How to Govern (Better) the World Economy, Flemming Larsen, Director of European Offices

December 2, 2002

By Flemming Larsen
Director of European Offices
International Monetary Fund
Helsinki Conference 2002
Searching for Global Partnerships

December 2-4, 2002

It is a daunting challenge to discuss the topic for this session. It is implicit in the title that the world economy somehow is not governed as well as it should, and that there must be a better way to manage economic life on this planet.

I accept this premise. Of course, we should not forget that the past century has witnessed greater progress in raising life expectancy and living standards than any other period of human history. The world has never seen such prosperity shared by so many; never before have so many families been lifted out of poverty in just one or two generations; nor have freedom and democracy ever been shared so widely across so many countries. Economic progress has been truly remarkable. Clearly, it would be fully justified to consider the glass to be at least half full.

Nevertheless, I agree with those who view the glass as half empty because it is also true that never before has the gap between rich and poor been as wide as it is today. And the gap is continuing to widen. At the same time, we have been witnessing financial crisis after financial crisis as emerging market countries have experienced abrupt reversals of investor sentiment, with devastating consequences. Whether motivated by ethical considerations or by enlightened self-interest, it has become increasingly urgent to make globalization work to the benefit of all. Today it is all too clear that globalization is not working as well as it should.

So far, I am sure that we all agree.

The Need for a Diagnosis

It is much harder to agree on the reasons for the widening income gap and for the volatility and instability of international financial markets, and on what should be done, by whom, to address the problems.

For me, a good place to start is to look back at the successes and failures of the 20th century because never before has the human race experimented so boldly with radical ideas and alternative policy prescriptions. Never before has the world economy been such a laboratory for economic and political experiments. Some of them worked, others worked for a period, others failed miserably. What have we learned from this extraordinary period?

We have in fact learned a great deal about what promotes economic and social progress and about the factors that affect countries' abilities to withstand financial shocks. There is ample evidence, for example, to suggest:

  • that the price mechanism is absolutely essential for the economy to function;

  • that it is critical for governments not to promise more than can be financed on a sustainable basis, i.e., to uphold what can be called the social contract across today's generations, and between future and present generations. A good indicator of whether governments abide by this principle is the overall government budget position and the evolution of public sector indebtedness—including off-balance sheet liabilities;

  • that monetary policy must ensure a high degree of price stability that then, in turn, also permits monetary policy to be used for stabilization purposes in the short run;

  • that the exchange rate must be consistent with a country's economic fundamental;

  • and that international trade plays a critically important role by fostering competition and technology transfers.

We have also learned that however essential market forces are to allocate resources efficiently, there are many market failures and a need for public policies:

  • to build and defend the essential infrastructure of the economic system, such as property rights, a legal framework, standards and codes to guide enterprises and consumers. For example, the Enron scandal has demonstrated how crucial it is for investors to be able to trust enterprises' published accounts;

  • to redistribute incomes, enhance opportunities for low-income segments, and foster a strong social fabric;

  • to safeguard the stability of the financial system. It seems unavoidable that market-driven financial systems are associated with volatility, market excesses, and occasional bubbles. Government policies can help to reduce the severity of financial crises through appropriate regulatory frameworks and by fostering the resilience of individual institutions and the financial system to financial shocks.

And finally, we have learned that good policies are unlikely to succeed if they are simply imposed from outside—country ownership is essential if a country is to tackle its problems on a durable basis.

These basic principles—which can be called the fundamentals—are a gross simplification of what it takes to foster development and financial stability. But it is striking how often countries fail because some of these principles have been systematically neglected. This was the case in the Soviet Union; it was the case in many Latin American countries when they experimented with import substitution schemes; and it certainly is the case today in Zimbabwe.

Globalization—A Double-edged Sword?

