Reforming the International Financial Institutions: A Dissenting View

It was a privilege and pleasure to be appointed to the International Financial Institutions Advisory Committee in January to replace Paul Volcker, who had to resign due to heavy commitments elsewhere. I enjoyed working with the group and appreciate this opportunity to spell out the views of the four commissioners who dissented from the recommendations of the majority. (Mr. Richard Huber signed both the report and the dissent, and explained his rationale for doing so in a statement of his additional views.)

I and my fellow dissenters share the view that reform of the international financial institutions (IFIs) is desirable. We agree with a number of the proposals of the majority, in particular the need to clearly delineate the responsibilities of the IMF and the World Bank. But there are four central issues on which we disagree; I will summarize them briefly here and append the full dissenting statement signed by myself, Mr. Huber, Mr. Jerome Levinson and former Congressman Esteban Torres.

First, the 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. The severe monetary crises of recent years have been overcome quickly. Hundreds of millions of the poorest people on earth have been lifted out of poverty. The IFIs have contributed substantially to this record. The "bottom line" is unambiguously positive but the majority portrays a negative tone that badly distorts reality.

Second, the recommendations of the majority would totally undermine the ability of the IMF to deal with financial crises and hence would promote global instability. The majority would authorize the Fund, when facing a crisis, 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.²

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."

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;


• 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 volatile private capital markets; and


• most importantly, they would in the future rely wholly 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.

Third, the report makes a series of sweeping and radical proposals without a shred of supporting evidence or analytical support: closure of the International Finance Corporation and the Multilateral Investment Guarantee Agency, shifting all non-concessional lending to Latin America from the World Bank to the Inter-American Development bank and shifting all non-concessional lending to Asia from the World Bank to the Asian Development Bank. Some of these proposals may have some merit but the report fails to make a case for any of them.

Further, the report misses most of the central trade issues in its chapter on the World Trade Organization. This is not surprising since it is a report of the International Financial Institutions Advisory Commission and the members were not chosen for their knowledge of trade. The legislation authorizing the commission did not even ask it to review the statutes relevant to trade and we believe that the Congress should simply ignore this component of the report.

We believe that there are a number of other important errors of both commission and omission in the report but that the four cited are the most critical. At the same time, we reiterate that there are numerous recommendations that merit serious attention. We hope that the Congress will focus on those and ignore the several damaging ideas highlighted in this statement and in the attached joint dissent.

Dissenting Statement

There are numerous constructive proposals in the report. We agree that reform is needed at the international financial institutions (IFIs) and support a number the report's most important recommendations: to clearly delineate the responsibilities of the International Monetary Fund and the World Bank, to promote stronger banking systems in emerging market economies, to publish the IMF's annual appraisals of its member countries, to avoid any use of the IMF as a "political slush fund" by its donor members, to fully write off the debt of the highly indebted poor countries (HIPCs) to the IFIs, to increasingly redirect World Bank support to the poorest countries and to the "production of global public goods," and to provide that assistance on grant rather than loan terms.

But some of the central proposals in the report are fundamentally flawed and/or unsubstantiated. They rest on misinterpretations of history and faulty analysis. They would greatly increase the risk of global instability. They would be inimical to the interests of the United States. We reject them totally and unequivocally.

Misreading History

Most importantly, the report presents a misleading impression of the impact of the IFIs over the past fifty years. A visitor from Mars, reading the report, could be excused for concluding that the world economy must be in sorry shape. But we all know that the postwar period has been an era of unprecedented prosperity and alleviation of poverty throughout the world. The bottom line of the "era of the IFIs," despite obvious shortcomings, has been an unambiguous success of historic proportions in both economic and social terms. The United States has benefited enormously as a result.

