March 8, 2006
I thank the Stern School for inviting me to deliver the Krasnoff lecture. It is a pleasure to return to academia from the world of international finance. Here, the only true currency of exchange is ideas, and the exchange rate is simply how valuable those ideas are. Of course, that rate is determined in a market place. I will attempt to talk up the exchange rate for my ideas against the increasingly crowded marketplace. I should note that, in the spirit of academia, I will be expressing my personal views only throughout this talk.
There are many questions being raised about the future of the International Monetary Fund. I will argue in today's talk that it is not that the IMF is faltering in its tasks - we were just repaid by our largest debtors, a cause for celebration in any financial institution -- but that even while the linkages among countries grow and the need for economic dialogue among nations increases, the spirit of internationalism is ebbing. There is a belief that IMF reform will somehow restore the quality of the international dialogue. In my view, any proposal that does not focus squarely on reviving the spirit of internationalism is doomed to failure. IMF reform can be part of the solution and, unlike some, I believe the IMF's lending function will be critical to this process. But we must get the diagnosis of the problem right before attempting solutions.2
The origins of the Fund and its objectives.
Let me start with why the Fund was founded. The midwives at the Fund's birth in 1944 were political tragedy and economic despair. During the inter-war depression years, countries, suffering from overcapacity and unemployment, tried to export their way out of trouble by devaluing their currency, even while raising their own tariffs to protect against imports. Of course, other countries had the same problem, and tried the same solution - known colloquially as beggar-thy-neighbor policies. The result? Global trade collapsed, while exchange rates and capital flows became volatile.
What the world needed, according to the Fund's founders, John Maynard Keynes and Harry Dexter White, were rules to govern international exchange and flows, and an impartial arbitrator to point out when those rules were being violated. With the spirit of internationalism reinforced by recent memory, the Fund was conceived at the 1944 Bretton Woods Conference with the prime objective of facilitating "...the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income...". i
It was to do this, in part, by "promoting exchange [rate] stability" and avoiding "competitive exchange depreciation". This required the Fund to "exercise firm surveillance" over the exchange rate policies of members so that they "avoid manipulating exchange rates or the international monetary system" to prevent adjustment or "gain an unfair competitive advantage over other members".ii
In addition to monitoring country policies through surveillance, the Fund was set up to work as a sort of credit union, lending to countries that suffered adverse external shocks.iiiThe availability of this line of credit helped a member in a number of ways. The IMF could help countries correct balance of payments difficulties by providing temporary financing to smooth the required adjustment and limit the impact on economic activity at home and abroad. Thus the country's incentives to export its problems to the rest of the world were mitigated; in fact, the IMF's financing would be conditional on policies that would limit or avoid such effects. Furthermore, countries became more welcoming of trade, knowing that they could borrow resources to weather adverse external shocks. The importance of Fund financing should therefore not be underestimated - it was a carrot that gave countries an incentive to play by the rules.
The Ebbing of Internationalism
Since the early days of the Fund (leaving out the abnormal post-war lows), world trade has grown, from 10% of world GDP in 1960 to almost triple that in 2005. World GDP itself has grown at an average rate of 3.5% over this period, faster than at any other period in human history. In short, judging by the Fund's goals at its founding, it has been a great success. We could spend the rest of the evening here debating how much it contributed to that success but I want to focus on something else.
It is this: Even as the world has become more interconnected through trade and finance, even as the Fund's members have become more successful, the spirit of cooperation that prevailed amongst the members at the time of the founding of the Fund, seems to have waned. I believe the trends are not unconnected. Let me explain.
At the risk of simplifying to the point of caricature, in the initial post-war years, virtually all countries with the possible exception of the United States had fragile economies. Given that they might need help, they were willing occasionally to subsume domestic interests for the international good. The Fund was a partnership of the heedful, and given that a country could be a creditor one day and a debtor the next, it was also a community of common interests.
Over time, however, industrial countries recovered from their post-war weakness. They rebuilt their capability to undertake policy analysis. And the system of capital controls and fixed but adjustable exchange rates broke down for reasons well described elsewhere. Most industrial countries moved to floating exchange rates. This move, coupled with their political stability and strong institutions, ensured that private capital markets would be a reliable source of finance. As a result, industrial countries stopped borrowing from the Fund - as late as 1975, nearly half of Fund lending was to industrial countries, but by the late 1980s, it was zero.
This had two important consequences. The first was that with little to gain from the vetting of their policies by the larger Fund membership, important industrial countries started forming groups outside the Fund, with serious policy discussion and economic co-operation taking place within these groups. The most prominent avatar of this First Circle is now the G-7. While not denying the global benefits of frank policy dialogue and coordination within the group, an unfortunate consequence has been to diminish the relevance of the multilateral discussion that takes place within the Fund.
