Reforming the International Monetary Fund
Testimony before the Subcommittee on International Trade and Finance Committee on Banking, Housing and Urban Affairs
United States Senate
The international financial crises of the 1980s and 1990s have spawned widespread calls for reform of the "international financial architecture." A good deal of reform is already taking place:
- most emerging market economies have floated their exchange rates, reducing the risk of disruptions due to doomed efforts to preserve unsustainable parities;
- private lenders are increasingly "bailed in" to country workout situations, spreading the burden of international rescue packages and dampening the prospects for excessive future flows to emerging markets;
- there is growing acceptance of host-country restraints on short-term capital inflows-as deployed in different forms by Chile, China and Malaysia-to avoid excessive buildups of liquid foreign debt;
- progress is being made to reduce imperfections in the private capital markets through improved statistics, expanded disclosure of country data and IMF analyses of its members' economies, and implementation of international best-practice benchmarks for the reform of national banking systems; and
- modest but politically important institutional innovations have taken place with the creation of the G-20 and the Financial Stability Forum.
To date, however, little reform has occurred in the functioning of the main international financial institutions (IFIs)-the International Monetary Fund and the World Bank. Two reports have recently been published on this set of issues. The first, from an Independent Task Force sponsored by the Council on Foreign Relations (CFR), was unanimously agreed by its members and released in September 1999.1 The group included a number of notable Americans including Paul Volcker, George Soros, several corporate CEOs, former Cabinet members Ray Marshall and Jim Schlesinger, top economists including Martin Feldstein and Paul Krugman, former members of Congress Lee Hamilton and Vin Weber, and political experts Ken Duberstein and Norman Ornstein. It was co-chaired by former cabinet members Peter G. Peterson and Carla Hills, and directed by my colleague Morris Goldstein.
The second report, released in March 2000, is from the International Financial Institutions Advisory Committee (IFIAC) created by Congress in 1998.2 According to the Dallas Morning News of March 13, its "majority was handpicked by (House Majority Leader Richard) Armey." The IFIAC split by a vote of 7 ½ - 3 ½ (with the halves reflecting the fact that one member signed both the majority and the dissenting statements). I and three colleagues submitted a joint dissent, which is included in the published report.
As the only person who was a member of both commissions, I believe it is valuable to compare the two reports in considering the proper path for reform of the IMF. There was significant agreement between them on several key issues:
- a clearer delineation of the future responsibilities of the IMF and the IBRD: the Fund should be responsible for macroeconomic, exchange rate and financial sector problems while the Bank should pursue long-term, microeconomic and largely structural difficulties;
- the need for much stronger banking systems in emerging market economies and that the IFIs should devote priority attention to promoting such improvements;
- that the IMF urge countries to avoid adjustable peg currency regimes, because they frequently become unsustainable and lead to crises;
- the need for greater transparency and accountability in the member countries of the organizations and in the functioning of the IFIs themselves, including through full publication of the IMF's annual appraisals of its members' economies; and
- rejection of the idea of abolishing the IMF (although two members of the IFIAC majority indicated a preference for such a radical step in their separate statements and the chairman of that group has proposed abolishing the Fund in numerous presentations over the years).
The differences between the two reports, however, are much more significant than their similarities. Some of the central proposals of the IFIAC majority are radical, would almost certainly increase rather than decrease global monetary instability, and thus would be deeply injurious to the national interests of the United States. The differences between the CFR and IFIAC reports with respect to the IMF, the focus of today's hearing, can be grouped under two main headings.
First, the IFIAC report paints a very misleading picture of the impact of the IFIs over the past fifty years. The economic record of that period is a success unparalleled in human history, both for the advanced industrial countries and for most of the developing nations. Hundreds of millions of the poorest people on earth have been lifted out of poverty. The severe monetary crises of recent years have been overcome quickly with little lasting impact on the world economy. The IFIs have contributed substantially to this record.
In his article on the IFIAC report in the Financial Times on March 8, Martin Wolf concluded that "on most measures, the IFIs have been a staggering success." The bottom line is unambiguously positive but the IFIAC majority portrays a negative picture that badly distorts reality. By contrast, the CFR report emphasizes that "As costly as the Asian crisis has been, no doubt we would have seen even deeper recessions, more competitive devaluations, more defaults and more resort to trade restrictions if no financial support had been provided by the IMF to the crisis countries."
Second, the recommendations of the IFIAC majority would severely undermine the ability of the IMF to deal with financial crises and hence would promote global instability. As Paul Krugman put it in his op-ed on the report in the New York Times on March 8, the majority "suggested restrictions that would in effect make even emergency lending impossible."
The problem is that the majority would authorize the Fund to lend only to countries that had prequalified for its assistance by meeting a series of criteria related to the stability of their domestic financial systems. This approach has two fatal flaws:
- it would permit Fund support for countries with runaway budget deficits and profligate monetary policies (because the majority believes that IMF conditionality does not work); this would enable the countries to perpetuate the very policies that triggered the crisis in the first place, squandering public resources and eliminating any prospect of resolving the crisis;3 and
- it would prohibit support for countries that were of systemic importance but had not prequalified, again running a severe risk of bringing on global economic disorder. For example, the IFIAC model would have prohibited the Fund from lending to any of the East Asian crisis countries in 1997-98.4
In contrast, the CFR report would retain the fiscal and monetary policy conditionality necessary to underpin improvements in the balance of payments in crisis countries, and it would avoid the "all or nothing" flaw of the IFIAC proposals by permitting IMF financial support to countries of systemic importance. At the same time, it would promote the proper incentives by allowing countries who did more to prevent crises to pay less for their IMF borrowing, and by permitting very large loans only after a super-majority of creditor countries had determined that the situation did indeed represent a systemic crisis.
