Role of the IMF

There is a view that the IMF has not much relevance in a world characterized by floating exchange rates, the predominant role of the private sector in the provision of international liquidity, and the rise of such exclusive clubs as the Group of Seven for coordinating macroeconomic policies of major industrial countries. To my mind, the progressive reduction in the role of the Fund, particularly in matters involving effective surveillance of macroeconomic policies of major industrial countries, is a matter of regret, and the trend needs to be reversed.

The Fund was created to supervise the system of fixed but adjustable exchange rates and to support it as a lender of last resort. The system worked well for a while but it came under severe strain in the early 1970s and was soon abandoned as the major players moved to a system of floating exchange rates. The new system, combined with an explosive growth of private flows in global capital markets freed from exchange controls, made the Fund’s role as a lender of last resort irrelevant for countries accounting for three fourths of world trade. No industrial country has borrowed from the Fund since the late 1970s, and the Fund’s lending activity has concentrated on developing countries and more recently has extended to the economies in transition.

The expectation that a regime of generalized floating exchange rates would enable countries to pursue independent macroeconomic policies in line with their domestic objectives has not materialized. In practice, exchange rates have been characterized by pronounced and prolonged deviation from the fundamentals, and there has been excessive volatility, all of which has imposed significant economic costs. Indeed, floating exchange rates make coordination of macroeconomic policies among the major countries even more important than earlier. This should have meant a strengthening of the surveillance function of the Fund, but this has not happened. The truth is that the task of coordination is not being performed as much as it should be in any forum. Attempts at coordination through the exclusive groupings of major industrial countries such as the Group of Seven, or in even smaller groupings, have achieved only limited success.

The experience with the non-system that has been in place since the mid-1970s does not inspire confidence that it represents a viable long-term arrangement. It has led to increased uncertainty in the world trading environment, growing volatility of exchange rates and capital flows, and a slowdown in the growth of world trade and output. I believe that today, more than ever before, we need a truly multilateral mechanism, above and beyond national instruments, for monetary coordination and stabilization of exchange rates. The GATT-Bretton Woods system, described as “unilateral global Keynesianism,” worked well until the early 1970s largely because the United States was single-handedly prepared to direct and maintain the system. As the world became economically multipolar, the United States was neither willing nor able to perform that role. And yet there is clearly a need for effective coordination of macroeconomic policies of major developed countries for a successful and orderly functioning of a multipolar, increasingly open, and interdependent world economy.

The world community would gain by using the Fund as the principal forum for multilateral surveillance and coordination of national fiscal and monetary policies. An act of statesmanship on the part of the major industrial countries is called for, since the line between coordination and loss of sovereignty is thin. But if interdependence is to have any meaning, it should be possible to accept multilateral surveillance and discipline. We need to give the Fund a new political mandate. The developing countries have a particularly strong stake in this development, as it is only in a multilateral forum that major countries’ policies are likely to be coordinated in a manner that accords due weight to the impact and implications of these policies on the rest of the world community.

Questions are also sometimes raised on whether the financing role played by the Fund should continue. I have no doubt it should. The financing role may have become irrelevant for the industrial countries, but it will undoubtedly remain highly relevant for the vast majority of developing countries and economies in transition for many years to come. It will take time before these countries are sufficiently integrated into world capital markets to be able to access the pool of liquidity available in the world, or at least to access it on reasonable terms. Until that time, they will need the assurance of the facilities provided by the Fund to correct maladjustments that may arise in their balance of payments, without resorting to measures that could be detrimental to national or international economic interests.

The growing integration of the world’s money and capital markets and the inevitable increased role of private capital flows can at times greatly complicate the task of orderly economic management, particularly in developing countries with limited policy instruments at their disposal. One has to take particular note of the volatility and unpredictability of portfolio capital flows. The world needs credible international safety nets that, while preserving the freedom of capital markets, will ensure that “enterprise does not become a bubble in the whirlpool of speculation.” Countries pursuing sound domestic policies ought to be able to rely on the IMF for timely help to protect the integrity of their development programs in the face of sudden outflows of private capital.

