Today, the Financial Times reported, “The International Monetary Fund on Thursday rejected claims that it should have better foreseen the onset of a global financial crisis and instead singled out the US for refusing to adopt its ¬programme to improve the stability of national economies.” The IMF’s Financial Sector Assessment Programme (FSAP) was created in 1999 and two-thirds of the IMF’s member countries joined the program at that time. The U.S. did not sign onto the program in 2006 and the evaluation of its financial sector is not scheduled to begin until 2009.

Putting aside the policy disagreement as to whether early U.S. participation in FSAP might have contributed to a better understanding of the structural vulnerabilities in the U.S. financial system that have exacerbated the ongoing economic downturn and contributed to the spread of financial contagion beyond U.S. borders, the issue arises as to whether the IMF provided adequate notice of looming risks.

Were there indications of a possible housing bust?
In my view, the growing risk of a housing bust was sufficiently visible to warrant concern before housing prices began descending in July 2006. The following chart compares changes in housing prices as measured by the Case-Shiller (CSXR) Index vs. changes in nominal GDP:



To be fair, it should be noted that not every housing boom is followed by a housing bust in which home prices fall significantly from their peak levels. According to research conducted by the IMF “housing booms have been followed by busts about 40 percent of the time…” Furthermore, the magnitude of the gap between increases in home prices vs. increases in nominal GDP was enormous. Looking back in hindsight, that chasm suggested that risks could have been skewed toward a bust. However, what was arguably most worrisome was the trend toward rising home prices and a continuing rise in such prices relative to changes in nominal GDP during the 2000 recession, from 2000 Q3 through 2001 Q3 in which the economy saw three quarters with negative real growth, and the short-lived growth pause that occurred from 2002 Q4 through 2003 Q1. Therefore, while one probably could not have predicted that a housing bust would occur with a great deal of confidence, there was sufficient data that suggested that a housing bust was one possible scenario. That the economic literature showed that the adverse impact of housing busts is, in general, more substantial than that associated with equities busts and the reality that international markets have become increasingly interconnected making it easier for financial contagion to spread rapidly across borders, the scenario was an important one to consider.

What was the IMF saying?
As early as September 2004, the IMF was beginning to call attention to rising home valuations. In its September 2004 World Economic Outlook, the IMF observed:

House prices in industrial countries have increased unusually rapidly in recent years, with their momentum seemingly little affected by the bursting of the stock market bubble or the subsequent global economic downturn. In some cases, notably Australia, Ireland, Spain, and the United Kingdom, prices have risen by 50 percent or more since 1997—increases that are difficult to explain in terms of economic fundamentals alone… This has led some observers to suggest that a house price correction is imminent, possibly triggered by the tightening of monetary policy as economic recovery takes hold. Even an orderly correction would clearly weaken growth in the countries in which it occurred… an abrupt price correction could have significantly more serious adverse effects.

That report also noted that mortgage loans had increased to 63.73% of GDP in the U.S. in 2003 vs. 44.59% of GDP in 1990. Such an elevated ratio suggested high economic vulnerability should a housing contraction get underway. Of the sample of European and North American economies studied, only the Netherlands (99.88% of GDP) and Britain (63.83% of GDP) had a situation where mortgages comprised a larger share of GDP.

Any significant weakening in housing prices would have global implications. The report noted, “…just as the upswing in house prices has been mostly a global phenomenon, it is likely that any downturn would also be highly synchronized, with corresponding implications for global economic activity.”

A year later, in its September 2005 World Economic Outlook, the IMF published a section entitled “United States and Canada: Strong U.S. Growth, but Rising Housing Market Risks.” The IMF had grown increasingly concerned about the combination of rising U.S. home prices, very low household savings, and increasingly risky fashion of financing such mortgages. The IMF reported:

…the very low level of household savings—closely linked to developments in the housing market—remains a significant concern… IMF staff estimates suggest that at least 18 states, accounting for more than 40 percent of U.S. GDP, are currently experiencing housing booms, and by some measures, the implications for the national level are such that—for the first time since 1970—the national housing market is booming as well. Rising prices have supported the increase in home mortgage borrowing from about 3 percent of GDP in 2000 to close to 8 percent of GDP in early 2005, with about one-third in the form of net equity extraction, which, in turn, has been underlying the household sectors’ financing gap… Moreover, a rising share of new mortgages is being financed in a riskier fashion, including through negative amortization and floating rate instruments.

The IMF then warned, “While house price booms do not necessarily end in busts, recent house price increases have raised concerns that the market could be increasingly susceptible to a correction.”

In its April 2006 World Economic Outlook, just months before the U.S. housing downturn began to unfold, the IMF stated:

…the future course of the housing market is a key uncertainty for the U.S. economy. House prices have grown strongly in recent years, providing a boost to economic activity through their effect on consumption, residential investment, and employment. But house pries are now looking more richly valued—and as affordability has declined, buyers have increasingly resorted to interest-only and negative amortization loans to gain access to the market. These nontraditional mortgage products accounted for over 40 percent of mortgage loans for purchase during 2005.”

