There are significant concerns that the exchange rate may be fundamentally misaligned and exchange rate policies could be a significant contributor to external instability....Accordingly, staff recommends that the executive board initiate an ad hoc consultation with China that would be expected to be concluded within about six months.
The September 22 board meeting was never held. The Article IV report was buried. Indeed, the US Treasury lost interest in prodding the IMF to label China. The bankruptcy of Lehman Brothers, and the financial chaos that ensued, shifted the balance of power again away from the United States and toward China — this time seismically, by several orders of magnitude greater than anything that had come earlier in the crisis.
Henry Paulson’s book, On the Brink, offers helpful insight on why, although it never mentions the 2007 decision. In his chapters about events immediately following the Lehman bankruptcy, the former Treasury secretary recounts numerous phone calls to Beijing in which he and other Treasury officials were essentially imploring Chinese leaders to see that it was in their own self-interest to help keep the rest of the US financial system afloat.15 On the Saturday after Lehman collapsed, for example, Paulson called Wang Qishan, the vice premier responsible for economic and financial affairs, in the hope that a Chinese state-owned company would invest in the investment banking giant Morgan Stanley, which was in desperate need of a cash infusion. According to his book, the Treasury chief told Wang that Washington would “welcome” such an investment, adding that the US government “viewed Morgan Stanley as systemically important” — a virtual promise that American taxpayer dollars would be tapped, if necessary, to protect the Chinese against major losses. Wang’s “unenthusiastic tone” convinced Paulson to back off. “China was already providing tremendous support to the US by buying and holding Treasuries and [other US] securities,” Paulson writes.
15 Henry M. Paulson, Jr. (2010), On the Brink: Inside the Race to Stop the Collapse of the Global Financial System, New York: Business Plus.
According to the recollections of a senior US official who held major policy-making responsibilities:
It was a terribly volatile time. The last thing we wanted in the middle of a crisis was a public row with China over its exchange rate policy. It was never explicit — it wasn’t like the Chinese came back and said, “if you do this, we’ll do that.” It’s just — of all the things that US policy makers had to deal with, was this the thing you wanted to make a priority at this point?
Believe me, Hank Paulson thought it was in the best interests of China and the United States for China to move to a market-based exchange rate, but he didn’t seriously consider labelling the Chinese as currency manipulators during the global financial crisis — and I don’t think he should have. It wasn’t a point-in-time decision. I think it was just the pragmatic evaluation that we were focussing on the most important things, and that moving down that path — particularly given that we were in the middle of a crisis — would have likely failed in influencing the Chinese to alter their policy and could easily have backfired and created greater risk at a very precarious time.
China not only emerged unscathed from the 2007 decision, it also turned the tables on Washington by taking pointed note of which country had, in the final analysis, proved most guilty of “external instability.” Yi Gang, deputy governor of the People’s Bank of China, delivered a speech at the IMF-World Bank annual meetings on October 11 in which he asserted that the crisis “underscores the need for the Fund to maintain a sharp focus on risks in the major developed countries and their potential spillover effects.”16 He accused the IMF of “mis-focused surveillance,” and in a little-noticed but barbed rhetorical thrust, called on the Fund to “consider an ad hoc consultation with the United States.”17
16 Yi Gang (2008), “Statement by Dr. Yi Gang, Deputy Governor of the People’s Bank of China, at the Eighteenth Meeting of the International Monetary and Financial Committee,” Washington, DC, October 11, available at: www.imf.org/external/am/2008/imfc/statement/eng/chn.pdf.
17 Ibid.
With a Whimper — or a Glorious Bang
So in the end, the most perverse sort of symmetry and even-handedness prevailed — that is, all countries escaped labelling. This was a sad mockery of the idealism that, in some quarters at least, had once inspired lofty aspirations for the 2007 decision. The Tim Adamses and Mark Allens of the world had genuinely wanted to see the IMF adopt a mission it had never performed during the era following the end of the Bretton Woods fixed-rate system — that of a rule-setter and arbiter capable of speaking out forthrightly and effectively when unbalanced economies and distorted policies threatened the global common weal. Allen’s view that this mission had to encompass threats of all sorts, ones involving US domestic policies as well as Chinese currency practices, was in the most hallowed Keynesian tradition. It was also an admirable attempt to turn a Washington-driven scheme into an undertaking that would elevate the Fund’s stature as an impartial body capable of letting chips fall even on its most powerful members.
