Who knew international finance could be so . . . riveting?
I won’t try to convince you that what’s really interesting about l’affaire Strauss-Kahn are the implications for International Monetary Fund policy and Europe’s debt crisis.
As far as the IMF is concerned, it’s hard to think of an institution more impervious to exogenous shocks. Its bench of economists and financial bureaucrats is so deep, its beliefs and culture and ways of doing things so entrenched that when a spokeswoman declares it’s “business as usual” at 19th and Pennsylvania, you can believe it.
Dominique Strauss-Kahn’s resignation is just a matter of time — even if he is found to be not guilty, the damage to his reputation and the IMF has been done. The ideal replacement would be French Finance Minister Christine Lagarde, who can provide continuity in the management of the euro crisis, with Singapore Finance Minister Tharman Shanmugaratnam as her first deputy and designated successor, providing the long-overdue recognition of the growing importance of Asia in the global economy.
At the time of his arrest, Strauss-Kahn was headed to a meeting with German Chancellor Angela Merkel, reportedly to talk her out of a debt restructuring plan for Greece. The official IMF view, like that of the European Central Bank, is that allowing any euro-zone country to restructure its debt will trigger another global financial crisis as investors rush to indiscriminately dump all their European bonds, forcing European banks, which hold large piles of them, into insolvency. In this scary scenario, a debt default or restructuring in any euro-zone country would cause the collapse of the euro.
To hear it from the financial mandarins, the only viable option for the euro zone is to increase the size of its rescue loan package for Greece while imposing even more austerity, in the hope that somehow the country will magically grow out of its debt problem.
There are several problems with this diagnosis and prescription.
The most obvious is that Greece is already caught in the early stages of a debt spiral. The austerity measures necessary to bring Greece’s government budget into balance have caused such a deep recession, and tax revenues have fallen so steeply, that the primary deficit is increasing, not decreasing. History shows that once such a dynamic gets going, it is self-reinforcing and very hard to pull out of. A similar dynamic seems to be taking hold in Ireland, Portugal and even Spain, where economies are shrinking and unemployment continues to rise to alarming levels.
Second, unlike the autumn of 2008, when Lehman Brothers, Fannie Mae, Freddie Mac, Merrill Lynch and American International Group all suddenly came crashing down, markets have been anticipating and pricing in the risk of a Greek debt restructuring for more than a year. That is why the interest rate on short-term Greek bonds is 25 percent and why those of Ireland and Portugal are not far behind. At the same time, interest rates on bonds of many other euro-zone countries have barely risen at all. What this suggests is that the markets are calm and rational enough to distinguish between the creditworthiness of different euro-zone countries. This is a solvency crisis, not a liquidity crisis; the fear of a contagion is overblown.
The final problem with the mandarins’ solution is that it makes sense only if you ignore political reality. It’s not just that governments of Ireland and Portugal have already fallen as a result of the harsh austerity measures they’ve been forced to adopt as a condition of E.U.-IMF rescue plans. (The Greek government is holding on by a thread.) What’s more significant is that the voters of Germany, Finland, Austria and a number of other euro-zone countries have begun to balk at the idea that they have a moral or economic obligation to rescue countries that have lived beyond their means or let their bankers run wild. Political support for the euro rescue effort is quickly evaporating.
The way out of this political predicament, it seems to me, is to stop demanding that European taxpayers finance what looks to them like bailouts of profligate neighbors, or the bailout of a currency most of them never wanted anyway, and ask them instead to help bail out their own banks that have too many Greek or Portuguese or Irish IOUs on their balance sheets. By recapitalizing their banks, European countries can target assistance to those parts of the financial system where the risk of contagion is greatest, with a good chance the money will eventually be repaid. And by making bondholders and other creditors take some losses, they can give the people of Greece, Ireland and Portugal a fighting chance to revive their economies and pay back most of what they owe.
I spoke with Bill Rhodes, the former Citigroup executive who played a central role in every sovereign debt crisis of the past 30 years and who has written a book about his experiences, “Banker to the World.” Rhodes knows how to drive a hard bargain with profligate countries, but he also knows when it’s foolish to push them too hard and load them up with too much debt service. And that’s exactly what Rhodes sees happening with Greece, Ireland and Portugal.
The question isn’t whether creditors will take a haircut. The question is whether they’ll take a small one now or a big one later.