Conversations: Credit Crisis Poses Challenges for IMF

John Lipsky ’68 of the International Monetary Fund discusses the changing role of this key organization.

By William L. Holder ’75

The Number Two official of the International Monetary Fund, First Deputy Managing Director John Lipsky ’68, P’08, is keeping a close watch on the international ramifications of the unfolding credit crisis. He brings to his position wide experience in the private sector as chief economist for JPMorgan Chase Manhattan Bank and Salomon Brothers. In May he received a Distinguished Alumnus Award from Wesleyan.

WILLIAM L. HOLDER: Has the IMF changed as the global economy has evolved?

JOHN LIPSKY: The IMF was one of the triad of economic, financial, and political institutions created in the wake of World War II that was designed to provide a global governance framework. The three key components were the United Nations, to deal with political and security issues; the General Agreement on Trade and Tariffs (now the World Trade Organization), to reopen the avenues of global trade; and the IMF, which was assigned the responsibility for maintaining economic and financial stability. The IMF began with about 45 member countries; today there are 185 members with rapid growth occurring in the post-1990 period. The growth in membership has brought with it a governance challenge—not just for the IMF, but for all the global institutions.

WLH: And don’t you have another major change in the growth of market-based economies in Russia, China, and elsewhere?

JL: The collapse of centrally planned economies and their conversion into market-linked economies participating in international trade has created, for the first time since WWII, something we can realistically call a global economy. The resulting period of economic transformation and growth has created wonderful opportunities but also significant challenges.

WLH: The global credit crisis is still very much with us, isn’t it?

JL: The financial crisis is still unfolding, as are the economic consequences. Global credit markets have not been restored to anything close to normal. In any case, financial markets will not return to the status quo ante, as the crisis will leave significant changes in its wake. We have substantial work to accomplish in order to repair the credit markets.

WLH: Did the crisis reflect a lack of transparency in global financial markets?

JL: Should some participants have better understood the risks they were taking? That’s almost inevitable in any financial crisis. At the heart of the difficulties was an elemental failure of some lenders and borrowers to accurately appreciate and price risks.

WLH: Does the IMF advocate any regulatory changes to prevent a recurrence of the credit crisis?

JL: We’ve been working together with our partners in the Financial Stability Forum to agree on a set of regulatory and supervisory improvements that would make this kind of market disruption much less likely in the future. But not all the solutions will come from regulatory reforms. I’m confident that some of the problems and failures we’ve witnessed over the past year will be taken care of by a process first described by Charles Darwin. In other words, market responses will play an important role in reforming and repairing the financial system.

WLH: Can you set this crisis in a larger historical perspective?

JL: It’s easy to forget that the past 60 years have represented the greatest period of economic growth in the history of mankind. The growing presence of the emerging market countries in the global economy has accelerated growth and produced exactly the broad effect that was hoped for. The poorest countries are growing the fastest, with some difficult and challenging exceptions. Specifically, 2003–2007 represented the fastest five-year period of global growth in the past 40 years, and in many ways it was the best balanced, accompanied by slowing inflation. Over the past 20 years, the most striking progress on economic growth and stability has been accomplished by emerging economies that previously were plagued by repeated setbacks and the fastest inflation. This stabilization and growth process has represented the most powerful antipoverty program ever known. It has lifted literally hundreds of millions of people from poverty. We have to make sure that we can sustain this process.

WLH: What about the larger economies?

JL: Even though overall GDP growth was well balanced earlier this decade, it was accompanied by the largest international payments imbalances ever recorded, mainly reflecting the U.S. current account deficit. Moreover, this strong global growth was accompanied by increasing pressures on commodity and energy prices; and there was an explosive growth and innovation in financial markets. Stepping back, it is not surprising that a period of rapid financial innovation would lead to a period of testing and that some of the innovations will fail this market test. Even so, the scope and magnitude of the financial sector problem has been disturbing.

WLH: How will the credit crisis affect global growth in the year ahead?

JL: We are experiencing a financial crisis with the potential to be damaging economically, and that primarily has involved the advanced countries. So far, we hope it can be contained and ultimately reversed without serious damage to the global economy. Our forecast of global growth suggests that this year and next virtually all advanced economies will be growing below the trend pace for the first time since the early years of this decade. There will be a slowdown in emerging economies as well, but their growth will remain well above their medium-term average.

WLH: Can the IMF claim some credit for the progress made by many emerging economies?