Over the years, the Fund has attempted to adjust the nature of its facilities, as well as its approach to conditionality, to improve its effectiveness as a lender for developing countries and economies in transition. It has moved away from an exclusive concern with stabilization in the design of programs to an explicit recognition of the need to protect growth. It has also recognized the need for adjustment to be stretched over a longer period. A new concern, which it must now address, is the need to design adjustment programs that avoid adverse distributional effects. In practice, this poses difficult trade-offs that may in many cases warrant a more gradual path of adjustment. These are difficult issues, and there are no ready solutions. It is to the credit of the Fund that it has shown flexibility in assisting many developing countries, my own included, at critical times. However, there is considerable scope for improvement. In the rapidly changing and uncertain world that we live in, the Fund must develop greater flexibility to respond purposefully and quickly to fast-changing economic conditions.

Role of the World Bank

Let me now turn to the role of the World Bank. The Bank too has changed over time in response to changing circumstances. It graduated very quickly from its original role of reconstruction in Europe to become the world’s premier international development bank, responsible for channeling long-term loans to developing countries. The establishment of the International Development Association (IDA) in 1960 meant a significant enhancement of the World Bank Group’s capacity to assist low-income countries. In the 1960s and the early 1970s, the World Bank lending program expanded rapidly, with an increase in resource transfers to developing countries. Bank flows were also a significant portion of total flows to many developing countries. The situation has changed very substantially since then. Bank lending in real terms has not increased since the early 1980s, and net resource flows have since turned negative. IDA flows have also not increased commensurate with need. Meanwhile, private flows to developing countries have expanded dramatically to swamp official and multilateral flows.

The World Bank has adjusted to these developments by altering the nature of its lending, especially by shifting from traditional project finance to policy-based lending. This shift enabled it—often in combination with the Fund—to provide quick-disbursing assistance to countries facing severe balance of payments problems in the 1980s. However, policy-based lending has posed its own problems. From the perspective of borrowers, it is often difficult to agree to wide-ranging policy conditionalities as part of a lending program even when many of these conditionalities may be in tune with the borrowers’ own perceptions. Adjustment programs must be seen to be home-grown to be fully accepted. From the side of the donor countries, policy-based lending has been subjected to growing pressure to add new policy objectives that such lending must achieve. All this is made more difficult because the resources being made available to the Bank are not increasing, and tighter conditionality is therefore often seen as a device to ration scarce resources rather than as an effort to increase the effectiveness of assistance.

What should be the role of the World Bank Group in the future? First, a word about IDA, which is of particular importance for the low-income countries. In a world of massive income disparities among nations, in which fully a fourth of the world’s population still lives in abject poverty, the ameliorative role of concessional multilateral development assistance, as provided by IDA, is self-evident. The issue is one of commitment. IDA has played a role in some of the major achievements of developing countries.

In India, IDA assistance was part of the effort launched by the Government of India almost 30 years ago that led to the Green Revolution and food self-sufficiency. Even today, IDA must provide critically needed finance for social infrastructure, human resource development, and the environment—all sectors that need large injections of resources in many countries and where the outcome cannot be left to market forces. However, the scale of assistance being provided by IDA is modest compared with the enormous need. If the international community is serious about the goal of eradicating the blight of poverty from our planet, there can be no better instrument than an expanded IDA commitment for the next two decades.

Turning to the World Bank itself, its role as a source of capital has been questioned in some circles on the grounds that private capital flows now amply meet the needs of developing countries. The growth of international private capital markets is undoubtedly a very important positive development for developing countries, and it is gratifying that most countries are tailoring their policies to maximize access to these flows. We must recognize, however, that the overwhelming bulk of private capital flows to the developing world are concentrated in about a score of countries. For all the other developing countries, and also the economies in transition, access to international private capital is still highly restricted or nonexistent. In all these countries, substantial lending by the World Bank will remain essential for many years to come as an assured supply of long-term capital. Indeed, with most of these countries undergoing major economic reform, it is not difficult to sketch a larger—and not a diminished—need for the World Bank Group to sustain and support investments for development, particularly in the expansion of infrastructure facilities.

I do not see any contradiction in the expansion of activity by the World Bank or the International Finance Corporation (IFC) and the expansion of private sector lending or private investment flows. On the contrary, I see these processes as complementary and mutually reinforcing. After all, the Bank and the IFC are themselves intermediaries of private capital and provide a valuable service to savers and investors in the private sector at very little public cost.

