Finance minister of France as the financial crisis began, Lagarde became managing director of the International Monetary Fund (IMF) in June 2011. This is the edited transcript of an interview conducted on Feb. 28, 2012.
We've had over the last 10 to 15 years a tremendous amount of growth in the financial sector, and we were aware that there were a number of financial tricks used by governments to dress their balance sheets to get into the euro zone. How is it, with all that, that it seemed no one could see the trouble [that] was coming from Europe?
There has been a lot of growth in the financial sector, and that financial growth was very much out of control, very much off-site, because if you remember, the spirit prior to 2008 was very much about soft regulations, flexibility, financial creativity, sophistication of instruments.
I remember myself having had quite a few battles with some of my banking-sector interlocutors when I was minister of finance about precisely that. And that debate lasted quite a long time, actually the battle between those that were in favor of strong supervision and regulations and those who were eventually admitting that it was necessary but that we should, by all means, protect financial inventions and the creativity in the financial sector.
Now, that was clearly, in my view, at the root of the strong development of the financial sector. But that was the private-sector development; it had very little to do with sovereign credibility, with sovereign debt, and with the sovereign balance sheets.
In parallel -- and I think you're probably referring to a country like Greece, for instance -- there was some inaccuracy of data reporting. There was some shortfalls in the statistic agencies in that country. And possibly with the support of financial, highly reputable institutions, the actual portrait and landscape of the financial situation of a country such as Greece was inaccurate. I think there is no question in retrospect about that.
Now, at the time there was an element of "irrational exuberance," to quote Mr. [Alan] Greenspan, who was a very, very highly regarded and reputed central banker of the time. And that irrational exuberance also affected the way in which those data, numbers and statistics were looked at, because they were beautifully presented.
I was talking to a banker with JPMorgan who told me that it wasn't just Greece that was using derivatives to dress its deficit in order to gain admittance to the euro zone, but it was France, it was Germany, it was Italy.
Well, everyone was using derivatives, you know. Let's face it.
Everybody was using derivatives, but people were using them, and Eurostat was sort of looking the other way. Were you aware at the time of the kind of misuse of derivatives to dress balance sheets of governments?
Everybody was using derivatives. All agencies were looking somewhere else; all statutory auditors were looking somewhere else; all supervisors were looking somewhere else; many shareholders were looking somewhere else.
Were you aware of what the situation was when you took the job as finance minister in France?
I took the job as finance minister in July 2007. The first development of the big financial crisis hit the screen on Aug. 15. ... In those six weeks in the job, I had no idea of, number one, what was coming up; number two, the potential crisis of confidence that was going to hit all our radar screens in relation to the private sector, because don't forget that 2008 was really a crisis of the financial private sector, some portions of which had to be eventually nationalized in various corners of the world.
But the sovereign debt issues and the crisis of confidence toward sovereigns came as a second stage of that same crisis.
It was in the summer of '09 when Greece revealed that it was running a budget deficit twice as high as what it had previously stated. ... What was your reaction? Were you aware this was coming?
No, and we felt betrayed, to be fair, because all of a sudden the public deficit that had been reported by the Greek authorities at the time suddenly ballooned on the occasion of the change of government. And it was very much to our surprise when Minister [of Finance Giorgos] Papakonstantinou, who tried to do as good a job as he could under the circumstances, reported the situation of the Greek public finances.
And then it went sort of downhill from there on, because there were successive revisions of those numbers on several occasions.
Did you call Papakonstantinou? Did you get him on the phone? ...
Well, we'd met.
What was your reaction?
But don't forget that when I was minister of finance, we had a monthly meeting, and it's on the occasion of one of those monthly meetings that he reported on the Greek numbers, so I didn't have to call him. He was in the room, and all of us, the 17 of us, were just appalled by the numbers.
Can you describe that meeting and that moment when he revealed that and how you reacted? What went through your mind? How serious did you think it was?
