April 12, 2011
The Guardian Unlimited, April 12, 2011
Last month, the International Monetary Fund’s Independent Evaluation Office issued a remarkable report. The report quite clearly blamed the IMF for failing to recognize the factors leading up to the worst economic crisis since the Great Depression and to provide warning to its members so that preventive actions could be taken.
The report noted that several prominent economists had clearly warned of the dangers facing the world economy prior to the collapse that began in 2007. One of these economists was Raghuram Rajan, who was actually the chief economist at the IMF when he gave a clear warning of growing financial fragility back in 2005. Yet these warnings were for all practical purposes ignored when it came to the IMF’s official reports and recommendations to member countries.
The IMF deserves credit for allowing an independent evaluation of its performance in the years leading up to the crisis. It would be great if the Fed, the Treasury, the Securities and Exchange Commission and other regulatory bodies allowed for similarly independent evaluations of their own failings. Nonetheless, readers can be very confident that nothing at the IMF will fundamentally change because of this report.
The first reason for confidence in the enduring power of the status quo is that the report never clearly lays out what the basis of the crisis was. This is important because the basic facts show the incredible level of incompetence of the IMF in failing to recognize the dynamics of the crisis.
The housing bubbles that were driving growth in the United States, United Kingdom, Spain, Ireland and several other countries in this period were front and center in the crisis. These bubbles created sharp divergences in house prices both from historic trends and also from rents. There was no plausible story whereby these prices could be sustained. The only question was when the bubbles would burst.
Furthermore, there was no plausible story whereby the bubbles could burst without leading to a serious falloff in demand and a sharp jump in unemployment. In the case of the United States the bubbles in the residential and non-residential real estate had raised construction spending by close to 4 percentage points of GDP and consumption spending by an even larger amount.
The overbuilding from the bubble virtually guaranteed that construction would fall below its trend level following the collapse of the bubble. This means that the collapse of the bubble would leave a gap of 8-10 percentage points of GDP. In the United States this gap in annual demand is between $1.2 trillion and $1.5 trillion.
What mechanisms did the IMF’s economists think existed to fill such a gap? The facts here are really simple, it would have been helpful if they had been spelled out more clearly so that readers could appreciate the incredible incompetence of the IMF’s staff in this instance.
It is worth noting that the financial crisis was a sidebar. It is difficult to see how anything would be different, at least in the United States, if the financial crisis had not occurred. At this point, large firms can directly borrow on capital markets at extraordinarily low interest rates. Surveys of smaller firms show that lack of demand is their biggest complaint. Very few mention the availability of capital.
Featuring the financial crisis so prominently in the story makes it more complex than necessary. Credit default swaps and collaterized debt obligations are complicated. Bubbles are simple.
One of the problems highlighted in the report was the problem of groupthink. This is when people say what they expect their bosses and their peers want them to say, rather than independently evaluating the situation. The report does some serious hand-wringing over the issue and comes up with a set of proposals which are virtually guaranteed to have no effect.
Remarkably, these economists never suggested the remedy that economists usually propose for bad performance: dismissal. There is a vast economics literature on the need for firing as a mechanism to properly motivate workers to perform. This report provides great evidence of the need for such a mechanism.
The proposals to combat groupthink are all very nice, but the bottom line is that the economists at the IMF all know that they will never jeopardize their careers by repeating what their bosses say. If we want economists at the IMF and other institutions who actually think for themselves they have to know that they will endanger their jobs and their careers if they mindlessly follow their boss.
Whenever I have raised this point in conversations with economists they invariably think that I am joking. When I convince them that I am serious, they think the idea of holding economists responsible for the quality of their work to the point of actually jeopardizing their careers is outrageously cruel and unfair.
The reality is that tens of millions of people across the globe have seen their lives wrecked because these economists did not know what they were doing. It is outrageous that ordinary workers who were doing their jobs can end up unemployed, but the economists whose mistakes led to their unemployment can count on job security.