Then in September 2012, Lagarde had the guts to question the very foundation of Europe's austerity program -- suggesting that it could undermine the very goal of stabilizing the European periphery's public finances. She directed her chief economist, Olivier Blanchard, to publish new estimates showing that the fiscal multipliers -- a measure of the impact of budgetary tightening on economic growth -- on which the IMF had based its financial support programs in Greece, Ireland, and Portugal were excessively low. The new estimates put the fiscal multipliers between 0.9 and 1.7 -- up from the 0.5 that had been previously assumed. In other words, the damage done by budget tightening was likely to be two to three times as bad as the IMF had previously estimated.
Armed with these estimates, Lagarde has pushed back against the ECB and EC, arguing that by deepening the recession, excessive budget tightening can be counterproductive in stabilizing a country's public finances. This has led her to recommend that Ireland, Portugal, and Spain not be subjected to another round of belt tightening if their economies continue to falter. Instead, she has argued that they should delay meeting their final budget deficit targets to allow domestic economic recovery to take hold.
Lagarde is also one of the few policymakers to recognize the severity of Greece's public finance problem -- and to challenge the European policymaking establishment on its repeated denials. In December 2012, she refused to go along with the European charade that Greece's public finances were sustainable without a large write-down of its official debt obligations. Despite considerable pressure, she would not budge until European finance ministers committed themselves to a round of official debt reduction after 2014, putting Greece back on track to reduce its public debt to GDP ratio to 110 percent by 2022.
Lagarde's impressive performance over the past year and a half leaves little doubt that she grasps the contradictions inherent in Europe's present approach to the crisis. One has to hope that this understanding, coupled with the rare political courage she has demonstrated thus far, will enable her to persuade the ECB and the EC to shift gears to prevent Europe from sinking ever deeper into recession. Ultimately, however, saving Europe will require forcing some of the weaker countries out of the euro. Whether or not Lagarde has the courage to break that news to European policymakers will be the true test of her greatness.