Friday, January 12, 2007

The International Monetary Fund/Assignment 1 FE 201

Ronald Rutherford
Assignment #1
FE 201
The International Monetary
Fund & Economic Policy

Write an essay discussing some of the key criticisms of the IMF’s financial programming approach. With reference to country examples, discuss whether or not you consider these criticisms to be valid.

Before I get into the key criticisms, I would like to mention one important aspect of any macroeconomic policy is to consider the health and vitality of the banking system including the role of the central bank. As Hoggarth and Saporta (2001) have pointed out, the costs to the economy as well as the Fiscal costs (of a financial crisis?) can be substantial and the effects long lasting. While the crisis typically is longer in developed countries, it can be much deeper in developing countries with widespread disruptions. But I do have a problem with methods used to calculate the trend lines to identify the effects of crises. By taking a simple average as a point estimate instead of using a confidence intervals it may either underestimate or overestimate the true (or expected) trend line in less economically stable countries. If the variance is wider then it may even under or overestimate the duration of the crisis also. (11)

During this discussion of the criticisms of the IMF Financial Programming Approach I will focus on the following seven criticisms (1. Unit 3 pages 3-17):
1. Problems arising from overstepping the IMF’s traditional Mandate.
2. Failure to recognize the importance of the financial sector.
3. A one-size-fits-all approach to stabilization.
4. Imbalanced representation and imbalanced policy advice.
5. IMF policy on conditionality.
6. The challenge of inadequate growth.
7. Excessive social costs arising from IMF-supported financing arrangements.

It would be useful to describe or at least outline the financial programming approach. The question does not explicitly ask for this, but the Assignment Guide does suggest you refer to the extensive literature challenging the behavioural assumptions which underlie the financial programming approach.

Problems arising from overstepping the IMF’s traditional Mandate:
To more fully understand the IMF’s traditional mandate, I will now explore the Articles of Agreement. In summation of the points of Article One-Purposes (3), the IMF is to: promote international monetary cooperation, facilitate the expansion and balanced growth of international trade, promote exchange stability, assist in the establishment of a multilateral system of payments, give confidence to members by making the general resources of the Fund temporarily available, and shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members. As this clearly shows nothing mentions long term growth or structural matters to be addressed. It might also be good to point out the mandate to oversee the exchange rate policies of its member countries. Article IV - Obligations Regarding Exchange Arrangements provides the mandate for surveillance under Section 3 Surveillance over exchange arrangements. And this allows the IMF to provide the necessary service of technical assistance (4).
So now that the IMF has gone past its initial mandate, and it is claimed that it has gone into areas that it has not the expertise to fully handle. Although the IMF can call upon the resources of the World Bank and other IFI (International Financial Institutions), it may end up being the ‘Lead Agency’ to handle the situation and thus be in even more areas it is not suited to handle.

Failure to recognize the importance of the financial sector:
The experiences of the IMF with regard to Indonesia was marked by correctly identifying areas of vulnerability, namely, large capital inflows increasing foreign debt, an unstable banking system that was linked to nepotism and cronyism combined with lack of strict government oversight, and interventionist policies in the market. But it underestimated the seriousness of the situation and thus failed to provide sufficient warning. (5, Pages 12, 48) Indonesia was a special case because of governance issues and corruption. It would be better to use Korea as an example.

Even though the “[s]urveillance identified the central problems in Brazil reasonably accurately” (5, Page 48), there was “[i]nsufficient attention paid to the buildup of short-term debt.” (5, Page 140) But even here the authorities had conflicting data as well as a reluctance to be completely transparent by the authorities.

As mentioned in my opening paragraph, the financial sector is very important to the stability of the entire economy. So having better and more complete data could help the IMF to identify areas of vulnerability, but it does not mean that actions can and will be able to be implemented in time, given the reluctance of various governments to take the advice of the IMF until a crisis occurs. This was especially pronounced in the situation with Indonesia.

But for an East Asian country that weathered the storm, Hong Kong maintained its fixed exchange rate to the US dollar during the East Asian financial crisis without major disruption. So when other nations suffered from one way speculations on the currency depreciation, Hong Kong was still able to maintain the exchange rate: at US$ 1 to HK$ 7.8. This was done through the stability of the currency board. While its proactive Monetary Authority effectively lacks the ability to control the money supply, it has a variety of ways to maintain the peg to the US dollar. Two of those methods are through cash arbitrage and specie-flow mechanism. (6). Argentina adopted a similar policy to that of HK and it ended in disaster. Eventually the link to the $ had to be abandoned.

