Being wrong pays for the IMF - on Greece and elsewhere

Strange mea culpa from the IMF on Greece.

On the one hand, it admits that it was over-optimistic in its assessments of the impact that fiscal tightening would have on growth/public debt sustainability etc. On the other hand, Wall Street Journal reports, the lessons learned would lead them to take a tougher stance in future bailouts.

Sounds like a contradiction? Yes, it is. It's also indicative of the way that IMF has designed and implemented conditionality wherever it goes: always too optimistic. Pawel Morski, on Twitter, unearthed a couple of similar quotes for Asia and Argentina. I found the same for IMF programs in Eastern Europe during 2009-2010 (Romania, Hungary, Latvia). We can go back even further: the IMF's own Independent Evaluation Office 2003 report on Fiscal Adjustment in IMF supported programs:

Overoptimism about fiscal adjustment is partly caused by overoptimism about growth projections. 

Absolute levels of revenue respond to growth with shortfalls in growth leading to corresponding shortfalls in revenue. However, absolute levels of expenditures, projected on the basis of optimistic growth forecasts, do not fall when growth falls below expectations, leading to an increase in expenditure ratios.  (p.13)

Let's put aside the fact that austerity has a very poor record, as Mark Blyth so thorougly documented in his last book and turn to the more mundane question of too-optimist forecasts.

Forecasting errors are to be expected in a crisis when uncertainty prevails and conditionality is applied. Hardly fair to fault the IMF for that. Yet the question remains, how come the IMF is always too optimistic? Because it doesnt want to scare markets, is the typical answer. But that, in my opinion, ignores an important angle of the politics of the IMF's crisis interventions. The IMF does not negotiate with markets over austerity, but with governments.

Growth forecasts are central to fiscal conditionality. The IMF sets fiscal targets as budget deficits to GDP ratios. For example, the Greek deficit target for 2012 was 6.6% of GDP.  The choice that the IMF makes about being optimistic or pessimistic about its forecasts is a political choice. Consider again the quote from above: absolute levels of revenue fall with the lower growth, whereas absolute levels of expenditure dont. The numerator  (budget deficit) gets bigger. If the IMF chooses to be optimistic about future Greek growth, then the actual denominator will be smaller. The budget deficit to GDP ratio becomes much bigger than its target. To meet the target, the Greek government has to choices: cut more or re-negotiate targets with the IMF. 

So, it's not that the IMF somehow magically recruits optimistic people. It's rather that optimistic growth forecasts strengthen the IMF’s leverage in negotiations. Think about Greece: governments have to go back, hat in hand, to the negotiating table in order to persuade the IMF that its political survival depends on slightly less draconic targets. Being wrong pays for the IMF, as long as its being optimistically wrong.

Change at the IMF: interconnectedness, financial fragility and global banks

I attended recently a workshop organized by Cornel Ban and Kevin Gallagher, with support from Governance, at Boston University on how the crisis has changed the IMF.

My presentation explored the way in which the IMF has grappled with financial innovation since the crisis, both theoretically and in its policy advice.

This is important, it argues, because the global economic crisis has brought an important shift in the IMF’s understanding of crisis, its triggers and its actors. Its research on macro-financial linkages now identifies large capital inflows as the main conduit for the transmission of global shocks, in contrast to previous concerns with current account dynamics; and transnational banks as the key carriers of capital flows across borders. With this, the IMF has included private financial institutions in its analytics of crisis, previously focused on governments (fiscal policy), central banks (monetary policy) and trade union/state-owned companies (structural reform). 

Outsourcing Financial Stability: the ECB and Cyprus

I have just finished revising a paper on the ECB's learning from the Japanese crisis management in early 2000s. The important lesson of that episode is that the shift to market-based finance confronts central banks with a trade-off between financial stability and institutional stability defined through central bank independence. To fight liquidity spirals, runs on repo and pro-cylicality induced by shadow bankign activities (as large in Europe as in the US), the central bank must abandon independence understood in the most narrow, and politically sensitive, definition of severing links with government debt markets. The traditional lender of last resort approach cannot address the systemic risks generated by market-based finance.

This matters immensly for understanding the ECB's choices since the crisis.

It is important to remember first that the ECB has no explicit mandate for financial stability of the Euro-area. European Treaties, and the ECB's institutional design, are built on the premise that national governments can, and should, provide financial stability. That design reflects a flawed theoretical assumption in pre-crisis mainstream macroeconomics that central banks could pursue price stability alone, and that would ensure financial stability. The mea-culpas from other central banks across the world, including Ben Bernanke, can be stil heard if one listens carefully. This is why those central banks abandoned indepedence and directed their considerable fire power at preserving the stability of a financial system with new sources of systemic risk.

In contrast, the ECB has played a more dangerous game that simultaneously increased its political power and financial instability. By its own addmission, the Enhanced Credit Support, and then the LTROs, outsourced financial stability to the banking sector - with fingers crossed that delevraging banks would want/be able to perform such a function. That the strategy ultimately failed became clear when Draghi announced that it would do whatever it takes (the OMT) to stabilize market-based finance. But the OMT did not solve the trade-off between independence and financial stability in the same manner that other central banks did. The OMT instrument has been designed as an  escape clause from the 'no-debt monetization rule', and the ECB gained greater political powers as a non-indepedent arbiter to impose costs (conditionality) and to verify compliance.

So the Cyprus moment is just another episode in the long struggle of the ECB to use the crisis in order to cement its power while abdicating an essential central bank function. That such a paradox is possible testifies to how dangerous this institution has become to the European project. Outsourcing financial stability to the Russian government or to the political willigness of a small country to tax the big players (those with large deposits) is a risk no central bank should take. Fingers crossed over the weekend.