Financial markets and public policy
A panel on financial markets and public policy, moderated by James L. Bicksler of Rutgers University, considered the failure of current economic theory to provide a foundation for economic policymaking and private sector involvement in crisis prevention and resolution.
Toward a new economic theory.The ability to enact good policy is limited by inadequate theory, according to Douglas North of Washington University, St. Louis. North, an economic historian and Nobel laureate, said that neoclassical economic theory is obsolete. The world we are living in is changing so quickly that it is almost impossible to predict or build policy on the existing body of theory, he said. Current theory is static, designed to solve a problem that exists at a single moment in time. But all the problems we have are dynamic. We need to develop tools that let us be conscious of what may lie down the road. Such theory may, of necessity, be less precise or consistent than current static theory, North said, but even in a rough form, it may provide a more solid base on which to fashion policy.
Private sector and financial crises.In the aftermath of recent financial crises, the need to involve the private sector in both crisis prevention and crisis resolution has become a major focus of attention, IMF First Deputy Managing Director Stanley Fischer said. The need to ensure private sector involvement arises, Fischer explained, for two main reasons: moral hazard and the fact that the public sector will not—nor should it—be able to provide very large financing packages in the future.
Moral hazard is almost inevitable whenever insurance is provided, Fischer said. At the same time, public financing in the event of a serious external financial crisis may be needed to help restore financial stability and reduce the effects of the crisis on economic activity. Therefore, in the event of an external financial crisis in which official financing is provided to the country, private sector involvement will typically be needed, both to ensure that the needed balance of payments adjustment by the country is not excessive and to reduce moral hazard.
The first step in trying to resolve the issue of private sector involvement, Fischer said, is to find ways to prevent crises. For countries, this will involve good macro-economic policies, including choosing an exchange rate regime that effectively resolves the "incompatible trinity" of mobile capital, fixed exchange rates, and domestic monetary policy. However, crises cannot be prevented altogether, whatever the exchange rate regime, so there is still a need to reduce the moral hazard inherent in any workout scheme, Fischer said. Bankruptcy procedures are needed to handle private sector claims, while workout procedures for public sector claims will need to be developed. Fischer acknowledged that problems persist in both private and public sector debt-resolution procedures. Many countries have weak bankruptcy laws and legal systems. In the case of sovereign debt, the international community and creditors do not want to make debt restructuring easy. But the harder creditors make it to default, the more severe the default when it happens. Various proposals for changing the structure of debt contracts are under consideration, he said, but consensus among debtors, creditors, and advanced and emerging markets on the way ahead remains to be developed.
Monetary policy in the United Kingdom
At a luncheon, Mervyn King, Deputy Governor of the Bank of England, spoke about the pursuit of monetary policy with an independent central bank. The granting of independence to the Bank of England in 1997, King said, represented a convergence of theory and practice. Although it has long been recognized that institutional arrangements matter for monetary policy, much has changed over the past several years. What was once perceived as a "dark art practiced in secret by magicians" has given way to transparency and openness. The hallmarks of U.K. monetary policy now include the adoption of more explicit inflation targets as a framework for monetary policy, communication to the public of expectations and targets, and a new interest in monetary policy in an environment of low inflation.
Decade of transition
In the past decade, many countries in Asia and Eastern and Central Europe have been in the process of transforming their economies from centrally planned to market based. As discussed in this session, moderated by Fischer, the speed and success of transition have varied markedly across countries.
“Good” and “bad” federalism. Why has the Chinese experience been so much more successful than the Russian? Olivier Blanchard (Massachusetts Institute of Technology) and Andrei Shleifer (Harvard University) attempted to answer this question by analyzing the relation of the central government to local governments. The central government in China provides incentives to the private sector, while the Russian government, which has consistently protected state firms, has stood in the way of private sector growth. The difference, Blanchard said, lies in the amount of control the central government can exert over local governments. In China, local governors are appointed by the central government. If they misbehave—say, by withholding from the central government locally collected taxes—they are removed from office. Officials who play by the rules are allowed to retain a higher proportion of the revenue from locally collected taxes. In Russia, local governments are elected. Although the Russian central government is perennially revenue-hungry, its hold on the local governments is so tentative that misbehaving local politicians are unlikely to be punished.
The implications for Russia, Blanchard and Shleifer suggested, are that the development of an effective democratic electoral process should involve the emergence of strong, unified parties that, when voted into office, can assert unified and consistent political pressure on local governments.
