Blog Post

Is the ECB sacrificing reforms on the altar of inflation?

This blog post explores whether the European Central Bank (ECB)'s large programme of sovereign bonds purchases (QE) could slow down reform efforts in the coming months and therefore, in boosting short-term demand, risk inadvertently shrinking long-term supply. 

By: Date: March 13, 2015 Topic: European Macroeconomics & Governance

Roughly one month ago, Mario Draghi announced that the European Central Bank (ECB) would activate a large programme of sovereign bonds purchases (QE), in an effort to re-anchor euro area inflation expectations to the 2% target. In the run up to that decision one of the main naysayer arguments was that, by doing so, the ECB was reducing pressure on governments to engage in painful, but necessary, structural reforms (German Council of Economic Experts, 2014). At the time, the argument was dismissed on the grounds that the ECB’s mandate is to control inflation, not foster reform efforts. The question however remains as to whether QE will slow down reform efforts in the coming months and therefore, in boosting short-term demand, risks inadvertently shrinking long-term supply.

In order to explore the determinants of reform efforts in advanced economies, and in the euro area more specifically, I analysed a highly balanced panel dataset of the OECD’s reform responsiveness rate[1], an indicator of whether wide-ranging reform packages were adopted. The data is available for all 34 OECD members, with biannual frequency, for the time span 2007-2014. The technical results are illustrated in Table 1 (at the bottom).

The main findings can be summarised as follows:

1. Countries under an IMF programme significantly step up structural reform efforts. This should come as no surprise, given the carrot-and-stick structure of IMF lending, involving frequent reviews that need to be approved in order to access the Fund’s payment tranches[2].

2. Countries with a high unemployment rate tend to implement significantly more reforms. This result is in line with what Williamson (1993) calls the “crisis hypothesis”: the public perception of a crisis is needed to create the conditions under which it is politically possible to undertake extensive policy reforms. As we see in Figure 1 (below), the relationship does not seem to be dictated by the programme countries.

Figure 1. Relationship between reform effort and unemployment rate

Source: OECD, Bruegel calculations

3.  Advanced economies tend to implement fewer reforms when under financial market pressure and the relationship becomes insignificant when zooming in on the euro area. In OECD countries, the statistical relationship between financial market pressure – proxied by the 10-year government bond yields – and reforms seems to be at best U-shaped: as financial market pressure mounts, governments are less likely to implement reforms[3]. However, above a certain threshold, this effect might be reversed. Evidence for this non-linear relationship does not seem to be highly compelling, judging from a joint reading on the two panels in Figure 2 (below). When looking at euro area countries only, any effect of financial market stress on reforms disappears. As can be seen in Figure 2 (rhs), although there seems to be a positive correlation between financial market stress and reform efforts in the euro area, this is driven by IMF programme countries, which in any case have typically lost financial market access.

Figure 2. Relationship between reform effort and market stress

Source: OECD, Bruegel calculations

Although it is true that this analysis lends itself to clear methodological challenges, some concerns can be immediately addressed.

First, the results do not seem to be dictated by extreme outliers. Models 6 and 7 in Table 1 (below) show how financial market stress continues to be a non-significant determinant of reform efforts in the euro area even when Greece is excluded (as a country which underwent an economic collapse), or when Spain is excluded (as the other country where unemployment soared to unprecedented levels). High unemployment rates continue to be significantly associated with reform drive.

Second, and possibly more concerning, is the potential for reverse causality. The claim here would be that what the analysis above is capturing is not that high unemployment rates lead the electorate to push governments to reform, but rather that reforms have short-term negative effects on the economy and therefore lead to temporarily higher unemployment.

Although reverse causality cannot be directly tackled in this setting, I attempt to take this problem into account by controlling for GDP growth. If a problem of reverse causality was at play, then the relationship between reform implementation and GDP growth should be negative. However, Table 2 shows how in all specifications the coefficient of GDP growth remains insignificant.

Actually, when looking at non euro area countries only (model 4), the relationship is positive and significant. This is illustrated further in Figure 3 and 4 (below), which shows how GDP growth (lhs) displays no clear relationship with reform implementation, whereas unemployment (rhs) does.

