Congress Should Ask Treasury: Can the US Self-Regulate?

365px-International_Monetary_Fund_logo_svg.pngAs Congress debates bills to let government buy $700 billion of distressed mortgage assets, it may want to ask if the US can still self-regulate or needs advice from outside experts. With little fanfare or media coverage, the Treasury Department recently signaled willingness to invite representatives of the International Monetary Fund to conduct an examination of the US economy, financial infrastructure, regulatory apparatus and other systemic elements.

This IMF examination, commonly performed for emerging economies, could identify causes of the current crisis and offer reforms less subject to domestic political pressures. It may be premature for the current bill to address causes or prescribe cures with specificity. But Members and Senators could ask both Treasury and the IMF about whether anything should be in the asset purchase legislation to enable or require Treasury to undertake such an examination.

The IMF is imperfect, of course, having occasionally failed to forestall looming financial crises or offered policies that worsened a brewing crisis. But it has plenty of experience with these problems. An example, with parallels to the current crisis, and indeed a contributing cause of it, is 1997’s Asian financial crisis.


That crisis arose because borrowing in the region’s countries, including Indonesia, Korea and Thailand, increased heavily, financial risk was measured poorly, and a speculative asset bubble formed. When the bubble burst and prices collapsed, defaults on debt spiked. The IMF intervened with a series of policy prescriptions, including directives to allow certain financial institutions to fail, support to rescue others, and stringent conditions on those economies, including limitations on debt.

One result of IMF’s stringency was a massive increase in personal savings rates in the affected economies. This, in turn, produced cash that would find its way into the US mortgage finance system, which was already expanding. Expansion in the US mortgage market arose in part from low interest rates maintained to combat a recession threatened by the collapse of the US tech bubble in 2000 and terrorist attacks of late 2001. Existing institutions, including Fannie Mae and Freddie Mac, supported this expansion by continuing to buy or guarantee mortgage loans. Expansion was propelled by growing use of mortgage-backed securities, pools of mortgages that pay interest and principal to investors.

These forces led lenders to offer attractive deals to large numbers of borrowers lacking traditional indicia of creditworthiness. Trillions of dollars worth of loans were made on easy terms, including loans not requiring a down payment and low or no interest payments for extended initial periods, subject to reset at higher rates later. Reinforcing this expansion in weak credit were novel financial insurance products, called credit default swaps. These promised investors in mortgage backed securities, and other debt, repayment by an insurer if their own debtor defaulted.

The result was an increase in housing prices that assumed dimensions of a speculative bubble. The bubble began to deflate in 2004. Interest rates rose, sales slowed, lenders tightened standards and rating agencies identified greater risk in financial instruments supporting the expansion. Large numbers of people defaulted on mortgage loans when their outstanding balances exceeded a home’s market value.

In outline, if not details, these forces parallel those leading to the 1997 Asian financial crisis. Clean-up efforts now fall not to the IMF, but to the Fed and Treasury. They have struggled but failed to stabilize the situation. This is so despite supporting the takeover of mortgage-backed securities player Bear Stearns by JP Morgan Chase in March; taking control of mortgage-finance lubricators Fannie Mae and Freddie Mac in early September; extending credit to credit default swap insurer American International General two weeks ago; and expanding credit to other financial institutions, including investment banks.

Now, the Fed and Treasury ask Congress for authority to buy up all the bad assets. Treasury Secretary Hank Paulson and Fed Chair Ben Bernanke will testify today about why they want a “clean” bill, simply granting the authority. Lawmakers, apparently not ready to consider such causes as those I’ve suggested or reforms they may indicate, talk of adding provisions to protect homeowners (limiting foreclosure rights or loosening bankruptcy laws) and taxpayers (giving them warrants to buy the assets) or address collateral matters like capping executive compensation for recipient firms and prohibiting recipients from managing the governmental program. On the campaign trail, neither Senator Obama nor Senator McCain offers specific diagnosis or reform, other than loose of talk of deregulation as a cause and re-regulation as a cure.