The second consequence was that the Fund itself was divided - between industrial country creditors who would never borrow and held the weight of the shareholding, and potential debtors who had to subject their policies to multilateral advice either within the context of a Fund-supported policy program or for fear they might otherwise lose access to Fund resources in their time of need. The tensions between these groups centered around program conditionality - the conditions the Fund imposed in lending programs to ensure repayment, and to ensure that the resources were used to promote, rather than postpone, adjustment and reform.
In the early days of the Fund, conditions were primarily imposed on a country's exchange rate and macroeconomic policies. But as the Fund began lending to more developing, emerging market, and formerly planned economies, it began to place conditions relating to structural reforms - such as privatization, fiscal reforms, financial sector reforms, trade reforms, central bank independence, etc. These were more intrusive than prior Fund conditionality - the canonical example of what generally came to be viewed as excess being the 140 or so conditions imposed on Indonesia in 1998 including measures dealing with reforestation programs, disbanding the clove monopoly, and introducing a micro-credit scheme.ivWhether all these conditions were really needed, or whether the Fund was freer with conditionality because its largest shareholders did not ever anticipate borrowing is something that can again be debated for a long time. What is true is that even though the Fund has taken important steps to streamline conditionality - as exemplified by the recent program with Brazil -- the fear of excessive conditionality persists.
Most recently, some emerging markets have built up their foreign reserves to such an extent that they are unlikely to need Fund resources at least in the short term. Given the precedent set by the industrial countries, these "advanced" emerging markets are not keen to be seen heeding Fund advice, though many of them value it privately. Unfortunately, paying attention to the global community is seen as weakness today rather than responsible global citizenship.
This development is particularly pernicious for a number of reasons. Unlike industrial countries, these advanced emerging markets still have structural vulnerabilities. They could continue to benefit tremendously from Fund surveillance, for reasons I will describe, and may well need Fund resources in the future.
More important, many of them are now significant players in the world economy, who affect each other, as well as the rest of the world. They could play a valuable role in the multilateral dialogue - and I will give some examples shortly. Their collective will could be a powerful force in reforming multilateral fora, but it is not being asserted, partly because they have diverse interests. Equally problematic, industrial countries are only slowly, too slowly in my view, figuring out that their groups need to be reformed - the smallest countries are a particular drag here because any reform that includes new members is likely to leave them out. Moreover, industrial countries have gotten used to domestic policy independence. They need to realize that if they want the advanced emerging markets to alter their policies to further the common interest, they themselves have to accept some multilateral constraints on their policies.
So even as the linkages among economies grow, the places where dialogue among nations can reasonably take place are diminishing. Multilateralism is in retreat everywhere. As just one example, we see signs every day in the financial press of a revival of beggar-thy-neighbor policies, except it is now also on the capital account. Simply put, it is ok for firms in industrial countries to take over firms in emerging markets, but God forbid that the emerging markets contemplate the reverse. Then all sorts of "non-tariff" barriers start emerging such as understandable but ultimately specious concerns about national security, and even concerns about etiquette, "Sacrebleu! He was so rude, he made the takeover proposal during dinner! What more evidence of hostility could there be?" ......And now these barriers, as is typical, are being raised against neighbors. Protectionists recognize no friends across borders.
It is amidst this background of diminishing multilateral dialogue that calls are being made to reform the Fund. Part of the Fund's response to its largest shareholders has to be, "Physician, heal thyself". But the larger part of the Fund's response has to be to find ways to re-engage all of its member countries. Let me offer an example of a current issue where the Fund is playing a role.
Fund Surveillance in an Era of Floating Exchange Rates
IMF surveillance - that is its periodic monitoring of a country's economic policies - focuses on two related issues: the sustainability of a country's policies and their external effects.vWhile the exchange rate is at the heart of the IMF's mandate for surveillance, the level of the exchange rate (and its departure from some notion of equilibrium), is just one of the gauges of the appropriateness of policy.
Why do we need the Fund to analyze the sustainability of a country's policies? In the past, one hurdle used to be that countries simply did not have the high quality personnel or the wealth of data and country experience the Fund staff had. Increasingly, though, our member countries recruit officials with qualifications comparable to those of Fund staff, and have access to the same databases that the Fund uses. While they do not usually have the wealth of cross-country experience we have, countries do talk to one another.
But as important as the quality of analysis is impartiality. This is where the Fund still has an important advantage. Let me explain.
Politicians need to be re-elected. This shortens their policy horizons and increases their incentive to take on long-dated risks with short-dated returns. Growth before elections is much valued, growth after elections is highly discounted. Inflicting pain on current generations, especially those who are vocal and vote, in order to ease the way for future generations, is especially difficult. Unfortunately, future generations do not have a voice, and not all the electorate see the consequences of myopic policies. Populism is indeed popular!
