Alamy

IN RECENT months many economists and policymakers, including such unlikely bedfellows as Paul Krugman, an economist and New York Times columnist, and Hank Paulson, a former American treasury secretary, have put “global imbalances”—the huge current-account surpluses run by countries like China, alongside America's huge deficit—at the root of the financial crisis. But the IMF disagrees. It argues, in new papers released on Friday March 6th, that the “main culprit” was deficient regulation of the financial system, together with a failure of market discipline. Olivier Blanchard, the IMF's chief economist, said this week that global imbalances contributed only “indirectly” to the crisis. This may sound like buck-passing by the world's main international macroeconomic organisation. But the distinction has important consequences for whether macroeconomic policy or more regulation of financial markets will provide the solutions to the mess.

In broad strokes, the global imbalances view of the crisis argues that a glut of money from countries with high savings rates, such as China and the oil-producing states, came flooding into America. This kept interest rates low and fuelled the credit boom and the related boom in the prices of assets, such as houses and equity, whose collapse precipitated the financial crisis. A workable long-term fix for the problems of the world economy would, therefore, involve figuring out what to do about these imbalances.

But the IMF argues that imbalances could not have caused the crisis without the creative ability of financial institutions to develop new structures and instruments to cater to investors' demand for higher yields. These instruments turned out to be more risky than they appeared. Investors, overly optimistic about continued rises in asset prices, did not look closely into the nature of the assets that they bought, preferring to rely on the analysis of credit-rating agencies which were, in some cases, also selling advice on how to game the ratings system. This “failure of market discipline”, the fund argues, played a big role in the crisis.

As big a problem, according to the IMF, was that financial regulation was flawed, ineffective and too limited in scope. What it calls the “shadow banking system”—the loosely regulated but highly interconnected network of investment banks, hedge funds, mortgage originators, and the like—was not subject to the sorts of prudential regulation (capital-adequacy norms, for example) that applied to banks.

In part, the fund argues, this was because they were not thought to be systemically important, in the sense that banks were understood to be. But their being unregulated made it more attractive for banks (whose affiliates the non-banks often were) to evade capital requirements by pushing risk into these entities. In time, this network of institutions grew so large that they were indeed systemically important: in the now-familiar phrase, they were “too big” or “too interconnected” to fail. By late 2007, some estimates of the assets of the bank-like institutions in America outside the scope of existing prudential regulation, was around $10 trillion, as large as the assets of the regulated American banking system itself.

Given this interpretation, it is not surprising that the IMF has thrown its weight strongly behind an enormous increase in the scale and scope of financial regulation in a series of papers leading up to the G20 meetings. Among many other proposals, it wants the shadow banking system to be subjected to the same sorts of prudential requirements that banks must follow. Sensibly, it is calling for regulation to concentrate on what an institution does, not what it is called (that is, the basis of regulation should be activities, not entities). It also wants regulators to focus more broadly on things that contribute to systemic risk (leverage, funding and interconnectedness), the significance of which was probably under-appreciated until the collapse of Lehman Brothers and the subsequent chaos. And there is much more to be done, it suggests, involving cross-border banking, disclosure requirements, indices of systemic risk and international co-operation.

Yet there is an underlying inconsistency here. The IMF's version of “how it all happened” is a classic example of institutions gaming the regulatory system. It is impossible to anticipate all the possible ways in which regulations can be evaded. And while the wisdom of hindsight may make it appear blindingly obvious that non-bank financial institutions could become large enough to pose a risk to the entire system, clearly this was not apparent to policymakers at the time. Increasing the scope of regulation may well prevent the precise problems that led to this crisis from recurring in the same way, but nothing stops financiers from finding ways to evade the plethora of regulations that the fund is proposing. It is hard to shoot a moving target.

And what about those pesky imbalances? The IMF's view, broadly speaking, is that without excessive risk-taking by financial institutions, which was aided by the absence of regulation, imbalances would not by themselves have caused the meltdown. But equally, without the flood of money seeking returns, the risky financial instruments that the IMF is blaming for increasing systemic risk may not have grown and posed the risk that they did. Some blame the IMF's policies during the Asian crisis for spurring countries in the region to build up enormous reserves. That may offer part of the explanation for why the Fund has come down so strongly on one side of the debate.