WASHINGTON—The International Monetary Fund failed at one of its most basic tasks—acting as the world's economic watchdog—ahead of the global financial crisis, an independent fund auditor said Wednesday.
"The IMF provided few clear warnings about the risks and vulnerabilities associated with the impending crisis before its outbreak," Moises Schwartz, director of the IMF's Independent Evaluation Office, said.
The 59-page report on the fund's surveillance performance from 2004-2007 said one root of the problem is that while the IMF's staff confidently addresses problems in smaller developing economies, they are fearful of challenging authorities of wealthier countries. The finding is a nod to many emerging-market criticisms of the fund.
Managing Director Dominique Strauss-Kahn said the failure of the fund to warn about the systemic crisis in a timely and effective way "is a humbling fact" it has acknowledged.
"Indeed, the focus of the reform agenda being implemented is precisely on strengthening surveillance and financing for systemic stability," he said.
The banner message from the IMF in the lead up to meltdown of financial system and subsequent global recession "was one of continued optimism after more than a decade of benign economic conditions and low macroeconomic volatility," the auditor said. The fund largely endorsed many of the types of policies and financial practices that help to precipitate the credit crunch, pronouncing that financial markets were fundamentally sound and large financial institutions could weather any likely problem. That "lessened the sense of urgency to address risks or to worry about possible severe adverse impacts," the auditor said.
In its core mandate of surveillance, the fund didn't pay enough attention to risks of contagion or spillovers from a crisis in rich economies, such as the credit crunch that ricocheted around the world and spawned the global recession. And despite calls from board members, advanced economies weren't included in the so-called Vulnerability Exercise launched after the Asian crisis in the late 1990s.
"Staff in general is more reluctant to challenge the views of authorities in advanced economies," Mr. Schwartz said. While many within the IMF offered prescient analysis about mounting risks and vulnerabilities, "unfortunately, the incentives within the organization weren't conducive for them to alert and raise their voices since they had to challenge the traditional wisdom," he said. IMF is much more confident challenging the views of authorities in middle-sized emerging market economies.
While the IMF did mention some risks in their annual Global Financial Stability Report, they were only presented in general terms, without an accurate assessment of the scale of the problems and "undermined by the accompanying sanguine overall outlook," the auditor said.
One major problem that prevented the IMF from doing its job, the auditor said, is a general mindset that a major financial crisis is unlikely in large, advanced economies such as the U.S. and Europe. Also, there weren't enough contrarian views included in their assessments, the fund's review process wasn't able to "connect the dots," and political sensitivities trumped candor.
Since the outbreak of the crisis, the fund has implemented new policies designed to prevent such oversight in the future. Besides boosting its surveillance of financial markets and instituting new reports that show spillover vulnerabilities, the IMF has also launched two new types of loans. Both the precautionary and the flexible credit lines are designed to lend countries funds to prevent a crisis rather than bail out economies after meltdowns.
Mr. Strauss-Kahn said these measures "will go a long way to enhance the candor and traction of surveillance, and arguably already have done so."
But, he said, there's room for more work, including better stress testing and allowing outside experts to comment on IMF reports. The managing director said the IMF is conducting more early-warning exercises, though "in restricted settings" where only the board and the IMF's policy committee are able to review the results.
Schwartz said the effectiveness of those reforms remains to be seen. "The IEO still believes much more change is still required. We are calling for a more fundamental change that would change the institutions culture, governance, incentives and practices," he said.
Specifically, the auditor said even with the steps management has already taken, the fund needs to better encourage candor, "speak truth to power," and better integrate economic and financial sector issues.
Critics have often focused, for example, on how final reports that touch on politically sensitive issues such as exchange rate policy are often muted from their original drafts, dulling the effectiveness of the surveillance.
Write to Ian Talley at ian.talley@dowjones.com
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