrowing costs. However, the key message of this research is that there is a fine line between self-defeating austerity measures and expansionary austerity measures. When the anticipated duration of the recession is longer – one year or longer - the picture changes radically. For countries in relatively good fiscal shape, with a low sensitivity of the sovereign risk premium to future deficits, the direct effect dominates and becomes quite large. Because of the size of the fiscal multiplier, immediate austerity measures are self-defeating: the deficit-to-GDP ratio actually rises. In contrast, for countries that are not in a good fiscal shape, hence with a high initial public debt and/or a higher sensitivity of the risk premium to future deficits, the macroeconomic impact of immediate austerity measures are expected to lead to a positive outcome: at some point, fiscal contractions become expansionary. In the case of Greece and Portugal, both in a long recession and with a weak fiscal shape, this model would expect austerity to be expansionary. Contrary to these model expectations, the austerity measures of the IMF did not have an expansionary impact on the Greek and Portuguese economy, but did on the Irish economy. These wrong predictions of policy impact might be due to the stylized nature of this model. Despite these model limitations, there are still some lessons to be learnt. In support of the IMF, Corsetti et al. argue that it is quite difficult for any institution of economist to assess and capture the impact of economic reform. Plans that are well designed under a certain scenario may turn out to be counterproductive for a seemingly minor revision in market expectations. Furthermore, Corsetti et al. also argue that the line between self- defeating and expansionary austerity is very thin: small differences in the state of expectations and market attitudes may make a large difference regarding the impact of austerity measures. Moreover, when the anticipated duration of the recession becomes longer, the economy becomes more and more vulnerable to self-fulfilling crises.
Like Greece and Portugal, Ireland also endured significant hardship in implementing IMF’s austerity measures since 2010 in response to the financial crisis. As was also the case in Portugal and Ireland, this has further slowed economic activity, which in turn has further depressed revenues and lowered GDP and debt to GDP ratios in the following years after the crisis in 2008 (Hardiman and Regan, 2013). However, Ireland’s economy possessed of a number of strong fundamental factors including high productivity and a relatively flexible labor market (Whelan 2013). These factors have helped Ireland cope somewhat better with fiscal austerity in recent years than Portugal and Greece. Despite serious problems with overhangs of public and private debt and a difficult external environment, there are signs that the Irish economy is slowly getting back on track. In 2011, Ireland even found itself boasted by some European newspapers as the ‘poster boy’ for good practice in the implementation of austerity. A self-defeating debt trap due to IMF’s austerity measures is not observable in the case of Greece (Lane, 2011). Furthermore, one argument that supports IMF’s position in the Greek case, is that Greece has a long record of poor complying with objectives (Martins 2012). For example, the objective that was traced for Greece, after being decided it would adopt the Euro in 2001, was never fulfilled. A high level of tax evasion, consistent overspending and overoptimistic
tax projections are the main causes of this situation. The poor skills of Greece to implement and comply with reform objectives make it a more difficult case for the IMF to implement reform in a rigorous manner (Martins 2012).
In his research, conditional on a diagnosis of the underlying problems of the Portuguese economy, Reis (2015) sheds a positive light on the effectiveness of the economic reform program implemented by the IMF in Portugal. Reis argues that the program succeeded in leaving promising signs of reform in the structure of the Portuguese economy. By using a general equilibrium model with heterogeneous agents, the paper of Viegas and Ribeiro simulates the fiscal consolidation strategy of the IMF in Portugal, and explores the impacts of the fiscal adjustments on welfare as well as on the distribution of welfare, income and wealth. While being far from a path that lowers the public debt, also Viegas and Ribeiro (2014) also claim there to be promising changes in the structure of the Portugese economy. Portugal is seen as a potential example of success to counterbalance the failure in Greece (Reis, 2015; Viegas and Ribeiro, 2014). Portugal’s economic reform program was extensive, precisely followed by the Portuguese authorities and and benefitted from the accumulation of some experience from the programs of Greece and Ireland. Looking back in its 2015 anual report, the IMF describes the adjustment program as a success (IMF, 2015).
