The 2011 Economic Policy Forum held in Jackson Hole, WY, featured several distinguished speakers. Most notable among them was the head of the International Monetary Fund (IMF), Christine Lagarde.
In her speech, her first since replacing the disgraced Dominique Strauss-Kahn, she addressed the world economy and unveiled her strategy for rescuing both America and Europe from faltering economies.
“The global economy continues to grow, yet not enough,” she said before the crowd. “Some of the main causes of the 2008 crisis have been addressed, yet not adequately.”
“Resolving the crisis would require two key re-balancing acts—a domestic demand switch from the public to the private sector, and a global demand switch from external deficit to external surplus counties,” Lagarde confidently asserted before the forum's attendees.
She continued, “But the actual progress on re-balancing has been timid at best, while the downside risks to the global economy are increasing."
Having thus set the stage for her plan, she launched into a presentation of a multifaceted strategy to “save” the world economy.
“We need a new approach—based on bold political action, with a comprehensive plan across all policy levers, implemented in a coordinated global way. A major cause of the crisis was too much debt and leverage in key advanced economies,” she said.
“In 2008, governments took bold action to prevent a calamitous collapse in demand. They offset private contraction with fiscal expansion and used public resources to recapitalize financial institutions. They strengthened financial regulation, and reinforced the capacity and resources of international institutions. And monetary authorities did their part as well. Global growth is also being held back by policies that slow demand in some key emerging market economies while balance sheet risks are increasing in others,” she said.
She then went on to propose a series of actions that would, “Deliver savings tomorrow which, in turn, will help to create as much space as possible for supporting growth today—at least by permitting a slower pace of consolidation where possible. Among these actions were, “Measures that change the rate of growth of entitlements, health, or retirement.”
She then directed her attention toward Europe and claimed that the best route to recovery, as far as she could tell, would be to enable “more financing” for the banks.
“Banks must recapitalize,” she flatly stated and that, “Sufficient financing can come from the private or official sector—including continued support from the ECB [European Central Bank], with full backup of the euro area members.”
Recapitalization can be done for a number of reasons: ensuring against a hostile takeover, minimizing tax losses or implementing an exit strategy for venture capitalists. Companies often want to diversify their debt-to-equity ratio to improve liquidity (the degree to which an asset or security can be bought or sold in the market without affecting its price). A good example is when a company issues stock in order to buy back debt securities, thereby boosting its proportion of equity capital as compared to its debt capital.
However, what Lagarde is most likely advocating is a “leveraged” recapitalization of the banks, that is, a change of the capital structure of the banks by substituting equity for debt by issuing bonds to raise money, and by using that money to buy the company's stock or to pay dividends.
Restructuring a bank using this method involves a deposit insurance fund, as in a bailout of a failing bank, where the insurance fund pays the acquiring bank the difference between the book value of a troubled bank's assets and the estimated market value. The insurance fund may also take an equity position in the restructured bank.
What is odd about this is that recapitalizing the banks will most likely have a negative effect on investor confidence (something she claimed she wanted to improve). Leveraged recapitalization in a bank increases its liabilities (because of the extra debt) while reducing its equity. This tends to make it unattractive to anyone who is interested in the financial longevity of said organization.
What is even more interesting is that she suggests recapitalizing the banks after volunteering the private sector as the first to help in these efforts (followed by the European Central Bank). How will the private sector provide for this refinancing? How will the European Central Bank help finance?
Tax first and (perhaps) print money later.
“Europe needs a common vision for its future. So Europe must recommit credibly to a common vision, and it needs to be built on solid foundations—including, for example, fiscal rules that actually work,” she said.
After her plan for Europe, she addressed the U.S.
She began by incorrectly stating that, “A fair amount has been done to restore financial sector health,” but also notes that, “house price declines continue to weaken household balance sheets.”
She then went on to say that she believes the cure with America lies in, “Credible decisions on future consolidation—involving both revenue and expenditure—create space for policies that support growth and jobs today.”
However, the "Ah-ha!" moment occurred when she encouraged American politicians to be more intrusive in regards to the housing market:
“[Halt] the downward spiral of foreclosures, falling house prices and deteriorating household spending. This could involve more aggressive principal reduction programs for homeowners, stronger intervention by the government [emphasis added] housing finance agencies, or steps to help homeowners take advantage of the low interest rate environment.”
She framed all of her strategy, of course, through the prism of moral urgency:
“As in the first phase of the crisis, we have reached a point where actions by all countries, doing what they can, will add up to much more than actions by a few. There is a clear implication: we must act now, act boldly, and act together,” she sermonized in her peroration.
Fortunately, not everyone agrees with Lagarde. European Central Bank President Jean-Claude Trichet scoffed at the suggestion that the banks need to be recapitalized and said that measures already taken would “prevent a liquidity crisis in the European banking sector.”
It is also interesting to note that Angela Merkel, considered the “most powerful women in the world” and on whom the hopes and fate of the euro zone rest, agrees with Trichet.