Even a somewhat narrower "bottom line" evaluation would be much more favorable to the IFIs than is the report. Almost all of the crisis countries of the past few years, ranging from Mexico through East Asia to Brazil, have experienced rapid "V-shaped" recoveries. All of the East Asians except Indonesia, for example, have already regained output levels higher than they enjoyed before the crisis. Even Indonesia and Russia, the two laggards with deep political problems, are now growing again. The world economy as a whole rebounded quickly and smoothly from what President Clinton called "the greatest financial challenge facing the world in the last half century." Whatever the difficulties along the way, the IMF strategy has clearly produced positive results.

The history of successful development over the postwar period is even more dramatic. Never in human history have so many people advanced so rapidly out of abject poverty. The World Bank and the regional development banks contributed significantly to those outcomes. The report itself notes, at the outset of Chapter 1, that "in more than fifty postwar years, more people in more countries have experienced greater improvements in living standards than at any previous time." It ignores that reality for the remainder of the text, however, and the tone throughout is so critical as to convey the message that very little progress has occurred.

The other great success story of the postwar period is democratization. More than half of the world's population now lives under democratic governments-a dramatic shift over the past decade or so. Yet the report repeatedly argues that the IFIs undermine democracy by somehow precluding local governments from pursuing autonomous economic policies. The report is particularly critical of the Fund's role in Latin America, where virtually every country has become democratic during the very period when the IMF has been most active there. IMF conditionality is obviously not a roadblock to democracy. The allegations of the report simply fail to square with the facts of history.

Promoting Financial Instability

Turning to the specific recommendations, the most damaging relate to the central responsibility of the International Monetary Fund for preventing and responding to international monetary crises. The report would limit the Fund to supporting countries that 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.

First, the majority would have the IMF totally ignore the macroeconomic policy stance of the crisis country-"the IMF would not be authorized to negotiate policy reform." Hence they would sanction Fund support for countries with runaway budget deficits and profligate monetary policies. This would virtually eliminate any prospect of overcoming the crisis; it would instead enable the country to perpetuate the very policies that likely triggered the crisis in the first place and thus greatly increase the risk of global instability. It would also provide international public resources for countries whose own policies were likely to squander them in short order, without any assurance of their even being able to repay the Fund. No reputable international institution would adopt such an approach.

The proposal for adding an undefined "proper fiscal requirement" to the prequalification list smacks of an international equivalent to the Maastricht criteria, which have been extremely difficult to apply in the relatively homogenous European Union and would be totally unrealistic at the global level. If the "fiscal requirement" were left open as to content, it would require Fund negotiation ("conditionality") of precisely the type that the major rejects-as well as the strong likelihood of periodic dequalifications and requalifications of countries that would be immensely destabilizing. Hence the prequalification list would in practice be limited to financial sector considerations, as clearly intended by the majority in any event, and fiscal as well as monetary policy would be completely ignored.

Second, limiting Fund activity to any set of prequalifying criteria would almost certainly preclude its supporting countries of great systemic importance and thereby substantially increase the risk of global economic disorder. Whatever criteria might be selected, it is totally unrealistic to think that all systemically important countries will fulfill them even after a generous transition period. The Fund would then be barred from helping such countries and financial crises in them would carry a much greater risk of producing a severe adverse impact on the world economy. No reform of the Fund should block it from fulfilling its central responsibility as the defender of global financial stability through providing emergency support for all countries which could generate systemic threats. (The Executive Summary suggests a takeout from these requirements "in unusual circumstances, where the crisis poses a threat to the global economy" but Chapter 2 on the IMF calls only for "extraordinary events" to be handled by "vehicles other than the IMF.")

