Thursday, November 20, 2014

The IMF’s False Confession

PRINCETON – “Do I have to go on my knees?” the International Monetary Fund’s managing director, Christine Lagarde, asked the BBC’s Andrew Marr. Lagarde was apologizing for the IMF’s poor forecasting of the United Kingdom’s recent economic performance, and, more seriously, for the Fund’s longer-standing criticism of the fiscal austerity pursued by Prime Minister David Cameron’s government. Now endorsing British austerity, Lagarde said that it had increased confidence in the UK’s economic prospects, thereby spurring the recent recovery.

Lagarde’s apology was unprecedented, courageous, and wrong. By issuing it, the IMF compromised on an economic principle that enjoys overwhelming academic support: The confidence “fairy” does not exist. And, by bowing to the UK’s pressure, the Fund undermined its only real asset – its independence.

The IMF has dodged responsibility for far more serious forecasting errors, including its failure to anticipate every major crisis of the last generation, from Mexico in 1994-1995 to the near-collapse of the global financial system in 2008. Indeed, in the 6-12 months prior to every crisis, the IMF’s forecasts implied business as usual.

Some claim that the Fund counsels countries in private, lest public warnings trigger the very crisis that is to be avoided. But, with the possible exception of Thailand in 1997, the IMF’s long-time resident historian, James Boughton, finds little evidence for that view in internal documents. The IMF’s Internal Evaluation Office is more directly scathing in its assessment of the Fund’s obliviousness to the US subprime crisis as it emerged.

Given that the IMF is the world’s anointed guardian of financial stability, its failure to warn and preempt constitutes a far more grievous lapse than its position on British austerity, with huge costs borne by many, especially the most vulnerable. For these failures, the Fund has never offered any apology, certainly not in the abject manner of Lagarde’s recent statement.

The Fund does well to reflect on its errors. In a September 2003 speech in Kuala Lumpur, then-Managing Director Horst Köhler conceded that temporary capital controls can provide relief against volatile inflows from the rest of the world. He was presumably acknowledging that the Fund had it wrong when it criticized Malaysia for imposing such controls at the height of the Asian crisis. Among the countries hurt by that crisis, Malaysia chose not to ask for the Fund’s help and emerged at least as well as others that did seek IMF assistance.

Malaysia’s imposition of capital controls was a controversial policy decision. And even as the Fund opposed them, prominent economists – among them Paul Krugman – endorsed their use. In his speech, Köhler reported that the Fund had taken the evidence on board and would incorporate it in its future advice.

But in the current crisis, the academic evidence has overwhelmingly shown that fiscal austerity does what textbook economics says it will do: the more severe the austerity, the greater the drag on growth. A variety of studies confirming this proposition, including one by the IMF’s chief economist, Olivier Blanchard, have withstood considerable scrutiny and leave little room for ambiguity.

The two public voices arguing for the magical properties of austerity are official agencies based in Europe: the OECD and the European Commission. The Commission’s stance, in particular, is animated by an institutional commitment to a fiscal viewpoint that leaves no room for evidence.

Among the G-7 economies, only Italy has done worse than the UK since the Great Recession began. Indeed, the UK’s GDP has only just regained its 2008 level, lagging behind even France.

This is all the more remarkable given that the crisis in the UK was comparatively mild. The fall in property prices was modest relative to Ireland and Spain, and, because there was no construction boom, there was no construction bust. Having missed the warning signs about the bank Northern Rock, which needed to be bailed out by the UK government after a run on its deposits in September 2007, the British authorities, unlike their eurozone counterparts, quickly dealt with the economy’s distressed banks. For these reasons, the UK should have had a quick recovery; instead, the Cameron government’s gratuitous austerity stifled it.

The IMF’s apology was a mistake for two reasons. Thumbing one’s nose at scholarly evidence is always a bad idea, but it is especially damaging to an institution that relies so heavily on the credibility of its technical competence and neutrality. If the Fund embraces muddled economics, on what basis will it defend its policy advice?