Figure 3 and 4. Relationship between reform effort and GDP growth (lhs) and unemployment rate (rhs)

Source: OECD, Bruegel calculations

Note: Greece excluded as an extreme outlier. Results however are only reinforced by its inclusion.

Two main conclusions can be drawn from this short analysis. First, the crisis mechanism put in place by the euro area, composed of the ESM + OMT, seems to be well equipped to step up reform efforts and hence boost competitiveness in crisis countries. However, as seen lately in Greece, programmes risk producing popular backlashes and can therefore not be seen as the sustainable way to foster competitiveness in the euro area on a long-term basis. As such, alternative mechanisms of euro area economic governance should be devised, as argued recently, inter alia, by Sapir and Wolff (2015).

Second, the ECB’s bond buying programme seems unlikely to lead to a disproportionate setback in reform efforts in stressed countries. In particular, economies affected by large unemployment rates are expected to continue facing pressure from the electorates to enact reforms and should do so benefiting of the temporary boost in aggregate demand offered by a weaker euro and lower oil prices (as I have argued here).

Fostering structural reforms is not only outside the ECB’s mandate, but apparently also outside its direct influence. It is for euro area governments, and EU institutions, to ensure that reforms continue progressing in the months to come, laying the foundations of sustainable long-term growth.

Table 1. Panel regression results

Source: OECD, Bruegel calculations

Technical Notes

IMF is a dummy variable taking value 1 when an IMF programme is in place, 0 otherwise.
Source: IMF

Unemployment rate (avg) is the average monthly unemployment rate over each two-year period.
Source: OECD

GDP growth (avg) is the average yearly growth in real GDP for each country over each two-year period.
Source: OECD

Peak yield is the maximum value of the quarterly 10-year government bond yield experienced by each country over each two-year period. All regressions allow for the possibility of a non-linear relationship between the yields and reform efforts (hence the inclusion of peak yield-squared). Main results are confirmed when allowing only for a linear fit.
Source: OECD

All regressions are run using country fixed effects, to control for time-invariant country-specific characteristics like political systems, cultural characteristics, etc.

All regressions (but Model 1) include time fixed effects to control for uniform shocks affecting all countries in a given year. Results seem however to be all but weakened by their exclusion.

All specifications adopt clustered standard errors at country level, hence allowing for heteroskedasticity.


[1] The reform responsiveness rate indicator is based on a scoring system in which recommendations set in the previous year’s issue of Going for Growth take a value of one if “significant” action is taken and zero if not. An action is considered as “significant” if the associated reform addresses the underlying policy recommendation and if it is actually legislated: announced reforms are not taken into account (OECD, 2015).

[2] This result is confirmed in all specifications, except model 4 (OECD non-EA only). However, there are reasons to suppose this result is driven by the poor reform track record of Iceland, which is the only non-EA OECD country to have undergone an IMF programme over the period 2007-2014.

[3] This result can be rationalised by the fact that, as yields increase, governments are likely to be pushed to consolidate their finances. OECD (2006) finds that budget consolidation appears to retard structural reforms, possibly reflecting the corresponding call on political capital.


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.

View comments
Read article More on this topic

Blog Post

Whose (fiscal) debt is it anyway?

The authors map how much fiscal debt is in the hands of domestic and foreign holders in the euro area. While the market for debt was much more international prior to the crisis, this trend has since been reversed. At the same time, central banks have become important holders of fiscal debt.

By: Maria Demertzis and David Pichler Topic: European Macroeconomics & Governance Date: February 6, 2019
Read article More on this topic

Blog Post

The higher yield on Italian government securities is becoming a burden for the real economy

Francesco Papadia and Inês Gonçalves Raposo have recently written on Italian fiscal policy and the increase in the spread between Italian (BTP) and German (Bund) government. Since then, two developments have taken place: one good, and one bad. This blog post reviews them.