Even if it is too soon to be sure what caused the crisis and what, if anything, to change to prevent recurrence, and even if some of the additions that some lawmakers want in the bill are reasonable, it may not be premature for Congress to consider whether someone other than officials within Treasury, the Fed or Congress should have an independent look. Few candidates appear qualified for such a task. The IMF, imperfect though it is, may offer requisite expertise and independence to contribute useful insight.

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7 Responses

  1. A.J. Sutter says:

    As Max Beerbohm said, “The ant sets an example to us all; but not a good one.” I don’t understand your argument here: Yes, the IMF has experience in these matters, but even you don’t claim that the results were good.

    Indeed, one of the countries that resisted IMF, Malaysia, went its own way, with much better result than some of the countries that allowed themselves to be guided by IMF advice. Many others, especially in Africa, have shifted from being food exporters to being net food importers because of IMF advice or conditions. The organization’s track record isn’t just limited to the Asian crisis of a decade ago.

    What evidence is there that IMF has grown wiser from its experience? (Could it be that IMF’s expertise at protecting the interests of commercial lenders, rather than of a country’s citizenry, is what recommends it to Paulson & Co.?)

  2. Frank says:

    Perhaps “capping executive compensation for recipient firms” is a “collateral matter.” But it really diminishes public confidence in the plan when it seems like the very people who caused the crisis are going to become ever richer working on its solution. Consider this scathing article from our H.L. Mencken, Dana Milbank:

    “‘If we design it so it’s punitive and so institutions aren’t going to participate, this won’t work the way we need it to work,’ Paulson, whose net worth is said to be north of $600 million, told Chris Wallace on ‘Fox News Sunday.’

    “It was a message of mercy and humanity — who, after all, would be so cruel to deny executives their eight-figure bonuses merely because they drove their companies into insolvency? — and administration officials and Republican lawmakers joined the cause of the unappreciated CEOs.”

    from:

    http://www.washingtonpost.com/wp-dyn/content/article/2008/09/22/AR2008092202849.html?hpid=opinionsbox1

  3. Lawrence Cunningham says:

    A.J.—

    Please allow me both a weaker and stronger form of response to your queries:

    1. Weaker Form Response: I am not confident endorsing, and am not here endorsing, having Congress require Treasury to engage IMF for a review, advice, direction or assistance in managing the proposed government program; I am confident suggesting, and am here suggesting, that Congress should consider it a responsible idea for debate and discussion.

    2. Stronger Form Response: IMF policies, especially conditionality, are controversial and empirical evidence of success either mixed or contestable. For net favorable analysis, see, for example:

    a. John Norberg, In Defense of Global Capitalism (2001) 177-181 (noting that countries following IMF policy advice, including Uganda and Ghana, benefit, while those not doing so, including Nigeria, Kenya and Zambia, do not);

    b. Jagdish Bhagwati, In Defense of Globalization, 4-5 (2004/2007 paperback) (characterizing routine criticism of IMF, and especially regular public protests at its and World Bank’s annual meetings, as “clever guerilla tactics”) and 260 (noting IMF policy reversals after its “wrongheaded deflationary prescription in the East Asian crisis”); and

    c. Stanley Fischer, IMF Essays from a Time of Crisis: The International Financial System, Stabilization and Development (2004) (including reviews thereof, such as Patrick Conway 44 Journal of Economic Literature 115-144 (analyzing Fischer’s empirical data and comparing it empirical data elsewhere in the literature)).

  4. A.J. Sutter says:

    Thanks for your reply. Johan Norberg says that countries complying with IMF “have had on average higher growth *and thus* reduced poverty” (emphasis added), while the others “remain economically unimpressive, having become bogged down in poverty and inequality of unimaginable dimensions” (@181). One could question whether the causation of higher growth reducing poverty is correct, to say nothing of the implied causation regarding IMF advice. And while probably the US is not (yet) in danger of poverty of unimaginable dimensions, it’s interesting to compare the 2007 Gini coefficients of some countries (UN and CIA figures agree, unless otherwise noted): Ghana 40.8, Uganda 45.7, Kenya 42.5 (UN)/44.5 (CIA), Nigeria 43.7, USA 40.8 (UN)/45 (CIA). While Zambia is off the charts, at over 50, it’s hard to draw a strong connection between following IMF advice and reducing inequality, as Norberg contends.