5.2. Moral hazard
This chapter investigates to what extent the IMF economic reform programs of Greece, Ireland and Portugal have led to debtor and investor moral hazard problems. Unfortunately, there is not an extensive amount of literature published on this specific topic. One reason for this is that empirical research investigating moral hazard generates a number of difficulties (Li et al. 2015). First and foremost, it is difficult to quantify moral hazard, because the excessive risky behavior of creditors and debtors cannot be directly observed and measured. In addition, it is difficult to separate the effects of IMF intervention from those of other macroeconomic factors (Lee and Shin, 2008). Additionally, IMF financial support encourages investors and debtor countries to behave in a different, more risky, manner, which leads to a radical change in market conditions and country economic fundamentals. In this regard, how to control for market conditions and country economic fundamentals in empirical studies remains a challenge for researchers. As a result, it is understandable that there are not many empirical studies to be found in this field.
5.2.1. Literature in support of IMF policy
One major drawback of large-scale IMF support programs is that it might induce irresponsible and risky behavior by recipient governments. During 2011 it became more and more difficult for Portugal to get funding from the private market (Magonea 2014). However, the Prime Minister of the time, José Socrates, was determined not to ask the IMF for financial support, scared to follow the Greek example, which had to implement stringent reforms under monitoring from the IMF. After a failed vote of confidence at the end of March 2011, the interest rates for sovereign debt skyrocketed, making it impossible for the Portuguese government to get funding at reasonable rates. After considerable pressure from the banking sector, his own Socialist party (Partido Socialista) and the EC, José Socrates requested a loan from the IMF. Magonea (2014) argues that this resistance to ask for funding from the IMF shows that the debtor moral hazard problem did not take place in the case of Portugal. The conditions of the IMF placed on Greece were scaring off Portugal to behave irresponsibly. In addition, losing sovereignty over economic affairs was a major traumatic experience for Portugal. The Portuguese political elite never expected that it would be in this situation within the European Union, which was meant to be a safe haven for the Portuguese. Furthermore, after Portugal did enter an IMF program, Portugal became known as a ‘good pupil’ of the IMF, implementing all their austerity measures as precise and
quick as possible to escape the IMF supervision as soon as possible. One can conclude that the Portuguese governments did not behave in a risky manner due to the insurance of IMF financial support (Magonea 2014).
Afonso et al. (2015) performed an analysis of austerity reforms in Greece and Portugal during the sovereign debt crisis from 2009 onwards. They find that, in contrast to Portugal, there was a much greater difficulty in finding compromises about austerity with the Greek governments, and adversarial politics have been the leading feature of economic reforms in Greece (Afonso et al., 2015). In the beginning of 2015, a new Greek government was elected based on a platform of strong aversion to IMF’s austere program composition (Wilkinson 2015). The priorities of this new Syriza government suggested right from the beginning that they were going towards a different direction than IMF’s guidelines. Syriza bet his election campaign on rejecting the steep budget cuts and tax increases of the IMF that Greece agreed to in exchange for economic reform program. Tsipras promised, first, to deliver a spending package aimed at Greece’s struggling poor, and then to use money meant for debt payments on social programs in Greece. This new push from Greece for expansionary fiscal policy created substantial uncertainty on the international financial market. The ten-year Greek government bond spread with respect to Germany, as of February 2015, had risen again beyond the 10-percentage point threshold. This deviating direction of the Greek government, eventually lead to the first default ever of a developed country to the IMF. Although the Syriza government clearly behaved too risky for IMF guidelines, Afonso et al. argues that this was not due to debtor moral hazard caused by the IMF: the case that the Greek government would not feel responsible for fixing its economy due to support of the IMF. Instead, Afonso argues that the deviating policies of the Greek are due to an often-overlooked variable with designing reform programs: the greater extent of corruption within the institutional framework. For Greek mainstream parties, agreeing to IMF’s austere economic reforms severely undermined their own organizational base. This was however not the case for Portuguese parties, who did not rely to such an extent on corruptive strategies.