An important feature of the past decade or so is the remarkable convergence of policies followed by different developing countries all over the world. This convergence has resulted from greater knowledge of what policies have worked well in different situations. The World Bank is uniquely placed to promote greater awareness of the best practices and to disseminate this knowledge effectively to its member countries through its operations and development dialogue. As developing countries open up their economies and integrate with the world, there will be much greater need for such information as an aid to policy. The Bank can play an important role in meeting this need. However, it must also show a greater awareness of the need to keep in mind country-specific characteristics in devising appropriate strategies. Reform of economic policies has to be accompanied by institutional reforms, which, in turn, require not only legislative change, but more important, change in attitudes and mindsets, all of which take time. Impatient reformers must not forget that complex societies cannot be turned around overnight.

It is generally accepted that the World Bank Group can play a valuable part in promoting environmentally sound programs and policies in its member countries. What is not equally well recognized is that any credible effort at protecting the environment will require massive investments. The Bank should therefore be properly equipped if it is to play a significant role, and this means the ability to deploy much larger resources for environmentally sound development. It is particularly important to ensure that a concern with the environment does not take the form of obstructing development and thus letting the poor remain poor. Poverty is often the root cause of environmental damage, and poverty cannot be overcome without providing more electricity, more water, more food, and more work for the world’s poor. All this requires more investments and more lending, not less. Nor should genuine concerns about the environment and the need for improving social conditions in poor countries be allowed to become vehicles for protectionism in international trade. That would cause a setback to the cause of social and environmental progress in developing nations. Environmental protection measures must also take into account the social and cultural factors, the stage of development, and the administrative capacities of developing countries. Much more work is needed to transform the Rio conference’s vision of sustainable development from a mere buzzword to an operationally effective strategy of human development. The Bank is well placed to perform this task.

Finally, the World Bank of the future must return to a more focused set of priorities and activities. The past several years have witnessed a paradoxical development, in which a widening of the mandate of the Bank is sought by including new objectives to guide Bank policy even as the material resources made available to it are kept on a tight leash. A tendency has developed among industrial country shareholders to introduce new objectives under pressure from one or another domestic political constituency. Many of these concerns are in themselves unobjectionable and respond to important and legitimate interests and concerns. But when directly introduced to influence the Bank’s lending priorities, they lead to a too diffused pattern of lending, whose impact on development in the recipient countries is far from certain or beneficial. The effectiveness of the World Bank as an international institution depends upon a measure of self-restraint by all shareholders to refrain from using the Bank to promote all objectives. A strengthened United Nations system would be a more appropriate forum for reaching consensus on political and social issues of general concern.

I remain a firm believer in the virtues of international cooperation. The Bretton Woods institutions can serve as vital instruments for realizing our vision of one world in which all the citizens of the world have an equal opportunity to lead productive and purposeful lives. The future is ours to make; let us prepare for it now.

The IMF at Age 50

The conventional wisdom is that the world economy and the IMF prospered together during the first quarter century of the postwar period. Global growth was rapid and widely distributed. Inflation was low. Trade was steadily liberalized and expanded rapidly. International investment and capital flows increased substantially. Payments imbalances were modest. Exchange rates were stable.

The Fund stood at the center of the international institutional structure. Countries sought convertibility and, with it, “first-class” status in the organization. The Fund was the lender of last resort, including to the largest countries in the world. Its rules for macroeconomic management were generally accepted and faithfully implemented.

Unfortunately, reality was not so rosy. Western Europe took almost 15 years to achieve convertibility. Sterling crises, systemically vital because sterling was still the world’s second key currency, occurred frequently throughout the 1960s. The gold markets produced widespread disruptions. The dollar, already by far the leading currency, also came under periodic attack after 1960—leading to capital controls in the world’s largest creditor nation. The inadequacies of the adjustment process were already apparent by the mid-1960s, when France sought to “dethrone the dollar” by buying gold, and U.S. policies on the balance of payments even played an important role in bringing down a German Chancellor.

On the real side of the world economy, growth of output and trade was indeed robust. But much of this was simply catchup from the devastation of the Second World War and had little to do with the new policy regime. The dominant economy of the period, the United States, grew very slowly in the late 1950s and early 1960s. By the end of the period, inflation was creeping upward almost everywhere and inter alia sowing the seeds for the oil shocks of the 1970s. Scores of developing countries—including many of the later “economic miracles”—adopted strategies of import substitution or even comprehensive socialism that produced subsequent stagnation.

