A mea culpa by the IMF

THINK ASIAN By ANDREW SHENG 

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Independent Evaluation Office has set an example of what should be done for the fund

LATIN American social philosopher George Santayana said those who forget history are doomed to repeat it.

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REUTERS: International Monetary Fund (IMF) Managing Director Dominique Strauss-Kahn delivers a speech about global economy and IMF reform at Tsinghua University in Beijing November 16, 2009.

Why didn't the International Monetary Fund (IMF) see this global crisis coming? This was the question posed by the Independent Evaluation Office (IEO) of the IMF in its report published on Jan 10.

Some readers will remember that the IEO was established after the Asian financial crisis to evaluate independently where the IMF had gone wrong during the Asian crisis. To the IMF's credit, it understood that it had to be transparent to be credible and the IEO's specific mission is to provide independent feedback to the IMF board on the IMF's effectiveness.

This time, the IEO focused specifically not the fund's handling of the crisis, but its surveillance performance in the period from 2004-2007.

The IEO should be commended on its methodical analysis. Since the IMF did not warn its members of the unfolding crisis, the study concentrated instead on whether the fund evaluated the proper risks and vulnerabilities before the crisis, what message the fund gave to its board and members, and what constraints the IMF had in conveying the difficult messages.

The facts are even up to April 2007, the IMF's main message was continued optimism after the prolonged period of benign stability. Even though it warned of the global imbalance, there was insufficient focus on the balance sheet fragilities, so it missed the key elements that underlay the crisis.

For example, in the annual review of the United States, it did not discuss the mortgage problems until the crisis had already happened. In a 2006 study of Iceland, the fund staff had concluded: “Fortunately, in Iceland's case, and as found by the 2006 Article IV mission, hedging behaviour and generally sound balance sheets and asset-liability management made the financial system relatively robust to the recent shocks.” In the next year, the largest Irish banks failed.

This was like a doctor giving good health report to a patient before he dropped of a heart attack.

One of the oft repeated criticism of the fund by its smaller members is the uneven treatment, since the fund could be quite tough on them but less tough on the members with more shareholdings. This was particularly true in the mandatory annual review of the United States, the largest shareholder. The fund did not conduct an FSAP (Financial Sector Assessment Programme) for the United States before 2009 because its authorities did not agree.

The report itself doubted that even if an FSAP review was done, whether the current analytical methodology would have identified the scale of the risk. For example, the 2006 FSAP update for Ireland had concluded that the “outlook for the financial system is positive”.

The annual Article IV surveillance reports on the United States and United Kingdom, the main financial centres, were sanguine on financial innovation and behind the curve on risks. Overall, the fund staff felt that these authorities were on top of their risks. In the 2006 report, the fund staff felt that “the credit rating agencies were uniquely positioned to assess a wide range of structured transactions”. True, they were uniquely positioned, but they told the world that these toxic products were triple-A rated.

In most countries, the person who certificates that a drug is safe and found to be toxic goes to jail. It is remarkable that no rating agency has been punished for their behaviour.

The next question is why did the fund fail to give clear warnings?

The funny thing is that the IMF economic counsellor, Raguram Rajan, had given a famous 2005 Jackson Hole Conference warning that leveraged financial innovation would leave countries more exposed than past experience. His warnings to all the leading central bankers fell on deaf ears and his work was not followed up even within the IMF's own work programme.

It goes to show that if the crowd's mindset goes in one direction, a lone voice would not necessarily stop the tide. Sometimes it takes a crisis to force a change of mindset.

The internal failings were identified as analytical weaknesses, particularly cognitive biases such as group think, intellectual capture and confirmation bias. If the group thinks that financial innovation is good, it becomes very difficult for lone dissenters to say that there are serious risks to be examined. Intellectual capture means that students find it very difficult to argue against the intellectual power of a teacher. This was the position where IMF staff were overly influenced and perhaps in awe of the largest members' reputation and expertise.

Confirmation bias refers to selective attention people tend to focus on what they expect and ignore information that is inconsistent with their theories. If the conventional wisdom thinks that global imbalance was the problem, then there may be failings to look at other areas, such as balance sheet vulnerabilities.

The IMF economists relied heavily on their macro-economic models, but these flow models often did not incorporate balance sheet data and, therefore, underestimated macro-financial linkages. The report also pointed out the fact that stress tests do not reveal second-round effects such as liquidity shocks.

The report also pointed out the organisational impediment in terms of departmental silos, where staff did not share information and did not “connect the dots”. The incentives also failed to “foster the candid exchange of ideas that is needed for good surveillance”.

Finally, to what extent was the fund subject to political constraints? The report quoted staff as saying that there were limits as to how critical they could be regarding the policies of the largest shareholders that “you cannot speak truth to the authorities” since “you are owned by these governments”.

History has not changed. Every wise government must have an independent voice to give “ruthless truth-telling”, one of the key roles for the fund by one of its intellectual founders, John Maynard Keynes.
The IEO has set an example of what should be done for the fund. Perhaps its member countries can learn from this.

Andrew Sheng is author of the book “From Asian to Global Financial Crisis”.