WASHINGTON D.C. -- Until recently, the International Monetary Fund’s main job was lending to countries with balance-of-payment problems. Today, however, emerging countries increasingly prefer to “self-insure” by accumulating reserves (and sharing them through regional pooling arrangements). As a result, the Fund must change, reinforcing its supervisory role and its capacity to oversee members’ compliance with their obligation to contribute to financial stability. So its failure to press the United States to redress the mortgage-market vulnerabilities that precipitated the current financial crisis indicates that much remains to be done.
Indeed, in its 2006 annual review of the US economy, the IMF was extraordinarily benign in its assessment of the risks posed by the relaxation of lending standards in the US mortgage market. It noted that “borrowers at risk of significant mortgage payment increases remained a small minority, concentrated mostly among higher-income households that were aware of the attendant risks,” and concluded that “indications are that credit and risk allocation mechanisms in the U.S. housing market have remained relatively efficient.” This, it added, “should provide comfort.”
Likewise, the problem was not mentioned in one of the IMF’s flagship publications, the Global Financial Stability Report (GFSR), in September 2006, just ten months before the sub-prime mortgage crisis became apparent to all. In the IMF’s view, “[m]ajor financial institutions in mature...markets [were]...healthy, having remained profitable and well capitalized,” and “the financial sectors in many countries are in a strong position to cope with any cyclical challenges and further market corrections to come.”
The IMF began to take notice only in April 2007, when the problem was already erupting, but there was still no sense of urgency. On the contrary, according to the IMF, “weakness has been contained to certain portions of the sub-prime market (and, to a lesser extent, the Alt-A market), and is not likely to pose a serious systemic threat.” Moreover, “the US housing market appears to be stabilizing....Overall, the US mortgage market has remained resilient, although the sub-prime segment has deteriorated a bit more rapidly than had been expected.”
The GFSR confidently noted that “stress tests conducted by investment banks show that, even under scenarios of nationwide house price declines that are historically unprecedented, most investors with exposure to subprime mortgages through securitized structures will not face losses.”
Why has the Fund’s surveillance of the US economy been so ineffective?
Suppose that the vulnerabilities piling up in the US mortgage market – right under the IMF’s Washington-headquartered nose – had taken place in a developing country. It is, frankly, inconceivable that the Fund would have failed so miserably in detecting them. The IMF has been criticized for burdening borrowers with unnecessary and sometimes perverse lending conditions, but its highly qualified staff has not been shy in blowing the whistle when it perceived domestic vulnerabilities in other countries. So why didn’t they scrutinize the US economy with equal zeal?
The answer may be found in the IMF’s governance structure. Currently, the distribution of power within the IMF follows the logic of its lending role. The more money a country puts in, the more influence it has. This may be prompting the Fund to turn a blind eye to the economic vulnerabilities of its most influential members – precisely those whose domestic policies have large, systemic implications.
This “money-for-influence” model of governance indirectly impairs the IMF’s capacity to criticize the economies of its most important members (let alone police compliance with their obligations). In any event, if its staff’s criticism ever becomes too candid, these countries can always use their leverage to water down the public communiqués issued by the IMF’s board.
The Fund can help to prevent future crisis of this kind, but only if it first prevents undue influence on its capacity to scrutinize, and if necessary criticize, influential countries’ policies and regulations. This requires a different governance structure in which power is more evenly distributed, so that the IMF can effectively exercise surveillance where it should, not just where it can.