Trade policy also presented a mixed picture despite the rapid expansion of trade flows. Protectionism was already on the rise, and the failure of the Bretton Woods system to correct the growing currency misalignments of the 1960s triggered an outbreak of U.S. import controls. Both key currency countries, the United States and the United Kingdom, even resorted to import surcharges—blatantly violating the rules of both the Fund and the GATT, the institutions that these same two countries had worked so hard to create barely a generation earlier.

The institutional scene was much less clear-cut than the conventional wisdom would suggest. The IMF was totally bypassed by the Marshall Plan and other intergovernmental lending in the initial reconstruction period. Its “golden age” of the 1960s in actuality relied heavily on the newly created Group of Ten for crisis management, through frequent weekend meetings to rescue sterling or the dollar; supplementary financing via the General Arrangements to Borrow and the participants’ bilateral swap lines; and general systemic guidance, as in the creation of SDRs. Working Party No. 3 of the Organization for Economic Cooperation and Development, rather than the Fund, was the chief locus for discussing adjustment among the industrial countries.

Hence, neither the system nor, especially, the Fund prospered quite so dramatically. The real story, as usual in history, is much more complex and nuanced.

Contrary to the conventional wisdom, one could even argue that the Fund reached the peak of its institutional influence over the last dozen years—long after the collapse of the Bretton Woods exchange rate system and long after it had conducted its last program in a major industrial country. The IMF indisputably played a more central role in managing the Third World debt crisis of the 1980s than in managing the global monetary system of the 1960s. It is probably also playing a larger role today in managing the transformation of the former command economies.

So neither nostalgia for a past golden age nor a desire to “restore the monetary role of the Fund” can credibly motivate future reform of the international monetary system. Any such case must be made in more substantive terms: the need to remedy the severe weaknesses of the current monetary regime and its institutional underpinnings. In my view, both parts of that case can be made quite clearly and quite persuasively. In what follows, I argue that the International Monetary Fund of the twenty-first century should become the steward of a system of currency target zones that could evolve, over time, into an effective regime of macroeconomic policy coordination among at least the European Union, Japan, and the United States. In doing so, the Fund could finally assume the global monetary role intended for it at Bretton Woods by becoming the system’s co-manager, along with the major countries and a new committee of central banks.

The Case for Systemic Reform

The recent report of the Bretton Woods Commission correctly concludes that “the costs of extreme exchange rate misalignment and volatility are high. When current exchange rates are misaligned, resources are misallocated;…. Exchange rate misalignment adds to protectionist pressures … in one major country after another …” (Bretton Woods Commission, 1994, p. A-4). “The governments of the major industrial countries should give a high priority to international monetary reforms aimed at reducing large exchange rate fluctuations and serious misalignments” (Bretton Woods Commission, 1994, p. A-1).

The most dramatic recent misalignment was, of course, the massive overvaluation of the dollar in the first half of the 1980s. The resulting decimation of U.S. competitiveness and massive trade deficits led the Reagan Administration, to quote its Secretary of the Treasury, James Baker, “to grant more import relief to U.S. industry than any of its predecessors in more than half a century” (Baker, 1987). Free traders in Congress despaired that “the Smoot-Hawley tariff itself would pass by an overwhelming majority” had it come to the House floor in the fall of 1985. The infamous Super 301 provisions of U.S. trade law, and U.S. “aggressive unilateralism” more broadly, whose implementation has come to have significant effects on the currency markets as well as on world trade, are part of the trade policy legacy of that particular currency misalignment.¹

The most recent case of severe misalignment is Japan. The yen reached an equilibrium level (about 120:1 against the dollar, the equivalent in real terms of about 100:1 today) at the end of 1987, and, largely as a result, Japan’s global current account surplus dropped to a mere $35 billion (1.2 percent of its GDP) in 1991. But the yen was permitted to weaken by 30 percent in 1989–90, despite continued improvement in Japan’s international competitive position, producing the huge renewed surplus in the early 1990s that triggered sharp trade reactions elsewhere—including the “managed trade” onslaught from the United States and comprehensive automobile quotas in the European Union.

