Euro zone needs more than a currency in its toolbox, says Lagarde

Europe Letter: IMF head wants EU to set up rainy-day fund for next crisis

"It is not natural for men to unite. It is necessity that pushes them." Jean Monnet, the architect of European construction, was advising the German chancellor Willy Brandt on the creation of a monetary union when he said that.

On Monday Christine Lagarde, citing Monnet, was doing her own prodding in the same vein. "The reality is that the euro area does have a necessity today," she argued, "the necessity of filling in the missing pieces of the architecture so that the region is prepared for the next crisis."

The former French finance minister, now managing director of the International Monetary Fund, was presenting her organisation’s ideas on creating an EU “fiscal capacity” in a speech in Berlin.

The idea was there too on the agenda of last week’s EU summit, eclipsed by more immediately “sexy” issues, like a trade war, or Brexit, or the Salisbury attack. But the debate on “fiscal capacity” is arguably as important as any of them. It is central to competing concepts of what the whole European Union project is about: solidarity, economic as much as political.


Put simply, it's about whether the union collectively should enhance its ability to help member states weather economic downturns. And help itself in the process. That means creating, Lagarde and others, such as France's president, Emmanuel Macron, say, a "rainy day fund", or a grand insurance scheme for the euro zone, to which all contribute in good times and those in need dip into in bad times.

The summit debate was a testing of the water, and Taoiseach Leo Varadkar, speaking to journalists afterwards, suggested that Ireland takes the alternative view that "national measures" are the best way to safeguard the euro.

He was almost certainly joined in pouring cold water by fellow members of what is being called, with a degree of ahistorical liberty, the Hanseatic league, the informal alliance of Baltic nations, with Ireland and the Netherlands, that are staking out common ground on a range of issues, as flag bearers of fiscal conservatism.

Germany, too, not part of the league these days, has its strong reservations, mostly to do with an aversion to "fiscal transfers" from north to south and what economists call moral hazard: the fear that flighty southern states will abandon fiscal responsibility if they know there is a safety net to protect them from their recklessness.

We recommend that countries pay a premium in good times, based on the benefits they receive in bad times. It is a bit like raising the cost of insurance after a car accident

In Berlin Lagarde made an important, timely contribution to the debate, pointing to the precedent of collective action to defend member states in the European Stability Mechanism, which, with its predecessor, between 2010 and 2016 provided more than €250 billion in loans to five countries, Ireland included, hit hardest by the crisis.

The IMF’s suggested rainy-day fund is a euro-zone-wide collective-financing facility aimed not at bailing out basket-case economies but at supporting investment in economies suffering on the down side of economic cycles.

Under the IMF’s proposals governments could draw down funds when unemployment rose above a seven-year average for their economy. And although it “may not be enough to solve the next crisis, it certainly would help”, Lagarde argues, adding that it could halve the size of a downturn for “the relatively modest cost” of 0.35 per cent of gross domestic product a year.

“During the last crisis monetary policy had to do much of the heavy lifting,” Lagarde says. “Raising taxes and cutting spending, as many in the euro area did between 2011 and 2013, exacerbated weaknesses and contributed to a double-dip recession.

“To avoid a painful repeat of this experience, the euro area needs a central fiscal capacity. This would supplement members’ own fiscal efforts, which will always be the first and main line of defence in any downturn.”

It is not a matter of some countries’ altruistically helping others. “A central fiscal capacity will reassure investors that the euro area has better tools to stop the next crisis from spreading. This will help prevent the near panic we saw last time.

“And the benefits go beyond crisis prevention. This capacity can help smooth out the economic cycle and improve the functioning of the currency union, especially when monetary policy proves insufficient,” Lagarde says.

Responding to concerns about moral hazard and permanent transfers from one set of countries to another, the IMF urges that transfers from the fund depend on a member’s compliance with EU fiscal rules.

And “we recommend that countries pay a premium in good times, based on the benefits they receive from the fund in bad times. It is a bit like raising the cost of insurance after a car accident. This would help avoid the problem of permanent transfers”.

Having created in the euro zone a single, increasingly integrated economy, member states must now give themselves the tools to manage their collective endeavour. A common currency is not enough, Lagarde is saying. We need a fiscal capacity.