GENEVA – Now that the global financial crisis is abating, it is time to take stock of our mistakes and ensure that they are not repeated. Beyond regulatory improvements, preventing payment incentives from rewarding reckless risk taking, and building Chinese walls between originators of securities and rating agencies, we need to discover what made this crisis so difficult to predict.
The International Monetary Fund is our global watchdog, and many believe that it failed to foresee the crisis because it was distracted or looking in the wrong places. I disagree. The problem is that the IMF was unable to interpret the evidence with which it was confronted.
I served on the IMF Board in June 2006 when it discussed its annual review of the United States. The staff “saw” the relaxation of lending standards in the US mortgage market, but 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.”
A few months later, in September 2006, just ten months before the sub-prime mortgage crisis became apparent to all, the Global Financial Stability Report (GFSR), one of the IMF’s flagship publications, stated that “[m]ajor financial institutions in mature...markets [were]...healthy, having remained profitable and well capitalized.” Moreover, “the financial sectors in many countries” were supposedly “in a strong position to cope with any cyclical challenges and further market corrections to come.”
The IMF’s radar started blinking only in April 2007, virtually when the problem was already hitting its windshield, but still with little sense of urgency. Clearly the Fund’s surveillance of the US economy was ineffective, and its multilateral surveillance of financial markets no better. Admittedly, the IMF was not alone in failing to interpret the underlying facts that triggered the crisis, but that is little consolation.
Before the crisis, the IMF’s best-known function – lending to countries with balance-of-payment problems – was becoming irrelevant. Many emerging markets preferred to self-insure by accumulating reserves rather than borrow from the Fund. Ironically, this was leading the IMF to focus on its supervisory role. So, in searching for the causes of the IMF’s failure, we can rule out distraction by more urgent matters.
The Fund normally expects that problems come from the usual suspects – economically volatile developing countries – but this time the crisis was developing a few miles away from its headquarters. Perhaps this proximity was at the root of the IMF’s failure to interpret the evidence right under its nose.
If so, it is a failure that raises two key questions. First, is the Fund’s governance structure suited to exercising arms-length surveillance of its main shareholders? And, second, did ideological blinders prevent the IMF from acknowledging that deregulation could contribute to a disastrous outcome?
It is inconceivable that the Fund, with its qualified and dedicated staff, would have failed so miserably in detecting and calling attention to the vulnerabilities piling up in the US mortgage market had they occurred in a developing country. But power in the IMF currently follows the logic of its lending role. The more money a country puts into the pool of resources, the more influence it gets.
I, for one, am not happy with the way in which “quotas” to the IMF are calculated, but I have to admit that exchanging money for votes is a perfectly adequate governing structure for a lending institution. But it is not adequate for an institution that is meant to exercise arms-length surveillance of its members – particularly its most influential member, whose domestic policies have global systemic implications.
That “money-for-influence” governance structure indirectly impairs the Fund’s capacity to criticize its most important members’ economies (let alone police compliance with their obligations). And, as I have witnessed several times, if the IMF staff ever do become too candid in their criticism of powerful members, the target governments use their leverage to water down the public communiqués issued by the Board.
Let us now consider the second question – whether the Fund suffered from a mindset that blinded it to the causes of what was happening. As early as August 2005, Raghuram Rajan, the IMF’s Economic Counselor (chief economist) at the time, was warning of weaknesses in the US financial markets. Rajan saw that something potentially dangerous was happening, warning that competition forces were pushing financial markets “to flirt continuously with the limits of illiquidity” and concealing risks from investors in order to outperform competitors.
Perhaps most revealingly, though, Rajan nonetheless optimistically argued that “[d]eregulation has removed artificial barriers preventing entry of new firms, and has encouraged competition between products, institutions, markets, and jurisdictions.” In other words, he clearly believed that regulation created “artificial barriers,” and that “competition between jurisdictions” – that is, between regulators – was to be welcomed.
Such beliefs come naturally to those committed to the view that markets perform better without regulation, and Rajan’s statement is a good illustration of the IMF’s creed at the time. And it was this boundless faith in markets’ self-regulatory capacity that appears to be at the root of the Fund’s failure to find what it was not looking for.
There are now encouraging signs of change at the IMF, but this should not reassure us. As the political economist Fred Block has noted, “societies invariably draw back from the brink of full-scale experimentation with market self-regulation.” Unfortunately, this also makes self-regulation a faith that is very difficult to dispel, because its priests can always claim that its failures result not from theological bankruptcy, but from insufficient orthodoxy.