Furthermore, the analysis of Fahrholz and Wójcik (2010) suggests that the IMF support to Greece was unavoidable and that this financial support was not associated with a future moral hazard problem. Fahrholz and Wójcik argue that the IMF’s program design did not induce a high degree of moral hazard, due to the possibility of withholding financial support. Schwarzer (2015) also mentions in her paper on ‘The Sudden Decisions Taken On Crisis Management And Reform’ that the IMF can avoid debtor moral hazard by withholding a credit line. Given the concern to effectively reduce moral hazard, the international character of the IMF can be seen as having the advantage of an ‘exit threat,’ that is it can withhold a credit line or even withdraw an economic reform program. These are measures that the European Commission and member states could not credibly threaten to take towards other weak EU-members. For this reason, Schwarzer claims that, in the case of Greece, the EC and EU are more to blame for inducing a moral hazard than the IMF, because when the crisis unfolded, European policy makers came to realize that the financial stability of the whole EU was at risk. This realization soon tilted the cost-benefit analysis towards saving Greece at any cost. This attitude of IMF’s other Troika member were much more likely to induce moral hazard problem with investors.
In their paper on the role of the IMF in the European debt crisis, Seitz and Jost (2012) describe that the problem of moral hazard during the European sovereign debt crisis was even stronger than in all other crises in emerging markets of the last two decades. However, they argue that for the most part, it wasn’t IMF’s large-scale lending that induced moral hazard during this crisis. The heads of the politically strongest European members have endlessly repeated that a default and/or exit of a country from the Eurozone must and will be prevented. This unlimited financial support of the strongest European members lead
to a rise of insurance that everything would be done to save countries in financial distress. Seitz and Jost argue that these announcements of unlimited financial support created a prospect of future bailouts, which would be the main cause for investors and governments to behave in irresponsible ways.
In his research paper on Moral Hazard and the Greek Bailout (2012), Muhanzu tried to capture the change in investors’ perceived risk by studying the sovereign bond market. He studied Eurozone’s ten-year government bonds, focusing on the level of spreads, the slope coefficients relating spreads to country-specific fundamentals and the cross-country variance of spreads. Figure 7 shows the evolution of ten-year government bond spreads of six Eurozone countries: Greece, Portugal, Ireland, Italy, Spain and Belgium. As predicted by theory, at the height of the financial crisis – the end of 2009 – the Greek, Irish and Portuguese sovereign bonds were considered as by far the most default-risky investment in the Eurozone. This is visualized in figure 7 by the widening of government bond spreads between Ireland, Greece, Portugal and the German reference rate.
Figure 7: Ten-year bond spreads in the EMU 2008-2011
Source: Reuters EcoWin
In the presence of investor moral hazard, one would expect that a declaration of IMF financial support would lead to a decrease in the level of spreads. Muhanzu shows that investors did not perceive the IMF economic reform program of Greece in 2010 as an insurance against future risk. In fact, Ireland and Portugal also experienced a sharp increase in their long-term interest rates after the IMF declared the Greek economic reform program in September 2010. Contrary to the assumption posed by traditional literature on IMF reform programs (Vaubel, 1983; Goldstein, 2001; Bird, 2007), Greek sovereign bonds were even perceived as a riskier investment than before it the declaration of IMF support took place. Despite the fact that Greece received IMF’s financial support, investors were still frightened and continued to demand higher interest rates, as well from several other fundamentally weak governments. Muhanzu speaks of the Greek paradox: the IMF economic reform program, instead of reduced, appears to have increased the need for investors to concern themselves with country’s creditworthiness.
