What useful lessons can be gleaned from the often turbulent 1990s? In a February 2 lecture in the World Bank’s Practitioners in Development series, Larry Summers—President of Harvard University, former U.S. Secretary of the Treasury, and former Chief Economist at the World Bank—offered practical advice in five areas. His remarks drew commentary from two who had also been in the trenches during that period: Pedro Malan, formerly a central bank governor and finance minister under Brazil’s Cardoso government; and Michael Mussa, former IMF Economic Counsellor and Director of Research and now a senior fellow at the Institute for International Economics.
For Summers, now more than three years away from the day-today demands of economic policy-making, the 1990s held five chief lessons for development practitioners: the importance of institutions; the practical steps that could be taken in financial crisis prevention, management, and resolution; the need to reconsider how much of a build-up in reserves is needed to help guard against future crises; the importance of reflecting further on the fungi-bility of development aid; and the priority of building a constituency for development in the richest countries.
Summers placed particular emphasis on recognizing the “transcendent” importance of the quality of institutions and the closely related question of the efficacy of political administration. Institutional capacity—or lack thereof, as evidenced, for example, by the inability in many countries to collect a bounced check or evict a person for failure to pay rent—surely has more to do with success and failure in development than has been suggested historically, Summers argued. The quality of a country’s government cannot be dissociated from the quality and the functioning of its institutions, Malan added, while recalling that, back in 1958, Albert Hirschman’s classic work highlighted how critical government efficiency is for economic development.
Mussa, too, gave top mention to the importance of institutions. Reciting from a 1947 speech delivered by George Marshall—best known for the Marshall Plan, which helped fund the reconstruction of Western Europe after the Second World War—Mussa noted that the transition of Central and Eastern Europe and the former Soviet Union from centrally planned to market-oriented economies had certainly brought the issue to the fore again. Harking back to Adam Smith’s Wealth of Nations and Thucydides’ history of the Pelopon-nesian War, Mussa showed how economic development has been linked with the quality of institutions and the protection of property rights for some time. “When ownership and control of all of society’s wealth and productive assets are up for grabs every day,” Mussa noted, “you don’t get much economic development.”
Disproportionate crisis punishment
Turning to the series of financial crises that erupted in emerging market countries in the 1990s, Summers surmised that in each case the eruption could be attributed to a “combination of policy error and bank run mentality,” with the “crisis punishment heavily disproportionate to the policy crime.” A serious problem afflicting the current system, he continued, is that there are, at any given time, several dozen countries that have borrowed money with wide spreads—300-600 basis points—which implies that the market believes the odds are 50 percent or greater that default will occur within a decade.
Summers argued that a capital market can function in either of two healthy ways. One is to emulate the functioning of the U.S. municipal bond market, whereby money is borrowed at small spreads (in this case, the collective judgment is that default is extraordinarily unlikely for those borrowing). The other is to emulate the functioning of the high-yield (junk) bond markets in the United States and Europe (where bonds are issued with wide spreads reflecting their high risk and with the market viewing the stated interest rate and principal as the maximum possible payoff). In this case, the bondholders know that they are unlikely to be repaid in full, and when they are not, there is renegotiation and then business resumes.
In contrast, emerging markets today are characterized by pricing associated with an expectation that crises will be likely, but when a crisis occurs, the market responds to it as a highly unlikely event. It doesn’t make a lot of sense, Summers said, for the market to look at an emerging market country with a 500-600 basis point spread on its bonds, observe that this means that it is unlikely the bond will be paid in full, but then react at a later point with shock and horror when a crisis occurs. Stating that he was much more confident of the problem than of the best solution, Summers suggested it may be wiser to push for less and lower-yield cross-border debt than for an easier work-out solution. Taking into account the riskiness of high-yield debt, there is a lack of evidence that it is consistently used in ways to produce returns that are at least equal to its costs.
Look, Summers said, at each of the major financial crises of the 1990s. The situation was not one of an innocent country somehow overwhelmed by a flood of capital from a herd of speculators. It was, instead, a situation in which countries—for domestic policy reasons—”made very active efforts to dine with the devil (speculators) and ended up on the menu.” Examples abound in the affected countries, he argued. Mexico’s tesobonos (short-term government securities nominally issued in pesos but effectively indexed to the U.S. dollar) were customized to suit short-term speculators; the Thai offshore banking facility had as its objective attracting short-term interbank credit; the explicit purpose of the Korean capital control regime was to ensure that internal capital flows were short term rather than longer term for reasons of control; and Brazil’s financial strategy involved the issuance of debt instruments carefully designed to meet the needs of hedge funds.
