IMF managing director Christine Lagarde said Europe needs a stronger financial firewall to prevent the spread of a debt contagion.
NEW YORK (CNNMoney) -- The director of the International Monetary Fund said Monday that Europe needs a stronger financial firewall to stop the spread of debt contagion in the eurozone.
Speaking in Berlin, IMF chief Christine Lagarde supported a plan to fold the resources of the European Financial Stability Facility into its permanent replacement, known as the European Stability Mechanism, which has yet to be fully established.
The EFSF is valued at €440 billion, while the ESM is expected to have €500 billion in lending capacity. Combining the funds could result in a total firewall worth €1 trillion, according to eurozone officials.
"We need a larger firewall," said Lagarde. "Without it, countries like Italy and Spain, that are fundamentally able to repay their debts, could potentially be forced into a solvency crisis by abnormal financing costs."
Lagarde stressed that the ESM should be funded with "real tangible capital," as opposed to the loan guarantees that make up the EFSF.
The comments came as finance ministers from the 17 nations that use the euro currency, known as the Eurogroup, met to discuss ways to speed up implementation of the ESM. They are also expected to hash out the details of the fiscal pact European leaders proposed in December.
In addition to calling for a stronger firewall, Lagarde said eurozone officials need to do more to boost economic growth, which could include additional action by the European Central Bank.
Lagarde also said the eurozone needs to move toward greater "fiscal integration." She pointed to a number of options for "fiscal risk-sharing," including the creation of so-called euro bonds, an idea that has proved controversial.
She welcomed steps the ECB has taken so far, including a long-term lending program that has already pumped nearly €500 billion into the banking system.
"That has helped enormously," Lagarde said, adding that "there is a role for the ECB to play in terms of monetary policy."
European banks need to raise more capital, but they must do so in a way that will not cause credit conditions to contract, cautioned Lagarde.
She said governments with large deficits need to continue to tighten public finances, although she warned the aggressive budget cuts could increase the risk of a deeper recession. However, nations that are in better financial shape should contribute to the "common effort" by scaling back fiscal consolidation, she added.
Separately, Lagarde said the IMF will lower its growth forecasts for "many part of the world" when it releases an update to its World Economic Outlook early Tuesday.
She called on global policymakers to do what is necessary to prevent a deeper decline, saying last year's economic problems were driven "by a lack of a collective determination to reach a cooperative solution."
"Now the world must find the political will to do what it knows must be done," she said.
While the debt crisis in Europe is the biggest threat, Lagarde also pointed to the challenges facing the U.S. economy.
"The United States, as the world's largest economy and the center of the global financial system, has a special responsibility," she said.
Despite signs of a modest recovery, the U.S. economy remains hindered by high unemployment and a weak housing market.
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