5.3. One-size fits all approach
To what extent the IMF uses a one-size-fits-all approach with the economic reform programs of Greece, Ireland and Portugal, and if this approach leads to an adverse effectiveness of the reform programs is unfortunately not widely investigated in academic literature. In his research paper on IMF adjustment programs, Martins (2012) analyzed the IMF reform program designs of Greece, Ireland and Portugal. His research concludes that, despite some remarkable differences between the problems and country specifics of Greece, Ireland and Portugal, their IMF economic reform programs appear to have only little difference. All three programs expected an adjustment based on three main pillars: securing the banking system, fiscal consolidation and correction of imbalances and structural reforms to enhance competitiveness. Within each of these pillars, Martins also found a lot of similarities. Furthermore, similar structural reforms were carried out in all three countries.Martins does not investigate or suggest that these similarities in economic reform have any impact on the effectiveness of IMF policy. He does argue that the similarity in program design is remarkable considering the differences between the problems and country specifics of Greece, Ireland and Portugal. The rest of this chapter will shed some light on a one-size-fits-all approach by respective academics. 5.3.1. Literature opposing to IMF policy As described in §5.1.1., some economists object to a one-size-fits-all approach in the cases of Greece, Ireland and Portugal due to the unique in country specifics. Weisbrot and Montecino (2010) argue that a country specific situation of economic downturn and a weak governmental system is more prone to end up in a self-defeating debt trap. Hanssgen and Papadimitrio (2012) determine the quality of the governmental system to be an important asset in deploying an appropriate reform strategy and preserve IMF’s interests. Amaral and Lopes (2015) show in their ex-ante assessment of the forecast errors made by the IMF, that errors could be avoided if the country specific productive structure of the economy and the unemployment/external deficit trade-off were taken into account. Furthermore, Boyer (2011) argues that applying austerity policies, regardless of the country’s causes of the public deficits and of the governmental strength of each national, repeats the error of the Washington consensus, which is described in §2.2 as the one-size-fits-all approach. Boyer suggests that this is what happened with the economic reform program in Greece. Also Corsetti et al. (2012) stress the importance of country-specific designs of IMF’s economic reform programs. Their analysis argues that the best strategy for economic reform is not the same for all countries: the early implementation of austerity measures depends on a country’s fiscal shape and the expected duration of the economic downturn. Because of this Corsetti et al. (2012) do argue that this consideration calls for a cautious approach to the design of economic reform programs, preferring steady reforms instead of immediate austerity measures. According to the model underlying figure 5 and 6, Corsetti et al. find that adopting austerity measures phased over time in a credible way, has a greater chance of improving the macroeconomic outcome in all situations. 5.3.2. Literature in support of IMF policy Citizens, academics and some of the world’s most authoritative economists on fiscal matters argue that IMF policy is not leading to desired outcomes. However, it is quite difficult for any institution to assess and capture the impact of economic reform. Plans that are well designed under a certain scenario may turn out to be counterproductive for a seemingly minor revision in market expectations, as discussed in §5.1.2. with the model of Corsetti et al. (2012). Furthermore, expectations about output growth, and the sensitivity of risk premia can vary significantly over time.
Conclusion
The stakes for IMF economic reform programs are high. With more than 35 new country arrangements put into place since 2010, IMF’s capacity and scope to carry out deep and lasting structural changes make it one of the principal financial institutions of this time. This paper examined the effectiveness of IMF’s economic reform programs from 2010-2014. For a constructive answer to this research question, this paper investigated to what extent the three leading arguments against IMF’s policy – self-defeating austerity measures, moral hazard problems and a one-size-fits-all approach - hold water in the case of Greece, Ireland and Portugal. Despite being related to the same event – the financial crisis of 2008 – Greece, Ireland and Portugal encountered unique problems that were not fully shared by all.
The assumption that the IMF economic reform programs of Greece, Portugal and Ireland encouraged investors and debtor countries to behave more risky, and therefore creating a moral hazard, is rejected. The governments of Portugal and Ireland did not pursue riskier fiscal policies during the duration of their IMF reform program. Greece did pursue deviating policies, however, this was due to an overlooked country variable of corruption within the Greek institutional framework. Furthermore, the IMF economic reform programs of the IMF appear to not have lead to investor moral hazard, as the declaration of the Greek IMF reform program remarkably increased the need for investors to concern themselves with the creditworthiness of Greece, Portugal and Ireland. However, it is noteworthy to mention that this specific assumption is not yet widely investigated in academic literature. The reason for this lack of information might be due to the fact that empirical research investigating moral hazard generates a number of fundamental difficulties.
The ending conclusion of this literature research is that it is of particular importance for the IMF to account for country specifics in designing economic reform programs. Under certain scenarios, fiscal policies that are well designed in an economic model may in practice not lead to desired outcomes. For an economic reform policy to be effective, country specifics such as the expected duration of the crisis, the economic conjuncture, economic fundamentals (e.g. country productivity and the flexibility of the labour market), the extent of corruption within the institutional framework and a country’s fiscal shape are important specifics to take into account.
With changing expectations about output, growth and the sensitivity of sovereign risk premia, it is quite difficult for any institution to assess and capture the impact of economic reform. However, in order to prevent prolonged recessions and humanitarian crises, this thesis suggests that IMF’s policy makers might consider a new policy mix in which more importance is given to country-specifics.
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