The G-20 wants an early warning system to thwart future crises, and so has decreed periodic survey and review of major economies. The International Monetary Fund (IMF) will have a key role in this surveillance, since it already has highly-qualified staff and sophisticated forecasting models.
Yet, the IMF\’s track record in predicting crises is lousy. This is not because the IMF has third rate economists or models, but because forecasting is a very uncertain business. Olivier Blanchard, chief economist of the IMF, is rightly regarded as one of the world\’s top economists. On September 2, 2008, he was asked about global challenges including the financial crisis and high oil prices. He replied, \’\’If the price of oil stabilizes, i believe we can weather the financial crisis at limited cost in terms of real activity.\’\’
Really? Within two weeks, some of the biggest financial companies in the world collapsed, including the two biggest mortgage lenders (Fannie Mae and Freddie Mac), the biggest insurance company (AIG) and the four top investment banks (of which Lehman Brothers went belly-up, while others were rescued by the Fed). The $4 trillion money-market fund business was paralysed when one top fund (Reserve Primary Fund) confessed that its unit value had fallen below one dollar.
So, global finance fell of a cliff in September 2008. Yet, the IMF had no inkling of the coming calamity. Instead, Blanchard seemed to see oil as the key issue. \’\’If, for example, the price of oil returned toward $100 – not a crazy scenario, as few of us understand how it got much above $100 in the first place – then inflation pressure would rapidly subside, and i would be even more optimistic.\’\’ Famous last words! In actuality, oil soon fell below $40/barrel, but the overall outcome was a disaster, not reprieve.
Economist Arvind Subramanian says bluntly, \’\’The IMF\’s cock-up was two-fold. First, it was weak and/or ineffective in addressing the problem of global imbalances that contributed to the crisis. It was ineffective in making countries that ran large current account surpluses, notably China, to adjust, and equally ineffective in influencing policies in the current account deficit countries, notably the United States. Second, and arguably the bigger failure, was to preside over large capital flows to Eastern Europe despite the lessons that it should have learned from the experience of the Asian financial crisis in the late 1990s. These flows to Eastern Europe were in some cases so large that it did not require hindsight to see the problems that they would lead to. Warnings about the unsustainability of these flows should have been loud and insistent. And they were not.\’\’
The biggest fiasco occurred in Iceland, where foreign debt by 2008 was 800% of GDP, of which four-fifths was foreign borrowing by Iceland\’s banks. The IMF should have flagged this financial insanity in its annual Article 4 consultation, held with every member state. Instead, its 2007 Article 4 consultation with Iceland had this priceless sentence: \’\’The banking sector appears well placed to withstand significant credit and market shocks.\’\’
Queen Elizabeth II asked why nobody foresaw the crisis. In fact, a cavalcade of economists had issued warnings. The 2005 edition of Robert Shiller\’s bestseller Irrational Exuberance predicted the housing collapse. Alan Greenspan and Ben Bernanke, two Fed chiefs, both knew of the housing bubble, but feared that squashing it might cause a recession, and so preferred to let the bubble burst and clean up later. Martin Wolf repeatedly highlighted the unsustainability of global imbalances – huge deficits in the US and surpluses in China – that would end one day in tears. IMF economists, too, spoke of global imbalances and high debt in some countries.
While all these economists could see unsustainable bubbles inflating, none could say when each bubble would burst, or how many would burst together. Economists like Nouri El-Roubini had for years been predicting disaster. But when the months passed and disaster did not strike, they were dismissed like the boy who cried wolf. When the wolf finally arrived, nobody was on guard.
The IMF\’s shareholders are governments, and the IMF often pulls its punches with major shareholders. Governments struggling with problems keep assuring the public that all is well, and discourage IMF warnings which might cause panic. Large creditor countries ignore IMF lectures: only borrowers listen, out of compulsion. This adds to the earlier problem – that prediction is very difficult, and the IMF\’s forecasting record is dreadful.
So, expect an avalanche of surveillance reports from the IMF in coming years. But do not believe for a minute that these will end future crises.