IMF Special Reports: “They Should Have Known Greece Was Insolvent”

Barry Eichengreen, professor of economics and political science at the University of California, Berkeley, has some stinging criticism of the European Union’s handling of the Greek crisis.


Europe’s banking system is on the verge of melting down, as the ECB and the IMF struggle to contain the crisis that began in Greece and has spread throughout most of the continent and the world. Barry Eichengreen, professor of economics and political science at the University of California, Berkeley, has been a forceful critic of those institutions. Eichengreen, whose most recent book is Exorbitant Privilege: The Rise and Fall of the Dollar, has argued that the policymakers have been in denial about the depth of the financial and economic crisis. Here Eichengreen – himself a former senior policy advisor to the IMF – explains why he believes Europe is once again at the precipice and how to pull it back from the brink. Here are highlights of his conversation with Institutional Investor contributing writer Steve Rosenbush.

Institutional Investor: How critical is the debt crisis in Europe and is world political and economic leadership managing it properly?

David Eichengreen: As I put it in a recent article, Europe is at the precipice. The survival of the euro and the European Union itself are at stake. So far, the policy response has been ineffective. (“Ineffective” is the most polite description I can think of.) To address the crisis, three things must be done, immediately. Most important is that European banks be recapitalized. There is absolutely no doubt that Europe has a bank funding problem. So far, the euro area has preferred to deny the existence of that problem.

Second, Greece needs breathing room. The debate is over how much of a haircut investors will have to take, and over the timing of that haircut. The markets are finally recognizing the extent of the problem. They are now asking: Will it be taken all at once, or over time? Investors may be left with less than one half, or as little as one third, of the original value of that debt.

Third, Greece and Europe more generally need to promote growth, with labor market reform and tax reform that encourages investment. Coordinated fiscal stimulus and lower taxes would be ideal, but if that is not possible, then the ECB must act by lowering interest rates and buying debt. Over the longer run, leaders in Europe can address deficit reduction and structural changes in the euro zone.


On Tuesday, Greek finance minister Evangelos Venizelos said that satisfactory progress had been made in reaching an agreement with EU and IMF lenders, so that the next installment of Greece’s bailout can be released, and the country can avoid an immediate default. Do you buy it? Have the odds, or the timing, of a default, now priced into the markets, changed in the last two days?

I don’t think that much has changed. The most likely scenario remains that Greece gets their next disbursement, but restructures when the reformed EFSF has been ratified.

IMF policy was totally ineffective – again to put it politely – at the beginning of the crisis. They should have arrived in Athens at the end of 2010 with a restructuring plan in their pocket and insisted on its implementation. They should have known Greece was insolvent. No country can remain solvent for long when debt is 160 percent of GDP.

The IMF warned Wednesday of a new $410 billion/300 billion euro credit risk to European banks. Does that estimate sound right, or is it too low? Will banks in Europe be able to recapitalize, and at what cost to banks and shareholders? Do you expect to see European bank failures beyond Greece?

Yes, the IMF estimate sounds like it’s in the right ballpark. I’ve been guessing $500 billion. Will European banks be able to recapitalize? That depends on how far the problem extends – will it be limited to Greece, in other words? And will they be able to recapitalize with or without government help? I’m am guessing that the answer to that one depends on whether the banks in question are French or not.

What is the broader outlook for European sovereign debt?

Much depends on how the Greek problem is handled. The prospects for the rest of Europe will turn on whether a Greek default is orderly or disorderly – on whether the default is controlled or uncontrolled. And it will depend on how euro-area policy makers respond. When the inevitable Greek restructuring occurs, the ECB should ring-fence other countries by purchasing their debt. More generally, what happens in other euro-area countries will depend on how much progress they have made in terms of fiscal and structural reform.

Spain and Portugal have made significant progress in fiscal and structural reform, Italy less so. The case of Italy is worrisome because of the country’s size and because it lacks political leadership. At the end of the day, the outlook for European sovereign debt depends on economic growth. If you think that Europe can grow again, then European debt is a very good value.

Will the euro zone survive in its current form?

The answer depends on what you mean by “current form.” If current form means membership, then I don’t think that the membership will change. People use the analogy of the song “Hotel California.” You can check in [any time you like] but you can never leave. I think that analogy is still right. No country that is currently a member of the euro zone can to afford to leave. And for a country such as Poland, the appeal of joining the euro zone isn’t exactly what it once was. It’s like the Groucho Marx saying – I wouldn’t want to belong to any club that would want me as a member.

But, unlike the membership, the structure of the euro zone has to change. A lot of proposals have been made – full fiscal union, common budgets, common regulations, and common euro bonds. Europe can pursue these options once it has drawn a line under its crisis.