Fiscal Austerity and the Fund: Examining Tensions within the Troika

Gabrielle Favorito

The European Crisis & Aftermath Professor Henning, School of International Service University Honors Spring 2014

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Abstract

Faced with exceptional circumstances in 2010, as Greece, Ireland, and other heavily indebted, stagnant economies plunged into sovereign debt crises, European authorities responded with the creation of a financial support mechanism known as the “Troika”, which consists of representatives from the International Monetary Fund (IMF), the (ECB), and the (EC). However, the Troika has been challenged both by internal discord over the magnitude and pace of fiscal austerity, as well as by external political pressures. The Troika’s divergence on the issue of fiscal austerity has perpetuated a crippling internal power struggle, which in turn has bred problems of policy confusion and questions of the Troika’s legitimacy, to the ultimate end of reduced efficiency and a slower, more painful European recovery. This research will use fiscal austerity, and the subsequent fiscal multiplier debate, as a microcosm for the underlying tensions of the Troika. Specifically, this paper will utilize a comparative analysis of the Troika bailouts in Greece and Ireland to highlight the Troika’s inherent friction over the issue of austerity, and the resulting policy inconsistencies. This analysis highlights how internal ideological, political, and structural constraints have produced “fatal flaws” for the Troika, which ultimately threaten the body’s future and assert the need for continued integration of the EMU.

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Fiscal Austerity and the Fund: Examining Tensions within the Troika

I. Introduction

As the crisis persists, the troubled national governments of Ireland, Greece, and

Portugal have been cast as puppets in the economic and political drama of the Troika, with the body’s three members jostling over who pulls the policy strings. Faced with exceptional circumstances in 2010, as Greece, Ireland, and other heavily indebted, stagnant economies plunged deeper into sovereign debt crises, European authorities responded with the creation of a financial support mechanism, known as the “Troika,” which consists of representatives from the

International Monetary Fund (IMF), the European Central Bank (ECB), and the European

Commission (EC). Currently, the Troika, whose chief mandate is to coordinate joint programs of bilateral loans under strict conditionality, has facilitated bailouts for Greece, Ireland, Portugal, and Cyprus. However, this body has proven to be controversial, with politicians and academics alike criticizing the Troika’s internal politics, restrictive policy remedies of fiscal austerity, debt restructuring, and structural reforms, as well as its perceived incompetence. Fiscal austerity, a central component of the Troika’s policy prescriptions, has also been a bitter source of contention for both the program countries and the Troika members, as the ECB continues to vocalize its support for strict fiscal austerity, while the IMF has wavered and begun to promote slower consolidation. The general weakness of the Eurozone recovery and the visible tensions within the Troika raise questions about the body’s internal politics, such as how have the Troika members expressed differences of opinion on the topic of fiscal austerity? And, how have these nuanced differences played out in policy, and in particular, in the bailouts of Greece and Ireland?

These questions ultimately speak to a larger issue: how do these tensions reflect the underlying Favorito 3 power relations among the IMF, EC, and ECB? Thus, the debate surrounding fiscal austerity can effectively serve as a litmus to understanding the complex, internal dynamics of the Troika.

i. Hypothesis

The Troika has been challenged both by internal discord surrounding controversial issues like the magnitude and pace of fiscal austerity, as well as by external political pressures. The

Troika’s underlying ideological differences between the more conservative ECB and the more lenient IMF have given rise to pervasive inconsistencies and weaknesses within Troika policies, especially in relation to Greece’s bailout programs, effectively allowing policymakers to

“scapegoat” the Troika for Europe’s troubles. The Troika’s divergence on the issue of fiscal austerity has perpetuated a crippling internal power struggle, which in turn has bred problems of policy confusion and questions of the Troika’s legitimacy, to the ultimate end of reduced efficiency and a slower, more painful European recovery.

ii. Research Design

In order to properly analyze the Troika’s internal dynamics using the contentious debate on fiscal austerity, this paper must first define the concept of fiscal consolidation. Fiscal austerity may take the form of expenditure-based policies, or reductions in government spending, revenue- based measures, such as raising taxes, or a combination both. However, this simple definition becomes complicated by reality, and specifically by fiscal tightening’s impact on growth and debt sustainability. Intrinsic to the discussion of fiscal austerity is the debate on the size of the fiscal multiplier, which measures the change in GDP that results from a change in tax and spending policy. While the Troika’s fiscal policies are predicated on the assumption that the fiscal multiplier is below 1, allowing for strict fiscal discipline like Greece’s “freezing of public Favorito 4 sector wages, partial cancellation of civil servant bonuses, and increases in indirect taxes,”1 this assumption has been increasingly contested, due in large part to Olivier Blanchard of the IMF’s work on the miscalculation of the Greek multiplier. This research will therefore use fiscal austerity, and the subsequent fiscal multiplier debate, as a microcosm for the underlying tensions of the Troika. Specifically, this paper will utilize a comparative analysis of the Troika programs in Greece and Ireland, as these two extreme cases highlight the Troika’s discord on the issue of austerity, and its resulting policy inconsistencies and varied levels of effectiveness. In addition, this analysis relies on an examination of the rhetoric employed by the IMF and ECB on the topic of fiscal austerity in working papers, speeches, and memos. Thus, the data encompasses both qualitative research, specifically economic and political rhetoric regarding fiscal reform, and quantitative analysis of the Eurozone crisis and the impact of the Troika programs.

