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The Role of the U.S. in the Global Financial System

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The mandate of the Federal Reserve is clear: “…promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” How to achieve those goals, of course, has been the subject of great debate: should the central bank use interest rates or monetary aggregates? should it rely on rules or discretion? The ongoing controversy within the U.S. over the benefits and costs of globalization opens up the issue of the geographic scope of the Fed’s responsibilities: does the Fed (and for that matter the U.S. Treasury) need to worry about the rest of the world?

Stanley Fischer, Federal Reserve Vice Chair (and former first deputy managing director of the IMF) sees a role for limited intervention. Fischer acknowledges the feedback effects between the U.S. and the rest of the world. The U.S. economy represents nearly one quarter of the global economy, and this preponderance means that U.S. developments have global spillovers. Changes in U.S. interest rates, for example, are transmitted to the rest of the world, and the “taper tantrum” showed how severe the responses could be. Therefore, Fischer argues, our first responsibility is “to keep our own house in order.” It also entails acknowledging that efforts to restore financial stability can not be limited by national borders. During the global financial crisis, the Fed established swap lines with foreign central banks so that they could provide liquidity to their own banks that had borrowed in dollars to hold U.S. mortgage-backed securities. Fischer cautions, however, that the Fed’s global responsibilities are not unbounded. He acknowledges Charles Kindleberger’s assertion that international stability can only be ensured by a financial hegemon or global central bank, but Fischer states, “…the U.S. Federal Reserve System is not that bank.”

The U.S. did hold that hegemonic position, however, during the Bretton Woods era when we ensured the convertibility of dollars held by central banks to gold. We abandoned the role when President Richard Nixon ended gold convertibility in 1971 and the Bretton Woods system subsequently ended. Governments have subsequently experimented with all sorts of exchange rate regimes, from fixed to floating and virtually everything in between.

While many countries do not intervene in the currency markets, others do, so there is a case for a reserve currency. But perhaps more importantly, we live in an era of global finance, and much of these financial flows are denominated in dollars. The offshore dollar banking system, which began in the 1960s with the Eurodollar market, now encompasses emerging markets as well as upper-income countries. This financial structure is vulnerable to systemic risk. Patrick Foulis of The Economist believes that “The lesson of 2007-08 was that a run in the offshore dollar archipelago can bring down the entire financial system, including Wall Street, and that the system needs a lender of last resort.”

Are there alternatives to the U.S. as a linchpin? The IMF is the international agency assigned the task of ensuring the provision of the international public good of international economic and financial stability. Its track record during the 2008-09 crisis showed that it could respond quickly and with enough financial firepower to deal with global volatility (see Chapter 10). But it can only move when its principals, the 189 member nations, allow it to do so. The Fund’s subsequent dealings with the European nations in the Greek financial crisis demonstrate that it can be tripped up by politics.

Is China ready to take on the responsibilities of an international financial hegemon? Its economy rivals, if not surpasses, that of the U.S. in size, and it is a dominant international global trader. China’s financial footprint is growing as well, and the central bank has established its own series of swap lines. This past year the renminbi was included in the basket of currencies that are used to value the IMF’s Special Drawing Rights. But the government has moved cautiously in removing capital account regulations in order to avoid massive flows in either direction, so there is limited liquidity. Chinese debt problems do not encourage confidence in its ability to deal with financial stress.

The Federal Reserve is well aware that international linkages work both ways. Fed Chair Janet Yellen cited concerns about the Chinese economy last fall when the Fed held back its first increase in the Federal Funds rate. And Fed Governor Lael Brainard believes that the global role of the dollar and the proximity to a zero lower bound may amplify spillovers from foreign conditions onto the U.S.

Whether or not the U.S. has a special responsibility to promote international financial stability may depend in part on one’s views of the stability of global capital markets. If they are basically stable and only occasionally pushed into episodes of excess volatility, then coordinated national policies may be sufficient to return them to normalcy. But if the structure of the global financial system is inherently shaky, then the U.S. needs to be ready to step in when the next crisis occurs. Andrés Velasco of Columbia University believes that “Recent financial history suggests that the next liquidity crisis is just around the corner, and that such crises can impose enormous economic and social costs. And in a largely dollarized world economy, the only certain tool for avoiding such crises is a lender of last resort in dollars.”

Unfortunately, if a crisis does occur it will take place during a period when the U.S. is reassessing its international ties. Donald Trump, the presumptive Republican candidate, achieved that position in part because of his argument that past U.S. trade and finance deals were against our national interests. He shows little interest in maintaining multilateral arrangements such as the United Nations. Trump has announced that he would most likely replace Janet Yellen because of her political affiliation. It is doubtful that the criteria for a new Chair would include a sensitivity to the international ramifications of U.S. policies.

The interest of the U.S. public in international dealings has always waxed and waned, and Trump’s nomination is a sign that we are in a period when many believe we should minimize our engagement with the rest of the world. But this will be difficult to do as long as the dollar remains the predominant world currency for private as well as official use. Regardless of domestic politics, we will not escape the fallout of another crisis, regardless of where it starts. It would be better to accept our international role and seeks ways to minimize risk than to undertake a futile attempt to make the world go away.

The IMF and the Next Crisis

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The IMF has issued a warning that “increasing financial market turbulence and falling asset prices” are weakening the global economy, which already faces headwinds due to the “…modest recovery in advanced economies, China’s rebalancing, the weaker-than-expected growth impact from lower oil prices, and generally diminished growth prospects in emerging and low-income economies.” In its report to the finance ministers and central bank governors of the Group of 20 nations before their meeting in Shangahi, the IMF called on the G20 policymakers to undertake “…bold multilateral actions to boost growth and contain risk.” But will the IMF itself be prepared for the next crisis?

The question is particularly appropriate in view of the negative response of the G20 officials to the IMF’s warning. U.S. Treasury Secretary Jacob J. Law sought to dampen expectations of any government actions, warning “Don’t expect a crisis response in a non-crisis environment.” Similarly, Germany’s Minister of Finance Wolfgang Schaeuble stated that “Fiscal as well as monetary policies have reached their limits…Talking about further stimulus just distracts from the real tasks at hand.”