Escaping the “underreform trap” Countries lacking a strong democratic process that enables voters to throw corrupt, rent-seeking officials out of office tend to get stuck in the "underreform trap," according to Simon Johnson (Massachusetts Institute of Technology). Looking at a range of transition economies, Johnson said, he and his coauthors, Anders Aslund (Carnegie Endowment for International Peace) and Peter Boone (Brunswick University), found that countries with a history of social democracy, such as Poland and Hungary, or that had radically transformed their economy and rooted out entrenched interests, such as the Czech Republic and Slovakia, were most successful in beating back “bureaucratic predation.” In contrast, transformation is incomplete in countries, such as Ukraine and Russia, where the Communist Party retains a stronghold and electoral backlash is weak.
Some solutions to the underreform problem, Johnson said, include adopting a system of fiscal federalism, narrowing opportunities for corruption, passing effective laws, and firing bureaucrats and managers unwilling to adapt to the new environment.
Performance in transition economies. In a survey of the experience of transition economies over the past decade, Fischer and Ratna Sahay (IMF) analyzed output performance and transition strategy. Although all countries experienced a fall in output at the beginning of the transition process, their study found considerable differences in the recovery process. Some—especially in Central and Eastern Europe and the Baltic states—recovered more rapidly than others, such as Russia, Ukraine, and some other states of the former Soviet Union. Sahay said that slower structural reforms contributed more to the initial decline than adverse initial conditions. In most countries, recovery started after two years of macroeconomic stabilization. The driving force behind the high growth observed in some countries was the speed with which structural reforms were implemented. Transition economies seemed to have received substantial technical assistance but relatively little external financial assistance, Sahay said. But while external assistance was important, its effectiveness depended on policy commitment by domestic policymakers.
Is transition complete? After 10 years, are transition economies still a unique phenomenon, to be treated differently from other countries at a similar stage of development? Or have they successfully thrown off the legacy of central planning and should they now be regarded as fully functioning emerging markets? In his presentation, Daniel Gros of the Center for European Policy Studies attempted to answer this question by measuring the performance of a sample of transition economies against a control group of countries in Southeast Asia. Using indicators such as share of industry and services in employment, levels of corruption, importance of the financial sector in the economy, and financial liberalization, Gros found that the legacy of central planning was still strong in the countries of the former Soviet Union. By contrast, the countries of Central and Eastern Europe can be said to have "graduated" from the transition process, and their future development efforts should be based on the same principles as other comparable emerging market economies.
A roundtable on the euro, the dollar, and the international monetary system was held on the first anniversary of the launch of the euro. Opinions among the participants varied about the value of a single currency for Europe and its chances for survival in the long run.
The European Central Bank (ECB), the sole monetary policy authority for all European Economic and Monetary Union (EMU) members, has a single mandate—maintaining internal stability within the EMU. According to Otmar Issing, a member of the ECB Executive Board, after only a year, the bank has apparently gone far toward fulfilling that mandate. But, he continued, because the transition to a single monetary policy was relatively smooth, people tend to forget the daunting challenges the ECB faced last year. In particular, the ECB was obliged to adopt a monetary policy strategy for a newly launched and untested monetary system, without benefit of real time series or data that could provide indications of possible outcomes. Further, the Maastricht Treaty, which gave the ECB its mandate, did not provide an operational definition for price stability. Issing said it would take a few years to determine if the strategy the ECB adopted has been successful, but after only one year, the bank already appears to enjoy a high degree of credibility, as measured by long-term interest rates. This is remarkable, Issing said, because an institution usually needs several years to build up a track record of keeping its word. He attributed this success to a belief by financial markets that the ECB’s adopted strategy is capable of fulfilling the provisions of the Maastricht Treaty. Another important contributor is the ECB’s transparent communications policy.
Sounding a dissenting note, Martin Feldstein (Harvard University and National Bureau of Economic Research) said EMU was an “expensive device for the political unification of Europe.” In his view, the single currency will have negative effects on employment and could lead to trade conflicts between Europe and the United States. In the single year of its existence, the value of the euro vis-à-vis the U.S. dollar has declined by about 15 percent, the European economy has been weak, and unemployment in Europe has been more than twice that in the United States.
The ECB’s ability to maintain stability in the long run, Feldstein said, will depend on the ability of member countries to contain excessive demand. Differences in demand conditions among countries will be a problem, particularly with low labor mobility and no central fiscal authority that can offset fiscal differences through transfers.
