GLOBAL ECONOMIC RELATIONS The Politics of International Finance James Raymond Vreeland School of Foreign Service Georgetown University

The questions we will address tonight: 1.Why did we ever invent the International Monetary Fund? 2.What is the IMF and what does it do?

Why was the IMF created? To answer this, we need… a little historical perspective…

1 st : A reminder of The “Inconsistent” or “Unholy” Trinity Or “Trilemma”

The Trilemma Fixed Exchange Rate Open Capital FlowsSovereign Monetary Policy

Why would you want… Free Capital Flow? –Draw on the savings of the rest of the world –Investment opportunities abroad Fixed Exchange Rate? –Reduce uncertainty in trade Sovereign Monetary Policy? –Address inflation/unemployment

The Trilemma Fixed Exchange Rate Open Capital FlowsSovereign Monetary Policy Eurozone countries Switzerland PRC

Why did we ever need the IMF? A puzzle 1944 Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows

Conclusion: Cannot maintain (global) fixed exchange rates in the presence of high capital mobility…?

Why did we ever need the IMF? A puzzle 1944 Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1870 *

A puzzle: Why were countries able to maintain fixed exchange rates with high capital mobility in the late 19 th century? 1944 Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1870Interwar period Fixed exchange rates + Open capital flows

Why? Discussion…

Answer: Democracy 1944 Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1870Interwar period Fixed exchange rates + Open capital flows Growing #’s of democracies Few democracies

Growth of democracy (minimalist definition) 1870 (7):1884 (8):1897 (12):1911 (17): United StatesNorwayNetherlandsSweden Canada1885 (9):1901 (14):Portugal FranceUnited KingdomAustralia1912 (18): Switzerland1890 (10):DenmarkArgentina GreeceLuxemburg1909 (15): Orange Free State1894 (11):Cuba New ZealandBelgiumChile (lost OFS – 1902)

Why? So, why do fixed exchange rates pose a problem for democracies in the face of highly mobile capital?

Pure gold standard Country A imports from Country B Gold moves from A to B (re-coined/minted) Less money in A  lower prices More money in B  higher prices  Country B imports from Country A Balance is restored

With paper money Central Banks intervene by adjusting interest rates So gold doesn’t actually flow Gold Standard  strict discipline!

What is “discipline”? What do “lower prices in Country A” mean? Supply of money down More expensive to borrow Jobs cut! People don’t eat!

People don’t eat Under authoritarianism: Let them eat cake Under democracy: Incumbents lose elections

Hazard Rate over Time for Democracies (Solid Line) & Dictatorships (Dotted Line) – Time in years

Under democracy, The “pocketbook voter model” –people vote according to changes in their income – Sociotropic model – voters consider macro performance (economic growth, unemployment, inflation)

Fixed exchange rates + Open capital flows No problem under authoritarianism –(no problem for governments) Big problem under –Democracy –Labor Unions

What was the IMF supposed to do? Soften the blow Lend to “Country A” deficit-countries so that adjustment can be gradual

Problem Keynes Plan called for contributions totaling $26 billion (with $23 billion from the US) The White Plan called for only $5 billion (with $2 billion from the US) Compromise: –$8.8 billion, with just $2.75 billion from the US The US would only provide Marshall Plan assistance to countries that did not seek additional assistance from the IMF On the eve of the current crisis: –instead of having reserves approximating half of the value of global imports, the IMF holds on reserve a total of less than 2 percent of global imports

Stylized history so far… Late 19 th century: –Mobile capital, authoritarian governments Interwar years: –Mobile capital + democracy  beggar-thy-neighbor Still to come… Bretton Woods ( /3): –Capital controls + democracy Post Bretton Woods: –Floating exchange rates

What was the IMF supposed to do? After a 15 minute break

Part 2: What is the IMF and what does it do?

What is the International Monetary Fund? Based on: Vreeland, James Raymond, The International Monetary Fund: Politics of Conditional Lending (Routledge, January 2007).

1944: 44 countries signed the Bretton Woods agreement –International Monetary Fund (stability) –World Bank (development) The “Bretton Woods” Institutions.

The IMF was given 2 tasks: 1.Surveillance. 2.Lending. The IMF has mainly focused on the latter function – so we will too… But I’ll touch on surveillance at the end.

Why lending? Gold standard – each currency’s value was ultimately backed up by gold. A balance of payments deficit could lead to a depletion of gold reserves  Lowered confidence that the government can really back up the value of the currency  Run on the currency… hyperinflation, breakdown of economic order! Governments close up trading!

A run:

37 Sweeping the pengő inflation banknotes after the introduction of the forint in August 1946 Zimbabwe

Stepping back: Who is the IMF? Where does it get its resources from? How are decisions made?

Who is the IMF? Currently 187 members. Who’s not a member? –Andorra, Liechtenstein, Nauru, Taiwan, Cuba, and North Korea Members have “votes” according to the size of their subscription to the IMF…

Where do the resources for “loans” come from? Members provide a contribution called the member’s quota (held on reserve). The size of the quota is a function of the country’s economy: GDP current account transactions official reserves Largest: USA (SDR 37,149.3 million). Smallest: Palau (SDR 3.1 million).