In the first place, there is always the suspicion that a new government comes into place and is as negative and as pessimistic as possible when it comes to power.
To set low expectations?
Well, yeah. You set low expectations, and you provision as much as you can so that if you actually work your way through and do a good job, you will look better.
That's a typical approach by any political group or political party or political leader. You want a clean plate to start from. So we had that suspicion, but it could not possibly encompass the entire massive revision that took place. And it was major disappointment.
So a bit of suspicion as to the reality of that revision and a huge disappointment, because prior to that we had been actually a little bit too relaxed with the previous government, because it was arguing that it was very, very much pro-Europe and that they were a strong supporter of the European integration.
What did you think would happen next as a result of this revelation from Greece? At the time, what were you thinking?
At the time I think we trusted the Maastricht mechanism, which was a European mechanism by which member states have to redress the situation and have to restore the deficit and debt positions. ...
To be fair to Greece, during the first year it significantly improved its situation, cutting the deficit by 5 GDP [gross domes
Now, little did we know at the time that Greece would require not only the Maastricht mechanism to work out, but the IMF [International Monetary Fund] to come and support the designing of a program. Little did we know that it was going to then entail the setting up of a bailout mechanism that was the European Financial Stability [Facility] [EFSF]. And little did we know that it was going to then lead to Ireland and Portugal to also be under very, very close scrutiny and in need of a program as well.
... It was in July of '09 that you called for regulation of financial derivatives. You made that a particular focus of your work as finance minister. Why that? Why were you so concerned about financial derivatives?
I was very concerned about it because it was one of the areas that was totally dark. When I asked my central banker and other central bankers that we met on occasions, they had no idea who were the parties buying and selling those products. The clearing of those instruments was very much what they call OTC, over the counter, which really means under the table, because we didn't know who was there.
And I thought, that cannot go on. You know, by background, I've done a lot of antitrust cases, and I'm a competition [antitrust] lawyer at heart, and I think that anything that is dark and ... obscure, not disclosed, is wrong and is not going to help.
So that's why I made a point of regulating derivatives, enabling the supervisor to actually hold and stop the clearing of particular derivatives, particularly in the financial sector and on sovereigns. And in my previous position, I battled for that.
How much [are] derivatives responsible for magnification of the crisis in Europe?
I think it's not only derivatives. Derivatives play a part. The entire sort of transparency, financial instruments, the lack of traction by the supervisors -- as I said, a lot of people were asleep at the wheel. All of that contributed to the European developments.
But all of it originated, in the first place, from the U.S. financial markets being in total disarray as well.
Right. But it's said often that the financial crisis at its root was about subprime mortgages.
In Europe it's about overspending, fiscal irresponsibility.
It's about excess really.
It's about excess credit, but without the magnification and the increased leverage from the use of financial innovations, the crisis would not have been as great as it was.
You come into the job in June of '11 as the IMF chief. ... There are a series of EU [European Union] summits in July and September, and during that period of time the crisis is really ramping up, just as you step into office. There's riots on the streets of Greece. Describe that time, if you can, briefly.
Well, some would argue that I had to hit the ground running and that I was reasonably well equipped for that because I had seen it from the other side, sitting on the Eurogroup --
As a finance minister.
As a finance minister of France. Others would argue that it was just a lot to begin with, because when you join as a newcomer at an institution like the IMF, you have to learn the ropes and at the same time continue to hit the ground running.
So it was a very, very tense period of time, and one where we had to focus actively on how to push, how not to push too far, because we have to be equally concerned with the macroeconomics, with the fiscal situation of the country, but also with the social fabric of a country.
And all of that with the background of political challenges for each and every partner in this multidimension[al] equation given that there are 17 member states that participate in the debate.
You have a European central bank that was going to change boss and which had a very special doctrine about what it could and what it shouldn't do., and a European Commission that is the agent but also a strong proponent of the relationship between the partners.
