Sunday, March 14, 2010

Why Europe needs its own IMF

Why Europe needs its own IMF
By Giancarlo Corsetti and Harold James

Published: March 8 2010 16:27 | Last updated: March 8 2010 16:27

Like every good tragedy, the current Greek crisis has its origins in events and decisions long past. In particular, two historical flaws in the European approach to monetary and fiscal management have emerged as threats to European stability. They are not fatal; but they need to be fixed.

The first is the absence of a mechanism to address financial crises that could threaten, via contagion, the whole European market. It is worth recalling that this problem was well understood by the founding fathers of the common currency. The agreements of 1978 that produced the European Monetary System as a comprehensive fixed exchange rate regime also provided for the establishment of a European Monetary Fund within two years. An EMF would play an analogous role to that of the International Monetary Fund in the defunct international fixed exchange rate regime that had been created at Bretton Woods. In particular, it would allow countries that were hit by a sudden or unanticipated crisis to draw on its resources, and, like the IMF, would have allowed formal policy conditions to be imposed on countries. The EMF was never realised – but is once again under discussion.

The second historical shortcoming emerged during the negotiation of the 1985 Single European Act, which laid the foundation for the subsequent process of monetary union. At that time, Greece was facing substantial fiscal and payments problems, and feared being forced into a difficult negotiation with the IMF. Since the act required the unanimity of all European Community members, Greece could leverage its vote into a more or less condition-free Ecu 1.75bn emergency credit from the EC. In other words, despite the agreement on the principles of fiscal stability and no bail-out as a foundation of the common currency, the political process has often led to convenient leniency – at times even rationally so, given the limitations of the agreed-upon rules. So, while the creation of the EMF was forgotten, the temptation may now be to improvise an informal structure, performing, inefficiently, the same task.

European monetary integration rested on the idea that the adoption of quantitative rules on deficit and debt levels, coupled with surveillance, could be enough to prevent future problems. This approach was criticised early on, exactly as regards the shortcomings of the rule, and the lack of institutional provisions consistent with the need to address systemic risks and contagious crises.

Even if the rules operated perfectly, as they clearly have not, they do not deal with the situation of a country with an apparently strong fiscal position that is suddenly hit by a fiscal shock by an event such as major bank collapses (or the collapse of a major industry, or the bursting of a housing bubble). Ireland, for example, had a strong fiscal position until the outbreak of the banking crisis, and was comfortably within the rules of the stability and growth pact, but now requires major remedial treatment.

When a crisis occurs, it can in consequence only be handled by high-level and very politicised negotiations. These inevitably give the appearance that some special favour is being given: an impression that produces deep resentments in both the debtor and the creditor countries.

The advantages of IMF procedures are twofold. First, they follow established procedures. They are thus less likely to produce moral hazard and the assumption that a country can, just by letting matters slip and getting into a bad situation, trigger a costly international rescue operation.

Secondly, the attractions of an IMF deal lie in the fact that they take some of the political sting out of support operations. In the mid-1990s, for instance, a purely bilateral support operation by the US for Mexico would have revived memories of a century-old history of US interventions. In the mid-1970s, when Italy needed international support, it could have concocted a deal with Germany, but the Germans preferred to see the IMF negotiating with Rome. Multilateralising the deal through the IMF in both cases was a way of extracting political poison from a situation that was complicated by historical sensitivities and historical injustices.

The disadvantages of the IMF approach lie in the fear that Europe might give the impression that Europeans are not capable of dealing with their own problems; that the IMF action might come too late and thus cost more than if financial crisis and contagion had been prevented at an earlier stage; and that the involvement of the IMF might give a negative signal to markets and lead to the downgrading of credit ratings. History has taught us that one should never underestimate the possibility of mis-communication and market instability after official interventions meant to achieve the opposite.

The European Central Bank is not a substitute for an EMF, because the central bank is barred from giving credit to governments, and because a politically independent central bank is not the right institution to lay down policy conditions. Only an institution that has a clear measure of political responsibility to its member governments could take on such a task.

In the long run, Europe needs something like an EMF, through which support operations can be calmly negotiated without exciting political passions. Designing such an institution may take some time, but it would be an important complement to existing European institutions, and even perhaps a complement to the IMF. In the short run, Europe may have to make do with the IMF.

Giancarlo Corsetti is Pierre Werner professor at the European University Institute. Harold James is professor of history and international affairs at Princeton University and Marie Curie professor at the European University Institute.

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