Is globalization also to blame, as many do? The liberalization and integration of financial markets have clearly increased the urgency for countries to address shortcomings in their policies—policy changes and reforms that may have appeared less pressing in the past but that today can provoke sharp swings in confidence when domestic and foreign investors suddenly begin to doubt the adequacy of a country's policies or have other reasons to sell the assets they hold in a country. For example, investors may suddenly begin to worry about the sustainability of a country's fiscal outlook because they begin to fear that the authorities do not have the will to contain public sector indebtedness. Or investors may simply adjust the composition of their portfolios because of a decline in risk aversion caused perhaps by developments elsewhere in the financial system such as the recent bursting of the bubble.

In this new financial world, globalization can sometimes present itself as a double-edged sword. When countries have solid fundamentals and constantly strive to improve them, globalization clearly contributes to boosting investment, trade, and growth on a durable basis. That is precisely the reason developing countries typically want more globalization rather than less. When the fundamentals are weak, however, and when governments neglect their duty to address weaknesses in time, as was the case in Argentina, then the forces of globalization can turn against the country for a time, exacerbating the ensuing crisis and raising the social cost of the delayed but inevitable policy reforms.

The IMF's Role

In the IMF, we are constantly engaged with our 184 member countries to assist them in strengthening economic performance and addressing problems as early as possible. Much too often, the problems are not addressed in time—which then results in an economic and financial crisis requiring temporary financial assistance provided by the international community through the IMF. It is only natural for the international community to insist, as a condition for the assistance, that the crisis-ridden country takes strong action to tackle the root causes of the crisis. The specific measures required vary from case to case but will typically include reforms and policy adjustments intended to improve the fundamentals, i.e., bring the country closer into compliance with the basic principles mentioned earlier.

It is not always easy in a crisis situation to give the right diagnosis immediately and to restore quickly the confidence of domestic and international investors. So the IMF is often blamed for failing to get the diagnosis and prescriptions right. Moreover, the IMF is frequently being accused of causing undue hardship by imposing solutions considered too orthodox. What is often ignored is that without the assistance of the international community and the program with the IMF, the country would almost certainly be much worse off, resulting in deeper crises and even greater hardship.

Working with the poorest countries represents a particular challenge. Many of them suffer from having gone through too many unfortunate experiments in the past, and most have been plagued by civil wars, disease, or simply corruption and general policy mismanagement. To help a country address such problems, there is obviously a need for close cooperation with other development partners, especially the World Bank, other UN agencies, and bilateral donors. Country ownership has often been missing, which may explain the lack of progress in many cases—a deficiency that is now being addressed by attempts to include civil society in the formulation of countries' poverty reduction strategies. Nevertheless, despite the difficulties, persistent efforts to strengthen the fundamentals are clearly paying off, helping to raise growth and living standards also in poor countries even though progress often appears too slow and irregular.

The Governance Challenge—at Home and Internationally

After all of this, you will not be surprised by my conclusion that many of the most pressing governance problems that need to be addressed to strengthen global economic performance are at the national level. Unless domestic policymakers in weak or lagging countries are prepared to tackle their problems and strengthen their countries' fundamentals the global disparities will remain and will probably continue to worsen. And their countries will remain vulnerable to financial crises.

But there are also burning global governance problems for the international community to tackle. Some obvious initiatives that should have been taken years ago have simply not been addressed because of vested interests in the rich countries. Despite numerous studies that have provided evidence of the detrimental impact of high agricultural trade barriers and export subsidies in Europe, the United States, and Japan, very little has been done. In fact, the advanced countries are systematically denying farmers in poor countries their only chance for progress by excluding their products from the rich countries' markets and by depressing world market prices through the dumping of unneeded agricultural surpluses. This means that the advanced countries' efforts to assist the developing countries are being significantly offset as a consequence of this serious coherence problem. Since so many speakers today have focused on this issue, perhaps the Helsinki Process will become known as the Helsinki policy coherence initiative.