The IMF, then, may be the “first responder” in the event of more volatility and weakening. The approval of the long-delayed 14th General Quota Review has allowed the IMF to implement increases in the quota subscriptions of its members that augment its financial resources. Managing Director Christine Lagarde, who has just been reappointed to a second term, has claimed the institution of new Fund lending programs, such as the Flexible Credit Line (FCL) and the Precautionary and Liquidity Line (PLL), has strengthened the global safety net. These programs allow the IMF to lend quickly to countries with sound policies. But outside the IMF, Lagarde claims, the safety net has become “fragmented and asymmetric.” Therefore, she proposes, “Rather than relying on a fragmented and incomplete system of regional and bilateral arrangements, we need a functioning international network of precautionary instruments that works for everyone.” The IMF is ready to provide more such a network.

But is a lack of liquidity provision the main problem that emerging market nations face? The Financial Times quotes Lagarde as stating that any assistance to oil exporters like Azerbaijan and Nigeria should come without any stigma, as “They are clearly the victims of outside shocks…” in the form of collapses in oil prices. But outside shocks are not always transitory, and may continue over long periods of time.

There are many reasons to expect that lower commodity prices may persist. If so, the governments of commodity exporters that became used to higher revenues may be forced to scale down their spending plans. Debt levels that appeared reasonable at one set of export prices may become unsustainable at another. In these circumstances, the countries involved may face questions about their solvency.

But is the IMF the appropriate body to deal with insolvency? IMF lending in such circumstances has become more common. Carmen M. Reinhart of Harvard’s Kennedy School of Government and Christoph Trebesch of the University of Munich write that about 40% of IMF programs in the 1990s and 2000s went to countries in some stage of default or restructuring of official debt, despite the IMF’s official policy of not lending to countries in arrears. Reinhart and Trebesch attribute the prevalence of continued lending (which has been called “recidivist lending”) in part to the Fund’s tolerance of continued non-payment of government debt.

More recently, the IMF’s credibility suffered a blow due to its involvement with Greece and the European governments that lent to it in 2010. (See Paul Blustein for an account of that period.) The IMF ‘s guidelines for granting “exceptional access” to a member stipulate that such lending could only be undertaken if the member’s debt was sustainable in the medium-term. The Greek debt clearly was not, so the Fund justified its lending on the grounds that there was a risk of “international systemic spillovers.” But the IMF’s willingness to participate in the bailout loan of 2010 only delayed the eventual restructuring of Greek debt in 2012. The IMF now insists that the European governments grant Greece more debt relief before it will provide any more financial government.

Reinhart and Trebesch write that the IMF’s “…involvement in chronic debt crises and in development finance may make it harder to focus on its original mission…” of providing credit in the event of a balance of payments crisis. Moreover, its association with cases of long-run insolvency may “taint all of its lending.” This may explain the limited response to the IMF’s programs of liquidity provision. Only Colombia, Mexico and Poland have shown an interest in the FCL, and the Former Yugoslav Republic of Macedonia and Morocco in the PLL.

Even if the IMF receives the power to implement new programs, therefore, its past record of lending may deter potential borrowers. This problem will be worsened if the IMF treats countries that need to adapt to a new global economy as temporary borrowers that only need assistance until commodity prices rise and they are back on their feet. The day when the emerging market economies routinely recorded high growth rates may have come to an end. If so, debt restructuring may become a more common event that needs to be addressed directly.

Can Systemic Financial Risk Be Contained?

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Risk aversion is a basic human characteristic, and in response to it we seek to safeguard the world live in. We mandate airbags and safety belts for automobile driving, set standards for the handling and shipment of food, build levees and dams to control floods, and regulate financial transactions and institutions to avoid financial collapses. But Greg Ip in Foolproof shows that our best attempts at avoiding catastrophes can fail, and even bring about worse disasters than those that motivate our attempts to avoid them. Drivers who feel safer with antilock brakes drive more quickly and leave less space between cars, while government flood insurance encourages building houses on plains that are regularly flooded.

Is the financial sector different? The traditional measures implemented to avoid financial failures are based on attaining macroeconomic stability. Monetary policy was used to control inflation, and when necessary, respond to shocks that destabilized the economy. When a crisis did emerge, the primary responsibility of a central bank was to act as a lender of last resort, providing funds to institutions that were solvent but illiquid. There was a vigorous debate before the global crisis of 2008-09 over whether central banks should attempt to deflate asset bubbles, but most central bankers did not believe that this was an appropriate task.

Fiscal policy was seen as more limited in its ability to combat business downturns because of lags in its design, implementation and effect. A policy that established a balanced budget over the business cycle, thus limiting the buildup of public debt, was often considered the best that could be expected. Automatic stabilizers, therefore, were set up to respond to cyclical fluctuations.

In open economies, flexible exchange rates provided some insulation against foreign shocks, and avoided the dangers that a commitment to a fixed rate entailed. Countries that did fix, or at least manage, their exchange rates stockpiled foreign exchange reserves to forestall speculative attacks. IMF surveillance provided an external perspective on domestic policies, while IMF lending could supplement foreign exchange reserves.

The global financial crisis demonstrated that these measures were inadequate to provide financial stability. The Federal Reserve led the way in implementing new monetary policies—quantitative easing—to supplement lower policy rates that faced a zero lower bound. But policymakers also responded with a broad range of innovative financial regulations. A new type of regulation—macroprudential—was introduced to minimize systemic financial risk, i.e., the risk associated with the collapse of a financial system (as opposed to the microprudential risk of the failure of an individual institution). These measures seek to prevent speculative rises in asset prices and credit creation, and the establishment of risky balance sheet positions. They include limits on interest rate and foreign exchange mismatches on balance sheets, caps on bank loan to value ratios, and countercyclical capital requirements (see here for an overview of these measures).

