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Unwinding Crisis Policies in Europe: Are We There Yet?

Much is riding on getting the timing of the exit right from the stimulative policies used to combat the global economic and financial crisis. This is something that IMF Managing Director Dominique Strauss-Kahn has repeatedly emphasized. Exiting too early may jeopardize the recovery. But exiting too late may sow the seeds for the next crisis, as Wolfgang Munchau and others have argued recently. I also agree with Jean Pisani-Ferry and his colleagues that exiting in an uncoordinated fashion will lead to a renewed build up of financial instability.

To successfully unwind the extraordinary policy measures taken in response to the crisis, we need more than just a good sense of the state of the economic recovery and the degree of financial stability. We also need to know to what extent the global economy currently is influenced by those supportive policy measures. Is it safe yet to change course?

Continued macroeconomic support

We are no longer at the edge of the abyss that loomed in early 2009, with all but a handful of Europe’s economies now pulling out of recession.

But it is less clear that we have reached safe ground:

  • Financial market participants do not seem to be able to make up their mind about the scenario we are in: equity valuations anticipate a solid and durable recovery, yet investors are willing to meet governments’ extraordinary financing needs at very low interest rates as if growth prospects were poor.
  • Bank lending, crucial for Europe’s smaller and medium sized enterprises, remains tight, but capital markets are very active in funding larger corporations.
  • Unemployment is still rising but consumers appear to be “believing in inflation again”, which is helping dispel lingering worries over deflation.
  • The euro is close to a historic high in real effective terms, and tensions in the euro area from divergences in economic performance and policy implementation have risen. I will return to this issue in depth in my next blog.

This ambivalence can perhaps be attributed to the fact that extraordinary policy support, not just in Europe but also globally, impairs our ability to read the underlying economic fundamentals. The crisis has been very deep, and is likely to require economic restructuring and widespread balance sheet repair--processes that necessarily take time.

Taking these factors together, I believe that it is important for fiscal and monetary policies to continue to support the recovery. While a rebound is under way, the recovery is still fragile, subject to important downside risks, and uneven across the continent. We plan to publish revised growth forecasts at the end of January in the next quarterly update of the World Economic Outlook.

Cautious switch from systemic to specific financial intervention

With so many policy measures shoring up the financial system, it is hard to get an accurate read of its pulse and see whether it is stable enough to leave the emergency room. Yet equally important is the concern about these supportive policies turning into an addiction.

So, where are we? There is ground for guarded optimism. As ECB Vice-President Lucas Papademos noted when presenting the ECB’s Financial Stability Review, confidence and resilience in financial markets has improved and remaining problems appear to be no longer systemic. But I also share his view that vulnerabilities are still high. Will banks be able to sustain the recent increase in profitability? Will they succumb to concentrations in lending to commercial property or emerging markets? And how would they handle a sharp increase in sovereign yields if fears about fiscal sustainability became widespread?

Still, on balance, the time seems to have come to begin to progressively unwind some of the financial sector support measures. Technically, such unwinding is made easy because most of Europe’s supportive measures have built in sunset clauses (most enhanced credit support measures), provisions linked to market conditions (for instance, debt guarantees), or costs that become more onerous as time progresses (for instance, recapitalization schemes).

I would encourage policymakers to remove financial system supports in line with their built-in expiration dates. Indeed, the ECB has started doing this by ending its one year liquidity support measures and some countries have allowed debt guarantee schemes to lapse. The policy priority, instead, is to tackle remaining weaknesses with specific interventions.

Next: financial sector reform and credible fiscal consolidation

As IMF First Deputy Managing Director John Lipsky pointed out two weeks ago, we should not forget the need for fundamental reforms in the financial sector. Europe has seized the crisis as an opportunity to put in place new pan-European financial stability arrangements. It now needs to play its part in implementing global regulatory reform. Clarifying quickly what the new rules will be would allow financial institutions to focus on their core business: provide credit where credit is due.

The crisis has also exposed the weak underlying state of public finances in Europe.

While a strong fiscal policy response to the crisis was necessary, I worry about the surge in government indebtedness and the potential for an adverse shift in sentiment about fiscal sustainability. To avert this, countries need to demonstrate credible plans for fiscal consolidation. Yet while Europe’s finance ministers tabled ambitious intentions, guided by the Stability and Growth Pact, translating these promises into credible plans has become more urgent than is generally perceived. Some of these issues are particularly pertinent for the euro area. I plan to blog on this next.


See also José Viñals on Exit Strategy and Unwinding Public Interventions in the Financial Sector.