The Strategic Role of the IMF:Risks for Emerging Market

Economies Amid Increasingly Globalized Financial Markets

Paper prepared for the G24 Technical Group MeetingSeptember 15 - 16 2005

Joseph E. StiglitzColumbia University

Andrew CharltonLondon School of Economics

BASIC OBJECTIVE

• ENHANCING GLOBAL FINANCIAL STABILITY

• AND THE FLOW OF FUNDS TO DEVELOPING COUNTRIES

FINANCIAL STABILITY IS OF CRITICAL IMPORTANCE

• FOR ECONOMIC STABILITY

• AND ECONOMIC STABILITY IS IMPORTANT FOR– GROWTH– AND POVERTY ALLEVIATION

STABILIZATION POLICIES IN PERSPECTIVE

• BUT STABILIZATION DOES NOT AUTOMATICALLY PRODUCE GROWTH

• AND POORLY DESIGNED STABILIZATION POLICIES MAY ADVERSELY AFFECT GROWTH

CANNOT SEPARATE OUT STABILIZATION AND GROWTH POLICIES

STABILIZATION POLICIES IN PERSPECTIVE

• WE HAVE LEARNED THAT GROWTH DOES NOT NECESSARILY REDUCE POVERTY– TRICKLE DOWN ECONOMICS DOES NOT WORK– SOME POLICIES INTENDED TO PROMOTE GROWTH MAY

ACTUALLY INCREASE POVERTY

• IMPLICATION: WE HAVE TO HAVE PRO POOR GROWTH POLICIES

• SO TOO, WE HAVE TO DESIGN STABILIZATION POLICIES IN WAYS THAT PROMOTE GROWTH AND REDUCE POVERTY

• Some stabilization policies may have more adverse effects on poverty than others

ROLE OF GOVERNMENT IN STABILIZATION

• markets do not automatically adjust to ensure full employment – or at least not quickly enough

• there is a role for government to facilitate the adjustment process

• The losses in output and welfare of these macro-failures are of an order magnitude greater than those associated with most of the micro-inefficiencies

• market imperfections--absence of insurance markets-- means that the welfare costs of instability are substantially greater than the loss in output

Further roles of government

• With imperfect risk markets and incomplete and asymmetric information markets by themselves do not result in efficient resource allocations.

• There is a role for government to improve on the market

Government and financial markets

• Market failures are particularly pronounced in financial markets, – no theoretical basis for the contention that financial

and capital market liberalization will necessarily lead to greater economic efficiency and increased societal welfare

– May be true with perfect markets, no information imperfections, or no information asymmetries but such analyses are of no relevance to the real world

– financial and capital market liberalization may lead to greater economic volatility and lower welfare (Stiglitz, 2004)

Government and Risk

• Must evaluate effect of any policy reform on the risk properties of the economic system – exposure to risk– the ability of the economy to respond to

shocks,– and of individuals and firms within society to

cope with shocks

Risk Evaluation of Policies

• CML– exposes an economy to more shocks – reduces the ability of policy markers to respond to

shocks, by circumscribing the ability to use monetary policy

• Automatic stabilizers, like progressive income taxation and unemployment insurance– help the economy respond to shocks – and at the same time promote greater equality and

reduce poverty

Risk Evaluation of Policies

• the value added tax (a proportional tax) – reduces the economy’s ability to respond

automatically to shocks– And reduces progressivity of tax system

• excessive reliance on capital adequacy standards with little forbearance– may actually act as automatic destabilizer

Trade-offs in Design of Stabilization Policy

• policies which may have beneficial effects in reducing the likelihood of a crisis may have adverse effects on the consequences of a crisis if one occurs

• There also may be complicated trade-offs in growth and poverty

IMF—focusing on Global Public Goods

• maintaining global economic stability is a global public good requiring global collective action

• important externalities in each country maintaining its economy at full employment

IMF POLICIES CAN PROMOTE—OR HURT—GLOBAL STABILITY

• in encouraging countries to have countercyclical fiscal policy to stabilize their economy and providing funds with which to do that (especially important given imperfections in capital markets), can help promote global stability

• in engaging in pro-cyclical lending and not encouraging (or actually discouraging) countercyclical fiscal and monetary policies, it contributes to global instability.

