3.1 Surveillance of euro area member states

21. For several member states of the euro area, the Fund issued strong and relevant policy recommendations. For example, in the case of Portugal, strong warnings about weak fundamentals were given.¹⁷ This included clear warnings about weak productivity, current account deficits, private sector debt, and the necessity of significant adjustments on the labour markets. These warnings were issued despite significant pushback from national authorities.¹⁸ In the case of Greece, significant problems in fiscal management were identified in a 2006 report.¹⁹ Some issues in Spain were also rightly identified. For example, the Fund issued warnings about the risks associated to private sector indebtedness and general warnings about lost competitiveness. In 2004, important warnings about the tax deductibility of mortgages that were further fuelling the housing boom were given. In Ireland, warnings about housing market bubbles were made.

22. However, the focus of surveillance sometimes appears arbitrary and important issues were left untouched. National as well as euro area Article IVs typically focus on one or two core issues. It is unclear, however, how the focus was chosen and the choices in retrospect do not always reflect the most pressing policy priorities. In the case of Ireland for example, labor market flexibility was given significant weight in the 2007 discussions.²⁰ This appears somewhat surprising given the comparatively high degree of labor market flexibility in Ireland compared to other countries.²¹ At the same time, the 2007 report gave banking sector problems less attention than would seem appropriate in hindsight. In Greece, problems in the area of fiscal management were downplayed in the 2007 report while they received significant attention one year earlier.²² In Spain, there was little discussion of the housing boom and of the implications of an end to this boom for the Spanish financial system even in 2007. The problems of exceptionally high tax revenues due to a boom in tax-rich income bases were hardly mentioned.²³ Instead, the 2007 Article IV discusses the question of fiscal discipline in a decentralized economy at great length.

23. Follow-up to previous policy recommendations was not always ensured. In Greece, the important 2006 findings about public accounting did not find their way into the subsequent Article IV reports and did therefore not have the effect they could and should have had. In other euro area countries, important findings in one year were not followed-up in the ²⁴ following year. A frequent explanation given for this pattern is that the IMF did not want to make policy discussions overly repetitive and instead aimed to bring in fresh ideas. While this is certainly an important concern, it does not justify leaving out major policy problems identified earlier. In fact, such omissions could be perceived by national authorities as a sign that the problem had in fact become smaller.

24. The Fund did not exploit its comparative advantage deriving from international experience with crises-prone countries. In many respects, crises in emerging economies show similarities to current problems in some euro area member states. The Fund was the institution best placed to recognize that credit booms, large current account deficits and large external indebtedness are eventually associated with significant turbulences. It had a clear comparative advantage with respect to the institutions responsible for EU surveillance. However, the Fund fell victim to the mind-set that “Europe is different”. It may also have been encouraged to tone down its doubts because of the weight of European countries in Fund governance.²⁵

3.2 Euro area dimension of surveillance

25. Economic linkages in monetary union were not systematically taken into account.

The analyses performed in national Article IVs rarely took into account the fact that policy action in an integrated economic area has direct consequences for other members of the euro area. Typically, the assumption made was that the euro area context should be taken as given. While this is a useful approximation for the very small members of EMU, it is not a useful approach for the large economies and medium-sized economies. For example, policy action in Spain has direct implications for Portugal but this is rarely alluded to in either the Spanish or the Portuguese Article IVs. Problems in the governance of German public banks were raised²⁶, but the link between these governance problems and the fact that Landesbanks may have fuelled harmful borrowing in other parts of the euro area was not made.

26. The Fund's surveillance failed to take account of the implications of being in a monetary union. Before the foundation of EMU, Fund discussion about the benefits and costs of being part of a monetary union were framed by the theory of optimal currency areas. After EMU foundation, central insights of this theory were not taken into account in the IMF surveillance. Structural policy advice of the Fund to its members was general but almost never referred to EMU. For example, while labor market reforms were being called for in several countries, the Fund did not underline that in a common currency area such reforms areparticularly needed so as to facilitate adjustment.²⁷ Growth dynamics that inherently resulted from the low real interest rates and the resulting excessive domestic demand were not identified as being unsustainable.²⁸

27. Divergences in monetary union were typically interpreted in a narrow way based on a trade view. Divergences in the euro area in terms of current accounts were almost exclusively understood as resulting from trade and competitiveness developments, thereby neglecting the financial dimension to the problem. Current account divergences were typically looked at from the point of view of trade flows and competitiveness. Typically, it was argued that competitiveness losses produced the observed trade flow imbalances. This analysis ignored the underlying financial flows and also failed to see that trade imbalances were often not driven by weak export performance but rather by strong import dynamics due to buoyant domestic demand.²⁹ While current account divergences and the resulting deterioration in net foreign financial asset positions was often mentioned in national Article IVs, the general line was that this would not constitute an immediate concern. The main reason given for this position is that in a monetary union, funding for external deficits cannot dry up.

