The IMF’s performance on financial sector aspects of the euro area crisis

Bruegel just published “The IMF’s Role in the Euro Area Crisis: Financial Sector Aspects” in its Policy Contributions series, and the Peterson Institute posted a near-identical text on its website. Both are lightly edited versions of a background paper on financial-sector aspects which formed part of a broader evaluation of “the IMF and the crises in Greece, Ireland and Portugal,” published in late July by the Independent Evaluation Office of the International Monetary Fund. The IEO report, which was accompanied by eleven background papers (including mine), received wide coverage in international media, and prompted a welcome debate on the weaknesses and shortcomings it highlighted at the Fund.

My work evaluated the financial-sector aspects of the IMF’s performance on two levels. For the euro area as a whole, I give the Fund high marks for its ground-breaking analysis of the vulnerabilities of the currency union’s banking policy framework, starting years before the crisis and developed near-continuously during the crisis itself. The IMF was the first public institution, and among the first observers more generally, to identify the vicious circle between banks and sovereign states, which then became increasingly widely acknowledged as the central driver of the euro area crisis, and which euro area leaders memorably pledged to break when first announcing the reform now known as banking union in late June 2012. As early as May 2009, an IMF working paper by Ashoka Mody is the earliest public description I found of that vicious circle, presumably inspired by his experience of Ireland at that time. It was closely followed by a euro-area-wide analysis by Silvia Sgherri and Edda Zoli emphasizing the links between sovereign risk and financial-sector fragility.

In terms of euro-area-level policy recommendations, the IMF was an early advocate of what we now call banking union, including through a series of publications in 2007 and a detailed proposal in 2010, which can be seen as the precursor of the euro area’s single resolution mechanism that came into force earlier this year. (My own first contribution to the banking union debate in 2007 was largely inspired by joint work with two IMF economists, Jörg Decressin and Wim Fonteyne.) The Fund was an equally forceful champion of banking union in the immediate run-up to euro area’s decision to initiate it, with a landmark blueprint provided in a January 2012 speech by the IMF’s managing director, Christine Lagarde. The IMF’s advocacy of European banking policy was not entirely continuous and was occasionally weakened by internal disagreements, but deserves significant credit for its contribution for the major steps the euro area has taken since 2012 towards banking union, arguably the most important structural reform adopted by the euro area in response to the crisis.

At the level of individual countries, my assessment highlights the contrasts between different programs, as does the IEO’s main report. On financial-sector aspects, the first Greek program (2010-12) successfully prevented short-term financial instability but couldn’t avert the sharp deterioration of Greek banks’ balance sheets in the run-up to the sovereign debt restructuring of March 2012. The Irish program (2010-13) was as close as it gets to a textbook example of effective banking sector restructuring. By contrast, the Portuguese program (2011-14) missed the opportunity to bring Portugal’s banking sector back to soundness, a collective failure for which Portugal is now paying a significant price. The Spanish program of 2012-14, to which the IMF contributed in major ways even though not under the “troika” arrangement, was, like Ireland, a remarkable success. The second Greek program (2012-16) and Cypriot program (2013-16) are not covered by the IEO evaluation because they were still ongoing when most of the evaluation work was being done. The paper attempts to explain how these diverse outcomes resulted from different country contexts but also from internal circumstances within the Fund.

The paper’s title and context clarify what it is and isn’t. First, it was written as part of an evaluation of the IMF. While a number of facts and assessments are provided on other actors such as national governments and EU institutions, these are only intended to help pass judgment on the performance of the IMF itself. In other words, the paper does not seek to evaluate the actions of any of these governments and institutions, even though it provides materials that may be used for such evaluations. Second, the paper focuses on financial-sector aspects, and to be more specific, on banking-sector issues, since banks represent the overwhelming majority of financial intermediation in the euro area. Fiscal and structural policy challenges, in particular, are covered in other parts of the IEO evaluation but are not assessed in this text. Third, as highlighted in a disclaimer on the background paper published by the IEO, the views expressed in the paper are mine and not those of the IEO. As the IEO puts it, background papers “are published to elicit comments and to further debates.” Only the main report represents views of the IEO itself.

My evaluation supports the view that the euro area crisis is best understood as a set of complex interactions between fiscal and financial-sector developments, even though mainstream narratives tend to focus single-handedly on the fiscal aspects (and, correspondingly, on Greece). It also highlights the IMF’s contribution as a highly valuable partner for the euro area throughout the crisis, despite flaws on which the IEO project has shed an unforgiving light. The IMF has acted as a welcome check against European tendencies for insular and inward-looking thinking, and has provided important insights to the European policy process based on the Fund’s experience elsewhere in the world, even though European policymakers haven’t always heeded the IMF’s advice as they should. The Fund should try to build on its successes and learn from its mistakes to keep bringing essential value to European policy decision-making in the years ahead.

Finally, I wish to express my personal gratitude to the IEO, particularly to Shinji Takagi who led this evaluation project and to the Office’s Director Moises Schwartz, for having allowed me to participate in their collective effort. The IEO, which started in 2001, is a unique institution. It has once again demonstrated its capacity for ruthless truth-telling to the IMF, which in turn supports the Fund’s capacity for ruthless truth-telling to its member countries. The ability of the IEO to prepare and publish independent assessments, and to enable background papers authors to express independent judgments of their own, is truly impressive. For me, contributing to the IEO’s work over the last eighteen months has been a great honour and privilege.