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IMF Book Forum: Are IMF-prescribed fiscal targets too tight?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 2004
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One aspect of IMF operations that has traditionally drawn a great deal of attention is its fiscal policy advice to member countries. Is it, as some critics argue, too stringent, too inflexible? At a June 8 IMF Book Forum, Marcelo Selowsky (Assistant Director of the IMF’s Independent Evaluation Office (IEO)), Allan Meltzer (Carnegie-Mellon University and American Enterprise Institute), and Nancy Birdsall (Center for Global Development) debated these questions.

Does the IMF use a “cookie cutter” approach when it dispenses fiscal policy advice? Critics often characterize the IMF’s fiscal policy advice as “one size fits all” and argue that its steady prescription of fiscal austerity curtails economic growth and social expenditures, and harms the poor in particular. Others suggest that its focus on reducing fiscal deficits introduces inefficiencies and inequalities and may not help countries achieve durable structural changes.

Unwarranted criticism?

But how valid are these criticisms? A September 2003 report, Fiscal Adjustment in IMF-Supported Programs, by the IEO provides some answers. Selowsky, lead author of the report, explained that the IEO study found much more variation in the pattern of fiscal adjustment across programs than is generally assumed. Contrary to the general perception that IMF-supported programs invariably enforce austerity, for example, the study identified many instances in which fiscal deficits were actually projected to widen and expenditures to increase as a percentage of GDP. It also found no generalized evidence (other than in capital account crises) of a slowdown in growth during program years compared with precrises averages.

In certain areas, however, Selowsky noted a possible bias in program design. “We found that the IMF is extremely optimistic in projecting the recovery of private demand and growth, particularly when the country is going through a very rough period,” he said. This optimism can lead to an understatement of the need for a more countercyclical fiscal stance and to a fiscal stance that is too tight. As private demand recovers less than projected, the end result may be a shortfall in total aggregate demand. Obviously, the fiscal stance should not depend solely on countercyclical considerations when the level of debt is already too high, Selowsky explained. The problem is that all these considerations behind the fiscal stance are not well explained in program documents. There is no clear rationale for the magnitude and pace of the envisaged fiscal adjustment. In Selowsky’s view, programs rely too much on value-added taxes and not enough on efforts to reduce evasion of customs, income, and corporate taxes. “The IMF is not forceful enough in encouraging the authorities to collect from well-known taxpayers in arrears, particularly if they are powerful.”

Looking at the impact of fiscal adjustment on social sector expenditures—which are critical for the welfare of the poor—the study concluded that, on the whole, social spending was not lower than it would have been in the absence of an IMF program. In-depth country studies show, however, that even when aggregate social expenditures are maintained, those most relevant to the poor may be crowded out by, for example, government salaries.

The IEO report makes specific recommendations in these areas. Surveillance should set a clear roadmap of structural fiscal reforms and unbundle constraints to action. Surveillance and programs should mutually reinforce each other over time, with subsequent programs picking up reforms that require more time so as to ensure cumulative progress. Regarding social issues, the report urges the IMF to play a major role in encouraging countries to prepare programs and systems to protect the most vulnerable segments of society in case of budgetary retrenchments. Such measures cannot be put together at the last minute in the midst of a crisis. Governments should take the lead, which would also strengthen their program ownership, Selowsky said.

Importance of politics

Both Meltzer and Birdsall praised the IEO’s study as technically sound. It is, Meltzer observed, “comprehensive, careful, and balanced in its judgment.” Birdsall applauded it for “responding to long-standing, sometimes misguided, exaggerated criticism of the way the IMF deals with fiscal reform issues.” At the same time, however, she said “the report is willfully naive about the difficult politics of distribution and welfare, particularly in developing countries” where institutions are weak, checks and balances are missing, and sound economic institutions are not yet well developed.