Lack of sustainability as politicians follow willfully myopic policies is why so many countries have had to borrow from the Fund in the past, and why so many emerging markets have got into trouble in the past decade. Foreign investors are willing to finance unsustainable spending for a while - they give you a long rope to hang yourself, but when the drop finally comes, it is quick and extremely painful.
Sustainability could be a domestic matter. It is because unsustainable policies will eventually require outside (Fund) financing, or force costly adjustment on other countries, that the Fund, representing the global community, has a legitimate interest. And in matters of unsustainability, emerging markets are not the only offenders.
Consider the United States, which is running a current account deficit of 6.5 percent of GDP - meaning it spends far more than it saves - in the process absorbing nearly 70 percent of world external savings. Any industrial country running such a large deficit becomes reliant on the mood of foreign investors not so much because foreign investors will inflict a "sudden stop" but because they are likely, at some point, to start demanding a much higher premium for continuing to finance. Thus far they have not, not even pricing in the eventually needed real dollar depreciation, perhaps another example of the long rope markets provide.
But even if we accept that the United States is special, and foreign investors will continue to accumulate for a long time, there is another side of this that is unsustainable. U.S. household savings rates have been negative for the last six months. A recent study finds that U.S. households are overly reliant for their retirement savings on the value of their house. With bold moves on social security reform postponed into the indefinite future - the brevity of President Bush's brave foray reaffirming the adage that social security reform is the third rail of U.S. politics -- U.S. households will wake up one day to the fact that their retirement savings are insufficient, especially if the housing market continues slowing.
When they cut back on spending, the effect on U.S. output may well be limited under some scenarios, especially if the spending slowdown is accompanied by interest rate cuts and exchange rate depreciation. Perhaps this is why there seems so little concern amongst U.S. lawmakers about the problem. They would do well to worry more. Almost certainly though, the rest of the world, which has become reliant on U.S. demand, will face a serious adverse shock to growth and significant adjustment costs. This is why the Fund has been so vocal about the problem of global current account imbalances, and the need for the United States to increase savings in a measured way.
Moreover, the counterpart of the U.S. deficit, the current account surpluses and reserve build-up that have so fortified emerging markets, are also unsustainable. When the deficit shrinks the surpluses will shrink - this is simply a matter of adding up. The question every country has to ask itself is "Am I prepared for the day the U.S. consumer finally decides to hang up the shopping bag and save?"
It is concerns about sustainability and external effects that motivate the Fund's advice to China. China is becoming overly reliant on external demand. Its exchange rate policy distorts the pattern of investment even while weighing on consumption, and prevents the central bank from using interest rates as an effective tool of policy. While corporate and financial sector reform is probably key to medium-term sustainability in China, allowing exchange rate appreciation must be an integral part of the strategy.
Ultimately, adjustment of the global imbalances will be a good thing, for it does seem against the natural order for countries with massive development needs to finance the asset price booms and the under-saving of rich countries (leaving aside the distortionary exchange intervention and demand compression that underlies some of the reserve build-up). I have to admit, though, that while the Fund has increased awareness of the need for adjustment, while everyone recites the Fund mantra on the policies needed to deliver adjustment in a smooth way, and while the Fund is working to enhance the quality of the dialogue, movement on the policies themselves has been limited. This is not because we are asking countries to do anything against their long term interests - in fact, for reasons of their own sustainability, it is important that they undertake these policies. No, the problem is that the policies have political costs in each of the countries concerned, and with multilateralism at an ebb, no country deems the common benefit a sufficient offset.
In sum, a number of observers have offered valuable suggestions on improving the quality of Fund surveillance - sharpening Fund advice, adopting a medium-term framework for Fund advice with some kind of a scorecard on how well the Fund's advice has been adhered to, being more explicit on disequilibrium exchange rates, making surveillance more "independent", etc.viMany of these imply subtle shifts in emphasis in what the Fund does rather than radical changes. While I would be the last to say the quality of Fund advice cannot be improved upon, let us be clear about where the problem really lies. The suggestions are likely to have only marginal impact unless our members-especially those with the most systemically important economies--decide they truly want to listen to the Fund, they truly care about multilateralism. And multilateralism begins at home - for example, industrial countries cannot press in public for the need for Fund transparency and candor, while discouraging the Fund, when it comes to their own countries, from holding a press conference to disseminate its findings at the end of a surveillance mission.
I do not have any illusion that the spirit of internationalism will suddenly be reawakened. But there is reason for hope. Surveillance is likely to be most effective when countries use it as a basis for constructive give and take, and not as a means of censoring each other. As industrial countries recognize they are affected by policies in advanced emerging markets like the BRICs (Brazil, Russia, India, and China), they want to be able to influence those policies. But the advanced emerging markets no longer need funding - at least for the foreseeable future. They are unwilling to be lectured to. At the same time, they too want influence over the policies of the industrial countries, for these have serious external effects. If the Fund can re-engage both groups more, it will not only be the natural and legitimate forum for much needed multilateral dialogue (given its near universal membership), it will also be a more effective one. And it will be better able to serve its poorest members.
