The G20 has a full agenda, but in truth the only issue that matters is Europe. As political chaos in Greece and the explosive rise in Italian spreads underscore, last week’s euro-zone summit did nothing to change the facts. European banks are still overleveraged and undercapitalized. Reaching even an underwhelming capital-adequacy ratio of 9% will take fully 8 months to complete. The banks will raise their capital ratios by limiting their lending, which will only diminish the prospects for growth.
Meanwhile, the promised reduction in Greek debt by a third, such being the implication of a 50% haircut on that two-thirds of the debt in private hands, is achievable only with full private-sector participation. And even that will not render the Greek government’s debt sustainable or put the country back on the road to growth. More austerity without more debt reduction will only result in more recession. Greek politicians understand this, which is why the government has now turned, in desperation, to a confidence vote and referendum.
Greece will need much more debt relief in order to stay in the euro area and the European Union, and European banks will need much more capital in order to absorb the blow. Plan B will have to give way to Plan C, and quickly. Whether European politicians are up to the task, we will see. Given their recent track record, it is hard to be optimistic.
For all these reasons, more turmoil and volatility are ahead. This makes it especially disturbing that the EU, at its summit, failed to supersize the European Financial Stability Mechanism and erect a firewall adequate for containing the crisis. A 20% first-loss guarantee will not reassure investors who know that bondholders suffer losses of more than 20% when a government defaults. China will not have more than token interest in a special purpose investment vehicle (SPIV) to purchase Italian bonds, since Beijing will have no say in the reforms that the Italian government is supposed to implement in return. The SPIV will lack the resources to buy bonds on the scale necessary to return Italian yields to pre-crisis levels and give the Italian government the breathing space it needs to put in place pro-growth measures.
A Greek default is coming, and Europe has shown itself incapable of constructing an adequate firewall. China is not running to the rescue. From where, then, can outside help come?
By process of elimination, the answer is the IMF. The BRICs and other interested parties might contribute to a trust fund overseen by the IMF’s Executive Board, for example, to lend directly to the EFSF’s special purpose vehicle. Better, however, would be for the IMF to lend directly to Italy by extending it a precautionary credit line (PCL). This would halve the Italian government’s borrowing costs and give it time to convince the markets of its reform-mindedness. The PCL is for countries with a track record of sound policies but significant vulnerabilities. Italy has balanced its budget. Its leaders and Europe’s believe that it is solvent. But it now needs to put reforms in place in order to grow its economy. What more appropriate focus for the IMF’s “focused conditionality?”
But this one operation would immediately tie up about a quarter of the IMF’s remaining resources. More funding for the institution is therefore essential. When the idea of the BRIC countries providing it was mooted last month, the United States and other advanced countries put the kibosh on the idea. If their motive was to increase the pressure on the Europeans to solve their own problems without outside help, then the stratagem failed. It is time to acknowledge that failure and move on.
IMF intervention is now the only alternative left for solving the crisis. Only the G20 can put the Fund in the driver’s seat and give it the resources it needs to complete the task.
Barry Eichengreen is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley