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The Portuguese bailout experiment: does the IMF learn? José Castro Caldas Centro de Estudos Sociais Coimbra University, Portugal Ana Costa Dinâmia-CET ISCTE-IUL, Portugal Paulo Coimbra Centro de Estudos Sociais Coimbra University, Portugal ECONOMIC EXPERTISE AND THE “REAL WORLD”, 6th CES International Seminar on the Foundations of Economics, Lisbon 28th September, 2015 “The crisis was a traumatic event during which we all had to question many cherished beliefs” “It would have been intellectually irresponsible, and politically unwise, to pretend that the crisis did not change our views about the way the economy works” Olivier Blanchard (Interview with Olivier Blanchard, IMF SURVEY, 31 AUGUST 2015) How deep was the belief revision? To what extent does it affect the IMF policies and practices? The Portuguese bailout as a field experiment The Portuguese bailout was a “field experiment” on how to “adjust” within a currency union? “… academic economics employs another method for advancing and testing its arguments. It is sometimes able to use the world as a laboratory” (Mitchell, 2005) The program: grounded on “scientific” (economic) “consensus views” (“common or widespread views of economists and policy makers”, (IMF, 2013a)) The architecture of the Portuguese bailout Internal devaluation (competitivene ss) Fiscal consolidation (public deficit and debt) Recapitalization of the banking system (stability of the financial system) The architecture of the Portuguese bailout: potential internal inconsistencies • Internal devaluation vs fiscal consolidation • Recessive effects of internal devaluation leads to less fiscal revenues and more public spending • Internal devaluation vs stability of financial system • Recessive effects of internal devaluation leads to more non-performing loans • Stability of financial system vs fiscal consolidation • In the absence of the access of banks to market solutions, recapitalization becomes a burden to the public budget • Fiscal consolidation vs stability of financial system • Recessive effects of fiscal consolidation leads to more non-performing loans Theoretical devices to overcoming internal inconsistencies (“scientific underpinings”) (Expansionary) Internal devaluation (Jaumotte F. and P. Sodsriwiboon, 2010) “internal devaluation”, mimics a real devaluation by reducing labor costs at home relative to trading partners. One instrument … lowering social security contributions financed by increasing VAT rates … Other instruments: reducing indexation of wages to inflation…. The (possibly) recessive effect of internal devaluation might be offset by the improvement of the external balance Theoretical devices to overcoming internal inconsistencies (“scientific underpinnings”) (Expansionary) Fiscal consolidation (Alesina and Perotti 1995, 1997; Alesina and Ardagna 1998, 2009, 2010; Alesina 2010; Barro 1974, Giavazzi and Pagano 1990): a fiscal adjustment may be expansionary if agents believe that the fiscal tightening generates a change in regime that “eliminates the need for larger, maybe much more disruptive adjustments in the future” [the wealth effect of expectations of lower taxes and lower interest rates in the future spurs present spending and investment]. The (possibly) recessive effect of internal devaluation might be offset by the expansionary effect of fiscal consolidation The Portuguese bailout as a field experiment: main surprises On the downside: “The current level of unemployment is higher than the historic relationships with output would suggest - in line with findings for balance sheet recessions” (fourth review, July 2012) “a larger-than-expected decline in investment” (fifth review, October 2012) “evidence of higher fiscal multipliers at work in Portugal” (fifth review, October 2012) … “recession is now set to be deeper than previously envisaged” (seventh review, June 2013) “The debt peak has been revised upward and is now set to have peaked below 129.5 percent of GDP in 2013 [115.3%, MoU]” (tenth review, February 2014) On the upside: “external position has improved much faster than expected” (fifth review, October 2012) IMF’s Staff reassessment (IMF 2013) Pre-crises "consensus view“ Reassessment Advanced Economies are not at risk The crisis exposed shortcomings in the euro area of a fiscal crises institutional architecture Multiple equilibria can emerge even at low levels of Financial markets discipline debt…, a smaller move in interest rates can shift government finances the sovereign from solvency to insolvency Central bank financing of the budget could undermine its independence and its control of inflation Central bank purchases of government debt have turned out to be useful to allow for a more gradual fiscal adjustment Discretionary fiscal policy has a limited role to play in fighting recessions Fiscal policy can ... have powerful effects on the economy in the short run IMF’s Staff reassessment (IMF 2013) Pre-crises "consensus view“ Reassessment Positive confidence effects can Most famous episodes of expansionary dominate the adverse mechanical contractions observed in Europe in the 1980s and effects of cuts in spending or 1990s were typically driven by external demand increases in revenues, and lead to more than by a surge in internal private demand on “expansionary fiscal consolidations" the back of confidence effects Frontloaded fiscal consolidation is the most effective approach to restoring the health of public finances Excessive frontloading can hurt growth to the point that it undermines social and political cohesion, and weakens rather than strengthens market confidence… frontloaded