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Europe’s policymakers are at their reality checkpoint

The eurozone crisis needs to be solved to end the market turmoil. But can 17 countries, the US, China, German consumers and central banks find a way out of this mess?

Parker’s Piece is an open space that separates town and gown in Cambridge. Colleges sit on one side of the green, residential streets on the other. There is a lamp-post in the middle, which in the 1970s had a message scrawled on it for the benefit of students entering the real world: reality checkpoint.

The global economic community arrived at its own reality checkpoint late last week. Against a backdrop of falling financial markets and rapidly cooling activity, there was a sense of urgency at the annual meeting of the International Monetary Fund (IMF). “Fear is a great motivator,” one participant said. “And there is much to be frightened about.”

Recovery from a crisis that exploded deep within the financial systems of the most advanced countries and left an overhang of indebtedness was always going to be long and difficult.

But the situation has been made far worse by blundering policymakers who have made a series of mistakes. The list includes, in no particular order, the failure to resolve the Greek debt crisis, the infantile squabbling on Capitol Hill over the US budget, the two hikes in interest rates by the European Central Bank this year, China’s refusal to allow the yuan to be revalued to an appropriate level on the foreign exchanges, allowing the benefits of quantitative easing to be squandered on speculation, the German reluctance to expand domestic demand, and George Osborne’s deficit-reduction zeal.

Gordon Brown, who was in Washington last week, rightly noted that the world was drifting “rudderless and leaderless towards a second downturn”. The former prime minister declared that muddling through had failed. He was right about that as well.

The communique from the IMF’s policymaking committee yesterday insisted that the days of fudging the big issues was now over. “We agreed to act decisively to tackle the dangers confronting the global economy,” it said. That would certainly make a welcome change, since the story of the past two years has been of financial markets dictating events, with policymakers always a few steps behind.

This has, of course, been particularly true of Europe, where the problems of securing the support of all 17 eurozone members to patch up a fundamentally flawed monetary union have prevented the decisive action the IMF now wants.

Eurozone finance ministers came under immense pressure in Washington to get their act together, with the Americans leading the attack. Barack Obama already faces a struggle to win a second term and fears that a collapse of the euro triggered by a disorderly Greek default would push the US economy back into recession and thereby cost him a second term in the White House. Hence the particularly sharp warning to Europe from the US treasury secretary, Tim Geithner, that the “threat of cascading default, bank runs and catastrophic risk must be taken off the table”.

What Geithner wants is the sort of “shock and awe” Europe has failed so miserably to provide until now. In July, the leaders of the 17 eurozone nations committed €440bn (£380bn) to a European Financial Stability Facility, which would operate as a bailout fund for members in trouble. The intensification of the crisis means that the pot of money is now too small, so even before the EFSF has been formally agreed by all 17 member states there have been attempts to leverage €440bn in capital into something close to €2tn. That, it is believed, will give Europeans the firepower to seal off Spain and Italy from the financial market pressure that has seen the cost of debt financing rise to just below the levels that triggered the crises in Greece, Ireland and Portugal. Europe has a deadline of mid-October, when finance ministers of the G20 group of developed and developing nations reconvene in Paris to decide how it will leverage up the EFSF and recapitalise its banks.

That, given the normal glacial pace at which decisions are taken in Europe, looks like a demanding timetable, but last week’s market turmoil clearly shows the dangers of getting behind the curve.

So, arriving at reality checkpoint, what can policymakers do about it? Judging by the recent poor news, the eurozone is already on course to slide back into recession, and there is a risk that the US and the UK will join them. There is a chance, however, that the downturn could be short and shallow provided the right decisions are taken over the coming months:

• Greece cannot be allowed to continue in its zombie existence. Either it has to default in an orderly manner or it has to be properly rescued. This is no longer a real choice: there has to be a managed default in which Greece’s debts are reduced by more than 50% to make it financially sustainable.

• Europe needs to scale up the EFSF fivefold to show markets it means business. A €2tn fund would be big enough to prevent it having to be used.

• The ECB should reverse this year’s interest rate cuts in order to help recapitalise Europe’s vulnerable banks.

• Quantitative easing needs to be more effective. It would need collective action by the Federal Reserve, the Bank of England, the European Central Bank and perhaps banks in emerging countries – a move that would allay fears that QE was being used to manipulate the dollar downwards – and the creation of investment banks to channel electronic money into productive investment.

• The big surplus countries, notably China and Germany, must boost domestic demand. There is little chance of this judging by the comments of Germany’s finance minister, Wolfgang Schaüble, in Washington . Arguing that the 2008-09 crisis was due to excessive deficits and debt, he said: “You can’t cure an alcoholic by giving him alcohol.” China is also retrenching and is not willing to let the yuan float freely. But if these two big surplus countries don’t take up the slack from deficit countries painfully cutting budgets, there will, says Charles Dumas of Lombard Street Research, be a global slump next year.

“The global deflation is caused by too much saving, centred on China, Japan and Germany, plus surrounding North European countries,” he said. “Until consumption grows in the excess savers, necessary cuts in government deficits in the US, UK, Club Med etc, will ensure that global demand is inadequate.”

That makes it all the more desirable that countries go easy on tightening the belts. The US should look to helping struggling homeowners than cutting deficits. George Osborne should heed the IMF’s warning that he will need a Plan B should the economy continue slowing.

It is unclear, even now, whether those in charge of our affairs realise just how serious things have become. Let’s hope they do because if anything has been learned in the past 18 months it is that if policymakers don’t act decisively and swiftly, the financial markets certainly will. © 2011 Guardian News and Media Limited or its affiliated companies. All rights reserved. | Use of this content is subject to our Terms & Conditions | More Feeds