Last updated:November 30, 2011 6:32 pm
What the IMF should tell Europe
By Martin Wolf
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Can the International Monetary Fund save the eurozone? No. But it can help. The world, whose interests the IMF represents, has a stake in what happens. That gives the IMF the right to act. The question is how.
.
The world has reached a new and potentially even more devastating stage of the financial crisis that emerged in the advanced countries in the summer of 2007. Its epicentre is the eurozone. Unwilling to focus on the critically ill patient in front of it, eurozone leaders spend their time on designing an exercise regime to ensure he never has another heart attack. This is displacement activity.
.
In the view of many policymakers outside the eurozone, “they just do not get it”. Its members, above all Germany, the most important player, seem paralysed by domestic politics. That is not surprising, since politics remain national. But it also suggests that the project was premature at best, and unworkable at worst.
The latest economic outlook from the Organisation for Economic Co-operation and Development paints a grim picture. Even if catastrophe is avoided, the economy of the eurozone is forecast to stagnate next year. But, notes the OECD, “serious downside risks remain”. Moreover, “a large negative event would ... most likely send the OECD area as a whole into recession, with marked declines in the US and Japan, and prolonged and deep recession in the euro area”. Even emerging markets would suffer.
How bad might things become? The OECD explores a downside scenario that starts from a disorderly sovereign default in the eurozone. The outcomes of such events are unpredictable. But a default by a significant advanced country is likely to be a huge blow to confidence. Adverse effects would be felt directly – and via contagion – on both other sovereigns and financial institutions and markets. Other countries might be directly affected by the need to rescue their banks.
.
As economies weakened, fiscal positions would come under greater strain everywhere. A vicious downwards spiral in confidence and activity could emerge, with results far beyond the eurozone itself.
Exit from the eurozone would not necessarily follow a sovereign default. But that outcome could not be ruled out. The OECD uses apocalyptic language: “[T]he political fall-out would be dramatic and pressures for euro area exit could be intense ... Such turbulence in Europe, with the massive wealth destruction, bankruptcies and a collapse in confidence in European integration and co-operation would most likely result in a deep depression in both the exiting and remaining euro area countries as well as in the world economy.”
So what is to be done?
.
First, there needs to be a credible commitment to halt the contagion, for sovereigns, banks and markets. One possibility would be to guarantee financing of rollover of public debts and fiscal deficits for Italy, Spain and Belgium for 2012 and 2013. That would cost up to €1,000bn ($1,300bn), though even this might be insufficient to arrest the contagion, given its current extent (see chart). The resources needed could come from leveraging the European Financial Stability Facility or from the European Central Bank or both, with the former taking on the risk of loss and the ECB offering liquidity. In the longer term, a conditional eurobond may provide a workable answer, as John Muellbauer of Nuffield College, Oxford, has argued.
.
Second, the eurozone must have policies for economic growth and adjustment. Moreover, these cannot solely be on the supply side. The eurozone now clearly suffers from deficient aggregate demand.
.
Moreover, the more vulnerable countries will be unable to recover without restoration of their external competitiveness. Without that, they are doomed to a downward spiral of fiscal austerity, weakening demand, higher unemployment, poor fiscal outcomes and then even more austerity. In the years before the crisis, the financial surpluses of eurozone households were absorbed by the deficits of non-financial corporations and, to a lesser extent, of governments (see chart). After the crisis, companies’ deficits disappeared as profits fell and they slashed investment, leaving the burden of supporting demand on governments. If fiscal deficits are to disappear, households and companies have to spend more. Policy must help to achieve this.
.
Third, the eurozone also needs long-term reforms that address its true weaknesses. But these will fail if Germany insists that fiscal discipline is all that matters. Fiscal indiscipline did not cause this crisis.
.
Financial and broader private sector indiscipline, including by lenders in the core countries, was even more important. If the eurozone introduced reforms to make it work far better in future, rather than to continue as a machine for generating financial and fiscal insolvencies in weaker countries, confidence would return.
.
What role can the IMF play? Not much of one. It lacks the firepower: its total uncommitted usable resources are only about $440bn. True, it might raise more money from interested outside countries.
.
But it cannot hope to make up for the reluctance of the eurozone’s leading players to provide the support needed. Even if it had the resources, programmes for individual members would surely fail.
.
The only programme that would make sense would be one for the eurozone as a whole, since programmes for troubled countries would have to include a reasonable prospect for higher aggregate eurozone demand.
Without that, there is little chance for success by, say, Italy or Spain. Ireland can adjust as a small, open economy by displacing tradeable output elsewhere, where necessary. If Italy and Spain both tried to do this, they would be engaging in a costly and probably hopeless effort at beggaring their neighbours: costly, because the main way to do so would be to drive down wages via yet higher unemployment; and now hopeless, because the competitive advantage of Germany is so strong.
.
So how might the IMF help? Now is the time for what John Maynard Keynes called “ruthless truth-telling”. And what is the truth that it should tell? It is that the eurozone has a choice between bad and calamitous alternatives. The bad alternative is radical policies to promote adjustment, while warding off a wave of sovereign debt restructurings, financial crises and a true depression. The calamitous alternative is that depression, along with a break-up of the project. The IMF should speak up for the world’s interest in the less bad outcome. The eurozone alone can make the choice.