These proposals apparently derive from five faulty lines of analysis in the report:

• that the overwhelming systemic problem that needs to be addressed is moral hazard, despite a dearth of empirical evidence that this phenomenon had much to do with any of the three sets of crises in the 1990s (except for Russia, where the market's "moral hazard play" was related primarily to that country's being "too nuclear to fail" rather than to its economy or to prior IMF policies);


• that countries will be deterred from getting into crises, and hence having to borrow from the Fund, by according senior status to the IMF's claims on the country and by charging them "penalty interest rates"; the Fund already has de facto senior status and has already sharply increased its lending rates, however, and a crisis country in any event is motivated primarily by acquiring additional liquidity rather than by the terms thereof;


• that the IMF fails to require banking reform in borrowing countries, whereas it has done so in every crisis case in recent years;


• a misrepresentation of the extensive literature that assesses IMF conditionality, which reaches agnostic conclusions concerning its effectiveness rather than the negative verdict claimed in the report; and, closely related,


• a failure to compare actual outcomes in crisis countries with what would have happened in the absence of IMF programs; crisis countries obviously experience losses of output and other negative developments but the issue is whether they would have fared even worse without IMF help and the report, while noting the need to consider the "counterfactual," does not even attempt to address that central issue.

Much more desirable proposals for reforming the International Monetary Fund can be found in the recent report Safeguarding Prosperity in a Global Financial System: The Future International Financial Architecture by an Independent Task Force sponsored by the Council on Foreign Relations. That group, unlike the current Commission, reached unanimous agreement. Its members included Paul Volcker, George Soros, several corporate CEOs, former Secretaries of Labor and Defense, former members of Congress Lee Hamilton and Vin Weber, President Reagan's former Chief of Staff Kenneth Duberstein, and top economists including Martin Feldstein and Paul Krugman.

For example, the Independent Task Force suggested that the IMF should offer better terms on its credits to countries that have adopted the Basel Core Principles to strengthen their domestic banking systems in order to provide incentives for such constructive steps; this is far superior to the report's all-or-nothing approach, which would have the deleterious effects outlined above. That group also offers constructive and realistic reform proposals on how to alter the IMF's lending policies so as to reduce moral hazard without jeopardizing global financial stability, through better burden sharing with private creditors, and on how to shift the composition of international capital flows in longer-term and therefore less crisis-prone directions.

Undercutting the Fight Against Poverty

The second major problem with the report is that its recommendations might well undercut the fight against global poverty, despite its stated intention to push the world in the opposite direction. In particular, its proposal to eliminate the nonconcessional lending program of the World Bank represents another reckless idea based on faulty analysis.

First, the report would totally shut down two major sources of funding for the poor-the World Bank's nonconcessional lending program and the IMF's Poverty Reduction and Growth Facility. These programs help hundreds of millions of the world's poorest people, many of whom live in the poorest countries but many of whom also live in countries (e.g., Brazil and Mexico) whose average per capita income now exceeds the global poverty line.

The report would in fact return substantial amounts of World Bank capital and more than $5 billion of IFC capital to the donor countries. This proposal would amount to massive "reverse aid" to the richest people in the world! It would be financed through sizable repayments of prior World Bank loans, draining real resources from some of the poorest people in the world (e.g., in Africa and India). The proposal belies the avowed intent of the report to improve the lot of the poor.

Second, the report would bar World Bank lending even to the poorest countries if those countries had obtained access to the private capital markets. Why penalize countries like China and Thailand for doing precisely what the majority says it wants them to do-qualify for market credits?! This proposal would create negative incentives for a large number of key developing countries.

Third, and most critically, the report would rely wholly on appropriated grant funds from rich-country governments for future assistance to the poor. Callable capital that was no longer needed at the World Bank because of the shutdown in its lending programs could not simply be given to IDA; an entirely new authorization and appropriation process would be required in our own Congress and other legislatures around the world. Indeed, IDA would lose the funds now transferred to it from World Bank profits (and, under another of the report's proposals, the repayments of earlier IDA credits as well). This proposal comes at a time when Official Development Assistance, as measured annually by the OECD, has declined enormously-especially, as a share of total income, in the United States. Even if the report's proposals were to promote dramatic improvements in aid effectiveness, the results would take many years to show up and it takes a great leap of faith to believe that donor governments would provide substantially increased funds even then-let alone in the longish transition period when the changes were being implemented.

