Will these men save the world?

Last spring the IMF said the world economy was under control; now it faces the reality of the crunch. Heather Stewart and Larry Elliott report from Washington on an organisation in shock

By (The Guardian)

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Published: Mon 14 Apr 2008, 5:38 PM

Last updated: Sun 5 Apr 2015, 11:39 AM

Double helpings of humble pie must surely have been on the menu in Washington on Friday evening, when a clutch of Wall Street's richest bankers were hauled in to dinner with finance ministers from the world's most powerful economies to account for their role in unleashing what the International Monetary Fund has called 'the largest financial shock since the Great Depression'.

Outside, on Washington's sun-baked sidewalks this weekend, concrete crash barriers were dragged into place, gun-toting police guarded every doorway and roads were blocked off in all directions. Inside the ring of steel, there was an air of shocked contrition among the ministers and central bankers, many of them new to their jobs, who have found themselves hostage to the forces unleashed by the failures of high finance.

Since the sub-prime crisis began to engulf the global financial system last August, the men and women who run the global economy have jostled to appear decisive and statesmanlike, while cobbling together one costly emergency rescue package after another, to prevent the losses sustained by the banks bringing the entire financial system grinding to a halt. Hardly the stuff of dinner party chat - but the contrite bankers from both sides of the Atlantic who gathered at the US Treasury on Friday night were asked to give their side of the story.

All the power-brokers gathering for the IMF's spring meetings this weekend were faced with a global financial system that bore little resemblance to that of a year ago, when the private equity boom was at its height and markets were awash with unbridled optimism.

At its spring meetings last year, when the US housing downturn was already under way, the IMF, long the cheerleader for unfettered liberalisation and light-touch regulation of financial markets, predicted that the global economy would sail merrily on. It quipped that the 'financial tail' would not wag the 'economic dog'; in other words, that the losses created among banks and other financial institutions by mass defaults among US homeowners would not derail the strongest expansion in the world economy since the late 1960s. But as Simon Johnson, the IMF's director of research, said last week: 'Everyone in the world has learnt a lot about dogs, and their tails, and how that works, over the past year.'

Like most of those working in the City or on Wall Street, few of the policy-makers gathered in Washington had any first-hand experience of dealing with a crisis. Ben Bernanke, chairman of the Federal Reserve, is two years into the job. He made his reputation by studying what the authorities did wrong during the Great Depression; but he cannot have guessed that he would be faced with the task of avoiding a repeat performance.

Alistair Darling has had nothing but trouble since taking over at the Treasury last June; Christine Lagarde, the French finance minister, has also been in the job less than a year. And Hank Paulson, the US Treasury Secretary, is a seasoned Goldman Sachs banker, hardly the obvious candidate to sketch out radical solutions to a crisis propagated by the banks themselves. Around the G7 table at the US Treasury on Friday afternoon, only Mervyn King, chief economist at the Bank of England at the time of Black Wednesday in September 1992, had any hands-on knowledge of what it was like to be a policy-maker under siege.

When the Fund last met in Washington in mid-October there was still hope that the problems caused by the collapse of the US sub-prime mortgage market could be contained. The IMF noted the rapid response from the Fed and other central banks and expressed confidence that the American economy was resilient enough to shrug off the impact of its ailing housing market. At a global level, the consensus was that growth would be barely dented, with the leading developing countries taking over the role of locomotive for the world economy from America.

The mood changed over the winter. Financial markets have remained frozen, with credit hard to come by and expensive when available. The poison from the US mortgage market has infected the rest of the economy; consumer confidence has collapsed, unemployment is rising and spending on durable goods has fallen sharply.

Since last summer the Fed, haunted by its policy inaction at the time of the Great Depression, has slashed interest rates by an extraordinary 3 per cent to boost activity, but the impact has been more immediately felt on the world's foreign exchanges, where the dollar has dropped to a record low against the euro. The weakness of the greenback has added to the sense of crisis, making it more likely that countries in Europe and Asia dependent on the US market will grow more slowly, leading to increases in the price of commodities such as oil, which are bought and sold in dollars.

The threat of a global recession traditionally leads to a collapse in the cost of energy; last week the price of crude hit a record $112 a barrel and food prices have risen so fast that Robert Zoellick, the President of the World Bank, warned that growing problems of malnutrition and hunger had set back the fight against poverty by up to seven years.

Even Wall Street has been humbled in recent months, which have seen one of its number - Bear Stearns - bought for a rock-bottom price in a government-backed fire sale. The bankers' trade body, the Institute of International Finance, issued a rare mea culpa last week, confessing to 'major points of weakness in business practices' - including bulging pay packets, awarded in many cases on the basis of short-term performance.

Against this gloomy backdrop, the IMF could hardly be accused of pulling its punches. On Tuesday it said that the total losses resulting from the sub-prime crisis were likely to be close to $1 trillion; on Wednesday, it said the 'financial market crisis that erupted in August 2007 has developed into the largest financial shock since the Great Depression, inflicting heavy damage on markets and institutions at the core of the financial system', and warned of a one-in-four chance of a world recession.

Johnson exhorted governments to use all the weapons at their disposal to tackle the crisis. He outlined three 'lines of defence' for embattled policy-makers: interest rates, tax policy, and, where necessary, more state-backed bailouts. 'Room may need to be found for additional public support for housing and financial markets,' the IMF said, in its weighty World Economic Outlook.

Next day it was the turn of Dominique Strauss-Kahn, France's former finance minister, to host his first press conference since becoming the IMF's managing director six months ago. By a tradition established when it and the World Bank were created at the Bretton Woods conference in 1944, and which has become increasingly contentious with developing countries, the Europeans choose the person to lead the IMF while the bank is the fiefdom of the White House.