A one-size-fits-all approach to stabilization:
This is an important consideration in that since all crises are neither created the same nor have the same actors involved, it seems to not make sense that nearly all of the IMF stabilization policies include the following:
1. Targets for net international reserves and for government borrowing. The government borrowing aspect turned out to be an incorrect judgment with respect to Indonesia and Korea as this caused a severe collapse of aggregate demand and thus output. (5, Page 48) This was especially apparent with regard to Korea when public debt was only 6% of GDP and the deficits were projected at .2% in 1997 and a projected surplus in 1998 of .25%. (5, Page 106) A better approach is to target discretionary expenditures as the target rather than fiscal deficits. This allows for automatic fiscal stabilizers and the freedom for the government to address crises outside the normal budgetary process and still maintain overall fiscal discipline. (5, Page 53)
2. All programs include similar types of conditionality. Financial programming is used in all IMF lending.
3. All negotiations use the same identical process.
4. Structural conditions are nearly always included in the financial programming approach. (1, Unit 3, Page 8)

I wish to address point two, three and four separately now. This is due to the fact that all financial programming approaches have a basis on the simple four key identities by Polak. (1, Unit 2, Pages 27-36) Even though the model has been tried to be used on medium-term models it has failed to deliver results, which includes some of the “transition countries” (former Soviet Empire States) in the early 1990s. (8)
The identities and the behavioural assumptions made for the Polak model could be discussed in more detail and their weaknesses identified.
Structuralist theory does not assume that inflation is simply a money supply issue, but can arise from distributional conflict and the set of rules for price information. (7, Page 13) One way that this is manifested in is through ‘market makers’ that have economic power to control prices in their sector and can price push inflation. (7, Page 149) Even Lance Taylor acknowledges the contributions that Jacques J. Polak has contributed to macroeconomic theories. (7, Page 162) But he does have 8 recommendations for improving the methodology of the IMF stabilization programs along with adding some macroeconomic equations that are missing. (7, Pages 159-164) And lastly Taylor does not want to do away with the present models but to add to and enhance the models with more realistic theoretical formulations. (7, Page 169)

Matias Vernengo places the Structuralists, Post-Keynesians, and Inertialists as having the view that inflation is caused by distributive conflict, propagation mechanisms or balance of payments problems. In his paper from 2003, the inflation model he describes is a cost push based on external constraints. (11.)

This arrangement seems more like a mechanic that always wants to fine tune the car than to do a simple oil change. Instead of being a lender of last resort and following the mandates to help out countries in temporary Balance of Payments problems, the staff and management see the need to tamper with the structural economy of a country. Considering that “The Three Crisis Cases” programs failed in their initially stated objectives, and then it is easy to suspect a knee jerk reaction to crisis instead of considering some of the true causes of the crisis. (5, Page 11)

Going along with the last paragraph, the IMF should give countries the benefit of the doubt when the IMF is first approached by a member country at least initially, since its “mandate gives it an obligation to support member countries necessary efforts to address their economic difficulties.” (9, Page 207)

Imbalanced representation and imbalanced policy advice:
I think this is best summed up by: “For developing countries to be able to carry a decision in their favour, they therefore clearly require to build alliances with creditor members.” (1, Unit 3, Page 11)
But since the IMF is basically like a bank then it seems reasonable that the creditors are given preferential treatment in the decisions of the funds. If creditors decided to take their money and go, then the bank (no matter how many debtors) will cease to exist. This of course does not mean that other ideas of management or governance should be avoided.
The debtor countries would have fewer resources to make loans but they could perhaps follow the example of mutual societies. All contributing to the fund and loans being made to some members.
It should also be noted that no program will work if there is not a sense of ownership of the program by authorities that are to administer and carry out such policy changes. The general problem on hardening to conditionality is manifested in the following examples:
1. By enacting a law but not implementing it.
2. Making so many exceptions to the new tax laws that it minimizes new tax revenue streams.
3. Creating new exemptions while abolishing others, thus creating no net effect.
4. Reversing or suspending measures either before implemented or shortly after. (9, Page 199)
And when all else failed, there was a tendency to blame the IMF as a scapegoat in both Pakistan and Indonesia. (9, Page 200) (5, Page 15, Footnote 9)

IMF policy on conditionality:
This is broken down into five broad types of criticism:
1. IMF conditionality is too extensive and intrudes on the sovereign decision-making authority. Recommendation #6 in the IEO has some good advice for the IMF in regard to this. Basically the IMF needs to develop political economy skills of the staff while encouraging sufficient country specific knowledge is retained over the long term. (5, Page 54)
2. IMF structural conditionalities are not politically feasible and may place too much burden on the leaders of a sovereign country. Which this issue was addressed in the IEO Evaluation Report 2003 by trying to develop staff that had a greater understanding of the political constraints that affect decision makers in the member country. (5, Page 49)
3. The time frame between stabilization policies and structural conditionalities is mismatched. And as stated in the IEO evaluation: “A crisis should not be used as an opportunity to force long-outstanding reforms…” (5, Page 53)
4. And going back to the mandate, some conditionalities are clearly beyond its mandate. I believe that in the case of Pakistan, the IMF overstepped its bound by having conditions on the Fiscal reforms without proper implementation and timing of the shift in taxes which resulted in adverse affects especially in tax revenues and thus the budget. (9, Page 194-195)
5. Too many conditions placed on the terms of the IMF, as for example Indonesia with 130 conditions. (1, Unit 3, Page 13)
This can definitely cause governments to be hesitant about asking for assistance. It can also create reluctance to ask for help early enough, instead of waiting until the situation becomes worse. If the role of the IMF is similar to central banks (Federal Reserve Board), then why should the IMF always ask for conditions when the problems may be just temporary illiquidity and not insolvency?