But vindication belonged to those who reckoned all along that this approach was far too quixotic and vulnerable to the vagaries of international politics. In retrospect, it was obvious that making the US dollar the first target for labelling as FM was both unwise and impractical, if only because doing so would have completely undermined support for the Fund in the United States. Equally, it was ill advised to insist that an institution purporting to speak for the international community should use a term plucked from a US Senate bill to criticize China. Instead of “de-stigmatizing” the business of labelling as Adams had once proposed, the use of FM exacerbated the problem of stigmatization, most explosively of all in the Chinese case, increasing the political difficulty that the Fund already faced in ruthless truth-telling. And trying to apply the term to the US dollar would inevitably have been seen in Washington as going too far in the opposite direction — that is, eliminating the label’s stigma entirely, rendering it useless. No matter how sincere their desire to multilateralize, destigmatize and apply policy symmetrically, policy makers couldn’t translate their dreams into a workable solution.
Humiliating retreat came almost exactly two years after the IMF board’s approval of the 2007 decision, when the Fund essentially vowed to give the term “fundamental misalignment” a rest. There was general acknowledgement that the 2007 decision still had many desirable attributes — notably, the way in which it had induced IMF staff to devote much more attention than before to exchange rate issues in their Article IV reports. But nobody had faith anymore that the Fund was capable of applying the FM label to countries. The obligation to do so was technically only a matter of management guidance, based on the edict issued by de Rato in late June 2007 ordering staffers to use the term in Article IV reports when they were confident that it was justified. So, while the decision itself was left intact, de Rato’s order could be revoked on Strauss-Kahn’s authority, which he did with alacrity after informing the board of his intention and hearing no objection.
The formal excision of the decision’s discredited appendages took place on June 22, 2009, in “revised operational guidance” for the 2007 decision that the IMF put on its website. “The attempt to apply exchange rate-related ‘labels’ — for instance, the use of specific terminology such as ‘fundamental misalignment’…has proved an impediment to effective implementation of the Decision,”18 the document said, candidly acknowledging that the result had been “damaging [to] the Fund’s credibility.” So, henceforth, when staffers were preparing Article IV reports, they needn’t use the FM term but should instead include “a clear and candid discussion — using plain economics terms — of the exchange rate and the full range of policies that affect external stability.”19 They should do so for both floaters and peggers, and in cases of “egregious” violations of the decision’s principles — when, for instance, a country was manipulating its currency for unfair competitive advantage, and its motive was beyond reasonable doubt — staffers
were expected to say so in their reports.
18 IMF (2009), “The 2007 Surveillance Decision: Revised Operational Guidance,” June 22, available at: www.imf.org/external/np/pp/eng/2009/062209.pdf.
19 Ibid.
One final scene was left in this ill-fated drama — and it was emblematic of the elevated geopolitical status with which China emerged in the wake of the crisis.
Having been mollified by the revised guidance to the 2007 decision, China allowed the long-delayed completion of its Article IV report, as the board finally met to consider it on July 8, 2009. Tellingly, the staff document that the board was deliberating that day was different from the 2008 one expressing “significant concerns that the exchange rate may be fundamentally misaligned,” which existed only in email inboxes at IMF headquarters; it had never attained official force, and never would. Rather, the report placed before directors was in accord with the IMF’s new approach abandoning the use of the FM terminology. This report assessed the RMB as “substantially undervalued,” and even then, the board declined to go as far as the staff. Only “some” directors agreed with the assessment of “substantial undervaluation,” according to the IMF’s public information notice about the meeting.20
20 IMF (2009), “Transcript of a Press Teleconference Call with International Monetary Fund Officials on China’s 2009 Article IV Consultation,” July 23, available at: www.imf.org/external/np/tr/2009/tr072309.htm.
