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The IMF and Good Governance -- A Factsheet
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By Horst Köhler
Managing Director of the International Monetary Fund
Inaugural Lecture on the Occasion of the Honorary Professorship Award at the Eberhard Karls University in Tübingen
Tübingen, October 16, 2003
It is a great honor and pleasure for me to return to my Alma Mater as Honorary Professor 34 years after graduation, almost to the day. I am grateful for this honor and I am particularly thankful that I had the opportunity to study at the Eberhard Karls University. What I learned and took in at the time, including during my work as Senior Research Fellow at the Institute for Applied Economics then under the direction of Professor Alfred E. Ott, has been of great help to me in my subsequent professional career. It is therefore a special pleasure for me to welcome some of my former teachers here today. It is they, in particular, to whom I owe gratitude. I would like to add, however, that they are in no way to blame for the economic policy imperfections that may have accompanied my career.
A practical definition of globalization
Searching in Google under the key word "globalization" yields more than 5 million hits — ample proof that both interest and definitions abound. For most economists globalization primarily means a process of increasing international division of labor and the accompanying integration of national economies through trade in goods and services, cross-border corporate investments and financial flows. This integration is boosted by technological progress, in particular in transport and communications. Ideally, globalization is a win-win proposition, in which all economies ultimately benefit through productivity and growth effects. However, it also means that these economies face rising cross-border competition, requiring constant change and adjustment. And it is not simply forced upon us, but is rather the result of forces of change that are deeply rooted in human nature: the drive for freedom and a better life, for new discoveries and broader horizons.
Globalization therefore has more than merely an economic dimension. And it encompasses problems that go far beyond economics. Environmental problems, contagious diseases, and organized crime do not have national borders any more. And the question posed by Samuel Huntington in the early 1990s whether globalization will lead to a "Clash of Civilizations" has become even more relevant at the beginning of the 21st century.1 Today however, I will focus mainly on the economic implications and challenges posed by globalization.
A brief history
Globalization is not a recent phenomenon. Back in the 11th century the Venetian Republic based its prosperity on trade with other cities and regions. The 16th century, the age of the Portuguese, Spanish, and Dutch voyages of discovery, gave further impetus to global integration through rapid advances in maritime technology. However, the first comprehensive boost to globalization occurred in the second half of the 19th century, with the harnessing of electricity, the invention of steam engine, the expansion of the railways, and establishment of the gold standard.
It is important to remember, however, that this first great wave of global economic trade and financial integration was interrupted by a phase of protectionism and aggressive nationalism, leading to the Great Depression of the 1930s and World War II.
The willingness to resume international cooperation after World War II — not least thanks to the revival of the United Nations and the creation of the International Monetary Fund and the World Bank — resulted in a second great wave of global economic integration. The main beneficiaries of this development were the industrialized countries, where real per capita income more than tripled in the second half of the 20th century; in Germany it increased even fivefold.
However, a recent comprehensive World Bank study clearly shows that opening markets and integration into the global economy have contributed to enormous economic progress for many developing countries, too, particularly in the last 20 years.2 In this third wave of globalization, developing countries such as Brazil, China, India, and Mexico have doubled their ratio of trade to income. And many of these countries now no longer export only raw materials, but also finished products and services. In India, for example, IT exports today account for nearly 40 percent of export earnings.
These "new globalizers", with a combined population of more than 3 billion people, have on average increased their annual per capita economic growth from 1 percent in the 1960s to 3 percent in the 1970s and 5 percent in the 1990s. In China, for instance, real per capita income has increased more than fivefold since 1978 and the number of people living in absolute poverty has fallen by 200 million. This means that, mainly thanks to strong economic growth in Asia, global income distribution has improved rather than deteriorated.3 And we can observe progress in other areas, too: While in the industrialized countries life expectancy increased by about 10 years from 1950 to 1999, it increased by nearly 20 years in developing countries, and in India and China it increased by nearly 30 years.4
The risks of globalization
Yet not all people are benefiting from globalization. According to a World Bank classification, nearly 1.2 billion people — one fifth of mankind — continue to live in absolute poverty, with incomes less than $1 a day.5 In many countries, durable economic and social progress remains elusive. In most of these countries, trade has decreased in the last 20 years and on average, economic growth has not kept pace with population growth. The situation in Africa is particularly dramatic because it is aggravated by the AIDS pandemic. I believe that the fight against global poverty is the greatest challenge for stability and peace in the 21st century.
