Call in the IMF!
By: Fredrik Erixon
Subjects: European Union Eurozone Crisis Services WTO and Globalization
Imagine that a troika of enlightened creatures from Mars, Venus and Pluto would set their feet in Europe to pass a judgment on the eurozone crisis. What would they say? Free from future ambition, friendship ties, and diplomatic politeness they could bluntly point to the obvious: the Eurozone does not have requisite institutional and political-leadership capabilities to manage its own crisis. Unless there are good reasons to believe there will be a change very soon, the only reasonable conclusion is to call in other institutions and leaders, preferably through the International Monetary Fund (IMF), to solve the problems.
Yes, it is that bad. An IMF-led solution to the crisis is likely to be an indigestibly embarrassing proposition for Eurozone leaders, but there is no longer much time left for them to repair the grossly inadequate governance structure to make a difference now.
Crisis management in every democratic political entity is a combination of institutional instinct and imaginative leadership by elected representatives. Crisis politics is always turbulent. Yet experience has forced countries to establish institutional structures that almost automatically will react in the event of financial crises. Often, these institutions were created in the ashes of a financial crisis. The German Reichbank, for example, was born shortly after the financial crash in 1873, and the US Federal Reserve System was a direct response to the financial turmoil in 1907.
The past two decades have witnessed a sea-change in crisis management, with governments and central banks improving the capacity to manage crises. Such pre-crisis preparedness is imperative to successful crisis management. Countries should not have to invent new institutions and practices, let alone re-write constitutions to enable them, at the height of a crisis. Yet this is where Eurozone leaders are right now: they are trying to invent new institutions and leadership structures to manage a profound crisis. But they have now hit the buffer of political and electoral reality. It is unrealistic to think that governments in some Eurozone countries could avoid asking for the electorate’s permission in order to construct a defence of the scale needed to protect Italy and Spain. It is equally unrealistic to believe that majorities in these countries to cast the vote in favour of vastly expanded financial contributions to such a defense.
Monetary economists have a name for this discussion: “rules versus discretion”. Should policy be guided by pre-legislated rules or by discretionary political action? In the EU, the choice between the Scylla of predictability and the Charybdis of flexibility has by necessity been erring of the side of the latter. After all, European co-operation has evolved progressively; the desire to forge stronger EU policy has often been seasoned by countries interest to maintain sovereignty. Consequently, the political personality of post-war European co-operation, especially outside the realm of the single market, has been individualistic. Its history is one of extraordinary individuals stepping forward at critical moments. Cometh the hour, cometh the man. And this group of men, the Berlaymont royalty, is memorialized in every corner of Brussels European quarter. If you start at the rond-point Schuman it takes you five minutes to pass the Charlemagne building and the Jacques Delors building to get to the Altiero Spinelli building. You could have stopped at places that tribute Jean Monnet, Paul-Henri Spaak, Jean Rey, Simone Weil, and other luminaries. But you will not have crossed a Rome Treaty Avenue or Maastricht Treaty Square.
A political entity based on the presence of extraordinary leaders is extraordinarily vulnerable. When the hour now has come for leaders to step forward, it is difficult to find willing or capable candidates. There are capable leaders in individual countries, but no one has the power or appeal to lead Europe. Italy is crippled by a defunct government and polity. It is a long time ago since France, now firmly in the electoral season, elected a President with broader European appeal. And the progressively globalised Germany cannot be expected anymore to produce political leaders willing to narrate his or her career on Germany-financed European co-operation. It is an open secret that these leaders of the Eurozone’s biggest economies do not trust each other.
So even if the Eurozone needs a new set of institutions – Eurobonds, an ECB with the mandate to act as lender of last resort, a fiscal union, or a political union – such initiatives stand little chance to materialize. Even if they did, they would be of little use today. To establish a Eurobond system, for instance, there would have to be negotiations over treaty changes, constitutional reviews of these changes, and in some countries referenda to change the constitutions to allow for a new EU treaty. Under the Panglossian assumption that all this would be a smooth sail, Eurobonds would still be a couple of years away from now.
The most realistic model for the Eurozone is that it operates what Citigroup economist Willem Buiter has called a “default union” – a union that addresses insolvencies through selective defaults. This does not rule out, say, increasing co-operation on fiscal and financial issues, not even an aneamic form of a fiscal union, but co-operation is likely to be far too small to give the Eurosystem a lender-of-last-resort function. Nor does it rule out financial assistance to countries that can raise enough capital on private markets to finance deficits. Yet this structure can only fit small countries whose defaults and needs for assistance would not throw the entire Eurozone economy into chaos. Bigger economies, however, can only be defended up to a point through the Eurozone’s own structures. A default in a big economy can only be marginal. Beyond that point, it will need external assistance in order to offer credible solutions. And this is where the Eurozone is now.
There are four good reasons to engineer an IMF-led package for the Eurozone.
Firstly, Eurozone members do not have the political willingness to vastly expand the tax-based guarantees on which the EFSF is based. It is primarily not an issue of money. It is rather an issue of countries not having the willingness to risk their own resources and credit ratings, with ensuing increases in their own borrowing costs, to stem a tide of increasing suspicions against Italy and Spain, and possibly in a second round Belgium and France. The absence of willingness also reflects constitutional limits. For Germany, one of the reasons to reject an expansion is that it would effectively create a transfer union, which is constitutionally and electorally a no-go zone.
Secondly, leveraging the current assets in the EFSF, as currently being discussed, would sharply increase the risk for a Eurozone collapse to break the neck of global financial markets. Even if the risk for such a development today looks to be manageable, it is a risk that simply is not worth taking.
Thirdly, the ECB is not a lender of last resort and cannot act as such without violating the treaties and externalizing market suspicion against a limited number of countries to the entire Eurozone. The ECB is currently buying government bonds on the secondary markets. The purpose of these actions is of course to bring down bond yields, but that the ECB cannot acknowledge officially. Instead the justification for its actions is that they are necessary to increase the effectiveness of orthodox monetary-policy measures and objectives. It is an open question if the ECB has already stretched its mandate too far; even if it would be undesirable to bring this matter to court, a good legal case can be made for the ECB having overstepped its mark. However, vastly expanded operations to effectively engineer a bailout of a couple of bigger economies would simply not be possible.
Fourthly, other countries has a material interest in helping Eurozone members to arrange an efficient defense of bigger economies. Increasing default risks in these countries alone would have sharp effects on the entire world economy. Other countries can together also offer a greater pool of resources. Such resources, effectively under the guidance of the IMF, would be better managed and stand a far better chance of not having to be utilized.
An operation of this kind would be unprecedented. There are also legal complications involved, but they seem to be less profound than those inside the Eurozone. Importantly, individual members in the Eurozone would have greater freedoms to act within an IMF-led package than in a vastly expanded Eurozone package.
An IMF-led solution would no doubt run into some other problems. Perhaps those problems would be big enough to prevent such a solution. But it is an alternative that needs to be considered for the simple reason that most other reasonable options now are close to being exhausted.