Fourth, the report wants the more advanced developing countries to henceforth rely wholly on the private capital markets for external finance. But those markets are enormously volatile as we have seen in the crises of both the 1980s and 1990s; the private money can flow back out, deepening crisis conditions, even faster than it came in. Moreover, the markets do not care if their funds are used for developmental purposes, especially poverty alleviation.

Unsubstantiated Proposals

The third major problem with the report is its cavalier recommendations for several sweeping institutional changes without any analytical foundation at all. While there may be legitimate reasons for some of these proposals, the rationale for pursuing them has not been established:

• elimination of the World Bank's Multilateral Investment Guarantee Agency on the basis of three lines of assertions;


• elimination of the International Finance Corporation, one of the most successful components of the World Bank family, and the parallel entities at the regional development banks, without a shred of evidence that such actions would be desirable (and without acknowledging that such a step, along with the elimination of MIGA, would undercut the report's stated goal of increasing the flow of private sector resources to the poor countries);


• a shift of funding for all country and regional programs for Latin America and Asia from the World Bank to the Inter-American and Asian Development Banks, respectively, solely on the basis of cryptic assertions that the latter would do a superior job-which run counter to the judgments of most observers.

The fourth major problem is the chapter on the World Trade Organization. The global trading system, and US policy toward it, is an enormously complex and important issue at this point in time. The Congress will indeed shortly be considering a vote on whether the United States should maintain its membership in the WTO. The chapter is totally inadequate and indeed full of errors in dealing with the issue, understandably so because the Commission members were not chosen for their expertise on trade topics.

For example, the chapter suggests that "there is considerable risk that WTO rulings will override national legislation" when there is no such risk. It believes that WTO rulings "should not supplant legislative decisions" when there is no risk of their doing so. It recommends that "WTO rulings…should (have) no direct effect on US law" when they neither do so now nor ever could do so. The group's title is the International Financial Institutions Advisory Commission and the report admits that "the Commission had neither the time nor the expertise to evaluate all the changes that have occurred or the many proposals for future changes."

Additional Problems

There are numerous other flaws in the report:

• there is no reason to preclude the IMF from future assistance to high-income countries, which might need its help in future crises if global consequences are to be minimized;


• there is no reason to bar it from pushing member countries to adopt more stable exchange rate systems;


• there is no reason to propose a new set of ideas for strengthening banking systems in emerging market economies when the Basel Core Principles have already been agreed and the correct priority is to promote their adoption and effective implementation;


• it ignores the fact that the dozen countries which receive the bulk of the World Bank's loans also have the bulk of the world's population, and hence deserve substantial official funding;


• it ignores the valuable role of the Bank in strengthening the hand of reformers in developing countries and thereby tilting national policies in constructive directions; and


• it ignores central issues such as sustainable development and core labor standards that must be addressed by all of the IFIs.

The report also fails to address some of the central issues that must be part of any serious reform of the IMF. It should advocate, for example, much more effective "early warning" and "early action" systems to head off future crises. It should offer a formula for "private sector involvement" in crisis support operations, to assure sharing their financial burden between private creditors and official leaders (including the IMF), rather than simply "leaving that issue for participants." It should address the cardinal practical issue of how emerging market economies will manage their floating exchange rates, rather than simply reiterating that these countries should either fix rigidly or float freely-which very few now or ever will do. It should promote more stable exchange-rate arrangements among the major industrial countries, which are crucial for global stability and without which the emerging markets will continue to have severe problems whatever their own policies.

To conclude where we started: reform is needed at the IFIs and there are a number of constructive proposals in the report. But its recommendations on some of the most critical issues would heighten global instability, intensify rather than alleviate poverty throughout the world, and thereby surely undermine the national interests of the United States. These recommendations must be rejected and their presence requires us to dissent from the report in the strongest possible terms.

C. Fred Bergsten, Director, Institute for International Economics
Richard Huber, Former Chairman, President and CEO, Aetna, Inc.
Jerome Levinson, Former General Counsel, Inter-American Development Bank
Esteban Edward Torres, US House of Representatives, 1983-99

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 never explained or defended so it cannot be taken seriously.