Globalization is also linked to the accelerated expansion of international financial markets. In the last two decades, private capital flows to emerging market countries have overtaken public flows in terms of volume and variety. These capital flows surely boosted growth and development significantly in countries like Brazil or China. However, the volume and complexity of these flows — for instance with regard to the kind of financing (direct investment, portfolio investment, bank loans), maturity structure, currency pegs — raises many new questions concerning crisis vulnerability. Indeed, in the 1990s we experienced a series of financial crises in Latin America, Asia, and Russia with devastating economic and social consequences. The economic and political implications of these crises have been addressed extensively — by the IMF and others—including the extent to which international financial crises can be caused by developments in the financial centers of industrialized countries. And we also have to ask ourselves whether the deregulation of financial markets initiated in the 1980s has reinforced trends towards "irrational exuberance" (Alan Greenspan, 1996). I think that we still do not know enough about the causes and implications of financial bubbles. But when financial bubbles burst, as was the case in the late 1990s, they can have serious repercussions on the real economy. I therefore welcome the ongoing debate on how to strike the right balance between the free play of market forces in capital markets and the regulatory framework required to ensure their efficient functioning.
Globalization requires political management
Persistent poverty and recurring financial crises therefore rightly led to a critical debate on globalization. However, here, too, not all arguments are new. Adam Smith dedicated a major part of "The Wealth of Nations" to discussing the negative repercussions of the specialization and division of labor that accompanied the industrial revolution.6 One of his key recommendations was, by the way, the introduction of universal public education, and in Germany, for instance, more than 100 years were to pass before this objective was finally achieved. Justus Möser, a historian and statesman who lived in the Prince-Bishopric of Osnabrück in the second half of the 18th century can probably be considered one of the first anti-globalization activists since he was vociferous in the fight against increasing economic integration, and vehemently defended the role of guilds and the corporatist society. His misgivings that a free market economy destroys both jobs and national cultural identity, can be found in the globalization debate of today, too.7
From my perspective, globalization is neither good nor bad. It all depends on what we make of it — i.e. the extent to which we are able to exploit its opportunities and at the same time limit its risks. What we need is a better globalization. I therefore agree with the conclusion of German President Johannes Rau: Globalization must be shaped politically.8
I see six guide posts that can help us in our quest for a better globalization:
First, we must recognize that globalization requires formulating what I would call a "global domestic policy." We are all in the same boat and this increasing interdependence requires as a minimum that each country give more consideration to the consequences of its actions on others. Moreover, we must recognize that many problems can no longer be solved without multilateral cooperation. This applies, for example, to the alarming evolution of the current account deficit of the United States and the corresponding surpluses, primarily in Asia, but also in Europe. An orderly resolution of these imbalances, which pose a risk for sustained global economic growth, consequently requires a cooperative strategy involving all major economic areas.
Second, multilateral solutions can only work if they do not undermine national self-responsibility. At the recent Annual Meetings of the IMF and the World Bank in Dubai we clearly addressed the responsibilities of the individual countries: the United States must return to a balanced fiscal position in the medium term; in Europe and Japan, a return to sustained growth is not possible unless structural reforms are implemented vigorously. And developing countries have to recognize even more strongly that good governance, the rule of law, and the fight against corruption are essential for a good investment climate and effective poverty reduction.9
Third, the market has doubtlessly proven itself as the best coordinating mechanism between free agents. But there is also no doubt that market forces alone will not suffice. That is why we need an international regulatory framework for globalization, with recognized rules and effective institutions. This framework also has to ensure that global public goods such as international financial stability, a clean environment, and free trade are defined and provided, even if this means that nation states have to give up a part of their sovereignty. A political framework for delivering global public goods is provided by the UN, and in the economic area particularly through the World Bank, the World Trade Organization, the International Labor Organization, and the International Monetary Fund. And I also agree with the proposal by Mario Monti from the European Commission, that globalization requires a clearly defined international competition policy.