efforts may even be “self defeating,” and fail to achieve the consolidation targets in the short run due to negative growth... IMF’s Staff reassessment (IMF 2013) Pre-crises "consensus view“ Reassessment Expenditure-based consolidations The crisis has not offered conclusive lessons are more durable than revenueregarding the relative size of revenue and based ones government spending multipliers A large and protracted fiscal consolidation is likely to exacerbate income inequality Adjustment packages should be carefully designed to limit their negative social effects and improve their sustainability Keeping rules simple and Fiscal rules should be made more binding in good transparent helps enforcement via economic times, while allowing room to maneuver market discipline and public when the economy is weak pressure The Portuguese bailout as a field experiment: rhetorics of justification ‘Immunization against falsification’: ‘Strategic uncertainty’ - statements which are put on conditional manner cannot be wrong: “downside risks are significant, especially in the near term. The global market turmoil has heightened risk aversion, and funding problems could intensify, especially for banks.” (first review, September 2011) “Delayed fiscal implementation would undermine fiscal sustainability and confidence in the program.” (first review, September 2011) “Sustained social and political support is necessary for the comprehensive structural reform program. Strong vested interests could weaken reforms, or reform fatigue could set in” (first review, September 2011) “The intensification of euro area stress is a major risk factor to the attainment of the program’s key objectives.” (fourth review, July 2012) “the program’s success will also critically depend on improvements in the euro area economic environment and, more specifically, implementation of the steps being considered to strengthen the incomplete economic architecture of the currency union” (fifth review, October 2012) The Portuguese bailout as a field experiment: rhetorics of justification ‘Immunization against falsification’: ‘Strategic uncertainty’ - statements which are put on conditional manner cannot be wrong: “it remains unclear whether these [structural] reforms will prove adequate to engender the relative price adjustment required to raise competitiveness, employment, and potential growth rapidly enough to avoid adjustment through a drawn-out economic depression. The mission urged the authorities to continue exploring options to reduce production costs and compress mark-ups in the non-tradable sector and boost productivity.” (fifth review, October 2012) “some of the fiscal measures under the program could be challenged on constitutional grounds” (sixth review, January 2013) “migration of contingent liabilities from either state-owned enterprises or the private sector to the sovereign balance sheet remains a possibility” (sixth review, January 2013) The Portuguese bailout as a field experiment: rhetorics of justification ‘Immunization against falsification’: ‘Moving targets’ - economic indicators related to GDP performance, public deficit or debt are always under continuous adjustment: The bailout’s moving targets The bailout’s moving targets The bailout’s moving targets The bailout’s moving targets The bailout’s moving targets The Portuguese bailout as a field experiment: rhetorics of justification ‘Firewalling’ - (division of labor) within the IMF: Research (scope for exploration, and some expression of dissent) Policy (sticking to old habits) “The fact that the economic counsellor, or the research department, has a view on a particular topic does not move things very much by itself. An essential part of the job is to convince, or try to convince, the rest of the building, from management to the department desks, of that view. This can be hard work. To treat all countries in a consistent way, the Fund must have a corpus of beliefs, and this corpus is not easily changed. Ideas do not only need to be developed, they need to be sold to the rest of the building.” Olivier Blanchard (Interview with Olivier Blanchard, IMF SURVEY, 31 AUGUST 2015) The Portuguese bailout as a field experiment: rhetorics of justification ‘Accommodation’: ‘Materialization of risks’: “Social and political resistance to adjustment has heightened.” (fifth review, October 2012) “fiscal adjustment measures need to meet legal criteria that are at times difficult to anticipate” (sixth review, January 2013) … “the Constitutional Court in August ruled against a key public expenditure reform, effectively limiting the government’s scope to dismiss public sector employees. More recently, the Court also overturned labor reforms that had softened at the margin Portugal’s rigid employment protection rules for dismissing individual workers with permanent contracts.” (eight and ninth reviews, November 2013) “the fiscal gap … reflects a structural shift in the composition of output towards net exports.” (fifth review, October 2012) The Portuguese bailout as a field experiment: rhetorics of justification ‘Accommodation’: ‘Implementation errors’: “An alternative policy package to the fiscal devaluation earlier proposed by staff would considerably improve growth prospects and deliver a significant narrowing of external current account deficit in the near-term. Such a package could include deeper labor and product market reforms. In its absence, the program unavoidably relies on front loaded fiscal adjustment, increasing the risk of undermining growth in the near-term. … staff calls on the authorities to continue urgently exploring swiftly implementable alternatives to the