In the years leading to the 2007 financial upheaval, the IMF routinely failed to detect the vulnerabilities that brought economies to fragility and kept an overall tone of optimism, even after the crisis had started. How is it possible that the global organisation mandated to preside over international financial stability could not see the crisis come and warn its members accordingly? This is the question to which the Independent Evaluation Office of the IMF has devoted its just released report (IEO 2010a)1. Its findings are the stuff of a “psychodrama”.
A self-delusional ego
The Independent Evaluation Office analysed the IMF’s performance during 2004-2007. It found that, while stressing the urgency of addressing growing global current-account imbalances, the IMF neglected to link such imbalances to the risks that were building up in financial systems. Rather, it held the belief that financial markets and large financial institutions in advanced countries were sound, and that financial innovation was conducive to optimal risk sharing. Worrying about system failures was unjustified because – the IMF economists assumed – financial markets and institutions were apt to weather the severest stress. Well into the crisis, and notwithstanding the already emerging problems, the IMF still gave a clean bill of health to large financial institutions, stating that problems were local and unlikely to become systemic. Surveillance did not sound the alarms even when the staff identified critical risks. Concerns were muted and banner messages reassuring (see the background paper, Banerji 2010).
The IMF had a tendency to be upbeat in the case of systemically important financial centres and yet to express concern with emerging markets showing similar vulnerabilities. When it acknowledged financial risks in multilateral surveillance, it dropped reference to them in discussions of advanced economies. The IMF endorsed the monetary and financial policy stance of the countries at the epicentre of the crisis. On the US, IMF views paralleled those of the Federal Reserve even when tensions in the housing and financial markets were evident. The IMF took no notice of how loose monetary policy could impact asset prices and private sector indebtedness. Even after house prices began to drop, it reckoned that no repercussions would reverberate on the financial system or internationally. The IMF supported the US regulatory philosophy that spurred the growth of unregulated market segments. It did not see the risks breeding in the shadow banking system and in the use of innovative financial products (see background paper, Dhar 2010).
The Independent Evaluation Office’s analysis attributes the IMF’s failure to a number of factors2. Cognitive biases – including groupthink, intellectual capture, and insularity – seem to have moulded the institution’s mindset in ways that constrained its ability to scan for risks. IMF economists shared similar background and were unreceptive to contrarian views. Most of them were intimately persuaded that market discipline would stave off financial predicaments. They ruled out that crises could start off in large advanced countries, and assumed that structural changes in advanced financial systems would be benign, especially for risk allocation. This narrow mental picture reflected the IMF’s choice of analytical approaches and knowledge gaps – shared by most of the economics profession – that bounded its capacity to identify financial risks and their links to the real economy. The quality of surveillance was also affected by a “silo” mentality, whereby staff resisted sharing information or seeking advice outside of their units, and by organisational incentives geared to conforming internal opinions with prevailing views. Internally, dissenting opinions were discouraged and voices pointing to systemic risks neglected.
Staff self-censorship vis-à-vis large-country shareholders inhibited the IMF’s will to “speak truth to power”, even when there was no overt political pressure from national authorities to influence surveillance. Staff felt there were limits on how critical they could be about these countries’ policies, as the internal agenda was to get on well with the authorities. They felt their careers would be in jeopardy if their views did not conform to those of the authorities, whose reputation and expertise they were sometimes in awe. In contrast, IMF staff were much less complacent with smaller advanced countries (see background papers on bilateral surveillance by Bossone 2010 and Wagner 2010).
A powerful alter ego
The evaluation’s findings prompt further “introspection” of the IMF’s “inner-self”. This leads us to consider the special relationship between the IMF and its largest shareholder – the US – and the ways in which the latter influences the former. In good or bad times, the IMF has always felt the predominant influence of the US. More than that, the US has consistently been the IMF’s dominating ego. Indeed, no major decisions could ever be taken by the IMF without US consent, while it would be next to impossible for the IMF to oppose initiatives that the US wanted the institution to pursue. It is no secret that US government officials enjoy de facto “privileged access” to IMF staff and management, which grants them extra voice on IMF matters (Tabb 2004).
In recent decades, the US power-play has manifested itself in a number of prominent undertakings, where the IMF has fulfilled key agency roles on behalf of US strategic interests, including a conduit for capital market liberalisation globally (Cohen 2003), a vehicle to implement the US-led effort to strengthen international financial policy cooperation in the 1990s (Bossone 2008c), and a facilitator in bringing exchange-rate and external current-account policies back into the international agenda, when both issues regained critical importance for the US in the mid-2000s (Bossone 2008b)3. Even when the US exerted its influence indirectly, through the G7 or other country coalitions, its prime leadership was undisputed4.
