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CIGI PAPERS NO. 60 — MARCH 2015 OVER THEIR HEADS THE IMF AND THE PRELUDE TO THE EURO-ZONE CRISIS PAUL BLUSTEIN OVER THEIR HEADS: THE IMF AND THE PRELUDE TO THE EURO-ZONE CRISIS Paul Blustein Copyright © 2015 by the Centre for International Governance Innovation The opinions expressed in this publication are those of the author and do not necessarily reflect the views of the Centre for International Governance Innovation or its Board of Directors. This work is licensed under a Creative Commons Attribution — Non-commercial — No Derivatives License. To view this license, visit (www.creativecommons.org/ licenses/by-nc-nd/3.0/). For re-use or distribution, please include this copyright notice. 67 Erb Street West Waterloo, Ontario N2L 6C2 Canada tel +1 519 885 2444 fax +1 519 885 5450 www.cigionline.org TABLE OF CONTENTS iv About the Author iv Executive Summary iv Introduction 2 High Dudgeon in the Egghead Haven 4 Not Even a Cat to Rescue 5 IMF on the Euro Zone: “Outlook is the Best in Years” 7 The Ultimate Symbol of Cluelessness 8 The Fire Bell Clangs at Last 9 A “Reverse Hungary” 15 Works Cited 16 About CIGI 16 CIGI Masthead CIGI PAPERS NO. 60 — MARCH 2015 EXECUTIVE SUMMARY ABOUT THE AUTHOR The years prior to the global financial crisis were a peculiar period for the International Monetary Fund (IMF). The IMF was struggling to define its role and justify its existence even as trouble was brewing in countries it would later help to rescue. To understand the Fund’s current strengths and weaknesses, a look back at this era is highly illuminating. This paper chronicles three major developments that span the years 2005 to 2009. First, the IMF’s very purpose and relevance came under question during a seemingly crisis- free era, and it was forced to downsize. Second, the IMF failed to perceive or raise sufficient alarm about forces that would eventually trigger crises in countries where its aid Paul Blustein is a CIGI senior fellow. An award- would be required — first in Eastern Europe, later in the winning journalist and author, he has written euro zone. Third, the Fund was relegated for the first time extensively about international economics, trade to the status of “junior partner” when a crisis erupted in and financial crises. Prior to joining CIGI in 2010, Latvia, with the European Commission playing the senior Paul was a staff writer for The Washington Post and partner role. The Wall Street Journal. At CIGI, he is working on a book about the IMF’s role in the euro-zone crisis. These developments merit extensive exploration for the insight they provide on controversies that have flared over A native of Washington, DC, Paul attended the the IMF’s role in the euro-zone crisis, the greatest the Fund University of Wisconsin (B.A., history), before has ever faced. The IMF has come under intense criticism heading to Oxford University on a Rhodes for having succumbed at key junctures to pressure from Scholarship, graduating with an M.A. in powerful European policy makers, the result being an philosophy, politics and economics in 1975. Paul erosion of the Fund’s most precious asset — its credibility began his career as a business and economics as an independent, neutral arbiter and fixer of economic journalist shortly thereafter, returning to the problems. The critics often blame the IMF’s governance United States to work as a writer at Forbes problem, namely European dominance over the Fund’s magazine. He then moved to The Wall Street board and management. But that is only part of the Journal, where he became the newspaper’s chief backdrop to the IMF’s travails in the euro zone; a more economics correspondent, covering the US Federal informative picture emerges from a full account of pre- Reserve, budget and tax policy. In 1987, Paul crisis events. moved to The Washington Post and began to focus his writing on the global economy, serving five The IMF remains haunted by these events. They put the years in the paper’s Tokyo bureau and eventually Fund in a weak position at the time the euro-zone crisis becoming the paper’s international economics erupted in 2010, making it difficult for the Fund to avoid correspondent in 1995. the situation now deplored by critics. The implications for future crises are disturbing, and in the absence of Paul is the author of The Chastening: Inside the corrective action, the Fund’s ability to fulfill its historic Crisis That Rocked the Global Financial System and role of fostering global stability will be diminished. Humbled the IMF; And the Money Kept Rolling In (and Out): Wall Street, the IMF, and the Bankrupting INTRODUCTION of Argentina; Misadventures of the Most Favored Nations: Clashing Egos, Inflated Ambitions, and the In the early spring of 2006, an economist at the IMF, Bas Great Shambles of the World Trade System; and Off Bakker, gave a presentation to colleagues, which was a Balance: The Travails