The challenge of inadequate growth:
While any manmade system is in need of constant scrutiny and processes of always trying to improve the designs of the program, I am not sure that this criticism takes the IMF farther away from its mandate of temporary imbalance of payments and in areas more suited for long term growth facilities such as the World Bank or other IFIs. Many of the new members of the IMF, including sub Saharan countries, do not face temporary imbalances in their balance of payments. They have fundamental long-term problems. So the question could be raised: Is the fault of the IMF objectives of the stabilization programs not being achieved or that the wrong objectives are chosen given the IMF’s mandates?

Excessive social costs arising from IMF-supported financing arrangements:
There is no doubt that reducing absorption in the economy can have dire effects on the people (sectors of society) that have the least ability to handle a drop in income and spending. Development of social safety nets should be of concern when implementing any financial programs, which we will study in Unit 8.

“In the future, one could also think of stabilizations ‘with a human face’, which would at least maintain the income and welfare positions of the poor and vulnerable groups in the society.” (7, Page 23)

I think the IMF needs to decide which direction to take before we can adequately decide if the criticisms are merited. If the IMF’s mandate is to maintain the present articles then it clearly has overstepped its mandate. Before the late 1980’s, the IMF narrowly focused on macroeconomic policies and a few structural areas, but then when concessional facilities were created the IMF broadened into more structural and long-term financing packages. (9, Page 190) Presently it states on the ‘Introductory Information’ page on the IMF web site: “It was established to promote international monetary cooperation, exchange stability, and orderly exchange arrangements; to foster economic growth and high levels of employment; and to provide temporary financial assistance to countries to help ease balance of payments adjustment.”

Since the world has changed drastically since the Bretton-Woods agreements, then maybe the IMF needs to change also (Surely, it has made substantial changes including new lending programs). After the collapse of the gold standard and most developed and many developing countries changing to a strictly floating exchange-rate, then maybe the IMF mandate is no longer necessary. And this would open it up for mid-term financing and not just short financing of Balance of Payments problems. The World Bank and other IFIs would still provide financing for long-term projects, but the IMF could look for helping out countries that have structural concerns that need financing and especially advice on the transitions.

So if we accept that the IMF’s mandate should change, then yes many of the criticisms are justified. With the exception of one, being that the governance issue will continue to plague multinational organizations. Is it fair that the EU gets more votes (United Nations) because of the individual states or should it get only one vote with a veto such as the USA? (Europe has two vetoes France’s and the UK’s. The IMF voting structure is more complicated and is related to quotas – which are based on measures of the size of economies. This gives the USA and other advanced economies a large share of the votes.)Who decides what is fair or not fair? And can an organization be truly a democracy when not all people in the world are free to decide their own potentates.

(1.) The International Monetary Fund & Economic Policy Unit 1-8, Dr. Cyrus Rustomjee, 2005.

(2.) Hoggarth G, R Reis and V Saporta (2001) ‘Costs of Banking System Instability: Some
Empirical Evidence’, Bank of England Working Paper, Financial Stability Review,

Articles of Agreement of the International Monetary Fund/Article I – Purposes

Article IV - Obligations Regarding Exchange Arrangements

(5.) Independent Evaluation Office, ‘The IMF and Recent Capital Account Crises,
Indonesia, Korea and Brazil’

(6.) Strength of the Hong Kong Dollar:
The Defiance and Stability of the Hong Kong Currency Board
During the 1997 Asian Financial Crisis, Glen Vierk

(7.) Taylor, Lance (1991) Varieties of Stabilisation Experience: Towards Sensible Macroeconomics in the Third World; Oxford: Clarendon, Chapters 2 and 5.

(8.) Polak, Jacques (April 1997), The IMF Monetary Model at Forty: IMF Working Paper No. 97/49

(9.) A case study of Pakistan’s experience with IMF financial programmes since the late-1980s by the IMF Independent Evaluation Office, ‘The Evaluation of Prolonged Use of IMF Resources’

(10.) About the International Monetary Fund, IMF, Introductory Information,

(11.) Balance of Payments Constraint and Inflation, Matias Vernengo, Working Paper No: 2003-06

The essay demonstrates familiarity with the sources and raises a number of interesting issues. Ideally, the IMF’s financial programming approach would at least be outlined early on in the essay. Also, the progress the IMF has made adapting its policies to the different requirements of its newer members could be given more weight. It has made many changes in part in response to criticisms.


Labels: ,


Post a Comment

Links to this post:

Create a Link

<< Home