European leaders will meet on Thursday and Friday for yet another ‘historic’ summit at which the fate of Europe is said to hang in the balance. Yet it is clear that this will not be the last meeting convened to deal with the financial crisis.
If public previews from France and Germany are a guide, there will be commitments to assuring fiscal discipline in Europe and establishing common crisis resolution mechanisms. There will also be much celebration of commitments made by Italy, and a strong political reaffirmation of the permanence of the monetary union. All of this is necessary and desirable, but the world economy will remain on edge.
Given that Europe is the largest single component of the global economy, the rest of the world has a stake in helping to avoid major financial accidents. It also has a stake in aiding continued growth in Europe and ensuring that the European financial system supports investment around the world – particularly as cross-border European bank lending dwarfs that of banks from any other region.
Now is also a historic juncture for the International Monetary Fund. The focus of the policy response to the crisis must now shift from Brussels and Frankfurt to the IMF’s boardroom.
From the problems of the UK and Italy in the 1970s, through the Latin American debt crisis of the 1980s to the Mexican, Asian and Russian financial crises of the 1990s, the IMF has operated by twinning the provision of liquidity with strong requirements that those involved do what is necessary to restore their financial positions to sustainability. There is ample room for debate about the precise policy choices the fund has made in the past. But, the IMF has consistently stood for the proposition that the laws of economics do not and will not give way to political considerations. At key points the IMF has offered prescriptions, not just for countries in need of borrowed funds, but also for those whose success is systemically important for the global economy.
Christine Lagarde, the head of the IMF, highlighted the seriousness of problems in Europe to members of the international financial community assembled in Jackson Hole in August. She pointed to capital shortfalls in the European banking system and the need for adjustment to be carried on in ways that were consistent with continuing growth. Now the IMF needs to speak and act on several fronts.
First, it is essential that Italy’s adjustment be carried out within the context of an IMF program. After European authorities emphasised that Greece was fully solvent and able to service all debts in full, it is unlikely that they, acting alone, have the capacity to reassure markets. Moreover, there are profound intra-European political problems if northern Europe either does or does not impose conditions on Italy. It would be much better to outsource those traumas to the IMF.
Second, as the IMF deals with individual European countries, it needs to recognise more than it did in the past that they are embedded within a monetary system and community of nations with an increasing number of common institutions. It would be inconceivable that the IMF would lend money to a country whose central bank was not committed to an appropriate monetary policy, or that was ignoring contingent liabilities in the banking system. IMF support for any European country should be premised on understandings with the European Central Bank that controls that country’s monetary policy.
Third, when engaging with individual members of a monetary union, the IMF cannot assess the prospects of one member of the monetary union in isolation. If some countries are to enjoy reduced trade deficits, others must face reduced surpluses. If there is no clear path to reduced surpluses, there is no clear path to reduced deficits and hence to solvency. More generally, the sustainability of any program must be assessed in the context of realistic projections of the economic environment. The IMF must be careful not to approve adjustment programs that are not realistic.
Fourth, the IMF has a responsibility to speak clearly about threats to the global economy. Even if debt spreads in Europe fall and modest growth is re-attained, the global economy is threatened by the large-scale deleveraging of European banks. An improvement in the fiscal position of sovereigns will help, but this is insufficient. If banks are not recapitalised on a substantial scale soon, there will be a large contraction of credit in the global economy.
After the summit, attention will and should shift to the IMF. It must act boldly but no one should ever forget a fundamental lesson of all past crises. The international community can provide support but a nation or a region’s prospect for prosperity depends ultimately on its own efforts.
The writer is Charles W. Eliot university professor at Harvard and was Treasury Secretary under President Bill Clinton.
Copyright The Financial Times Limited 2011.