Last week, the Independent Evaluation Office (IEO) of the International Monetary Fund released its report entitled "IMF Performance in the Run-Up to the Financial and Economic Crisis: IMF Surveillance in 2004 - 2007". This report assessed the "performance of IMF surveillance in the run-up to the global financial and economic crisis and offers recommendations on how to strengthen the IMF's ability to discern risks and vulnerabilities and to warn the membership in the future.". Basically, despite all of the warning signs, the IMF was too busy emplacing its head up its butt and, in being otherwise engaged, was not in a position to warn the world about the risks and vulnerabilities inherent in the world's economy. Imagine that, one of the guardians of the world's economy didn't see the impending train wreck of the Great Recession. It seems to me that we've heard that story from at least one central banker, haven't we?
In this posting, I’ll be dealing primarily with the issues regarding the United States economy that seem to have slipped through the grasp of the IMF.
By way of introduction and, should we have forgotten, here is a time-line of the crisis from the IMF's perspective showing the events that led up to the near collapse of the world's economy:
The world's worst financial crisis since the Great Depression started in mid-2007 with the initial phases of the collapse in the price of residential real estate in the United States. This resulted in the failure of several hedge funds and mortgage companies in the United States and Europe. This was followed by the collapse and nationalization of the Northern Rock Bank in the United Kingdom. In the spring and summer of 2008, a series of near collapses took place on Wall Street and in Washington necessitating federal government rescue of Bear Sterns, Fannie Mae and Freddie Mac. In September of 2008, Lehman Brothers filed for bankruptcy; this led to a complete freezing of the credit markets and a rapid deterioration of the world's economy from which it has barely recovered. Much of the blame has been rather unfairly laid at the feet of over-indebted consumers and a massively over-heated housing market that stemmed directly from an extended period of near zero interest rates. It was the bundling of this debt into various rather worthless financial instruments by the creative collective mind of Wall Street that nearly brought the financial world to its knees.
Here, from the IEO's report, is a summary of what the IMF had to say about the world's economy leading up to the 2007 summer of economic discontent. Note that the WEO is the World Economic Outlook and the GFSR is the Global Financial Stability Report; both reports are published twice annually by the IMF and discuss issues facing the global economy:
"According to the WEO, the world economic outlook was “among the rosiest” in a decade (April 2004); expected to be “one of its strongest years of growth” unless events take “an awful turn” (September 2004); in the “midst of an extraordinary purple patch” (April 2006); and “strong” (September 2006); all the way up to April 2007 when the report forecast that “world growth will continue to be strong” and opined that global economic risks had declined since September 2006.
Public statements by senior officials—largely based on the WEO—reiterated these messages; as late as August 2007, Management considered the global economic outlook to be “very favorable.” Even in the summer of 2008, Management was prematurely reassuring, with “...the U.S. has avoided a hard landing” and “the worst news are behind us.” Meanwhile, at the July 2008 WEMD session, the message was that “risks of a financial tail event have eased.”
The GFSR echoed these sentiments, declaring that the global financial outlook was “enjoying a ‘sweet spot’” (April 2004); that it was “hard to see where they [systemic threats] could come from in the short-term” (Fall 2004); with the global financial system “improved;” “strong and resilient” (various years); and “not bad” (April 2006).
The overall tone of the GFSR became more cautious thereafter, but this was not reflected in the IMF’s other public messages. The April 2007 GFSR struck a more somber note of warning that “underlying financial risks have shifted” and that the “collective build-up of investment positions in certain markets could result in a disorderly correction when conditions change.” Even this cautious note, however, was accompanied by an assessment that the foundations for global financial stability were “strong.”"
It certainly looks like the IMF missed the building storm clouds, doesn't it? Perhaps they were distracted by something. Maybe it was that "purple patch" they referred to in the April 2006 World Economic Outlook (WEO).
Here, from their April 2006 WEO, is a graph showing the massive increase in United States mortgages and, in particular, interest only mortgages:
Here's a chart from the same report showing the growth in equity extractions (using your house as an ATM) from United States mortgages:
Last, but not least, here's what the April 2006 WEO had to say about the United States housing situation:
"Indeed, the future course of the housing market is a key uncertainty for the U.S. economy. House prices have grown strongly in recent years, providing a boost to economic activity through their effect on consumption, residential investment, and employment. But house prices are now looking more richly valued—see Box 1.2—and as affordability has declined, buyers have increasingly resorted to interest-only and negative amortization loans to gain access to the market. These nontraditional mortgage products accounted for over 40 percent of mortgage loans for purchase during 2005 (Figure 1.11). And there are now indications that the housing market is cooling—mortgage applications have declined, the supply of homes on the market is rising, and confidence among homebuilders has slipped.
Through the impact on wealth accumulation, a slowdown in real house price appreciation from last year’s pace of around 10 percent (year-on-year) to zero would usually be expected to reduce consumption growth by 0.5–1 percentage point after one year. In present circumstances, however, the wealth effect could be larger. The withdrawal of equity from the housing market— which amounted to 7.5 percent of household disposable income in the first three quarters of 2005—has provided a convenient way of borrowing, which has helped boost consumption in recent years. If house price appreciation were to slow sharply, equity withdrawal would likely fall. Further, real estate and related sectors have been important sources of job creation, and a slowing housing market could adversely affect employment in these sectors. These factors could induce a more severe slowdown in consumption and overall GDP growth." (my bold)
Hardly alarming, is it? In fact, the IMF seems quite comfortable with the "convenience" of borrowing from home equity, don't they? It seems quite odd that their own publication shows that a fairly obvious problem is developing. Let me rephrase that – obvious to those outside the cloisters of the IMF.