II. Background

i. The “Troika”

As the Eurozone plunged into unsustainable debt, unemployment, and despair in 2010,

European authorities scrambled to form a crisis resolution mechanism, informally known as the

“Troika.” Lacking a European bailout institution, the Euro Summit assembled the Troika task force in March 2010 to coordinate bilateral, conditional loans to Greece and to stop the spread of debt disease across Europe. Comprised of representatives from the IMF, ECB, and EC, the

Troika is neither a “lending nor a decision-making institution,”2 but rather is a vehicle for evaluating, negotiating, and overseeing European bailouts. The fundamental purpose of the

Troika is to negotiate and monitor financial assistance between recipient governments and

1 Greece: Ex Post Evaluation of Exceptional Access under the 2010 Stand-By Arrangement, country report no.13/156 (Washington, DC: International Monetary Fund, 2013), 7. 2 Jean Pisani-Ferry, André Sapir, and Guntram Wolff, EU-IMF Assistance to Euro-Area Countries: An Early Assessment, no. 19 (Brussels, Belgium: Bruegel Blueprint Series, 2013), 23. Favorito 5 official lenders, namely the IMF and the ESM (European Stability Mechanism). The Troika assembles economic adjustment programs that involve conditionality on three key fronts: “fiscal measures aimed at reducing public debts and deficits; financial measures to restore the health of the financial sector; and structural reforms to enhance competitiveness.”3 Currently, the Troika has provided substantial assistance to Greece, Ireland, Portugal, and Cyprus, managing two bailout programs in Greece, valued at €274.5 billion total, a €85 billion bailout in Ireland, a €78 billion bailout in Portugal, and €10 billion worth of funds in Cyprus.4 However, in December

2013, Ireland became the first country to exit its Troika bailout program, finishing “clean” without any further assistance or a precautionary credit line.5

The Troika’s institutional structure is complex, both in theory and in practice. While the

IMF, ECB, and EC share responsibilities such as program negotiation and monitoring, they also each play a specific, individual role within the body, at least in theory. The IMF is the only

Troika member with lending capabilities, and has provided roughly a third of the funding for the bailout programs in Greece, Ireland, and Portugal, while the other two-thirds comes from

European partners.6 However, with the development of the ESM in 2012, much of the IMF’s lending responsibility has been transferred to this fledgling European institution. The EC acts as the “agent” of the within the Troika, negotiating on behalf of member states, which in turn provide the requisite funds to Troika programs. The EC must also protect the mandate of the

Maastricht Treaty and other EU regulations in Troika policies.7 The ECB has a more ambiguous, undefined role within the Troika, which is formally stated as working “in liaison” with the

3 André Sapir et al., The Troika and Financial Assistance in the Euro Area: Successes and Failures (, 2014), 5. 4 Ibid, 13. 5 Ibid, 57. 6 Ibid, 12. 7 Ibid, 7. Favorito 6

Commission to assess economic conditions; this vague mandate translates into general freedom for the ECB, which participates in policy discussions in order to defend ECB policies in the face of IMF recommendations. In theory, the Troika functions based on equitable power sharing rather than a formal division of labor, as much of the negotiation and policy responsibilities are handled jointly.8

However, the Troika has been increasingly criticized for its flawed internal structure and methods. In March 2014, the European Parliament responded to mounting criticism, which largely stemmed from those countries most negatively affected by the Troika’s harsh austerity, by conducting an investigation of the Troika’s operations and policies. The inquiry found that

Troika members “do not have equal responsibility and their decision-making structures came with different levels of accountability,”9 which underpins the Troika’s unpleasant reality of power struggles and internal discord. These power dynamics were visible during the Greek bailout, as the domineering influence of the ECB, in contrast to the “junior role of the IMF,”10 drove the program toward the ECB’s conservative stance; for example, the IMF faced

“institutional constraints,”11 in which the ECB and Eurozone governments ultimately overruled the IMF on issues like Greek debt restructuring, fearing the impact on European banks. In addition to internal challenges, external political pressures have helped to shape the Troika’s

“pro-austerity” stance, specifically due to the assertiveness and large lending capacity of

Germany, the Netherlands, and Finland, or the pro-austerity core. The ruling “ordoliberals” in

Germany firmly pressed for debt problems in Greece and Ireland to be resolved through

8 Sapir et al., The Troika and Financial Assistance, 26. 9 European Parliament, "Troika Helped to Avoid the Worst, but Flawed Structure Harmed Recovery," news release, March 13, 2014. 10 Alan Beattie, "Troika a Barrier to IMF New Fiscal Faith," Financial Times, October 11, 2012. 11 Ibid. Favorito 7 domestic cutbacks rather than through the use of communal debt instruments.12 The Troika has also faced criticism surrounding the effectiveness of its policies, especially in relation to the

Greek bailouts, as debt-to-GDP ratios continued to soar and output plummeted after the Troika’s intervention. Critiques of Troika policies highlight the body’s overoptimistic assumptions about fiscal adjustments, misunderstanding of the fiscal multiplier, and underestimation of administrative weaknesses.13 These questions about the Troika’s structural, ideological, and political constraints have cast doubts on the mechanism’s longevity.

ii. The IMF’s “Passive Role” in Europe

The IMF and Europe have a complex history, as Europe has both shaped IMF policy through its formal strength on the IMF Executive Board, but has also been the occasional recipient of IMF assistance. The IMF has therefore struggled as an institution to exert a leading role in European economic affairs, due to deep-rooted institutional and political constraints.

While the IMF has sought to maintain an active role in its European programs, the institution tends to be more passive, “acting principally as a buttress between national governments and the domestic political consequences of their economic policies.”14 Within the fund, Eurozone countries have the potential to directly or indirectly influence IMF austerity policies, as they account for 36.02 percent of the IMF Executive Board and routinely head the Fund’s leadership, which is currently run by former French Prime Minister, . During the Eurozone crisis, policymakers turned to the IMF as an “impartial arbiter of good economic policy,”15 in order to borrow IMF credibility for its structural and fiscal policy reforms and to “generate

12 The Politics of Austerity (Chapel Hill, NC: University of North Carolina at Chapel Hill European Union Center of Excellence, 2013), 4. 13 Sapir et al., The Troika and Financial Assistance, 5. 14 Chris Rogers, The IMF and European Economies: Crisis and Conditionality (New York, NY: Palgrave Macmillan, 2012), 149. 15 Ibid, 182. Favorito 8 politically acceptable discourses of blame in the wider Eurozone”16; however, in effect,

European monetary authorities were able to “launder preferences”17 through the financially- constrained Fund. Given the European power dynamics within the Fund and the ideological differences between the Fund and the EU, with the IMF leaning toward Keynesian countercyclical policies and the EU tending toward more orthodox policies, the IMF was clearly at a loss in terms of upholding its recommendations for the Eurozone.

