Anne O. Krueger
Anne O. Krueger

Speeches

India and the IMF

IMF Surveillance -- A Factsheet

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Heeding Hippocrates: The IMF and the Reform Process
Address to the Council on Foreign Relations
By Anne O. Krueger
First Deputy Managing Director
International Monetary Fund
New York, November 22, 2004

Introduction

Good morning and thank you for that kind introduction, Peter. I am delighted to be here. It is always useful to get out of Washington and get a fresh perspective on our work at the Fund. So I am looking forward to the discussion this morning.

I should first elaborate on the title. At least some of you will have guessed that I was referring to that part of the Hippocratic Oath that warns doctors that they should first do no harm. This is advice that can—and should—equally apply to policymakers embarking on economic reforms. And it should be heeded by those of us who seek to advise and support policymakers committed to reform.

For doctors, of course, this part of the Hippocratic Oath has become more difficult to gauge as medical technology has advanced. As more powerful therapies have been developed, the choice of treatment has often become more complicated—something sufficiently powerful to do good might also have unpleasant side-effects. At what point does one outweigh the other? How does the doctor choose, especially when circumstances require a quick decision?

Policymakers face equally acute dilemmas. Action to deal with a pressing problem might have unwelcome but inevitable short-term consequences. A government that takes the measures necessary to curb soaring inflation might, in the short term, have to accept rising unemployment. A necessary evil we economists might say: but those losing their jobs might not see it quite like that.

Policymakers also have to consider that inaction can inflict economic harm. Failing to curb inflation, doing nothing about overly rigid labor markets, ignoring the need to bring government borrowing under control—these will all undermine economic performance. They might not do so during the time horizon of elected officials, however, which is another factor those seeking to guide policymakers must take into account.

I want this morning to share some observations about the economic reform process and set out where I think the Fund can help policymakers develop sound economic policies. I then want to say something about the prescriptions for policy reform.

The Fund and economic reform

Let me start by reiterating something so obvious to us all that it sometimes gets overlooked. Reform is above all a process, and a continuing one at that. So often we talk about reform as if it is a single step, or a discrete, finite group of steps. It is not, of course. We need look no further than Washington and look at the scale of economic reforms envisaged by President Bush for his second term to appreciate that. The United States is the world's largest, most sophisticated and dynamic economy: yet it is that very dynamism that ensures it is continuously evolving. Economic policy, in turn, needs to adapt to the needs of the evolving economy if it is to facilitate economic growth

So we are talking about a process that has no end and those who speak of "reform fatigue" or of the need for a pause in the reform process rather miss the point. Failure to push on with reforms will at best stifle growth; and at worst undermine macroeconomic stability. The chance to improve living standards and reduce poverty will be diminished if not lost; and any improvement in living standards or reduction in poverty will be less than it might otherwise be.

It is against this background that I want to outline the Fund's role in the reform process. I think there are four aspects we need to consider: the objectives of the reform process; the balance between what is economically desirable and politically feasible; the circumstances in which reform programs are undertaken; and the IMF's relationship with national policymakers. Let me take each of these in turn.

First, the objectives of the reform process. When embarking on economic reforms, policymakers need always to have a clear vision of what they hope to achieve, and why. It is important to distinguish clearly between ends and means. Fiscal discipline is essential as a means because without it there cannot be macroeconomic stability, and without that, sustained rapid growth will prove elusive. It is growth that is the ultimate objective. The failure to set objectives with clarity can lead to misunderstandings, both about the objectives of economic policy in general and about the Fund's role in particular.

In working with our 184 member countries, the Fund's overarching aim is the promotion of international financial stability and therefore economic growth. The two are inextricably interlinked, and this was clearly understood by the founders of the Bretton Woods institutions sixty years ago. A stable international economic and financial environment is vital for sustained economic growth and the rising living standards and lasting poverty reduction that only growth can bring.

How we work towards those objectives has changed over time, of course—the Fund must also continue to adapt as the global economy evolves. But the objectives remain the same. We exist to maintain international financial stability, without which economic growth in our member countries will be elusive.

Pro-growth policies are not a new IMF invention—the advocacy of such policies has been at the core of our work since our inception. And let's face it, rapid economic growth is not a new phenomenon either. The postwar record among both industrial and developing countries alike has been one of spectacular growth performance, with no historical parallel. Think of Germany's rapid recovery from the destruction of the Second World War, or the Japanese miracle; Korea, the Asian tigers, and more recently China and India. And that list doesn't include the United States, the locomotive of global growth for virtually the whole of the postwar period.

Sound macroeconomic policies have delivered sustained and rapid growth and that in turn has resulted in rapidly-rising living standards and poverty reduction on a dramatic scale. In the 1990s alone, an estimated 200 million people escaped poverty, mainly in India and China.