Now, in its own words, is the IEO's overview of its main findings and how they were unable to actually envisage the obvious:
"During the period 2004 through the start of the crisis in mid-2007, the IMF did not warn the countries at the center of the crisis, nor the membership at large, of the vulnerabilities and risks that eventually brought about the crisis. For much of the period the IMF was drawing the membership’s attention to the risk that a disorderly unwinding of global imbalances could trigger a rapid and sharp depreciation of the dollar, and later on the risks of inflation from rising commodity prices. The IMF gave too little consideration to deteriorating financial sector balance sheets, financial regulatory issues, to the possible links between monetary policy and the global imbalances, and to the credit boom and emerging asset bubbles. It did not discuss macro-prudential approaches that might have helped address the evolving risks. Even as late as April 2007, the IMF’s banner message was one of continued optimism within a prevailing benign global environment. Staff reports and other IMF documents pointed to a positive near-term outlook and fundamentally sound financial market conditions. Only after the eruption of financial turbulence did the IMF take a more cautionary tone in the October 2007 WEO and GFSR." (my bold)
Apparently, at the IMF, hindsight really is 20:20…and common sense is not all that common.
Here’s what the IEO had to say about the IMF's version of the mortgage situation in the United States:
“The IMF missed key elements that underlay the developing crisis. In the United States, for example, it did not discuss, until the crisis had already erupted, the deteriorating lending standards for mortgage financing, or adequately assess the risks and impact of a major housing price correction on financial institutions. It was sanguine about the propensity of securitization to disperse risk, and about the risks to the financial system posed by rising leverage and the rapid expansion of the shadow banking system. In fact, the IMF praised the United States for its light-touch regulation and supervision that permitted the rapid financial innovation that ultimately contributed to the problems in the financial system. Moreover, the IMF recommended to other advanced countries to follow the U.S./U.K. approaches to the financial sector as a means to help them foster greater financial innovation. The IMF did not sufficiently analyze what was driving the housing bubble or what roles monetary and financial policies might have played in this process.8 Furthermore, the IMF did not see the similarities between developments in the United States and United Kingdom and the experience of other advanced economies and emerging markets that had previously faced financial crises.
Imagine that, the IMF thought that the United States model of mortgage securitization was such a great idea that they promoted it to other countries! The viewpoint of the IMF on the housing market in the United States was in sharp contrast to reports of a potential bursting of the housing bubble in the mainstream media. Perhaps all that was needed to fix the problem of a missed downturn in the housing market was a subscription to the Wall Street Journal or the Economist since both reported on the housing bubble well prior to 2006.
Here’s what the IMF thought of the fiscal situation of both Canada and Germany, two countries who weathered the coming storm quite well:
“For some advanced countries with relatively more stringent regulation, IMF policy prescriptions seemed to champion the approaches taken by the United States or the United Kingdom. The focus of this advice was to foster innovation, which was seen as a main factor behind the soaring profitability in the United States and the United Kingdom, with little or no discussion of the risks involved. Germany and Canada were among those advanced countries for which the IMF believed “...profitability is not yet on par with international levels and innovation needs to advance further” (2006 Germany Article IV staff report) or “conservative Canadian banking strategies yield significantly lower returns on assets than in the U.S” (2007 Canada Article IV staff report). In these countries, the IMF’s advice concentrated on market-oriented reforms to overcome structural “impediments,” some of which helped protect them from becoming exposed to the crisis triggers.” (my bold)
In conclusion, here is what the IEO thinks went wrong at the IMF.
1.) Analytical weakness.
2.) Cognitive biases – adherence to a paradigm by IMF macroeconomists who believed that crises were unlikely to happen in advanced economies where markets could thrive with minimal regulation.
3.) IMF staff basically agreed with United States and United Kingdom authorities that their financial systems were sound. Basically, the fox told the IMF that the chickens were safe in the fox-built coop.
4.) Gaps in knowledge by the whole profession that caused them to fail to identify risks and vulnerabilities.
5.) Available data and information was ignored and misinterpreted.
Basically, the IMF suffered from a severe case of clusterthink. While there were apparently some IMF economists who raised the alarm bells, their warnings went unheeded because they were “thinking outside the box”.
What is particularly frightening about those who control the world’s economy is that these economists actually believe that economics is a science, that stimulus always creates the same response. In reality, economics is more like herding cats; it looks good on paper but it never quite turns out the way that you expect. When you read speeches like this by Mr. Charles Bean, Deputy Governor of the Bank of England, you realize that those of us who can actually balance our chequing accounts probably have a better grasp of economic reality than either central bankers or IMF economists. Here’s what Charles had to say about central bankers ability to predict the Great Recession:
“The lesson I want to draw from this is not that the problems in financial markets which began in August 2007 and culminated in the near-meltdown of the global financial system a little over a year later were an inherently unpredictable Act of God. Rather it is that one would need to be endowed with perfect foresight to have been able to predict how the financial crisis would unfold, spilling over from one institution to another, and from one market to another. And who knows what would have happened if, for instance, Lehman Brothers had successfully found a buyer that weekend in September 2008?” (my bold)
I’m certain that the IMF is likely to miss the next economic storm so here’s a hint for them. With the United States and Japan having nearly $25 trillion in net federal debt between the two of them, I'd say that common sense would tell us that the whole system is certainly on the verge of calamity. But then again, apparently common sense is not as common as one would hope. And here’s the link to the TreasuryDirect website so they can see the United States debt to the penny.