September 19, 1997
I would like to compliment Michael Mussa on a very thought-provoking and witty paper which touches on all the important issues that are relevant in evaluating the role of the International Monetary Fund as it has evolved over time. I particularly liked the characterization of the IMF as a sort of "macroeconomic doctor." The medical analogy lends itself naturally to treating Article IV consultations as "annual check-ups" while viewing Fund programs as unfortunate, but possibly unavoidable, spells of hospitalization which also helps to explain why Fund programs attract controversy-- hospitalization is rarely pleasant however good the hospital.
Michael mentioned en passant that he would not deal with the Fund's experience with India as he expected me to deal with this issue. I suspect he wanted me to put in a plug for the Fund's macroeconomic health care system based on India's experience. India's experience with Fund programs has indeed been very salutary. India went to the IMF in 1981 and again in 1991; the treatment was clearly successful on both occasions. India was able to terminate both programs earlier than originally expected, and in both periods the "post-hospitalization" health of the economy, in terms of growth rates of GDP and other indicators, was not only significantly better than before the crisis, it was also better than what was projected during the program period.
And yet, the programs attracted considerable controversy at the start. Some of this is understandable. After all, countries adopt Fund programs only when they face serious problems, and if there are serious problems it is natural--especially in a highly participative democracy with an unambiguously free press as prevails in India--that there will be blame, accusations, and inevitably, different views on how to set things right. The fact that Fund conditionality is seen as being externally imposed can add to the controversy even when there is agreement on what needs to be done. I discovered this in connection with our IMF program of 1981 when I was invited to defend the government of India's letter of intent at a seminar on the subject in the University of Delhi. The government was furiously attacked by those who disagreed with the usual conditions restricting credit to the government sector. It was also criticized by a charming elderly professor, for having accepted externally imposed conditions. This gentlemen clarified that he had absolutely no problem with the Fund conditions, but he felt we should have adopted them on our own, without taking financial assistance from the Fund. Indeed he argued that if the government had adopted tighter conditionality than the Fund had proposed, we would have been able to get out of the crisis without any additional financial support. But this sort of criticism was the exception. More commonly, Fund programs are criticized because of disagreement about their basic approach, especially their restrictive impact upon government expenditure. The tendency of Fund programs to restrict public sector investment has been a constant source of concern about the programs among developing countries largely because public investment is often associated in the public mind with developmental objectives. More generally, restrictive policies limiting investment whether public or private met with similar responses.
Attitudes changed dramatically in the 1980s with the wave of economic reform which swept developing countries, and this change was reinforced in the 1990s by a similar wave in the countries in transition. The result is a broad-based consensus on the elements of good economic management, especially on the need for fiscal discipline as a core requirement for macroeconomic stability, and on the need for structural reforms to promote efficient growth. The consensus is obviously more evident in periods of normalcy than in periods of crisis, but even so it is substantial and this should make it much easier to design Fund programs without attracting too much controversy.
However, other developments have made the Fund's task more difficult. One of these is that the Fund has decided to accept a large number of objectives. It no longer views itself as being concerned only with stabilization. I recognize that it was never concerned with stabilization alone--maintenance of "high levels of employment and real income," for example, is one of the objectives listed in Article I--but broader objectives of achieving high rates of growth, which have always been important in developing countries, were not explicitly recognized and were typically subordinated in the short run to the task of stabilization. Over the years the Fund has refined its definition of objectives very considerably. Objectives relating to economic growth were incorporated into Fund analysis by the 1980s, and were typically reconciled with deflationary policies in the short term by focusing on efficiency inducing structural reforms as the key instrument for promoting growth. More recently, the Fund's objectives were expanded to include the distributional implications of adjustment programs, especially the impact of these programs on the poor. This in turn led the Fund to modify its traditional recommendation to reduce the fiscal deficit, by tempering it with concern about the "quality" of fiscal deficit reduction. It is no longer sufficient to "adjust" by reducing government expenditure--the focus now is on reducing the "wrong" kind of expenditures (administrative expenditure on bloated bureaucracies, untargeted subsidies, financing of public sector losses and a variety of other non-productive expenditure), while maintaining adequate levels of the "right" kind of expenditure (i.e. public investment in health, education, and non-privatizable infrastructure), and perhaps even substantially increasing expenditures specifically aimed at cushioning the impact of adjustments on the poor.