The pursuit of pro-growth policies can involve some tough decisions. Economic adjustment can be painful in the short-term: that is why adequate social safety nets are important. And there is a trade-off between the strength and speed of adjustment and the improvement in growth performance that can be achieved. But the development of macroeconomic stability; putting government finances on a sound footing; curbing inflation; liberalizing trade as well as labor and capital markets; and institutional reform are all essential if growth is to be sustainable over a long period.

The difficulty of the adjustment process brings me to the second aspect of the Fund's role in economic reform: the need to strike a balance between what is economically desirable and what is politically feasible. This is an area fraught with difficulty, of course, because it involves highly subjective judgments.

Let me illustrate what I mean. Some years ago, before I joined the Fund, I became involved in the reform process in a country that shall remain nameless. (This is a true story, but it could as easily be an apocryphal one.) Economic policymakers with whom I was working drew up proposals for quite radical changes—a big reduction in the budget deficit, a substantial devaluation, and so on. I was asked to support them as they argued their case to the head of the government.

He listened very carefully and appeared persuaded of the case for change. He then went through the proposed policy changes one by one and sought to trim here and there. How much difference would it make if the devaluation was a shade smaller? If the budget deficit reduction a tad less ambitious?

These were all good questions and he knew it. Neither I nor those I was seeking to assist could say unequivocally that x% change was critical and that y% would be certain to fail. He, of course, had the task of selling the new policies at the political level. He had to marshal popular support for them. And those small changes he was inquiring about did matter in that context—at the margin they would soften opposition.

So it was difficult to mount a strong argument against any one change. What concerned me, though, was the cumulative impact of the small modifications the head of government wanted to make. The result of the changes did not mean that the reform program would necessarily fail. But it did mean that the room for maneuver was alarmingly small. There was no margin if the economy was confronted with external shocks—such as an unexpected rise in global interest rates or energy prices, or a sudden fall in commodity prices.

We were dealing in that grey area where what is economically desirable can be politically difficult to deliver. This is true of much of the process of economic reform. Political leaders, who have to take responsibility for policy changes, do not want to go further than they have to, they do not want to use up scarce political capital unnecessarily. Economists, however, want to build in as much room for maneuver as possible, to make policy as robust as possible.

This is a particular challenge for the Fund. Our advice has to reflect political realities. We want it to be accepted. So we cannot ignore the political and economic constraints that restrict policymakers' freedom of maneuver. Otherwise we would risk our advice being ignored altogether.

But we must guard against tailoring our advice in such a way that we appear to endorse policies that we know will be ineffective.

We must also recognize that there may sometimes be a distinction between a genuine constraint and a reluctance to adopt policies that are politically unpalatable in the short-term. Opposition to policy reforms might have wide popular backing, which is why governments have to carry their citizens with them. But opposition will often come from special interest groups who see their benefits at risk of erosion-protected industries opposed to trade liberalization measures, for example. Opponents of economic change might have political clout. But the interests of a narrow group rarely coincide with broader economic interests of society as a whole.

One important way we in the Fund seek to navigate these difficult policy areas is through our emphasis on what has become known as national ownership of the reform process. Governments—and their citizens—will not feel committed to a policy path if they are unconvinced of its desirability or its prospects for success. This lack of commitment will manifest itself in a reluctance to pursue a program of reform beyond the initial measures or in a willingness to make adjustments or concessions in the face of political opposition.

The Fund has always sought to ensure that member countries are fully committed to economic reform programs when these are supported by financial assistance from the Fund. It has always been the case that less than wholehearted commitment would be likely to lead to weak implementation and the risk of failure.

The extent to which the Fund's advice is sought and heeded will depend on the specific circumstances in which reforms are undertaken—the third point in my list. Clearly if reforms are introduced in response to a crisis, speed will be of the essence. The need for urgent action to deal with a short-term crisis—whether it be capital outflows, a collapse of confidence in the banking system, or hyperinflation or, indeed, any economic shock—will override everything else. There will be no time to prepare a detailed, long-term program of reform. That will have to come later.

But a crisis can make it easier to undertake radical reforms because opposition is likely to be more muted. It can be easier for governments to argue that sweeping changes are an essential component of longer-term recovery and necessary to prevent further crises. Exploiting the window of opportunity means policymakers have to act swiftly not just to deal with the immediate crisis but to put in place a broader reform program. It could therefore be argued that the policy community could make a significant contribution to crisis resolution by having a blueprint for action in the event of crisis ready for implementation or at least at an advanced stage.