In the international sector, the Basel Committee on Banking Supervision produced “Basel III,” a new set of regulations designed to strengthen the resilience of its members’  banking systems. Capital control measures, once viewed as hindrances to the efficient allocation of savings, are now seen as useful in limiting inflows of foreign funds that contribute to asset bubbles. Swap lines allow central banks to draw upon each other for foreign exchange to meet the demand from domestic institutions, while the IMF has sought to make borrowing more user-friendly. Meetings of the member governments of the newly-formed Group of 20 allow them to coordinate their policies, while the IMF’s surveillance purview has expanded to include regional and global developments.

Are these measures sufficient? The lack of another global crisis to date is too easy a criterion, given that the recovery is still underway. But there may be inherent problems in the behavior of financial market participants that could frustrate policies that seek to prevent or at least contain financial crises. Moral hazard is often blamed for shoddy decision-making by those who think they can dodge the consequences of their actions. Many who were involved in the creation and sale of collaterized securities may have thought that the government would step in if there were a danger of a breakdown in these markets. But many banks held onto these securities, indicating that they thought that the reward of owning the securities outweighed the risks. Bank officials who oversaw the expansion of mortgage lending generally lost their jobs (and reputations). It is difficult to believe after the crisis that anyone thought that they could manipulate the government into absorbing all the consequences of their actions.

But if moral hazard is not always at fault, there is ample evidence that asymmetric information and behavioral anomalies result in hazardous behavior. Will the regulatory provisions listed above minimize the incidence of risky financial practices? There is some evidence that the provisions of the Dodd-Frank Act are working. But the regulatory framework continues to be implemented, and bankers and other financial market participants will always seek to find loopholes that they can exploit.

Regulatory practices on the international level are also subject to manipulation. Roman Goldbach, a political economist at Deutsche Bundesbank, in his book Global Governance and Regulatory Failure: The Political Economy of Banking points out that the overlap of national and global standards in what he calls the “transnational regulatory regime” results in layering “gaps.” The resulting loopholes in the policymaking process allow private interest coalitions to have a disproportionate influence on policy formulation. Moreover, policy officials consider the competitiveness of domestic financial structures as a goal (at least) equal to financial stability in international negotiations over regulatory standards. While there have been substantial changes since the global crisis, including the formation of the Financial Stability Board, the incentives in the governance structure of global finance have not changed.

Even regulations that work as intended may have unintended and unwanted consequences due to externalities. Kristin Forbes of MIT and Marcel Fratzscher, Thomas Kostka and Roland Straub of the European Central Bank examined Brazil’s tax on capital inflows from 2006 to 2011. They found that the tax did cause investors to decrease their portfolio allocation to Brazilian securities, as planned. But other countries also felt the impact of the tax. Foreign investors increased their allocation to economies that had some similarities to Brazil, while cutting back on those countries that were likely to impose their own control measures. Capital control measures that are imposed unilaterally, therefore, may only divert risky funds elsewhere, and are not a tool for controlling global financial risk.

The flow of money looking for higher yields outside the U.S. may diminish in the wake of the rise in the Federal Funds rate in the U.S. But Lukasz Rachel and Thomas D. Smith of the Bank of England claim that long-term factors account for a decline in the global real interest rate that will not be soon reversed. This poses a challenge for policymakers, as measures implemented in one country to contain a domestic credit boom may be undermined by foreign inflows. Domestic actions, therefore, ideally would be matched by similar measures in other countries, which would require macroprudential policy coordination.

Barry Eichengreen of UC-Berkeley has studied the record of international policy coordination, and finds that it works best under four sets of circumstances: when the coordination is centered on technical issues, such as central bank swaps; when the process is institutionalized; when it is aimed at preserving an existing set of policies, i.e., regime preserving, rather than devising new procedures; and when there exists a sense of mutual interests on a broad set of issues among the participants. Are such conditions present today? At the time of the crisis, central bankers cooperated in setting up the currency swap agreements while discussing their monetary policies. The formation of the Group of 20 provided a new forum for regular consultation, and there was widespread agreement in preserving a regime that encouraged international trade while preventing competitive currency devaluations. But the passage of time has weakened many of the commitments made when the crisis threatened, and the uneven recovery has caused national interests to diverge.

Perhaps a more basic issue is whether it is possible to design a financial system free of volatility. A government that is willing to replace markets in directing financial flows and allocating financial returns can maintain stability, but at a price. Such a system is characterized as “financial repression,” and includes limits on interest rates received by savers, control of banks and their lending, and the use of regulations to prevent capital flows. These regulations penalize household savers, and allow the government and state-sponsored enterprises to receive credit at relatively low rates while blocking credit to firms that do not enjoy government backing.

China used these types of measures during the 1980s and 1990s to finance its investment- and export-led growth, and its self-imposed financial isolation allowed it to escape the effects of the Asian financial crisis. But more recently China has engaged in financial liberalization, removing controls on interest rates and bank activities while deregulating its capital account and allowing more exchange rate flexibility. The responses have included the emergence of a shadow banking system and a boom in private credit, which will require government actions to avoid a crisis.

Several years ago Romain Rancière of the Paris School of Economics, Aaron Tornell of the University of California-Los Angeles and Frank Westermann of Osnabrueck University coauthored a paper (here; working paper here) on the tradeoff between systemic financial crises and economic growth. They showed that financial liberalization leads to more growth and a higher incidence of crises. But their empirical estimates indicated that the direct effect on growth outweighed the negative impact of the crises. They contrasted the examples of Thailand, which had a history of lending booms and crises with that of India, which had a more controlled financial sector, and showed that Thailand had enjoyed higher growth in per capita GDP. In a subsequent paper (here; working paper here), they explored the relationship between crises that produced a negative skewness in the growth of real credit, which in turn had a negative link with growth.

If there is a tradeoff between the volatility associated with financial liberalization and economic growth, then each society must choose the optimal combination of the two. Financial innovations will change the terms of the tradeoff, and lead to movements back and forth as we learn more about the risks of new financial tools. The advantages of novel instruments at the time when they seem most productive must be weighed against the possible (but unknown) dangers they pose. Perhaps the greatest threat is that the decisions over how much control and regulation is needed will be made not by those public officials entrusted with preserving financial stability, but by those who will profit most from the changes.

