Blog Post

Eurozone I: Bail-outs are no substitute for reforms

The Eurozone’s fiscal problems are triggering memories of policies used to deal with similar crises in the past. In years past we have seen the IMF and comparable institutions acting as crisis lenders offering official bail-outs to distressed sovereign borrowers. We have witnessed the monetisation of public debt by central banks, and the outright reduction […]

By: Date: April 5, 2012 Topic: European Macroeconomics & Governance

The Eurozone’s fiscal problems are triggering memories of policies used to deal with similar crises in the past. In years past we have seen the IMF and comparable institutions acting as crisis lenders offering official bail-outs to distressed sovereign borrowers. We have witnessed the monetisation of public debt by central banks, and the outright reduction of this debt, either uni-laterally with defaults or through negotiation. Other crises have ended in fiscal consolidation or reforms.

The current debate on the Eurozone’s fiscal problems is in my view excessively focused on official bail-outs, including the proposed massive purchases of government bonds by the European Central Bank (ECB), to the detriment of fiscal consolidation and reforms. We are reminded almost every day that either the bail-out efforts must be greatly expanded or the Euro will perish. The biased pressure being exerted reflects the advantages to be gained by certain parties, and the erroneous beliefs of others. As to the advantages to be gained, it is easy enough to understand why creditors should prefer bail-outs for the debtor countries. And many political leaders also welcome the way that official crisis lending can ease market pressures. The media, meanwhile, thrives on its role as bearer of bad news.

Then there are the mistaken beliefs that contribute to the bias towards bail-outs. The uninhibited use of metaphors like “contagion” or “domino effect” expresses the idea that, once disturbed financial markets become blind, violent and undiscriminating powers, so that once confidence in a given country is lost, all other governments are then in danger. On this basis, it must follow that only a formidable countervailing power like massive official intervention can break the presumed dynamics of the financial market. The widespread use of expressions like “a bazooka” or “it’s them or us” show just how prevalent is this manichean view of the behaviour of financial markets vis-à-vis the sovereigns.

But the financial markets, even though disturbed, are not blind. They are capable of distinguishing, however imperfectly and belatedly, between the macroeconomic situations of various countries. That’s why we can see the widening spreads on government bonds between Germany and other Nordic countries and those of the “problem” governments in the Eurozone.

Another related fallacy is the assumption that reforms, although necessary, can bring benefits only in the longer run. Under this assumption, the short-term solutions (i.e. the reduction in the sharply increased yields an affected government has to pay) are reduced to bail-outs. Yet this is a misleading representation of the available policy options because properly structured reforms have both short-term and longer-term effects. One does not need, for example, to wait for the completion of a pension reform to see short-term benefits in the shape of reduced yields on government bonds. Markets react to the credible announcement of reforms and their implementation.

A brief look at the countries that have been especially affected by the financial crisis, and that suffered a huge increase in the yields on their government bonds in 2009, is very illuminating. One group – Bulgaria, Estonia, Latvia and Lithuania (the BELL group) – saw a surge in these yields in 2009, followed by a sharp decline. Another group – Portugal, Ireland, Italy, Greece and Spain (the PIIGS) – registered divergent developments: the yields on Greece’s and Portugal’s bonds have surged and so far have not declined, while those of Ireland have displayed, at least until recently, the downward dynamics.

These differences can be largely explained by the differences in the extent and structure of reforms in all these countries, because proper reforms can produce confidence and growth. Official crisis lending can at best buy time to prepare reforms, and can help to stop the banking sector crisis. But it cannot act as a substitute for reform. And all bail-outs can create moral hazard as they weaken the incentives for reforms that will avoid bad polices in the future. Official crisis lending to some extent replaces the pressure from financial markets with pressure from experts and politicians of creditor nations. It is not difficult to see that the latter form of pressure is likely to have some unpleasant consequences for European cohesion, both in creditor and debtor countries.

Among the proposed Eurozone bail-outs, none has come under the spotlight as much as the idea of massive purchases of problem countries’ bonds by the ECB. Three rhetorical devices are being used to press for this option:

The concept of the “lender of last resort” is being stretched. It’s as though the central bank’s provision of liquidity to commercial banks was the same as its funding of governments;

The alternative to this proposed option is starkly presented as “catastrophe”

The policies of the US Federal Reserve System, the Bank of England and the Bank of Japan are referred to as though the mere reference to past examples is enough to prove the efficacy of ECB lending.

These rhetorical devices simply cannot be allowed to overshadow careful analysis of the various options. There has been surprisingly little comparative analysis of the effects of quantitative easing (QE) that involved massive purchases of government bonds in Japan, the U.S. and Britain. Yet what we know indicates that this operation is far from a free lunch because although potential benefits may appear in the short-run, costs and risks emerge later. In Japan, for example, QE could actually have contributed via very low interest rates to delays in reforms and the restructuring of the economy, thus weakening the longer-term economic growth and exacerbating fiscal distress. In the U.S., the slowdown during 2008-2011 was clearly not averted and QE has also contributed to the growth of asset bubbles in the world economy. As to Britain, economic growth is even slower but inflation much higher.

