Some Market Discipline for Economists

Last month, the International Monetary Fund's independent evaluation office issued a remarkable report. The report quite clearly blamed the IMF for failing to recognise the factors leading up to the worst economic crisis since the Great Depression and to provide warning to its members so that preventive actions could be taken:

"It [the report] finds that the IMF provided few clear warnings about the risks and vulnerabilities associated with the impending crisis before its outbreak. [...] The IMF's ability to correctly identify the mounting risks was hindered by a high degree of groupthink, intellectual capture, a general mindset that a major financial crisis in large advanced economies was unlikely, and inadequate analytical approaches."

The report noted that several prominent economists had clearly warned of the dangers facing the world economy prior to the collapse that began in 2007. One of these economists was Raghuram Rajan, who was actually the chief economist at the IMF when he gave a clear warning of growing financial fragility back in 2005. Yet these warnings were, for all practical purposes, ignored when it came to the IMF's official reports and recommendations to member countries.

The IMF deserves credit for allowing an independent evaluation of its performance in the years leading up to the crisis. It would be great if the Fed, the Treasury, the Securities and Exchange Commission and other regulatory bodies allowed for similarly independent evaluations of their own failings.

Nonetheless, readers can be very confident that nothing at the IMF will fundamentally change because of this report. The first reason for confidence in the enduring power of the status quo is that the report never clearly lays out what the basis of the crisis was. This is important because the basic facts show the incredible level of incompetence of the IMF in failing to recognise the dynamics of the crisis.

The housing bubbles that were driving growth in the United States, United Kingdom, Spain, Ireland and several other countries in this period were front and centre in the crisis. These bubbles created sharp divergences in house prices both from historic trends and also from rents. There was no plausible story whereby these prices could be sustained; the only question was when the bubbles would burst.

Furthermore, there was no plausible story whereby the bubbles could burst without leading to a serious falloff in demand and a sharp jump in unemployment. In the case of the United States, the bubbles in the residential and non-residential real estate had raised construction spending by close to 4 percentage points of GDP and consumption spending by an even larger amount.

The overbuilding from the bubble virtually guaranteed that construction would fall below its trend level following the collapse of the bubble. This means that the collapse of the bubble would leave a gap of 8-10 percentage points of GDP. In the United States, this gap in annual demand is between $1.2tn and $1.5tn.

What mechanisms did the IMF's economists think existed to fill such a gap? The facts here are really simple, so it would have been helpful if they had been spelled out more clearly - in order that readers could appreciate the incredible incompetence of the IMF's staff in this instance.

It is worth noting that the financial crisis was a sidebar to the main story. It is difficult to see how anything would be different, at least in the United States, if the financial crisis had not occurred. At this point, large firms can directly borrow on capital markets at extraordinarily low interest rates. Surveys of smaller firms show that lack of demand is their biggest complaint. Very few mention the availability of capital.

Featuring the financial crisis so prominently in the story makes it more complex than necessary. Credit default swaps (CDSs) and collaterised debt obligations (CDOs) are complicated. Bubbles are simple.

One of the problems highlighted in the report was the problem of groupthink. This is when people say what they expect their bosses and their peers want them to say, rather than independently evaluating the situation:

"Several senior staff members felt that expressing strong contrarian views could 'ruin one's career'. Thus, views tended to 'gravitate toward the middle' and 'our advice becomes procyclical.' Staff saw that conforming assessments were not penalised, even if proven faulty. A lack of accountability was frequently highlighted as a serious obstacle to getting the incentives right."

The report does some serious handwringing over the issue and comes up with a set of proposals that are virtually guaranteed to have no effect.

Remarkably, these economists never suggested the remedy that economists usually propose for bad performance: dismissal. There is a vast economics literature on the need for firing as a mechanism to properly motivate workers to perform. This report provides great evidence of the need for such a mechanism.

The proposals to combat groupthink (pdf) are all very nice, but the bottom line is that the economists at the IMF all know that they will never jeopardise their careers by repeating what their bosses say. If we want economists at the IMF and other institutions who actually think for themselves, they have to know that they will endanger their jobs and their careers if they do mindlessly follow their boss.

Whenever I have raised this point in conversations with economists, they invariably think that I am joking. When I convince them that I am serious, they think the idea of holding economists responsible for the quality of their work to the point of actually jeopardising their careers is outrageously cruel and unfair.

The reality is that tens of millions of people across the globe have seen their lives wrecked because these economists did not know what they were doing - or worse, had doubts but chose the safer route of groupthink. It is outrageous that ordinary workers who were doing their jobs can end up employed, while the economists whose mistakes led to their unemployment can count on job security.