The Challenges of the Greek Crisis

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The Greek crisis has abated, but not ended. Representatives of the “troika” of the European Commission, the European Central Bank and the International Monetary Fund returned to Athens for talks with the Greek government about a new bailout. This pause allows an accounting of the many challenges that the events in Greece pose to the international community.

The main challenge, of course, is to the Greek government itself, which must implement the fiscal and other measures contained in the agreement with the European governments. These include steps to liberalize labor markets as well as open up protected sectors of the economy. While these structural reforms should promote growth over time, in the short-run they will lead to layoffs and reorganizations. At the same time, Prime Minister Alex Tsipras must oversee tax rises and cuts in spending. The combined impact of all these measures, which follow the virtual shutdown of the financial sector during the protracted negotiations with the European governments, will postpone any resumption in growth that past efforts may have generated.

It is not clear how long the Greek public will endure further misery. Any form of debt restructuring may give policymakers some justification to continue with the agreement. New elections will clarify the degree of political support for the pact. But the possibility of an exit from the Eurozone has not been removed, either in the eyes of Greek politicians or those of officials of other governments.

The Greek crisis, however, is not the only hazard that the Eurozone faces. The Eurozone’s governments have yet to come to terms with the effects of the global financial crisis on its members’ finances. A split prevails between those countries that ally themselves with the German position that debt must be repaid and those that seek with France to find some sort of middle ground. Other European countries with debt/GDP ratios of over 100% include Belgium, Portugal, and Italy. Weak economic growth could push any of them into a situation where the costs of refinancing become daunting. How would the Eurozone governments respond? Would they bail out another member? If so, would the terms differ from those imposed on Greece? Would European banks be able to pass the distressed debt on to their own governments?

In the long-term, the governments of the Eurozone face the dilemma of how to reconcile centralized rule-making with national sovereignty. The ECB, for example, has been granted supervisory oversight of the banks in the Eurozone. It will exercise direct oversight of over 100 banks deemed to be “significant,” while sharing responsibility with national supervisors for the remaining approximately 3,500 banks. The ECB has a Supervisory Board, supported by a Steering Committee, to plan and executes its supervisory tasks, which supposedly allows it to separate its bank supervisory function from its role in setting monetary policy. All these agencies and committees must work out their respective jurisdictions and responsibilities. Meanwhile, the European Commission, which oversees fiscal policies, faces requests for exemptions from its budget guidelines by governments with faltering growth. But if it shows flexibility in enforcing its own rules, it will be derided as weak and ineffective.

The IMF has its own set of challenges. The IMF was sharply criticized for its response to the wave of crises that struck emerging markets in the last 1990s and early 2000s, beginning with Mexico in 1994 and extending to Turkey and Argentina in 2001. Critics charged that the IMF was slow to respond to the rapid “sudden stops” of capital outflows that set off and exacerbated the crises. When the Fund did act, it attached too many conditions to its programs; moreover, these conditions were harsh and inappropriate for crises based on capital outflows.

The global financial crisis gave the IMF a second chance to demonstrate its crisis-management abilities (for a full account, see here). The Managing Director at the time, Dominique Strauss-Kahn, seized the opportunity to redeem the IMF ‘s reputation, as well as reestablish his own political career in France. The IMF lent quickly to its members, attached relatively few conditions to the loans, and allowed the use of fiscal measures to stabilize domestic economies. The result was less severe adjustment, the avoidance of excessive exchange rate movements and a resumption of economic growth. By the time the global economy recovered, the IMF had proven that it could respond in a flexible manner to a financial emergency.

The IMF’s response in 2010 to the Greek debt crisis was very different. The IMF’s loan to Greece was the first to a Eurozone member; moreover, the loan was much larger than any the IMF had extended before, whether measured by the total amount of credit or as a percentage of the borrowing country’s quota at the Fund. To make the loan, the IMF had to overlook one of it own guidelines for granting “exceptional access” by a member to Fund credit. Such loans were to be made only if the borrowing government’s debt would be sustainable in the medium-term. Greece’s debt burden did not pass this criterion, so the Fund justified its actions on the grounds that there was a risk of “international systemic spillovers.”

The IMF’s involvement in the Greek program was also unusual in another sense: the IMF’s contribution, as large as it was, was still smaller than that of the European governments. The IMF was, in effect, a “junior partner.” While it had worked with other governments before (such as the U.S. when it lent to Mexico in 1994-95), this was the first time that the IMF was not in a lead position. This may have initially made it reluctant to disagree with the other members of the troika.

The subsequent contraction in the Greek economy far exceeded the IMF’s forecasts. The IMF later admitted that it underestimated the size of the multipliers for the fiscal policies contained in the program in a paper co-authored by the head of the IMF’s Research Department, Olivier Blanchard (see also here). The failure to properly estimate the impact of these conditions calls into doubt the basic premises of the 2010 and 2012 programs.

More recently, the IMF has challenged its European partners over their projections for the Greek debt, as well as the budget and fiscal targets contained in the latest agreement. The Fund claims that the debt projections are much too optimistic. Greece’s debt will only be sustainable if there is debt relief on a much larger scale than the European governments have been willing to undertake. Moreover, the IMF states that it will not be part of any new programs for Greece if debt relief is not a component.

The public admission of error and the rebukes of the European governments will only partially restore the IMF’s reputation. The generous treatment of Greece as well as Ireland and Portugal reinforces the belief that the European countries and the U.S. control the IMF. The members of the European Union have a total quota share of almost one-third, much larger than their share of world GDP. This voting share combined with the U.S. quota gives these countries almost half of all the voting shares at the IMF. The need for a realignment of the quotas to give the emerging market nations a larger share has long been acknowledged, but approval of the reform measures is mired in the U.S. Congress.

Another aspect of European and U.S. control of the “Bretton Woods twins”—the IMF and the World Bank—has been their selection of the heads of these organizations. All the Managing Directors of the IMF have been Europeans, and until the appointment of Ms. Lagarde, European males. All the heads of the World Bank have been U.S. citizens. Ms. Lagarde’s term expires next July, and the pressure to name a non-European will be tremendous. How the Europeans and U.S. respond to this challenge will go a long way in determining whether these institutions will be shunted aside by the emerging market nations in favor of institutions that they can control.