• Similarly, by pushing some of the “reforms” discussed earlier (like capital market liberalization), the IMF may have contributed to global instability.

GENERAL POINTS:

POLICIES ADOPTED FOR WHATEVER PURPOSE HAVE IMPLICATIONS FOR THE STABILITY OF THE NATIONAL ECONOMY AND THE GLOBAL ECONOMIC SYSTEM

• Global impacts particularly import in the new era of globalization

• And paying attention—and calling attention—to these global impacts is especially the responsibility of the IMF

TWO MAJOR GLOBAL PROBLEMS

• DEVELOPING COUNTRIES BEAR RISK OF INTEREST RATE AND EXCHANGE RATE FLUCTUATIONS

• GLOBAL RESERVE SYSTEM

CONTRIBUTE TO MAGNITUDE OF GLOBAL VOLATILITY AND IMPACT OF THIS VOLATILITY ON DEVELOPING COUNTRIES

RISK BEARING

• IN WELL FUNCTIONING CAPITAL MARKETS, RISK WOULD BE SHIFTED FROM THOSE LESS ABLE TO THOSE MORE ABLE TO BEAR IT

• BUT DEVELOPING COUNTRIES STILL BEAR MOST OF THE RISKS OF INTEREST RATE AND EXCHANGE RATE FLUCTUATIONS

CONSEQUENCES

• THE CONSEQUENCES CAN BE ENORMOUS• THE DEBT CRISIS OF THE 80S

– LATIN AMERICAN COUNTRIES BORE THE RISKS OF INTEREST RATE INCREASES

– WHEN US RAISED INTEREST RATES TO UNPRECEDENTED LEVEL COUNTRIES THESE COUNTRIES WERE FORCED INTO DEFAULT

– LEADING TO THE LOST DECADE OF THE 80S

• INTEREST RATE INCREASES OF LATE 90S HAD MUCH TO DO WITH CRISES AND POOR PERFORMANCE

• SIMILAR PROBLEMS ASSOCIATED WITH EXCHANGE RATE CHANGES

• IMPEDES PRUDENTIAL LEVELS OF CAPITAL FLOWS

• WITH LESS CAPITAL AND MORE VOLATILITY GROWTH IS LOWERED AND POVERTY INCREASED

MAKING MARKETS WORK BETTER

• WHAT COULD THE IMF DO TO SHIFT MORE OF THE RISK BURDEN TO THE ADVANCED DEVELOPED COUNTRIES?

• IN WAYS THAT DID NOT CREATE “MORAL HAZARD” (WITH EXCHANGE RATE FLUCTUATIONS)

• HELPING DEVELOPING COUNTRIES CREATE OWN DEBT MARKET—SO THEY CAN BORROW IN THEIR OWN CURRENCY

REDUCING RISK

• AT THE VERY LEAST, MORE OF THE FUNDING FROM IFI’S SHOULD ABSORB MORE OF THE RISK IN THEIR OWN LENDING– COULD BE DONE BY HAVING

REPAYMENTS BASED ON BASKETS OF SIMILAR CURRENCIES

– ESSENTIALLY ELIMINATING MORAL HAZARD PROBLEM

GLOBAL RESERVE SYSTEM

• Essential for global stability

• But it has not been working well—growing dissatisfaction– Stability– Equity– Deflationary bias

Deflationary Bias

• Every year, several hundred billion dollars of “purchasing power” are buried in ground

• Under gold system, gold buried in ground gave rise to employment—though hardly productive

• Previously, profligate governments and lose monetary policies made up for deflationary bias