But that was only the first manifestation of this latest currency problem. The extremely rapid appreciation of the yen that inevitably followed has traumatized much of Japanese industry and, in the continuing (and inexplicable) absence of significant fiscal stimulus despite continued budget surpluses, has extended that country’s recession through a record third year. Japan has thus received a double hit from this latest misalignment.

The currency misalignments that developed in Europe are even more widely recognized. The crises in the exchange rate mechanism (ERM) of 1992 and 1993, though different in nature from the dollar and yen episodes, have had equally profound (or even greater) effects on the economies of the countries involved and on the global financial system. Unemployment levels in Europe have been much higher for much longer, owing to the effort to preserve disequilibrium parities in the face of major changes in the underlying economic fundamentals, most notably German reunification but also differential inflation in Italy and elsewhere (and sterling’s entry into the system at a clearly overvalued rate).

Any international monetary system that permits such large and recurrent disequilibria, with such major economic costs, is a failure. The proximate causes of the problems I have addressed were, of course, the national policies of the countries cited, not the international monetary system per se. But the system provided no help in preventing those policy errors, although a central function of any effective international monetary system is to push national policies in directions that are sustainable internationally and thus in the long-term interests of the countries themselves. The only relevant question is whether a better system can be constructed intellectually and implemented operationally.

Search for Stability

Both extremes have been tried. Fixed exchange rates were attempted at the global level under the original Bretton Woods system and in Europe during the second phase of the European Monetary System (EMS) after 1987. Both broke down because they became too rigid and could not accomplish needed parity changes on a timely basis.

Flexible exchange rates have existed for the past 20 years. They were implemented in nearly pure form in the first half of the 1980s and permitted the largest misalignment of all time for a major currency (and an equally large misalignment for at least one other major currency, sterling). Both “pure systems” have clearly failed.

Hence, governments have constantly sought a better regime. It is fascinating to note that much of today’s discussion of international monetary reform echoes the discussion that ensued, at least outside official circles, around the time of the collapse of fixed rates in the early 1970s. Now, as then, the focus is on intermediate systems. They were then referred to as “wider bands” or “crawling pegs” or some combination of the two (see Bergsten and others, 1970). Today’s proposals for “crawling target zones” are largely an amalgam of such ideas. This similarity of thinking occurs across more than two decades despite the enormous changes that have taken place in the underlying economic and political landscape—the huge increase in capital mobility, the dispersion of economic power around the world, and the end of the Cold War.

There was, of course, no agreed monetary reform in the early 1970s. But the new de facto regime of freely floating rates had a very short half-life as governments immediately revealed their preference for something better. At the regional level, Europe adopted the “snake” in the early 1970s and the EMS more recently, and now seeks full economic and monetary union (EMU).

At the global level, coordinated intervention strategies were adopted in the late 1970s and again in the middle 1980s—most dramatically, with the Plaza agreement in 1985, when the Group of Five explicitly admitted that its previous “benign neglect” and reliance on national “convergence” had failed to produce equilibrium exchange rates. Even more ambitiously, the Group of Five/Group of Seven created a system of target zones—which they called reference ranges—in the Louvre accord of 1987 (see Funabashi, 1988, for the definitive account).

The Louvre bands were too narrow, and its rates were set prematurely and, hence, did not last long because the dollar had not yet completed its needed correction. But the major industrial countries have been operating a system of de facto (or “quiet”) target zones since that time:

• The trade-weighted dollar has been relatively stable since 1987, confined to a range within 10 percent on either side of its late-1987 base;

• The dollar-deutsche mark rate has fluctuated between about 1.40:1 and 1.80:1 during the past five years, with repeated intervention to preserve both ends of the range; and

• The dollar-yen rate has for most of the period ranged between about 120:1 and 160:1 (although, as indicated, the yen became significantly undervalued at that level and hence broke into a new range in 1993–94).

Moreover, the EMS responded to its crisis of 1993 not by abandoning or realigning its parities but by sharply widening the margins around them. This largest regional arrangement also thereby created a system of de facto target zones, whose record so far is quite encouraging.

Both the global and key regional monetary arrangements are thus coalescing toward an intermediate regime. Such a regime would seek to incorporate the virtues of the two extreme systems: limitation of volatility and thus greater business predictability for fixed rates, and responsiveness to market changes for flexible rates. It would try to avoid their vices: excessive rigidity and thus periodic misalignments for fixity, and extreme misalignments and volatility under flexibility.

