Bill Jamieson: Credit crunch myopia devalues IMF credibility

WHAT is the point of the International Monetary Fund? Why, if it so signally failed to give advance warning of the property and credit bubbles in the world's biggest economy, should its prescriptions be listened to now?

How does it reconcile its current advice to Western governments and central banks with almost the exact opposite advice given to the Asian economies a decade ago? And why should its calls for government intervention carry weight, when so many have misgivings?

The IMF was set up in 1944 to stabilise exchange rates and supervise the reconstruction of the world's international payment system. Countries contributed to a pool which could be borrowed from, on a temporary basis, by countries with payment imbalances. It now spans 185 countries, and works to foster global monetary cooperation, financial stability, international trade, high employment, sustainable economic growth and poverty reduction.

This is all noble and high-minded and swathed in consensus. Unfortunately, the meeting this weekend of the Group of Seven major industrial nations and the IMF's governing body in Washington could hardly be less agreeable. Global food prices are soaring and the oil price has climbed to $110 a barrel, piling on the pressure both for advanced Western economies and low income economies with a billion people still living on less than $1 a day.

Now, on top of this, has come unprecedented turbulence in financial markets, a global credit crisis and massive losses sustained by the world's biggest banks. Wholesale money markets in America and Europe have seen a drying up of liquidity as banks fear to lend to each other.

Where there should be consensus on the role and credibility of the IMF to help tackle these problems, there is little in evidence. The run-up to this year's spring conference has been marred by charge and counter-charge over the IMF's failure to recognise the severity of the crisis that has unfolded.

Only this week, after months of evident trauma in financial markets, has the IMF sonorously declared that the crisis "has developed into the largest financial shock since the Great Depression". It now admits to being "humbled" in failing to recognise how bad things are, but says there has been a "collective failure to appreciate the extent of the leverage taken on by a wide range of institutions and the associated risks of a disorderly unwinding".

And the IMF's managing director, Dominique Strauss-Kahn, has waded in, saying the United States refused to adopt its programme to improve the stability of national economies. About two-thirds of IMF member countries chose to take part in a Financial Sector Assessment Programme, a joint World Bank-IMF initiative set up in 1999 to help alert member countries to vulnerabilities in their financial systems.

"What is interesting," says Strauss-Kahn, "is that, until a few weeks ago, the US has refused to have an FSAP. We can't be held responsible for lack of supervision… owing to the fact that our main instrument to make that kind of supervision was not used in this country."

The clear inference is that if the IMF had been called upon to comment on US credit markets, it would have identified the problems and demanded action.

Is this a credible defence? According to Stephen Lewis, economist at Isinger de Beaufort, Strauss-Kahn's case gains no credibility at all when considering the IMF's approach to the UK, a longstanding participant in the FSAP. The last published assessment was in March 2003, long before the global explosion in structured financial products. It concluded, "the quality and effectiveness of financial sector supervision in the UK is strong in the banking area". Another, more recent IMF consultation under Article IV on aspects of economic and financial policy suggested no cause for concern. In December 2006, in the last Article IV consultation with the UK before the market turmoil erupted, the IMF's view was: "The financial sector starts from a position of strength and the authorities continue to promote the system's resilience."

The text added that the UK was "appropriately, aiming to balance the costs and benefits of regulation" – sentiments that would have been warmly welcomed by the then chancellor, Gordon Brown, even though the balance proved hardly up to the job. Perhaps, says Lewis, this explains why Brown and Alistair Darling now strongly support giving the IMF the lead role in dealing with global market woes: "They subscribe with IMF officials to a common fund of presuppositions and bathe in the same pool of complacency."

The IMF also conducted Article IV reviews of US policy in the run-up to the credit market troubles. The most pertinent of these was published in July 2006. At that time, there had already been a massive build-up in credit transfer instruments and the US housing market had peaked out. This was the very latest moment when the IMF could usefully have sounded the alarm. But after consultations with Fed officials, the IMF noted, "staff and officials agreed that a range of indicators suggested that systemic risks were at a low ebb".

This was after the officials had drawn attention to how "banks had been remarkably adept in responding to changing market conditions... even small and regional banks had traded parts of their loan book against mortgage-backed securities, reducing their vulnerability to regional shocks". What is more, "financial sector risks related to household borrowing appeared relatively manageable… Stress tests indicated that borrowers at risk of significant mortgage payment increases remained a small minority, concentrated mostly among higher-income households that were aware of the attendant risks".

This was the IMF's judgment at the height of the sub-prime mortgage boom.

Nor has the IMF's conduct found much favour with Paul Niven, head of asset management at F&C Investments. He recalls that, back in the 1990s, the IMF "encouraged" predominantly Asian authorities to hike local interest rates and cut government spending in order to boost confidence from investors and regain access to overseas lending. While there are numerous differences between the Asian crisis of the 1990s and the current credit crisis, both, Niven notes, were born out of reckless lending leading to a collapsing asset bubble (and currencies). But the US has been adopting a rather different set of solutions to domestic problems through aggressive rate cuts, provision of liquidity and fiscal expansion.

"Not," says Niven, "the IMF prescribed medicine of a decade ago… The IMF, and policymakers, learned many lessons from the Asian crisis and many would now argue that the measures used a decade ago to 'solve' the crisis in developing countries were, in reality, in real danger of 'killing the patient'. The real irony, however, is that the current crisis arguably has at least part of its roots in the IMF policies of a decade ago which led to many developing economies swearing that they would never again go cap in hand to the Fund and be beholden to external parties in the time of a crisis. This determination to build huge foreign reserves in Asian economies led, in part, to depressed interest rates in the US and fuelled reckless mortgage lending there. The seeds for the next bubble, boom and subsequent bust," he warns, "may well be being sown amidst the current gloom."

This weekend will see both Chancellor Darling and Dominique Strauss-Kahn calling for government intervention to bring an end to the market turmoil. But the suggestion that the taxpayer should bear some of the cost of the market meltdown is unlikely to find much favour among taxpayers either in the US or the UK. Voters recoil from tax revenues being diverted to support a financial sector characterised by breathtaking levels of reward for the growth and leveraging of sub-prime debt. The pay-off for Northern Rock's departing chief executive strongly undermines taxpayer support for further interventions of this kind. In the US, ideological objections will be greater than reported so far. That leaves member governments with a problem. But at the heart of the IMF, a supranational authority charged with providing financial supervision and stability, there is clearly some sorting out to do.