Longitude

IMF + ECB = OMT

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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