But the present de facto target zone system, although a decided improvement on the failed extremes of the past, still embodies significant weaknesses. There is no orderly mechanism for adjusting the ranges to respond to changes in economic fundamentals, as revealed in the recent case of the yen. The markets are not confident that the ranges will be maintained and are constantly tempted to bet against them. Most important, implementation depends almost wholly on the individuals who are in office at a given time and has no institutional locus (or even memory).² The present regime should thus be viewed as a temporary way station en route to lasting reform rather than as a satisfactory terminus.

Adopting Announced Target Zones

The best step would be to convert the present de facto regime into a de jure system of announced target zones among the major currencies. The zones could start at plus or minus 10 percent around notional midpoints, determined by calculating the exchange rates needed to produce and maintain sustainable current account positions—a wholly realistic objective within the prescribed margin of plus or minus 10 percent.³ The zones would be kept under constant review, with changes in bilateral nominal rates as needed to hold real rates constant and more substantial changes in response to large external shocks (such as the sharp changes in world oil prices in the 1970s or German unification more recently).

It is nonsense for officials to reject target zones on the grounds that their limited resources do not permit them to cope with the $1 trillion of daily activity in the currency markets. The vast bulk of that flow is self-balancing, reflecting routine steps by market participants to rebalance their portfolios following normal financial transactions. Although very large sums will move if the market is convinced that the authorities are trying to defend a disequilibrium rate, net market movements for most currencies on most days are quite small.

Indeed, a credible target zone regime could convert present destabilizing private flows into stabilizing flows in the future (see Krugman, 1988). As long as the zones are set properly and defended effectively, private capital movements will help maintain rather than disrupt them. When rates approached the edges of the zones, speculators would know that they could make little money pushing further in that direction but that there was substantial scope for profit from reversing course. Governments and central banks, in their pursuit of economic and financial stability, would gain much more from these stabilizing properties of an effective monetary system than they would lose by giving up their present ability to surprise the market on occasion—and they would, of course, retain that ability for intramarginal intervention.

There is also strong empirical evidence that coordinated, announced intervention in the exchange markets can effectively defend exchange rate targets—even when the intervention is sterilized and, hence, conducted without changes in monetary policy. Dominguez and Frankel (1993), using previously unavailable German and U.S. intervention data, show that publicized intervention can be extremely potent. A study by the research staff of the Banca d’Italia, using even more extensive intervention evidence from all Group of Ten and EMS countries, reaches even stronger conclusions: that all 17 episodes of concerted intervention from 1984 to early 1992 were “definitely successful,” that in no case was intervention steamrollered by the market, and that all but one major turning point in the dollar-deutsche mark and dollar-yen rates since 1985 were “exactly coincident” with episodes of concerted intervention (see Catte, Galli, and Rebecchini, forthcoming).

The combination of wide bands and effective intervention suggests that macroeconomic policy, including monetary policy, would rarely have to be devoted to external purposes under a credible target zone system. Hence, monetary and fiscal policies could largely retain their focus on domestic policy targets.

In those cases when domestic policy had to be altered, however, it would generally be in directions that are quite healthy from the long-term standpoint of the country in question (as well as the world economy as a whole). Improved international policy coordination could in fact promote better domestic policy coordination—a problem for most of the major countries despite their sophisticated policy regimes. A target zone system could on occasion reduce the short-term flexibility of macroeconomic policy in participating countries, but, in practice, it would primarily reduce their flexibility to make policy errors, as indicated in some of the most spectacular recent cases of such error:

• A target zone system, in addition to calling for intervention that would have limited the final (and totally irrational) stage of the appreciation of the dollar in 1984–85, would have pushed the United States to restrain its run-up in interest rates in the early 1980s through less fiscal expansion—surely a desirable outcome and one that many Americans now seek through far more artificial and arbitrary devices, such as balanced budget amendments and legislative procedures like Gramm-Rudman-Hollings;

• A target zone system centered on the end-1987 equilibrium rates would have sought to avoid the sharp depreciation of the yen in subsequent years, thereby pushing Japan to use fiscal rather than monetary policy to expand domestic demand and shielding it from at least the worst excesses of the “bubble economy”; and

• A target zone system would have facilitated German revaluation in the wake of reunification,⁴ reducing the need for subsequent sky-high real interest rates that pushed all of Europe (especially outside Germany) into prolonged recession.⁵

The relationship between the monetary regime and macroeconomic policy coordination is an issue on which the Bretton Woods Commission and many other analysts make a critical error. They argue that governments should first achieve more successful coordination of their macroeconomic policies and then adopt target zones or some other better monetary regime. Unfortunately, there are no historical examples of such agreements on policy coordination. Hence, such recommendations represent pious statements of principle that are destined to remain totally nonoperational.