The radical proposal of the IFIAC is based on the view that "moral hazard" is the dominant problem facing the global financial system. The problem with this view is that there is no empirical support for it. The majority's argument that the Mexican support package caused the East Asia crisis is pure theory and, indeed, theology. The CFR report recognizes that some degree of "moral hazard" exists whenever insurance contracts are written but places that concern in proper perspective relative to other risks and addresses it through a series of much more constructive steps (smaller IMF lending packages, greater flexibility of exchange rates, greater private-sector sharing of debt workout costs, etc.).
The recent meetings in Washington of the IMF's International Monetary and Financial Committee (IMFC), and of the Finance Ministers and Central Bank Governors of the G-7, addressed several of these issues. They properly rejected virtually all of the radical proposals of the IFIAC majority:
- They reaffirmed the central role of the IMF as lender of last resort, acknowledging the potential risk of moral hazard but placing it in a decidedly secondary position (see especially paragraph eight of the IMFC communique). Canadian Minister of Finance Paul Martin, the chairman of the new G-20, pointed out in a speech at my Institute for International Economics on April 14 that the IFIAC majority's proposal for limiting IMF lending to 120 days with a one-time rollover "would have meant pulling needed support from Thailand in the spring of 1998 just when the Indonesian situation was spinning out of control" and that "this could well have set off another round of contagion." He concluded that "the net result (of such a limitation) would be unreasonable suffering."
- They clearly reaffirmed the central importance of conditionality in all IMF programs (see especially page 6 of the G-7 communique).5
- They strongly supported maintaining the Poverty Reduction and Growth Facility in the Fund (see repeated reference throughout both communiques, especially paragraph 29 of the IMFC and page six of the G-7).
I believe that neither the CFR nor the IFIAC reports, nor the recent IMFC and G-7 meetings, have addressed some of the key problems still facing the international monetary system. Proposals to deal with them are laid out in the additional views that I and several other participants appended to the CFR report:
- crisis prevention needs to be augmented by much more serious "early warning" and "early action" systems, through which the IMF-and perhaps new regional mechanisms-use the sophisticated new "early warning indicators" now being developed to anticipate crises and head them off;6
- the IMF needs to guide emerging market economies on how to manage their flexible exchange rates, since very few will (or should) float freely despite the advice of most academics (and the IFIAC report) that they do so;
- clear guidelines need to be developed for "private sector involvement" in debt workout situations, to replace the ad hoc approach now being pursued to "bail in" the private creditors; and
- we need new arrangements among the major industrial countries-especially the "G-3" of the United States, the Economic and Monetary Union in Europe, and Japan-to limit the frequently prolonged misalignments in their own exchange rates which are so destabilizing to the rest of the world as well as to their own economies.7
Further reform of the international financial architecture thus remains essential. The CFR and IFIAC reports point the way toward a number of constructive steps. The IFIAC report also suggests a number of destructive ideas, however, that must be rejected. Secretary of the Treasury Lawrence Summers did so in his testimony to the House Banking Committee on March 23, echoing much of our joint dissent from the recommendations of the IFIAC majority, and so did the official bodies that met here recently. I believe that renewed attention to the CFR Report, in whose direction Secretary Summers has made several initial proposals, would be a fruitful step toward further desirable reform.
1. Safeguarding Prosperity in a Global Financial System: The Future International Financial Architecture, Report of an Independent Task Force Sponsored by the Council on Foreign Relations. A Council on Foreign Relations-sponsored Report published by the Institute for International Economics, Washington, September 1999.
3. The final version of the report added a sentence including a "proper fiscal requirement" to the prequalification list. No rationale for that addition is stated, however, and the term is not even defined. If the "fiscal requirement" were intended to be a quantified level of permissible budget deficits, it would represent an international equivalent of the Maastricht criteria that have been extremely difficult to implement in relatively homogenous Europe and would be impossible globally. If it were simply a qualitative notion, the Fund would be back in the business of conditionality which the report rejects-and would face the prospect of dequalifying and requalifying countries as their policy stance shifted, adding an important new element of destabilization to the picture.
4. The report again made a last-minute addition, suggesting a takeout from its own prequalification requirements "in unusual circumstances, where the crisis poses a threat to the global economy." But the concept is never explained or defended and hence cannot be taken seriously.
5. Chairman Meltzer of the IFIAC has recently argued that conditionality is not only ineffective but that it takes so long to work out that the impact of IMF support packages is attenuated. This is simply incorrect: bridge loans from the BIS, the U.S. Treasury or other sources are routinely worked out to cover the negotiating period whenever necessary.
6. One excellent example is Morris Goldstein, Graciela L. Kaminsky and Carmen M. Reinhart, Assessing Financial Vulnerability: An Early Warning System for Emerging Markets, Institute for International Economics, Washington, forthcoming June 2000.