... The Americans are urging more action, quicker action. They're frustrated. They feel the Europeans are putting Band-Aids on a big wound. What is Secretary [of the Treasury Timothy] Geithner saying to you?
It's not only the United States which is becoming irritated by the slow process taking place in Europe. The IMF is a big house, and it has many members, 187. And granted, the United States is the biggest member and the biggest shareholder in the institution, but it's a sentiment that is shared by many around the table, excluding the Europeans, of course -- you know, "What are they doing? Why is it so slow? Why can't they resolve the matter? Why is Greece, which represents only 2 percent of the EU GDP, why is it taking so much and so long? And why do they come up so late and so short?"
That's pretty much the sentiment around the table. And most then say, "Number one, Europe has to get its act together; number two, it has to build a firewall that can avoid contagion," because at that time there was already the fear, which developed a lot further in the middle of August, that other countries could be drawn into that. So there was a lot of impatience.
Italy, Portugal, Spain?
Yes. By then, don't forget, Portugal and Ireland were already under joint program, but the concern which was beginning to loom in the background was about Italy.
You went to Jackson Hole in August for the Fed's meeting, and you spoke and said, "We are in a dangerous new phase."
At this point you're starting to feel things are --
Unraveling. Don't forget, this is the second half of August. From the beginning of the month, the situation has considerably deteriorated, at least from a market point of view. The spreads have widened significantly. Italy is borrowing on the 10-year bonds at roughly 7 percent, or getting close to 7 percent.
And it makes the whole situation extremely tense. The banks, the European banks in particular, are not trusting each other. The interbanking lending system is pretty much down. And the ECB [European Central Bank] continues to say: "None of my business. I'm not going to interfere and do any type of interest-rate monitoring."
So the month of August is a very difficult period, and one where I feel the necessity to actually publicly say a number of things like, "We are in a dangerous position"; like, "Austerity and deficit cutting is not the only panacea. We need to look at growth."
That message did go a little bit unnoticed at the time, because the third message was, "Banks have to be stronger to be able to actually do their job, which is finance the economy." That last message had a lot of echo and pushback.
From the banks?
What was at stake here? Why should Americans be concerned?
The economies are strongly interconnected, and it's a good thing. If you look at the relationship between the U.S. and Europe, for instance, Europe is the largest trading partner of the United States. Half of foreign direct investment are made by European Union companies in the United States.
If you look at the financial sector, there is also there a very strong relationship with U.S. banks engaged on European markets and European banks having subsidiaries and activities in the United States.
So [there are] strong links between the economies, and if something goes wrong somewhere, it is going to have consequences -- we call them spillover effects -- in the rest of the world. But you can see, given the strength of the linkages, whether it's financial, trade, foreign direct investment between Europe and the United States, it does have an impact on the United States.
At the same time you're dealing with markets that remain in major parts dark, not transparent. I'm wondering what keeps you up at night during this period of time -- August, September, October, November -- as you think about all the things that might go wrong.
You know what keeps me up at night? Work, because during those periods, I didn't get much sleep because we were working pretty much on European as well as on U.S. times. ...
More seriously and to your point, during August and September, probably into October, we all feared that something was going to crack, that something was going to break, that an auction would not materialize, that this --
That a country would not be able to refinance.
And a country would not be able to refinance itself. So there was that constant attention paid to spreads, to yields, to how the auctions were going, to the timing of the refinancing, to all of that. And there was strong cooperation, collaboration, contacts between the European actors and the IMF and other key members of the institution.
How did banks behave during this period of time?
After my call to action, if you will, in my Jackson Hole speech, there was I think an element of resentment, an element of denial, and certainly very strong and vocal pushback about what I had said and a little bit about me, you know: "Who is she to say that? How does she know, and who has informed her of such things?"
To be clear, they're reacting to your call for new liquidity and capital rules.
What I said in my Jackson Hole speech was that banks, but European banks in particular, needed to be recapitalized in order to be just stronger so that we could avoid the vicious cycle that we were in.
