Reforming International Financial Institutions Joseph E. Stiglitz Third Annual Forum Funds Public Policy Lecture UCLA May 8, 2000

Policies recommended by current international financial institutions: “Washington Consensus” Application to Economies in Transition Application to Crises (with examples) Criticisms of the Washington Consensus Policies neither necessary nor sufficient The emerging consensus and suggested reforms in the international architecture OUTLINE

POLICIES RECOMMENDED BY CURRENT INTERNATIONAL FINANCIAL INSTITUTIONS “Washington Consensus”: largely formulated in Washington among the IMF, World Bank, and US Treasury Countries should focus on Stabilization Liberalization (including trade, financial market, and capital account liberalization, and eliminating subsidies) Privatization

APPLICATION TO ECONOMIES IN TRANSITION Privatization more important than competition Restructuring existing enterprises through privatization more important than job creation Stabilization more important than growth or enterprise creation Rapid reform (read: rapid privatization) more important than establishing institutional infrastructure Social capital, consensus building less important

APPLICATION TO CRISES Fiscal austerity Monetary austerity More attention to impact on foreign investors than to capital flight Little attention to impact of social and political turmoil on economy More attention to ensuring that capital adequacy standards are satisfied than to macro-economic consequences of resulting liquidity constraints

Example 1: Thailand Crisis Sequence of Events: –Real estate boom supported by huge capital inflow –Associated with large trade deficit –Real estate bubble bursts, capital stops flowing in, starts to leave –Government tries to support exchange rate –Reserves run out (uses forward/futures markets to hide transactions) –IMF called in...

IMF response: –“Rescue package”: fiscal austerity, high interest rates, “structural reforms,” bail-out Package fails to work –IMF announces that government not doing “right” thing Crisis exacerbated as capital flight worsens Consequences of Thailand Crisis: –Economic recession sets in –Rising unemployment –Falling real wages –Massive bankruptcies, financial sector collapse –New IMF programs, new government complies with all IMF directives

Recovery after Thailand Crisis: –Recovery very slow existing recovery is driven by exports, which are helped in large part by currency devaluation –Nearly half of loans still non-performing this constrains financing of new investment –Output still below 1997 level poverty and inequality are up

Example 2: Korea Crisis Sequence of events: –Excessively high leverage –Combined with investment in highly cyclical industry –Lack of confidence inspired by problems elsewhere in the region –Combined to lead banks to refuse to roll over loans –Korea tried to sustain exchange rate, and used up its reserves

IMF response –Standard package (fiscal austerity, high interest rates, huge bail-out, mixture of relevant and irrelevant structural reforms) failed to restore confidence –IMF again blames country for failures, worsening crisis Consequences of Korean Crisis: –Exchange rate stability only restored with debt standstill –Deep recession –Large defaults –Increasing unemployment

Recovery after Korean Crisis: –Rapid recovery due to : –Decrease in exchange rate, combined with strong government action to maintain financial institutions –Cyclical recovery of chip market –Strong role of government in forcing financial restructuring –Consensus building by new government IMF Advice Contrary to Recovery Policies –Maintain exchange rate –Scale back chip market –Stand-off role for government in restructuring –Ignore importance of consensus building

CRITICISMS OF WASHINGTON CONSENSUS POLICIES âPoor crisis prevention and response Global financial architecture has led to increasingly frequent and deep financial and economic crises Key IMF Failures: Pushed policies that led to crises (capital and financial market liberalization) Bail-out policies created moral hazard, reduced incentives for lender due diligence Supported artificially high exchange rates (provided food for speculative sharks, undermined incentives for obtaining cover for exchange rate risks) (continued…)

CRITICISMS OF W.C. Key IMF Failures (continued): Misdiagnosed severity of downturns –Simple macro-model should have made them worried –More sophisticated macro-models incorporating finance should have made them even more worried Ignored lags and irreversibilities –Easier to destroy firms than to recreate them Applied strategies appropriate for isolated incidents to systemic situation Huge costs of crisis response imposed on bystanders Adverse legacy, e.g. huge indebtedness âThe failure of the economies in transition Plummeting GDP Increased poverty âIncreased poverty in the developing world

Policies Neither Necessary nor Sufficient Most successful countries did not follow policies –e.g. China, Botswana –many countries following policies did not grow IMF policies actually contributed to poverty –Advocated policies that increased instability –Problems exacerbated by manner in which they responded to crises Contractionary policies Beggar-thyself policies Maintenance of high exchange rates Repayment of creditors, with burden borne by workers Some policies did not even increase growth Some policies (open capital markets) made it more difficult to tax wealthy (owners of capital)

IMF Policies Undermine Democracy Conditionalities imposed without social consensus Negotiations often conducted behind closed doors Continuation of colonial mentality –Especially inappropriate given nascent democracies and increasing competence of those within countries Go beyond areas in which there is a broad consensus among economists –Into areas of politics—such as promoting independent central banks

How do we explain these consistent failures? Lack of openness, transparency Lack of competition Desire to shift blame –Clear failure of surveillance –Policies had actually contributed to crisis –Wanted to protect financial interests who had advised clients to invest in countries Poor governance structure –Leads to policies designed to protect special interests rather than global interests –Who has a seat at the table?

Going Beyond the Washington Consensus Policies Recognition of: Inadequacies of underlying economic models The important role that ideology played in formulation of Washington Consensus The important role that special interests have played ELEMENTS OF AN EMERGING CONSENSUS:

BROADER OBJECTIVES Development entails more than addressing just technical issues Democratic development Sustainable development (politically, environmentally) Equitable development Transformation of society –Changes in ways of thinking –Important role for social capital –Change cannot be imposed –Isolated developments (e.g. remote mining) may enhance resources (e.g. foreign reserves) but may have little impact on developmental transformation

MORE INSTRUMENTS Even in pursuing narrow objectives, Washington Consensus policies have been excessively narrow e.g. macro-instability can also arise from financial sector weakness must be aware of multiple equilibria, have “evolutionary thinking” Economic efficiency requires competition, good legal system Issue is getting right role of government, not minimal role Government complements market by providing necessary “institutional infrastructure”

NEEDED REFORMS Need to consider impacts of policies on poor people Unlikely to occur with current governance structures Some suggestions: Limit IMF to crisis lending Change governance structure Change operating “modes” e.g. more transparency, more participation Impose restrictions e.g. on extent of crisis lending, who bears cost? and on nature of conditionalities that can be imposed