28. The link between capital inflows and systemic risk was ignored. The large capital inflows to countries such as Spain and Ireland led to the build-up of significant financial risk. This risk was often not properly identified. For example, in the case of Ireland, national Article IVs failed to issue warnings on the vulnerability of the banking system and basically relied on the assessment of national authorities in this regard. Better data may have allowed more pertinent warnings to be issued. The interconnectedness of the financial system and the implications of national instabilities for the euro area financial system were not highlighted.

29. The vulnerability arising from the link between high debt and competitiveness adjustment was not identified. In a monetary union, the basics of debt dynamics change as countries forego monetary policy and the exchange rate as adjustment tools. A country with a high debt to GDP ratio and low competitiveness faces the challenge that adjusting competitiveness increases the real burden of debt. As a consequence, the market tolerance of what constitutes a sustainable level of debt is therefore likely to shift downward after what has been a learning experience. The Fund failed to warn about the potentially negative implications of having high debt and competitiveness adjustment needs.

30. FSAPs existed on a national level only and were not designed to be used as a warning tool. FSAPs did not warn appropriately and early enough about the risks in the Selected IMF Member Countries, IEO Background paper, BP 10/03. In some other countries, the assessment is probably different. financial system in some cases.³⁰ In the case of Ireland, the FSAP of July 2006 failed to spot the risks in the financial system. The Spanish FSAP of Summer 2006 was more helpful in this regard and integrated real economy and financial developments with more success. Despite the Fund's concerns about the financial architecture of euro area financial supervision, the FSAPs were not integrated across euro area countries to take account of the strong financial links. There was no desire on the part of the EU to let the Fund perform an FSAP at the level of the euro area. An EU FSAP is currently being designed and scheduled for 2012.

31. Multilateral surveillance provides useful guidance for national surveillance, but can spot national problems only in general terms. The WEO and GFSR are excellent publications to form a view about global trends and developments. They include regional analysis that identifies broad trends. For example, the October 2007 WEO sounds some warnings about the implications of global tightening on housing markets and also points to competitiveness problems in some euro zone countries. It also points to potential vulnerabilities in the banking system. These warnings are too general to be suited for country-level policy action but constitute important messages to frame debates. The Regional Economic Outlook for Europe, which is not an official surveillance document, started only in 2007 and moves in the direction of providing more detailed analysis that can more directly shape policy action. However it doesn't attract much attention from policymakers at the senior level.

32. Weaknesses in the governance framework of the euro area were not fundamentally criticized. Before the euro was introduced, there was much debate regarding the institutions necessary to ensure that a monetary union is viable. This debate was fuelled by leading economists from the US and Europe. It was very present in the Fund and IMF research contributed significantly to it. Once the euro was introduced, however, the Fund stopped taking into account lessons from this debate. It is certainly a difficult balancing act to point to weaknesses in the governance framework of the euro area without fundamentally questioning the project of the euro itself. The Fund, however, chose to remain mostly silent on the governance issue. It pointed to the weakness and problems of the Stability and Growth Pact, especially when it was reformed. However, it did not fundamentally raise the issue of missing surveillance in areas other than the SGP and did not raise the question of fiscal integration.

33. In the area of financial supervision and resolution, the Fund played a leading role in emphasizing the relation between monetary and financial integration and it pushed for progress towards more policy integration. The Fund called on the euro area to improve its governance of cross-border banking groups, to make provisions for resolution of cross-border crises and to address the question of ex-ante burden sharing and supervision. While the push was often framed in terms of cross-border banks, the Fund clearly also had large banking groups and their spillover effects in the focus of analysis.³¹ Thus, in the area of financial integration, the Fund did warn European policy makers of the inadequacy of the system in place.

3. 3 Institutional issues as regards euro area surveillance

34. Surveillance was process-driven rather than analysis-driven and had difficulties coping with the set-up of EMU. In addition to the economic mind-set, the way the surveillance was structured hampered effective surveillance. IMF surveillance continued to be structured in the same way as for countries outside of a monetary union³² whereas euroarea-wide surveillance largely mimicked European processes.

35. As a result, national and euro area-wide follow-up to recommendations were not sufficiently integrated. The different national surveillance processes were not linked to each other to reflect interdependence within the common currency area. Policy recommendations developed in the euro area Article IVs were rarely translated into concrete country-specific policy advice. Conversely, problems identified at the national level were not generally brought to the attention of the broader euro area policy community. For example, warnings about the dismal state of Greek public sector management and fiscal reporting were raised to Greek authorities (e.g. in the technical assistance report of 2006³³ ) but the IMF did not undertake to warn the Eurogroup or EU institutions that a significant problem existed.³⁴ Conversely, broader trends in terms of monetary policy and the euro area exchange rate were not systematically translated into advice relevant at a national level. For example, the implications of an interest rate increase, that was discussed in the euro area Article IV, was rarely brought to the attention of national policy makers in countries where there was a significant proportion of variable-rate mortgages, such as Spain and Ireland.

