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It is not a moment too soon for the IMF to start planning how to respond to a spate of Euro-zone sovereign debt defaults, and the possible Euro exit of a few countries within the next year or so. For the worst outcome both for the European peripheral countries and for the global economy would be if disorderly defaults and Euro exits were to result in a collapse in the peripheral economies, and in their subsequent move toward hyperinflation. The IMF is the one organization that still has the capability to prevent that outcome.
By now the IMF must recognize that its strategy for the European periphery of draconian budget belt-tightening, and of wage and price deflation to restore fiscal sustainability and international competitiveness has failed. Since, within the straightjacket of Euro membership that precludes currency devaluation to promote export growth, the pursuit of this policy mix has already resulted in the deepest of recessions for Greece and Ireland.
Real GDP in those two countries has already declined from its peak by 9 percent and 12 percent, respectively, while their public debt to GDP ratios are now expected to peak at levels well in excess of 150 percent. This is already eroding those countries’ tax bases and sapping those countries’ political willingness to stay the course.
“By now the IMF must recognize that its strategy for the European periphery of draconian budget belt-tightening, and of wage and price deflation to restore fiscal sustainability and international competitiveness has failed.”–Desmond Lachman
Under the best of circumstances, one would expect that the major multi-year IMF budget belt tightening being imposed on Greece, Ireland, Portugal, and Spain will result in a meaningful deepening in those countries’ already very painful recessions. However, these are hardly the best of circumstances. For a double-dip recession is now stalking both core-Europe and the United States, which almost certainly eliminates the prospect that the peripheral countries might export their way out of their problems. At the same time, the recent intensification of financial market strains across Europe is resulting in the equivalent of a further monetary policy tightening for the peripheral countries at the very time that they are engaged in a major round of fiscal austerity.
The IMF’s own unsuccessful experience at propping up Argentina’s Convertibility Plan in 2000-2001 should be informing the IMF that there are clear political limits to how much austerity a country can bear. And the recent difficulties that Mr. Papandreou had in securing passage of his austerity budget in July 2011 should be informing the IMF that Greece is now very rapidly approaching the limit of how much further austerity that country can tolerate.
Like Argentina before it, there is now the very real risk that Greece’s body politic will decide that there has to be a better economic alternative to years of deep recession stuck in an IMF arrangement that does not permit default or devaluation. In time, as their domestic economic recessions deepen, the Portuguese and Irish body politic will also arrive at the same conclusion.
The recent great difficulty that the IMF had in obtaining financing assurances from the European Union for the second Greek bailout package should also be informing the IMF that bailout fatigue has taken hold in the core European countries. This has to raise the real possibility that Europe will not find the political will to come up with the additional EUR 1.5 trillion, either in the form of an expanded EFSF or of a Euro bond issue, that might be needed to hold the Euro together should Spain and Italy come under renewed market attack.
The IMF’s rich experience over the years with countries forced to default and devalue has to sensitize it to the serious risks associated with disorderly debt restructuring and hasty Euro exit by the Eurozone’s peripheral countries. For if there is one thing that the IMF should have learnt from its experience, it is that default and devaluation must be backed by credible fiscal and monetary policy and must be supported by adequate official international lending if it is not to lead to economic collapse and a move towards hyperinflation in the Eurozone periphery.
The IMF would still appear to be uniquely placed to provide both the financial support and the policy credibility to ensure the successful radical change in policy direction that now seems to be indicated for the countries in the Eurozone’s periphery. The all too real danger is that, if the IMF sticks with its failed policy prescriptions to date for the European periphery, it will lose both policy credibility in the periphery and the appetite to commit additional financial resources for the periphery at a time when it most needs it.
That would be the greatest of shames not only for the European periphery but for the global economy at large. For it would only magnify the blow to the European banking system from the inevitable series of sovereign debt defaults now required to restore fiscal sustainability in the Eurozone periphery.
Desmond Lachman is a resident fellow at AEI.
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