The eurozone's banking crisis is on the verge of becoming a global economic catastrophe. But do the economic heavyweights meeting in Washington this week know what to do about it?
As policymakers from around the world gather in Washington this week for the International Monetary Fund/World Bank annual meetings, they would be well advised to remember a key lesson from the 2008 global financial crisis: In today’s intricately interconnected world, a crisis is very hard to contain once it spreads beyond its epicenter. And with Italy and European banks once thought to be safe now looking decidedly shaky, Europe’s crisis now poses a material threat to global stability and prosperity. This is why more dithering by policymakers is so costly and why the solution is no longer only in Europe’s hand.
When Greece’s debt crisis erupted almost two years ago, prompting rating downgrades and a stock market panic, too many European officials characterized the situation as "contained" — not dissimilar from how many U.S. officials labeled the subprime crisis back in 2007. But Greece’s crisis has now deeply infected a rapidly multiplying number of sectors.
It is no longer just about the "outer peripheral" economies such as Ireland and Greece, but also the "inner peripheral" ones like Italy and Spain, the banking sector, and balance sheets at the very core of the eurozone — and worryingly at the European Central Bank (ECB).
Interest rates on Italian government debt are at alarming levels, despite visible buying by the ECB. Banks are having difficulties convincing other private institutions to lend them money. And the ECB’s balance sheet is increasingly burdened, fueling internal divisions and turning this critical institution from being part of the solution to a part of the problem.
As in the fall of 2008, virtually no country will be spared if continued policy incoherence leads — as it inevitably will — to a recession in Europe, dysfunctional financial markets, and bank failures. When policymakers convened at the IMF/World Bank meetings three years ago to contend with this situation, they at least had a road map of sorts: a bold bank recapitalization plan that Britain brought to the meetings and that served as a catalyst for common analysis and joint policy actions.
This year, it seems that policymakers will have no such luck. The international community lacks an effective policy coordinator. Indeed, it does not even share a common analysis of what ails the global economy. And the sense of shared responsibility has fallen victim to bickering and finger-pointing.
There are now two distinct but interrelated sets of challenges to address — and that must be addressed — if the world is to avoid another cardiac arrest: a sovereign debt and growth problem, and inadequate bank capital and asset quality. Each needs a focused solution, and neither can be solved unless the other is, too.
Instead of reacting to the potential consequences of twin sovereign and banking crises, European policymakers have fallen deeper into the "active inertia" policy trap: the temptation to maintain the status quo in the hopes that some immaculate solution will emerge. It won’t. Instead, many more sectors of the European economy will be contaminated, including companies and households. Indeed, this was the trap that engulfed the United States after the 2008 crisis, and it is what contributes today to the prospects of years of slow growth, excessive unemployment, and recurrent balance sheet concerns.
Instead of seeking to maintain an increasingly unstable and dangerous situation, policymakers must now attempt bold and coordinated approaches. As I have argued elsewhere, Europe must lead by recognizing the inherent inconsistencies of the current eurozone and opt for a smaller, less imperfect, and therefore stronger union. At the same time, national governments must embark on proper structural reforms that increase actual and potential growth and jobs. Banks must be forced to recapitalize and come to terms quickly with their weakening asset quality. And the rest of the world must help by providing focused capital injections and, in the case of some developed and emerging economies, more expansionary policies rather than austerity for the sake of austerity.
In their gathering in Washington this week, policymakers from all over the world have a unique chance to change the course of events. But they must recognize the depth of the problem and the degree to which they all have a stake in finding a solution, quickly. Perhaps first, though, they need to appoint a conductor to harmonize what are increasingly incoherent policies across national borders. Idealists would opt for the IMF, while realists would choose Germany.
Policymakers face a stark choice. They can either lead an orderly economic response or be forced to clean up after a chaotic, ad hoc, messy one. Europe’s problem is now the world’s; and such a global problem requires a global solution.
Mohamed A. El-Erian is chief economic advisor at Allianz and president of the University of Cambridge’s Queens’ College. Twitter: @elerianm