By contrast, there are at least two recent historical examples of monetary systems that, in turn, induced participating countries to achieve at least a degree of policy coordination. The original Bretton Woods regime of adjustable pegs produced such results to an important extent despite the caveats cited above (see Michaely, 1971). So has the EMS, most dramatically in the case of French adjustment to the disastrous effects of its “dash for growth” in 1982–83, but also in its evolution into a much more extensive regime of policy coordination in the 1990s and the subsequent plans for full monetary and even fiscal coordination through EMU. History suggests that the more feasible progression is from monetary accord to policy coordination rather than the reverse.⁶

There is a problem of transition in the adoption of any new monetary regime. If the starting point is fixed exchange rates, as under the original Bretton Woods system, a comprehensive realignment is required. Much of the debate in the early 1970s centered on where the new parities should be set.

If the starting point is floating rates, or even de facto target zones like today, it is much easier to launch a new system “around current levels.”⁷ Any need to jump to new rates could be disruptive and make institution of the new regime substantially more difficult, thus deterring governments from making the effort. Hence, governments must look for an opportune moment to launch a system of target zones (or anything more ambitious).

Fortunately, there is widespread agreement that today’s exchange rates are close to long-term equilibrium levels. IMF Managing Director Michel Camdessus (1994, p. 31) has recently noted that “exchange rates among the key currencies are probably not very far from the professional consensus on the rates that are appropriate.” Hence, the present moment, unlike most of the past dozen years, would permit a smooth start-up of a new regime with a dollar-yen zone centered on 100:1 and a deutsche mark-dollar zone centered on 1.60:1. Had such a regime already been in place, recent currency movements would have been viewed as well within the ranges and thus generated much less attention and concern. The opportunity should not be wasted.

Target Zones and the IMF⁸

Who would manage a system of target zones? The Group of Seven is clearly inadequate. It has no staff nor even a secretariat to keep records and produce an institutional memory. Its members frequently disagree on what they said soon after an agreement is reached. No decision-making system, let alone a procedure to resolve disputes effectively, is provided.

The only satisfactory forum within which to manage a new international monetary regime is the IMF. It is the only institution that would permit the needed integration of the decisions by participants in the regime with those of nonparticipants (for example, with respect to the selection of current account targets). Only the Fund could provide a channel for the interests of nonparticipants to be brought to bear on the decisions of the participants. It already has available the robust staff of economists, analysts, and technicians that would be needed to support the regime.⁹

At the same time, the Group of Seven industrial democracies account for a substantial majority of world economic activity and will continue to do so for some time.¹⁰ All of the countries that are crucial to the initial success of a target zone regime are contained within that Group. They are the most likely participants in a target zone regime at its outset. They bear responsibility for systemic stability and so must play a central role in the management of any successful monetary regime.¹¹

The Group of Seven finance ministers and central bank governors should therefore remain the initial locus in which implementation and administration of target zones are negotiated and discussed. They would establish the targets for the current account balances of the participants in the regime, establish the exchange rates needed to achieve and maintain those positions, and realign the target zones in response to real shocks or new evidence about the need for a payments adjustment. Decisions within the Group would continue to be taken by consensus. The ministers might meet quarterly, as they agreed at the Group of Seven summit meeting at Naples in July 1994, with their deputies meeting as often as necessary.

The finance ministers and central bank governors should, however, draw much more fully on the Fund staff by giving it responsibility, along with the staffs of the national finance ministries and central banks, for preparing discussion papers and decision memoranda for Group of Seven meetings. The Managing Director, who presently participates only in the portion of Group of Seven meetings devoted to multilateral surveillance, should be included throughout. He or she should participate in the discussion of current account targets, setting the target zones, and pursuing any policy adjustments needed to defend them—in order to bring global systemic concerns, and those of the remaining members of the IMF, to the table.