The last challenge of the Greek crisis comes for the Federal Reserve. Federal Reserve Chair Janet Yellen has been explaining that a rise in the Fed’s policy rate, the Federal Funds rate, is likely to occur later this year. This forecast, however, is contingent on continued economic growth and favorable labor market conditions. These plans could be threatened by any financial volatility that followed a disruption in the latest Greece bailout.

The Federal Reserve is also aware that a rise in interest rates would affect the dollar/euro exchange rate. The euro, which has been depreciating, could fall lower when the Fed raises rates while the ECB keeps its refinancing rate at 0.05%. A further appreciation of the dollar would threaten U.S. exports, thus endangering a recovery.

The Fed also faces concerns about the broader impact of its policy initiatives on the world economy. The IMF is worried about how a rate rise would affect the global economy, and has urged the Fed to hold off on interest rate increases until 20016. Companies that borrowed in dollars through bonds and bank loans will be adversely affected by the combined effects of an interest rate rise and a dollar appreciation.

Greece’s GDP accounts for only 0.4% of world GDP and about 1.3% of the European Union’s total output. But the global financial crisis demonstrated how financial linkages across sectors and countries can disrupt economic activity no matter what their source. The response to these incidents by national and international authorities can risk global stability if they are based on self-interest and organizational agendas. Commitments to cooperation disappear quickly when national concerns are threatened.

(A Powerpoint version of this post is available here.)

Greek Tale(s)

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No matter what new twist the Greek debt crisis takes, there can be no question that it has been a catastrophe for that country and for the entire Eurozone. The Greek economy contracted by over a quarter during the period of 2007 to 2013, the largest decline of any advanced economy since 1950. The Greek unemployment rate last year was 26.5%, and its youth unemployment rate of 52.4% was matched only by Spain’s. But who is responsible for these conditions depends very much on which perspective you take.

From a macroeconomic viewpoint, the Greek saga is one of austere budget polices imposed on the Greek government by the “troika” of the International Monetary Fund, the European Commission and the European Central Bank in an attempt to collect payment on the government’s debt. The first program, enacted in 2010 in response to Greece’s escalating budget deficits, called for fiscal consolidation to be achieved through cuts in government spending and higher taxes. The improvement in the primary budget position (which excludes interest payments) between 2010-11 was 8% of GDP, above its target. But real GDP, which was expected to drop between 2009 and 2012 by 5.5%, actually declined by 17%. The debt/GDP level, which was supposed to fall to about 155% by 2013, actually rose to 170% because of the severity of the contraction in output. The IMF subsequently published a report criticizing its participation in the 2010 program, including overly optimistic macroeconomic assumptions.

To address the continuing rise in the debt ratio, a new adjustment program was inaugurated in 2012, which included a writedown of Greek debt by 75%. Further cuts in public spending were to be made, as well as improvements in tax collection. But economic conditions continued to deteriorate, which hindered the country’s ability to meet the fiscal goals. The Greek economy began to expand in 2014, and registered growth for the year of 0.8%. The public’s disenchantment with the country’s economic and political status, however, turned it against the usual ruling parties. The left-wing Syriza party took the lead position in the parliamentary elections held this past January, and the new Prime Minister, Alexis Tsipras, pledged to undo the policies of the troika. He and Finance Minister Yanis Varoufakis have been negotiating with the IMF, the ECB and the other member governments of the Eurozone in an attempt to obtain more debt reduction in return for implementing new adjustment measures.

The macroeconomic record, therefore, seems to support the position of those who view the Greek situation as one of imposed austerity to force payment of debt incurred in the past. Because of the continuing declines in GDP, the improvement in the debt/GDP ratio has remained an elusive (if not unattainable) goal. (For detailed comments on the impact of the macroeconomic policies undertaken in the 2010 and 2012 programs see Krugman here and Wren-Lewis here.)

Another perspective, however, brings an additional dimension to the analysis. From a public finance point of view, the successive Greek governments have been unable and/or unwilling to deal with budget positions—and in particular expenditures through the pension system—that are unsustainable. Pension expenditures as a proportion of GDP have been relatively high when compared to other European countries, and under the pre-2010 system were projected to reach almost 25% of GDP by 2050.  Workers were able to receive full benefits after 35 years of contributions, rather than 40 as in most other countries. Those in “strenuous occupations,” which were broadly defined, could retire after 25 years with full benefits.  The amount that a retiree received was based on the last year of salary rather than career earnings, and there were extra monthly payments at Christmas and Easter. The administration of the system, split among over 100 agencies, was a bureaucratic nightmare.

Much of this has been changed. The minimum retirement age has been raised, the number of years needed for full benefits is now 40, and the calculation of benefits changed so as to be less generous. But some fear that the changes have not been sufficient, particularly if older workers are “sheltered” from the changes.

Moreover, government pensions are important to a wide number of people. The old-age dependency ratio is around 30%, one of the highest in Europe. The contraction in the Greek economy means that the pension is sometimes the sole income payment received by a family. It is hardly surprising, therefore, that the pension system is seen as a “red line” which can not be crossed any further in Greece.

The challenge, therefore, is for the government to establish its finances on a sound footing without further damaging the fragile economy. This will call for some compromises on both sides. The IMF’s Olivier Blanchard has called for the Greek government “to offer truly credible measures“ to attain the targets for the budget, while showing its commitment to a limited set of reforms, particularly with pensions. But he also asks the European creditors to offer debt relief, either through rescheduling or a further “haircut.” Other proposals have been made (see here) that also attempt to satisfy the need to restructure the government’s finances while offering the Greek people a way to escape their suffering. There may be a strategy that allows Greece to reestablish itself on a new financial footing. But if the European governments insist that Greece must also pay back all its outstanding debt, then there is only one possible ending for this saga, and it will not be a happy one.

