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News : Global Economy Last Updated: Aug 29, 2011 - 7:46 AM

Lagarde says global economy in a "dangerous new phase"
By Finfacts Team
Aug 29, 2011 - 6:16 AM

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International Monetary Fund (IMF) managing director, Christine Lagarde, at the Council on Foreign Relations, July 26, 2011, New York.

Developments this summer have indicated that the global economy is in a "dangerous new phase," Christine Lagarde, International Monetary fund managing director, warned on Saturday.

"The stakes are clear: we risk seeing the fragile recovery derailed. So we must act now," the former French finance minister told the Federal Reserve's 2011 symposium for central bankers, in Jackson Hole, Wyoming. "It is a matter of vision, courage and timing. Decisive action will bolster the confidence that is required to restore and rebalance global growth."

Lagarde focused in her speech on the fragility of European banks, and the continuing drag that the US housing crisis has on economic confidence.

She said the fundamental problem is that in these advanced economies, weak growth and weak balance sheets - - of governments, financial institutions, and households - - are feeding negatively on each other. If growth continues to lose momentum, balance sheet problems will worsen, fiscal sustainability will be threatened, and policy instruments will lose their ability to sustain the recovery.

The IMF managing director said European banks must be strong enough "to withstand the risks of sovereigns and weak growth. This is the key to cutting the chains of contagion. If it's not addressed, we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis."

Lagarde said each country needs a dual focus: a primary emphasis on durable measures that will deliver savings tomorrow which, in turn, will help to create as much space as possible for supporting growth today - - at least by permitting a slower pace of consolidation where possible. For instance - - measures that change the rate of growth of entitlements, health or retirement.

On European banks, Lagarde said they must be strong enough to withstand the risks of sovereigns and weak growth. "This is key to cutting the chains of contagion. If it is not addressed, we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalization - - seeking private resources first, but using public funds if necessary. One option would be to mobilize EFSF (rescue fund) or other European-wide funding to recapitalize banks directly, which would avoid placing even greater burdens on vulnerable sovereigns."

Jean-Claude Trichet, ECB president, told the same forum that European banks should move to reinforce their balance sheets. But he dismissed worries about a liquidity crisis, saying the extraordinary lending the ECB has offered means such concerns are "just plain wrong."

On the response to the Eurozone debt crisis, Lagarde said  that an unclear or confused message will add to market uncertainty and magnify the Eurozone’s economic tensions. So Europe must recommit credibly to a common vision, and it needs to be built on solid foundations—including, for example, fiscal rules that actually work.

On the United States, Lagarde said "credible decisions on future consolidation - - involving both revenue and expenditure - - create space for policies that support growth and jobs today. At the same time, growth is necessary for fiscal credibility - - after all, who will believe that commitments to cut spending can survive a lengthy stagnation with prolonged high unemployment and social dissatisfaction?" she asked.

The second priority for the US is halting the downward spiral of foreclosures, Lagarde said.

President Obama plans to announce a set of economic proposals, early next month, after Labor Day.

The European Storm:

CNBC's Liesman about Bernanke's speech on Friday:

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