September 19, 1997
Thank you, Toyoo. While I have been told that the essence of effective public speaking is a good man speaking well--and briefly, I've always thought that two out of three wasn't bad. As Mr. Fischer suggested, this seminar on Asia and the IMF now promises to be somewhat more interesting than when the topic was selected some months ago. We might all recall the ancient Chinese curse: May you live in interesting times.
I have been asked to discuss the IMF approach to macroeconomic policies. Such policies are at the heart of the IMF's two most important functions as established in its Articles of Agreement: surveillance over the international monetary system and over the economic performance and policies of its members, especially their exchange rate policies; and the provision of conditional financial assistance to members experiencing balance of payments difficulties in support of their adjustment efforts.
To begin, let me emphasize that the general IMF approach to macroeconomic policies is not fundamentally different for Asia than it is for other areas of the world. Of course, members of the Fund differ substantially in their levels of development and in the major issues confronting their economies, and the IMF's economic analysis, its policy advice, and the programs that it supports with its financial assistance need to recognize these important differences--differences that exist among Asian economies as they exist more broadly among the different economies around the world. Despite what one sometimes reads in the press, the Fund approach is not, "one size fits all." Rather the philosophy may more aptly be described as, "if the shoe fits wear it."
In its functions of surveillance and programs of financial support, the Fund is much like a "macroeconomics doctor" for its members. In surveillance, the Fund seeks to provide sound analysis and advice to assist members in maintaining good macroeconomic health and financial stability and in avoiding the accidents or bad habits that may contribute to poor health. In providing support to members experiencing macroeconomic difficulty especially difficulty in their international payments, the Fund seeks to support adjustment programs that will successfully restore good macroeconomic health, although sometimes with a uncomfortable period of recuperation. In pursuing these activities, the Fund is necessarily subject to two important limitations.
First, is seeking to provide sound economic analysis and policy advice, the Fund is limited by the accumulated wisdom of the economics profession--just as medical practitioners are limited by the knowledge of their profession. And, just as knowledge is continually advancing and being revised in medicine, the same is true in economics. Despite its advances, the economics profession has clearly not discovered the magic formula that assures rapid and steady economic growth, low inflation, financial stability, and broader social progress; and the good Lord, in his wisdom, has also denied such knowledge to the Fund. However, based on experience across many countries over many years, a consensus has emerged about the broad guidelines for policies that tend to promote, if not absolutely assure, these desirable goals.
I will not attempt here to summarize the main elements of that broad consensus (see Mussa, 1997), but rather would want to note that the IMF has not been a passive bystander, but has played an active intellectual role in developing this consensus and thus in providing the intellectual basis for its own key operations. Important contributions include the development of the Mundell-Fleming model, work on the monetary approach to the balance of payments, analysis of determinants of the behavior or exchange rates, papers on the functioning of the international monetary system, development of policy-oriented models of multi-country macroeconomic interactions, analyses of economic crises and speculative attacks, studies of policies to achieve efficient stabilization from high inflation---the list is very long and growing. References to a few key contributions are provided in the bibliography. More specifically, careful reading of the footnotes to recent WEOs or international capital markets reports, or casual perusal of the Fund's Web site, reveals the Fund's continued intense activity as an intellectual and research institution.
The point here is not that the Fund is the leading institution in expanding the frontiers of economic knowledge, but it is an active and significant contributor. This is important in the Fund's operational work in surveillance and programs. If the economic analysis and policy advice that the Fund supplies to its members is to be credible, effective, and responsible, then it needs to be based on the best that the economics profession has to offer. This poses a continuing challenge that can only be met by an institution that is aware of and actively engaged in efforts to extend and revise the essential body of professional knowledge in its areas of competence.
