Reforming the International Financial Architecture

Reforming the International Financial Architecture

I greatly appreciate the opportunity to testify today on reform of the international financial architecture. Despite much talk of such reform, relatively little has been accomplished to protect the world economy from future crises á la Europe 1992-93, Mexico 1994-95, East Asia 1997 and Russia/Brazil 1998. Additional reforms are needed both to help prevent such crises in the future and to respond more effectively to those disruptions that will inevitably occur.

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 last September. 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 Paul Krugman and Martin Feldstein, 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 Institute colleague Morris Goldstein.

The second report, released earlier this month, is from the International Financial Institutions Advisory Committee (IFIAC) created by Congress in 1998. According to the Dallas Morning News of March 13, its "majority was handpicked by (House Majority Leader Richard) Armey." As you know, 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).

As the only person who was a member of both commissions, I would like to briefly compare their two reports as of possible assistance to the Committee in its deliberations on the proper path for international financial reform. Attached to this statement are copies of both the Executive Summary of the CFR report and the joint dissenting statement signed by myself and three other members of the IFIAC.

It should be noted at the outset that the two reports did not have precisely identical coverage. The mandate of the CFR group was the international monetary system, which precluded its devoting much attention to the World Bank and global development issues. The IFIAC was charged with addressing the international financial institutions (IFIs) and thus included the Bank and some other development programs. The main overlap between the two was the IMF's role in managing global financial stability, and I will concentrate on those issues today in light of the Committee's focus on the international financial architecture.

There was significant agreement between the two reports on several key elements of reform:

• both propose 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;


• both agree on the need for much stronger banking systems in emerging market economies and that the IFIs should devote priority attention to promoting such improvements;


• both recommend that the IMF urge countries to avoid adjustable peg currency regimes, because they frequently become unsustainable and lead to crises;


• both agree on the need for greater transparency and accountability in both 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


• both reject 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 had proposed abolishing the Fund in presentations that he had made prior to the creation of the Commission).

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. I would group the differences between the CFR and IFIAC reports under three main headings, the details of which are elaborated in the joint dissenting statement.

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 crisis¹; 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 1997-98.²

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 right incentives by allowing countries who did more on crisis prevention to pay less for 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-repeat, 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.)

Third, the recommendations of the majority might well undercut the fight against global poverty despite their avowed intent to have the opposite effects:

• they would shut down two major sources of funding for the poor, the regular lending program of the World Bank ($20-25 billion per year) and the Poverty Reduction and Growth Facility at the IMF ($1-2 billion per year). The majority in fact proposes a program of "reverse aid" to the world's richest countries, returning capital to them from both the World Bank and the International Finance Corporation (which they would also shut down);


• they would terminate lending to even the poorest countries if they had obtained access to the private capital markets, which we should obviously be encouraging rather than discouraging by cutting them off from World Bank lending if they do so;


• they want the more advanced developing countries, even those which still include tens of millions of the world's poorest people (e.g., Brazil and Mexico), to rely wholly on the very volatile private capital markets; and


• most importantly, they would in the future rely primarily on grant aid appropriated by rich-country governments when we know that this Congress, and parliaments in many other countries, are highly unlikely to support sharp increases in such funding even if the majority's reforms were to produce much more efficient aid programs.

As noted above, the CFR report does not address these development assistance issues directly. And, as noted above, there clearly is a need to reform the Fund and the Bank to avoid duplication and overlap in the conduct of their respective responsibilities. But the CFR Task Force properly envisages continuation of the World Bank's current lending programs, including an "expansion of its work on social safety nets."

Finally, I personally believe that neither the CFR nor the IFIAC reports address some of the key problems still facing the international monetary system. 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.³ 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 totally ad hoc approach now being pursued to "bail in" the private creditors. 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.

Further reform of the international financial architecture 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. I commend the Committee for holding these broad-gauged hearings to debate the issues and look forward to discussing them with you.

Notes

1. 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.

2. The report again made a last-minute addition suggesting a takeout from these requirements "in unusual circumstances, where the crisis poses a threat to the global economy." But the concept is mentioned only in the executive summary and not even in the chapter of the report dealing with the IMF, is never explained or defended, and hence cannot be taken seriously.

3. 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, DC, forthcoming May 2000.