How will the euro zone crisis play out in the next few weeks? With luck, Italy may soon get a credible government of national unity, Spain will obtain a new government in November with a mandate for change, and Greece will do enough to avoid roiling the markets. But none of this can be relied upon.
So, what needs to be done? First, euro zone banks have to be recapitalized. Second, sufficient funding must be available to meet Italy’s and Spain’s needs over the next year or so if their market access dries up. And, third, Greece, now the sickest man of Europe, must be treated in a way that does not spread the infection to the other countries on the euro zone’s periphery.
All of this requires financing—bank recapitalization alone could require hundreds of billions of euros (though these needs would be mitigated somewhat if the sovereign debt of large euro zone countries looked healthier).
In the short run, it is unlikely that Germany (and northern Europe more generally) will put up more money for the others. Germans are upset at being asked to support countries that do not seem to want to adjust—unlike Germany, which is competitive because it endured years of pain: low wage increases to absorb the former East Germany’s workers and deep labour-market and pension reforms. The unwillingness of the Greek rich to pay taxes, or of Italian parliamentarians to cut their own perks, confirms Germans’ fears. At the same time, German politicians have done a poor job explaining to their people how much they have gained from the euro.
But we are where we are. A glimmer of hope is Europe’s willingness to use the European Financial Stability Facility (EFSF) imaginatively—as equity or first-loss cover. Clearly, some of the EFSF funds will have to go to recapitalize banks that cannot raise money from the markets. As for the rest, the amounts that are not already committed to the peripheral countries could be used to support borrowing that can be lent onward to Italy and Spain.
There is, however, no consensus about how to do this. Some propose bringing in the European Central Bank (ECB) to leverage EFSF’s funds. This is a recipe for trouble. Giving ECB a quasi-fiscal role, even if it is somewhat insulated from losses, risks undermining its credibility. And if Italy were helped, the incoming ECB president, Mario Draghi, an Italian, would be criticized, no matter how dire is Italy’s need. Moreover, financing would have to be accompanied by conditionality, and these institutions have neither the requisite expertise nor the necessary distance from the countries at risk to apply and enforce appropriate conditions.
Finally, both EFSF and ECB ultimately rely on the same euro zone resources for their financial strength. If markets start panicking about large euro zone defaults, they could question whether even a willing Germany has the necessary capacity to support the EFSF-ECB combine. Put differently, these institutions do not offer a credible, non-inflationary, external source of strength.
Indeed, the euro zone’s problems might soon become too big for its members to address. The world has a stake in their resolution. And it has an institution that can channel help: the International Monetary Fund (IMF). IMF could set up a special vehicle along the lines of its New Arrangements to Borrow (NAB), which would be capitalized by a first-loss layer from EFSF with IMF’s own capital comprising a second layer.
This NAB-like vehicle could borrow as needed from countries, including the US and China, as well as tap financial markets. It would offer large lines of credit to illiquid countries like Italy, with conditionality intended to help such countries resume borrowing from markets at reasonable cost.
A special vehicle is required because the amounts that must be made available far exceed what IMF members can usually access, and it is only right that if the euro zone seeks such amounts for its members, it should bear a significant portion of any potential losses. At the same time, IMF’s capital resources would back the vehicle if the first-loss buffer provided by the euro zone were eroded; that way, the market would understand that strength from outside the euro zone can be brought to bear.
IMF is not an institution that inspires warm and cuddly feelings. But it is also not the mindless preacher of fiscal austerity that it is accused of being—and it should start taking the lead in managing the crisis, rather than holding up the rear. The euro zone needs an independent outside assessment of what needs to be done, and rapid implementation, before it is too late and the incipient bank runs become uncontrollable.
Of course, IMF cannot act without the permission of its masters, the large countries. The euro zone should suppress any wounded pride, acknowledge that it needs help, and provide quickly what it has already promised. The US should continue pushing hard for a solution. And the emerging-market countries should pitch in too, once some safeguards for their money are in place. Unresolved, the crisis will spare no one.
As for the birthplace of the euro crisis, Greece’s debt will almost surely have to be restructured. But adequate funding structures for Italy and Spain must be in place before any resolution. So, while others have to step forward to do their part, it is best if Greece steps back from the brink.
Raghuram Rajan is professor of finance at the University of Chicago’s Booth School and author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.
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