iii. The Sovereign Debt Crisis in Greece

As the first program country of the Troika experiment, Greece displayed a unique set of vulnerabilities related to its fiscal and financial position, prompting international action to prevent contagion. Greece’s exceptional circumstances were the result of its toxic combination of high fiscal deficits, dependency on foreign debt, weak competitiveness, limited supply capacity, and poor business environment.18 Greece’s fiscal and structural imbalances were largely a result of an unstable “external credit-fueled boom”19 following Greece’s acceptance into the EMU. These weaknesses were exposed during the 2008 financial crisis, as its fiscal balance plunged to -15.5 percent of GDP, while its public debt rose to 129.7 percent of GDP in

2009.20 Greece was also dealt a blow to its credibility in 2009 when the Papandreou government revealed that the previous administration had misreported official deficit statistics, which caused

Greece’s credit rating to plummet and market volatility to rise. Greece’s problems continued to spiral after its credit was downgraded, with spreads rising exorbitantly and banks losing access to wholesale funding. As market confidence plummeted while fears of a potential default soared in

16 Rogers, The IMF and European Economies: Crisis and Conditionality, 175. 17 Ibid. 18 Greece: Staff Report on Request for Stand-By Agreement, country report no.10/110 (Washington, DC: International Monetary Fund, 2010), 4. 19Greece: 2013 Article IV Consultation, country report no.13/154 (Washington, DC: International Monetary Fund, 2013), 4. 20 Sapir et al., The Troika and Financial Assistance, 23. Favorito 9

2010, Greece turned to the international community for financial assistance, prompting the first of two Troika bailout programs in the country, designed to shrink Greece’s debt and stimulate its long-term competitiveness and growth.

iv. The Financial Crisis in Ireland

As a result of a devastating boom-bust cycle in the Irish property market, coinciding with the 2008 global financial meltdown, Ireland found itself in the midst of a triple crisis, far from its former glory as the “Celtic Tiger.” In the early 2000s, low interest rates, large capital inflows, tax incentives for home purchases, and poor banking regulation produced a massive, credit-driven property boom in Ireland. However, Ireland’s economic prosperity proved to be unstable due to the country’s dependence on the housing market, which subsequently collapsed in 2008. The bursting of the property bubble caused public revenue to collapse, unemployment to rise significantly from 4.6 percent in 2007 to 14.3 percent in 2011, and property prices to plummet.

Ireland quickly descended into a recession, as the country experienced falling domestic consumption, a rising fiscal deficit, and a pull back of bank lending, producing a credit crunch and a mounting fiscal crisis.21 In addition, the cost of the government’s efforts to recapitalize the banking system in 2009 only exacerbated the structural budget deficit, plunging the country deeper into debt. As confidence in the Irish government’s ability to fix the banking system, restore economic growth, and repair fiscal stability wavered, the Irish financial system collapsed and bond yields on Irish debt skyrocketed to an unsustainable 9 percent.22 Ultimately, the Irish government was unable to fund the deficit through capital markets and turned to the Troika for assistance in November 2010; Ireland received an €85 billion bailout package with strict conditionality, which aimed to bolster the crippled financial sector, put public finances on a

21 Philip Lane, "The Irish Crisis," The World Financial Review, September 25, 2011. Sapir et al., The Troika and Financial Assistance, 31. 22 Lane, "The Irish Crisis." Favorito 10 sustainable path, and encourage growth and a return to global capital markets. However, the case study of Ireland is unique because the country has regained its fiscal autonomy after successfully exiting its bailout program in December 2013.23

III. Literature Review

The current discourse on fiscal austerity is rooted in a broader debate on the necessity and effectiveness of fiscal rules in the EMU. Ideological tensions related to fiscal policy in the

Eurozone resurfaced in 2009 as the EMU’s weak periphery, specifically Greece, Spain and

Portugal, plunged into sovereign debt crises.24 The Troika, with the ECB at the helm, pushed fiscal austerity as the fundamental policy remedy to excessive debt accumulation, in an effort to comply with underlying fiscal rules. These rules, established in the Stability and Growth Pact

(SGP) and later strengthened in the Six-Pack and Two-Pack reforms, serve as the fiscal framework of Eurozone policy. Thus, the current debate on the policy response to the Eurozone crisis can be linked to a much larger conflict between fiscal rules and discretion. In order to understand the context in which fiscal austerity is deemed essential, this literature review will explore the theoretical and practical debates on fiscal rules in the Eurozone.

Before one can examine the discourse on fiscal discipline, one must first define the concept of fiscal rules. The conventional argument for fiscal rules, which impose constraints on fiscal policies related to debt, budget balance, structural balance, expenditures, and revenue, focuses on the need to force fiscal discipline in order to maintain low deficits in the short-run and to counter incentives for excessive public debt in the long-run.25 Within a currency union like the

EMU, monetary authorities are fundamentally concerned with moral hazard spurring fiscal recklessness, as well as the potential spillover of fiscal excesses to the entire monetary union in

23 Karl Whelan, "Ireland Exits Bailout with No Backstop: A Good News Story?," Forbes, November 15, 2013. 24 "Central Government Debt, Total (% of GDP)," World Bank. 25 Allen Schick, "The Role of Fiscal Rules in Budgeting," OECD Journal on Budgeting 3, no. 3 (2003): 9. Favorito 11 terms of interest rates and output.26 Fiscal rules have thus been promoted as a means to

“constrain individual countries from running fiscal policies inconsistent with the needs of

…monetary union.”27 The fiscal framework of the EU is enshrined in the Stability and Growth

Pact (SGP), which sets up two key fiscal rules: a fiscal deficit of no more than 3 percent of GDP and a 60 percent GDP debt ceiling. The “Six-Pack” and “Two-Pack” reforms attempted to strengthen the EU’s fiscal structure following the financial crisis, instituting greater fiscal surveillance, a debt reduction rule, and growth benchmarks. However, the issue of fiscal rules has sparked controversy, with opponents of these rules citing the need for independent fiscal policies in order to adjust to shocks and criticizing the overall weaknesses of the SGP in relation to budget flexibility, investment, and sustainability.