Most of the unemployment in Europe is structural, not cyclical, Feldstein noted, but, in his opinion, EMU will reduce the likelihood of countries introducing structural reform. They will tend, rather, to blame unemployment on the high interest rates mandated by the ECB. This resistance is not likely to break down over time and could reduce European competitiveness, leading to the erection of protectionist barriers, especially against the United States, he said.
Although initially skeptical about EMU, Rudiger Dornbusch of the Massachusetts Institute of Technology said the ability of planners “to pull it off” had converted him. The introduction of the euro has already had beneficial effects both on inflation and in European capital markets, he said. In the face of a falling euro, the ECB “learned to stop talking about the exchange rate” and concentrated instead on internal stability. The collapse of European interest rates led to a cleanup of financial sectors.
The single currency does face considerable challenges, Dornbusch acknowledged—in particular, how to cope with an upturn. What happens, he asked, if labor markets stay unreformed and growth goes up? The ECB and the euro have not changed the reality of a "totally unreconstructed supply side," he said, but that is not the fault or the responsibility of the ECB. The ECB should not give in to inflationary pressures, Dornbusch warned; it will have to control growth by sticking to stability and leave structural concerns to national governments.
Economists have used the arguments in Robert Mundell’s seminal essay on optimal currency areas to rail against EMU ever since the paper was published in 1961, according to Ronald I. McKinnon of Stanford University. But whereas economists have tended to oppose EMU, politicians have pushed it. Where, asked McKinnon, did the economics profession go wrong? The "1961 Mundell" posited stationary expectations in capital markets, labor mobility, and the use of a flexible exchange rate outside the currency union area. But in 1970, Mundell published two further papers on optimum currency areas that have gone largely unregarded, McKinnon said. A closer look at the 1970 papers reveals "a second Mundell," who had, according to McKinnon, changed his mind. In the 1970 papers, Mundell introduced the idea that the exchange rate was forward looking and therefore subject to volatility in the short run. But an uncertain exchange rate made it difficult to organize capital markets to deal with asymmetric shocks unless there was a single currency to share the risks. McKinnon said Mundell’s conclusion—that the exchange rate should be removed from international consideration—presaged EMU.
The promise of EMU has been realized, McKinnon said. European countries signing Maastricht accepted the stick of fiscal control in exchange for the carrot of shared risk and narrowing premiums. The euro will not replace the U.S. dollar, McKinnon said, but as EMU continues to expand, fluctuations in the euro will matter less and less.
Macroeconomics of emerging markets
The fallout from financial crises—both in the country of origin and in other countries to which the contagion spreads—has focused attention on exchange rate issues in emerging market economies, according to Guillermo Calvo of the University of Maryland.
Presenting a paper coauthored with Calvo, Enrique Mendoza (Duke University) said that incomplete or asymmetric information was instrumental in creating the problems—namely, financial vulnerability, economic collapse, and contagion—emerging markets encountered in the capital market crises in the 1990s. When an investor is perceived to have inside information, other traders blindly follow, regardless of whether the so-called informed investor is following fundamentals or responding to an unrelated signal (like a margin call). This herd behavior could precipitate a major disruption in capital flows, with far-reaching consequences for vulnerable emerging markets.
Policy lessons that have emerged from analyses of recent crises, Mendoza said, include the need to improve information channels and develop "information-efficient" systems. Dollarization, the internationalization of financial systems, and lengthening of debt-maturity profiles are other measures that could help increase the resilience of emerging markets.
“Mirage” of floating. Recent turbulence in emerging markets has suggested to many observers that countries trying to peg in a world of mobile capital are "fighting against the wind," Carmen Reinhart of the University of Maryland said; therefore, these observers argue, emerging markets should let their currencies float. Most emerging markets do, in fact, claim that they are floating, suggesting that the fixed exchange rate is no longer a preferred option. But after looking at the experience of the past forty years, Reinhart said she discovered that the apparent demise of fixed exchange rates was“a myth.”
With a freely floating exchange rate, Reinhart said, the exchange rate varies as the interest rate responds to money demand shocks; reserves do not vary. With a fully credible peg, the exchange rate does not vary, as the central bank intervenes in the foreign exchange market to maintain the nominal interest rate at the level of the international interest rate. Noncredible pegs, Reinhart said, which carry with them the likelihood of default, also feature a fixed exchange rate, but it is stabilized through open market operations and not through purchases and sales of foreign exchange. This operation of fixed exchange rates masquerading as managed floats is, according to Reinhart, currently “very fashionable.”
Observing the behavior of 146 countries, Reinhart concluded that the systems of most countries that claim to float more closely resemble noncredible pegs. The reason, she said, is widespread “fear of floating.” This fear is fueled by liability dollarization (most liabilities of emerging markets are denominated in U.S. dollars), contractionary devaluations (income does not go up when the current account increases), and credibility problems.
