Can Europe Build a Better EMF?
Daniel Gros and Thomas Mayer, writing on the Economist website, propose that Europe build a European Monetary Fund (EMF) that would be better than the International Monetary Fund (IMF). The EMF would be financed by its weakest members, would be stricter than the IMF in its policy conditionality, and would have a pre-positioned resolution mechanism to address sovereign default. Their proposal is an economic, financial, and political nonstarter. Pursuit of their suggestion would be counterproductive to the European project. Europe would be better advised to send Greece to the IMF for a comprehensive economic reform program than to continue to nurture it in the European context.
Successfully addressing a country's financial crisis via outside assistance involves striking a balance between financing and adjustment. Enough external financing should be available to prevent a liquidity crisis from becoming an insolvency crisis. If insolvency emerges, the financing should be sufficient to prevent other countries being dragged into crises through market contagion. Enough adjustment measures—changes in policies—have to be applied to correct the underlying problems and to lay a foundation against future crises.
Gros and Mayer propose that Europe do a better job in getting this balance right than the IMF would. The last time that the world watched one of these dramas was the Japanese proposal in 1997 for an Asian Monetary Fund (AMF), which is still being advocated in Asia. The original AMF proposal was intended to redress the IMF's balance from adjustment and toward financing. The proposed EMF would tilt the balance in the opposite direction. It is a deeply flawed proposal for four main reasons.
First, it would take some time to negotiate the terms of the EMF. As was the case with the AMF in the Asian crisis, the EMF would not be useful in addressing the Greek threat to European Monetary Union (EMU). The Gros-Mayer proposal is a diversion attractive only to Europeans who obsess over moral hazard concerns.
Second, setting practical considerations aside, if the EMF were tougher than the IMF is on average in terms of its economic and financial conditions, then euro area countries would prefer to go to the IMF for assistance. For three decades, members of the European Union have preferred to go to Brussels because that assistance is tilted more toward financing and less toward adjustment. The Europeans could try to forbid a participant in the euro area to go to the IMF. However, that approach would call into question the European insistence that their representation in the IMF should not be consolidated and their collective voting power should not be reduced. Alternatively, they might try to muster enough votes or leverage in the IMF to ensure that IMF conditionality would be more painful than EMF conditionality, which would be another strange, historical twist.
Third, the Gros-Mayer proposal would finance the EMF initially by authorizing it to borrow in the market, presumably against the explicit guarantee of the financially stronger European countries. Subsequently, however, the financing would come from fines on the members who have failed to adhere to the Maastricht entry criteria. Based on estimates for 2010 issued by the European Commission in the fall of 2009, this list currently would include more than half of euro area participants with respect to the level of their public sector debts and all of them with respect to the size of their budget deficits. The original Stability and Growth Pact anticipated fines for excessive deficits. It was not politically acceptable in practice. What makes one think it would be more palatable now?
Fourth, the Gros-Mayer proposal would embed in the EMF statutes a formula for haircutting claims on the government of a member country that was forced into sovereign default. The formula would be based on a country's prior profligacy and would potentially affect the borrowing costs of all EU members. Gros and Mayer analogize to Chapter 11 in the US bankruptcy code. But the US bankruptcy code does not apply Chapter 11 to political jurisdictions; they are subjected to substantially more limited intrusions on their political decisions. Gros and Mayer complain that the IMF lacks such a mechanism, which is one reason why the EMF would be superior. They have forgotten that in 2001 Anne Krueger—then first deputy managing director of the IMF—proposed a more limited Sovereign Debt Restructuring Mechanism (SDRM). The SDRM proposal subsequently was further watered down, inter alia, by eliminating any applicability to debt issued on domestic markets. But even then it was judged to be unacceptable, including to Europeans.
European Monetary Union is a bold extension of the European project. The aim is to create a structure of close economic and monetary collaboration among member governments in the absence of a corresponding political structure. The Greek threat to the European project is first political, second financial, and only third economic. Unless a political solution can be found quickly, the risk is that the European project will unravel. I believe this is unlikely. Unless enough financial support is potentially available to Greece from its European partners and, preferably, the IMF, the Europeans will have violated the Powell doctrine, which calls for applying overwhelming force in a crisis to prevent it from spreading. The Greek threat is an economic crisis, but that is least important. Whatever happens, the economic consequences for Greece will be painful.
The critics are right when the say that "Greece" should have known the potential consequences when it joined the euro area, but that is an elitist view. The truth is that the political groundwork was not laid among the citizens of Greece or those of most other European countries. The consequences of the Greek tragedy for the overall European project could be severe. The Gros-Mayer proposal is not the answer to Europe's problems today.