36. The euro area Article IV missions and reports were generally felt by European policymakers to be of little help, mostly due to their set-up. Euro area Article IVs are typically quite general and only discuss some broad trends. Major concerns such as intra-euro area macroeconomic divergence were not raised as a significant problem until the 2008 Article IV. The role of the euro area in the global economy was typically covered but in rather general terms, essentially referring to the current account balance and whether or not the exchange rate was in line with fundamentals. Several interview partners in Europe argued that they felt that analysis and tone of the euro area Article IVs was too close to the official line of the Commission and the ECB. This makes it difficult to see exactly where the value added lies.

37. A fundamental difficulty of surveillance of the euro area is that a clear counterpart to the Fund is missing. The weakness of the euro area Article IV appears to reflect the problems inherent to the complex governance of the euro area. In fact, in the absence of a clear central decision making entity (except for the ECB), the Fund faces a large number of interlocutors. Moreover, the Fund needs to have a view as to who are the most relevant partners in the euro area with whom surveillance discussions can be most effectively held. In the euro area today, it can be argued that the identity of the best counterpart shifts relatively quickly depending on the problem and on domestic and European credentials. Indeed, on several occasions, the Fund warned that the euro area needed stronger internal governance.

38. Close relations between the Fund and the authorities as well as downsizing reduced the effectiveness of the Fund as an independent and critical observer. Fund officials in many instances had very close contacts with European officials. Many interview partners remarked that this drew the Fund into the European policy game too much, making it more difficult to exploit its comparative advantage and to carry out independent, process-free economic analysis. The Fund placed excessive focus on fiscal policy and neglected private sector vulnerabilities, much in the same way as the EU's own institutions did in their surveillance. In addition, the Fund underwent a period of significant staffing cuts during the period we survey and the effects of this downsizing should not be underestimated.

39. A combination of self-restraint and resource constraints may also explain why the Fund failed to detect the full extent of Greek misreporting of public accounts. Problems were spotted, and in program conditions Fund staff would certainly have been able to uncover the extent of misreporting; surveillance teams, however, probably lacked the authority and the resources necessary to carry out the further investigations³⁵.

40. The collaboration between Staff and executive directors was not always smooth.

European executive directors were sometimes found to be more critical than staff and, pushed for greater integration of analysis. Our reading of different board meeting minutes, as well as the interviews we conducted, indicate that on occasions, executive directors appeared aware of linkages and often also came forward with a common view on issues, via the EURIMF presidency in particular. The executive board was not always active in real time. For example, there was no board discussion after the release of revised Greek data. Moreover, staff often felt that executive directors were pushing them back on several issues, by calling in staff members and lecturing³⁶ them. Overall, the relation between staff and EDs could be strengthened and made more effective.

4.1 Regular surveillance during the crisis years

45. Regular surveillance of euro area countries with difficulties became more relevant during the crisis years. Awareness of the fundamental problems that some euro area countries face increased significantly. IMF analysis also became more relevant pointing to the bigger problems. In Portugal, the combination of low productivity, weak competitiveness and high debt was rightly identified and the urgency of keeping control of public finances was adequately stressed (Article IV of January 2010). In Ireland, the focus of surveillance shifted to the problems in the banking system and the need to separate banking sector woes from the sovereign. With the benefit of hindsight however, the staff report appears to have been somewhat optimistic about the prospects of dealing forcefully with such problems (Article IV of July 2010). In Spain, the issue of labour market reform and consolidation of the banking sector was more forcefully raised. There is also an extensive discussion of private sector balance sheet adjustment needs (Article IV of July 2010).

46. Nonetheless, the urgency of problems in Greece was not properly captured in the regular Article IV of 2009. In Greece, warnings about the need for fiscal consolidation were somewhat stepped up in the report of August 2009. However, the report mentions public sector data problems only in passing and does not properly assess the risks stemming fromfurther market pressure, taking a benign view that these pressures would be receding. The report is upbeat about the measures taken to stabilize the banking system but failed to account for the exposure of the banking system to the sovereign itself. With hindsight, the banking sector assessment was probably also overly optimistic given the later agreement to include a bank stabilization fund in the Greek assistance programme agreed upon in May 2010.

47. The quality of the analysis and policy recommendations increased, but the structure of formal surveillance remained an obstacle to an integrated assessment. The euro area Article IV staff report of July 2010 points to the fundamental problems underlying the construction of the euro area in clearer terms than before the crisis and overall is very much to the point. Some details of the euro area Article IV's core messages will be discussed below in sections 4.4 and 4.5. However, regular surveillance during the crisis followed the same organizing principles as before the crisis. As before the crisis, national Article IVs remained the core of the surveillance of the euro area. The euro area Article IV is an additional document with a focus on institutional issues, which does not (and does not intend to) take up specific problems in individual member states.