IMF Insurance.
The obvious countries to re-engage first, in my view, are the advanced emerging markets. I argued earlier that the advanced emerging markets still have vulnerabilities - such as underdeveloped financial sectors -- that are being papered over by massive reserve holdings. As I have just suggested, the underlying imbalances driving the reserve build-up may reverse in the future.
As the reserves of advanced emerging markets fall, they may well want to re-engage with the Fund, but on their own terms. They will be open to some kind of insurance from the Fund, but will be wary of the creditor-biased conditionality that they believe accompanies it. Some industrial countries do not want to offer automatic access for fear of encouraging lax policies or moral hazard. Is there any way to satisfy both potential debtors and creditors, draw the advanced emerging markets back to the Fund, and in the process give industrial countries more of an incentive to engage?
A proposal for future Fund "insurance" to emerging markets.
Let me speculate on what a potential solution could be. The more automatic access a country wants to financing in case of crisis, the more pre-screening is necessary. One way to offer this is to condition a country's automatic access to Fund financing on the quality of its policies, as determined by regular Fund surveillance. If a country's policies are judged to be sensible, its access to automatic financing in case it is hit by an unexpected shock improves. Access to automatic financing then becomes a precise, meaningful, and continuous signal of a country's policies. Precise because it is a number, meaningful because it implies automatic access, and continuous because it is constantly updated based on a country's policies. Such a system of "ex ante" conditionality would give countries added incentive to stay on the straight and narrow, even outside normal Fund programs.vii
Industrial countries may be reluctant to provide financing for such a scheme. But there may be ways of minimizing the call on their purse. The range of innovative possibilities that would give advanced emerging markets more of a say over Fund policies, a greater role in financing, and more attractive insurance facilities from the Fund, is large and is well worth further examination. Indeed, the Managing Director has called for such an examination in his strategic review.
With advanced emerging markets more engaged, perhaps industrial countries will also see more value in the Fund as a forum for dialogue, and the spirit of internationalism will be rekindled once more.
Conclusion
Let me conclude. A little over 60 years after Bretton Woods, it is legitimate to ask whether the Fund indeed has a role. I have no doubt that it has, but the role is not the same as the one that was envisaged at the time of its founding. The times have changed. So has the Fund, and more change will be needed. The Fund is not perfect, and we have a host of critics - well-meaning and otherwise - to remind us of that. But in my view the greatest danger to the Fund, and to other multilateral organizations, is not that its superb, highly-motivated, and qualified long-time staff will be found lacking, but that the spirit of internationalism that abounded when it was set up is faltering. As emerging markets grow and gain economic power, they do not seem as interested in multilateral dialogue, or in combining forces to mold multilateral institutions in ways they think appropriate. Growth and increasing self-confidence are leading to disengagement. Industrial countries do not help by holding on to archaic power structures, or by attempting to exercise the influence of an era that is long past. We have precious few multilateral institutions. We owe it to the generations that bequeathed these strong institutions to us, as well as to the generations that will follow, that we rediscover the spirit of internationalism. Thank you.
1 I thank, without implicating, James Boughton, Graham Hacche, Laura Kodres, Jonathan Ostry, David Robinson, and Arvind Subramanian for valuable comments on earlier drafts. This talk reflects my views and not necessarily those of the International Monetary Fund, its management, or its Board.
2 While my focus will be selective, Mr. Rodrigo de Rato, the IMF's Managing Director has laid out a comprehensive vision for the Fund's medium term strategy and it is available on the IMF web page www.imf.org.
i Quotes are from the Articles of Agreement of the International Monetary Fund.
ii These words were adopted by the Fund in the late 1970s in the Second Amendment of its Articles of Agreement, following the collapse of the "Bretton Woods" system of pegged exchange rates.
iii The Fund was asked to "give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with the opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity."
iv See "IMF Structural Conditionality: How much is too much?" by Morris Goldstein, October 2000.
v Subsumed within sustainability is the development of the country's economic institutions.
vi See, for example, "Working with the IMF to Strengthen Exchange Rate Surveillance", speech delivered at the AEI by Tim Adams, "Reform of the International Monetary Fund", speech delivered by Mervyn King, Governor of the Bank of England at ICRIER on Feb 20th, 2006 and A Strategy for IMF Reform by Edwin M. Truman, Institute for International Economics, Washington DC, February 2006.
vii See Jonathan Ostry and Jeromin Zettlemeyer, "Strengthening IMF crisis prevention", WP/05/206, IMF working paper for a detailed proposal.
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