Daily Archives: September 26, 2011

The world markets expected concrete steps from Washington over the weekend on how governments would resolve the European crisis. They did not get it. Instead, the International Monetary Fund’s policy setting body asserted that the “Euro-area countries will do whatever is necessary to resolve the euro-area sovereign debt crisis”. Unfortunately, this statement seems to be based more on hope and prayer than on evidence.

Hope, unfortunately, cannot convince markets at times like these. With luck, Italy may get a credible government of national unity in the next few weeks, Spain will obtain a new government in November with a mandate for change, and Greece will do enough to avoid roiling the markets. But none of this can be relied upon.

So what needs to be done? First, eurozone banks have to be recapitalised. Second, enough funding has to be available so that Italy’s and Spain’s needs can be met over the next year or so, if the markets dry up. Third, Greece has to be managed in a way that does not infect the other periphery countries. All this requires financing – bank recapitalisation alone could require hundreds of billions of euros — but no new commitments were made in Washington.

In the short run, it is unlikely that Germany (and northern Europe in general) will put up more money. Germans are upset at being asked to support countries that do not seem to want to adjust – unlike Germany, which is competitive because it endured pain. It had years of low wage increases post-unification to absorb East Germany’s workers and deep labour market and pension reforms. The unwillingness of the Greek rich to pay taxes or of Italian parliamentarians to cut their own perks confirms their worst fears. At the same time, German politicians have done a poor job explaining to their people how much they have gained from being in the eurozone.

But we are where we are. A glimmer of hope in Washington was the European willingness to use the European financial stability facility imaginatively – as equity, or first loss cover. Clearly, some of the EFSF funds will have to go to recapitalise banks that cannot raise money from the markets. But of the rest, the amount that is not already committed to the periphery countries can be used to support borrowing by Italy and Spain.

There is, however, no consensus on how to do this. Some propose bringing the EFSF and the European Central Bank together, to leverage the EFSF’s funds. This is a recipe for trouble. Giving the ECB a quasi-fiscal role, even if it is somewhat insulated from losses, risks undermining its credibility. And if Italy is helped, Mario Draghi, the ECB’s incoming president, will be criticised no matter how dire the country’s needs.

Moreover, financing will have to be accompanied by stronger conditionality, and these institutions neither have the requisite expertise nor the distance from the countries at risk to apply appropriate conditions. Finally, both the EFSF and the ECB ultimately rely on the same eurozone resources for their financial strength. If markets start panicking about large eurozone defaults, they could question whether even a willing Germany has the necessary capacity to support the EFSF and ECB combined. Put differently, these institutions do not offer a credible, non-inflationary, outside source of strength.

The world has to recognise that the eurozone’s problems are too big to leave to eurozone countries alone to deal with. The world has a stake in their resolution. And it has an institution that can channel help, the IMF.

The IMF could set up a special vehicle along the lines of its current New Arrangements to Borrow, which would be capitalised by a first-loss layer from the EFSF and a second layer of the IMF’s own capital. This vehicle could borrow as needed from countries, including the US and China, as well as the financial markets. The special vehicle would offer large lines of credit to illiquid countries like Italy, with conditionality intended to help the countries resume borrowing from markets at reasonable cost.

Why a special vehicle? Because the amounts that need to be made available far exceed what IMF members usually have access to, and it is only right that if the eurozone seeks such amounts for its countries, it should bear a significant portion of any potential losses. At the same time, the IMF’s capital resources would back the vehicle if the eurozone-provided first loss buffer is eaten through, so the market will understand that there is strength from outside the eurozone that can be brought to bear.

The IMF should start taking the lead in managing the crisis rather than playing second fiddle. The eurozone should suppress any wounded pride, and not only acknowledge that it needs help but also provide quickly what it has already promised. The rest of the world should pitch in recognising that, unresolved, the crisis will spare no one. And what about Greece? Its debt will almost surely have to be restructured, but we must have the funding structures in place for Italy and Spain before any resolution. So while others have to step forward to do their bit, it is perhaps best if Greece stepped back from the brink.

The writer is professor of finance at the University of Chicago’s Booth School and author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.

Response by Simon Tilford

Europe doesn’t lack funds, just political will

The current strategy for addressing the crisis has failed and International Monetary Fund’s official support for that strategy is a threat to the organisation’s credibility. But it is unclear what purpose greater IMF involvement would serve. Increased funding, as suggested by Mr Rajan, would provide a stopgap, but not a solution to the key problem facing the indebted members of the eurozone: how will they generate economic growth?

IMF involvement, along the lines suggested – additional firepower, but more of the same in terms of policy prescriptions – will not provide a long-term solution to the euro crisis but would pose a further threat to the IMF’s credibility. Why, the emerging economies would rightly ask, is the IMF getting ever more involved in what is essentially an internal European political problem? The debtors and creditors are both members of a currency union, which also happens to be one of the wealthiest regions in the world. It is up to Europe to sort out this mess. It is not that Europeans lacks the firepower to deal with the crisis: they lack the political will to acknowledge the implications of their creation.

The eurozone needs debt mutualisation, not an IMF programme. But it also needs expansionary macroeconomic policies. There is no devaluation option for the likes of Spain and Italy, so if they are to cut their costs relative to Germany – without experiencing deflation and debt traps – German inflation will need to rise more quickly than the current projections of around one per cent. Aggressively expansionary fiscal policy (in those countries with the scope) and a massive programme of unsterilized bond purchases by the European Central Bank, would help arrest the slide in stagnation and debt deflation. The inflationary implications of such a strategy should not be feared. Without some inflation, the euro is not going to survive.

The writer is the chief economist at the Centre for European Reform, a London-based think-tank.

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