The Shifting Consensus on Capital Controls: Gallagher’s “Ruling Capital”

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Among the many consequences of the global financial crisis of 2007-09 was a shift in the IMF’s stance on capital controls. The IMF, which once urged developing economies to emulate the advanced economies in deregulating the capital account, now acknowledges the need to include controls in the tool kit of policymakers. Kevin Gallagher of Boston University explains how this transformation was achieved in his new book, Ruling Capital: Emerging Markets and the Reregulation of Cross-Border Finance.

By the 1990s the Fund had long abandoned the Bretton Woods solution to the trilemma: fixed exchange rates and the use of capital controls to allow monetary autonomy. Instead, the IMF encouraged developing economies to open their borders to capital flows that would increase investment and achieve a more efficient allocation of savings (see Chapter 5 here). IMF officials proposed an amendment to its Articles of Agreement that would establish capital account liberalization as a goal for its members, but the amendment was shelved after the Asian financial crisis of 1997-98. The IMF subsequently continued to recommend capital account liberalization as a suitable long-term goal, but acknowledged the need to implement deregulation sequentially, beginning with long-term foreign direct investment before opening up to portfolio flows and bank loans.

The IMF’s position evolved further, however, as the full scale of the global crisis became apparent. First, the IMF allowed Iceland to use controls as part of its financial stabilization program. Then, in the aftermath of the crisis, Fund economists reported in a Staff Position Note that there was  “…a negative association between capital controls that were in place prior to the global financial crisis and the output declines suffered during the crisis…” The next stage came in 2012 when the IMF announced a new view–named the institutional view–of capital flows.  This doctrine acknowledged that capital flows can be volatile and pose a threat to financial stability.  Under these circumstances, controls, now named “capital flow management measures” (CFMs), can be used with other macroeconomic policies to minimize the effects of the capital volatility. Moreover, the responses to disruptive flows should include actions by the countries where the capital flows originate as well as the recipients.

Gallagher explains that these changes were due to both intellectual and political currents. IMF economists had been among those researchers who found little empirical evidence supporting the proposition that capital flows contributed to increased growth rates. This was not a surprise to those influenced by the work of economists such as Ragnar Nurske or Hyman Minsky, who were outside the mainstream. But new theoretical advances by Anton Korinek and Fund economists, including Olivier Jeanne and Jonathan Ostry, showed that the costs of volatile capital flows could be analyzed using the accepted tools of welfare economics. The adverse impact on financial stability of capital outflows can be considered as an externality that private agents ignore in their decision-making. Prudential controls seek to correct these market distortions.

Gallagher points out that at the same time as this new theoretical work was being disseminated, representatives of the emerging markets were lobbying the IMF to allow their governments the freedom to implement measures that they found necessary to offset destabilizing capital flows. The BRICS (Brazil, Russia, India, China, South Africa) coalition, which had worked together to promote reform of the IMF’s governance procedures, joined their efforts to resist any position on capital flows that could restrict their flexibility to limit them. They used the new theoretical perspectives to buttress their arguments in favor of the use of controls, and made similar arguments in other forums such as the meetings of the Group of 20. The BRICS representatives also urged the IMF to pay equal attention to the policies of the upper-income nations where capital flows originated.

The IMF’s Independent Evaluation Office has issued a report updating its 2005 evaluation of the Fund’s approach to capital account liberalization. The IEO describes the discussions leading up to the adoption of the institutional view as “contentious,” and the final document as reflecting a “fragile consensus” among the Executive Directors regarding the merits of full capital account liberalization and the proper use of CFMs. The IEO also reports that the new view seems to have influenced the IMF’s policy advice on capital account liberalization as well as its bilateral surveillance. However, the report cautioned that it is too early to tell whether the adoption of the institutional view will lead to greater consistency in the IMF’s advice on the use of CFMs.

Gallagher shows, moreover, that the battle over the use of capital controls has not ended, but shifted to new arenas. Free-trade agreements (FTAs) and bilateral investment treaties (BITs) signed with the U.S., for example, generally allow governments much less freedom to regulate financial flows. Similarly, the IEO report finds that there is “…a patchwork of bilateral, regional and international agreements regulating cross-border capital flows…” Moreover, the IMF’s attempts to promote international cooperation to reduce volatility due to capital flows have been unsuccessful.

There will be more developments in the story of the (re)regulation of capital. There are still disagreements on the side-effects of capital controls, and a rise in interest rates in the U.S. will test the effectiveness of controls on outflows. Until then, Gallagher’s book serves as a valuable account and analysis of the most recent changes.

Global Stability, National Responsibilities

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The global financial crisis demonstrated clearly how the flow of money across borders could deepen and widen a financial crisis. A decline in U.S. housing prices led to a re-examination of the safety of financial securities based on them and an implosion in credit markets as financial institutions sought to re-establish their soundness by shedding the securities that were now seen as toxic. These institutions included European banks that had purchased mortgage-backed securities and other collateralized debt obligations. Eventually the emerging markets were brought into the vortex by capital outflows that disrupted their own financial markets. But are we ready to change the rules governing global finance if they impinge on national sovereignty?

Andrew Haldane, chief economist of the Bank of England, spoke last October about the need to manage global finance as a system. He identified four areas that require strengthening: global surveillance, improvements to national debt structures, the establishment of macro-prudential and capital flow management policies, and improved international liquidity assistance. Advances have been made in all these areas since the crisis.

The IMF, for example, has expanded the scope of its surveillance activities to focus more on the spillovers of national policies on other countries and regions. The latest Pilot External Sector Report, for example, examines global imbalances and finds that

“…disorderly external adjustment in some deficit economies remains a risk, particularly in an environment of tightening external financial conditions, and if the policy/institutional environment were to deteriorate or other idiosyncratic shocks materialize. Moreover, country-level risks would have spillovers and carry the potential of becoming systemic, e.g., if a group of EMs (Emerging Markets) with excess deficits were simultaneously affected by negative shocks.”

