November 15, 2011

Amid Europe’s economic turmoil, a question nags: Where is the IMF?

Created in 1945 — and reflecting the breakdown of global cooperation in the Great Depression — the International Monetary Fund was intended to prevent a few countries’ problems from dragging down the world economy. Countries that got in trouble would borrow temporarily from the IMF. Under IMF supervision, they would adjust their economies gradually so that they wouldn’t destabilize the entire system. Well, that’s exactly the danger now posed by Europe.

It’s tempting to think that new governments in Rome and Athens will resolve Europe’s deepening economic crisis. Perhaps they will, but the odds against this are long: more like 20 to 1 than 2 to 1. Already, high interest rates have barred Greece, Portugal and Ireland from borrowing in private markets. In 2012, Italy has to refinance 360 billion euros (nearly $500 billion at current rates) of maturing debt. If it can’t, it will default or require a huge rescue that, for the moment, seems beyond any European or global entity.

The fallout could be tumultuous. A default would probably cause mass failures among Italian banks, which hold 164 billion euros (more than $220 billion) of Italian government debt. Depositors might stage a run. French banks, with 53 billion euros of Italian debt (nearly $72 billion), would also be imperiled. If Italy defaulted, bond buyers might abandon France and Spain. Already, financial markets have raised interest rates on Italian, Spanish and French debt.

Facing these grim possibilities, the IMF has been mostly missing in action. It has provided some funds for Greece, Portugal and Ireland. But more is needed, as economist Arvind Subramanian of the Peterson Institute makes clear in an open letter to IMF Managing Director Christine Lagarde. What the IMF should do is organize a huge rescue fund — at least $1 trillion to $2 trillion, says Subramanian — to backstop Europe in case more countries lose access to private credit markets.

Countries could tap it in return for agreeing to IMF conditions to overhaul their economies. This way, the IMF might fulfill its basic mission. It couldn’t avert a European recession, which may have already started. But it could preempt a chaotic implosion of credit, confidence and spending that would threaten the wider world economy.

Three realities define Europe’s situation.

First, the crisis is as much political and social as it is economic. The “European model” of generous social benefits and secure jobs is besieged. Welfare states have become too costly for many countries’ economies to support. Benefits must be curtailed. The austerity being imposed or recommended inflicts direct hardship and assaults beliefs and expectations that have been nurtured for decades.

Second, Europe can no longer rescue itself. There are too many potentially needy debtors and too few credible lenders. The main rescue mechanism — the European Financial Stability Facility (EFSF) — has already committed about 250 billion euros of its 440 billion euros to Greece, Ireland and Portugal, reports the Institute of International Finance, an industry group (and the source of most data cited here). Even an expanded EFSF probably couldn’t handle Italy and certainly not Spain and France. The European Central Bank — Europe’s Federal Reserve — could buy unlimited amounts of government bonds. But it has so far disdained this role, fearing the inflationary consequences.

Finally, the IMF (whose European department head resigned Wednesday) is in no position to rescue Europe. At last count, it had about $400 billion in available funds. This wouldn’t cover Italy’s refinancing needs for a year. So the IMF needs more money.

Getting it would be a chore, notes Subramanian. The Europeans don’t want to admit that they need help. The United States, he says, is resistant because its own high debts would prevent it from contributing, thereby diminishing its power. China fears being hoodwinked into throwing good money after bad; but without China, contributions from other countries (Brazil, India, Saudi Arabia) would be meaningless. Against these obstacles, he says, Lagarde could argue that, absent IMF help, a financial meltdown might cause a new global slump.

When created, the IMF was a political institution dedicated to stabilizing the world economy. Does it still work? “A tectonic shift has occurred in the global economy,” Subramanian writes. Traditional creditors (rich countries) and traditional debtors (poor countries) have switched places. Meanwhile, the social contracts written by most advanced nations, including the United States, will be rewritten by either design or events. Economic stability depends on managing political change.

Can China, Brazil, India and some major oil exporters deploy their financial power for the collective good — including the health of their export markets? Can Europe modify its welfare systems without being paralyzed by civil strife and feuds among nations? Or are we on a collision course with some future crisis whose advancing outlines we can dimly perceive but seem powerless to stop?