Changing of Lagarde

This week, the president of the European Commission, José Manuel Barroso, declared the euro crisis over. On Jan. 7, he told reporters, "I think we can say that the existential threat against the euro has essentially been overcome." It was a shocking expression of denial, even for a member of the European policymaking establishment that has had its head in the sand since the beginning of the crisis. Fortunately, a new voice has emerged to disrupt the European echo chamber, that of International Monetary Fund chief Christine Lagarde.

Under Lagarde’s refreshingly bold, imaginative, and courageous leadership, the IMF is at last proving to be an effective force in counterbalancing the excessive budget policy orthodoxy of the European Central Bank (ECB) and the European Commission (EC) in the search for ultimate solutions to the European economic crisis. She has delivered a desperately-needed reality check.

It’s quite a turnaround. In the pre-Lagarde era, the IMF’s record on Europe was nothing short of abysmal. In the run-up to the crisis, the IMF failed miserably in its oversight of the European economy, despite the fact that balance-of-payments problems were supposed to be its main area of expertise. Rather than sounding the alarm about outsized external current account deficits in the European periphery, the IMF bought into ECB President Jean Claude Trichet’s now demonstrably mistaken view that balance-of-payments imbalances were of little concern in a monetary union with a single currency. That failure blinded the IMF to a crisis of epic proportions that still constitutes the most significant threat to the global economic recovery.

If the IMF’s failure to anticipate the European crisis was regrettable, its handling of it was even worse — revealing how little the fund had learned from previous economic and financial crises. Instead of addressing the crises in Greece, Ireland, Portugal, and Spain as the solvency problems that they were, the IMF approached them as a liquidity issue. More disturbingly yet, the fund threw its full weight behind severe budgetary austerity programs even though a euro straitjacket and a European credit crunch made those programs almost certain to fail.

Since taking over from Dominique Straus-Kahn in 2011, Lagarde has emerged as a courageous truth-teller to a European economic policymaking establishment that remains largely in denial about the severity of the crisis. In August 2011, in her first major policy speech as IMF chief, she broke the news to her European peers that the European banking system was undercapitalized by at least 200 billion euros, or around double the amount that the European policy establishment was prepared to admit. After taking considerable heat for her comments, subsequent events would prove that, if anything, her estimate was an underestimate of the true extent of European banks’ capital problem, which is now estimated by the OECD to be around 400 billion euros.

Then in September 2012, Lagarde had the guts to question the very foundation of Europe’s austerity program — suggesting that it could undermine the very goal of stabilizing the European periphery’s public finances. She directed her chief economist, Olivier Blanchard, to publish new estimates showing that the fiscal multipliers — a measure of the impact of budgetary tightening on economic growth — on which the IMF had based its financial support programs in Greece, Ireland, and Portugal were excessively low. The new estimates put the fiscal multipliers between 0.9 and 1.7 — up from the 0.5 that had been previously assumed. In other words, the damage done by budget tightening was likely to be two to three times as bad as the IMF had previously estimated.

Armed with these estimates, Lagarde has pushed back against the ECB and EC, arguing that by deepening the recession, excessive budget tightening can be counterproductive in stabilizing a country’s public finances. This has led her to recommend that Ireland, Portugal, and Spain not be subjected to another round of belt tightening if their economies continue to falter. Instead, she has argued that they should delay meeting their final budget deficit targets to allow domestic economic recovery to take hold.

Lagarde is also one of the few policymakers to recognize the severity of Greece’s public finance problem — and to challenge the European policymaking establishment on its repeated denials. In December 2012, she refused to go along with the European charade that Greece’s public finances were sustainable without a large write-down of its official debt obligations. Despite considerable pressure, she would not budge until European finance ministers committed themselves to a round of official debt reduction after 2014, putting Greece back on track to reduce its public debt to GDP ratio to 110 percent by 2022.

Lagarde’s impressive performance over the past year and a half leaves little doubt that she grasps the contradictions inherent in Europe’s present approach to the crisis. One has to hope that this understanding, coupled with the rare political courage she has demonstrated thus far, will enable her to persuade the ECB and the EC to shift gears to prevent Europe from sinking ever deeper into recession. Ultimately, however, saving Europe will require forcing some of the weaker countries out of the euro. Whether or not Lagarde has the courage to break that news to European policymakers will be the true test of her greatness.