Then, the IMF dropped a bombshell: And there are now indications that the housing market is cooling—mortgage applications have declined, the supply of homes on the market is rising, and confidence among homebuilders has slipped.

In its September 2006 release of the World Economic Outlook, the IMF observed that U.S. home prices were overvalued and that a correction was getting underway. The report explained:

The most likely source of headwinds in the short term is the housing market. Rising house prices have provided a significant boost to consumption, residential investment, and employment in recent years, but the market now looks overvalued and, as mortgage rates have risen, activity has slowed. Mortgage applications have declined sharply from their peak, the supply of homes on the market is rising, homebuilder confidence has fallen to a 15-year low, and house price appreciation has slowed… The impact of slowing house price appreciation on consumption would be reinforced by a further decline in equity prices or an increase in gasoline prices.

Conclusion:
The IMF provided repeated and ample warning that the housing boom could be followed by a correction. It pointed specifically to the increasingly risky instruments that were being employed to finance home mortgages. It singled out the housing sector as posing the greatest risk to U.S. economic growth. In short, the IMF should not be blamed for having provided inadequate warning.

If you are interested in the FSAP's audit reports, you can find them at: Financial Sector Assessment Program (FSAP). The FSAP can highlight imbalances, regulatory weaknesses, etc., but it is up to national authorities in the respective countries to act on the findings.

This is not in dispute. According to the article I cited, some in the U.S. accused the IMF of not having provided ample warning. The IMF provided sufficient notice of the rising dangers presented by the swelling housing bubble. In short, the charges made against the IMF were unfounded.

Regulatory changes will be coming. Part of the G-7 discussions concerned the weaknesses in U.S. and other G-7 states' regulatory framework. Treasury has laid out its own initiative that would expand the Fed's regulatory authority.

That was not the point of my post. Its point was to address whether the U.S. criticism of the IMF, specifically that the IMF did not provide ample warning, was fair. It was not. Sufficient and repeated warning was given.

On the other point, the contraction of the housing bubble highlights what a number of economists have argued since at least the early 1990s: asset prices need to be viewed in the context of the overall economy. When they get out of line with economic fundamentals, the excess is not healthy valuation but stored inflation. There is debate as to whether central banks should broaden their measures of inflation to include asset prices in a more comprehensive index. Experience with asset bubbles, particularly housing ones that tend to have sharper and longer-lasting adverse economic impacts when they bust than equities-related ones, suggests that this is an important policy question.

One might need more precise policy tools to address the risk of rising bubbles. Monetary policy alone could create a kind of "Dutch disease" impact where, let's say, housing prices are damped, but real economic growth is also dragged down. Following the 1997-98 Asian financial crisis, Singapore considered the idea of applying a real estate surtax on the sale of real estate when valuations get out of line with economic fundamentals to soak up the excesses and, more importantly, impose a correction on home prices. To date, such an approach has not been tested.

Often as bubbles expand toward maturity, one sees a breakdown in lending, borrowing, and investing discipline. It happened prior to the 1989-94 housing downturn. It happened ahead of the most recent housing bubble's peak in June 2006. Unfortunately, in human nature, the appetite for risk is never in equilibrium. One sees it swing back and forth from a lack of risk aversion to an excess of risk aversion as economic conditions evolve.

Originally Posted by donsutherland1 [left] According to the article I cited, some in the U.S. accused the IMF of not having provided ample warning.... Its point was to address whether the U.S. criticism of the IMF, specifically that the IMF did not provide ample warning, was fair.

From the article's opening paragraph:

The International Monetary Fund on Thursday rejected claims that it should have better foreseen the onset of a global financial crisis and instead singled out the US for refusing to adopt its *programme to improve the stability of national economies.

I do not believe the IMF would have singled out the U.S. in rebuting the criticism if at least an important share of the criticism did not originate from the U.S.

Beyond the article in question, and behind the scenes, the U.S. has been pushing for myriad IMF reforms, many of which have merit, in my opinion. A lot of what has been said behind closed doors in the preparations for the just concluded G-7 summit has not been released in the form of public transcripts, though the ongoing housing bubble-induced economic weakening and financial market turmoil was a subject that received much attention. The IMF's Managing Director may well have been reacting to such discussions.

For a flavor of the breadth of issues discussed leading up to the G-7 summit, one can examine statements of various Finance ministries. IMF reform/deficiencies was one such matter. For example, on April 8, Under Secretary of the Treasury David McCormack told the media:

The U.S. will underscore that the IMF must vigorously reform itself to remain legitimate and relevant and resemble today's world economy. We will emphasize the need for firm implementation of the IMF's new framework for exchange rate surveillance. To date, the Fund has strengthened its focus on exchange rate analytics, but implementation of the new framework is a work in progress and there is clearly far more progress to be made.