In fact, US leadership has transcended its hyper-power dominance. It has worked in a much less visible and yet concrete way, winning over people’s hearts and minds through its unique soft power (Nye 2004), of which the IMF has been an instrument of diffusion in the realm of international finance. While this has guaranteed stewardship of the IMF and of international financial relations toward freedom and prosperity, in the run-up to the global crisis it has proven an obstacle to the IMF understanding what was brewing within the system and the possible impact.
The mainstream paradigm of general-equilibrium-with-finance-is-a-veil economics5; the interest of big finance to keep a light regulatory environment for fear of killing innovation and investment opportunities (or so the alibi went); global competition and the pressure on national authorities not to undermine the international competitiveness of domestic firms; and the fast revolving doors across the academic, business, and policymaking worlds, making them highly osmotic to one another, are all deeply rooted in US culture and values, and all have contributed to laying the foundations of globalisation and the “Great Moderation” that preceded the crisis. Yet all of these factors have also shaped the kind of global groupthink to which the IMF has been integral and organic, receiving and reinforcing the “world finance is stable and resilient” refrain for years.
Prior to the crisis, the US focused on exchange-rate misalignments and global current-account imbalances, and this is where the IMF turned its multilateral surveillance. On the other hand, the US turned down the IMF’s reiterated request to undergo a financial sector assessment program, and the IMF had to live with this refusal, thus leaving the world’s major financial centre unchecked. This reveals who was running the show, and reflects both the US persuasion of its financial invulnerability and the IMF’s lack of leverage on its largest member. One could presume that a US financial sector assessment might have rung some bells early on. But the IMF’s candidness in this regard almost betrays a ‘Freudian denial’: “[I]t is not clear that the analytical approach typically employed in the FSAP would have identified the sub-prime problems … and risks associated with structured credit products in the US”6.
To a “psychoanalyst” it would be apparent that the IMF’s mindset was oblivious to signals stemming from the pivot of the global financial order. The crisis happened precisely where the IMF was less prepared to see it coming. But the IMF’s unpreparedness just didn’t happen, it was intrinsic to the system’s built-in complacency that obfuscated minds and precipitated the world into crisis – wherein the delusional egos finally met reality.
Much of the above may change in due course with changes in international power relations. In the meantime, the recommendations issued by the Independent Evaluation Office would help the IMF correct the biases that affected its surveillance:
- creating an environment that encourages diversity of views and truth-telling to power;
- better integrating financial sector and macroeconomic assessments;
- breaking the silo mentality;
- and delivering clear messages to the membership on the global outlook and risks.
Such actions would restore sanity not just in the IMF, but in the whole international financial community. Yet it is hard to imagine that they could effectively be implemented in the absence of deep IMF governance reform. In particular, it would be crucial to empower the IMF’s Executive Board to act as a filter between the interests of individual members and the objectives of the IMF’s membership as a whole – much as the European Commission is meant to do within the EU context, where it is expected to act as an independent supranational authority, separate from governments, and as “the only body paid to think European”7.
This would call for making the board authoritative, able to make decisions independently of members’ influence or pressure, and responsible for holding management to account for its performance8. Such a board should ensure that the IMF handles surveillance to the highest standards of competence and integrity, and should protect the staff’s prerogative to exercise autonomous judgment, with no special regard for or subjugation to individual members. If necessary, the board should stand up to large members and check against management’s undue pressure on the staff. The board should ensure that management allows for diversity of views within the institution, and that the staff is maximally exposed to unorthodox perspectives and “what if” questions. Finally, an authoritative board should facilitate full coordination between the IMF and the Financial Stability Board – a necessary pillar for effective global macro-prudential surveillance.
Will those who caused the IMF to fail now help it to change?
The views expressed in this column are those of the author.
Banerji, A (2010), “IMF Performance in the Run-up to the Financial and Economic crisis: Multilateral Surveillance”, Independent Evaluation Office (IEO) Background Paper BP/10/02, IMF.
Bluestein, P (2001), The Chastening. Inside the Crisis that Rocked the Global Financial System and Humbled the IMF, Public Affairs.
Bossone, B (2008a), “The design of the IMF’s medium-term strategy: A case-study on IMF corporate governance,” Independent Evaluation Office (IEO) Background Paper BP/08/09, IMF.
Bossone B (2008b), “IMF Surveillance: A Case Study on IMF Governance”, Independent Evaluation Office (IEO) Background Paper BP/08/10, IMF.
