The U.S. economic recovery is only tepid and faces two major risks — the "fiscal cliff" and what’s going on in the euro zone, International Monetary Fund Managing Director Christine Lagarde told CNBC.
The fiscal cliff is when tax increases and spending cuts are slated to go into effect at the start of 2013.
Lagarde said that if the risks of the debt ceiling and the fiscal cliff were to hit, the U.S. economy could contract.
The IMFsees the U.S. economy growing about 2 percent in 2012 and 2.3 percent in 2013. “But if the risks materialized, it would reduce that growth to almost nothing,” Lagarde said.
While policy makers may not take up the fiscal cliff until after the election, it would be far better to address the fiscal cliff sooner rather than later, Lagarde said.
“If there was an agreement earlier on, it would be a serious confidence booster for the U.S. economy,” she said.
A deterioration in the euro zone is the other major risk to U.S. growth, Lagarde said. But the fact that the European Stability Mechanism, the bailout fund for the euro zone, can invest in the capital of the Spanish banks has helped Spain enormously, Lagarde said.
The IMF has long advocated allowing the ESM to invest in banks directly since it avoids going through the sovereign and doesn’t affect a country’s debt ceiling, Lagarde said. Moreover, if you invest in the capital of banks, you restructure them and you help in providing credit to the economy.
This plan for the ESM hinges on having a common European banking regulator with a clear role for the European Central Bank. “It’s terrific," Lagarde said. "From a strict monetary union, the euro zone is also moving into a banking union with one single supervisor who will have the authority to check what the national supervisors are continuing to do on a day-to-day basis.”
A banking union isn’t enough though. Lagarde sees fiscal union as the next step. According to Lagarde, it would give rise to common fiscal policy, agreed upon objectives and even a common euro-zone debt agency and finance minister. “It’s not going to happen overnight,” Lagarde said.
The ECB also can play a greater role. While the IMF sees room for lower European rates, Lagarde said it may be better for the ECB to use its asset program which can be used in a more "judicious way."