4.2 Macroeconomic policy response

48. The IMF appropriately assessed the macroeconomic risk to the global economy.

The Fund pointed to the severity of the financial crisis and the implications of it. It rightly emphasized that the global deleveraging process had strong implications for global demand, and that together with the risks in the financial system and the trade decline, a repeat of a global Great Depression was a distinct possibility. In view of this global risk, the Fund urged countries around the globe to enact significant demand-side policies.

49. As regards monetary policy, the right course for action was debated in the summer of 2008, with the Fund making a positive contribution. While Fund staff noted that indicators of inflationary pressure and activity would likely soften, thereby justifying an easing of monetar policy, the ECB pushed back strongly on this arguing that wage pressure was building up.³⁷ The ECB decision to tighten in July 2008, which in retrospect can be judged a mistake, was therefore assessed as not appropriate by the IMF. The IMF thus played a positive role in sounding a warning on the downside risks to the EA economy. The staff report maintained this scepticism regarding the monetary tightening, and stated that the case for keeping rates on hold was “compelling”.

50. As regards the aggregate fiscal policy stance, the IMF advice given to the euro area was appropriate and timely. The Fund urged euro area economies to enact a significant fiscal expansion. This policy advice was appropriate given the risks to the global economy. It was among the first institutions to understand the severity of the crisis and to call for a strong macroeconomic policy response.³⁸ The advice helped to significantly shape the debate in the euro area on fiscal policy.

51. However the Fund did not sufficiently differentiate its advice on fiscal expansion for the different EA countries, thereby contributing to the build-up of vulnerabilities. The Fund made the general point that fiscal policy needs to be differentiated according to fiscal space. While the advice for the EA aggregate was appropriate, the differentiation message was not sufficiently broken down across countries and remained general. In the euro area Article IVs, messages on differences in fiscal space given in 2008 and 2009 were weak or absent. The risks stemming from implicit liabilities in the financial sector are notmentioned prominently either. In its assessment, the Fund also missed the fact that fiscal revenues in Spain were artificially high before the crisis and that the structural deficit was correspondingly larger, and significantly so (see Box). This could have been seen in real time. Only in the late fall of 2009 did the Fund shift direction and become much more cautious on fiscal policy.³⁹ By May 2010, very strong warnings were issued: deep and frontloaded fiscal policy retrenchment measures were called for, and it was recommended that budget plans be based on more prudent macroeconomic forecasts.

4.3 Advice on the diagnosis and treatment of distressed banks in the euro area

52. The IMF played a positive role in the surveillance of banks in the euro area in the crisis years. Soon after the collapse of Lehman Brothers, the IMF pointed to the significant problems in the euro area banking sector and to the need to forcefully tackle the underlying problems. A number of facts can be brought forward in this regard.

53. The IMF was the first institution to publish estimates of potential write-downs in the European banking system, thereby raising awareness of the problem. The IMF was criticised for the publication of these estimates and some commentators at the time remarked that such publication could result in self-fulfilling prophecies. This criticism can, however, be dismissed. The write-downs on loans and securities were certainly driven by fundamental factors as the real economy corrected and the publication of such estimates significantly increased transparency. By publishing the numbers, the IMF significantly contributed to increasing public awareness of the underlying problem. This does not eliminate the fact that limitations in terms of access to data reduced the accuracy of the estimates.

54. While the overall estimates were too pessimistic, this mistake derived mostly from securities. The estimates of total losses in April were far too large. However, in October 2009, the estimates were already corrected downward to reach a level much closer to the final estimates. The main mistake derived from the estimates of losses in securities. Estimated losses on loans turned out to be accurate (see Box).

Box 2:

IMF advice on diagnosis and treatment of distressed banks in the euro area

GFSR estimates of potential write-downs in the European banking system were first published in April 2009. Estimates were revised in each GFSR until October 2010, after which no further revisions were added and publication was discontinued.

Table 1 gives the evaluations released in the successive GFSRs (note the data are in current dollars, so not corrected for exchange rate changes). The first estimate for the euro area and the UK proved to be over-pessimistic, however it should be noted that this was presumably attributable to an exaggeration of estimated losses on the securities portfolio. Losses on the loan portfolio were in fact correctly estimated when first published in October 2009.