JL: Most important of all, the improvement in the performance of emerging economies has been supported by the improvements in their basic economic policies, including a linkage to international markets, reforms and improvements of their financial systems, a reduction in their budgetary imbalances, and a focus on stable monetary policies. Strikingly, the improvement in emerging market economies’ growth performance until this year has been accompanied by a dramatic decline in their inflation rates and a strengthening of the balance of payments. The sort of structural improvements that the IMF has supported have been at the heart of this economic success. We can’t take credit for that, but we have the satisfaction that we’ve been pointing in the right direction. Nonetheless, it will be important that the recent rise in inflation can be reversed, thus helping to restore the stability that has been such a powerful spur to sustained growth.

WLH: Has the credit crisis helped us understand aspects of the global economy that weren’t sufficiently appreciated?

JL: The past year has offered up many challenging surprises. At the same time, I suspect that there is a need to reassess our understanding of what has occurred. For example, a common interpretation of the events of the past year is that the U.S. sub-prime crisis was the source of the problem. However, the latest index of U.S. housing prices showed a national average decline of nearly 16 percent from a year earlier. There is no precedent since the 1930s. Moreover, the stock market is down to a similar extent from its 2007 peak. Perhaps this crisis is better understood as a still ongoing process of asset price deflation that has placed great strains on the financial sector in the United States and elsewhere. The subprime problem was a first indicator of broader issues. A large canary in the mineshaft.

WLH: How have the various major economic players in the public and private sectors responded to this broad process?

JL: I have been encouraged by the willingness of the institutions and individuals involved to examine the situation in a frank way and to act decisively. Have financial institutions made mistakes? Absolutely. They are revaluing assets in an alacritous manner. They are raising new capital, changing their internal processes, re-examining their risk management. The Financial Stability Forum’s Working Group, of which the IMF is a member, has already promulgated a plan for regulatory and supervisory reform that is being implemented. The central banks acted in general quite decisively, particularly the Federal Reserve. They learned the lesson of the 1930s: In times of crisis, monetary and supervisory authorities first have to make sure to maintain the liquidity and functioning of the financial system. The Bank of England, the Federal Reserve, and other central banks have responded sometimes in innovative ways, which almost always means that their actions have been controversial. They’ve been willing to think and act “outside the box” when the challenges have been outside the box.

WLH: What challenges has the crisis posed for the IMF?

JL: In many ways, the challenges have been novel. The emerging market economies are holding up very well relative to the advanced economies. The financial problems have appeared in private markets, not with sovereign borrowing. This isn’t a crisis of governments engaging in excessive borrowing. The big problems have come from big institutions in developed countries. The biggest institutions with the biggest problems simply did not have risk management that was up to the task. At the same time, public authorities in many advanced economies are facing the challenge of falling asset prices. Deciding whether and how to intervene in such circumstances is not an easy issue to decide.

WLH: How is the Fund adapting to handle the challenges posed by new kinds of crises?

JL: As much as anything, a clear understanding of the sources of the difficulties and the possible solutions is required. In particular, the IMF has needed to become much more expert about the workings of private financial markets since cross-border private sector capital flows have become huge relative to official flows. We’ve also been working with sovereign wealth funds, which have emerged as a counterpart to the unprecedented balance of payment surpluses of many economies. By now, such funds manage more assets than hedge funds, and they continue to grow rapidly. We’ve had to think about how to produce multilateral policy coordination when the basic institutions developed in the past are not used to this role. In particular, the G-7 economies are still dominant in terms of global GDP, but it’s clear that the challenges of stability and progress go well beyond the G-7. After all, most of global growth at present is accounted for by emerging economies. One of the challenges for the Fund is to create new methods of addressing specific issues that involve differing groups of our member countries. An example of that was the Multilateral Consultation on Global Imbalances that was held in 2006–07. This comprised a series of confidential policy discussions among the United States, Japan, China, Saudi Arabia, and the Euro area to develop mutually consistent policy plans that would sustain global growth while reducing the record payment imbalances.

WLH: Is there any chance that the IMF will become outmoded?

JL: The IMF remains the only institution with a global membership and a clear mandate from its members to promote financial and economic stability. We are moving aggressively to address the multiple challenges of a rapidly changing world. We have recently completed an agreement on a rebalancing of members’ quotas that increases the role of the most dynamic economies, many of which are emerging economies. We agreed on a new income model. This provides long-term financial stability for the institution. We are refocusing and restructuring the organization, bolstering our analytical abilities, agreeing with our members on a renewed basis for the engagement of member economies with the Fund’s oversight of the international system. We are reviewing the Fund’s financing facilities and developing new forms of multilateral policy reviews. In short, this is an exciting and historic period of modernizing this unique institution for continued success.