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Ms. Lagarde’s Poisoned Chalice

Tuesday, June 7, 2011

The front-runner to replace the disgraced Dominique Strauss-Kahn as IMF chief will inherit Europe on the brink of disaster.

Being nominated to be the managing director of the International Monetary Fund has the irresistible allure of being the ultimate prize for any ambitious politician interested in international finance. After all, the IMF is now at the very center of the European sovereign debt crisis, at the very time when the euro confronts its most serious challenge since its 1999 launch. And the IMF has never before had quite so much influence or money as it now has to shape events in West Europe’s periphery and to try to save the European banking system from a Lehman-style crisis.

However, before French Finance Minister Christine Lagarde, the front-runner to replace the disgraced Dominique Strauss-Kahn as IMF chief, rushes to assume the job, she might want to reflect on Federal Reserve Chairman Ben Bernanke’s troubled experience soon after he took over at the Fed from Alan Greenspan in January 2006. Some 18 months into the job, Bernanke found that he had the unenviable task of having to pick up the pieces of many years of Greenspan’s policy mistakes with cheap money and lax mortgage lending regulation. And in the process, Bernanke was confronted with a housing bust of epic proportions and the worst post-war U.S. financial crisis that cost him more than his share of heartache and sleepless nights.

Strauss-Kahn made the critical mistake of buying into the European fantasy that economic problems were ones of liquidity rather than of solvency, making them amenable to a quick fix.

The sad reality is that, just like Greenspan, Strauss-Kahn will have left to his successor the unenviable task of having to pick up the pieces of his gross mishandling of the European debt crisis. Right from the start of that crisis in early 2010, Strauss-Kahn made the critical mistake of buying into the European fantasy that the economic problems in countries like Greece, Ireland, Portugal, and Spain were ones of liquidity rather than of solvency, making them amenable to a quick fix.

Not to put a fine point on it, the countries in Europe’s periphery grossly abused the easy money conditions that Eurozone membership afforded them by going on massive spending sprees. These sprees, in turn, resulted in excessively large budget deficits, outsized external imbalances, and, in the case of Ireland and Spain, housing market bubbles that made the United States pale by comparison.

Strauss-Kahn should have recognized that Greece, Ireland, and Portugal were all essentially bankrupt.

The real problem for Europe’s peripheral countries is that the very large economic imbalances that they are now experiencing are extraordinarily difficult to correct within the straitjacket of EU membership. No longer having their own currency to manage, these countries cannot resort to currency devaluation to boost exports. Instead, they now have to earn competitiveness through the painful process of wage and price deflation. And a big boost in exports is exactly what these countries now need to withstand the many years of public sector belt-tightening that they will have to endure to put their public finances on sustainable paths.

Strauss-Kahn should have recognized that Greece, Ireland, and Portugal were all essentially bankrupt. In particular, he should have accepted that, without a meaningful write down of their government debt, there was no way that these countries could restore order to their public finances without provoking the deepest of economic recessions. Instead, Strauss-Kahn chose to believe that all that was required to tide these countries over their economic crises was the usual IMF recipe of draconian budget belt-tightening backed by very large public-sector bailout lending from the IMF and the European Union.

The countries in Europe’s periphery grossly abused the easy money conditions that EU membership afforded them by going on massive spending sprees.

If Lagarde has any doubt about the shortcomings of the IMF’s approach to the European debt crisis, all she need do is to take a look at Greece’s sorry experience over the past year under IMF-EU tutelage. In May 2010, the IMF and EU stitched together for Greece a $150 billion bailout package that was intended to cover all of the Greek government’s borrowing needs for 2010 and 2011 with a view to giving Greece breathing room to get its economic house in order. In return, the Greeks were required to commit themselves to a staggering 10 percentage points of GDP in budget tightening over the next three years and to start an ambitious structural reform program aimed at modernizing the sclerotic Greek economy. One year later, the Greek economy is literally in a state of collapse. Real GDP has now declined by a staggering 9 percent from its peak, while unemployment has risen to above 15 percent. Meanwhile, the country’s public finances have continued to disappoint. This has prompted Greece’s IMF and EU taskmasters to require that Greece redouble its fiscal austerity efforts at a time of deep economic recession, and to privatize as much as €50 billion in public assets over the next five years, albeit at fire-sale prices.

There can be little wonder that big cracks are now opening in Greek Prime Minister George Papandreou’s cabinet and that social unrest and bitter resentment is all too much in evidence on Greek streets. Nor can there be much surprise that the financial markets are now requiring that the Greek government pay 25 percent interest on two-year loans. Such astronomically high interest rates are as clear an indication as ever that the Greek government is for all intents and purposes shut out of the capital market, which now expects the Greek government to default on its debt in the not-too-distant future.

There can be little wonder that big cracks are now opening in Greek Prime Minister George Papandreou’s cabinet and that social unrest and bitter resentment is all too much in evidence on the Greek streets.

When Lagarde examines Greece’s desperate plight, she might consider that the same bitter medicine of draconian belt-tightening within the euro straitjacket is also being administered to Ireland and Portugal, another two of the IMF’s European wards. She might ask herself whether these countries are any more likely to be spared Greece’s economic fate as they are to be forced to swallow the IMF’s bitter medicine. She might also ask herself whether being so closely associated with the collapse of the European periphery, the IMF will be any less unpopular in Europe than it was in Asia and Latin America in the 1990s. More than a decade after those latter crises, the IMF is still a pariah in most of Asia and Latin America.

In a year’s time, as the IMF struggles with a wave of defaults in the European periphery and as it shares part of the blame for a European banking crisis, Lagarde is likely to be asking herself one question: Was the grass really greener on the banks of the Potomac than it was on those of the river Seine?

Desmond Lachman is a resident scholar at the American Enterprise Institute.

FURTHER READING: Lachman has recently written “Greece’s Unhappy Anniversary,” “Repeating Europe’s Charade?,” and “Till Debt Do Us Part.” He has also published “Partial Debt Restructuring Will Not Work” and “Is There Any Hope for Greece?” Other related articles include, “Athens on the Potomac” by Veronique de Rugy and “Toward a More Perfect (European) Union” by Vincent R. Reinhart.

Image by Darren Wamboldt/Bergman Group.

 

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