The second essential limitation on the Fund's operational activities is that it is a supplier of economic analysis and provider of policy advice; it does not, cannot, and should not determine or dictate the economic policies of its members. For program countries seeking the Fund's financial support, the pressure to negotiate a program consistent with Fund advice can be considerable. Even in such cases, however, economic policies depend largely on the authorities' judgment of what is desirable and feasible and on the willingness and capacity of the broader political system to pursue appropriate policies. The bright side, especially in surveillance cases, is that if the Fund supplies bad analysis or poor or infeasible policy advice, it can be ignored. Economic analysis and policy advice are generally available from a diversity of sources. The downside is that even sound analysis and good advice may be dismissed as ill-founded or may bow before political exigency.
To provide a more concrete idea of how the Fund's approach to macroeconomics is applied in practice, is useful to look at some recent experiences from Asia. As is generally true for countries around the world, it is important to distinguish between Fund surveillance and the Fund programs. The distinction is important because what needs to be done for a country whose macroeconomic health is seriously impaired is not a representative indication of what is needed and desirable to achieve and maintain good health in less dire circumstances. From personal experience of a year ago, I can tell you that the risk, discomfort, and expense of treatment for heart failure is not to be recommended for someone in good health, but can be highly worthwhile of someone with severe cardiac malfunction. Similarly, when a country is experiencing an intense balance of payment crisis, the Fund does generally recommend tight monetary and fiscal policies and often exchange rate adjustments to deal with such situations.
Because the Fund's operational work comes to public attention primarily in program cases and most intensively in cases of economic crisis, the impression is falsely created that the policies the Fund recommends in these circumstances are the universal Fund prescription for all countries in all circumstances. This is a general problem. There is an old motto in the media business, "Dog bites man, that's not news: Man bites dog, that is news." Thus, the impression one gets from the media is not one of dogs biting people, but rather of people running around biting dogs. Although it may be hard for some such critics of the Fund to believe, there are actually circumstances in which the Fund does recommends "expansionary" macroeconomic policies. Such recommendations, it might be noted, are not always greeted with enthusiasm--and I have some scars to prove it.
One important example in this regard is Japan during the past decade. In the late 1980s, partly as a consequence of a monetary policy that was allowed to be too expansionary for too long, Japan developed a "bubble" economy where equity prices and real estate values were pushed to irrationally high levels and where general business investment also expanded unreasonably in the face of very low capital costs. An unavoidable consequence of the inevitable collapse of the bubble economy was a substantial slowdown of economic growth. The tightening of Japanese monetary policy in 1989-91 helped to bring this about--and no other policy could have avoided it. However, it was clearly desirable to avoid an unduly large or prolonged decline in Japanese economic activity. Hence, after the bubble had been deflated, it was appropriate to ease monetary conditions in Japan, as was done by the authorities and endorsed by the Fund. Indeed, when the Japanese recovery was undermined by the strong appreciation of the yen in 1993 and again in 1995, the Fund urged further easing of monetary policy in Japan somewhat ahead of the authorities' decisions to implement such easing.
The strong fiscal position of the Japanese Government at the start of this episode also allowed considerable room for the automatic fiscal stabilizers to cushion downward pressures on activity and even allowed for discretionary action to countervail the predictable adverse consequences of the collapse of the bubble and of strong yen appreciation. This too was recommended by the Fund, sometimes somewhat in advance of actions by the Japanese authorities. I might note that it is quite rare for the Fund to recommend discretionary fiscal expansion anywhere around the world--and rightly so. Experience shows that discretionary fiscal action is difficult to time correctly and that discretionary fiscal expansion is politically difficult to reverse at a later stage. In contrast, allowing the automatic fiscal stabilizers to operate in a period of economic weakness is a frequent component of Fund advice, except in economies where concerns about confidence are an outweighing factor.
Another important example of Fund macroeconomic policy and advice in the Asian context, both in surveillance and in program mode, is India during the 1990s. As Montek Singh is one of my discussants, however, I will leave the description to him. Why listen to the monkey when you can hear it directly from the organ grinder?
