Off Balance

by Paul Blustein

  Mired in tedium as the IMF was on that day in early February 2007, the email received by a number of staffers around 5:45 p.m., just as they were preparing to head home, landed with the force of a thunderbolt. “THIS IS TO ANNOUNCE THE START OF A FUNDWIDE CRISIS SIMULATION EXERCISE,” trumpeted the message, which came from a small team that had been working secretly on the project for weeks at the direction of the Fund’s top management. As the email explained, “The exercise is for training purposes only, aiming to enhance the Fund’s preparedness to handle future events.”3 The choice of an early evening start was deliberate, since crises often erupt at inconvenient times.

  3 This email is one of many confidential documents, not available in the public record, from which excerpts will be quoted in this book. See the author’s note and acknowledgements for an explanation of these documents. Henceforth, the documents will be cited without footnotes.

  The mock crisis concocted by the organizers was imagined to take place in Eastern Europe, an area where a number of countries appeared much more vulnerable than other emerging markets because of their large trade deficits and booms in the issuance of credit. The crisis epicentre was Hungary, and real Hungarian economic data were used. The possible consequences of this information leaking out terrified the team of organizers, so they avoided using Hungary’s name and took elaborate precautions to ensure that the existence of the exercise would never become publicly known. Participants were admonished to use pseudonyms (“Country A” instead of Hungary, for example, and “Country B,” “Bank X” and “Bank Y” for various other Eastern European entities that were to be affected). All memos, reports and other documents related to the exercise “should be clearly marked ‘Simulation,’” the email warned. Furthermore, any emails involving the exercise were to be sent using a special “SimulationMail” button, which the Fund’s IT managers had installed in the Microsoft Outlook email program in order to keep those emails from straying outside the Fund’s firewall. Extreme as these measures were, they made sense; news that the Fund was practising for a Hungarian crisis would surely fuel market anxiety about the country’s prospects and might, conceivably, trigger the real thing.

  The drill evoked exasperation and derision among some Fund staffers, who saw it as time-wasting at best and a potential PR catastrophe at worst. One cringe-worthy thought was the ridicule that journalists would heap on the Fund if they found out. David Hawley, a Fund press officer, received an email from one senior economist who fretted: “I am concerned about headlines suggesting that we now do this because we have nothing better to do.”

  But the IMF staff is a hierarchical organization with near-military discipline, and notwithstanding much eye rolling and teeth gritting, participants dutifully went along with the exercise. They responded as best they could to fictitious events and political developments invented by the organizers, who were playing the roles of Hungarian officials, market analysts, journalists, powerful finance ministers and members of the Fund’s executive board. For example, one document titled “Financial Market Update on Country A” reported that “the government has taken over the operations of Bank X, but this is seen by market participants as probably not sufficient to stabilize the banking system...it remains unclear whether the government will inject the resources into Bank X needed to recapitalize it.” Economists in the Fund’s European Department were informed that the finance minister of “Country A” was too immersed in meetings with the prime minister to talk on the phone, prompting the following email response from the department’s deputy director, Susan Schadler: “Please inform the Minister of Finance that we are very disappointed not to be able to speak with him as planned at 2 p.m. in view of the rapidly deteriorating situation.” Another email, drafted in response to a fake meltdown in markets, exhorted economists to “please start working on a Plan B for Country A.”

  Give the IMF credit: its top management saw that, notwithstanding the benign financial environment, something bad could happen that would necessitate an army of Fund economists swinging into action. They also picked a country that did end up having a crisis. But as the scope of the exercise suggests, the Fund’s imagination wasn’t nearly as vivid as it ought to have been. The simulation’s designers were evidently incapable of foreseeing just how much the international community would need this institution over the next several years. They never dreamt that IMF loans would be going to countries in the euro zone or that the financial system in the very country where they lived was only months away from starting to implode.

  The urgency of the need for a strong, effective IMF is now clear. The same goes for other international economic institutions. If only it were equally clear that these global institutions are up to the job.

  Lamentable Deficiencies

  The financial crisis that wreaked worldwide economic devastation in 2008 cast profound doubt over the governability of the global economy. Looking back at the crisis, that is one of the grimmest upshots, and looking forward, it is worrying on both a near- and long-term level. Economic policy makers face two overarching challenges in the wake of the crisis: the first is promoting a sustained recovery from the crisis and averting another dip into severe recession; the second is enhancing the stability of the global financial system so that it becomes much less crisis prone. Each of these necessitates an unprecedented degree of cooperation among major powers to effect policy change on a global scale.

  Sustaining expansion requires “rebalancing” the global economy — a task for which cooperation is obviously essential. The world went into the crisis with massive imbalances in trade and capital flows, which persist today, and must now be shrunk, preferably with a well-coordinated plan. After all, the countries that have run large trade deficits, such as the United States and the United Kingdom, as well as many nations in peripheral Europe, are obliged to impose significant austerity measures sooner or later; the United States in particular has depended for far too long on consumption, government budget deficits and foreign capital, and the crisis significantly worsened Washington’s fiscal situation. Belt-tightening in the deficit countries will endanger global growth unless countries with large trade surpluses — which are mainly in northern Europe, East Asia and the Middle East — take offsetting action by ramping up demand and importing more goods.

