Drastic reforms are required if the eurozone is to recover comfortably
The seemingly never-ending debate over the eurozone’s fiscal problems has focused excessively on official bailouts, in particular the proposed purchase of government bonds on a massive scale by the European Central Bank. Indeed, we are warned almost daily – by the International Monetary Fund and others – that if bailout efforts are not greatly expanded, the euro will perish.
For some, this stance reflects the benefits that they would gain from such purchases; for others, it reflects mistaken beliefs. Creditors obviously support bailing out debtor countries to protect themselves. Many political leaders also welcome official crisis lending, which can ease market pressure on them. The media, meanwhile, always thrives on being the bearers of bad news.
Mistaken beliefs, on the other hand, are reflected in metaphors like “contagion” and “domino effect,” which imply that financial markets become blind, virulent, and indiscriminate when they are disturbed. Such terms provoke fear that, once confidence in any one country is lost, all others are in danger.
According to this logic, it follows that only a formidable countervailing power – such as massive official intervention – can halt the ravenous dynamics of financial markets. Widespread use of expressions like “aim a bazooka at the eurozone,” and “it’s them or us,” demonstrates a pervasive Manichean view of financial-market behaviour vis-à-vis governments.
But financial markets, even when agitated, are not blind. They are capable of distinguishing, however imperfectly and belatedly, between macroeconomic conditions in various countries. This is why interest-rate spreads within the eurozone have been widening, with Germany and the Nordic countries benefiting from lower borrowing costs and the “problem” countries being punished by a high-risk premium.
Another, related, fallacy is the assumption that reforms can reap benefits only in the long run. This misconception reduces the short-term solution to affected governments’ sharply higher borrowing costs to bailouts. In fact, properly structured reforms have both short- and long-term effects.
For example, one does not need to wait for the completion of a pension reform to see reduced yields on government bonds. Markets react to credible announcements of reforms, as well as to their implementation.
The countries that have been severely affected by the financial crisis illustrate the impact of reform. One group – Bulgaria, Estonia, Latvia, and Lithuania (BELL) – experienced a surge in yields on their government bonds in 2009, followed by a sharp decline. Another group – Portugal, Ireland, Italy, Greece, and Spain (PIIGS) – has had more mixed outcomes: yields have soared on Greek and Portuguese bonds, while Ireland’s were falling until recently.
These differences can be explained largely by the variations in the extent and structure of these countries’ reforms. Proper reforms can produce confidence and growth. Official crisis lending can buy time to prepare, and it can help to stop a banking-sector crisis, but it cannot substitute for reform.
All bailouts can create moral hazard, because they weaken the incentive to implement reforms that will avoid bad outcomes in the future. To some extent, official crisis lending replaces the pressure from financial markets with pressure from experts and creditor countries’ politicians.
Among the proposed eurozone bailouts, none has come under the spotlight as much as the idea that the ECB should purchase massive quantities of the problem countries’ bonds. Advocates of this approach stretch the concept of “lender of last resort” to suggest that providing liquidity to commercial banks is the same as funding governments. They also present the alternative to a bailout as a “catastrophe.” Finally, they cite similar policies implemented by the United States Federal Reserve, the Bank of England, and the Bank of Japan – as though merely mentioning past examples is evidence that ECB lending will work.
These rhetorical devices must not overshadow careful analysis of the various options. There has been surprisingly little comparative analysis of the effects of quantitative easing (QE) in Japan, the US, and Britain. Yet the evidence indicates that QE is no free lunch. Although it may offer potential benefits in the short run, costs and risks invariably emerge later.
In Japan, QE may have contributed to delays in economic reform and restructuring, thereby weakening longer-term economic growth and exacerbating fiscal distress. In the US, it failed to avert the slowdown during 2008-2011, while America’s 2011 inflation figures may turn out to be higher than they were in 2007. In Britain, economic growth is even slower, while inflation is much higher. And these countries’ QE has also fueled asset bubbles in the world economy.
Massive purchases of government bonds by the ECB would be the worst type of bailout. The fact that such purchases are potentially unlimited would exacerbate the problem of moral hazard. It would also increase the risk of inflation, along with other negative economic consequences.
Moreover, such a bailout could undermine the ECB’s trustworthiness as guardian of the euro’s stability, particularly in light of the new political power that it would obtain. And it would further undermine the rule of law in the EU at a time when confidence in the Union’s governing treaties is already fragile.
The key to resolving the eurozone crisis lies in properly structured reforms in the ailing countries. Indeed, experience shows that there is no substitute.
Leszek Balcerowicz, a former governor of the Central Bank of Poland, and Deputy Prime Minister and Finance Minister in the first post-communist Polish government, is currently Professor of Economics at the Warsaw School of Economics.
© Project Syndicate 1995–2012