Fourth, the social dimension of globalization has to be given more consideration. Experience has shown, most recently in Latin America, that social equity is a crucial pillar of political stability and a sustained good investment climate. Social contracts differ across countries. However, we should reflect whether and how John Rawls's "Difference Principle" in conceiving of a fair and just society—tolerate inequalities only when they benefit the least well-off—can be used in international development policy.10
Fifth, we must ensure that globalization is not misunderstood as imposing a global harmonization of economic and social models. Without respecting human diversity globalization will not succeed. Indeed, we must regard the diversity of human experiences and cultures as part of the wealth of our planet. The market economy has many variations and I think that some degree of competition between systems is healthy for the world economy. It is in this spirit, for instance, that the IMF has granted technical assistance to several countries (Iran, Malaysia, Pakistan, Sudan) to support the development of different forms of Islamic banking as well as their regulation.
Sixth, I agree with Hans Küng that the world cannot survive without a global ethic. In this regard he is not calling for a new world ideology but for "...a basic consensus concerning existing binding values, absolute standards, and personal convictions."11 This ethic must respect human rights but also convey the idea that rights go hand in hand with duties. I think that the recent corporate scandals have proved right those business leaders who are guided by the conviction that ethical principles and striving for sustainable value creation are not incompatible with profitability and competitiveness.
These six guideposts are also the basis for my vision of the IMF's work toward a better globalization.
The fight against poverty
The dramatic and sometimes distressing scenes of poverty in the world should not make us lose sight of the fact that there is a remarkable degree of international consensus on the conceptual approach for fighting poverty. The concept has three key elements:
First, a specific objective: set at the UN level by the heads of state and government, the so-called Millennium Development Goals define objectives in eight key areas including, among others, halving absolute poverty and reducing child mortality by two thirds by the year 2015.
Second, a partnership for development: at the International Conference on Financing for Development held in 2002 in Monterrey, Mexico, industrialized and developing countries agreed that greater efforts on the part of poor countries, particularly to ensure good governance and a better investment climate, must be matched by more comprehensive support from the industrialized countries.
Third, a concrete implementation plan: every developing country establishes its own long-term poverty reduction plan in the form of so-called Poverty Reduction Strategy Papers. These plans provide for a broad-based consultation process involving civil society and set priorities for development (education, health, rural development, strengthening of the investment climate, fighting AIDS).
It is encouraging that African leaders themselves have reflected this concept in their New Partnership for Africa's Development (NEPAD). Hence, it is not very productive, in my view, to reembark on a search for new strategies to fight poverty every six months. What is important now is to ensure that all parties involved live up to their responsibilities in this partnership. I am pleased that IMF's Governors urged us at the Annual Meetings in Dubai to continue to play an active role in the fight against poverty in our areas of expertise.12 And under my leadership we will do so.
Experience shows that economic growth is essential for reducing poverty. And consequently, NEPAD is right to set a goal of achieving sustained growth of at least 7 percent per year in Africa. In my view, this is ambitious but doable. However, achieving this goal depends to no small extent on integrating African countries more strongly in international trade. Trade is the best form of self-help. To the disappointment of many, there was a set-back in the multilateral trade talks in Cancún a few weeks ago. But in Dubai there was general agreement that Cancún must be seen as a wake-up call for parties to return to the negotiating table as soon as possible. There is simply no economic or moral justification for spending over $300 billion annually to support the agricultural sectors in the industrialized countries, while overseas development assistance reaches barely $50 billion. Any reform of the multilateral trade system must set the stage for a further opening of markets in both the northern and the southern hemispheres and for drastically reducing trade-distorting subsidies, particularly in agriculture.
