Augusto Lopez-Claros was the Chief Economist and Director of the Global Competitiveness Program at the World Economic Forum in Geneva until 2006.
He has been the editor of the Forum’s Global Competitiveness Report and, in late 2006, he established himself as an international consultant based in Geneva, Switzerland, specializing in economic, financial and development issues.
He has a degree in mathematical statistics from Cambridge University, England, and a PhD in economics from Duke University in the United States. Before joining the Forum in 2003 he was Executive Director and Senior International Economist with Lehman Brothers International, in London. Before Lehman he worked as an economist with the International Monetary Fund in Washington, which he joined in the mid-1980s.
During his time in the Fund, he worked in the main policy making department and was the IMF’s Resident Representative in the Russian Federation during 1992–1995. Prior to the IMF, he was Professor of Economics at the University of Chile, Santiago, where, in addition to his teaching duties, he also headed a research team, financed by the Ministry of Health, which examined the economic aspects of alcohol abuse in Chile.
The International Financial System and Institutions
The 2008 global economic crisis and earlier episodes of market volatility during the past decade raise fundamental questions about the resilience of the international financial system and its ability to cope with shocks. It has become clear that we do not have the appropriate institutions and institutional mechanisms in place to deal with this new type of crisis, which originates in the inner workings of the financial system itself. This, in turn, has highlighted the huge costs associated with our present approach to crisis management, which involves a considerable degree of improvisation and ad-hockery. The recent calls by Messrs. Brown, Sarkozy, and others for a new Bretton Woods conference reflect the growing realization that, with tightly integrated financial markets and evermore complex linkages among them, a global economy may need some form of global economic governance, a task for which the International Monetary Fund (IMF) is woefully unprepared. In this article we explore some of the ways in which the IMF could be strengthened to enhance its role as a global crisis manager.
A Budding Lender of Last Resort
During much of the past decade the IMF has found itself in the middle of virtually all major emerging market crises, and questions about its effectiveness have been raised; indeed some have argued that the organization is no longer needed in an environment of largely floating exchange rates. It is clear, however, that in a world of fully globalized financial markets and in which policy missteps in one country have costly spillover effects on others, an institution that will have sufficient resources to deal with episodes of financial instability and that will help cushion or prevent the effects of future crises is indispensable.
As presently structured, the IMF falls far short of the role played by central banks in national economies. Like a central bank, it can create international liquidity through its lending operations and the occasional allocations to its members of SDRs, its composite currency. The IMF is already, in a limited sense, a small international bank of issue. As seen during much of the past decade and a half, the Fund can also play the role of lender of last resort for an economy experiencing debt-servicing difficulties. But the amount of support it can provide has traditionally been limited by the size of the country’s membership quota and there is obviously an upper limit on total available resources; as of early 2009 this amounted to US$250 billion, a sum which includes about US$53 billion of resources potentially available under special arrangements negotiated with a few rich countries.
In addition to the relative paucity of resources, which do not allow the Fund to respond to more than a handful of crises in a few medium-sized countries, there are other serious flaws in its lender of last resort functions. To begin with, its regulatory functions are extremely rudimentary. Its members are sovereign nations that are bound, in theory, by the Fund’s Articles of Agreement, but the institution has no real enforcing authority, other than some limited functions through the “conditionality” it applies to those countries using its resources. In particular, the Fund has no authority to enforce changes in policies when countries are engaged in misguided or unsustainable policy paths but are otherwise not borrowing from the Fund—this was the case with the Asian countries in 1997 and it certainly is the case with the current crisis, which originated in the United States with the bursting of the housing bubble. What little enforcement authority the IMF does have is sometimes eroded when the country in question has a powerful patron, who may try to persuade the Fund and its managers to exercise leniency or turn a blind eye if policies appear to be going awry.
There are a number of ways to deal with these shortcomings. One proposal some years back was to create an International Financial Stability Fund to supplement IMF resources. This would be a facility that could be financed by an annual fee on the stock of cross-border investment. This would also partially delink its lender of last resort functions from the periodic allocations of national currencies that currently form the basis of IMF liquidity growth. An alternative and more promising proposal would give the Fund the authority to create SDRs as needed, as a national central bank can in theory, to meet calls on it by would-be borrowers.
When this idea was first put forward, in the early 1980s, concerns were raised about the possibly inflationary implications of such liquidity injections, but international inflation was a serious problem then in ways that, in the midst of a global recession, it is clearly not one today and measures could be introduced to safeguard against this. This, of course, would involve giving the Fund considerably more leverage vis-à-vis the policies of those countries willing to have much larger potential access to its resources. Nobody questions the right of central banks to have a major say over the prudential and regulatory environment underlying the activities of the commercial banks under their jurisdiction; it is seen as a legitimate counterpart of its lender of last resort functions. A much richer Fund would, likewise, have to have much stronger leverage and independence.
