The Independent Evaluation Office of the IMF (IEO) recently released a critical report on how the IMF handled the crises in Greece, Ireland and Portugal. I have closely followed the role of the IMF in Greece and have identified where things went wrong. It turns out that my list differs quite considerably from that of the IEO. In what follows, I consider my conclusions against those of the IEO. But first, a little background on the IMF's role in the Greek crisis.
Who in Their Right Mind Would Have Bought Greek Debt?
Table 1 provides economic data for Greece. Anyone taking the time to look at these numbers should have seen that by 2008, the wheels were most definitely coming off. By then, the government deficit has grown to almost 10%. And while the deficit probably kept the unemployment rate from growing more rapidly, this was clearly not a sustainable economic path.
Table 1. - The Greek Economy
And yet, there were still plenty of buyers for Greek debt. Table 2 gives interest rates on Greece's 10 year debt for the years in question. Note how low they were until really spiking in 2012. Who were the buyers and why? To answer this question, a brief primer on required bank reserves is in order.
Table 2. - Interest Rates on 10 Year Greek Debt
Primer on Required Bank Reserves and the Greek Example
Banks attract deposits (liabilities) and use them to earn income. These income earning vehicles and cash constitute bank assets. Regulators insist that banks maintain certain minimum liquid assets (such as cash) to cover fluctuations in other deposits. As bank investments have become more complex, regulators have attempted to adjust them by risk. The more risky an investment is, the less of it will be allowed to count as part of its liquid reserves.
Consider now the Greek case. The regulators "in their wisdom" allowed banks to treat Greek government debt in the same manner as cash! That is, the Basel II rules allow national regulators to treat government debt as risk free! And this means banks do not have to hold any capital against it in to be in compliance with global rules. This explains the demand for Greek debt. The banks say why hold cash when we can buy Greek debt and get a healthy return?
So the Greek crisis started because of inappropriate bank regulation rules. The IMF was not yet involved.
The IMF has changed its position on what Greece should do several times since engaging with the powerful EU countries lead by Germany. The IMF joined the European Commission and the European Central Bank (hereafter referred together as "EU") to save Greece. Since 2010, the Fund has had almost as many disagreements with the EU over what should be done as it has had with the Greek government. Below, I document this with a timeline on changing IMF policies and conflicts with Greece and the EU.
Back in 2010, the IMF was working in lock step with the EU. Germany and the IMF agreed: austerity was the answer. And Germany knew the IMF would be the perfect enforcer. The IMF ended up negotiating an agreement with Greece that went far beyond austerity. In all the years I have been covering the IMF, I have never seen such a long list of policy changes being demanded of any country. The general categories included: fiscal reforms, pension reforms, health sector reforms, Social Security reforms, government performance reforms, and economic system reforms. In order to achieve those objectives, the Greek government agreed to foreign technical assistance in more than 20 different fields. The reforms demanded by the IMF with full support from the EU were intended to make Greece competitive with Germany!
The hope was that if Greece did everything on the IMF list, it could remain in the Eurozone and compete with the Germans.
b. What Went Wrong
The IMF is often criticized for not giving enough attention to the unemployment consequences of its austerity packages. It consequently did its own research on the subject. It concluded that a fiscal consolidation of 1% of GDP generally results in an increase of 0.3 percentage points in the unemployment rate. 1
However, Table 1 indicates that its 2010 estimates made in preparing the austerity package for Greece were horribly wrong. In 2010, it projected Greek unemployment would be 13.1% and 13.4% in 2011 and 2012, respectively. In fact the rates jumped by far more to 17.9% and 24.4%. This happened in part because of the draconian reductions in the government deficit insisted on by the IMF/EU combine.
c. IMF Staff Steps in
In 2012, Olivier Blanchard, the chief economist of the IMF and Daniel Leigh, another IMF economist, reviewed the IMF's earlier research findings on the unemployment effects of reducing government deficits. They concluded the earlier unemployment multiplier estimates were too low. Their new research suggested that a 3% fiscal consolidation would result in as much as a 1.8 percentage point increases in unemployment. But even this doubling of the unemployment multiplier does not explain the huge unemployment growth in Greece. The Greek economy was in a free fall.
