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Europe’s Financial Maginot Line

Tuesday, April 3, 2012

Europe’s proposed financial firewall around Spain and Italy will likely prove as effective in protecting those countries from another market onslaught as was the Maginot Line in protecting France from Germany.

In 1940, the Maginot Line proved woefully ineffective in protecting France from a German invasion, despite the great amount spent on its construction and the high hopes placed on its impregnability. One has to wonder whether Europe’s proposed financial firewall around Spain and Italy will prove any more effective in protecting those countries from another market onslaught than was the Maginot line in protecting France. The very design of the proposed firewall appears to be basically flawed in dealing with a renewed loss of market confidence in the euro’s long-run sustainability.

At the top of the policy agenda for the International Monetary Fund’s April 21-22 spring meeting is the construction of a financial firewall for Italy and Spain. Christine Lagarde, the IMF’s managing director, has been emphasizing that the IMF presently has only around $380 billion at its disposal in uncommitted resources for the IMF’s entire membership. Anticipating the real possibility of renewed market pressure on the European periphery, she is proposing that the IMF’s resources be augmented by at least $500 billion. To that end, she has been seeking commitments from non-European countries to complement the $150 billion in bilateral loan commitments that the IMF has already received from the European countries.

IMF and EU policymakers should be asking themselves why one should expect such a firewall to succeed for Italy and Spain when a similar firewall has been demonstrated not to have worked in Greece and Portugal.

At the recent G-20 Finance Ministers’ meeting in Mexico, the non-European countries, including most notably China and Brazil, insisted that any bilateral loan commitments that they make to the IMF must be preceded by a greater effort by Europe to help itself in dealing with its debt crisis. They were especially keen to have the Europeans beef up their own bailout funds. In particular, they wanted the Europeans to allow the European Financial Stability Fund (EFSF) to run through mid-2013, as originally envisaged, rather than to have it expire in June 2012. By extending the EFSF’s life, the Europeans could increase the size of their bailout by €250 billion, bringing it to €750 billion.

A common feature of the IMF and EU’s financial support programs for Greece, Ireland, and Portugal has been to commit resources conditionally to those countries in a sufficient amount to allow their governments to finance themselves without having to borrow in the private market for a two-year period. Even if the IMF were to augment its resources as planned and the Europeans were to allow the EFSF to continue in parallel with the ESM, the combined IMF-EU firewall would have barely enough money to cover Italy and Spain’s government borrowing needs over the next two years. For 2012 and 2013, the Italian government’s borrowing needs alone amount to around $750 billion, while those of the Spanish government are in the region of $350 billion.

The key weakness of the proposed firewall is not that its size might not match what the markets are seeking, but that the money to be provided falls far short of being a “bazooka” because it will not be provided in an unconditional or upfront manner. Any future IMF-EU financial support to Italy and Spain would be subject to IMF conditionality. And disbursements under any future IMF-EU support program would be dribbled out on a quarterly basis subject to the country meeting the macroeconomic performance criteria that the IMF would attach to its lending.

Before pushing ahead with a firewall in its present proposed form, IMF and EU policymakers should be asking themselves why one should expect such a firewall to succeed for Italy and Spain when a similar firewall failed to work in Greece and Portugal. Despite a €110 billion commitment to Greece by the IMF and EU in May 2010, which was sufficient to take the Greek government out of the market for two years, Greece was not spared from an economic collapse that culminated in its having to write down its private sector debt by 74 percent. And despite a similarly large IMF-EU loan commitment to Portugal in May 2011, that country’s government can still not borrow at sustainable interest rates and it is highly unlikely to be able to access the market in 2013 as planned.

For 2012 and 2013, the Italian government’s borrowing needs alone amount to around $750 billion while those of the Spanish government are in the region of $350 billion.

Two key lessons might be drawn from Greece and Portugal’s unfortunate experience with large IMF-EU support packages. The first is that large financing programs do not help to restore market confidence in countries’ debt sustainability if they come with conditions of severe fiscal austerity within a euro straitjacket that produces deep economic recessions. Those recessions highly complicate the attainment of a country’s budget deficit reduction programs and increase their debt service ratios.

The second cautionary lesson is that a rising proportion of senior official debt in a country’s overall debt necessarily raises the size of the haircut that a country would need to obtain from its junior private creditors in the event of a debt restructuring. That prospect highly complicates a country’s ability to regain access to private capital markets once they have gone down the official financing road, since investors will come to fear the risk of ever larger haircuts.

A careful review of the experience of large official lending programs for Greece and Portugal should make European policymakers reconsider the relative merits of their proposed firewall for Italy and Spain. It should also redirect attention on Europe’s recently agreed fiscal compact, which risks putting the European periphery on the road to a long and painful recession that will almost surely undermine market confidence in those countries’ prospects of restoring debt sustainability.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

FURTHER READING: Lachman also writes “Time for Greece to Leave the Euro,” “Binds and Bonds: Why the EU Should Break Up,” “Merkel’s Moment,” and “Misdiagnosis has made IMF Cavalier with Taxpayer Money.” Alberto Mingardi discusses “The Italian Tragedy.” Peter J. Wallison explains “Why the U.S. Doesn't Have the Debt Problems of the EU.

Image by Darren Wamboldt / Bergman Group

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