A dominant ideology within economic and political literature is the pro-fiscal rules camp, which asserts that fiscal rules and their practical application in the SGP are critical for the

EMU’s success. While both sides of the debate recognize that fiscal rules come at a cost to sovereignty and fiscal independence, supporters of the EMU’s fiscal rules claim that the benefits outweigh the potential negative consequences in terms of output gaps and reduced budgetary flexibility. Artis and Winkler outline this tradeoff stating, “the preservation of credibility to produce low and stable inflation may require limiting the flexible use of economic policy instruments to stabilize output and employment.”28 Authors including Bini-Smaghi, Beetsma, and Buti promote definitive fiscal rules as the price to be paid for a common currency; they argue that fiscal rules are needed to prevent moral hazard, fiscal indiscipline, cross-border spillovers, and pressure on the ECB to bailout indebted states, as well as to promote interest rate

26 Andrea Schaechter et al., Fiscal Rules in Response to the Crisis - Toward the “‘Next-Generation’” Rules: A New Dataset (Washington, DC: International Monetary Fund, 2012), 5. 27 Ibid, 12. 28 Michael Artis and Bernhard Winkler, The Stability Pact: Safeguarding the Credibility of the European Central Bank, report no. 1688 (London: Center for Economic Policy Research, 1997), i. Favorito 12 convergence and policy coordination.29 Beetsma’s paper lays out the theoretical defense of fiscal rules, asserting that rules prevent excessive fiscal deficits, which jeopardize the stability of the monetary union due to their upward pressure on the world real interest rate, negative spillover effects, and greater moral hazard.30 Both Beetsma and Bini-Smaghi differentiate their arguments by claiming that capital markets and interest rates alone are ineffective in ensuring fiscal discipline. Bini-Smaghi, Padao-Schioppa, and Papadia focus their defense of fiscal rules on the idea that market discipline cannot sufficiently rein in the Eurozone’s public finances; citing evidence from the Latin American debt crisis, the authors analyze the issue of budgetary discipline and conclude that “binding rules” are needed to maintain monetary stability.31 Buti and

Franco specifically defend the EU fiscal rules laid out in the SGP, centering their argument on the volatility of the EU’s decentralized fiscal framework. Calling the EMU without fiscal rules

“a leap in the dark,”32 Buti and Franco claim that the highly decentralized fiscal setting perpetuates moral hazard, and therefore, creates a compelling need for well-defined, simple, flexible, and consistent fiscal rules. While Buti and Franco find fault with the implementation and structure of the SGP, specifically calling for a “rebalancing of sticks and carrots”33 and enhanced enforcement mechanisms, they also firmly defend the theoretical basis of fiscal rules.

However, fiscal rules remain a polarizing issue, as many critics find fault with the practical application and implementation of these rules in the Eurozone. In general, critics fault fiscal rules, and specifically the SGP, for reducing budgetary flexibility, discouraging public

29 Barry Eichengreen et al., "The Stability Pact: More than a Minor Nuisance?," Economic Policy 13, no. 26 (April 1998): 71. 30 Roel Beetsma, "Does EMU Need a Stability Pact?," in The Stability and Growth Pact: The Architecture of Fiscal Policy in EMU, ed. Anne Brunila, Marco Buti, and Daniele Franco (n.p.: Palgrave Macmillan, 2001), 28-29. 31 Lorenzo Bini-Smaghi, Tommaso Padoa-Schioppa, and Francesco Papadia, The Transition to EMU in the Maastricht Treaty, report no. 194 (Princeton University International Finance Section, 1994), 27. 32 Buti, Marco, Slyvester Eijffinger, and Daniele Franco, Revisiting the Stability and Growth Pact: Grand Design or Internal Adjustment?, report no. 3692 (London: Center for Economic Policy Research, 2003), 28. 33 Ibid, 22. Favorito 13 investment, and undermining the EMU’s long-term stability.34 In the case of a currency union without monetary independence, flexible fiscal policies are seen as crucial tools for responding to shocks. Authors such as Feldstein, Eichengreen, and Wyplosz contest that the decentralized fiscal structure of the EMU makes the SGP’s rules unsuitable and ineffective; for these critics, the costs of rigid fiscal rules are greater than the perceived benefits. While Feldstein agrees that fiscal rules can counter moral hazard, he finds that the current EMU is unfit to implement these rules effectively. Feldstein, Franco, and Balassone argue that the European institutional structure, with its centralized monetary policy, but decentralized fiscal policies, “creates a very strong bias toward large chronic fiscal deficits and rising ratios of debt to GDP.”35 In addition to this asymmetry between supranational fiscal rules and decentralized national fiscal structures, the EU also requires fiscal independence because it lacks adjustment mechanisms related to labor mobility and wage flexibility.36 Feldstein proposes the need for more targeted rules, specifically in relation to subnational governments. Eichengreen and Wyplosz conclude that the justification for the SGP’s fiscal rules is weak and promote alternative measures like better public debt management and banking regulation. These authors argue that the SGP is more than a “minor nuisance”37 because it cripples automatic stabilizers and diverts efforts away from fundamental reforms needed to increase output. Fiscal rules and the SGP “suppress the symptoms without eradicating the disease”38 of Europe’s decentralized national fiscal procedures. Ultimately, while the ideological battle continues to rage between the supporters and critics of fiscal rules, the fiscal framework of the EMU indicates that the advocates currently dominate the debate.

34 Buti, Eijffinger, and Franco, Revisiting the Stability and Growth Pact, i. 35 Martin Feldstein, The Euro and the Stability Pact, report no. 11249 (Cambridge, MA: National Bureau of Economic Research, 2005). Fabrizio Balassone and Daniele Franco, Fiscal Federalism and the Stability and Growth Pact: A Difficult Union (Banca d'Italia, 1999). 36 Feldstein, The Euro and the Stability Pact, 4. 37 Eichengreen et al., "The Stability Pact: More," 69. 38 Ibid, 76. Favorito 14

While there is an abundance of literature exploring the theoretical debate on the EMU’s fiscal rules, there is a lack of understanding about how these fiscal rules have played a role in the current crisis, and specifically, how they relate to the fiscal austerity employed by the Troika.