I believe that massive purchases of government bonds by the ECB would be an even worse kind of bail-out. It would exacerbate the problem of moral hazard as such purchases are potentially unlimited, and would also increase the risk of inflation along with other negative economic consequences. More generally, trust in the ECB as guardian of the Euro’s stability could be undermined, and the ECB would be granted a powerful new political position with politicians attempting to influence its purchase decisions. It would also further undermine the rule of law in the EU at a time when confidence in the way the treaties are respected is so crucial. The main solution to the Eurozone crisis lies in properly structured reforms in the affected countries. And experience clearly shows us that such reforms offer both a short-term and long-term solution.

This article first appeared in the Spring 2012 edition of Europe’s World.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read article
 

Blog Post

Will European Union recovery spending be enough to fill digital investment gaps?

The recovery facility will boost digital transformation, but questions remain whether it will be sufficient to achieve Europe’s digital ambitions.

By: Zsolt Darvas, J. Scott Marcus and Alkiviadis Tzaras Topic: European Macroeconomics & Governance, Innovation & Competition Policy Date: July 20, 2021
Read article Download PDF
 

Policy Contribution

A new direction for the European Union’s half-hearted semiconductor strategy

The EU needs a more targeted strategy to increase its presence in this strategic and thriving sector, building on its existing strengths, while accommodating its relatively low domestic needs.

By: Niclas Poitiers and Pauline Weil Topic: European Macroeconomics & Governance, Innovation & Competition Policy Date: July 15, 2021
Read article More by this author
 

Blog Post

Fit for 55 marks Europe’s climate moment of truth

With Fit for 55, Europe is the global first mover in turning a long-term net-zero goal into real-world policies, marking the entry of climate policy into the daily life of all citizens and businesses.

By: Simone Tagliapietra Topic: Energy & Climate, European Macroeconomics & Governance Date: July 14, 2021
Read article More on this topic
 

Blog Post

Fair vaccine access is a goal Europe cannot afford to miss – July update

European countries must do more to tackle the vaccine uptake gap. Vaccination data should be published at the maximum granularity level so researchers and local decision-makers can monitor progress.

By: Lionel Guetta-Jeanrenaud and Mario Mariniello Topic: European Macroeconomics & Governance Date: July 14, 2021
Read article More by this author
 

Blog Post

SPACs in the gap

Special-purpose acquisition vehicles could fill a gap in European equity markets and lure risk-averse investors off the sidelines.

By: Rebecca Christie Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: July 13, 2021
Read about event More on this topic
 

Upcoming Event

Sep
1
12:30

The EU recovery fund - state of play and outlook

Bruegel Annual Meetings, Day 1- In this session we will discuss the EU recovery fund, its state of play and outlook.

Speakers: Nadia Calviño, Karolina Ekholm and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic
 

Upcoming Event

Sep
2
10:00

Conversation on the recovery programmes

Bruegel Annual Meetings, Day 2- In this session, we discuss the recovery programmes.

Speakers: Maria Demertzis, Mehreen Khan and Tadeusz Kościński Topic: European Macroeconomics & Governance Location: Palais des Academies, Rue Ducale 1
Read about event
 

Upcoming Event

Sep
2
13:00

European banks: under global competitive pressure?

Bruegel Annual Meetings, Day 2 - European banks have lost stature and remain generally low-profitability, low-valuation in comparison to their global peers. Is that a problem? If so, what can EU policymakers do to address it?

Speakers: José Antonio Álvarez Álvarez, Mairead McGuinness and Nicolas Véron Topic: European Macroeconomics & Governance, Finance & Financial Regulation Location: Palais des Academies, Rue Ducale 1
Read about event More on this topic
 

Upcoming Event

Sep
2
15:45

Blending physical and virtual: shaping the new workplace

Bruegel Annual Meetings, Day 2 - This panel will cover the changes the COVID-19 pandemic made to our workplaces, and what to expect in the near future.

Speakers: Nicholas Bloom, Michael Froman, Mario Mariniello, Sara Matthieu and Luca Visentini Topic: European Macroeconomics & Governance Location: Academy Palace
Read about event More on this topic
 

Upcoming Event

Sep
3
09:00

The role of the EU's trade strategy for an inclusive and sustainable recovery

Bruegel Annual Meetings, Day 3 - We are delighted to welcome Valdis Dombrovskis, Executive Vice President of the European Commission for An Economy that Works for People to talk about Europe's trade strategy.

Speakers: Valdis Dombrovskis and Alicia García-Herrero Topic: European Macroeconomics & Governance Location: Palais des Academies, Rue Ducale 1
Read about event More on this topic
 

Upcoming Event

Sep
3
10:15

Conference on the Future of Europe: envisioning EU citizens engagement

Bruegel Annual Meetings, Day 3 - Panellists will discuss different options and what they may entail while revisiting the debates on the future of Europe at national and EU-level that have been conducted thus far.

Speakers: Caroline de Gruyter, Kalypso Nicolaïdis, Niclas Poitiers and György Szapáry Topic: European Macroeconomics & Governance Location: Palais des Academies, Rue Ducale 1
Read article More on this topic
 

Blog Post

A breakdown of EU countries’ post-pandemic green spending plans

An analysis of European Union countries’ recovery plans shows widely differing green spending priorities.

By: Klaas Lenaerts and Simone Tagliapietra Topic: European Macroeconomics & Governance Date: July 8, 2021
Load more posts