Table 1:

IMF estimates of bank losses

Table 1:

IMF estimates of bank losses

Potential euro area bank writedowns (2007 - 2010)
Billions of dollars	April 2009	October 2009	April 2010	October 2010
Euro area	1109	814	665	630
-Loans		480	442	442
-Securities		333	224	188
Sources	Table 1.15,p.70	Table 1.2, p. 10	Table 1.2, p. 12	Figure 1.13, p.13 and breakdown provided by IMF

View Table

Table 1:

IMF estimates of bank losses

Potential euro area bank writedowns (2007 - 2010)
Billions of dollars	April 2009	October 2009	April 2010	October 2010
Euro area	1109	814	665	630
-Loans		480	442	442
-Securities		333	224	188
Sources	Table 1.15,p.70	Table 1.2, p. 10	Table 1.2, p. 12	Figure 1.13, p.13 and breakdown provided by IMF

Euro area and national authorities initially denied the accuracy of these estimates. Documents made available to the authors indicate that the Fund was harshly criticized in spring 2009 by the ECB for having released inaccurate estimates, and that there were still differences of view in spring 2010. Similarly authorities in Germany and Spain initially had a more benign view than the Fund.

Consistent with its estimates, from 2008 onwards the Fund urged national authorities throughout to conduct thorough assessments of the situation in their banking sector and to address weaknesses forcefully and comprehensively. This was especially the case in countries like Ireland and Spain which were affected by the bursting of the credit bubble. Indeed, the banking issue featured prominently in the 2009 and 2010 Article IV reports for Ireland and Spain.

The 2009 Article IV report for Ireland noted that “the losses faced by banks through the end of 2010 could be about €35 billion, or about 20 percent of GDP and it warned that losses are likely to extend beyond the property-development sector as the economy weakens and the design of NAMA should incorporate that possibility”. It also noted that “nationalization could become necessary but should be seen as complementary to NAMA”.

In Spain, the 2009 Article IV report indicated that “Staff stress tests based on published data suggest that banks may face capital needs — Bank of Spain's results, using detailed internal data, are more benign, but the authorities are not complacent (...) Staff noted that there is a need for (fiscal) contingency plans to assist banks with capital. The authorities viewed the severe scenario by staff as too pessimistic, especially regarding the assumption of loan impairments rising rapidly to double digit NPL ratios”.

55. Consistent with the pessimistic estimates, the Fund rightly urged authorities to conduct a thorough assessment and tackle the problems. The IMF all along urged EU authorities publicly and privately to undertake credible stress tests. In November 2010, after the Irish crisis proved that the first round of stress tests conducted by the Committee of European Banking Supervisors (CEBS) had been deficient, the Fund asked that the second round of CEBS stress tests be advanced and that their credibility and transparency be enhanced. After the creation of the European Banking Authority (EBA, the successor to CEBS) in January 2011, the IMF provided a note to European authorities making concrete suggestions on how to address the shortcomings of previous EU-wide stress tests. It also called on national authorities to tackle banking sector problems by ensuring adequate recapitalization of viable institutions and orderly resolution of non-viable ones.

56. The IMF's role in the discussion of the Irish bank guarantees and the following policy response including NAMA is limited. In the 2007 Article IV, the Fund essentially endorsed the Irish authorities' view that the Irish financial system was sound. According to the available evidence obtained, the IMF was not consulted prior to the introduction of the bank guarantees in September 2008 (see Box 3). Internal IMF documents indicate, however, that the staff was aware already in September 2008 that the size of the guarantee to the Irish banking system could ultimately pose a problem of fiscal sustainability.

4.4 Advice on the design of the crisis management and resolution framework

57. Starting at end-2009 in the context of increasing pressure from sovereign bond markets, the design of a crisis management and resolution regime for the euro area emerged as a major challenge. The architecture of the euro area initially relied on the primacy of crisis prevention (through the prevention and correction of excessive deficit and other surveillance procedures). There were no procedures, not even agreed principles for crisis management and resolution, and players in Europe (especially member states, the Commission and the ECB) had different interpretations of the EU treaty, especially as regards the so-called no bail-out clause. At the same time the euro area member countries remained individual members of the Fund and as such were entitled to financial assistance in case of need. A major challenge was therefore to design a cooperative crisis management and resolution regime within the euro area. Beyond the specific European question the broader, strategic issue for the Fund was to define how to collaborate with a regional entity while at the same time ensure consistency and equality of treatment across countries.

58. The Fund was an active participant in the search for institutional solutions. After an initial phase of hesitation, the Europeans determined that Fund involvement was a necessary component of crisis management and resolution. The Fund thereafter contributed actively to the European discussion, both through the direct and active involvement of the Managing Director at ministerial and head of state and government level or through staff contributions to the design of mechanisms and procedures. The Fund provided a series of non-papers to European policy makers, as well as oral advice on the design of new mechanisms. On several occasions, it played a crucial role in fostering solutions in European decision-making bodies such as the European Council and the Eurogroup. In national debates, the intervention of the IMF also proved decisive in some cases. Leaving out the programs themselves that are not covered by this report, key steps were: (a) the agreement in April 2010 amongst euro area member countries to provide, jointly with the Fund, financial assistance to Greece; (b) the May 2010 agreement to create the European Financial Stability Facility; and (c) the November 2010 decision on the creation of a permanent crisis management and resolution framework for the euro area, the European Stability Mechanism (ESM).

