IMF Urges More Drastic Action in Europe

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On Monday, IMF Managing Director Christine Lagarde called for quick action on the part of Eurozone leaders to implement policies designed to promote growth, increase the size of Europe’s bailout fund, and further integrate the Eurozone. The warning comes as the region faces a depression similar to the one that occurred in the United States during the 1930s if the crisis is not contained.

Lagarde stated that, with the Eurozone economy slowing down drastically, there is a risk that growth in the region will fall by 1.6% in 2012. This downturn could make it more burdensome for already distressed European economies to meet their debt obligations. Less economic growth means governments collect less tax revenue (as consumer demand decreases, companies lay off workers leading to less available income to be taxed) which in turn cuts the government revenue necessary to repay debt. For this reason, Lagarde urged the European Central Bank (ECB)—the entity in charge of monetary policy for the Eurozone—to take stronger measures to stimulate economic activity, such as lowering interest rates. Lower interest rates stimulate business investment by making investment projects more profitable to start as the cost of financing such investments is cheaper. With a reduced cost of investment, businesses purchase more goods, build new factories and warehouses, and employ more people. All this new activity creates more income for both businesses and people, which stimulates the economy. Likewise, banks need to establish guidelines aimed at preventing a dramatic worsening of the crisis. For example, implementing better regulatory oversight systems will ensure that banks always have enough capital reserves to be able to sustain themselves when risky investments fail. This change will ensure that banks have enough money to continue to continue lending to consumers and businesses even if they sustain losses. Finally, Lagarde urged countries to tighten their finances quickly by implementing policies directed at reducing government spending and raising taxes.

Additionally, Lagarde stressed the importance of European leaders increasing the bailout fund currently in place—the European Financial Stability Fund (EFSF). Without a larger fund, countries such as Italy and Spain that are currently solvent (capable of repaying their debt) would not be able to continue meeting their financial obligations if the crisis worsens and these countries need a bailout. Lagarde suggested merging the EFSF into the European Stability Mechanism (ESM) as well as doubling the ESM’s resources to approximately €1 trillion. Doing so would help prevent defaults and the negative consequences that may go along with them. Also, by boosting this “firewall” fund, Europe will be able to help banks in the region raise their cash levels without cutting down on lending since the fund can provide financing to banks as well.

Lastly, Lagarde called for greater fiscal integration in the Eurozone. Currently, member countries retain complete control over their fiscal (taxing and spending) policies, while the European Central Bank is in charge of monetary policy for the entire region. However, the current crisis has exposed the ineffectiveness of this system. Although European leaders are currently in talks to implement a “fiscal compact” to limit countries’ budget deficits, Lagarde believes there also needs to be a more cohesive fiscal policy among the countries. To achieve this goal, she calls for the creation of euro bonds---bonds that are backed by all by all the countries in the Eurozone. The euro bonds would make nations’ debt a shared burden while at the same time giving investors more confidence in the region as there is a lower risk on bonds guaranteed by the entire Eurozone.