The adoption of multiple objectives reflects a realistic recognition of the complex balancing act involved in designing adjustment programs in practice, but it certainly makes the design of Fund programs much more subject to dispute on purely technical grounds. Multiple objectives introduce familiar problems of trade-offs among objectives, e.g. between growth and investment objectives on the one hand and stabilization on the other, which are not easy to handle. Michael has stated that we are limited in designing Fund programs by the state of accumulated wisdom on these issues. This limitation is obviously magnified if the number of objectives is increased as it has been. Most recently, the Fund has added yet another objective derived from the growing concern with governance issues, an objective which is extremely difficult to quantify, let alone incorporate into a macroeconomic program.
One may be forgiven for looking back with some nostalgia at the old, grandmotherly approach of the Fund in the days of the par value system, when it was primarily concerned with bringing about stabilization when par values were threatened. The objective of those programs may have been narrow, but the range of policy alternatives under consideration was correspondingly narrower, and few doubted that the medicine prescribed by the Fund would at least succeed in achieving the stated objectives, whatever it may do to other objectives not explicitly recognized.
Multiple objectives apart, the task of the Fund has also become more difficult because financial markets have changed dramatically in the past two decades. Two changes which make surveillance and the design of programs much more complicated are worth mentioning. The first is the collapse of the system of fixed but adjustable exchange rates and the adoption of flexible exchange rates by most countries. This has made things easier in some respects by giving countries more flexibility in pursuit of domestic policy than they had under the par value system. However, this additional flexibility has also meant that adjustments needed in some dimensions can be more easily postponed by allowing exchange rates to adjust. Fiscal imbalances, for example, may not generate the same immediate pressure for correction in a world where exchange rates can adjust. This can be reflected in an accumulation of problems which are that much more difficult to handle when they are finally addressed.
The second development making the task of the IMF more difficult is the globalization of international capital markets and the resulting explosion in the size of private capital flows, including flows to many developing countries. Easier flow of private capital has many advantages but it also creates problems, especially in a world of fluctuating exchange rates where expectations of exchange rate depreciation can trigger large speculative flows. This adds new elements of vulnerability for countries with high levels of liberalization of the capital account and inadequately developed financial markets. The size of the shock that a country can experience can be very large for any given failure in economic performance simply because negative developments, or developments perceived to be negative, can lead to disproportionately large outflows of portfolio capital because of "herd instincts." A country could also experience shocks for reasons unconnected with its own economic performance because of so-called "contagion effects," which again can be disproportionately large. These new areas of vulnerability are bound to make the role of the IMF that much more difficult not only in evaluating performance and conducting surveillance, but also in designing and funding programs.
Some of these problems are exemplified by recent events in southeast Asia where member countries have run into problems despite having strong fiscal positions. Thailand had a large current account deficit, comparable to Mexico's in 1994, but as in the case of Mexico there was no evidence of fiscal stress. It is now being said that the key weakness in southeast Asia is fragility of the banking system. The Fund staff used to be chided for believing that "IMF" stands for "It's mainly fiscal." There is an equal risk of over-simplification in believing that it stands for "It's mainly fragility." Financial fragility is undoubtedly important and is a legitimate concern of Fund surveillance, but it has to be recognized that in practice it will be extremely difficult for the Fund to exercise surveillance effectively in this dimension. Unlike fiscal stress, which is relatively easily measured, the extent of financial fragility in a banking system can only be evaluated on the basis of extensive flow of information through an effective supervisory system. Even then it is extremely difficult to be confident about the underlying health of bank portfolios in a world where interest rates and exchange rates are more volatile, both of which could impose sudden strains on banks and financial institutions.
The Fund's task in assessing financial fragility will be further complicated because of the need to be cautious in making public pronouncements on the health of a banking system for fear of precipitating a crisis before corrective steps can be taken. This is going to make surveillance functions very difficult when combined with what seems at present to be a very legitimate concern in its own right--the concern for transparency. It is difficult enough in normal times to come to an objectively defensible judgment on the degree of financial fragility, but it is much more difficult to come to a judgment that can be fairly shared without causing controversy. And yet the pressure on the Fund while conducting surveillance is to share and air its findings. Failure to do so will only mean that when problems arise, somebody is bound to raise the question: Was the surveillance good enough? I don't pretend to know how to solve this problem, but Michael's presentation turned my thoughts in this direction, and I think there are some difficult issues here which the Fund and the rest of us need to address to determine how well the Fund performs its role as a macroeconomic doctor.