C.R.L. Narasimhan

Economic crisis: warning signals ignored

Members of the Financial Crisis Inquiry Commission speak at the release of the commission's report on the causes of the financial and economic crisis, in Washington late last month.  

It is well known that the financial crisis that morphed into a global economic crisis had its origins in the financial sectors of the advanced countries. The underlying causes of the crisis — proliferation of sub-prime housing mortgages, complex securitisation-based instruments and, in general, a total abandonment of meaningful risk assessment by leading banks — are all familiar by now. But the intriguing question is whether the crisis of such a magnitude could not have been spotted in advance? It is not as though that the crisis came all of a sudden.

Surely there were unacceptably high risks and complex financial structures of such a large magnitude that could not have remained unobserved even by those unconnected with the world of finance. But as it turned out even financial regulators of the advanced economies were complicit by not performing even the minimum regulatory role expected of them.

The time for fixing accountability has come in earnest. Two recent reports — one by the U.S. Congress appointed the Financial Crisis Inquiry Commission (FCIC) and the other by a watchdog committee of the International Monetary Fund (IMF) — are illuminating.

The FCIC report has cast the blame far and wide, but primarily on the regulators and banks within the U.S. Its focus on the U.S. is understandable but because the crisis has been truly global, it would have been more useful if the commission had touched upon those aspects as well.

The IMF's role before the crisis has come under critical scrutiny in a new report from the Fund's independent evaluation office. The report blames the Fund's dogmatic belief in the apparent invincibility of the financial system of the West as it existed then, as the principal cause for failure to spot the warning signals leading to the crisis.

U.S. blamed

The FCIC has not spared anybody who had a role in the financial markets during the period leading up to the crisis of 2008. Captains of finance and the regulators failed abysmally to identify the build up of risk, leave alone the corrective action. The Federal Reserve ‘neglected its mission by not piecing the housing bubble'. The then Chairman of the Federal Reserve, Alan Greenspan, received the largest share of criticism for any one individual for having presided over a culture of deregulation that implicitly believed that the markets would correct themselves.

The FCIC has used some strong language: it identified ‘widespread failures in financial regulation', ‘a dramatic failure of corporate governance and risk management' and ‘excessive borrowing' as some of the principal causes. The U.S. government naturally received its share of scathing criticism. It was ‘ill prepared' and ‘inconsistent' in letting Lehman Brothers fall while orchestrating the rescue of Bear Sterns earlier and bailing out giant insurer AIG later. The collapse of Lehman Brothers on September 15, 2008, signalled the lowest point of the crisis.

Even to a generally well reasoned report on the crisis there have been a few points of criticism. The report is authentic even though it covers what has by now become familiar ground.

Perhaps its most contested finding is that the crisis was ‘avoidable'.

That conclusion has been questioned in the light of the fact that the commission has blamed practically everybody. If so many individuals and institutions were responsible, would it have been possible to rein in all of them, even assuming that their shenanigans and risky behaviour could be detected before hand?

The biggest drawback of the FCIC report, however, has been its failure to win a consensus.

The report was split on partly lines. That is not surprising given that at the current juncture the U.S. is a highly polarised country when it comes to key political and social issues.

The internal report of the IMF does not mince words in its evaluation of the Fund's role during the years leading to the crisis. It badly missed the warning signals because of a naïve admiration of the U.S.-UK model of ‘light touch' regulation. Besides, the IMF's ability to identify the risks was hindered by a high degree of ‘groupthink' and ‘intellectual capture'. The Fund believed that a major crisis was unlikely in the advanced economies. It relied on traditional macroeconomic approaches and modelling, which failed to spot the huge risks building up in the U.S. financial sector. The crisis spread rapidly to other countries. The IMF failed to spot the severe interconnected problems in the financial systems of the West.

It is a telling commentary that as late as the summer of 2008 the IMF's top management believed that the U.S. would avoid a hard landing and ‘that the worst news is behind us.' Even the bilateral surveillance of the U.S. economy failed to warn the authorities of the pertinent risks and policy weaknesses. What is worse the Fund seemed to champion the U.S. financial sector. Critical voices from the IMF's own staff and outside were typically ignored. Even warnings in 2005 of its own chief economist Raghuram Rajan about the threat of widespread financial instability were not taken into account.

Finally, the IMF's internal report blames the Fund for its failure to think independently on economic surveillance. Instead in the pre-crisis period it toed the U.S. line by focussing on exchange rate misalignment and current account imbalances, thereby, directly pointing a finger at China and a few other leading emerging economies.

It is true that these have been among the causes of the global imbalance but by ignoring the housing and the financial bubble building up in the U.S. and other advanced economies, the IMF was doing itself a great disservice.

The article was corrected for factual errors.


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