A third example--the example du jour-- is Thailand.
As has been reported elsewhere, in its surveillance activities, the Fund was well aware of the emerging problems in Thailand, both specifically with the exchange rate and the balance of payments and more generally with the weakness in the economy and in the financial system. These concerns, along with relevant policy recommendations, were made known to the Thai authorities well in advance of the present crisis.
Was a better outcome possible in the case of Thailand? If so, why was it not achieved? And, what are the lessons for improvement in the future?
First, it is essential to recognize that no economy grows perfectly in line with its potential indefinitely or avoids occasional significant difficulties. Pegged exchange rate regimes are sometimes subject to intense pressures necessitating parity adjustments. Floating exchange rate regimes have their own deficiencies of shorter-term volatility and occasional serious misalignment. The best achievable economic policies, and the best advice about such policies even if rigorously adopted, will not avoid all of these difficulties. Allowing wide room for the operation of market forces is essential for achieving reasonable efficiency in resource allocation and for disciplining government policies. But markets, particularly financial markets, are subject to "irrational exuberances" on the upside and to overreactions on the downside. This is the real world, and we shall all have to live with it.
Second, that being said, careful analysis of many past economic crises clearly indicates that the economic difficulties presently afflicting Thailand (and spreading more broadly in the region) could have been lessened if appropriate adjustment policies had been forcefully implemented at an earlier date. By early this year, it had become clear that Thailand's large current account deficit could not continue to be financed and that sustained defense of the fairly rigid peg of the baht to the U.S. dollar was no longer viable. Despite its strong performance over many years, various weaknesses affecting the Thai economy and financial system implied that adequate and timely reduction of the current account deficit could not prudently be achieved solely by a severe and prolonged tightening of domestic financial policies.
Depreciation of exchange rate by itself, however, was not the answer. As often happens in such situations, depreciation was likely to generate a sharp adverse shock to confidence, both at home and abroad; and maintenance of reasonable confidence would clearly be important to avoid a self-reinforcing overreaction in foreign exchange and financial markets. To reinforce confidence, a moderate but meaningful tightening of the fiscal position was called for, despite Thailand's long record of sound budgets. Moreover, an improved fiscal position would also be needed to confront the likely public sector costs of dealing with severe problems in the financial sector. A determined effort to confront these financial sector problems, in manner that would both limit public sector costs and diminish moral hazard problems for the future, was an equally vital element in the recommended package of policy adjustments.
If an exchange rate adjustment had been combined with a forceful package of fiscal adjustments and financial sector reforms at an early stage, when Thailand's reserves were still quite large, external financial support might not have been needed for a successful result. Such support, nevertheless, could have been useful to underpin confidence as a signal of endorsement by the international community of Thailand's policy program.
Third, despite ongoing market pressures and other evidence of the need for action, the introduction of a forceful package of policy measures was delayed through the spring, and capital controls and exchange controls were introduced in an (ultimately unsuccessful) effort to ward off speculative pressures against the exchange rate of the Thai baht. The reasons for delay were manifold. Thailand had successfully financed large current account deficits for several years, and its high-growth and high-savings economy suggested to the unwary no absolutely compelling reason that this could not persist. Like going to the dentist, it is part of human nature to put off painful adjustments when the need for them is not absolutely compelling and immediate. Moreover, the existence of a large volume of uncovered foreign currency borrowing by the Thai private sector meant that a significant exchange rate depreciation would cause considerable economic losses and raise additional concerns about the financial sector. Also, the coalition government in Thailand was not in a strong political position to take necessary but painful economic measures, even if the need for such measures had been fully recognized. In most, if not all, of these respects, Thailand in 1996-97 was not very different from many other countries that have faced similar difficulties in the past--and, unfortunately, are likely to do so in the future. The incentives to delay recognition of a problem and action to correct it normally tend to be quite strong.
