IMF Greece Report Was Flawed. EU Did Even Worse.
In an internal report released this week on its involvement in Greece in the past few years, the International Monetary Fund takes on the European authorities much more bluntly than usual. Greece came to the IMF in 2010 later than it should have and needing more resources than could readily be provided -- primarily because of foot-dragging by its euro-partners. The Western Europeans also resisted Greek debt restructuring for far too long, creating a major handicap for the rescue program.
All of this is undeniable, but also relatively easy for the Europeans to dismiss. And dismissiveness was exactly the reaction from Mario Draghi, president of the European Central Bank, and from the European Commission. Their line is: Mistakes were made, and now we are on the road to recovery -- so why worry?
In fact, the IMF staff fully understands -- but cannot speak openly about -- a deeper and more serious weakness in the euro area that threatens not just Greece but all of peripheral Europe today. European banks are woefully undercapitalized -- meaning they operate with very thin cushions of equity financing (and therefore fund their balance sheets with 95 percent or 97 percent debt). As a result, they have only a very limited ability to absorb losses, creating the potential for insolvency to spread throughout their financial system -- and around the world -- in unpredictable ways.
The Europeans live in fear of encountering their own Lehman Brothers moment, when a relatively moderate fall in debt values triggers widespread panic and another round of collapse in the real economy.
For this reason, when a significant debt restructuring was first proposed for Greece, the financial elite of the euro area was united in their opposition. German and French officials were among those most worried by what could happen if Greece defaulted or even had an orderly restructuring.
The American financial system is no picnic, with our Dodd-Frank financial reforms substantially stalled by Wall Street lobbying, but even our worst-run big banks are in much better shape than most of their European counterparts. Deutsche Bank, BNP Paribas and Credit Agricole routinely operate with $50 billion to $100 billion in equity capital, with balance sheets in excess of $2.5 trillion. Risk has been mismanaged within those institutions and by their regulators. Deutsche Bank, the worst of a bad bunch, is frequently referred to by market participants as a very large hedge fund. It is not meant as a compliment.
At the heart of this European banking monster is the crazy notion that the banks and officials can jointly determine the risk-weights on assets. What’s a low or zero-risk weight in the European context today? Sovereign debt -- despite all we have learned from the Greek situation. Who lent excessively to the Greek government -- the supposedly mighty banks of the big euro area countries.
Why is the IMF substantially or completely silent on this key vulnerability (yes, there are some platitudes, but really nothing of any consequence)?
Because, in this report and in its other official communications, the IMF is prevented from speaking the full truth to authority by its current governance arrangements. The Europeans are grossly over-represented at the IMF, both in terms of their votes and seats on the board (the Europeans have up to one-third of the board seats, depending on how you do the math). Christine Lagarde, then finance minister of France, was the swift replacement as managing director when Dominique Strauss-Kahn’s career imploded in 2011. The IMF’s managing director has, in fact, always been a West European.
It is a big mistake to allow the Europeans to hold such disproportionate sway over the IMF. Allowing some debtor representation and voice at the IMF is entirely appropriate. But the powerful Europeans are not the debtors -- they are the trouble-makers. And they make trouble specifically because they deny the vulnerability in their banking system. This is simply not something that German or French politicians wish for their electorates to understand.
The IMF was dealt a bad hand on Greece and played it relatively well. No rescue program can be perfect, either in design or implementation. But the most difficult and regrettable constraints came not from any conceptual failure but from the attitudes and actions of larger euro-area countries.
It is the French and German governments that should be held responsible for the severity of the depression in Greece -- and for the excessive degree of hardship imposed on vulnerable people throughout the troubled periphery. There is much rhetoric about solidarity, but the reality is that an unwise approach to banking has been allowed to drive macroeconomic policy decisions.
Unless and until the IMF is able to confront the Europeans directly and publicly on this point, we should expect more Greek-style disasters.
(Simon Johnson, a Bloomberg View columnist, was chief economist at the International Monetary Fund in 2007 and 2008.)