With her first important speech as managing director of the IMF, Christine Lagarde stole all the headlines at the Federal Reserve Bank of Kansas conference at Jackson Hole. Market participants had hoped that Federal Reserve chairman Ben Bernanke would be the star, with a new announcement of further quantitative easing to calm the markets.
Instead, Lagarde commanded the spotlight with an unflinching analysis of what she calls a dangerous new phase of the crisis that began in 2008, amid signs that the fragile economic recovery is being derailed and confidence in policymakers capacity to respond is evaporating.
Her urging that governments should retain some capacity to support growth through fiscal expansion and focus more on reducing long-term funding commitments to entitlements such as pensions and health care and less on drastic up-front belt tightening, might sound simplistic and even the product of wishful thinking. At least it is a useful challenge to the now prevailing orthodoxy that markets are close to shutting out developed-world sovereign borrowers.
In any case, it was her call for urgent and even mandatory substantial recapitalization of Europes banks, drawing on private capital first and public funds if needed, that drew the most startled response. In a couple of sentences, it damns the European regulators recent stress tests.
Bankers scoff at Lagardes observation that a failure to achieve this recapitalization might lead to a debilitating liquidity crisis, saying it shows a failure to understand that the European Central Bank offers unlimited liquidity to Europes banks. Some question the relationship between high levels of tier 1 capital and lower funding spreads. But to Euromoney, this sounds like a more worrying example of wishful thinking.
In the summer months, it grew increasingly difficult for many European banks to raise unsecured term funding in the wholesale capital markets. Some banks have suffered startling share price declines, which, if they continue unchecked, might even begin to de-stabilize institutions by panicking depositors into withdrawing their funds. Renewed recession across Europe will cut into banks supposedly robust capital buffers even in the absence of further sovereign defaults.
Investors might worry that heightened expectations of further imminent sovereign debt write-offs prompted Lagardes call for recapitalization of the banks. Her observation that the crisis leaves no room for further ambivalence or confused messages over Europes direction, and that further integration must be based on fiscal rules that actually work, is at least unusually and refreshingly blunt.
Missing from Lagardes speech was any analysis of the IMFs own role in all this. It has, according to witnesses at the heart of the battle over Europes faltering sovereign finances, been a much more timid combatant than it was in Asia after 1998, or periodically in Latin America.
In the early days of Europes sovereign debt crisis, it was assumed that the German government had asked the IMF to play a prominent role because it did not trust the European Commission. Recently, it seems to have been relegated to the background even where it holds the key lever of withholding funds from recalcitrant borrowers backsliding on their budgeting and reform commitments.
The troika overseeing Greeces bailout supposedly comprises the IMF, the ECB and the European Commission. In reality, say bankers, it comprises Merkel, Sarkozy and Trichet. It might be useful in the months ahead if the IMF, as an independent body, were to step up to the plate in advising governments and holding them to account. At least its new leader has shown a welcome capacity for blunt speech in the teeth of a crisis, while many European policymakers remain in denial.
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