Prepare for disaster, IMF tells Eurozone

The International Monetary Fund (IMF), the world’s most influential government-owned financial institution, has issued a stark warning that the European Union may be incapable of managing a serious financial crisis involving one of its major cross-border banks.

The judgement of the Washington-based IMF, released this week (5 June), follows an assessment of the prospects for the eurozone economy by a team of its experts carried out last month. Its publication came hard on the heels of a speech by European Central Bank (ECB) President Jean-Claude Trichet in which he stressed that inadequate cross-border integration in eurozone financial markets is reducing the area’s growth potential and capacity to withstand economic shocks. He cited economic research showing that "countries with more liquid capital markets and a developed banking system are growing faster on average".

The IMF broke new ground with comments on the usually taboo topic of the threats to the stability of Europe’s banking system and a controversial call for the ECB to be part of a "revamped" cross-border supervisory structure. The IMF says that the EU’s financial market "home-host" regulatory principle, under which bank and financial market supervisors are "accountable only to their national authorities...rules out efficient crisis management and resolution", particularly when large complex cross-border financial institutions such as giant investment banks and financial conglomerates are involved.

The judgement will feed in to the ongoing debate about the threat to the stability of financial markets from the activities of hedge funds and private equity funds, especially in a Union whose efforts to improve cross-border financial sector co-operation and regulation are widely judged to be inadequate.

The IMF report also warns that, with the eurozone economy "moving from recovery to upswing", inflationary pressures are expected to intensify. It calls for the ECB to tighten monetary policy further. The central bank raised its key policy interest rate to 4.0% at its meeting on 6 June.

In his speech to the Lisbon Council in Brussels on 4 June, Trichet cautioned against complacency now that the eurozone economy seems to be growing strongly. "If all European economies summon up their strength and reinforce their push forward with structural reforms the improvement in economic activity will be broadened and made more sustainable in the long run," he said.

In particular, he gave no indication that he believed that the underlying long-term growth potential of the eurozone has increased, as some are arguing. He described longer-term growth trends as "relatively disappointing." The "significantly less flexible" eurozone economy was not able "to take advantage, as does the United States, of all the opportunities offered by the advances of science and technology, including, but not exclusively, in the information and communication technologies sector", he said.

"America’s more flexible labour markets, a higher degree of competition in product markets and lower barriers to entry for new firms are more conducive to the opportunities provided by new technologies than the more rigid and less competitive structures of Europe," he said.

The comments from Trichet, a former governor of the Banque de France, coincide with new French President Nicolas Sarkozy’s efforts to introduce a range of supply-side reforms into the French economy by, for example, lowering corporate taxes and making labour markets more flexible.

Trichet highlighted the success of such supply-side policies in three very different EU economies, the Netherlands, Denmark and Ireland. He pointed out that, in all three, "in 2006 the unemployment rate…stood below 4.5% while the overall employment rate was above or close to the US level, namely 72%". The equivalent EU-wide figures are 7.9% for unemployment and 64.5% for the level of labour market participation by those of working age.

The International Monetary Fund (IMF), the world’s most influential government-owned financial institution, has issued a stark warning that the European Union may be incapable of managing a serious financial crisis involving one of its major cross-border banks.