59. In general, the Fund pushed for more comprehensive and bolder solutions than what the Europeans were willing to accept. In spring 2010, it supported creating the ECB's controversial Securities Market Program. It also advocated the sharing amongst euro area member states of the burden of financing and adjustment costs; a pan-European approach to bank recapitalization; higher borrowing limits for the EFSF/ESM; the possibility for the EFSF/ESM to engage in precautionary lending (in parallel to the granting of a low-conditionality Flexible Credit Line by the IMF); a broader mandate for the EFSF (giving it the ability to purchase debt securities on the secondary market and to intervene in the recapitalization of ailing peripheral banks); and a more uniform approach to the seniority of official claims on peripheral countries (it was critical to the decision of choosing mid-2013 as a cut-off date).

60. Overall, there was a distinctive and positive Fund contribution to the European discussion. First, the Fund brought the experience gained with crisis management and resolution in the emerging world. Second, distance from European power games allowed the Fund to play the role of an impartial umpire. Third, several interview partners remarked that as the Fund was much closer to the market than European policy makers, it was able to accurately point out the dangers building up in the bond markets and the risks of contagion. While it is too early to pass a final judgment on the success of the policy measures recommended by the Fund, its positive role in raising the necessary awareness of the dangersof the situation and in fostering initiative and cooperation in the search for responses is widely acknowledged in Europe.

4.5 Reform of the governance of EMU

61. The crisis revealed significant shortcomings in the governance of EMU. First, fiscal surveillance was not intrusive enough to diagnose and prevent the massive failures of fiscal policy in Greece and it was not accurate enough to help avoid the build-up of fiscal risks in Ireland and Spain. Second, financial market supervision was insufficient and systemic risk was largely neglected. Third, macroeconomic imbalances in the private sector were left essentially unchecked or unnoticed. Overall, the perverse interaction between banking risk and sovereign risk that characterizes the current crisis was not adequately foreseen.

62. Starting in 2009, European policy makers decided to reform the governance of EMU along three dimensions by overhauling financial supervision, revisiting fiscal surveillance and introducing surveillance of macroeconomic imbalances. In early 2010, a task force at ministers' level was established under the chairmanship of President Van Rompuy to advice on reform priorities. The new system of financial supervision has been in place since January 2011. The fiscal and macroeconomic surveillance is currently still in the legislative process. The Fund did not contribute significantly to the decision on the priorities for surveillance reform.

63. The IMF contributed to the governance reform of financial supervision. The new European system of financial supervision with the new European authorities and the European Systemic Risk Board was set up during 2009 and 2010. To our knowledge, the IMF did not make high-profile interventions in these discussions, by drawing parallels with financial supervision systems elsewhere in the world for example. However, the Fund was an important political ally of the Commission in the Eurogroup and the Euro Working Group (EWG) and helped convince hesitant member states of the necessity to move ahead with the integration of financial supervision.⁴³

64. The IMF also contributed to the discussion on the fiscal reforms. Interview partners remarked that the IMF had provided them with technical material on how to improve the fiscal governance of EMU. This included documents on national fiscal councils as well as concrete comments on the Stability and Growth Pact reform.

65. The Fund's involvement in the debate on the designing of a system for prevention of macroeconomic imbalances was limited. The IMF is a key player in the discussion on global imbalances and also takes an active role in shaping the global governance reform debates via the G20. In the euro area, it left the issue of the governance of macroeconomic imbalances mostly untouched. In the euro area Article IV visit of 2010, the Fund remarked on some of the shortcomings in the design of the European Excessive Imbalances Procedure. However, these criticisms were not made sufficiently public and were also not brought to the attention of key decision makers, such as those involved in the Van Rompuy task force for example. This limited the overall effectiveness of the criticisms.

66. Overall, the IMF involvement in the governance reform was limited. While the Fund contributed to some aspects of the discussion - in particular regarding fiscal matters - it made no comprehensive effort to influence the shape of the overall Van Rompuy package.

5.1 Revisit the surveillance mandate

71. Because of their explicit reference to exchange rate policy, the Fund articles of agreement are a constraint to effective surveillance of countries in a currency union.

However, there is room for improvement both within the current legal framework and by revisiting the 2007 decision.

72. Fund surveillance of the euro area should focus its priority on threats to stability of the area as a whole. Some countries in the euro area experienced a sudden stop in 20102011 which forced the ECB to substitute the money market in providing liquidity to banking systems and EU-IMF assistance to substitute the bond market in providing funding to governments. This sudden stop represented a major threat to the stability of the euro area as a whole. The euro area's vulnerabilities exposed in the open in the recent period are unlikely to vanish any time soon. On the contrary, the years ahead are bound to remain challenging as a number of member countries grapple with excessive debt, financial weaknesses, high unemployment and misaligned real exchange rates. In this context it is more than ever necessary that the Fund provides national and European authorities with a candid assessment of the risks and frank policy advice.