Needless to say, what is presented to the public typically is provided in a diplomatic form so as not to worsen areas of disagreement while highlighting areas of agreement. Without actual transcripts, I am not in a position to speculate on the specific dialogue that took place in preparation for the G-7 meeting. That criticism was exchanged--and strong criticism at that--I have little doubt.

In assessing the Under Secretary's comments, one needs to understand how diplomatic expressions are made. For example, "frank discussion" really indicates that there were major areas of disagreement. With respect to the Under Secretary's characterization, he stated of IMF reforms, "there is clearly far more progress to be made." What specific deficiencies was he referencing? What were the consequences of such shortcomings?

Certainly "clearly far more progress to be made" is very strong diplomatic language. Had he been fully satisfied with the IMF's progress, while recognizing more needed to be done, he could easily have noted that the efforts were "a work in progress" and left it at that. He could also have said that there is "additional work to be done." Instead, he used strong language that falls just short of describing the progress as "unsatisfactory."

In any case, my intent was to examine whether the IMF had, in fact, provided ample warning of a potential U.S. housing bust. The earlier IMF reports that I quoted demonstrates that it did.

Originally Posted by donsutherland1 [left] From the article's opening paragraph: The International Monetary Fund on Thursday rejected claims that it should have better foreseen the onset of a global financial crisis and instead singled out the US for refusing to adopt its *programme to improve the stability of national economies. I do not believe the IMF would have singled out the U.S. in rebuting the criticism if at least an important share of the criticism did not originate from the U.S.

I do not disagree with you that my suggestion that the IMF was probably responding to rebut U.S. criticism might be incorrect. I make errors, too.

Moreover, upon looking further at your comments, I concede that I should have worded things a somewhat differently and only mentioned that the IMF was responding to criticism without suggesting that it was probably responding to U.S. criticism. In any case, I specified what gave me the impression that the IMF had been reacting to U.S. criticism, but note that my suggestion could be incorrect. I appreciate your raising the issue, as I try to be as clear and objective as I can.

On the other issue, I do not subscribe to the rather generalized notion that international organizations, specifically the economic/financial ones (IMF/World Bank/WTO), single out the U.S. by "habit." I do believe such criticism has been made, and sometimes when it was not warranted. The political entities e.g., the United Nations, are entirely another matter. They have had a much greater tendency to make unwarranted criticism of various nations largely on ideological/political grounds.

Finally, in the case of the FSAP, I do not believe such criticism is unwarranted. Whether or not the FSAP would have provided additional concrete evidence that the U.S. faced financial system vulnerabilities is a matter of speculation.

Originally Posted by donsutherland1 If you are interested in the FSAP's audit reports, you can find them at: Financial Sector Assessment Program (FSAP). The FSAP can highlight imbalances, regulatory weaknesses, etc., but it is up to national authorities in the respective countries to act on the findings.

This is not in dispute. According to the article I cited, some in the U.S. accused the IMF of not having provided ample warning. The IMF provided sufficient notice of the rising dangers presented by the swelling housing bubble. In short, the charges made against the IMF were unfounded.

Regulatory changes will be coming. Part of the G-7 discussions concerned the weaknesses in U.S. and other G-7 states' regulatory framework. Treasury has laid out its own initiative that would expand the Fed's regulatory authority.

That was not the point of my post. Its point was to address whether the U.S. criticism of the IMF, specifically that the IMF did not provide ample warning, was fair. It was not. Sufficient and repeated warning was given.

One might need more precise policy tools to address the risk of rising bubbles.

Monetary policy alone could create a kind of "Dutch disease" impact where, let's say, housing prices are damped, but real economic growth is also dragged down.

Following the 1997-98 Asian financial crisis, Singapore considered the idea of applying a real estate surtax on the sale of real estate when valuations get out of line with economic fundamentals to soak up the excesses and, more importantly, impose a correction on home prices. To date, such an approach has not been tested.

Often as bubbles expand toward maturity, one sees a breakdown in lending, borrowing, and investing discipline.

As the U.S. was late in joining the FSAP, there has been no FSAP audit of the U.S. financial system.

The IMF undertakes analyses in an advisory capacity. Financial risks are of a cross-border nature. Hence, the IMF is in a good position to assess risks that are of a potential global nature.

We both agree about the need for greater transparency and greater disclosure.

My sentence should have referred to a failure of monetary policy to damp housing prices.

The Singapore concept would not be practical right now. The idea would be to inhibit housing prices from rising to excessive levels. Once the bubble is contracting, it's too late. The IMF also suggests that it might be practical to use monetary policy to address "house price inflation in addition to consumer price inflation and the output gap" so as to limit the development of housing bubbles.

Originally Posted by donsutherland1 The IMF undertakes analyses in an advisory capacity. Financial risks are of a cross-border nature. Hence, the IMF is in a good position to assess risks that are of a potential global nature.