IMF issues new warning on Eurozone economy

The International Monetary Fund this morning released its latest review of the eurozone economy, a collection of 16 countries that, judging from the report’s conclusions, are becoming the continent’s new Brothers Grimm.

Growth is slow — and at risk of getting slower because bank credit has dried up. The banks themselves are undercapitalized and far too dependent on government support. Core prices are falling, raising the risk of a dangerous deflationary spiral. The entire project of the monetary union needs a full overhaul so that countries can be forced by a central authority to keep their budgets in line — so that near-broke countries such as Greece look a bit more like Germany, and that tightwad Germany spends a bit more freely to support neighbors like Greece.

The project is a complicated one: The architects of the common euro currency knew going into the venture that they were creating a union that was only half-formed. The 16 countries share a central bank and a common monetary policy. But they control their own fiscal affairs and set their own rules when it comes, for example, to labor markets — a fact that has prevented the type of labor mobility and wage adjustment considered necessary for an “optimal currency union.”

The IMF, however, is never shy on dishing out tough love. Typical of the report’s language was this staff appraisal: “The currency crisis results from unsustainable policies in some countries, delayed repair of the financial system, insufficient progress in establishing the discipline and flexibility needed for a smooth functioning of the monetary union, and deficient governance of the euro area.”

The agency was also skeptical — as have been many analysts — about the thoroughness of stress tests currently being performed on 91 banks across Europe to see whether they will be able to weather another financial shock. In a conference call with reporters, Luc Everaert, assistant director of the IMF’s European Department, said the fund will be looking closely at the release of the test results Friday to see what they do and don’t prove.

“For Friday, what is essential is that we see broad coverage, scenarios that are severe but plausible, and it is going to be very important the they are clear plans” for raising new capital for banks that are judged to be weak, Everaert said.

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