The world economy

A call to arms

The Economist

Aug 28th 2011, 4:16 by Z.M.B. | JACKSON HOLE, WY

IT IS largely a gathering of central bankers; at the outset of her speech she apologised for not being one. Yet by far the most hard-hitting words at this year’s Jackson Hole symposium came from Christine Lagarde, the former French finance minister and new managing director of the IMF. 

The world economy, she said, was entering a “dangerous new phase” driven by a sense that “policymakers do not have the conviction” to take decisions that are needed. That must change, and now. Ms Lagarde laid out a bold to-do list to support growth, including a forced capital injection into Europe’s banks, aggressive new action to deal with America’s foreclosure crisis, and a broad rebalancing of fiscal priorities.

The most headline-grabbing prescription was for Europe’s banks. More capital, Ms Lagarde argued, was essential to “cutting the chains of contagion” in the euro crisis. Without it there could easily be “the further spread of economic weakness to core countries, or even a debilitating liquidity crisis”. She called for what would essentially be a European version of America’s policy for its biggest banks in 2008—a mandatory capital increase using public funds if necessary. Those funds could come from the European Financial Stability Facility.

America, in turn, needed to do more to halt the downward spiral of foreclosures, falling house prices and weak household spending. Ms Lagarde suggested more aggressive schemes to reduce mortgage principal or help home-owners refinance at lower rates.

Echoing a theme raised by Ben Bernanke, the Fed chairman, in his speech the previous day, Ms Lagarde argued that fiscal policy should pivot, putting in place policies to reduce future deficits while supporting growth today. This was not a cop-out, she argued. Growth was 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?”

In America that pivot would require “credible decisions” on future deficit reduction involving both tax increases and spending cuts, coupled with a focus today on making a serious dent in long-term unemployment. In Europe, she argued, this fiscal rebalancing, and the bigger short-term deficits it implied, would mean more official financing for some countries. That ought to include “continued support from the ECB”.

While most of Ms Lagarde’s to-do list applied to Europe and America, the big emerging economies were not let off the hook. Global rebalancing had not advanced “sufficiently”, she argued, because some “key emerging economies” (read China) had done too little to boost domestic demand and appreciate their currencies.  “The lack of rebalancing hurts everyone”, she said. “Decoupling is a myth.”

All told, it was a feisty call to action—around a largely sensible agenda. Although European politicians will bristle at the thought of forced capital injections, many European banks do need a lot more capital—and, so far, have done far too little to secure it themselves. Fiscal austerity should be recalibrated on both sides of the Atlantic. But just as important as what Ms Lagarde said was the fact that she said it. Her stern words for Europe assuaged worries that a former French finance minister would be too cosy with her erstwhile colleagues. No other top policymaker has spoken so bluntly about the risks to the world economy or called so bluntly for a co-ordinated plan to address them. Now the question is whether governments will listen to her.

(Picture credit: AFP)