Thus, this paper seeks to address the gap in the literature regarding how the SGP’s fiscal rules have helped to shape the Troika’s fiscal austerity policies, and the overall effectiveness of this austerity within the Troika’s bailout programs.

IV. Analysis

i. Conflicting Ideologies

As a result of its historically conservative views, its narrow mandate for price stability, and persistent pressure from heads of state for fiscal discipline, the ECB has championed fiscal austerity as the cornerstone of the Eurozone rescue. Within the Troika, the ECB has developed a reputation for its hawkish defense of fiscal consolidation, or the “permanent reduction in the fiscal authority’s target for the long-run debt-to-output ratio.”39 The ECB has relied heavily on historical and theoretical arguments for fiscal discipline in its push for strict austerity measures, as ECB documents stress that “the need for fiscal discipline is even stronger in a monetary union, such as the euro area…there are no longer national monetary and exchange rate policies to respond to country-specific shocks.”40 The ECB’s fiscal concerns are rooted in the need to reduce exorbitant European debt, in order to reach reference values laid out in the Maastricht

Treaty. Thus, the ECB has pushed specifically for expenditure-based fiscal consolidation to be

“implemented without delay”41 in countries under the excessive debt procedure, in order to correct high deficits and reach balanced budgets by 2016. The ECB has defended the use of

39 Günter Coenen, Matthias Mohr, and Roland Straub, Fiscal Consolidation in the Euro Area: Long-Run Benefits and Short-Run Costs, report no. 902 (n.p.: European Central Bank, 2008), 15. 40 "Fiscal Policies," European Central Bank. 41 Philipp Rother, Ludger Schuknecht, and Jürgen Stark, The Benefits of Fiscal Consolidation in Uncharted Waters, occasional paper no. 121 (Frankfurt: European Central Bank, 2010), 6. Favorito 15 austerity measures during the crisis, emphasizing the long-term benefits of fiscal consolidation, while downplaying its short-term adjustment costs to output and employment. The ECB has praised austerity for reducing the Eurozone’s high fiscal deficits and structural balance, which fell from 41.2 percent in 2009 to 11.4 percent in 2013, while largely ignoring fiscal adjustment’s detrimental effects on the real economy; for example, with the advent of its bailout program,

Greece has witnessed a rise in unemployment to 25 percent, a 30 percent collapse of real domestic demand, and a 20 percent fall in real GDP from 2010 to 2013.42 ECB officials have merely stated that they recognize adjustments may “strain social cohesion,”43 but that Europe must remain committed to austerity because “‘any sort of wavering on this is counterproductive.

It would mean higher interest rates’ for government debt.”44 Despite widespread criticism and national protests against austerity measures, the ECB continues its strong rhetorical campaign in defense of fiscal consolidation, as evidenced by Joerg Asmussen’s statement, “delaying fiscal consolidation is no free lunch. It means higher debt levels. And this has real costs in the euro area where public debts are already very high."45 The ECB has also countered criticisms of

Greece’s “front-loaded,” rapid-pace consolidation, asserting that there is no alternative to austerity due to the grand scale of required adjustments.

Like the ECB, the EC has advocated for strong fiscal consolidation. While often described as a kind of “middle-ground” institution between the ECB and the IMF, the

Commission, under the influence of strong creditor states like Germany, tended to lean toward the conservative views of the ECB in the onset of the crisis. The EC’s motivations are rooted in

42 Sapir et al., The Troika and Financial Assistance, 24. 43 Marco Buti and Nicolas Carnot, The Debate on Fiscal Policy in Europe: Beyond the Austerity Myth, issue brief no. 20 (European Commission, 2013), 4. 44 Brian Blackstone, "ECB Chief Defends Austerity Measures," Wall Street Journal, December 17, 2012. 45 Marc Jones and Huw Jones, "IMF, ECB Square off in Europe Austerity Debate," Reuters (London), April 25, 2013. Favorito 16 its mandate to protect the fiscal rules enshrined in the SGP, without any specific responsibilities related to growth and employment. However, the Commission has proven to be more flexible than the Central Bank as the crisis continues to unfold, slightly relaxing its views on austerity and giving countries like Spain and France more time to meet their fiscal targets in 2013.46 While maintaining its public support for the current austerity approach, representatives from the EC have recently published works that undermine this position, such as a paper that supports

Blanchard’s conclusions about the underestimation of the fiscal multiplier.47 Representing the interests of the Eurogroup, the Commission is more sensitive to the political and social ramifications of austerity, thus highlighting their more flexible ideological position.

In contrast to the ECB’s avid promotion of fiscal consolidation, the IMF has displayed a more skeptical, lenient view of fiscal austerity in the Eurozone. In 2010, in solidarity with the

ECB and the EC, the IMF promoted the critical need for fiscal consolidation, as “the goal should be to present a comprehensive strategy aimed at lowering government debt over time to levels regarded as prudent and to keep debt at those levels during the following decades.”48 However, the IMF deviated slightly from the ECB by emphasizing the crucial need for simultaneous structural reforms, focusing on a more balanced program of austerity and growth-inducing measures. IMF Managing Director Christine Lagarde highlighted the need for prudent rather than rapid austerity in a 2012 speech, in which she stated, “we know that fiscal austerity holds back growth, and the effects are worse in downturns. So the right pace is essential—and the right pace will be country specific. The right mix between cutting spending and raising revenue is also