Acting pre-emptively, introducing reforms before a crisis strikes, gives policymakers more breathing space. There is time to put together a coherent and comprehensive plan. But implementation might be correspondingly more difficult because there is time and opportunity for opponents of change to act. Sectional interests might find it easier to marshal broader support for opposition to reform because the sense of crisis may be absent (even until quite a late stage before a crisis erupts).

Crisis, or the absence of one, is also likely to affect the last issue I mentioned—the Fund's relationship with individual member countries. Financial assistance from the Fund, in support of a program of economic reform, means that the Fund will be more closely involved in work on a reform program. And the Fund cannot lend without some assurance that policies put in place that will bring about a sustainable result.

Almost by definition, Fund-supported programs come at a time when policymakers must act in response to a crisis. At such points there will be little scope for debate about the appropriate measures because the circumstances of the crisis will largely determine what action is needed.

But for a large number of Fund member countries, the primary relationship with the Fund is through our Article IV surveillance consultations—annual, except for a very small number of countries where they might be slightly less frequent. This process is at the core of our work, since it is an integral part of our efforts to prevent crises.

Surveillance, and crisis prevention more generally, is a much more subtle process than crisis resolution. When crises erupt, the need for action is obvious and urgent; and so, in the short-term are the steps that need to be taken. Crisis prevention is by its nature imprecise, since success can only be measured by the absence of crises and this, to a considerable extent, is a matter of judgment.

Our Article IV surveillance work enables us to make probabilistic assessments of the risk of crisis in most instances. It will usually be clear when t is necessary to strengthen the macroeconomic framework, to ensure that policies are sustainable over the longer term. It is also likely to be clear when a reduction in the fiscal deficit is needed if the debt burden is not to become unsustainable (barring fortuitous developments). We can also say when an economy is particularly vulnerable to external shocks. And we can argue that growth performance could be significantly better if reforms are made.

But we are in that grey area I mentioned earlier, where the process is one of persuasion and argument. Transparency helps here: with very few exceptions, the results of Board discussions on, as well as staff reports from, Article IV consultations are now published on the Fund's website. So too is a wide range of other material.

This includes reports prepared under the Financial Sector Assessment program (FSAP), introduced in 1999 by the IMF and the World Bank. This program aims to help member governments strengthen their financial systems by making it easier to detect vulnerabilities at an early stage; to identify key areas which need further work; to set policy priorities; and to provide technical assistance when this is needed to strengthen supervisory and reporting frameworks. The end result is intended to ensure that the right processes are in place for countries to make their own substantive assessments.

It is not the role of FSAPs to examine the balance sheets of individual banks, or even the banking sector as a whole. Their purpose is to help our member countries ensure that the correct framework is in place so that domestic regulators and supervisors are able to make accurate judgments about the health of the banks and other financial institutions under their jurisdiction. A large number and a wide range of our member countries have now had an FSAP program. The feedback we get is overwhelmingly positive. Even the authorities in those industrial countries with highly developed financial sectors have found them to be useful.

We have also worked with the World Bank to develop a system of Standards and Codes—using internationally-recognized standards—that result in the somewhat unimaginatively titled Reports on Standards and Codes (ROSCs). These cover twelve areas, including banking supervision, securities regulation and insurance supervision. And research undertaken last year at the Fund suggests that in the case of ROSCs, both the publication and content of these reports can have an impact on borrowing costs for emerging market economies.

Governments do not have to heed the policy recommendations made by Fund staff and endorsed by the Board. But the fact that Article IV consultations are published does make it somewhat harder for these to be ignored altogether.

Policy prescriptions

I've talked about the Fund's involvement in the process. Let me say something about the content of economic reform programs.

Just as reform is an ongoing process, so is the learning process never-ending. Economists, like economic policymakers, have to adapt as national economies, and therefore the global economy, evolve. It is fair to say that the founders of the postwar multilateral framework would not recognize today's international financial system. As I said earlier, maintaining the stability of the system is as important now as it was then—perhaps more so.

But how we strive to achieve the unchanging objective is always being modified. What worked once might now be too feeble to have much impact. In the far-off days of the Bretton Woods system of fixed exchange rates, private international capital flows were a tiny fraction of what they are today. Central bank reserves were a much larger proportion of those flows. Supporting fixed exchange rates, while not always easy, was clearly a more feasible proposition than it would be today. Balance of payments crises were essentially static phenomena.

But the capital account crises of the 1990s, themselves a consequence of the rapid growth of private international capital flows, forced us to modify our crisis prevention tools. In particular, we now pay a great deal of attention to the sustainability of a country's debt burden.

We also have to adapt to reflect our increased understanding of how economies work and interact. Even as economies themselves are changing, so is what we know about them. This learning process has a direct impact on economic reforms. The more we learn about how the world works, the better-tailored our economy policy advice is likely to be.