Who controls the IMF? IMF vote shares have been “out of whack” with reality Top 5 members: –United States (16.8%) –Japan (6.0%) –Germany (5.9%) –France (4.9%) –UK (4.9%) Other important members: –China (3.7%) –Saudi Arabia (3.2%) –Russia (2.7%) –Italy? (3.2%) –Belgium? (2.1%) –Brazil? (1.4%) –India? (1.9%) –Turkey? (0.55%)

Who controls the IMF? (2010) Top 5 members: –United States (16.7%) –Japan (6.0%) –Germany (5.9%) –France (4.85%) –UK (4.85%) Other important members: –Italy? (3.19) –Saudi Arabia? (3.2%) –Canada? (2.9%) –Russia (2.7%) –Belgium? (2.1%) –China (3.65%) –India? (1.9%) –Spain? (1.4%) –Brazil? (1.4%) –Korea? (1.3%)

New vote-shares (for 2012) 1.United States: Japan: China: Germany: France: United Kingdom: Italy: India: Russia: Brazil: Canada: Saudi Arabia: Spain: Mexico: Netherlands: Korea: Australia: Belgium: 1.30

But real distortions also occur in the elections for the Executive Board Recall: –IMF Board of Governor votes: 53% –IMF Executive Board votes: 61%

Appointed & Elected Directors Appointed: –US, Japan, Germany, France, UK Elected: –China, Saudi Arabia, Russia Regionally elected (ad-hoc) –Australia South Pacific, New Zealand, Korea, Uzbekistan –Brazil Latin American countries –Togo African countries –Iran Afghanistan, Algeria, Ghana, Morocco, Pakistan, Tunisia

Really ad-hoc elected Directors: Italy –Greece, Malta, Portugal, San Marino, Albania, & Timor- Leste Belgium –Austria, Luxembourg, Belarus, Czech Republic, Hungary, Kosovo, Slovak Republic, Slovenia, & Turkey Netherlands –Armenia, Bosnia and Herzegovina, Bulgaria, Croatia, Cyprus, Georgia, Israel, Macedonia, Moldova, Montenegro, Romania, & Ukraine Switzerland –Azerbaijan, Kazakhstan, Kyrgyz Republic, Poland, Serbia, Tajikistan, & Turkmenistan

How do they do it? Foreign aid?

Buying Bretton Woods James Raymond Vreeland Georgetown University Paper prepared for presentation at the AidData Conference, University College, Oxford, March 22-25, 2010

Switzerland? New IMF member (1992) –Bloc does not have deep historical ties other than joining around the same time –Data for the entire period are available Switzerland has added incentives –Out of the EU, out of the G20

THE EXECUTIVE BOARD MAKES LENDING DECISIONS Suffice to say:

IMF lending as insurance A loan from the IMF enables a country to survive a temporary balance of payments deficit.

So…as an international lender, If a country gets into a balance of payments crisis, or for whatever reason, has a shortfall in its foreign reserves, The IMF can provide a loan (lest this country enter into destructive policies). Problem: This “bailing out” option lowers the incentive to pursue sound policy.  “Moral Hazard.”

How do we deal with moral hazard? Automobile insurance? Too big to fail? The IMF?

Solution? If the IMF determines that the need for an IMF loan is due to bad policy, The Fund imposes policy conditions in return for the loan. This arrangement of conditions for loans is known as “Conditionality.” Note that the loan is not provided upfront, but disbursed in “tranches,” subject to reviews of compliance with conditions.

Policy conditions have traditionally entailed: Fiscal austerity –cutting government services and increasing taxes Tight monetary policy –raising interest rates and reducing credit creation Sometimes currency devaluation What are the goals of IMF programs? –Economic stability –Economic growth

La loi LETTER OF INTENT Drafted (by whom?)… signed by finance minister, central bank president, and/or chief executive Sent to the Executive Board for approval 1 st “tranche” of loan released Ya want another tranche? –Conditionality (goodfellas)

What were the goals of Bretton Woods? Support Fixed XR’s with governments unwilling to sacrifice employment to address imbalances 4 INNOVATIONS: 1.Some XR flexibility (fixed-but-adjustable “snake”) 2.Capital controls 3.A stabilization fund (held on reserve at the IMF) 4.The International Monetary Fund – authority over XR changes + conditionality attached to loans

Bretton Woods failed for several reasons IMF lacked true authority over XR for Europe Governments did not like IMF conditionality The stabilization fund was never large enough Straws that broke the BW back: –USA: VIETNAM + SOCIAL SPENDING + INTERNATIONAL RESERVE CURRENCY –  SPECULATION that the US cannot maintain the fixed convertibility to gold + the French – regularly demanded American gold from the US for the $’s they accumulated

The world shifted away from the Bretton Woods-gold standard in the 1970s The old exchange system collapsed. The IMF faced a crisis of purpose. But the IMF was already involved in the developing world. Expanded this role – not just lending for stability, but also to promote development. The shift?

Was there really a shift?

Europe takes up a new path The European Monetary System – 1979

Recidivism was the norm Extreme examples from around the world: South Korea spent 13 years under consecutive agreements from 1965 to Zaire 14 years straight ( ). Liberia 15 years ( ). Peru participated in consecutive agreements from 1954 to 1971 (18 years). Panama from 1968 to 1987 (20 years of consecutive agreements) After a stint of seven years (1961 to 1967), Haiti entered into agreements again from 1970 to 1989, for a total of 27 out of 29 years.

One last question: Why do governments participate in IMF programs? –Domestic politics stories… –International politics stories…

Review of background on the IMF: Similar to a credit union (access to pool of resources). Can lend from this pool to countries in crisis. Moral hazard: lowers the incentive to avoid bad policies. Thus, Conditionality – force the country to follow “good” policies in return for a loan. So, you can think of an IMF program as having 2 components: loan + conditions.

Thank you WE ARE GLOBAL GEORGETOWN!