What the IEO report does tell us, Meltzer pointed out, is that many countries miss their planned fiscal, economic growth, and structural reform targets. Why? Although external developments clearly play a role, he observed, political support represents the critical difference in whether these targets are achieved, adding that the report offers some explanation along these lines. It tells us, he said, that “insufficient progress in structural reform in the fiscal area is an important factor behind shortfalls in fiscal adjustment” and that “revenue from shortfalls seems to be associated with weak implementation.”

Boosting program success

What changes are needed to make more programs succeed? In the report, the IMF’s Executive Directors point to the need for strong country ownership of the fiscal reform agenda and implementation process. Meltzer found this suggestion appropriate and desirable but added that “to be more successful in reforming fiscal and other policies in client countries, the IMF must reform itself.” The principal change must be “a shift away from current command-and-control procedures tied to dollops of money conditioned on the promise to make reforms.”

In Meltzer’s view, the IMF’s Executive Board lacks “curiosity about why programs do not succeed.” If Executive Directors were serious about wanting programs to succeed, he said, they would “shift to an incentive system where [IMF] payments are made for performance, not promises.” It is instructive, he noted, that Turkey took implementation far more seriously when it had the incentive of joining the European Union, and “India got its incentive from comparing the Hindu rate of growth to China’s vastly more successful program. Reforms that were previously politically impossible became distinctly possible.”

Taking his argument a step further, Meltzer asked why development occurs in some countries but not others. The answer is that institutions matter—a view that the current literature supports. Unless countries adopt supporting institutions, sustained development does not occur. Crisis resolution and crisis avoidance also depend on institutional reforms that require local leadership, sustained commitment, and the ability to maintain and support reform during the often costly adjustment period. The IMF, Meltzer said, “cannot bring a country to do what the citizens or their representatives do not want to do.” Birdsall agreed but added that if a country does not respond to incentives, “we can’t just throw up our hands” and walk away.

Redefining the social contract

The IEO report expresses concern about countries’ ability to maintain social safety nets during periods of adjustment and distress but says little about the effect of shifting the burden of adjustment up the income ladder, Meltzer said, adding that welfare decisions of this kind should be made locally, not in Washington. What incentive would the IMF have for reforming itself? It would be a way of telling its many vociferous critics, he observed, that the IMF provides incentives for reform and adjustment, and leaves these welfare and distributional decisions to the countries.

The report suggests that “the IMF could invite the authorities regularly during Article IV consultations to indicate which critical social programs and social services they would like to see protected in the event of adverse shocks.” The idea is basically for the country to take ownership and to work out the design and budgetary aspects of social programs with agencies that have expertise in this area, such as the World Bank and the World Health Organization, noted Selowsky.

Birdsall supported this recommendation, saying that inviting authorities to suggest which programs they would want to see protected is consistent with the IMF’s long-standing role in encouraging sound, medium-term fiscal programming, including fiscal restraint today to allow for countercyclical spending tomorrow. In her view, the IMF would, in implementing this recommendation, not only help countries protect fiscal adjustment from untoward political pressures but also rescue itself from the widespread perception—which is hampering its effectiveness—that its “mindless and callous support of fiscal discipline pushes spending reductions onto the poor.”

In the 21st century, Birdsall concluded, the IMF should be called upon to send the message more effectively that social policy involves more than increased spending on education and health care. The foundation of a good social contract in an open economy, she said, has to be fiscal discipline that will encourage lower interest rates, create jobs, minimize debt buildup, and allow for countercyclical spending to protect the poor. This will create the kind of political space on both the expenditure and tax fronts “that will ensure, in the long run, that the IMF is playing its worthy role in reducing poverty and inequality in the world.”

The full IEO report, Fiscal Adjustment in IMF-Supported Programs, is available at http://www.imf.org/External/NP/ieo/2003/fis/pdf/main.pdf. See also IMF Survey, September 8, 2003, page 262, for a discussion with Marcelo Selowsky about the study’s findings and recommendations.

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