46 Martin Sandbu, "Former Adviser Attacks European Commission over Austerity," Financial Times (London), April 7, 2014. 47 Jan in't Veld, Fiscal Consolidations and Spillovers in the Euro Area Periphery and Core, Economic Papers 506 (Brussels: European Commission, 2013). 48 Carlo Cottarelli, Strategies for Fiscal Consolidation in the Post-Crisis World (Washington, DC: International Monetary Fund, 2010), 11. Favorito 17 critical.”49 An IMF paper on fiscal consolidation concluded that the conventional mix of austerity instruments will continue to significantly reduce output in Europe’s “periphery” countries, estimating a reduction of about 1.2 percent of GDP in the periphery by 2018. This paper therefore considered the benefits of alternative structural product market and labor market reforms, in an effort to improve competitiveness and labor entry. The IMF found that the positive impact of structural reforms could offset consolidation’s negative effects on GDP in core countries by 2018, and several years later in the periphery.50 In addition, the IMF has urged caution in the speed of fiscal consolidation, emphasizing medium-term adjustments and criticizing unsustainable front-loaded programs, like that of Greece. While recognizing that some countries must front-load austerity when market access is limited, the IMF has advised a general slowing of fiscal adjustments in response to the negative external environment, as tightening during a downturn could “exacerbate rather than alleviate market tensions through its negative impact on growth.”51 Thus, the IMF has effectively countered the ECB’s aggressive promotion of fiscal austerity at all costs.

ii. Troika Divergence over the Greek Bailout

While the ECB and the IMF struggled to rectify their differing views on the scope and pace of austerity in 2010, the Troika’s financial assistance program in Greece largely reflected the stricter fiscal austerity stance of the ECB. As part of the Troika’s bailout, Greece committed itself to an ambitious fiscal consolidation program of 11 percent of GDP over three years, ultimately aiming to lower the government deficit below the 3 percent target by 2014 (from 13.9

49 Christine Lagarde, “Anchoring Stability to Sustain Higher and Better Growth,” (speech, University of Zurich, Zurich, May 7, 2012), International Monetary Fund. 50 Derek Anderson, Benjamin Hunt, and Stephen Snudden, Fiscal Consolidation in the Euro Area: How Much Can Structural Reforms Ease the Pain? (Washington, DC: International Monetary Fund, 2013), 3. 51 International Monetary Fund, "As Downside Risks Rise, Fiscal Policy Has To Walk a Narrow Path," Fiscal Monitor update, January 24, 2012, 5. Favorito 18 percent in 2009).52 Greece’s fiscal austerity included a reduction in government spending by 5.25 percent of GDP, which was to be achieved by reducing and freezing pensions and wages for three years, as well as by eliminating bonuses; the government also made plans to raise the value-added tax as well as taxes on luxury items to make up an additional 4 percent of GDP.

However, this austerity had a crippling effect on the real Greek economy, as unemployment climbed to 26 percent, while domestic demand, output, investment, and exports plummeted.53

Yet, even as Greece struggled to meet its fiscal austerity targets and faced widespread public protest, the ECB maintained its firm stance on the necessity of strict, short-term fiscal consolidation. For example, in 2012, Greece was forced to implement additional austerity measures in its second bailout program, which included cutting private-sector wages, firing

15,000 public sector workers, and cutting €3 billion in government-spending in 2012 alone.54

Despite early signs of progress, the Greek bailout program ultimately struggled in the face of an adverse external environment, insufficient policy implementation, and inherent Troika policy flaws. While Greece’s macroeconomic situation, defined by heightened market anxiety, plummeting investment, and stagnant exports, exacerbated its weak program performance, the

Troika’s poorly-crafted and poorly-executed policies were “aggravating factors” in the early stages of the bailout. Greece was substantially set back by inadequate program implementation, in sharp contrast to Ireland, as the Troika “overestimated the effectiveness of the Greek government machinery to follow through on policy recommendations and priorities,”55 highlighting the Troika’s problem with overoptimistic assumptions. In addition, Greece’s program floundered due to inconsistent policy objectives, “attempting to re-gain price

52 "Europe and IMF Agree €110 Billion Financing Plan with Greece," IMF Survey Magazine, May 2, 2010. 53 Sapir et al., The Troika and Financial Assistance, 24. 54 Alkman Granitsas, Matina Stevis, and Nektaria Stamouli, "Greece Passes Sweeping Cuts," Wall Street Journal, February 13, 2012. 55 Sapir et al., The Troika and Financial Assistance, 26. Favorito 19 competitiveness while, at the same time, trying to reduce the debt-to-nominal GDP ratios”56; these competing goals speak to larger debates within the Troika on issues such as policy composition and the fiscal multiplier. The Greek bailout program also raised serious questions about “excessive” austerity causing worse-than-expected GDP performance. While the Troika remains embroiled in the “battle of the boxes” over the fiscal multiplier, the IMF and other economic actors have contested that “a less rapid fiscal adjustment may have helped to preserve some of the productive capacity that, in the course of the adjustment, was destroyed.”57 The

Greek case clearly illustrates how the flawed Troika body has struggled to coordinate the individual agendas of the involved national, regional, and global actors.

iii. Ireland’s “Success Story”

While the Greek tragedy of harsh austerity and rising debt persists, European policymakers have highlighted Ireland’s clean exit from its bailout program in as evidence of the

Troika’s potential success. Unlike the rapid, front-loaded program imposed on Greece, Ireland’s fiscal consolidation featured a more moderate, balanced pace, which was favorable to future growth and market reintegration. While Greece’s bailout design was impeded by internal Troika discord, such as in relation to debt restructuring and the fiscal multiplier debate, Ireland’s program highlighted the potential success stemming from consensus among the Troika members.