Fourth, in the event, a depreciation of the Thai baht was forced by market pressures in early July. Subsequently, the Thai authorities committed themselves to a strong package of fiscal measures and financial sector reforms in the context of a standby arrangement with the Fund which was supported by large additional financial resources supplied by a group of Asian countries led by Japan. Nevertheless, the Thai baht depreciated somewhat further, and as of mid September, market confidence in Thailand clearly remained fragile. (Also, effects from events in Thailand continued to spill over to other South East Asian economies perceived to have problems qualitatively similar to those of Thailand.) In my view, part of the reason for this is that actions and commitments undertaken under duress usually do not carry the same conviction with the market as the same policy actions and commitments undertaken before a crisis is full blown. This is especially so for commitments to policies that cannot be put in place all at once and that are expected to be painful and difficult to implement--as will surely be true with the reforms of Thailand's financial sector. Also in the case of Thailand, as has happened too often before, large reserve losses and commitments to forward sales of foreign currencies during the last few weeks before the height of the crisis significantly weakened the apparent capacity of the Thai authorities to manage conditions in the exchange market in the aftermath of the crisis.
Fifth, while the economic crisis in Thailand was in many respects a classic balance of payments and exchange rate crisis, it clearly was not a crisis generated by excessive public deficits or money creation. The Thai budget was in surplus through last year. Inflation was generally well contained, and domestic interest rates had in fact been firmed to restrain overheating in the private sector economy. Aside from the exchange rate that had become moderately overvalued in real terms, the main failure of government policy was to adequately supervise and regulate activities in the financial sector. Even with adequate supervision and regulation, largescale capital inflows probably would have contributed to an unsustainable boom in the domestic economy, especially in the real estate sector. However, the inadequacy of supervision and regulation of Thai finance companies significantly exacerbated this problem, and the very weak condition of many financial institutions was clearly a deterrent to more timely and effective actions to confront the balance of payments and exchange rate problems.
Thailand is far from unique in having such serious structural deficiencies in its financial sector which can have dire macroeconomic consequences--as has been detailed in recent studies published by the Fund. Recognizing this important issue, a broad international effort is being mounted to generate greater recognition of these financial sector problems and of the best methods for dealing with them. The development of "core principles for effective banking supervision" by the Basle Committee is an important step in this effort. A special conference at this Annual Meeting is taking up these issues in greater detail. More broadly, recent events in Thailand and elsewhere in Southeast Asia reinforce the general lesson that more attention needs to be paid to vital structural issues in macroeconomic analysis and policy advice. This is an important and ongoing focus of research and operational work in the Fund. Greater focus on structural financial sector issues is a quite general concern in many emerging market countries, especially in the present environment of increasing international capital mobility. For many industrial countries with high rates of unemployment, the labor market is perhaps an even more important focus of concern. Across the membership of the Fund, issues of equity and good governance which can have important macroeconomic implications are a growing area of concern.
Finally, to end on a more positive note, I might suggest that part of reason why the crisis in Thailand, and more broadly in South East Asia, has been more disturbing and disruptive than it needs to have been is because it was so unexpected. After more than a decade of consistently strong growth in the economies of the region, without significant macroeconomic instabilities, and with the apparent prospect to sustain rapid and sound growth, the idea had grown that a major economic crisis like Mexico and Latin America in 1995 really can't happen in this region of the world. Complacency is the mother of crises. This complacency affected not only the official sector which was late to recognize the need for corrective action, it also affected private financial markets which continued to supply generous inflows of capital somewhat beyond the prudent limit. Then when the crisis came, in classic fashion, the market overreacted to the downside.
Looking to the future, complacency is likely to be somewhat less of a problem--at least for a while. Warned by the experience of Thailand and its spillover effects, the official sector and the private market will be more cautious in the future, more attentive to recognize emerging problems before they become serious, and more open to take timely defensive or corrective action. Hopefully, the Fund will be able to play a constructive role in this process.