By: Francesco Papadia and Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: February 5, 2019
Read article More on this topic More by this author

Opinion

The EU needs a Brexit endgame

Britain and the EU must try to preserve the longstanding economic, political, and security links and, despite the last 31 months spent arguing over Brexit, they should try to follow a new path toward convergence.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: January 31, 2019
Read article Download PDF More on this topic

Policy Contribution

Equity finance and capital market integration in Europe

Facilitating the financing of European companies through external equity is a central ambition of European Union financial regulation, including in the European Commission’s capital markets union agenda. Against this background, the authors examine the present use of external equity by EU companies, the roles of listings on public markets, and the regulatory impediments in national laws. They assess to what extent EU market integration has overcome the crucial obstacle of shallow local capital markets.

By: Inês Goncalves Raposo and Alexander Lehmann Topic: Finance & Financial Regulation Date: January 17, 2019
Read article More by this author

Blog Post

What 2019 could bring: A look inside the crystal ball

Economic performance prospects in Europe, the US and Asia in 2019. We start off by reviewing commentaries and predictions about the euro zone, which many commentators expect to perform below potential as uncertainties continue to dampen a still robust recovery.

By: Michael Baltensperger Topic: European Macroeconomics & Governance, Global Economics & Governance Date: January 14, 2019
Read article More by this author

Podcast

Podcast

Director’s cut: Wrapping up 2018

With 2018 drawing to a close, and the dawn of 2019 imminent, Bruegel's scholars reflect on the economic policy developments we can expect in the new year – one that brings with it the additional uncertainty of European elections.

By: The Sound of Economics Topic: Energy & Climate, European Macroeconomics & Governance, Finance & Financial Regulation, Global Economics & Governance, Innovation & Competition Policy Date: December 20, 2018
Read article Download PDF More on this topic

Policy Contribution

The euro as an international currency

Is a more important international role for the euro worth pursuing? What measures would achieve this result, if it is worth pursuing?

By: Konstantinos Efstathiou and Francesco Papadia Topic: European Macroeconomics & Governance Date: December 18, 2018
Read article More on this topic

Blog Post

Does the Eurogroup's reform of the ESM toolkit represent real progress?

The deal reached on euro-zone reform at the December 4th Eurogroup is not ground-breaking. However, it contains a number of incremental but potentially key technical reforms – in particular regarding the ESM toolkit. Some constitute an improvement, but there are also clear flaws that should be corrected at the Euro Summit.

By: Grégory Claeys and Antoine Mathieu Collin Topic: European Macroeconomics & Governance Date: December 13, 2018
Read article Download PDF More on this topic More by this author

Policy Contribution

Forecast errors and monetary policy normalisation in the euro area

What did we learn from the recent monetary policy normalisation experiences of Sweden, the United States and the United Kingdom? Zsolt Darvas consider the lessons and analyse the European Central Bank’s forecasting track record and possible factors that might explain the forecast errors.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: December 13, 2018
Read article More on this topic More by this author

Podcast

Podcast

Deep Focus: Consequences of European Central Bank forecasting errors

Bruegel senior scholar Zsolt Darvas speaks about his review of systematic errors in ECB forecasting, in another instalment of the Deep Focus podcast on 'The Sound of Economics' channel

By: The Sound of Economics Date: December 12, 2018
Read article Download PDF More on this topic More by this author

Essay / Lecture

A new statistical system for the European Union

Quality statistics are essential to economic policy. In this essay, Andreas Georgiou demonstrates the existence of fundamental risks inherent in the European Statistical System. He argues that a paradigm shift is necessary and sets out a model that would deliver the quality statistics the European Union needs.

By: Andreas Georgiou Topic: European Macroeconomics & Governance Date: December 12, 2018
Read article More on this topic

Blog Post

Providing funding in resolution: Unfinished business even after Eurogroup agreement on EMU reform

The recent Eurogroup agreement on euro-area reform foresees a greater role for the European Stability Mechanism (ESM) as a backstop to the banking union. This is a welcome step forward but important issues remain. We assess the agreement on how to fund banks after resolution and the best way to organise the fiscal role in liquidity provisioning to banks. We argue that the bank resolution framework will remain incomplete and its gaps could result in important financial instabilities.

By: Maria Demertzis and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: December 7, 2018
Load more posts