Despite the evidence presented in Reinhart’s paper, Roberto Chang (Federal Reserve Bank of Atlanta) and Andres Velasco (New York University) asserted that since the 1970s, emerging markets have moved toward floating or are opting for more flexibility. In their paper, Chang said, they considered the economic consequences of exchange rate policy. Although they leaned toward floating as the most appropriate regime for most emerging markets, they acknowledged that decisions were likely to be country specific, and there was a need to develop theoretical models that were applicable to actual cases.
The fear of floating mentioned by Reinhart has considerable validity, Chang and Velasco acknowledged. The case for flexibility is weaker the greater the extent of dollarization. Also, a devaluation hurts those who borrow in dollars but whose earnings are denominated in local currency. A devaluation could be contractionary because of the effect of the dollar value of collateral, leading possibly to a credit crunch caused by market imperfections.
As the effects of the financial crises have subsided, Chang and Velasco concluded, exchange rate policy needs to be analyzed as an aspect of monetary policy. The development of appropriate microfoundations is a priority.
Assessing the IMF
As panel moderator Joseph Joyce of Wellesley College noted, an assessment of the IMF is particularly timely, given IMF Managing Director Michel Camdessus’s impending resignation and emerging developments on the international monetary scene. Some panelists expressed reservations about the IMF’s effectiveness, but all agreed that commitment and reform efforts at the domestic level are as important as international financial assistance.
IMF as catalyst. How effective has the IMF been in mobilizing international finance? Graham Bird (University of Surrey) and Dane Rowlands (Carleton University) challenged what they called the commonly held belief that IMF financial support was guaranteed to generate additional financing from other sources.
The empirical evidence Bird and Rowlands examined did not, in their view, reveal any clear-cut evidence of a positive catalytic effect from IMF support. They found, rather, among countries with IMF-supported programs a high rate of recidivism (that is, countries returning to the IMF for additional assistance to support new or revised programs), low rates of completion, and no measurable improvement. What matters, they concluded, is credibility—markets respond to a government’s strong commitment to reform, with or without the IMF.
Recidivism. One of the consequences of the apparent failure of IMF support to mobilize capital flows is that some countries have become frequent users of these resources. In a related paper, Bird and coauthor Joseph Joyce asked whether recidivism was a case of “many happy returns,” or whether the IMF should be concerned about the recidivism rate.
Countries turn to the IMF, Bird said, because of balance of payments problems, macroeconomic mismanagement, external shocks, and failure to attract other external financial resources. If they keep coming back to the IMF, he argued, the reason may be that the programs the IMF supports either are not well designed or are not completed, or that some countries are “slower learners” than others.
According to Bird and Joyce, the IMF appears to regard recidivism as relatively benign—part of an “ongoing relationship.” A less positive interpretation, they said, might be that the programs are not working. Bird and Joyce suggested that a way to reduce recidivism is to examine its causes and consider these factors in the design of reform programs. Increasing structural efficiencies, providing incentives for program completion, and encouraging good governance should play a role in programs designed to help countries “graduate” permanently from IMF support.
Responding to the Bird and Joyce paper, Stanley Black (University of North Carolina) suggested that the authors should have distinguished more clearly between “slow” and “effective” learners, particularly with regard to their access to private capital markets. Countries with low access to private markets had far fewer options than those with high access and were, thus, more likely to keep coming back to the IMF, regardless of how effective their programs had been.
Another view.Some critics of the IMF’s advice to Asian countries hit by the financial crises of 1997 and 1998 have asserted that the IMF’s standard prescription—fiscal and monetary tightening—was inappropriate and dangerous, because the crises were structural, rather than macroeconomic in origin, according to James Boughton of the IMF. It was unreasonable, these critics say, to ask countries whose domestic economy was in balance before the crisis to tighten fiscal and monetary policy anyway. But, Boughton noted, tightening can be avoided only if investor confidence can somehow be restored quickly. How to do that is a question of psychology, not economics.
The appropriate policy response, Boughton said, does not depend on whether fiscal and monetary policy was appropriate before the crisis; what matters is what is appropriate after the crisis. The IMF advised tightening to countries suddenly in the position of having to attract capital flows. The choice was between tighter policy and a stable exchange rate or easier policy and a sharply devalued exchange rate. You cannot argue with the arithmetic, Boughton said: Maintaining external stability with limited financial resources calls for a tightening of macropolicy.