73. A focus on internal dimensions should not preclude the Fund from assessing developments in the euro area's relationship with the rest of the world. The Fund has a clear comparative advantage in assessing the global interconnectedness of the euro area. The new spillover report for the euro area provides a natural channel for this part of surveillance. It should address the global implications of both national and euro-area policies.

74. For these ends to be clearly defined and stated, a revision of the 2007 decision is desirable. In the absence of such a revision, the Fund should at least formally redefine its interpretation of its general mandate in the case of the euro area. This revision should allow other channels of instability, besides the exchange rate channel, to be properly taken into account.

5.2 Redefine the Fund's relationship with the euro area

75. The Fund should not have a “Europe is different” mind-set. Facts have proven that countries in the euro area can experience crises of the sort that is frequent in the emerging world. In its surveillance work the Fund should make full use of its comparative advantage which consists of the breadth of its expertise, the wealth of its experience across countries and over time, and an approach that is driven first and foremost by economic analysis rather than by institutional constraints. In the last years, the Fund has already moved in this direction and it will be important to retain this attitude.

76. The Fund should take notice of the EU's institutional constraints but it should not be bound by them. The EU by nature is process-driven and this affects its own surveillance work, which is structured around institutions and procedures. Furthermore, European processes are inevitably affected by power games between national governments and EU authorities (Council, Commission, Parliament and ECB). Being outside of this game gives the Fund freedom and objectivity. Those are precious assets that should not be squandered by attempts to be part of the European institutional game and to mimic European processes.

77. Attempts to limit the scope of Fund surveillance or to tone down its assessments should be resisted. The Fund's expertise and financial commitment in the euro area give it a duty towards its entire membership to be as thorough and comprehensive as needed. The claim that the euro area should be dealt with as a single entity only has lost justification.

78. While it may have been necessary in the context of the euro area crisis and the failures of European governance, the high-profile role of the IMF in European decision-making cannot be a permanent approach. The Fund under Dominique Strauss-Kahn played a crucial role in mobilizing energies and breaking deadlocks over important decisions for the euro area. This was appropriate in exceptional times but can evidently not be sustained. An IMF that would become a permanent player in the European institutional game would inevitably lose the possibility of being a trusted external adviser. It would also risk not being able to perform even-handed surveillance. The Fund should therefore gradually revert to its normal role and take full advantage of its exteriority. This does not mean, however, that traction should be weakened.

5.3 Restructure surveillance work

This section first discusses proposals to restructure surveillance more generally along dimensions useful for the euro area surveillance but also for other surveillance. It then turns to the more specific factors related to euro area surveillance.

79. Risk assessment should feature more prominently in surveillance work. In the context of multilateral surveillance the Fund has successfully developed an approach to vulnerabilities and early warnings but bilateral surveillance is still very much conducted in a first-moment framework. The value added of the Fund's short-term forecasts is questionable in the case of countries generally well-equipped with public and private forecasting capabilities (and for which Commission forecasts are also available). Rather, Article IV reports should borrow from VEA/EWE methodology and results and provide specific risk assessments. When doing so, it will be important to carefully manage communication so as to avoid market impact.

80. A more graduated approach to surveillance would be appropriate to deal with the situation of countries presenting evident weaknesses. Even-handedness does not imply that the same amount of resources is invested in the surveillance of strong and vulnerable countries. The Fund should give consideration to ways of differentiating its approach depending on the perceived intensity of threats to stability, especially as both the G20 and the euro area itself are moving increasingly in this direction. For vulnerable countries, more in-depth and higher-frequency investigations are desirable. To choose vulnerable countries, one could use objective criteria thereby pre-empting critique that Fund analysis is not evenhanded. This has been done before, for example when choosing the systemically important countries for obligatory FSAPs. Bringing in technical assistance at an earlier stage to those countries would improve the technical expertise necessary. The legal requirement that technical assistance can only be deployed at the request of national authorities should be reconsidered. It could be replaced, for instance, by the requirement that either national authorities or the Eurogroup make such a request.

81. In fast-moving conditions, real-time reports by the staff should trigger discussion within the Board and serve to alert authorities. Regular reports (annual if resources permit) are indispensable but the Fund should further improve capacities to react in real-time. Existing reports that come at a higher frequency, e.g., reports for Board country matter sessions, could be more effectively used for short-term risk assessments.

82. The Fund should strengthen the financial side of the Article IV reports. The separation of Art IV and FSAP reports has proved to be unhelpful because it discourages full integration of financial dimensions in the Art IV reports. Instead of perpetuating the 20th-century schism between the real and the financial economy, the Fund should allocate more resources in regular surveillance work to an integrated analysis of real and financial developments.