  International cooperation is, likewise, critical for the goal of regulating the global financial system. The nations of the world must avoid creating a hodgepodge of new rules lest banks move operations to countries with the most lax regulatory regimes. Better international banking rules — or at least broad, well-harmonized principles — are vital, as are improved systems for identifying vulnerabilities and managing crises that spill over from one country into others. In the absence of a clear understanding of how to handle thorny regulatory issues that may arise during crises, the narrow interests of individual countries may undermine globally optimal outcomes; for example, bank regulators in one country may seize the assets of a troubled international bank, destroying its viability in the process.

  Achieving effective coordination in both of these areas will entail adroit action by international institutions, some of which have long governed the global economy and others of which are relatively recent creations. These include the IMF, the Group of Twenty (G20) major economies, the Basel Committee on Banking Supervision, the Bank for International Settlements (BIS) and the Financial Stability Board (FSB) (a little-known body with origins in the late 1990s). Money flies around the globe with nary a hindrance; let us hope that global institutions will be commensurately robust in managing the resulting hazards.

  For those who share the above view — and I count myself among them — the story that unfolds in this book is dispiriting. It is a detailed account of the failings of certain international institutions before and during the early months of the crisis. It is based on interviews with scores of policy makers and on thousands of pages of confidential documents — memos, emails, meeting notes and transcripts — to which I obta
ined exclusive access. This wealth of material exposes serious weaknesses in these institutions, leading to the conclusion that in a world where capital is increasingly free to roam internationally, the institutions’ efficacy at fostering stability is sorely lacking. Also much in evidence is a related phenomenon, accelerated by the crisis — the decline in US power. For decades prior to the crisis, the United States dominated international economic institutions. It has been obliged to accept a significant dilution of its influence, and the absence of a clear leader compounds the institutions’ difficulties.

  The reasons for this book may not be apparent, since many books already describe how the crisis happened. Some are devoted to shenanigans in the US housing market, exposing how unscrupulous mortgage brokers earned rich fees by arranging loans to overstretched homebuyers. Other books recount what Wall Street did with those mortgages — bundling them together for sale as investments, typically in the form of collateralized debt obligations (CDOs), with the payments divided up into “tranches” of riskiness, so that safety-oriented investors were ostensibly assured of receiving full interest and principal before money went to other investors who preferred to earn higher yields. As readers of these books know, the fees and profits generated by this sort of activity fuelled greater demand for the creation of still more shaky mortgages, and the Triple-A ratings that many of these securities received from complicit ratings agencies helped lull investors into believing that they could reap higher returns without sacrificing safety. Still other books chronicle the downfall of individual Wall Street firms, such as Bear Stearns and Lehman Brothers, showing how financial engineering theoretically designed to make those firms safer ended up doing the opposite, as bonus-hungry traders relied on models that drastically underestimated the likelihood of large losses on CDOs, derivatives and other financial instruments. The desperate scrambling by policy makers at the Fed and the Treasury to keep the crisis from wrecking the entire financial system is the focus of other authors. Virtually all of these crisis books are united by one theme — the lapses by regulators who turned a blind eye to market excesses, either because of their “capture” by the financial industry or their zealous faith in laissez-faire.

  Nearly all of the best crisis books focus mainly on problems in the United States, which is appropriate, because that is where much of the misfeasance, nonfeasance and malfeasance occurred — the crisis was “Made in America.” But the crisis was also global, with some international origins and many international repercussions, which severely tested international institutions. Part of the reason for the housing bubble in the United States was the inflow of capital from abroad, a consequence of the US trade imbalance. Once the US bubble burst and turmoil began to spread, a number of other countries were hit hard — with Iceland, Hungary, Ukraine, Serbia, Romania and Latvia, among others, requiring IMF rescues. The crisis reflected the interconnectedness of global markets — some of the biggest buyers of US CDOs were conservative German Landesbanken (state-owned regional banks). Even foreign banks that had very little direct exposure to the US subprime market —Northern Rock in the United Kingdom being a canonical case — collapsed because the troubles on Wall Street led to investor demand drying up for short-term debt, which the British bank had used to fund its operations. The bankruptcy of Lehman Brothers caused all kinds of chaos in Europe and Asia — where bankruptcy rules were different from the United States — and that, in turn, exacerbated the turmoil in US markets. Following all of this came the eruption of the crisis in the euro zone.

  This book is not a comprehensive account of all those events; that would require a multi-volume series. Rather, it focusses mainly, though not exclusively, on two institutions, both of which failed in the missions set for them by the international community.

  The first is the IMF, now a household word as a result of the 2011 scandal involving its former managing director, Dominique Strauss-Kahn. Specifically, I will focus on the IMF’s efforts to deal with global imbalances before the crisis. As we shall see in chapters 4 and 5, the Fund proved utterly feckless at inducing policy changes in its most powerful member countries.

