“We need a larger firewall”

Europe, the United States, and the rest of the world will need to take coordinated action to solve the debt crisis. “We need to act quickly or else we could easily slide into a 1930s moment,” said the Managing Director of the International Monetary Fund (IMF) during her speech on January 23 at the DGAP.

2011 was not a successful year because many measures were not thought through, were half-heartedly implemented, or were not coordinated with other countries. But the IMF head sees a positive turnaround coming in 2012. “We know what needs to be done. It is now up to governments to show the necessary political will.” Eurozone countries have already taken important steps, including the establishment of the temporary European System of Financial Supervisors (ESFS) and the permanent European Stability Mechanism (ESM). But these are only “parts of a more extensive solution.”

Comprehensively Solving the Crisis

What would such a comprehensive solution look like? Lagarde thinks Europe needs stronger growth, higher financial firewalls, and more fiscal integration. Eurozone states now have a duty to expand financial firewalls to tackle the debt crisis: by increasing funds for the ESM, with further monetary easing through the European Central Bank, or through eurobonds (an idea that contradicts the German government’s present course).

In order to avoid decreased growth in the eurozone and to thwart a “credit crunch,” more money needs to be made available. Regarding fiscal measures, Lagarde said that some countries have no choice but to save and thus quickly and effectively consolidate their budgets. “But this is not true everywhere,” she warned. “There is a wide area where fiscal adjustment needs to proceed slower.” This can be seen as a nod to Germany. Lagarde pointed to the importance of mid- and long-term structural reforms, which should enable growth and competitiveness.

More Money to Avoid a Credit Crunch

Additionally, the eurozone bailout fund must be endowed with more than the planned 500 billion euros. “We need a larger firewall,” claimed Lagarde. The permanent bailout fund ESM should be expanded to include all funds set aside for the temporary EFSF. Otherwise, countries such as Spain or Italy could slip into a solvency crisis due to exceptionally high interest rates – with disastrous consequences for the stability of the European financial system.

Lagarde thus sees stronger fiscal integration within the eurozone as a third essential task. “We cannot have seventeen completely independent fiscal systems and one common monetary policy.” Risks must be more strongly distributed beyond national borders. Lagarde added that eurobonds could be another resource to fight the crisis: They could help more evenly allocate, and thus cushion, risk. Germany has led the opposition against eurobonds.

While the eurozone is currently the “epicenter of the crisis,” other economic powers have a duty to act. The United States has a particular responsibility as the world’s largest economy and the global center of finance. Lagarde appealed to the US government to cut its debt and to move quickly to solve impasses in Washington. Countries with strong export-oriented growth and large budgetary surpluses such as China should boost domestic demand in order to support worldwide growth.

Bulking Up the IMF

Lagarde envisions a massive increase in the IMF’s crisis reserves. This will allow the organization to help not only Europeans, but countries around the world that have been gripped by the crisis – even those without substantial debts of their own. “It is not about saving individual states or regions. Rather, it is about preventing a worldwide downward spiral.” Global crises call for global solutions. Lagarde estimates that 1 trillion dollars will be needed to fight the crisis in the coming years. A 500 billion dollar increase will be needed for the IMF – a move that has thus far been viewed skeptically by the United States and developing countries like Brazil or China.