IMF managing director Christine Lagarde in Peru, Nov 28, 2011

IMF managing director Christine Lagarde today called on the international community to take urgent collective action to save the world economy from a downward spiral. She also said the Eurozone needed a bigger firewall to prevent Italy and Spain sliding towards default.

“The longer we wait, the worse it will get. The only solution is to move forward together. Our collective economic future depends on it,” Lagarde said in a speech at the German Council of Foreign Affairs in Berlin. “Looking at it from this perspective, 2012 must be a year of healing.”

She laid out the main elements of a policy path forward. Europe, which is at the centre of global concerns, needs stronger growth, larger firewalls, and deeper integration, she said, but added that other economies also have an important role to play to restore balanced global growth. As for the multilateral component, Lagarde said that the IMF was ready to help and was seeking to increase its lending resources by up to $500bn.

We must all understand that this is a defining moment. It is not about saving any one country or region. It is about saving the world from a downward economic spiral, she said.

The IMF estimates that in coming years, additional global financing of potentially $1 trillion could be needed, which the Fund can help meet with additional lending resources. “A cooperative path means that all countries must work together with a common diagnosis toward a common solution,” Lagarde said, adding that the Fund can push for such a cooperative outcome through its analysis and policy advice, but also help by providing financing when needed.

“I am convinced that we must step up the Fund’s lending capacity,” she said. The goal here is to supplement the resources Europe will be putting on the table, but also to meet the needs of other countries, anywhere in the world, affected by the repercussions of the crisis, she added. Eurozone countries have already pledged to provide up to $200bn in new financing for the IMF.

Addressing the crisis in the Eurozone

The leaders of the 17 Eurozone countries have already taken a number of important steps to stem the sovereign debt crisis that has undermined confidence in the world’s financial markets, Lagarde said.

Major achievements include the establishment of the European Financial Stability Facility (EFSF)/European Stability Mechanism (ESM), agreement on a harmonized approach to recapitalize banks and the establishment of a systemic risk board, governance reforms to enforce stronger and more effective fiscal discipline, and the European Central Bank’s decision to make long-term liquidity available to banks.

“These major steps must be recognized. Yet I would not be the first to argue that these moves form pieces, but pieces only, of a comprehensive solution,” she said.

Three imperatives are needed to fully restore confidence: stronger growth, larger firewalls, and deeper integration.

Stronger growth

With the euro area economy slowing sharply, inflation is already declining. This creates a sizable risk that it will fall well below target next year, raising debt burdens and further hurting growth. For this reason, additional and timely monetary easing will be important to reduce such risks, Lagarde said.

“Stronger growth also means preventing banks from going into reverse gear, contracting credit in the face of market pressure. Solutions should focus on raising capital levels—rather than cutting back lending - - as the way to boost capital ratios,” she said.

With respect to fiscal policy, several countries have no choice but to tighten their finances sharply and quickly. But this is not true everywhere, Lagarde said. “There is a large core where fiscal adjustment can be more gradual.”

Also of paramount importance are structural reforms to lay the groundwork for boosting competitiveness and long-term growth.

Larger firewalls

Lagarde also called on European policymakers to create a larger firewall. Without it, countries like Italy and Spain, that are fundamentally able to repay their debts, could potentially be forced into a solvency crisis by abnormal funding costs  -- a development she warned would have disastrous consequences for systemic stability. “Adding substantial real resources to what is currently available by folding the EFSF into the ESM, increasing the size of the ESM, and identifying a clear and credible timetable for making it operational would help greatly,” she said.

Action by the ECB to provide the necessary liquidity support to stabilize bank funding and sovereign debt markets would also be essential.

“We must also break the vicious cycle of banks hurting sovereigns and sovereigns hurting banks,” she said. “This works both ways. Making banks stronger, including by restoring adequate capital levels, stops banks from hurting sovereigns through higher debt or contingent liabilities. And restoring confidence in sovereign debt helps banks, which are important holders of such debt and typically benefit from explicit or implicit guarantees from sovereigns.”

Deeper integration

Lagarde also called for more risk sharing across borders in the banking system to break the feedback loop between sovereigns and banks. “In the near term, a pan-euro area facility that has the capacity to take direct stakes in banks will help break this link,” she said. Further financial integration in the form of unified supervision, a single bank resolution authority, and a single deposit insurance fund is also necessary.

“The euro area also needs greater fiscal integration - - it is not tenable for seventeen completely independent fiscal policies to sit alongside one monetary policy,” she added. The “fiscal compact” that was agreed at the summit of European leaders in early December 2011 needs to be complemented by some form of fiscal risk-sharing. A number of financing options are available to support such risk sharing, including the creation of euro area bonds or bills or, as proposed by the German Council of Economic Advisors, a debt redemption fund, she said.

The rest of the world must do its share

While Europe is at the epicentre of the current crisis, other economies also have an important a role to play in helping secure a better outcome.

The United States, as the world’s largest economy and the centre of the global financial system, has a special responsibility, Lagarde said. She called on US policymakers to relieve the burden of household debt through programs to make mortgage debt sustainable and to act decisively to bring down tomorrow’s deficits without bringing down today’s economy.

As the world’s third largest economy, Japan must also play its part by putting in place a credible plan to bring down public debt and reforms to raise long-term growth.

Lagarde also called on both emerging and advanced countries with large current account surpluses to encourage more domestic demand as a way to support global growth. China, which has the world’s largest foreign currency reserves and runs a large current account surplus, is a case in point. “China can help itself and the global economy by continuing to shift growth away from exports and investment, toward consumption,” she said.

Lagarde concluded that while the economic outlook remains deeply worrisome, there is a way out. “Now the world must find the political will to do what it knows must be done.”

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