Thus ends the story of the 2007 decision — with a whimper that, from Beijing’s perspective, may have been a glorious bang. By that time, the IMF had moved on. It had responded to financial crises in Eastern Europe that were real, not drills invented for practice purposes. It had overcome its own existential crisis; there was no more talk about why the world needed the Fund. Indeed, it had received an enormous boost in resources at a meeting of the G20 in London in April 2009.
But the weaknesses exposed by the 2007 decision remained. So did global imbalances, and so did major problems in the regulation of the global financial system, to which we turn next.
6
Global Watchdogs, Missing a World of Trouble
“Great Defensiveness, and Excessive Politeness”
On March 29, 2007, 40 economic policy makers from around the world belonging to the FSF, a group few people had ever heard of, gathered in Frankfurt, Germany for a meeting. Public attention to the meeting was, as usual, virtually non-existent, which suited the attendees just fine. Their main job was to assess risks and vulnerabilities in the global economy, and the more obscure their assemblages were, the more comfortable they felt, especially at times like this.
Signs of strain in the US housing market were growing increasingly manifest. A report issued a few days earlier had shown foreclosures reaching record levels in the fourth quarter of 2006, and although most were concentrated among subprime borrowers, default rates were increasing on better-quality loans as well. “Crisis Looms in Mortgages,” warned a March 11 headline in The New York Times; two dozen mortgage lenders had gone bankrupt or closed their doors in previous weeks, and one of the biggest, California-based New Century, was reportedly on the verge of filing for bankruptcy protection.1 For the FSF, determining whether these sorts of developments presented a serious threat to the global financial system was precisely the purpose for which the body had been established in the late 1990s.
1 See Gretchen Morgenson (2007), “Crisis Looms In Mortgages,” The New York Times, March 11; see also Vikas Bajaj (2007), “Bad Loans Put Wall St. in a Swoon,” The New York Times, March 14; and Vikas Bajaj and Julie Creswell (2007), “Lender Said to Be Weighing a Bankruptcy Filing Soon,” The New York Times, March 28.
The answer FSF members got from Randall Kroszner, a governor of the Federal Reserve Board, was soothing. According to a confidential summary circulated after the meeting, Kroszner acknowledged that delinquency rates on certain types of subprime housing loans had risen sharply in 2006, but he said it was “important to recognize that the market segment affected, variable rate subprime mortgages, only constitutes 7 to 8 percent of the overall US mortgage stock.” Although prices for some securities backed by subprime mortgages had plummeted, “the secondary market liquidity for these securities has not dried up,” the document quotes Kroszner as telling the others, “and there has been little evidence of spillover into other market segments.”
It is not surprising that Kroszner would have offered such a sanguine assessment of the problems in the US housing market, and the potential for them to adversely affect other parts of the financial system. His private comments to the FSF were consistent with what other US policy makers, including Fed Chairman Ben Bernanke, were saying at that time. More noteworthy, however, is that his reassurances drew little if any challenge from others; the confidential document summarizing the meeting includes no indication that anyone voiced a contrary opinion.
“Nobody around that table said, ‘This is not believable,’” one former FSF member recalled in an interview. “We basically sat there and formed our own views.” And that, he added, was fairly typical of FSF meetings, especially during the years before the global financial crisis erupted in the late summer of 2007. “There was great defensiveness, and excessive politeness. It was interesting to talk to clever, thoughtful people about subjects that were my daily bread and butter. But it wasn’t something in which you went away thinking, ‘I’ve got a real sense there’s a problem developing, so now I’m going to do this or that differently.’ I don’t think that in the pre-crisis period I ever got that sense from the FSF.”2
2 This interviewee declined to be quoted by name.
The FSF no longer exists. And yet, in many respects, it lives on, in the body that replaced it, the FSB, which like the FSF consists of officials from finance ministries, central banks, financial regulatory agencies and international organizations and standard setters. Although the FSB is hardly a household name either, policy makers have touted it as a formidable new force on the global stage. US Treasury Secretary Tim Geithner once called it “in effect, the fourth pillar” of the international financial architecture — the other three being the IMF, World Bank and WTO.