of Institutions That Govern rare example of foresight in policy-making circles prior the Global Financial System, published by CIGI in to the global financial crisis. Bakker, who is from the October 2013. Netherlands, argued that Eastern Europe was a hotbed of financial vulnerability, with many countries becoming dangerously dependent on inflows of capital from abroad that could reverse abruptly with devastating consequences. Titled “Asia 1996 and Eastern Europe 2006 — Déjà vu all over again?” the presentation was kept strictly within the confines of the IMF, since its message might have sparked market perturbations. It was based on data showing Iv • CENTRE FOR INTERNATIONAL GOVERNANCE INNOVATION OVER THEIR HEADS: THE IMF AND THE PRELUDE TO THE EURO-ZONE CRISIS that many countries in the former Communist bloc bore alarm about the forces that would eventually trigger the alarming similarities to the economies of East and Southeast crises in Europe. Had the Fund been more perspicacious Asia in the mid-1990s prior to their financial crises. about these forces, it might have been able to rebut the claims about its irrelevance and, conceivably, it could It is now clear that Bakker was right; crises battered a even have resisted the demands for downsizing. Indeed, number of Eastern European countries in 2008 and 2009. when the global crisis erupted in late 2008, world leaders If anything, he was understating the case, because more began to realize that they needed a bigger IMF, rather advanced European economies that use the euro also than a smaller one. But then the third key development underwent severe turmoil starting in 2010, necessitating materialized — a crisis in Latvia, where the Fund was, for major international bailouts. But at the time his analysis the first time, relegated to the status of “junior partner,” was produced, it drew a sharply negative retort from contributing a minority share of the rescue money while members of the IMF’s European Department, which had Europe put up the lion’s share, and got a commensurate chief responsibility for overseeing the economies of the amount of influence over certain terms and conditions. countries involved. European Department economists contended that Bakker was exaggerating the peril in These developments merit extensive exploration and Eastern Europe, and although a couple of countries might accentuation because they provide historical perspective be at risk, he was misconstruing the situation in the region. on controversies that have flared over the IMF’s actions As for the possibility of crises in the euro zone, the Fund during the euro-zone crisis. This crisis was the greatest the missed the boat completely.1 Fund has ever faced, taxing its resources and testing its mettle in ways that were inconceivable a few years earlier. This is the story of that period — a peculiar one in the The sums the Fund lent to three euro-zone countries — IMF’s history, when it was struggling to define its role in a Greece, Ireland and Portugal — were of unprecedented seemingly crisis-free world, even as trouble was brewing magnitudes, far exceeding the rescues launched previously in countries it would later help to rescue. In the course for emerging economies such as Mexico, Indonesia and of researching a book on the IMF, I have been struck by South Korea. Also unprecedented was the scale of risk, and the profound ramifications of developments at the Fund complexity of forces, that the Fund was confronting as it during this era. A look back at this period is highly laboured to keep a financial conflagration from engulfing illuminating for anyone seeking to understand the Fund’s a regional economy comprising nearly one-fifth of global strengths and weaknesses in the wake of the series of output as measured by gross domestic product (GDP). calamities that swept the globe following the bankruptcy of Lehman Brothers in September 2008. Those calamities The IMF is widely credited with analyzing the euro-zone have underscored the importance of a healthy IMF crisis reasonably well after the crisis erupted, certainly capable of fulfilling missions that its founders envisioned compared with European officialdom. But the Fund has seven decades ago — fostering international economic also come under intense criticism, because at key junctures cooperation, maintaining financial stability and assisting it succumbed to pressure from powerful European policy countries undergoing temporary hardship. makers, who maintained heavy influence over the Fund’s levers of control. In the “Troika,” the tripartite grouping of Three major developments at the IMF during the years crisis lenders that also included the European Commission 2005 to 2009 are chronicled in this paper. First, the IMF’s and European Central Bank (ECB), the Fund accepted a very purpose and relevance came under question amid junior partner role.

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