While Greece, burdened with a much larger initial debt, higher initial deficit, and little savings from pre-crisis growth, faced a harsh fiscal adjustment that averaged 5.2 percent of GDP from

2010 to 2012, Ireland faced a moderate fiscal tightening of 1.7 percent of GDP over the same time period, due to its lower financing needs and higher cash reserves. This divergence in fiscal targets has produced long-standing consequences for growth and debt sustainability, with Ireland

56 Sapir et al., The Troika and Financial Assistance, 27. 57 Ibid. Favorito 20 witnessing a resurgence of growth and lower bond yields at less than 4 percent as early as 2011, due to stronger bond demand and overall confidence in Irish debt.58 In sharp contrast, Greece’s harsh fiscal consolidation has had a much more negative effect on GDP, as the economy has contracted by 20 percent since 2008 and unemployment has soared to 26 percent, underpinned by lingering doubts about Greek debt sustainability.59 Thus, while Ireland’s improved export sector and external competitiveness are credited in part for renewed growth, fiscal “headwinds” and the fiscal multiplier can explain a larger portion of the gap between Irish and Greek progress; for example, Greece’s fiscal multiplier is estimated at 1.5, while Ireland’s multiplier hovers around 0.5, which may explain why Greece has witnessed larger output gaps in the face of austerity.60 The IMF has avidly defended the moderate pace of the Irish bailout, stating that a faster rate would have produced “grave mistakes” because investors are responsive to growth.61

This defense slightly contrasts the position of the ECB, who Irish officials believe prioritized austerity over growth-inducing reforms due to their predominant concern with “getting their money back.”62

However, the proclaimed success of the Irish program, maintained by European policymakers and the ECB to assert the validity of their austerity policies, is largely contested.

Due primarily to fiscal consolidation efforts, Ireland exited its bailout program in 2013 with a reduced fiscal deficit of 7.4 percent of GDP and a structural primary deficit of ½ percent of GDP, which marked a decline of 10 percentage points since the start of the crisis.63 Concluding IMF

58 Jeffrey Anderson, Ireland and Greece: A Tale of Two Fiscal Adjustments (Washington, DC: Institute of International Finance, 2013), 2. 59 Ibid, 1. 60 Ibid, 6. 61 "Ireland’s Economy Back from the Brink, but Continued Progress Needed," IMF Survey, December 19, 2013. 62 Richard Tol, "Financieel Dagblad on Ireland," The Irish Economy (blog), entry posted April 23, 2013. 63 Ireland: Twelfth Review under the Extended Arrangement and Proposal for Post-Program Monitoring, country report no.13/366 (Washington, DC: International Monetary Fund, 2013), 6. Favorito 21 and EC reports praised Ireland for its strong fiscal adjustments, steady implementation of structural and financial reforms such as improved banking supervision, and strong external sector performance, which compensated for austerity’s negative effects on output. However, the Troika members have recognized that problems persist for Ireland after its “clean” exit, including high private sector debt, widespread unemployment, weak domestic demand, and poor growth forecasts; Ireland’s public debt remains high at 124 percent of GDP, signifying the need for continued fiscal consolidation, a reduction of the private sector debt “overhang,” and a strengthening of bank profitability. Irish growth has also proved to be a point of contention within the Troika, as the IMF has cautioned Ireland about its high unemployment of 12.8 percent as well as its declining growth, which turned negative in 2013 due to the expiration of patents

(“patent cliff”) in the pharmaceutical industry and slow global trade recovery.64 The EC’s concluding report on the Irish program also recognized modest growth, but remained optimistic about future output and employment, emphasizing ambiguity surrounding Ireland’s growth composition and suggesting a more positive growth estimate of 2.0 percent for 2014.65 While

Ireland’s financial sector and growth performance remain highly vulnerable, the Irish exit from its bailout program without a precautionary credit line stands as a lone victory for the Troika.

iv. Tensions over the Fiscal Multiplier

While much of the Troika’s public discord relates to issues surrounding fiscal austerity’s composition and implementation, the Troika has entered in another key debate regarding austerity, related to the size of the fiscal multiplier. The fiscal multiplier, which represents “the

István Székely and Martin Larch, eds., Economic Adjustment Programme for Ireland: Autumn 2013 Review, occasional paper 167 (Brussels: European Commission, 2013). 64 Ireland: Twelfth Review under the Extended Arrangement, 5. 65 Székely and Larch, Economic Adjustment Programme for Ireland, 20. Favorito 22 change in GDP following a 1 percent of GDP change in fiscal deficits,”66 was estimated at about

0.5 in the Troika’s economic models, indicating that austerity measures would reduce growth by only a moderate amount. However, in 2012, two separate IMF documents, the IMF’s WEO report and a study performed by chief economist Olivier Blanchard, concluded that potential forecast errors underestimated the fiscal multiplier and that austerity may have had more negative effects than previously assumed. Blanchard found that “actual multipliers were substantially above 1 early in the crisis,”67 indicating that a cut in the deficit would reduce growth by more than the fiscal correction itself, with serious consequences for growth, employment, and debt sustainability.68 Blanchard attributed this underestimation of the fiscal multiplier to exceptional Eurozone circumstances, such as interest rates at the zero-lower bound, a poorly functioning financial system, and Euro-wide synchronization of adjustment policies.

Blanchard’s findings would suggest the need for a reevaluation of the Troika’s austerity policies; however, the EC and the ECB have rejected the IMF’s claims and asserted the validity of the fiscal multipliers employed. The EC and the ECB advised caution in “using past forecast errors as indirect evidence for the true size of the fiscal consolidation multiplier,”69 as it is difficult to separate the effects of fiscal consolidation from other factors related to the sovereign debt crisis, which could also explain the forecast errors. This fiscal multiplier debate is particularly contentious because of the inherent challenge of assessing the precise level of the fiscal multiplier “at a time of effective structural break in the economy and erratic market

66 European Economic Forecast: Autumn 2012 (European Commission, 2012), 41. 67 Olivier Blanchard and Daniel Leigh, Growth Forecast Errors and Fiscal Multipliers (Washington, DC: International Monetary Fund, 2013), 20. 68 Alessandro Leipold, "IMF Spotlight on Balance between Adjustment and Growth," Il Sole 24 Ore (), January 12, 2013. 69 European Economic Forecast: Autumn 2012, 44. Favorito 23 sentiment.”70 In the wake of this debate, the Troika has continued to promote fiscal austerity, but has slightly eased the conditions of fiscal tightening within the Eurozone.

V. Conclusions

While the Troika continues to spar over issues like the size of the fiscal multiplier and attribution for the Greek failure, the body’s underlying ideological, political, and institutional tensions have risen to the surface. The comparative study of Ireland and Greece highlights how the Troika’s discord over issues such as the pace and scale of fiscal adjustment has produced policy inconsistencies, which have fundamentally impeded European growth and recovery.