But is calling attention to possible adverse shocks sufficient? Biagio Bossone and Roberta Marra (see also here) of The Group of Lecce have called for a new commitment by the members of the IMF to be “Global Good Citizens.” This would entail amending the IMF’s Articles of Governance to include ‘global systemic stability’ as a mission of the Fund and its members. This new goal would be defined to include sustainable equilibria in the members’ balance of payments, high levels of domestic employment and income and reasonable price stability, and management of the cross-border transmission of shocks. To achieve these goals, all members would be responsible for implementing external adjustment programs as well as ensuring domestic employment and low inflation, and cooperating with other members to minimize the international transmission of shocks. Moreover, the IMF would be granted the authority to assess whether the policies of its members were consistent with global stability. The Fund could use multilateral consultations to address systemic issues and to call on policymakers to take the cross-national effects of their actions into account.

How good is the IMF’s record on calling out members who have violated existing obligations? Not so good. There were consultations with Sweden and Korea in the 1980s regarding their exchange rates, and discussions in 2006 with China, the U.S., Japan, Saudi Arabia and the Eurozone regarding global imbalances. But the latter were unsuccessful in changing the national policies that led to the imbalances.  Large nations traditionally place little weight on the welfare of other countries when formulating policies, and, if pressed, will claim that their actions benefit the global economy.

But it would be short-sighted to dismiss Bossone and Marra’s innovative proposal to expand the responsibilities of national policymakers to include spillovers. Ignoring cross-border effects is at best myopic and possibly self-defeating. Charles Engel of the University of Wisconsin in a survey of research on spillovers concludes that:

“An optimal policy aimed at inflation and employment will increasingly need to take into account the impact of events in other countries, including the effects of foreign monetary policy. It may ultimately be the case that greater stability and growth at home depends on international coordination.”

Financial markets will continue to grow in the emerging markets as well as frontier markets, and financial flows across national borders will continue to rise. These flows may bring benefits but they also increase financial and economic linkages. Soon the question may be not whether to coordinate, but how and when.

The IMF and Sovereign Debt

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The continuing inability of the Eurozone economies to break out of their current impasse means that any optimistic projections of declining debt to GDP ratios are unlikely to be achieved. As long as European governments continue to raise funds in the financial markets on favorable terms, the current situation remains sustainable.  But the IMF is thinking ahead to the day when there is a change in the financial climate, and is proposing a change in the rules governing its ability to lend to governments that may need its assistance if they are to continue repaying their debt.

The Fund’s rethinking has been prompted by its concerns over its lending to Greece. The IMF, as part of a “troika” with the European Commission and the European Central Bank, participated in a loan arrangement in May 2010. The IMF’s contribution consisted of a $40 billion Stand-By Arrangement. The Fund had a problem, however: this amount far exceeded the normal amount of credit that the IMF normally provided to its members. Exceptions were allowed, but there were criteria to govern when “exceptional access” was permitted. One of these was a high probability that a government’s public debt was sustainable in the medium term. It was difficult to claim that was true for Greece in 2010, so an alternative criterion was established: exceptional access could also be provided if there was a “high risk of international systemic spillover effects.” This was used as grounds to justify the lending arrangement to Greece.

A restructuring of the Greek debt did take place in 2012. The IMF subsequently issued a review of its own response to debt crises, and found that “debt restructurings have often been too little and too late, this failing to re-establish debt sustainability and market access in a durable way.” The IMF was concerned that its money was used to pay off creditors who would otherwise have been forced to negotiate changes in the debt’s conditions with the Greek government.

The IMF has come back with a new lending framework for governments with problems in paying off their debt. The new option would be relevant for a country that has lost access to the capital markets, and when there are concerns about the sustainability of its debt. The government would ask for a “reprofiling” of its debt by creditors, which would consist of an extension of its maturity without a reduction in the principal or interest, while the IMF offered financial support with a plan for economic policy adjustment. Fund officials claim that “reprofiling tends to be less costly to creditors than debt reduction, less disruptive to financial markets, and hence less contagious.”

The new option would allow the IMF to operate in situations where the sustainability of a country’s debt is ambiguous. Those cases are more common than creditors want to admit. Ireland and Portugal have graduated from their respective IMF programs, and can obtain credit again. But the “good outcome” occurred in part because Mario Draghi, President of the European Central Bank, pledged to do “whatever it takes” to preserve the euro, and market participants took him at his word. To date, no one has called upon Mr. Draghi to back up his pledge, and lending rates to all the Eurozone members have fallen. But it is not too difficult to imagine a scenario in which the ECB’s credibility crumbles, particularly if deflation takes hold. What then happens to perceptions of debt sustainability?

As an agent of 188 sovereign principals (the member governments), the IMF is constrained in what it can do on its own initiative. But any ambiguity of the sustainability of debt gives the IMF some scope for autonomy. In addition, differences in the objectives of the members provide policy “space” for the IMF to maneuver.

Extending the maturity date of an existing bond would lower its net present value of the debt. Lenders, therefore, are unlikely to embrace the IMF’s proposal. But the concerns over the repayment of Argentine debt threaten to extend to other markets (see here), and are another source of uncertainty.  An association of lenders has issued a call for more flexibility in the terms governing collective action clauses, but these take time to implement. Moreover, European finance ministers are preoccupied by other, more pressing concerns.

As long as debt markets remain calm, “reprofiling” will be considered as an interesting policy proposal, which will be sent off for further study. But once the interests of the major stakeholders—which continue to be the G7 countries—are involved, then there will be an assessment based on the financial interests at stake. The response to the Greek debt crisis demonstrated that the European countries are quite willing to rewrite the rules governing the IMF’s policy options when they see an advantage for their national interests. But the response to a similar situation in another part of the world could be very different. And it is precisely that perception of unequal treatment that is driving dissatisfaction with current arrangements at the IMF.

 

The BRICS and the Bretton Woods Twins

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The World Cup was not the only event of global significance to take place in Brazil this summer. The leaders of Brazil, Russia, India, China and South Africa met in the city of Fortaleza and announced the formation of two new financial institutions. One is the New Development Bank (NDB), which will finance “sustainable development” projects, with an eventual $100 billion in capital. The second is the Contingent Reserve Arrangement (CRA), which will make $100 billion available to lend to members in financial distress.