Modernizing Lending Mechanisms
One criticism often directed at the Fund has been that it does not provide resources in a way that efficiently restores confidence. From the moment when it becomes clear that a country will need additional funding because it is facing a liquidity crisis until the time the money is available, several months may have passed. This is valuable time during which the underlying causes of the crisis may have deteriorated, further undermining investor sentiment. These delays are largely dictated by the demands of IMF conditionality, the tedious and lengthy process of negotiating loan conditions “while the house is effectively on fire.” This feature of IMF operations is well-known. In a nut shell, the IMF does not lend freely in the midst of a crisis to a country that may be illiquid but otherwise solvent. Rather, it disburses funds in tranches as the country meets a variety of “performance criteria.” Since these conditions may be quite onerous and take many months to implement, it will typically not be clear to the market whether the resources committed will actually be disbursed. This undermines confidence and makes the country vulnerable to speculative attacks. In contrast, a well-developed central bank facing a liquidity crisis in the financial system can typically respond in a manner of hours, as it understands that it must shape and manage expectations. Partly in response to this criticism the IMF created a special quick disbursing facility called the Emergency Financing Procedure, but it has been used only twice this decade, by Turkey in 2001 and Georgia in 2008. In any case, it is clear that giving the Fund potential access to a much larger volume of resources (as agreed by the G20 at their April 2009 London Summit) would have to be accompanied by significant internal reforms, both in terms of the content of the policies it advocates, as well as its internal management.
Better Policy Prescriptions
The above says nothing about the kinds of policies which the IMF advocates and whether these are generally welfare enhancing or not. IMF involvement in past crises has generated heated debates as to whether the IMF is part of the problem, part of the solution, or a bit of both.
If the Fund is to be given more of the functions of a lender of last resort, then it needs to modernize its philosophy, bringing into the center of its conditionality the kinds of concerns and policies which, so far, it has only tended to espouse in theory. In their speeches the Fund’s managers speak of transparency, social protection, good governance, and “high quality growth,” but they have not yet managed to incorporate these laudable aims into IMF program design. Indeed, most IMF programs yield distressingly disappointing results. Not surprisingly, the Fund finds itself often blamed for the failure of its policy prescriptions. This, in turn, undermines its credibility and prevents those who recognize the importance of the organization in today’s globalized financial markets from endorsing proposals aimed at enhancing its influence.
The above would need to be accompanied by a structural reorganization, whereby the Fund’s shareholders assigned it a greater measure of intellectual independence, making it at the same time more accountable for the consequences of its decisions. It would seem desirable to separate the Fund’s surveillance activities from its decisions in respect of lending, so that glaring conflicts of interest might be avoided. The emphasis in recent years on the implementation of code standards for fiscal, monetary, and other policies to diminish the likelihood of future crises is certainly a step in the right direction. Surely the focus should overwhelmingly shift to crisis prevention rather than crisis resolution.
But even an updated set of policy prescriptions is unlikely to suffice without corresponding reforms in the internal workings of the organization. There are several dimensions to this issue. First, the voting power of its member countries needs to be updated and made to reflect the major changes which have taken place in the structure of the global economy during the past quarter century. It is simply absurd that the voting power of the EU should stand at 32.4%, whereas the combined voting power of the United States, China, India, Brazil and Russia comes to 26.9%, though, collectively, these countries account for a much larger share of global GDP. This distribution of power leads to such anomalies as Belgium having a larger quota than India and China having a quota only marginally higher than Italy’s and well below that of France. Not surprisingly, Asian countries do not see they have a stake in empowering the IMF, regarding it increasingly as embodying power relationships which no longer reflect contemporary realities. (To add insult to injury, against the background of the current global credit crunch, surplus countries like China are being asked to recycle some of their ample reserves through the IMF to other emerging markets in crisis, clearly a third-best approach to boosting the institution’s liquidity and counter to its multilateral character.) An IMF without credibility is of no use to the international community, particularly at a time of world-engulfing crises.
Second, the international community might finally break with the convention adhered to ever since the IMF’s creation, which establishes that its managing director must be an EU citizen. (A similar recommendation applies to the World Bank, whose president has traditionally been a US citizen.) The organization is too important and its mistakes too socially costly for the nationality of the candidate for managing director to be the determining factor in assessing suitability for the job. The unseemly negotiating process, that is entered into every few years as efforts are once more set in train to locate the most suitable candidate from a specific country, is inherently offensive to the peoples of those countries who have to endure the rigors of IMF austerity, not to mention that it exemplifies that very inefficiency which IMF officials are quick to condemn in dealings with the Fund’s member countries. In this respect a further desirable reform would be to accord the managing director a nonrenewable fixed term of service, thereby freeing him from the conflict that may otherwise result between the interests of those who hold his appointment in their hands, and the countries which it is his mission to serve. In this way, he may never feel himself under pressure to forgo his principles by reconciling these divergent stances.
The present organizational structure has implications too for the Fund staff, who cannot under the present regime be held accountable for policy miscalculations. Deprived of full freedom to make intellectually independent assessments, inasmuch as the controlling influence rests with the large shareholders, they are constrained to represent themselves merely as executors—not a role calculated to enhance their standing with their counterparts in the Fund’s member countries.
A New Bretton Woods
Emerging from the 1944 Bretton Woods conference at which both the IMF and the World Bank were created, John Maynard Keynes expressed the view: “As an experiment in international cooperation, the conference has been an outstanding success.” The world has changed beyond recognition in the meantime, and, with the emergence of a global economy, the case for an institution that will help further the cause of international cooperation has only become stronger. Conditions seem now indeed propitious for the convocation of a global conference to consult upon the policy and institutional requirements for a more stable world financial system, one that will turn the International Monetary Fund into a more flexible and effective instrument for the promotion of global welfare.