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Panelists favor IMF involvement in building better institutions but differ on exact role

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 2002
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The IMF cares about the quality and scope of domestic institutions, which are critical for countries’ economic development, growth, and, especially, stability, according to IMF Deputy Managing Director Eduardo Aninat, who served as the forum’s moderator. But exactly what role should the IMF play in promoting sound institutions? Some critics believe that when the IMF gives advice or attaches conditions to loans—known as conditionality—it should stick to monetary, fiscal, and exchange rate issues and financial sector policies and avoid issues related to governance, accountability, quality of institutions, and standards and codes.

Institutions are backbone of society

Guillermo Ortiz noted that domestic institutions establish the “rules of the game” for a society—that is, they set the laws and practices sanctioned by custom and tradition that lend stability to the relationships between individuals and groups. Good institutions, he said, provide a framework for private agents to carry out their transactions efficiently. “They are the backbone of a market economy,” he said.

So why don’t governments devote more resources to improving them? One reason is a lack of knowledge and resources in the organizations that could help manage change. A second reason is that special interest groups, actively pursuing their own interests, do not allow change. A third reason is inertia.

Can international organizations help change domestic institutions? The answer, according to Ortiz, is yes. They can be very helpful in overcoming the first problem—knowledge base; somewhat helpful in overcoming the second problem—special interest groups; and of absolutely no help on the third problem—inertia.

The key, Ortiz suggested, is for the IMF and other international organizations to find the right degree of involvement, so that they help mobilize domestic support for reform but do not meddle in domestic affairs. That means they must ensure that countries stand behind their reforms (this is known as ownership). The IMF also needs to remember that it is as important to create institutions as to preserve them.

“Social contract”

Nancy Birdsall agreed on the importance of country ownership, but for her it was critical to ensure that it occurred in the context of a “social contract,” especially when it came to emerging market economies, which are subject to a lot of volatility and instability in part because they are open market economies. Birdsall defined such a contract as the outcome of a collective decision, usually through a political process, whereby a society and its citizens arrange to mitigate some of the cruelties of the unfettered market.

Why should the IMF be involved in promoting such a contract? Birdsall suggested two reasons. First, good fiscal policy, which is certainly IMF business, is the basic ingredient of a healthy social contract in an open economy. It promotes job creation and enables governments to both implement countercyclical policies and protect the most vulnerable groups—not just the poor but also, when times are bad, vulnerable middle-income groups. It also refers to the composition of the tax burden and expenditure benefits, which Birdsall argued had received inadequate attention from the international financial institutions.

Second, financial sector policies, which are also IMF business, affect the capacity of societies, particularly in open and emerging market economies, to manage the social contract. Financial sectors in emerging markets tend to be shallower and less able to help manage shocks, to which middle-income working-class households (the “political bedrock of a social contract that works”) are particularly vulnerable.

During the Asian crisis, it wasn’t the poorest households that suffered the largest losses, Birdsall said, but the “urban strivers”—the potential emerging middle class in urban areas. And in Latin America, so many households are close to the poverty line that it is a mistake to distinguish between the poor and the rest of the population. Indeed, she suggested that it was misleading to think that Brazil recently elected Luiz Inácio Lula da Silva as president for “populist reasons.” Brazil did so, she said, because middle-income working-class households were looking for a new kind of social contract.

What does this have to do with conditionality? Birdsall stressed that conditionality is not a substitute for ownership but rather a complement. As the IMF streamlines its conditions, she said, it should focus on limiting both their number and their breadth, crafting conditions that reflect more clearly the need for open economies to build social contracts that they own.

Where to expand?

Drawing on the recent growth literature, Jeffrey Frankel referred to the evidence found by some economists that institutions are the key determinants of economic growth, more important than geography and economic openness. But he suggested that the IMF’s involvement with institutions—in which he included property rights and the rule of law—was also important in terms of its narrower responsibility for helping countries solve balance of payments problems. The IMF should support structural reform in countries, and, in fact, the organization is increasingly doing so.

Frankel presented a table (see below) to illustrate his point. The major issues that countries deal with are ranked vertically according to their relevance to balance of payments problems and horizontally according to how sure economists are that they have the right answer. The IMF has traditionally focused on macroeconomic issues (bottom row of table). But it (and the World Bank) has slowly expanded into institutional issues (middle two rows) that are “fairly” and “somewhat” relevant to balance of payments problems. Some critics, he said, feel that by moving up from the bottom row, the IMF has engaged in “mission creep.” But Frankel believes the institution’s involvement is appropriate, especially on those issues where economists are most confident of their answers. The World Bank, he said, should probably be moving more toward the upper rows of the table.

Doing more

The IMF is increasingly getting involved in institutional issues (shaded area).

How relevant is

the issue to balance

of payments

problems?
How sure are economists that they have the right answer?
Not verySomewhatFairlyVery
Not veryreligioncapital punishment; drug policydemocratic elections; labor rightshuman rights; environment
Somewhatsocial capitalintellectual property rights rules; executive compensationlegal systems; competition policy; land tenurepoverty; education; military spending
Fairlyclosing banks; disposing of nonperforming loans; best accounting rules; bankruptcy procedurescorporate governance; financial systems (capital adequacy; or relationship banking versus securities markets)property rights; trade policycorruption; fiscal transparency
Veryrestoring confidence in a crisisexchange rate regime; capital control; private sector involvementbudget deficitsmonetary policy

Of course, country ownership of reform is highly desirable, he added, but may not always occur.

Ways that the IMF can help with institution building, according to Frankel, are by providing technical assistance and training; by assessing observance of standards and codes of best practices, including evaluations of countries’ financial systems (through Financial Sector Assessment Programs); by including structural conditionality in IMF-supported programs; and by looking for deeper institutional causes in countries that repeatedly miss their targets and end up as prolonged users of IMF financing. “If a lack of democracy and a lack of stability are giving rise to repeated failures,” he said, “then it may be appropriate to take that into account when deciding whether to cut a country off.”

Dangerous misdiagnoses

Jeffrey Sachs cautioned that it was easy to get institutional reform wrong. “It is tougher than it looks, and we are not always on the right track,” he said, stressing that it is the interconnectedness of the functions that is critical.

If one naively looks at a favorite institution, Sachs said, and sees that it is not flourishing, one may easily believe that the problem lies in the institution, even though it may be due to a failure of the interconnections. He said economists tend to focus on what they know best, engaging in endless debates about manipulating macroeconomic variables, when the roots of the problem may be much deeper—and thus need a different instrument for correction. Indeed, Sachs believes this misdiagnosis is partly to blame for the continued misery in what he referred to as the “dying societies” of sub-Saharan Africa, which is not a failure of macroeconomics.

If the IMF is going to maintain its involvement with Africa, he said, it should “take responsibility for understanding what it is doing,” which doesn’t mean taking responsibility for everything. But something it does mean is that the IMF should calculate a country’s “financing gap” in a way that shows the amount needed to achieve the international community’s development goals—and present this to donors. Countries should not just be told, “Here is what the donors are going to do, and you live within your means.”

The full text of the November 8 Economic Forum, “Promoting Better National Institutions,” is available on the IMF’s website (www.imf.org/external/pubs/ft/staffp/2002/00-00/arc.htm).

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