The episode recounted above about the FSF’s March 2007 meeting does not bode well for the FSB. Nor do many of the other revelations in the following pages, which provide a detailed look inside the operations of the FSF, from its creation in 1999 to its replacement by the FSB at the 2009 G20 summit in London.
Until very recently, an in-depth account of the FSF’s activities has not been available3 — in the generally secretive world of international economic organizations, the FSF was far at the non-transparent end of the spectrum, refusing to even disclose the attendees at its twice-annual meetings, beyond listing their countries and institutions. After most meetings, its website gave only cursory, anodyne accounts of the discussion. That has made it difficult for scholars and other outside observers to evaluate its activities and draw conclusions about how the FSB might improve on its predecessor’s record. As one expert wrote in 2010: “The problem with making assertions about the institutional nature of the FSF/FSB is that they are largely based on anecdotal evidence. No systematic comprehensive studies of the FSF/FSB as an institution exist and most of us have only an anecdotal appreciation of what goes on behind closed doors at FSF meetings and the full range of institutional and social dynamics at work.”4
3 The only other account is a research paper I wrote, on which this chapter and chapter 8 are based. See Paul Blustein (2012), How Global Watchdogs Missed a World of Trouble, CIGI Papers No. 5, July, Waterloo, Canada: CIGI.
4 See Andrew Baker (2010), “Mandate, Accountability and Decision Making Issues to Be Faced by the Financial Stability Board,” in The Financial Stability Board: An Effective Fourth Pillar of Global Economic Governance?, edited by Stephany Griffith-Jones, Eric Helleiner and Ngaire Woods, Waterloo, Canada: CIGI.
The narrative in this chapter and chapter 8 goes a substantial way towards rectifying that deficiency in publi
c knowledge.5 It is based largely on confidential FSF documents and interviews with people who used to work on the body, and also includes similar material from other bodies that were supposed to be on the lookout for crises. The instructive value of this information goes well beyond satisfying curiosity about what the FSF was doing all those years.
5 Chapter 7 examines how other institutions did in foreseeing the crisis, to see how the FSF stacks up by comparison.
Regulatory breakdowns and lapses are an oft-cited cause of the crisis, and the FSF’s story illuminates the international side of that problem. It is about the failure of regulators to keep pace with the globalization of the financial system — their inability to understand the transmission of risk across borders and oceans, and their lack of planning for the coordinated measures that would be necessary when a global crisis came. These failings underscore the magnitude of the challenges facing the international community today as it struggles to create rules and apparatuses for managing a system that has shown itself capable of massively destructive instability. The world needs regulations that are designed to keep the system safe from the greatest sources of vulnerability. At the same time, regulation must be sufficiently well coordinated to ensure that banks and other financial firms cannot simply shift operations — and risks — to lighter-touch jurisdictions. The FSF’s record does not inspire confidence that global bodies can effectively fulfill such complex and politically tricky missions.
The impact that the crisis had on the power and influence of the United States also features prominently in the narrative. The hubris that US officials sometimes exhibited in their dealings with the FSF is both sobering and galling to behold in light of subsequent events. Especially in the forum’s early days, they saw it as a vehicle for fostering policies and practices in developing countries that would conform more closely to those of the advanced world, the United States in particular. At the same time, they stymied any FSF initiative smacking of international influence over, or even monitoring of, US policy. Comeuppance came, of course, once the outbreak of the crisis brought glaring flaws in the US model to the fore. The emerging powers made it clear that the FSF’s membership arrangement — which gave seats at the table only to rich countries — was untenable. No longer would emerging economies accept the role of “rule takers” while allowing Washington and its wealthy allies to be “rule makers.”
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