While Ireland and Greece represent two extreme cases of the Eurozone crisis, as Ireland had a lower initial debt and deficit, a much stronger export sector, and faithfully implemented Troika policies, the pace of fiscal consolidation was a key contributing factor to the divergent outcomes of these two programs. The ideological and rhetorical debates between the conservative ECB and the more lenient IMF regarding the pace and magnitude of fiscal austerity, as well as the size of the fiscal multiplier, draw out key conclusions about the Troika’s fatal flaws, the IMF’s struggle for credibility, and the uncertain future of the Troika in Europe.

i. Fatal Flaws of the “Troika”

As an informal crisis resolution mechanism, the Troika lacks traditional oversight, governance, and regulatory structures, which has contributed to concerns about the body’s legitimacy and effectiveness. The European Parliament’s comprehensive investigation of the

Troika’s operations and policies highlighted the group’s pervasive ideological, structural, and external constraints, described in the previous analysis. The Parliament found that despite achieving their ultimate goal and preventing European debt contagion, the Troika was impeded by ideological differences and lack of unity, its “one-size-fits-all” policy approach, and its

70 Sapir et al., The Troika and Financial Assistance, 27. Favorito 24 overoptimistic assumptions regarding growth and cross-border spillover effects.71 In relation to organizational challenges, the IMF and the EC have displayed deep-seated ideological differences, reflected in their divergent priorities of internal devaluation and fiscal consolidation, respectively. These differences have resulted in inconsistent policy goals and public discord among the three members over issues such as debt restructuring and the size of the fiscal multiplier, which has effectively hurt the Troika’s credibility and allowed policymakers to use the divided body as a scapegoat. The report also recognized the existence of power imbalances within the Troika, stressing that the IMF’s minor lending of a third of the bailout funds has put the institution in a minority position, while the ambiguous “in liaison” mandate of the ECB has allowed the central bank to act autonomously and without real oversight in the Troika. The

European Parliament condemned the Troika’s “one-size-fits-all” policy approach, as well as its disregard for alleviating the negative economic and social impacts of its programs’ fiscal adjustments. The Parliament subsequently proposed radical changes to the flawed Troika structure, including making the ECB a “silent observer” and creating a permanent European

Monetary Fund, which would combine the financial means of the ECB and the human resources of the EC. Ultimately, the European Parliament’s inquiry raised questions about the future of the existing Troika, and highlighted how this complex institutional experiment has been undermined by ideology, politics, and external pressures.

ii. The IMF’s Struggle for Credibility

As a “junior member” of the Troika, the IMF has struggled to be heard in the context of the Eurozone crisis, which is indicative of a larger struggle for IMF credibility in the 21st

71 Report on the Enquiry on the Role and Operations of the Troika (ECB, Commission and IMF) with Regard to the Euro Area Programme Countries, 2013/2277(INI) (Strasbourg: European Parliament, 2014).

Favorito 25 century. At the onset of the crisis, the fundamentally incomplete EMU lacked a functioning crisis resolution mechanism, prompting policymakers to involve the IMF, and its decades of experience with financial crises, as a Troika member. While the Eurozone sought to borrow the long-standing credibility of the IMF in its bailout programs, the IMF had faced continuous criticism since the 1998 Asian financial crisis, specifically in relation to IMF conditionality and its detrimental economic and political effects.72 The IMF’s involvement in the Eurozone crisis has raised further questions about the credibility and future role of the institution in the modern era. The Eurozone crisis, with its overwhelming imbalances and need for financial regulation, has pushed the IMF back to the center of global finance as a key economic institution. While toward the end of the 20th century, the IMF increasingly worked within the developing world,

Europe’s desire for IMF funds, expertise, and credibility during the current crisis revitalized the role of the IMF in the developed world. As a result of this renewed global commitment and a higher lending capacity, the IMF has developed into a stronger, financially equipped institution, with more refined analytical tools and capabilities.73 However, the overwhelming influence of

European politics and the ECB’s assertiveness in designing and monitoring the bailout programs has effectively undermined the IMF’s credibility as an independent actor. IMF passivity was clearly on display during the Greek crisis, as the IMF was forced to negotiate its recommendations, as well as debate its estimates of debt and growth figures, with the Greek national government, influential states like Germany, and its Troika partners, each with their own

“parochial interests.”74 Deeply entrenched in the economic recovery of Europe’s periphery, yet

72 Robert Litan, Does the IMF Have a Future? What Should It Be?(Washington, DC: Brookings Institution, 1998). 73 International: IMF Faces Worsening Global Conditions (Oxford, UK: Oxford Analytica Daily Brief Service, 2013). 74 Howard Schneider, "IMF Got Tangled, Then Got Tough, on Greece," Washington Post, March 6, 2012. Favorito 26 consistently overruled or challenged by its European partners, the IMF has been dealt a blow to its credibility as the Troika’s most “junior member.”

iii. Final Thoughts on the Troika

While the Troika has proven to be a flawed institutional experiment, undermined by ideological discord, political pressures, and structural ambiguity, there is currently no viable alternative in place. Thus, while policymakers continue to “scapegoat” the Troika and its austerity for Europe’s troubles, Europe must continue to work within this failed mechanism.

However, sweeping claims about the overall effectiveness of the Troika’s policies and the body’s sustainability are largely futile, as several Troika programs and the Eurozone crisis are still underway. With Portugal’s impending exit from its program and the recent debate on a potential third Greek bailout, no concrete conclusions can be drawn about the viability of the Troika. The

Troika’s future thus remains uncertain, particularly in the face of Europe’s growing commitment to the ESM. Beyond the scope of this analysis, more qualitative research is needed to understand the role of the “middle-ground” EC within the Troika, how external factors like European and

U.S. political pressures shaped the Troika’s decisions, and the extent of Troika discord surrounding policies like debt restructuring. Ultimately, despite the controversy surrounding the

Troika’s internal dynamics and harsh policy prescriptions, the body has achieved marked success in relation to reducing excessive fiscal deficits, preventing European contagion, and putting countries like Ireland back on the path to growth.

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