The International Monetary Fund (IMF) has a lot to say about Europe. The Old Continent is mired in anemic growth — it forecasts a meager advance of 1.1% for this year — and the pace of its reforms is exasperating for many. But on this occasion, the Fund’s economists have emphasized the response to the consequences of the Iran war. In their specific diagnosis on Europe released this Friday, they warn that governments “must avoid wastefulness” in designing public aid packages for households and businesses to mitigate the rising cost of fuels.
“Those responsible for economic policy face intense pressure: to act quickly, visibly, and for the benefit of all. Often, this results in adopting policies whose long-term adverse effects outweigh their short-term benefits,” warns Alfred Krammer, director of European affairs at the IMF. “Targeted support measures, on the other hand, are much more effective.”
The bombing of Tehran by the United States and Israel has strained global oil markets. The retaliation by Iran’s Revolutionary Guard has been to block the Strait of Hormuz, through which a fifth of the world’s crude oil and a quarter of the liquefied gas from Gulf countries passed. As a result, energy prices have soared and threaten to create a new inflationary spiral, the extent of which will depend on the duration of the war.
Krammer, a renowned German economist who will leave his position at the Fund this year, advises that “Europe’s response to this disruption should be governed by two imperatives: first, the adoption of a solid macroeconomic policy adapted to an environment characterized by frequent and unpredictable disruptions; and second, building resilience that does not involve wasting fiscal resources or interfering with market functioning.”
Many European countries have launched aid packages funded with public money to ease the blow to their economies. Spain, for example, approved a plan of 80 measures a few weeks ago, valued at about 5 billion, including VAT reductions on fuels, tax cuts on electricity, direct subsidies to transporters and fishermen, as well as other aid to the most affected sectors.
Against price caps
The Fund does not want past mistakes to be repeated. In the last energy crisis triggered by the Russian invasion of Ukraine, some countries approved ambitious aid packages and measures to cushion the blow of rising energy prices for citizens.
“The temptation is simply to prevent price increases through tariff caps, universal subsidies, or cuts in fuel taxes,” warns Krammer. “These are imprudent measures,” he emphasizes.
The Fund insists that some of the measures governments are approving to protect their citizens from the consequences of the Middle East conflict are general and not targeted at the most vulnerable households. “Untargeted support disproportionately benefits higher-income households, which consume more energy,” it warns. Generalized tax cuts on fuels, like the one approved by Spain, are an example of this.
Officials from the multilateral institution recall that during the 2022 energy and inflation crisis, European governments allocated on average 2.5% of their GDP to energy support packages. “Of that figure, more than two-thirds corresponded to untargeted measures,” Krammer recalls. IMF analyses estimate that compensating the 40% of lower-income households for the entire increase in energy costs would have required only 0.9% of GDP. “It is essential to get the design and implementation of monetary and fiscal policies right,” stresses the German economist.
The risk of prolonging measures
But the budgetary cost, the organization reminds, is only part of the problem. “Broad support also suppresses the price signal, the market incentive that drives people and businesses to reduce consumption, improve efficiency, and invest in alternatives,” the organization points out in its analysis of the European economy.
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But not only that. The institution created after World War II within the framework of the Bretton Woods conference to provide financial support to countries warns that many states that approved measures affecting fuel prices in 2022 “were forced to maintain costly measures” long after the crisis had passed. And it points out: “As countries plan their responses, they should not repeat the same costly mistakes. Broad and indefinite support measures are difficult to reverse and should be avoided.” The Fund advises that approved initiatives be accompanied by an end date “to ensure that budgetary resources are not wasted nor necessary investments displaced to strengthen Europe’s energy system and reduce its vulnerability to future shocks.”
Because, moreover, there are EU countries burdened with heavy debt accumulated in recent crises, from the Great Recession, the pandemic, the energy crisis due to the Ukraine war, the subsequent inflationary one, or the disruptions created by tariffs last year. “Countries with high debt levels and no fiscal space cannot afford to widen their deficits; any energy-related measure must be fully offset to avoid overburdening public finances that are already under pressure,” warns Krammer.
The Iran war occurs at a complex moment for Europe, as it reflects on the scope of reforms to recover lost competitiveness, strengthen the internal market, and advance capital union, among other pending issues.
“Europe’s choice is not between helping people now or carrying out reforms later, but between opting for costly measures that, in reality, do not reduce vulnerabilities; …and policies that, instead, protect the most exposed today while laying the foundations for a more resilient tomorrow,” Krammer proclaimed during the press conference to explain the IMF report on Europe.
Pending reforms
The document, presented within the framework of the International Monetary Fund and World Bank spring assembly, emphasizes Europe’s pending reform agenda. “Fully closing internal structural policy gaps and integrating labor and product markets to reach levels observed in the United States could raise European productivity by 20%, mobilizing up to 800 billion euros in additional private investment over ten years,” the institution’s analysts calculate.
Energy reform is one of those pending to be addressed by Brussels. In the current context, it gains importance. “Industrial energy prices in the EU currently roughly double their pre-2022 levels and are substantially higher than those in the US. This is a chronic disadvantage rooted in dependence on oil and gas imports, as well as in the fragmentation of energy markets,” the Europe document reflects.
The Fund applauds the progress made by EU member countries after the energy crisis caused by the Ukraine war. Many accelerated the adoption of energy from renewable sources to replace fossil fuels. “More than 50% of electricity generation in the EU now comes from low-carbon sources, substantially reducing exposure to oil price fluctuations.”
But it reminds that tasks remain: completing the energy single market, maintaining the EU emissions trading system, and accelerating cross-border interconnection of electricity grids, among others, to reduce energy costs and be more competitive.
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