'IMF admits disastrous love affair with the euro led to immolation of Greece'.

So runs a press headline about the IMF Independent Evaluation Office (IEO)'s new report on the 2010 Greek crisis. It was already widely accepted that the IMF's handling of the crisis was badly flawed, so the IEO's report was more about providing careful detail, rather than startling revelation. Even so, it leaves tantalising gaps in the story and unresolved issues for future policy.

You could fill a library with the commentary on what went wrong (the IEO report gives a selection of references). The IMF itself has already issued a kind of mea culpa. Perhaps the best outsider's account is Paul Blustein's, because it goes beyond the technicalities and forecasts to cover the politics and draw out the conflicts, contradictions and unresolved issues within the IMF's operations. The IMF's Chief Economist Olivier Blanchard offered some rebuttal of these criticisms, but the judgment remains: the IMF should have done much better (a view clearly shared by the IEO report authors).

The report identifies weaknesses in pre-crisis surveillance: the IMF didn't see the crisis coming. Nor did anyone else, but this is the IMF's job (and it is well-placed, through its annual inspection visits). It failed to pick up the dramatic misstatement of Greece's budget deficit. When the new government came to power in October 2009, the deficit was revised from less than 4% of GDP to 12% (later turning out to be over 15%).

More fundamentally, it shared the common misunderstanding that currency unions like the Eurozone could not have balance of payments problems (any more than one of the states of the United States of America could have a balance of payments problem). This missed the possibility that those who had funded Greece's external deficit (which was running at 15% of GDP) would suddenly start worrying about default: their debt was denominated in euros, but it was issued by Greece and so should not have been treated by financial markets as being more-or-less equivalent to German debt. 

The IMF staff treated the Eurozone as being special, so that even when serious problems were identified in Greece in October 2009, the IMF was not involved in the initial discussion within the European Union to sort it out. Five months later, the IMF was precipitated into becoming a major participant in the April 2010 rescue, contributing 'exceptionally large' funds amounting to nearly 15% of Greece's GDP and a record-breaking 3200 % of quota

It is the circumstances of this participation which raise the most serious questions. The IMF faced a familiar problem. Should Greece's creditors (who had made foolish investment decisions) be paid out by providing new rescue funds? If a country is experiencing a temporary liquidity problem, perhaps resulting from a market scare, it may make sense to do so. When market calm returns, the IMF loan is repaid and so too are the other creditors. But if the country has borrowed more than it can repay, providing new support funds just lets the existing creditors get their money back, unloading the problem onto the future. Greece was clearly a case of unsustainable debt.

The IMF's well-rehearsed approach to unsustainable debt was to require a rescheduling of existing debt (a 'haircut' that reduces the nominal value of the debt, a reduction of interest, or delayed payment). This has to be severe enough to make the new debt repayment profile credible to financial markets, so that they will go on lending to the country. These procedures were built into the IMF's operating rules in order to make it harder for political pressure to be brought to bear in the heat of a crisis.

But by the time the IMF become involved in the unfolding crisis, the European authorities had already decided that there would not be a 'bail-in' of creditors. Some were concerned that a 'bail-in' for Greek debt would cause contagion in other tottering countries in Europe's periphery (especially Spain and Italy). Others knew that much of the Greek debt was owed to European banks (especially in France and Germany) and a bail-in would tip some shaky foreign banks into insolvency.

The IMF management and staff, for its part, were only too ready to be involved despite the late invitation to the party. Dominique Strauss-Kahn, the Managing Director at the time, had presidential aspirations back in France and was thus eager to cooperate with his European colleagues. The staff liked the idea of having some serious operational work to do.

Exactly what happened to get the IMF to participate in the rescue under these unpropitious circumstances is still tantalisingly foggy. The IEO explicitly complains that it was not given all the relevant documents on what was a clear breakdown of proper governance. Operational confidentiality at the time was clearly justifiable, but six years later, what is being hidden? 

The outcome of this still-murky process is that the IMF management broke its own rules on debt sustainability, slipping this key change through its executive board in such a low-key manner that it was hardly noticed.

The rest, as they say, is history. Greece's debt was, indeed, unsustainable and a rescheduling took place in 2012, by which time many of the private creditors had been repaid in full. The debt burden was shifted to the European taxpayers and the debt profile is still unsustainable (awaiting a further restructuring). The main burden so far has fallen on the Greek people, with GDP falling by 25 % (the IMF program forecast a fall of just 10%) and unemployment rising to 25%. Once more, the private sector financiers have come out of a crisis better than they deserve.

What was a better approach? The IEO report offers a range of options which were not pursued (including the possibility that the IMF should have declined to participate unless its debt rescheduling requirements were met) and argues that, at least, these should have been explored as a matter of good governance. 

These issues are never clear-cut, especially in the heat of a crisis. The IMF argued in favour of bailing-in private creditors in the case of Ireland (Ireland and Portugal were also covered in the IEO report), but participated in the rescue even though Europe once again vetoed a bail-in. And that rescue worked out well. Some argue that the IMF participation in 2010 bought time for Europe to get its act together (by 2012, the European Central Bank would address the danger of contagion with the promise the 'do whatever it takes'). 

But it's hard to argue that all this ad-hocery leaves sovereign debt rescheduling in a good place. The IMF has now formalised its new view that it can lend, even when debt is judged to be unsustainable. Thus it will be under political pressure to step in to fund repayment to foreign creditors who should be held responsible for their own risky lending decisions. Combining this with the creditor-friendly outcome of the Argentinian sovereign debt resolution leaves the process in a mess. The IEO findings on IMF governance failings are just as concerning. Bureaucracies are always ready to widen their mandate ('mission creep') and the executive board, dominated by a few large shareholder countries, is no defense against political pressure. Recent big loans to Ukraine and Iraq, neither of which seems like a good economic risk, demonstrate the political input into IMF lending decisions.

Photo: Getty Images/Milos Bicanski