To its credit, the Fund saw what was happening and gave up on it. This caused a serious rift between the IMF and the EU (most notably Germany). In early 2012, there were numerous reports of growing friction between the IMF and Euro countries over the Greek program. The reports were that the Fund was upset that the EU (Germany in particular) was focused almost completely on getting Greece to reduce its government deficit. The Fund insisted this one dimensional approach had failed. Andy Dabilis reported that the IMF was "attempting to distance itself from a 'counterproductive set of austerity measures' imposed on the country under the insistence of the EU."
An example of the "EU lunacy" is the following quote from Jean-Claude Trichet, the president of the European Central Bank: "the idea that austerity measures could trigger stagnation is incorrect….a credible fiscal-consolidation plan will restore confidence and foster economic recovery."
While the Fund staff had backed away from austerity, the IMF politicians took a different approach. The Fund's Managing Director Lagarde called on Europe to create a much larger "buffer/rainy day" fund. This was more of a "put your head in the sand" approach rather than a serious effort to resolve the problem.
Having given up on austerity, Fund staff staked out a position of its own. It argued that even though Greece had already obtained a debt reduction of 70%, more was needed. It now argues Greek debt now at 182% of GDP is not sustainable and must be lowered to 110% of GDP by 2022. However realistic this position might be, it is not what the EU wants to hear. It would mean another Greek default with European banks taking the hit.
Where Is All This Headed?
Looking ahead, the future is unclear. But one thing is certain: this will not end well. Greece's debt is not sustainable. The IMF is strongly pressing the EU to recognize this and allow another default.
But there is a more fundamental problem: Since 2011, I have argued that Greece will never be able to compete with Germany and consequently should exit the Eurozone. It appears that slowly and painfully this is in the process of happening.
And that brings me back to the next role for the Fund. I quote from an IMF spokesman: "Let me emphasize again what the objective is here. It is to help Greece, to support Greece in getting back on the path of sustainable growth, jobs, and better living standards for the Greek people. That's what all of this is about."
Consider next the Fund's mandate. Article 1 calls for it to: "Give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity." I see little chance of Greece remedying its balance of payments problems as long as it is a currency union with Germany. It needs its own currency that will adjust for differences between the Greek and German economies.
Greece is a dues paying member of the IMF. Consequently, the IMF is obligated to assist Greece to avoid disruptions in the international financial system. The IMF has no responsibilities to regional groupings of countries. So as this process moves forward, the IMF should provide assistance to Greece in leaving the Eurozone. At the very least, it should research the pros and cons of Greece staying in and leaving the Eurozone and discuss these options with the Greek government.
How my views differ from those of the IEO are covered in the following section.
The IEO's Primary Conclusions
I list the IEO's primary conclusions below with my comments following each one.
Recommendation 1; The Executive Board and management should develop procedures to minimize the room for political intervention in the IMF's technical analysis.
My Comment: I think the IMF staff performed well. When it realized it could not achieve the austerity and other measures contained in the original plan with the EU, it made it clear why that approach would not work and pulled out.
Recommendation 2; The Executive Board and management should strengthen the existing processes to ensure that agreed policies are followed and that they are not changed without careful deliberation.
My comment: I do not know what actually happened inside the Fund. But I expect that careful deliberation took place within the Fund before deciding it could not continue in support of the EU plan.
Recommendation 3; The IMF should clarify how guidelines on program design apply to currency union members.
My Comment: The Fund is responsible to member nations and not to currency unions. If, as I believe, Greece cannot perform satisfactorily within the Eurozone, the Fund should assist the Greek government to leave the Eurozone and re-establish its own currency.
Recommendation 4: The IMF should establish a policy on cooperation with regional financing arrangements.
My comment: The Fund's mandate does not cover cooperating with regional financing arrangements. By its mandate, it is responsible to its nation-state members.
Recommendation 5: The Executive Board and management should reaffirm their commitment to accountability and transparency and the role of independent evaluation in fostering good governance.
One might ask whether this is a good time to invest in the Eurozone via an ETF vehicle such as iShares MSCI Eurozone (BATS:EZU). I view it as a random bet. Far too many moving parts.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.