And I added that they should go to the private market to raise the funds necessary to strengthen their capital, but if that was not available, there should be some public funding made available so that they do not deleverage; in other words, reduce their commitment to finance the economy in order to make their balance sheet look better, therefore avoiding the need to go and raise capital.
That's what I said. And there was strong pushback, particularly by the European banks, French banks noticeably, to say: "Oh, this is not needed. Absolutely not."
A lot of that will sound technocratic to some people, but what the banks really are objecting to is that you're going to crimp their ability to profit. Isn't that the bottom line for the banks? ...
Well, there are multiple ways to recapitalize, and one of them is clearly to reduce the volume of dividends that you pay to your shareholders, or to incorporate, in capital, the reserves that you've kept to the side. So that's a way that clearly was resented.
And in the same fashion, the banks did not like the idea of having to go to market, because at that time, September, October, there was a huge doubt about the future of the banking business, and there was a lot of uncertainty about the worthiness of investing in Europe because there was this turmoil out there.
So their fear was twofold: Am I going to have to cut on my dividends to my shareholders? If I go back to my shareholders, will they be willing to recapitalize me, given the doubts that are looming over the profession of banking?
Because the debate had started as to what the profession of banking should be in the future. Should it still be this financial-instrument creativity, or should it be much more so the financing of the economy and the sort of basic and boring job of lending to households, to entrepreneurs and to companies?
The issue that all this raises is the question of whether banks have become, or the financial sector in general has become just far too powerful, that democracies have to bow down to the banks.
Well, don't you think it's a constant dialogue? Because the issue of should it be softly and lightly regulated, or should it be heavily and solidly regulated, should it be lightly or heavily supervised, that's a reflection of this debate, yes?
But it's a relatively new debate given that we've seen this explosion in the financial sector, that prior to the last 20 years the banks weren't as powerful as they are today.
You know what? It's not a recent debate. I think it's always been there. And if you look at Voltaire, for instance, back in the 18th century, ... you've heard about what he said?
If you see a banker jump out of the window, follow him, because there is for sure money to be made. And that was a criticism on the part of Voltaire about bankers.
So I think their business of moving money around, of turning short-term into long-term availability of funds, has always been looked at with suspicion, sometimes with envy, and certainly with, in my view, the urge to supervise, regulate and make their transactions, as needed as they are, transparent and known. …
The last question is, this business of negotiating haircuts for investors, many of them banks or insurance companies, large financial companies, has come with this argument over whether they should be voluntary haircuts or involuntary haircuts, and that's due to the credit default swaps that would come into effect if these are involuntary haircuts. Where are we on that debate, and do you know where these risks are in the financial system?I think central bankers and supervisors now know a lot more about where the risks are located, whether there is a concentration of risk in a particular country or in a particular bank.
A concentration of credit default swaps, for instance?
Yeah. You know, the credit default swaps are, to make it simple, an insurance policy that is bought by a bank or an institution that holds a bond, and if that bond defaults, then you have the insurance, which is the credit default swap, and you can put it to the person who sold it to you.
But based on the information we have, there is not that much concentration in any particular country or bank, and the volume of those insurance coverages is not huge; at least it's something that can be dealt with without major disruption to the system.
Given the lack of transparency in the market, how do you know that there isn't somebody sitting out there that's holding a lot of one-way bets?
Well, the ... Bank for International Settlement [BIS] and the central bankers have, as I understand, enough information to have the assurance that there is not a high degree of concentration of risk in the banking sector.
Now, in the non-banking sector, which is less regulated, in the shadow banking sector, if you will, with funds and possibly with insurance companies as well, there is a lot less information available. So, yeah, there is a doubt as to who holds what out there and against whom. But I think it applies to a much smaller portion of the landscape of risk that we have.
Do you worry that there will be another AIG out there somewhere?
I would doubt very much that there is something as voluminous as AIG. I would certainly doubt it.
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