    More generally contra on the IMF, see, e.g., Joseph Stiglitz & Andrew Charlton, Fair Trade for All (2005), noting, e.g., that “the IMF often forces developing countries to have high interest rates, well above the global ‘market rate’,” (@131), “monetary policies or structural adjustment programs advocated by the IMF may adversely affect the flow or affordability of finance to facilitate the restructuring of the economy in response to liberalization” (@208) and that IMF usually fails to consider the effects of its policies in conjunction with effects of the WTO (@81).

    I agree with the broad idea that the US shouldn’t be the sole regulator of the world’s financial system, but I doubt that IMF are the right folks for the job.

  5. Lawrence Cunningham says:

    A.J.—

    We seem to agree to ask a vital question: what expertise is available to offer national advice in a deeply inter-connected global financial system? Maybe IMF is not the ideal group, but what group is?

    US Congress, principally through its gifted staff, has valuable expertise. But this is limited concerning the crisis US Treasury and Fed ask it to address. The latter may equally fail to grasp all dimensions of the challenges posed. To overcome these limits, why not get advice from those who have addressed broad-scale financial crises akin to the present one before, even if (or maybe precisely because) results of their efforts are mixed?

    On your finer points, true, causal inferences about growth leading to poverty reduction, and IMF’s role, are contestable. An open question is how intensively US policy should seek eradication of such inequality as there is, or poverty that, perhaps not of “unimaginable dimensions”, is surely treacherous in pockets. Serious political questions arise, with stakes far beyond, though implicated in, this discussion. And, no doubt, Professor Stiglitz is right to remind IMF to consider how its policy recommendations interact with other constraints, including those emanating from the World Trade Organization.

    Shall we leave it at that? Or could we turn crisis into advantage by considering how the US economy’s performance poses global repercussions? Shall domestic institutions alone sort this out?

  6. A.J. Sutter says:

    I do agree that US domestic institutions shouldn’t sort this out alone. A first thought would be to consult with OECD finance ministers and central bankers. I may be a bit naive about how the IMF works, and I understand that technically the group I’m suggesting is a subset of the IMF Board of Governors, but by dealing with national teams (and their supporting bureaucracies, rather than IMF’s) more directly, I suspect there might be more political savvy in the room. But I also suspect a second thought about this — to say nothing of political change in some of the countries concerned — might be more fruitful.

    There is, of course, another option, which is to learn from the private sector in Nigeria. Here is an example: (Source: http://blogs.wsj.com/economics/2008/09/23/spam-du-jour-i-am-ministry-of-the-treasury/ ):

    From: Minister of the Treasury Paulson

    Subject: REQUEST FOR URGENT CONFIDENTIAL BUSINESS RELATIONSHIP

    Dear American:

    I need to ask you to support an urgent secret business relationship with a transfer of funds of great magnitude. I am Ministry of the Treasury of the Republic of America. My country has had crisis that has caused the need for large transfer of funds of 800 billion dollars US. If you would assist me in this transfer, it would be most profitable to you.

    I am working with Mr. Phil Gram, lobbyist for UBS, who will be my replacement as Ministry of the Treasury in January. As a Senator, you may know him as the leader of the American banking deregulation movement in the 1990s. This transactin is 100% safe.

    This is a matter of great urgency. We need a blank check. We need the funds as quickly as possible. We cannot directly transfer these funds in the names of our close friends because we are constantly under surveillance. My family lawyer advised me that I should look for a reliable and trustworthy person who will act as a next of kin so the funds can be transferred.

    Please reply with all of your bank account, IRA and college fund account numbers and those of your children and grandchildren to wallstreetbailout@treasury.gov so that we may transfer your commission for this transaction. After I receive that information, I will respond with detailed

    information about safeguards that will be used to protect the funds.

    Yours Faithfully Minister of Treasury Paulson

  7. Miriam Cherry says:

    Thank you, Larry, for your insightful commentary on this and related issues here.