Effective poverty reduction also requires more financial support, including through further debt relief. And I will not cease to remind the industrialized countries of their commitment to spend 0.7 percent of their gross national products on development assistance, mainly in the form of grants rather than loans. In Germany the ratio of official development assistance to GNP is 0.26 percent. This is about the same amount the federal government and the Land North Rhine-Westphalia spend on coal-mining subsidies. Anyone looking for causes and culprits for injustice in the world should at the very least reflect upon this number. It is a concrete expression of current social preferences in Germany.
Strengthening the international financial system
Since the Asian crisis, the international financial system has undergone significant reform. In my opinion, this has contributed to the remarkable resilience of financial markets in the face of a series of shocks over the past three years. There has been progress on three fronts:
First, the international dialogue has been broadened and made more inclusive. Developing countries and emerging market countries are increasingly involved in the discussion on the strengthening of the international financial system, for instance in the committees of the Bank for International Settlements (BIS) and through the creation of the G-20, where the finance ministers of industrialized countries and of systemically important emerging market countries regularly meet. Moreover, on the occasion of the G-8 summit of industrialized countries that was held in June of this year in Evian, France, the French president invited leaders from a wide array of emerging market and developing countries to join in a broad discussion of global economic issues. Participants included heads of state and government from Algeria, Brazil, China, Egypt, India, Mexico, Malaysia, Morocco, Nigeria, Saudi Arabia, Senegal, and South Africa, as well as UN Secretary General Kofi Annan and the heads of the World Bank, the IMF, and the World Trade Organization. I think that this format of international dialogue has a potential to strengthen global governance significantly.
Second, 1999 marked the establishment of the Financial Stability Forum, consisting of high ranking representatives of finance ministries, central banks, and supervisory agencies of the G-7 countries and major international financial centers. The explicit mandate of the FSF is to identify gaps and weaknesses in the international financial system. For example, I believe that we still know far too little about who bears the ultimate risks of derivative transactions or hedge funds and where the responsibility for their supervision lies.
Third, the IMF as a multilateral institution with 184 members is focusing more than ever before on crisis prevention. The foundation for this task is our bilateral and multilateral surveillance work, that is the regular examination of economic developments and economic policies at the national and international level. The basic pillars of our multilateral work are the semiannual World Economic Outlook and Global Financial Stability Report. In the WEO, for instance, we recently analyzed the risks of global deflation and in the GFSR we have started to examine the causes of volatility in financial markets. I also attach great importance to the results of a special study conducted by our Research Department suggesting that there is a clear positive correlation between sound institutions and economic growth. It underlines the relevance of "Ordnungspolitik"—that is an economy's institutional and regulatory framework—for crisis prevention and poverty reduction.13
In our bilateral dialogue with members, the focus of our advice has shifted considerably since the Asian crisis (1997-98). We are concentrating increasingly on identifying vulnerabilities—such as excessive sovereign debt or balance sheet mismatches. We recommend that capital account liberalization be preceded by a thorough assessment of the capacity to ensure effective financial supervision. And we advise our members to incorporate better shock absorbers in their economic policy, for instance through more flexible exchange rates, fiscal policies that maintain room for maneuver in difficult times, efficient and diversified financial sectors, and effective social safety nets. Moreover, together with the World Bank, we draw up profiles of strengths and weaknesses of our members' financial sectors as part of our Financial Sector Assessment Program. So far, we have completed more than 50 country analyses. In addition, this program has been extended to off-shore financial centers.
Since the Asian crisis, the international community has also developed a number of standards and codes in the economic and financial area, promoting meaningful comparable statistics, transparency rules for fiscal and monetary policies, and supervisory standards for the banking, securities, and insurance sectors. We are helping our members to implement these standards to facilitate their integration in the global economy. In addition, together with the Financial Action Task Force (FATF),we have developed a methodology to assist countries in their efforts to counteract money laundering and the financing of terrorism.
And in all our activities we are working hard to strengthen the transparency of economic data and policies. In this respect there has been a veritable revolution. This also holds true for the IMF itself. Today nearly all country and policy documents are published.
