Column: Should IMF have been called in

Written by Michael Walton | Michael Walton | Updated: Feb 13 2010, 03:27am hrs
The IMF has had a good crisis so far. It was nimble in action. The Pittsburgh meeting of the G-20 aspired to a new era of crisis management, with the IMF playing an enhanced role in surveillance and providing international insurance.

Now the next crisis is upon us, and its all about sovereign European debt. Spreads on Greek sovereign debt have shot up, spurred by the revelation that the size of the government deficit is really 13% (the numbers had been fiddled before) alongside concerns over structural weaknesses. Market concerns have spread to Portugal and Spain, with Ireland and Italythe other members of the so-called PIIGSalso under watch. Afraid that this could get nasty, EU members, on Thursday, reportedly agreed on a rescue package for Greece.

But they chose not to call in the IMF. This is not for lack of awareness. In early 2009, the IMF national surveillance mission was raising alarm bells over Greeces unsustainable public finances. So whats the problem

The heart of the issue lies with eurozone incentives. For many countries there were big incentives to join. This garnered substantial political support for efforts to satisfy conditions of membership, including on public sector deficits and debt levels. Once in the eurozone, incentives shifted. The market stopped differentiating between the credit-worthiness of different countries. All reaped the gains of perceived prudence in the monetary core. Countries such as Ireland and Spain enjoyed big booms, but also large losses in competitiveness, as domestic wage and price inflation ran ahead of the European average. Countries such as Greece, Italy and Portugal postponed structural change. Fiscal management remains an intensely domestic policy issue. There are penalties on exceeding the government deficit and debt limits, but their credibility was never strong, and was further weakened when large countries managed to avoid them.

Things started to change after the subprime crisis unfolded. As IMF economist Ashoka Mody has shown in a recent paper, after the bailout of Bear Stearns the market started to charge differential spreads on European sovereign bonds over the safe, German rate. Countries with worse domestic financial problems paid more, and especially when they had high public debt and problems of competitiveness. Market differentiation is now sharpening into market panic.

So the eurozone provided weak incentives for fiscal management, and had no mechanisms to prevent the slide in competitiveness. The markets ignored emerging problems on the upside, but have now really woken up and theres a risk of herd withdrawals. With the global slowdown, weaker countries are moving into a bad equilibrium: financial sector problems and the slowdown are blowing up fiscal positions; weak competitiveness makes it harder to grow out of difficulties; it is politically hard to fix structural change in public finances, labour markets, product market regulation and infrastructure; devaluation isnt an option.

What is needed is a combination of transitional finance and politically salient mechanisms to effect fiscal and other changes. But the eurozone does not have an effective mechanism when default threatens; there is formally a no-bailout clause. It also faces political problems: bailing out poor performers will be unpopular among German voters; the imposition of conditions from Brussels (or Berlin) will be equally unpopular among Greek voters.

So why not call in the IMF fire brigade The IMF has lots of experience in imposing conditions in return for (relatively cheap) finance. A big part of the resistance is pridethis would be perceived as humiliating for the eurozone. But there is a deeper problemthe IMF doesnt do domestic politics. While it is sometimes useful to blame an external agency, this is not sustainable, especially when the IMF is perceived, with some justice, to come in with a set of biasespro-creditor, pro-finance, anti-worker and so on.

There was another alternative. Let default happen. This would have had some advantages. It would have helped the short-fun financial position. Loss allocations are partly shifted on to external creditors. Domestic loss allocations and structural policy changes are shifted into the domestic political arena. This is where they belong, since they intensively concern inter-temporal and inter-group distributions. But the big problem with allowing defaultapart from hurting European pridewas that it could be even more contagious. Back to the Lehman dilemma.

For now, though, it seems that the EU, led by France and Germany, will lead the bailout. This is far from optimal. In the long term, Europe, like the rest of the world, needs a combination of more intensive, objective surveillance and pre-defined insurance arrangements of finance for adjustment, with default as an alternative. That this is hard even within Europe suggests we shouldnt hold our breath. In the meantime, the markets will be driving overoptimistic booms and disorderly busts.

The author is at the Harvard Kennedy School and the Centre for Policy Research