Moreover, in choosing to flatter the UK’s misguided policy, the Fund has confirmed its deference to its major shareholders. For years, the view has been that the IMF is a foreign-policy instrument of the United States. The softness in its annual surveillance of UK economic policy has also been well known.

But in taking this latest step, the Fund has undermined – perhaps fatally – its ability to speak “truth to power.” If so, a fundamental question may well become unavoidable: Why does the IMF exist, and for whom?

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    1. Commentedslightly optimistic

      The G20 in 2014 is chaired by Australia. It is in the powerful position to help determine whether the G20 [FSB]or the IMF is the anointed guardian of financial stability. [see below]
      The implications are immense.

    2. CommentedAlex Finch

      Earlier this year, after sending a team of economists to Australia, the IMF produced their latest Country Report on Australia, giving the country a clean bill of health. They appear to have simply used or endorsed the Reserve Bank of Australia's Dwelling prices and Household Income ratios and charts. But these charts are wrong. The RBA argues that when making international comparisons in dwelling prices to income ratios, the median income that most countries use is not well suited for Australia due to lack of up-to-date surveys, and therefore the average measure is more appropriate. It appears that the IMF has bought into this argument and also mixed up the median measure (which the RBA has at about 7 times income) with the average measure (which the RBA has at about 4 times income) and then compared Australia's average ratio with the rest of the world's median ratios. This is hiding Australia's true housing bubble. The IMF has also failed to understand the unsustainable dynamics at work in Australia's economy, which is due to the high net migration policy adopted after 2003 to contain the risk of a crash in house prices after a huge run-up in prices and credit from 2000 to 2003 (after the Sydney Olympics). It seemed to work so the government just kept on bringing in more migrants (first 100K, then 200K then 300K per year). High population growth has fuelled high GDP growth, high wages growth and very high household debt growth. The Australian Bureau of Statistics has just released an alarming update on household debt (4102.2 Australian Social Trends 2014). Total household debt in Australia now stands at $1.84 trillion or $79.000 per person; total household debt to gross household disposable income is 180%. But these ratios are misleading because Australia, similar to Spain before 2008, has been systematically raising real wages to internationally uncompetitive levels so that in absolute terms household debt levels are now about double that of households in Canada, UK, Germany and even the US. Recently the reserve banks of Germany and Austria reported that house prices in their countries were now overvalued. In contrast the Reserve Bank of Australia reports consistently maintain that house prices and household debt are not too high. And apparently the IMF sees nothing wrong either. As Paul Krugman writes in his book End This Depression Now: "once debt levels are high enough, anything can trigger the Minsky moment - a run-of-the-mill recession, the popping of a housing bubble, and so on". So if the IMF is trying to avoid causing any panic, then their reports need to be viewed as uninformative at best.

    3. CommentedAlasdair MacLean
      Britain projected to be the largest economy in Europe by 2030. And that was projected before the recent discovery of frackables south of London.
      But the problem with this projection is that it assumes that the EU and the euro will still exist by then. This is by no means a given. What will happen is that as the GB economy climbs the Germans will give up on Europe and negotiate a NEFTA excluding France and the south. And then the German economy will return to the top which is its natural position. But the rest are doomed, I say, doomed.

    4. Commentedslightly optimistic

      But is the IMF really the world’s anointed guardian of financial stability?
      Following the financial collapse in 2008, the G-20 intervened and established its Financial Stability Board to coordinate at the international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies in the interest of financial stability. The FSB is chaired by Mark Carney, Governor of the Bank of England.
      The G-20 is surely therefore responsible for financial stability, not the IMF.

    5. Commentedslightly optimistic

      "Why does the IMF exist, and for whom?"
      This question is partly answered in the article: "the IMF is the world’s anointed guardian of financial stability".
      Interestingly the permission of the US Congress is needed to improve the global organisation. However this is being withheld at present. Washington is said to be refusing a more balanced debate on the matter - there is scepticism that emerging economies support the existing norms and values of international financial institutions.
      Not all agree with this position of course. Not the G20, nor a former chairman of the US Federal Reserve who last month questioned the adequacy of the present financial arrangements. Paul Volcker suggested we might need a new Bretton Woods.