• Now US has played the role of “consumer of last resort”– Offsets deflationary bias– But causes problems of its own

Inequity

• Allows U.S. to have access to cheap credit

• Net transfer from developing countries

• Adversely affecting their growth

Instability

• Reserve currencies need to be good store of value

• Which is why inflation has always been viewed so negatively by central bankers

• But the credibility of a currency as a reserve currency depends also on exchange rates

• For foreign holders of dollars, weakening of the exchange rate is as bad as an increase in inflation

• Even true for domestic wealth holders, because of opportunity costs

DOLLARS HAVE BEEN USED AS RESERVE CURRENCY

• But can the current system continue?• Negative dynamics—as confidence erodes,

people move out of currency, weakens currency• Now there are alternatives to dollar• Problem is partly inherent—reserve currency

country gets increasingly in debt as others hold its currency; ease of selling debt entices borrowing; but eventually, debt gets so large that credibility is questioned

• Is this happening today?

• Major shift in thinking among central banks– Don’t need dollar as reserves– What matters is value of reserves– Reserves have to be managed like any other portfolio– With due attention to risk– With multiple hard currencies, prudent to hold

reserves in multiple currencies– And as dollar appears more risky, to shift out of dollar– This process is already well under way

Implications for medium and long run

• During transition an extra source of weakness for the dollar—posing problems for Europe

• In the long run, increased potential instability, as changes in expectations can lead to more shifting in portfolios

The Hot Potato of Global Deficits

• Deficits long recognized as contributing to instability

• But sum of trade deficits must equal sum of trade surpluses

• Surpluses are as much a part of the problem as deficits

• But it is in the interests of each country to run surplus—to avoid consequences of crisis

• And well managed countries actually succeed in doing so

• But if there are some countries that persist (prudentially) in having a surplus, the rest of the world must have a deficit

• If some country succeeds in eliminating its deficit, the deficit will appear somewhere else in the system (hence the term, deficits as hot potatoes)

• The current system “works” because the US has been willing to be “deficit of last resort”

• But even the United States has a problem in being “the deficit of last resort”– With imports exceeding exports, creates deflationary

bias in U.S.– Requires huge fiscal deficits to offset

• It is not a solution for there to be a two-reserve currency system– Europe too would then face a deflationary bias– Given its institutional structure, Europe would not be

able to respond effectively

A Simple Proposal

• Annual issue of global greenbacks (SDR’s, bancor)

• In amounts equal to amount of additions of reserves

• Would not be inflationary—would just undo deflationary bias of current system

• Allocation could be done in ways which promote global equity, help finance global public goods

A Simple Proposal

• Would enhance stability

• By eliminating the inherent instability from the reserve currency

• And countries would face risk of crisis only if the trade deficit exceeded their Bancor allocation—hence the “hot potato” problem would be reduced

Global Reserve System

• At the very least, there is a worry that the current global reserve system is not working well, that it is contributing to high level of exchange rate volatility, that this volatility has adverse effects on the global economic system

• It is essential for the functioning of the global economic system that the global financial system function well

• The global financial system and the global reserve system are changing rapidly

• But are they changing in ways which will enhance global economic stability?

• This should be one of the key questions being addressed by the IMF

Concluding Remarks

• The developing countries have experienced enormous instability

• At great cost to the people in their country

• Some of that instability is a result of instabilities in the global financial system

• And of the failure of markets to shift risk to those in the developed countries who could bear it better

THE IMF

NEEDS TO THINK CAREFULLY ABOUT• THE IMPACT OF EACH OF ITS POLICIES ON

THE “RISK” PERFORMANCE OF NATIONAL ECONOMIES AND THE GLOBAL ECONOMIC SYSTEM

• HOW TO IMPROVE THE RISK PERFORMANCE

• AND WHAT ROLE THEY CAN PLAY IN REDUCING THE ADVERSE IMPACTS ON THE DEVELOPING WORLD