If these stated aims seem familiar, they should: they copy the missions of the Bretton Woods “Twins,” the World Bank and the IMF. Why, then, would we need another set of institutions with these mandates? A possible answer could be that these institutions will operate on a smaller scale, and therefore fill a gap between national organizations and international ones.  The principle of subsidiarity states that decisions should be made at the appropriate level, i.e., national policymakers address domestic needs, regional organizations deal with issues of regional relevance, and international institutions address global problems.  In this case, it might be argued that these middle-income nations are better able to make decisions on their level than in a larger forum.

However, economic efficiency is not what is driving this process. The new organizations are a response to the breakdown of quota reform at the IMF and the World Bank. A visitor to Beijing, as I recently was, will hear the complaints that the U.S. government, by not passing the measures needed to implement the reform measures, is frustrating the aspirations of the emerging market nations. Attempts to explain the inaction as the result of domestic politics are dismissed as self-serving justification.

It is difficult not to be sympathetic to these complaints. There is no reason why the long-overdue reallocation of quotas should not proceed. The governments of the emerging market economies have long been promised that an adjustment of their positions would be made, but there was always a procedural hurdle to be cleared. Now, when the world’s governments (including the Obama administration) agree on the particulars, a new reason for inaction appears.

Of course, there are details to be worked out for the new bodies. Who is eligible to borrow from the new development bank? Will it seek to compete with the World Bank by offering more money/fewer conditions? Will there be political “litmus tests” for would-be borrowers?

The new currency arrangement resembles the Chiang Mai Initiative Multilateralization (CMIM), an agreement on currency swaps within Asia, which has been viewed as a complement, and not a substitute, for the IMF. Moreover, as under the CMIM, a country that wants to borrow more than 30% of the maximum access allocated to it would also have to enter an arrangement with —  the IMF! The world, it seems, is not quite ready to cast off the Fund.

But it would be wrong to underestimate the significance of the establishment of these institutions. They are the result of the continuing clash between the G7 countries and the emerging market nations that see themselves as perpetually marginalized within the Bretton Woods institutions. While economic growth in China may be slowing and India continues to strive to accelerate its pace of development, the size of these and other countries in Asia, Africa and Latin America ensure that they will become more dominant over time. If they are frustrated within the traditional bodies of international economic governance, they have the capacity to establish their own forums.

However, economic and financial instability does not respect political camps. Their avoidance are international public goods, requiring cooperation from the full range of nations. A breakdown in global governance only leaves the international economy more vulnerable to volatility that can sweep across borders, as we learned in 2008-09. Perhaps the biggest question about the new organizations is whether they will strengthen the resiliency of the international financial system. It may take another crisis to learn the answer.

Protesting the IMF’s Madame Lagarde

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The protests at Smith College that led to the withdrawal of Christine Lagarde, Managing Director of the International Monetary Fund, as this year’s commencement speaker have been widely denounced as a manifestation of intolerance. They also demonstrate a lack of understanding of the IMF and the many changes that have taken place at that institution in the last decade, as well as Ms. Lagarde’s own record. The IMF adjusted its policies in response to the criticisms it received after the crises of the 1990s, but apparently its critics are mired in the past.

A petition signed by several hundred Smith students and faculty (but not supported by many Smith faculty, including members of the Economics Department) explains the grounds for their opposition to Lagarde’s appearance on their campus:

“By having her speak at our commencement, we would be publicly supporting and acknowledging her, and thus the IMF. Even if we give Ms. Lagarde the benefit of the doubt, and recognize that she is just a good person working in a corrupt system, we should not by any means promote or encourage the values and ideals that the IMF fosters. The IMF has been a primary culprit in the failed developmental policies implanted in some of the world’s poorest countries. This has led directly to the strengthening of imperialist and patriarchal systems that oppress and abuse women worldwide.”

This statement exhibits the “vagueness and sheer incompetence” that George Orwell cited as characteristics of modern English prose, particularly political writing. In addition, the assignment of responsibility to the IMF for the “imperialist and patriarchal systems” is a contemporary example of the “staleness of imagery” that Orwell deplored. Holding the IMF responsible for global poverty reveals a lack of knowledge about the decline in global poverty in recent decades as well as a gross misunderstanding of the IMF’s role.  The IMF long ago retreated from the structural adjustment policies that were criticized as inappropriate, and ceded the lead role in addressing poverty to the World Bank. More recently, the IMF was active in responding to the global financial crisis. The Fund in 2008-09 provided large amounts of credit relatively quickly with limited conditionality, and the IMF’s programs contributed to the recovery of global economic activity (see here for more detail).

Blaming Lagarde for global poverty is particularly unjustified in view of her acknowledgement of this issue. She has spoken eloquently about the combined impact of the economic crisis, the environmental crisis and the social crisis that reflects a widening gap in income distribution. To tackle the latter, she has supported more spending on health and education, and the development of social safety nets. Lagarde has also been a strong spokeswoman for gender equality (see also here). The change in the IMF’s position on the use of capital controls predates Lagarde’s tenure, but she has encouraged the continuing intellectual evolution of its Research Department under Olivier Blanchard.

And then there is the irony of students at a prestigious women’s college protesting the invitation extended to a woman who has been a pioneer in raising the professional profile of women. In the male-dominated world of international finance she was the first female finance minister of a member country of the Group of 8, and is the first female head of the IMF. The top position at the IMF became available when her predecessor at the IMF, Dominique Strauss-Kahn, resigned after being charged with sexual assault at a New York hotel. Ironically, the controversy over Lagarde arose as a movie about Strauss-Kahn was being shown at Cannes.

If protestors want to do something to improve the position of the world’s poorest countries, they should aim their ire at those members of the U.S. Congress who are blocking reform at the IMF. The politicians have been stalling passage of the required authorization of changes at the IMF, which would increase the representation of emerging market countries at the Fund. In a rare act of (muted) public criticism, the government of Great Britain has publicly urged the U.S. Congress to ratify the required measures. Reforming the IMF would be a more effective response to global inequality than protesting against someone who has sought to lessen that inequality.