Can the International Monetary Fund save the eurozone? No. But it can help. The world, whose interests the IMF represents, has a stake in what happens. That gives the IMF the right to act. The question is how.
.
The world has reached a new and potentially even more devastating stage of the financial crisis that emerged in the advanced countries in the summer of 2007. Its epicentre is the eurozone. Unwilling to focus on the critically ill patient in front of it, eurozone leaders spend their time on designing an exercise regime to ensure he never has another heart attack. This is displacement activity.
.
In the view of many policymakers outside the eurozone, “they just do not get it”. Its members, above all Germany, the most important player, seem paralysed by domestic politics. That is not surprising, since politics remain national. But it also suggests that the project was premature at best, and unworkable at worst.
The latest economic outlook from the Organisation for Economic Co-operation and Development paints a grim picture. Even if catastrophe is avoided, the economy of the eurozone is forecast to stagnate next year. But, notes the OECD, “serious downside risks remain”. Moreover, “a large negative event would ... most likely send the OECD area as a whole into recession, with marked declines in the US and Japan, and prolonged and deep recession in the euro area”. Even emerging markets would suffer.
How bad might things become? The OECD explores a downside scenario that starts from a disorderly sovereign default in the eurozone. The outcomes of such events are unpredictable. But a default by a significant advanced country is likely to be a huge blow to confidence. Adverse effects would be felt directly – and via contagion – on both other sovereigns and financial institutions and markets. Other countries might be directly affected by the need to rescue their banks.
.
As economies weakened, fiscal positions would come under greater strain everywhere. A vicious downwards spiral in confidence and activity could emerge, with results far beyond the eurozone itself.
Exit from the eurozone would not necessarily follow a sovereign default. But that outcome could not be ruled out. The OECD uses apocalyptic language: “[T]he political fall-out would be dramatic and pressures for euro area exit could be intense ... Such turbulence in Europe, with the massive wealth destruction, bankruptcies and a collapse in confidence in European integration and co-operation would most likely result in a deep depression in both the exiting and remaining euro area countries as well as in the world economy.”
So what is to be done?
.
First, there needs to be a credible commitment to halt the contagion, for sovereigns, banks and markets. One possibility would be to guarantee financing of rollover of public debts and fiscal deficits for Italy, Spain and Belgium for 2012 and 2013. That would cost up to €1,000bn ($1,300bn), though even this might be insufficient to arrest the contagion, given its current extent (see chart). The resources needed could come from leveraging the European Financial Stability Facility or from the European Central Bank or both, with the former taking on the risk of loss and the ECB offering liquidity. In the longer term, a conditional eurobond may provide a workable answer, as John Muellbauer of Nuffield College, Oxford, has argued.
.
Second, the eurozone must have policies for economic growth and adjustment. Moreover, these cannot solely be on the supply side. The eurozone now clearly suffers from deficient aggregate demand.
.
Moreover, the more vulnerable countries will be unable to recover without restoration of their external competitiveness. Without that, they are doomed to a downward spiral of fiscal austerity, weakening demand, higher unemployment, poor fiscal outcomes and then even more austerity. In the years before the crisis, the financial surpluses of eurozone households were absorbed by the deficits of non-financial corporations and, to a lesser extent, of governments (see chart). After the crisis, companies’ deficits disappeared as profits fell and they slashed investment, leaving the burden of supporting demand on governments. If fiscal deficits are to disappear, households and companies have to spend more. Policy must help to achieve this.
.
Third, the eurozone also needs long-term reforms that address its true weaknesses. But these will fail if Germany insists that fiscal discipline is all that matters. Fiscal indiscipline did not cause this crisis.
.
Financial and broader private sector indiscipline, including by lenders in the core countries, was even more important. If the eurozone introduced reforms to make it work far better in future, rather than to continue as a machine for generating financial and fiscal insolvencies in weaker countries, confidence would return.
.
What role can the IMF play? Not much of one. It lacks the firepower: its total uncommitted usable resources are only about $440bn. True, it might raise more money from interested outside countries.
.
But it cannot hope to make up for the reluctance of the eurozone’s leading players to provide the support needed. Even if it had the resources, programmes for individual members would surely fail.
.
The only programme that would make sense would be one for the eurozone as a whole, since programmes for troubled countries would have to include a reasonable prospect for higher aggregate eurozone demand.
Without that, there is little chance for success by, say, Italy or Spain. Ireland can adjust as a small, open economy by displacing tradeable output elsewhere, where necessary. If Italy and Spain both tried to do this, they would be engaging in a costly and probably hopeless effort at beggaring their neighbours: costly, because the main way to do so would be to drive down wages via yet higher unemployment; and now hopeless, because the competitive advantage of Germany is so strong.
.
So how might the IMF help? Now is the time for what John Maynard Keynes called “ruthless truth-telling”. And what is the truth that it should tell? It is that the eurozone has a choice between bad and calamitous alternatives. The bad alternative is radical policies to promote adjustment, while warding off a wave of sovereign debt restructurings, financial crises and a true depression. The calamitous alternative is that depression, along with a break-up of the project. The IMF should speak up for the world’s interest in the less bad outcome. The eurozone alone can make the choice.
.
Copyright The Financial Times Limited 2011.
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