  The second is an institution that is very little known — the Financial Stability Forum (FSF), which was created shortly after the Asian crises of the late 1990s and based in Basel, Switzerland. The FSF merits far more attention than it has received, given that its primary aim was to coordinate efforts in preventing and mitigating future crises and its members included top-ranking officials from the finance ministries, central banks and regulatory agencies of the world’s richest countries. Moreover, the FSF’s successor body, the FSB — whose name reflects the two bodies’ many similarities — was established at a summit of world leaders in April 2009 amid solemn promises that the leaders were putting in place the mechanisms necessary to ensure the safety and soundness of the global financial system. Chapters 6 and 8 tell the behind-the-scenes story of the FSF.

  No claim is made here that these institutions caused the crisis or even played a major role — they did not. But a close look at their failings and limitations exposes the weaknesses of international economic institutions in general — and specifically institutions that are now tasked with enormous responsibility for coordinating the policies necessary to generate a balanced, sustainable global recovery and prevent future crises. These institutions will be shown to be lamentably deficient in two critical ways. First, despite their efforts to attain elevated, global perspectives on the workings of modern markets, they cannot accurately discern, amid all the bewildering complexity, where and how crises are likely to arise; indeed, sometimes they unwittingly take measures that exacerbate vulnerabilities. Second, they do not have the power, and often lack the will, to stop countries from pursuing policies that threaten the stability of their neighbours or even the stability of the entire financial system. These deficiencies are the chief reasons why the global economy’s governability should be perceived as so problematic.

  Readers of my previous work are familiar with this theme. In books about crises in emerging markets, I have highlighted the inadequacies of the IMF in responding effectively, both when money is pouring into a country and when it is flying out. I have repeatedly emphasized that I do not mean to cast any aspersions on the intellects, dedication or public-spiritedness of the people who work at the Fund; they are, as a rule, superbly able economists, motivated by a sincere desire to make the world a better place. This is what makes their failures so much more frightening; if replacing incompetent policy makers with better ones was all that was required, the job of policing modern financial markets would be less daunting.

  The “Great Crisis” that started in 2007 shows that these lessons apply not only to the IMF, and not only to emerging markets, but to other institutions and advanced countries as well. Of course, there is no substitute for countries doing what is best for themselves. Canada, for instance, sailed through the crisis with only modest economic damage, in large part because of its superior financial regulatory and supervisory regime. But international cooperation, multilateral rules and effective institutions are also essential. Multilateral institutions enable nations to share the responsibilities and burdens of solving global problems, while also providing a reasonable level of assurance that acting collectively will generate rewards for all. They provide what academics call “global public goods”; in the same way that a police force provides the public good of law enforcement at the local level, and the military provides the public good of defence at the national level, multilateral institutions provide public goods at the global level. In the economic realm, these global public goods include financial stability, crisis alleviation, open markets, poverty reduction and other such goods, from which all nations broadly benefit and which no single nation can deliver alone. The inability of multilateral institutions to deliver some of these public goods is especially disquieting at a time when popular support for democratic capitalism is waning; in the event of another crisis like the last one, this support could evap
orate.

  With the aim of achieving the goals of sustainable expansion and greater stability in the financial system, G20 leaders have fortified the major international institutions. The IMF has been endowed with significant amounts of new resources and the re-christened FSB has also been given a wider mandate and greater clout. The pre-eminence of the G20 is itself a major advance in global governance, placing emerging powers at the “head table” of international decision making. But deep skepticism is warranted concerning the ability of these institutions to settle on a proper set of measures and mobilize the necessary international consensus. Their pre-crisis performances (or those of their predecessor institutions) were less than impressive, and they must now forge policies among a broader group of countries at a time when the power of the traditional leader — the United States — is gravely diminished.

  American geopolitical might built and shaped the institutional machinery that has governed the international financial system since World War II, and these institutions have long depended on Washington to direct the way in devising and implementing policy. Considerable advantage has accrued to the United States as a consequence of assuming this leadership role. Not only has Washington exercised heavy influence over the rules of the global economy, it has also enjoyed extra leverage in the conduct of its foreign policy, enhanced the competitive position of the US financial industry and raised the living standards of American citizens in ways that are unavailable to other countries. Although the “rules of the game” rankled other countries’ policy makers, the rules endured, in part because the other countries enjoyed the benefits of the US security umbrella, and also because they recognized that US leadership was indispensable if they were to partake of global public goods.

  The crisis inflicted so severe a blow on the US economy and on America’s geopolitical stature that the result, according to some observers, is a “G-Zero” world, in which no country or group of countries is capable of steering the global economy as the Group of Seven (G7) once did, notwithstanding the G20’s claims of having supplanted the G7.4 The adherents of the G-Zero theory contend that the United States can no longer fulfill the role of hegemon — a country with the capacity and will to set and enforce clear rules for the system in ways that make global public goods possible. If the G-Zero school is right, the implications are ominous. The last time the world lacked a hegemon was the 1930s, when, as the eminent economic historian Charles Kindleberger put it, “the British couldn’t, and the United States wouldn’t,” referring to the financial straits that kept London from maintaining its previous hegemonic role, and the isolationism that kept Washington from picking up the mantle of global leadership.5