83. The Fund should restructure its surveillance work of the euro area and its members to better exploit its comparative advantage. As a result of the crisis, surveillance by European authorities (Council, Commission, ECB, ESRB, etc.) is widening and deepening. This does not mean, however, that there is no added value to IMF surveillance but it implies that its surveillance should be restructured. While national surveillance remains at the center of regular IMF surveillance due to its national membership, integrating surveillance at national, euro area and global level is the unique advantage of the Fund.

84. Surveillance of the euro area as a whole and the euro area Art IV report should be upgraded. Instead of focusing primarily on issues of relevance for interaction with EU institutions, EA surveillance should encompass all aspects of relevance for the stability of the euro area, including national policies in particular countries and their spillovers onto other member countries. Results from the surveillance of the individual member states should become an integral part of euro area surveillance and potential spillovers of policy developments to the euro area should be strongly emphasized when assessing national policies in the context of Article IV surveillance.

85. Euro area and national surveillance should be closely coordinated. Coordination should start at the ex ante stage: surveillance teams should consult during the preparation for surveillance missions and coordinate on the choice of priority issues, methodologies for assessment, major policy questions, etc., so that their findings can be exploited on a crosscountry basis or for the euro area as a whole. Common themes for national surveillance could include, inter alia, capital flows, competitiveness, the effectiveness of EU policy frameworks, etc. Similarly, ex post, major results of national surveillance should feed back into the ongoing surveillance of the other members as well as the aggregate, in a way that strengthens the policy messages of relevance for the functioning of the euro area as a whole.

86. National surveillance should focus on topics of importance for a country's performance within the euro area and potential threats to the stability of the euro area. Topics should better reflect perceived priorities for analysis and policy reform rather than the particular research interests and availabilities of IMF staff to participate in missions. Policy issues of major importance for the stability of the euro area should be clearly signaled in national Article IV reports. To achieve this, one should reconsider staff mobility patterns to ensure more in-depth knowledge of the country.

87. To foster the better integration of national and euro area Article IVs, an annual “Euro Area Surveillance Report” (EASR) report should be envisaged. This report should draw on existing multilateral surveillance (WEO, GFSR, EWE/VEA) as well as on bilateral surveillance (Article IV reports for the euro area and national Article IV reports) and the spillover reports. It should provide an assessment of risks arising from developments in the euro area as a whole or in particular countries and highlight recommendations of major importance for discussion by euro area authorities and action by the EU, the Eurogroup or relevant national governments. It should address all major areas of spillovers in the euro area and explore linkages between the euro area and the rest of the world. The report would make reference to the different Article IVs and would serve as a basis for subsequent national Article IV assessments of links between national economies and with the euro area as a whole.

88. To avoid unnecessary duplication, one should consider discontinuing the euro area article IV report in its current manner and fully include it in the EASR. The REO, whose policy content is limited, could also be discontinued and its analytical capacity could be used instead to reinforce the EASR analysis of the interconnectedness across the area.

5.4 Ensure better traction

89. Technical improvements will be of limited effectiveness unless the Fund engages policymakers at the highest level and communicates effectively with the wider policy community. Partial evidence suggests that the report on euro area Article IV discussions has limited impact at best and that the impact of national Article IV reports is very uneven across countries. The WEO and the GFSR are influential but by nature communication about them focuses on the broad message for the world economy, not on regional aspects. This is in principle the purpose of the REO report, but it gets barely noticed in spite of qualities.

90. Traction should be improved by making the Euro Area Surveillance Report the basis for the policy dialogue of the Fund and European policy authorities at EU and national level. The EASR would be presented by the MD to the Eurogroup as well as the European Parliament. This presentation could replace the current presentation of the narrow euro area Article IV, which failed to point attention to national problems of relevance to the euro area as a whole. By doing so, traction of national Article IVs would be increased as peer pressure in the Eurogroup would be added as an additional enforcement tool to the current obligations resulting from the bilateral Article IV. The role of the European Parliament should not be underestimated and the debate of IMF surveillance would thereby be enhanced. The report would also increase peer pressure on the EU institutions, thereby increasing the effectiveness of their own surveillance. As the report will soon become a flagship publication, it will also receive increasing attention from non-government players. This could be fostered by targeted outreach activity, for example to trade unions and national parliaments.

91. The Fund should press ahead with key messages on the prevention of major risks as long as they persist. Having warned about a risk but having failed to insist on the necessity to successfully address it is almost as blameworthy as not having warned about it at all. Again, these key risks should be highlighted in the national Article IV as well as in the EASR in order to maximize traction. Repeating key messages to national policy makers is one important way of increasing traction. Repeating the same message to euro area peers will further increase peer pressure.