In a dingy briefing room in the bowels of one of the IMF's two buildings in downtown Washington, Strauss-Kahn admitted that policy-makers faced a tough task of steering between what he called 'ice and fire'. They must balance the risk of a sharp slowdown in their economies with the danger of unleashing rampant inflation. Central bankers are alarmed at the extent to which interest rate cuts have proved almost powerless to reopen the credit markets.

Strauss-Kahn insisted his much-maligned institution was the right body to bring stability to the global economy, saying: 'The IMF is back.' But his audience could be excused for wondering where it had been since the crisis erupted.

From cash-strapped UK homeowners discovering their mortgage repayments are about to shoot up just as the value of their homes begin to fall, to the small businesses in emerging markets that are now finding it harder to raise finance, the crisis has powerfully demonstrated that what happens in the slick institutions of Wall Street and the City can have a devastating impact on the world outside.

Demand for radical action is growing, particularly in the US, which many economists believe is already in recession. Paulson admits two million people may lose their homes before the crash is over and basic questions are being asked about the power of global capital.

Just outside the ring of steel protecting finance ministers and central bankers this weekend, a rash of bright yellow posters appeared on the campus of George Washington University, carrying the slogan 'Bail out People, not Banks' and inviting campaigners to a public protest. Presidential candidate John McCain last week joined calls for direct government intervention to help mortgage-holders who cannot pay their bills, outlining a scheme that could cost up to $10bn.

Yet despite flagging up the crisis as the worst since the Wall Street crash of 1929, the IMF had few new recipes to offer the finance ministers it is meant to advise. Professor Joseph Stiglitz, the Nobel prize-winning economist, says this may reflect another challenge facing policy-makers: not only are they inexperienced and in uncharted waters, they are also unwilling to confront fundamental problems with the philosophy they have pursued for two decades.

'It is all based on a simplistic ideology,' he says. 'What these leaders are finding is that the heroes of the past 20 years have been the financial market wizards, and all of a sudden it's so obvious that the emperor has no clothes.' The lionising of the money men was 'ideology - and special interests, cloaked in ideology'.

The IMF has been in the vanguard of the drive for deregulated capital markets, urging the removal of restrictions on the activities of banks and other institutions in developed countries, and often insisting on such a policy stance for developing countries seeking financial help.

This 'Washington consensus' of liberalisation and deregulation has long been the target of anti-globalisation campaigners and development charities, which blame the Fund for imposing free market ideology on the poor. This dogmatic approach was criticised for exacerbating a series of major economic and financial crises, including one in Asia in the late 1990s, and later, in Latin America. But this time, the IMF and its fellow-travellers are accused of promoting the policies which have created a recession on its very doorstep - in America.

Strauss-Kahn found it impossible to admit last week that the IMF had itself been part of the problem, arguing that its warnings of impending problems from reckless lending had gone unheeded, especially in the US.

But the crisis comes at an unfortunate time. Morale at the IMF is low after the cost-cutting programme implemented by Strauss-Kahn, and the unwillingness of its big Western shareholders to give up anything more than a fraction of their voting power to developing countries has raised questions about its legitimacy. Peter Chowla, policy analyst for the Bretton Woods Project, which monitors the World Bank and the IMF, says: 'Part of the reason the fund doesn't have the ability to analyse the crisis well is because the major shareholders haven't wanted it to have a role in overseeing financial markets in their countries. The US has been particularly unwilling to cede authority.'

Stiglitz agrees: 'The IMF is structurally in a difficult position because it is really accountable to the finance ministers and central bankers, and they're really owned by Wall Street and the financial markets - and the financial markets are at the root of the problem.'

Darling delivered a speech to the Brookings Institution on Friday, calling for the IMF to be streamlined and given a stronger role in warning about financial crises. But even when the fund warns of trouble ahead, finance ministers often ignore it, as Darling himself knows well, having spent some time last week rejecting its forecast that the UK faces a deep slowdown over the next two years as a result of its collapsing housing market.

As if sensing that the response of policy-makers to the crisis was weak and confused, the banks last week sought to head off calls for the sort of draconian curbs on their activities imposed by President Roosevelt after the Wall Street Crash. Josef Ackermann, chief executive of Deutsche Bank and chairman of the Institute of International Finance, said that despite bearing some responsibility, it would be 'completely wrong' for the authorities to impose much tougher controls on the banks.

In more normal times, Ackermann's pleas for clemency would find an echo at the US Treasury and the Federal Reserve. The scale of the losses racked up by the banks, the large injections of taxpayers' money to help them through the crisis, and - perhaps most important - the impact on ordinary Americans in an election year means the banks' insistence they can clean up their own mess will be politely ignored in Washington. The Fed and the Treasury are under strong pressure from Congress to rein in the financial sector. At the very least they are likely to tighten controls on what capital they must hold and demand greater transparency about complex investments such as the mortgage-backed assets at the heart of the sub-prime storm.

For all their huffing and puffing, the banks would probably settle for that. What they fear is the return of the New Deal-style curbs imposed in the 1930s in response to the excesses of Wall Street in the 1920s. For the moment, the return of such controls is indeed out of the question. There is no Roosevelt or John Maynard Keynes waiting in the wings with a blueprint for how capitalism could be better managed, and the finance ministers at this weekend's meeting appeared to be more interested in using extra public cash to support the banks, than in unpicking the Washington consensus.

Chowla says it would need to get much worse to force a really radical rethink: 'The only way you are going to get the oversight you need is in the event of a really major crisis. That gets people to rethink their paradigm about how economies are managed and finance is structured.'

The New Deal reforms were the response to a crisis that not only saw a credit crunch and a banking collapse but also 25 per cent unemployment and a 50 per cent drop in industrial production. The economic fall-out from the sub-prime crisis has not been nearly so damaging - at least not yet.

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