However, past experience also suggests that a degree of modesty and realism is warranted. A well functioning market economy draws its strength and dynamism from competition, i.e., the constant striving for better results, better products, and higher productivity. We must acknowledge that overshooting and correction will always be part of this process. This means that in an open and dynamic market economy there are limits to our capacity to anticipate and prevent crises. Our objective can only be to have fewer and less severe crises. And, even in the event of a crisis, self-responsibility is indispensable, if only to minimize moral hazard. Consequently, the IMF cannot be a lender of last resort in the sense of limitless availability of liquidity.
Unfortunately, the Fund's proposal to establish an international insolvency procedure for unsustainable sovereign debt failed to achieve the high level of support required to amend the IMF's Articles of Agreement. However, our work has not been in vain. Not only has the discussion raised public awareness of this issue but it has helped to achieve a breakthrough in the introduction of Collective Action Clauses (CAC) in sovereign bonds. These will at least make it much more difficult for individual creditors to block an essential debt restructuring.
The IMF as a learning institution
In my view, the IMF must remain a learning institution. In recent years, we have introduced a series of reforms recognizing that changes in IMF policies were necessary. And in order to be effective in the global economy the IMF must remain open to change. In this process, I am convinced that the recommendations of the Independent Evaluation Office established two years ago will play a vital role.
In 1991 the philosopher Karl Popper said: "The open future contains unforeseeable and morally quite different possibilities. So our basic attitude should not be ´What will happen?' but ´What should we do to make the world a little better?'."14 To me this is how we should approach today's topic, too. It would be neither wise nor feasible to try and turn back the clock. We must look ahead and work to match global problems with global solutions that are both practical and can garner sufficient consensus. My vision for the IMF is to contribute to a better globalization. And I would like to encourage economics students here in Tübingen to take time to reflect on global economic issues. They are certainly not always straightforward, but they are always exciting. And we still need many good answers to create a genuinely better world. Please join me in this effort.
1 Samuel P. Huntington, The Clash of Civilizations?, Foreign Affairs, Summer 1993.
2 Globalization, Growth, and Poverty; A World Bank Policy Research Report, World Bank and Oxford University Press, 2002.
3 Stanley Fischer, Globalization and its Challenges, Richard T. Ely Lecture, January 2003; and Xavier Sala-i-Martin, The Disturbing "Rise" of Global Income Inequality, NBER Working Paper 8904, April 2002.
4 Angus Maddison, The World Economy: A Millennial Perspective, OECD 2001.
5 The World Bank defines absolute poverty as per capita income of less than US$1 a day (adjusted for purchasing power parity). In 1999, the last year for which a World Bank estimate exists, the number of people living in absolute poverty was 1.169 billion. However, this number is not undisputed. Surjit Bhalla, for instance, argues that absolute poverty is only half as high (Bhalla 2002).
6 Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, ed. R.H. Campbell and A.S. Skinner (The Glasgow Edition of the Works of Adam Smith, Oxford 1976).
7 See, for example, the chapter on Justus Möser in: Jerry Z. Muller, The Mind and the Market — Capitalism in Modern European Thinking, New York, 2002.
8 Opportunity, not fate — Giving globalization political shape, Berlin Address by Federal President Johannes Rau in the Communication Museum, Berlin on May 13, 2002.
9 The fact that corruption is in no way problematic in poor countries only but increasingly also in industrialized countries is shown in the latest report of Transparency International (Corruption Perception Index 2003, October 2003).
10 John Rawls, A Theory of Justice, 1971.
11 Hans Küng (ed.), Dokumentation zum Weltethos (Documentation on the Global Ethic), Munich/Zurich 2002.
12 Long-term development work is and remains the World Bank's responsibility.
13 Interestingly, there is no English word for "Ordnungspolitik". On the other hand, there is no German word for "governance".
14 Karl R. Popper, All Life is Problem Solving, R. Piper, Munich 1996.
IMF EXTERNAL RELATIONS DEPARTMENT