So the issue, Summers said, is not whether these countries should have had some type of Chilean-style capital controls. These countries were actually on the other side of neutrality in actively trying to attract short-term capital—and they were doing this not on the basis of any advice from the international institutions or major governments. Moreover, the implicit exchange rate guarantees entailed in pegged exchange rates, where they existed, had formed a “particularly pernicious subsidy to short-term capital”
Taking up this point, Mussa agreed with Summers’ criticism of Mexico’s tesobono issues but argued that Brazil was probably right in shifting toward foreign-currency obligations to absorb some of the pressure of the real’s depreciation in 2002. A clear lesson here, according to Mussa, is that emerging markets have much more limited options than industrial countries in terms of the types of currencies they can use for borrowing on international credit markets and in doing commercial business. It is for this reason, he continued, that the international financial community must devise better mechanisms for providing, in the event of financial crisis, conditional support (in international currencies) for countries that take responsible action to deal with the causes of their crises.
But it is important to recognize, Mussa said, that financial crises happened well before the 1990s and have not been limited to emerging markets. What makes industrial countries apparently less prone to the damage from major international crises and less prone now than they were a century or more ago? Economic policy in industrial countries today is generally much better able to cushion the effects of economic and asset-price declines. And emerging market countries as a group tend to have insufficient flexibility in their fiscal and monetary policies to cope with crises and shocks, as well as relatively long histories of financial instability.
Borrowing from the poor
Referring to the accumulation of international reserves by emerging markets, particularly in Asia, since the crises of the last decade, Summers’ third main observation was that policy advisors need to be careful what they ask for. Although he and others had recommended that these countries accumulate reserves to guard against future crises, this had proceeded so far that the largest international flow offixed-income debt today takes the form ofborrowing by the world’s richest country at (probably) negative real interest rates from countries with very large numbers of poor. This raises questions about how well the system is working: building up reserves to help guard against the risks of future crises was—and remains—good advice, but the financing of the U.S. deficit by emerging market countries indicates that this advice has been taken too far.
Taking a somewhat less critical view—at least for a number of emerging market countries that have been developing their tradable sectors in tandem with their increasing exports to the United States—Malan emphasized that these countries “think it is to their advantage for the time being, and this is important.” But, he cautioned, export-oriented growth is certainly not the only element needed for sustainable, poverty-reducing development.
Turning to his fourth observation, Summers cautioned the development community against losing sight of the set of questions associated with the fungible nature of aid money. Because aid flows are generally combined with other monies in a recipient country’s overall budget, it is difficult to track aid’s effectiveness or even to affirm that it is being used for the intended purposes. And if a donor gives aid for a project that the recipient government would have undertaken anyway, the aid, in reality, finances expenditures other than the intended project. This fungibility issue predates the 1990s, but, as Summers pointed out, there is a continuing need for careful reflection on its implications.
And, notwithstanding the good work done by the international development community over the past decade, there is a profound need—particularly in the United States—to build a constituency to promote development and poverty reduction, remarked Summers as a concluding observation. Young people as a group are inspired to work toward the solution of global ecological and health problems, he said, but they somehow tend not to take the same passionate interest in the continuing problem of the one billion people worldwide living on less than one dollar a day. And where this energy does exist, it commonly takes the form of anticapitalism and antimarket sentiment as much as it does a genuine desire to help the poorest. Malan echoed this view, adding that solutions must be found by those working within a given country. There is, he said, “no way that changes can be pressed from afar”
The webcast of the discussion can be accessed at http://info.worldbank.org/etools/bspan/PresentationView.asp? PID=1015 & EID=328.
Elisa Diehl Jacqueline Irving
Niccole Braynen-Kimani Maureen Burke
Art Editor Julio Prego
The IMF Survey (ISSN 0047-083X) is published in English, French, and Spanish by the IMF 22 times a year, plus an annual Supplement on the IMF and an annual index. Opinions and materials in the IMF Survey do not necessarily reflect official views of the IMF. Any maps used are for the convenience of readers, based on National Geographic’s Atlas of the World, Sixth Edition; the denominations used and the boundaries shown do not imply any judgment by the IMF on the legal status of any territory or any endorsement or acceptance of such boundaries. Text from the IMF Survey may be reprinted, with due credit given, but photographs and illustrations cannot be reproduced in any form. Address editorial correspondence to Current Publications Division, Room IS7-1100, IMF, Washington, DC 20431 U.S.A. Tel.: (202) 6238585; or e-mail any comments to firstname.lastname@example.org. The IMFSurvey is mailed first class in Canada, Mexico, and the United States, and by airspeed elsewhere. Private firms and individuals are charged $79.00 annually. Apply for subscriptions to Publication Services, Box X2004, IMF, Washington, DC 20431 U.S.A. Tel.: (202) 623-7430; fax: (202) 623-7201; e-mail: email@example.com.