October 13th, 2011
08:03 AM ET

A standby program for the eurozone

Editor's Note: Raghuram Rajan, a former chief economist of the IMF, is Professor of Finance at the University of Chicago's Booth School of Business and the author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.

By Raghuram RajanProject Syndicate

How will the eurozone crisis play out in the next few weeks? With luck, Italy may soon get a credible government of national unity, Spain will obtain a new government in November with a mandate for change, and Greece will do enough to avoid roiling the markets. But none of this can be relied upon.

So, what needs to be done? First, eurozone banks have to be recapitalized. Second, enough funding must be available to meet Italy’s and Spain’s needs over the next year or so if their market access dries up. And, third, Greece, now the sickest man of Europe, must be treated in a way that does not spread the infection to the other countries on the eurozone’s periphery.

All of this requires financing – bank recapitalization alone could require hundreds of billions of euros (though these needs would be mitigated somewhat if the sovereign debt of large eurozone countries looked healthier).

In the short run, it is unlikely that Germany (and Northern Europe more generally) will put up more money for the others. Germans are upset at being asked to support countries that do not seem to want to adjust – unlike Germany, which is competitive because it endured years of pain: low wage increases to absorb the former East Germany’s workers and deep labor-market and pension reforms. The unwillingness of the Greek rich to pay taxes, or of Italian parliamentarians to cut their own perks, confirms Germans’ fears. At the same time, German politicians have done a poor job explaining to their people how much they have gained from the euro.

But we are where we are. A glimmer of hope is Europe’s willingness to use the European Financial Stability Facility (EFSF) imaginatively – as equity or first-loss cover. Clearly, some of the EFSF funds will have to go to recapitalize banks that cannot raise money from the markets. As for the rest, the amounts that are not already committed to the peripheral countries could be used to support borrowing that can be lent onward to Italy and Spain.

There is, however, no consensus about how to do this. Some propose bringing in the European Central Bank to leverage the EFSF’s funds. This is a recipe for trouble. Giving the ECB a quasi-fiscal role, even if it is somewhat insulated from losses, risks undermining its credibility. And if Italy were helped, the incoming ECB President, Mario Draghi, an Italian, would be criticized, no matter how dire Italy’s need. Moreover, financing would have to be accompanied by conditionality, and these institutions have neither the requisite expertise nor the necessary distance from the countries at risk to apply and enforce appropriate conditions.

Finally, both the EFSF and the ECB ultimately rely on the same eurozone resources for their financial strength. If markets start panicking about large eurozone defaults, they could question whether even a willing Germany has the necessary capacity to support the EFSF-ECB combine. Put differently, these institutions do not offer a credible, non-inflationary, external source of strength.

Indeed, the eurozone’s problems might soon become too big for its members to address. The world has a stake in their resolution. And it has an institution that can channel help: the International Monetary Fund. The IMF could set up a special vehicle along the lines of its New Arrangements to Borrow (NAB), which would be capitalized by a first-loss layer from the EFSF with the IMF’s own capital comprising a second layer.

This NAB-like vehicle could borrow as needed from countries, including the United States and China, as well as tap financial markets. It would offer large lines of credit to illiquid countries like Italy, with conditionality intended to help such countries resume borrowing from markets at reasonable cost.

A special vehicle is required because the amounts that must be made available far exceed what IMF members can usually access, and it is only right that if the eurozone seeks such amounts for its members, it should bear a significant portion of any potential losses. At the same time, the Fund’s capital resources would back the vehicle if the first-loss buffer provided by the eurozone were eroded; that way, the market would understand that strength from outside the eurozone can be brought to bear.

The IMF is not an institution that inspires warm and cuddly feelings. But it is also not the mindless preacher of fiscal austerity that it is accused of being – and it should start taking the lead in managing the crisis, rather than holding up the rear. The eurozone needs an independent outside assessment of what needs to be done, and rapid implementation, before it is too late and the incipient bank runs become uncontrollable.

Of course, the IMF cannot act without the permission of its masters, the large countries. The eurozone should suppress any wounded pride, acknowledge that it needs help, and provide quickly what it has already promised. The US should continue pushing hard for a solution. And the emerging-market countries should pitch in too, once some safeguards for their money are in place. Unresolved, the crisis will spare no one.

As for the birthplace of the euro crisis, Greece’s debt will almost surely have to be restructured. But adequate funding structures for Italy and Spain must be in place before any resolution. So, while others have to step forward to do their part, it is best if Greece steps back from the brink.

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Topics: Debt Crisis • Economy • Europe

soundoff (3 Responses)
  1. j. von hettlingen

    "In the short run, it is unlikely that Germany (and Northern Europe more generally) will put up more money for the others".
    How much does the author know about Northern Europe? Of all the 5 countries – Island, Norway, Sweden, Finnland and Denmark – only Finnland is in the Eurozone!
    Who should supervise the task of recapitalising the banks? The European Central Bank? Does he know what's going on inside the ECB? Trichet is leaving and there's no guarantee that his successor will pursue the same policies.

    October 14, 2011 at 9:36 am | Reply
  2. Michael Ross

    This is what I would do in Bernanke's position: in order to save the world banking system from collapse The Fed will offer to guarantee 100% of all of these 'bad' securities based on sub-prime mortgages, over a ten year period, meaning you cannot cash them in now, only over time. Since they are all dollar based securities, think about it, it would strengthen the dollar and guarantee its continuing existence as the world currency because all the world central banks would now be dependent on the Fed to keep them afloat over the next ten years, long enough to get the economy going again.

    October 16, 2011 at 5:11 am | Reply
  3. daniel kim

    Immigrants like "professor" rajan, from filthy greedy rich versus the majority poor in India are the same overpaid tenured people in overpriced colleges like Univ of Chicago taking the jobs away from Americans and conspired with Wall Street, military weapons and oil barrons and yet has the audacity to complain too much focus is spent on funding and hiring teachers!!!

    It is the Iraq-Afghanistan wars, Defence and Veteran Affairs departments that cost $10 trillions that ballooned our national debt to $15 trillion and NOT paternalism or spending on educating and helping the disabled, poor and working class!!!! Even computer majors are discouraged not only in America but Asia because the finance industry is overpaying their greedy fraudsters manipulating the currency, interest rates and off course, CDOs bundling subprimed mortgages that made them trillions and yet no criminal charges have been brought to jail banks and hedgefunds like Chase Jaime Dimond, ex-Countrywide and BoA CEOs, etc!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

    July 7, 2012 at 2:03 pm | Reply

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