fiscal devaluation that would tilt the relative price structure in the economy towards tradable activities, and reduce the risks of a purely demand-driven adjustment.” (third review, April 2012) ” The composition of the package, however, has changed: the yield from the horizontal measures (cross-cutting reforms of wages and pensions) has been reduced by almost a half (to 0.9 percent of GDP), with higher sector-specific savings—which mainly include targeted nonrenewals of fixed-term contracts and cuts in intermediate consumption—picking up the slack. Staff regretted this rebalancing, as implementation of horizontal measures is easier to enforce, monitor, and maintain.” (eight and ninth reviews, November 2013) The Portuguese bailout as a field experiment: rhetorics of justification ‘Accommodation’: ‘Modifications of conventions of quantification’: “Debt is now expected to peak at some 118.5 percent of GDP in 2013, some 3 percentage points higher than at the time of the third review. This is due to a lower nominal GDP path and reclassification of liabilities.” (fourth review, July 2012) “the upcoming introduction of the ESA 2010 accounting rules in 2014 may lead to the inclusion of certain state-owned enterprises that are currently outside the general government perimeter. “(eight and ninth reviews, November 2013) The Portuguese bailout as a field experiment: rhetorics of justification ‘Belief revision’: “recent experience, both within Portugal and elsewhere, suggests the need for caution in this regard—indeed Portugal’s output has been broadly in line with projections but the degree of fiscal adjustment has been lower, suggesting the possibility of a higher multiplier. Staff and the authorities therefore agreed to use a higher multiplier for the incremental fiscal adjustment being undertaken in 2013” (fifth review, October 2012) The Portuguese bailout as a field experiment What should count as evidence of the (un)success of the experiment is an ex post rationalization, disputed in the public space: “the evidence never seems complete enough to establish conclusive arguments” “how facts about the economy are produced” (Mitchell, 2005, p. 297) The Portuguese bailout as a field experiment ‘Partial belief revision’ - qualifications giving scope to conservation in policy: “The crisis has provided evidence that fiscal policy is an appropriate countercyclical policy tool… Nevertheless, a number of reservations regarding the use of discretionary fiscal policy tools remain valid…” (IMF, 2013) “The design of fiscal adjustment programs, and particularly the merit of frontloading, has returned to the forefront of the policy debate. [But] frontloading is more justifiable in countries under market pressure…” (IMF, 2013) “With respect to outside, the issue I have been struck by is how to indicate a change of views without triggering headlines of “mistakes,’’ “Fund incompetence,’’ and so on. Here, I am thinking of fiscal multipliers. The underestimation of the drag on output from fiscal consolidation was not a “mistake’’ in the way people think of mistakes, e.g., mixing up two cells in an excel sheet. It was based on a substantial amount of prior evidence, but evidence which turned out to be misleading in an environment where interest rates are close to zero and monetary policy cannot offset the negative effects of budget cuts. We got a lot of flak for admitting the underestimation, and I suspect we shall continue to get more flak in the future. But, at the same time, I believe that we, the Fund, substantially increased our credibility, and used better assumptions later on. It was painful, but it was useful.” Olivier Blanchard (Interview with Olivier Blanchard, IMF SURVEY, 31 AUGUST 2015) The Portuguese bailout as a field experiment The controversy is not only about a quarrel between different theoretical economic approaches … it is a political issue Credibility Trust - conditions for the exercise of justification ???? References Alesina, A. (2010), “Fiscal adjustments: lessons from recent history”, Prepared for the Ecofin meeting in Madrid April 15 2010. IMF (2013), “Reassessing the role and modalities of fiscal policy in advanced economies”, IMF policy paper, September 2013 Jaumotte F. and P. Sodsriwiboon (2010), “Current Account Imbalances in the Southern Euro Area”, IMF WP/10/139 The bailout’s excel equilibria The bailout’s moving (double?) criteria Sixth review: “[a]ll performance criteria for which data are available and structural benchmarks for the 6th review have been met” (IMF, 2013a1: 4) “the 2012 deficit would be about 1⁄4 percentage points of GDP higher than the [revised from 4,5%] target of 5 percent of GDP (including receipts from the sale of an airport concession)” (IMF, 2013a1: 7). Seventh review: “general government deficit [2012] for program purposes is estimated at 4.7 percent of GDP, smaller than the 5 percent foreseen at the time of the last review” (IMF, 2013b: 9). The ESA-definition deficit for 2012 is estimated at 6.4 percent of GDP, reflecting a number of one-off transactions that were were “excluded from the program deficit measure because they either are related to banking sector support or represent accounting reclassifications and not discretionary activity of the government (IMF, 2013b: 9)” The Portuguese bailout as a field experiment “On the Fund’s part, we are favorably considering that this be done in as timely and flexible a manner as possible: slowing the pace of fiscal adjustment where needed; focusing on measures rather than targets (…)” By Christine Lagarde, Managing Director, International Monetary Fund https://www.imf.org/external/np/speeches/2012/092412.htm