CAMBRIDGE – As the eurozone crisis continues to deepen, the International Monetary Fund may finally be acknowledging the need to reassess its approach. New Managing Director Christine Lagarde’s recent call for forced recapitalization of Europe’s bankrupt banking system is a good start. European officials’ incensed reaction – the banks are fine, they insist, and need only liquidity support – should serve to buttress the Fund’s determination to be sensible about Europe.
Until now, the Fund has sycophantically supported each new European initiative to rescue the over-indebted eurozone periphery, committing more than $100 billion to Greece, Portugal, and Ireland so far. Unfortunately, the IMF is risking not only its members’ money, but, ultimately, its own institutional credibility.
Only a year ago, at the IMF’s annual meeting in Washington, DC, senior staff were telling anyone who would listen that the whole European sovereign-debt panic was a tempest in a teapot. Using slick PowerPoint presentations with titles like “Default in Today’s Advanced Economies: Unnecessary, Undesirable, and Unlikely,” the Fund tried to convince investors that eurozone debt was solid as a rock.
Even for Greece, the IMF argued, debt dynamics were not a serious concern, thanks to anticipated growth and reforms. Never mind the obvious flaw in the Fund’s logic, namely that countries such as Greece and Portugal face policy and implementation risks far more akin to emerging markets than to truly advanced economies such as Germany and the United States.
As the situation deteriorated, one might have guessed that the IMF would mark its beliefs to market, as it were, and adopt a more cautious tone. Instead, at the IMF’s April 2011 interim meeting, a senior official declared that the Fund now considers troubled Spain to be a core eurozone country like Germany, rather than a peripheral country like Greece, Portugal, or Ireland.
Evidently, investors were supposed to infer that for all practical purposes they should think of Spanish and German debt as identical – the old hubris of the eurozone. My own sarcastic reaction was to think, “Oh, now the IMF thinks that some of the core eurozone countries are a default risk.”
Having served as the IMF’s chief economist from 2001 to 2003, I am familiar with the Fund’s need to walk a tightrope between building investor confidence and shaking up complacent policymakers. But it is one thing to be circumspect in the midst of a crisis; it is quite another to spew nonsense.
The late Chicago-school economist George Stigler would have described the IMF’s role in Europe as reflecting acute “regulatory capture.” Simply put, Europe and the US control too much power in the IMF, and their thinking is too dominant. What European leaders may want most from the Fund are easy loans and strong rhetorical support. But what Europe really needs is the kind of honest assessment and tough love that the Fund has traditionally offered to its other, less politically influential, clients.
The IMF’s blind spot in dealing with Europe until now is only partly due to European voting power. It also stems from an “us” and “them” mentality that similarly permeates research at the top Wall Street investment houses. Analysts who have worked their entire lives only on advanced economies have learned to bet on things going well, because for the couple of decades prior to the crisis, things mostly did go well – very well.
That is why, for example, so many keep assuming that a normal rapid recovery is just around the corner. But the financial crisis should have reminded everyone that the distinction between advanced economies and emerging markets is not a bright red line.
In his recent speech in Jackson Hole, Wyoming, US Federal Reserve Chairman Ben Bernanke forcefully complained that political paralysis has possibly become the principal impediment to recovery. But analysts accustomed to working on emerging markets understand that such paralysis is very difficult to avoid after a financial crisis.
Rather than slavishly believing policymakers’ assurances, emerging-market researchers have learned to be cynical about official promises. All too often, everything that can be done wrong will be done wrong.
The IMF needs to bring much more of this brand of skepticism to its assessment of eurozone debt dynamics, instead of constantly seeking strained assumptions that would make the debt appear sustainable. Anyone looking closely at Europe’s complex options for extricating itself from its debt straightjacket should realize that political constraints will be a huge obstacle no matter which route Europe takes.
Even outside Europe, the IMF has long given too much credence to sitting governments, rather than focusing on the long-term interests of the country and its people. The Fund is doing Europe’s people no favor by failing to push aggressively for a more realistic solution, including dramatic debt write-downs for peripheral eurozone countries and re-allocating core-country guarantees elsewhere.
Now that the Fund has squarely acknowledged the huge capital holes in many European banks, it should start pressing forcefully for a comprehensive and credible solution to the eurozone debt crisis, a solution that will involve either partial breakup of the eurozone or fundamental constitutional reform. Europe’s future, not to mention the future of the IMF, depends on it.
Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.
Copyright: Project Syndicate, 2011.