Ms. Lagarde: Throwing Money at the Euro Problem – Not the Answer


Since becoming the Managing Director of the IMF last summer, Christine Lagarde, a French lawyer, has been campaigning for both the Europeans and the Fund to raise additional capital to contain the Euro Crisis. More capital? Fine. You can never be too safe. Unfortunately, more capital won’t solve the Euro problem: it will only postpone its resolution.

What the IMF Does Well

Consider first what the IMF does well. If a country is suffering from inflation and a balance of payments deficit, it is usually because the government is spending too much. In such circumstance, the Fund agrees to lend the country some “transitional funds”, providing the government agrees to reduce its deficit and slow growth in the money supply. OK. The Fund normally does a good job at this.

The IMF in Europe – A Different Assignment

Let’s now consider what the Fund is being asked to do in Greece. There is no excess demand in Greece. In fact, the unemployment rate is 18.5% and expected to increase further next year. But there are large government and trade deficits. Why? Because Greece is locked into the Euro currency and cannot compete with the strong Euro countries. The strong Euro countries asked the Fund to develop a reform program so Greece can compete with Germany et al. As I have written earlier, the program is large and complex. It calls for new government wage structures, budget procedures, tax and expenditure reforms, pension reforms, education reforms, etc. It will never get implemented. What will happen if the Euro countries and Fund keep pushing? More riots in the streets and more Greek governments thrown out.

And the situation is no different for Italy, Portugal or Spain. Their economic systems are not as efficient as the Germans’. So as long as they are locked into the Euro, they will run growing government and balance of payments deficits. Austerity programs to reduce their deficits? The unemployment rate in Spain is already 23%!

More Money

Ms. Lagarde is calling for a “cushion” of $2 trillion, half raised by the IMF and the other half from the Euro countries. How will this money help Europe? Well, it will allow a postponement of the inevitable – just keep lending these countries money…. And it is certainly true you don’t want a run on banks to start.

Not everyone agrees with Ms. Lagarde. The US, looking over its shoulder at its deficit, has been decidedly unsympathetic. Annie Lowrey reported that a US Treasury spokesman said: “The I.M.F. cannot substitute for a robust euro area firewall. We have told our international partners that we have no intention to seek additional resources for the I.M.F.”

Conclusion – The Only Viable End Game

The IMF and Euro Countries are sleepwalking ahead with policies that will not work. I have earlier spelled out a way that the “weak sisters” could leave the Euro and go back to the Drachma. But it would be messy. I think there is a better solution:

  • Austria, Germany and The Netherlands should leave the Euro and either go back to their own currencies or create a new one for all three;
  • The “Weak Sisters” should announce a 100% debt default.

Austria, Germany and the Netherlands will have no problem in launching their own currencies. If they “walk”, the Euro will fall in value, making the exports of the remaining Euro countries more competitive going forward.

Negotiated partial defaults are never satisfactory. There are always a few that won’t agree and can make life difficult moving forward. The defaults will immediately improve the ratings of the defaulting countries. It will also mean the lenders who took the precaution to get their purchases insured will finally get paid (when is a default not a default?).

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