One of the clearest examples of how greater understanding can have an impact on the content of reform programs is the role of the financial sector. It was always clear that a strong, well-regulated and diversified financial sector has a central role in economic development; but we nevertheless underestimated its importance. The experience of the 1990s, particularly the Asian crisis of 1997-98, helped shape our understanding here.

With hindsight, it should have been more obvious than it was. The history of economic growth is also the history of financial sector development. Even relatively unsophisticated economies need mechanisms that can allocate credit efficiently, and so ensure that resources are used in the most productive way possible.

As economies become more complex and diverse, mistakes from the misallocation of credit are easier to make without improved risk management. So the financial sector must become more sophisticated in its ability to manage risk appropriately. And financial intermediation becomes increasingly important. The stronger and more efficient the financial sector is—the wider and deeper it becomes—the more rapidly the economy will grow, and the less vulnerable to shocks it will be.

London's emergence as the leading world financial center in the nineteenth century undoubtedly reflected the rapid growth of the British economy. The economy needed London's financial sophistication as it grew and expanded. But then, in turn, the rapid development of London's financial expertise and power made it possible for the British economy to expand more rapidly.

The two are inextricably linked and our better understanding of this has informed out policy advice and shaped much of the Fund's work in monitoring the health of the financial sector and regulatory systems.

As economies grow and become more complex, the challenge of formulating the appropriate reform program becomes more challenging. The failure to address a significant area of economic policy—whether it be labor market reform, government spending, or any other key variable—can undermine an entire reform program. It would not be difficult to compile a list of countries where a promising reform program ended in failure because policymakers shied away from tackling one issue or another, or because the government ran out of steam and failed to maintain the reform momentum.

Let me take just one example, where the approach to reform was not sufficiently comprehensive, the result of which was to undermine future prospects for reform.

In 1966, in the midst of a foreign exchange crisis, the Indian government devalued the rupee by a little over 35%. Yet exports did not appear to respond. This was largely because the removal of export subsidies at the same time as the devaluation had, in effect, acted as a disguised appreciation of approximately the same magnitude as the devaluation, so the rupee price of exports had not increased significantly, and in some cases had fallen. To make matters worse, a bad harvest in a then predominantly agricultural economy led to a drop in real GDP. The outcome was a political backlash, blaming devaluation, which gave reform a bad name and resulted in a fifteen year period before reforms could be tried again.

But the more comprehensive the reform program, the greater the payoff. The benefits of both trade liberalization and labor market reform, for example, will be much greater for each if both are pursued together. And if these are undertaken in the context of stabilizing domestic prices and reducing inflation, the returns will be greater still, and the benefits of inflation reduction significantly enhanced.

Conclusion

Like medicine, economics has come a long way. Our understanding about how the world works is far greater than it was even twenty years ago. We know more about how economies function and evolve and how they interact with each other. But just as with medicine, we are dealing with a world of probabilities and there is still much to learn.

And much of what we have learned has served to reinforce many of the things we thought we knew but whose importance we had not fully appreciated.

Sound macroeconomic policies are a prerequisite for the sustained, rapid economic growth that will raise living standards and reduce poverty. We know sound policies must include stable, low inflation; well-managed public finances; efficient, targeted government spending and a properly functioning tax system. Sound policies include flexible labor markets and, usually, exchange rates; trade liberalization; a healthy, well-regulated financial sector. Sound policies also include an independent, effective judicial system, property rights, public institutions free from corruption.

Of course, this is all much easier said than done. Policymakers are beset with arguments from all sides as to why they should postpone difficult reforms, or ignore the need for change. Some of these arguments are no more than special pleading—those likely to lose out in the adjustment process can far more easily identify themselves than those likely to gain as more rapid growth brings more jobs, fewer people living in poverty, more firms able to compete overseas.

The IMF has an important role to play in the drive for economic reform. In extreme cases, we can provide financial assistance to member countries facing economic crisis, assistance that can help the government introduce the reforms needed to restore stability, lay the foundations for growth and increase resilience to future shocks.

More broadly, through our surveillance work across our whole membership—currently 184 countries—we can seek to argue the case for change, to persuade policymakers of the benefits to be gained and help win over the skeptics whose motives are well-intentioned but who are sometimes misguided about the best way to achieve what are almost universally shared objectives of growth and poverty reduction. And our comparative insights can enable policymakers to achieve more at less cost.

The current largely benign environment strengthens the case for introducing reforms sooner rather than later. Reforms are much easier and much less painful to implement at times of economic expansion than contraction. Now is therefore the time to seize the opportunity to strengthen economies, increase their resilience to future shocks and moderate the impact of the next downturn.

Let me end by returning to Hippocrates, who also said:

Time is that wherein there is opportunity, and opportunity is that wherein there is no great time.

Thank you.




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