Bossone B (2008c), “Integrating Macroeconomic and Financial Sector Analyses Within IMF Surveillance”, Independent Evaluation Office (IEO) Background Paper BP/08/11, IMF.
Bossone, B (2010), “IMF Performance in the Run-up to the Financial and Economic Crisis: Bilateral Surveillance in Switzerland”, (IEO) Background Paper BP/10/06, IMF.
Buiter, W. (2009), “The unfortunate uselessness of most ‘state of the art’ academic monetary economics”, VoxEU.org, 6 March.
Cohen, BJ (2003), “Capital controls: the neglected option”, in G R D Underhill and X Zhang (eds.), International financial governance under stress. Global structures versus national imperatives, Cambridge University Press.
Dhar, S (2010), “IMF Performance in the Run-up to the Financial and Economic Crisis: Bilateral Surveillance in the US,” Independent Evaluation Office (IEO) Background Paper BP/10/04, IMF.
IMF (2009), “Financial Sector Assessment Program After Ten Years: Background Material”, 28 August.
Independent Evaluation Office (IEO) (2010a), “IMF Performance in the Run-up to the Financial and Economic Crisis”, IMF.
Independent Evaluation Office (IEO) (2010b), “IMF Performance in the Run-up to the Financial and Economic Crisis: Summary of Views of the Advisory Group”, Independent Evaluation Office (IEO) Background Paper BP/10/01, IMF.
Leijonhufvud, A (2009), “Macroeconomics and the crisis: A personal appraisal”, CEPR Policy Insight 41, November.
Lombardi, D (2009), “Report on the Civil Society (Fourth Pillar) Consultations with the International Monetary Fund on Reform of IMF Governance”, Coordinated by the New Rules for Global Finance Coalition, Washington, DC.
Nye, JS, Jr (2004), Soft power: The means to success in world politics, Public Affairs.
Peretz, D (2010), “IMF performance in the run-up to the financial and economic crisis: Bilateral surveillance of the UK”, Independent Evaluation Office (IEO) Background Paper BP/10/05, IMF.
Spaventa, L (2009), “Economists and economics: What does the crisis tell us?” CEPR Policy Insight 38, August.
Tabb, WK (2004), Economic governance in the age of globalisation, Columbia University Press.
Wagner, N (2010), “IMF Performance in the Run-up to the Financial and Economic Crisis: Bilateral Surveillance in Selected Member Countries”, Independent Evaluation Office (IEO) Background Paper BP/08/03, IMF.
1 While I had the privilege to contribute to this IEO work, here I speak exclusively in my personal capacity. The opinions I express are only mine and involve neither the IEO nor any other institution with which I am associated. The report and background papers are available at www.ieo-imf.org/eval/.
2 The analysis, conclusions, and recommendations of the evaluation were supported by an Advisory Group of eminent experts (IEO 2010b).
3 As for other examples, think of the US influence in determining the role of the Fund in the transition countries; the emerging market crises of the 90s (Bluestein 2001); the AML/CFT agenda post 9/11; or the decision to freeze indefinitely the Fund’s Sovereign Debt Restructuring Mechanism initiative in the early 2000s.
4 When studying the role of the G7 in steering the Fund to integrate financial sector analysis into surveillance during the 1990s (Bossone 2008c), I could not but notice that all the key elements that eventually became part of the G7 agenda for international financial policy cooperation in the second half of the 1990s had been articulated by Larry Summers, then-Deputy Secretary of the US Treasury (see his remarks to the Fifth Annual Conference on the America on 8 October 1996). However, as was pointed out by a top US Treasury official I interviewed for that study, while the US did lead the effort, the high effectiveness achieved in launching and implementing the agenda was owed to the ability of US officials to garner the consensus of the G7 partners and to have them move consistently in support of shared objectives.
5 On the inadequacy of mainstream macroeconomics to accommodate financial phenomena, see Buiter (2009), Leijonhufvud (2009), and Spaventa (2009).
6 See IMF (2009). Significantly, the IMF had run an FSAP in the UK in 2006, where it found nothing alarming. See the IEO background paper on bilateral surveillance for the UK by Peretz (2010). The “Fourth Pillar” Report (Lombardi 2009) makes the point that the lack of Fund leverage on US policy decisions is such that surveillance would have been ineffective even if the IMF had anticipated the crisis.
7 See European Commission Secretary General Catherine Day speaking in 2007 here.
8 For analyses and proposals on IMF governance and surveillance, see Bossone (2008b) . For specific proposal on reforming the IMF’s Executive Board, see Bossone (2008a). For proposals to reform global governance, including of the IMF, see the reports of The Group of Lecce.