Occasionally there have also been useful initiatives taken that do not seem to have gone anywhere. A few years ago, the member countries of the OECD—the rich countries club—agreed on an international anti-bribery convention. But there has been little follow-up partly because of a lack of (fairly modest) financial resources needed for the OECD to put in place a peer review process without which it is just too tempting for individual countries to continue to ignore the problem.

The continuing failure to fulfill development assistance objectives and promises is another example. In fact, in recent years many donor countries have been cutting back on development assistance. Sometimes this is because of mounting frustration that the development aid does not seem to have been effective. This is undoubtedly true in many cases. But the lack of positive results also can be attributed to the fact that so much development aid was tied to the domestic interests of donor countries. Fortunately, that is now changing although there are few signs that development aid promises are about to be fulfilled. And this cannot be for a lack of worthwhile recipients, causes, and projects.

These three examples are areas where solutions clearly can and should be found through international cooperation and through existing institutions set up to address such issues. But just as the world is changing and becoming ever more integrated, institutions need to adapt and new ones may need to be created to address new concerns.

In the IMF, for instance, we have recently put forward a proposal to establish a debt resolution mechanism for sovereign debtors—an example of a new institution needed, in our view, to deal more efficiently, and in particular more quickly and with lesser cost for both the debtor country and its creditors, with those rare instances where a country is insolvent. This mechanism would complement other mechanisms that are currently being explored, such as contractually-based collective action clauses that can help to restructure specific bond issues.

Making the IMF more Accountable?

In recent years, the Fund has been criticized for having mishandled many of the financial crises we have had to deal with, for imposing undue hardship, and for mainly serving the interests of its rich member countries. We have been criticized as well for a lack of transparency if not for outright secrecy, and for being democratically unaccountable. Some critics have notably called for a greater role for developing countries in the Fund's decision making process as the solution to the governance problems they perceive in our institution.

Although we disagree with many of the charges that have been made, the discussion has had profound effects on the work of the Fund. On transparency, for example, almost everything is being published today compared with hardly anything just 10 years ago. We are now dialoguing with outside experts and representatives of civil society on a regular basis, for example by inviting comments on recent draft policy papers on conditionality and poverty reduction strategies. Our Executive Board has also established an Independent Evaluation Office, which interacts closely with civil society and other critics. Many of our member countries organize briefings for members of Parliament and civil society on the Fund and on the positions taken by their Executive Directors in the Fund's Executive Board. Democratic accountability is clearly increasing. The most striking example of the benefits of greater dialogue and the impact of the involvement of civil society has been the initiative to reduce substantially the debt burden of heavily indebted poor countries. The NGOs deserve a lot of credit for having convinced a number of key governments that this was the right thing to do.

Fundamental changes in the Fund's voting structure will be extremely difficult to introduce, and do not seem very realistic. Quotas and voting power in the Fund are determined essentially by the member's size and openness to trade, which are intended to capture the country's "stake" in the global economy and its ability to contribute to financial assistance operations to help other members in a crisis situation. The quotas are revised regularly in step with developments in the world economy. As a result, China's quota has recently been raised, and the next quota review seems likely to result in a general increase in the quotas of the fast-growing East-Asian emerging market countries. However, these financial criteria make it very difficult to raise the weight of African countries, whose relative weights in world trade and the global economy have been stable or sometimes even shrinking over several decades.

Some have argued that the best solution would be to introduce the country's population size in the quota formula, or perhaps to change a country's voting power to be linked to the size of its population only. Would this not provide for truly democratic representation? The problem is that such a system would create an imbalance between countries' financial contributions to the Fund and their ability to influence Fund policies. This could well endanger the Fund's ability to recycle the financial assistance we provide, and thus undermine the Fund's balance sheet. Eventually, the creditor countries might not be willing to continue to provide the resources needed for the Fund to assist countries in crisis. A good analogy would be to give a bank's borrowers the power to determine the bank's lending policies—it probably would not take long for that bank's depositors to vote with their feet.


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