Moreover, the Group of Seven should seek the concurrence of the appropriate bodies of the IMF before implementing any decisions that it has taken.¹² As presently constituted, however, the Fund’s Executive Board would then have to pass judgment on decisions taken by officials who are much more senior than the Executive Directors themselves. Hence, it would be desirable, when making important decisions to establish and implement the new regime, to constitute the Executive Board at ministerial level.

Such a body, called the “Council,” has already been provided for by the Second Amendment to the Articles of Agreement (1978) and could be activated by 85 percent of the voting power of the Fund (Article XII, Section 1; Schedule D). By involving the same finance ministers that represent their countries in the Group of Seven, the Council could consult and confer with those individuals responsible for the Group’s decisions. The Interim Committee, after its 20-year “interim,” should thus be converted into the Council as originally intended in the Second Amendment.¹³

To implement the new regime, and to dramatize the role that the Fund would now be playing in managing the global monetary system, the Executive Board itself should be upgraded through the appointment of ministerial deputies as Executive Directors (as proposed by Finch, 1994). Under this change, which would be implemented by each country group or “constituency” within the Fund, the Group of Seven deputies would be members of the Board that would be overseeing international monetary matters under the authority of the Council when the ministers were unable to convene (or did not need to do so). The Alternate Executive Directors, who would be appointees at roughly the same level as the current Executive Directors, would carry on the regular business of the Fund.

The Council would then exercise the Fund’s powers of surveillance over the exchange rate arrangements of its members, approving the new regime and decisions taken within it (Article IV, Sections 2(b) and 3(b)). It would examine and discuss the current account targets of both participants and nonparticipants in the regime, the target zones for the participating currencies, and policy adjustments needed to sustain them. The Council, or the Executive Board meeting under its aegis, would approve realignments, for example.

The Council and the Executive Board could be expected to accept the proposals of the Group of Seven, for whom these decisions would be far more consequential than for the nonparticipants, on most occasions. Concurrence by the Fund bodies, however, would be much more than a rubber-stamping of the decisions of that Group because:

• the Council and Board could reinforce the majority within the Group of Seven in exercising peer pressure over miscreants, adding to the prospects for prompt and constructive policy changes when needed;

• the Group of Seven would have to consult with the Council and Board throughout the process, giving them immediate notice of decisions and the right to cross-examine the representatives of the Group of Seven countries;

• the accumulation over time of a record of decisions and advice on the part of the Council and Board could contribute to both future decisions by Group of Seven countries and accession to the regime by others; and

• the Group of Seven governments do not quite command a majority of the votes within the IMF.

The actual role of the Council or Executive Board would depend on the type of Group of Seven decision being approved. General surveillance over the regime and consideration of future policy adjustments that might be required to meet regime targets, for example, could be conducted at ministerial level. A realignment of the target zones, on the other hand, would require avoidance of any substantial delay between a decision by the Group of Seven and its implementation. In this case, the Executive Board could convene on a few hours’ notice at the level of the deputy ministers (or even their alternates based in Washington) to approve the decision.

The central banks, acting together in a new committee of central banks that would, in turn, confer with the Group of Seven and work within the framework of its decisions, should make all operational decisions about intervention and monetary policy adjustments (Henning, 1994). The central banks should, for example, be given authority to assign intervention responsibilities and extend credits to finance intervention.

Through their participation in the Group of Seven meetings, and through their new committee, the governors of the central banks should advise the Group on the full range of macroeconomic and monetary issues. The committee, in particular, should warn the Group of Seven when the projected fiscal policies of governments could make maintenance of the target zones impossible without provoking inflationary or deflationary changes in monetary policies in one or more participating countries. It should have the authority to propose consideration of a realignment within the Group of Seven.

The advantages of this three-part institutional infrastructure for target zones are several. It builds on existing and operating institutions: the IMF, Group of Seven, and Basel meetings of central bankers that already take place monthly. It balances the need for efficiency in decision making with the need for broader participation to enhance legitimacy. It can be implemented without any amendment of the Articles of Agreement of the Fund (or any other “constitutional” changes). It would enable the Fund to fulfill its original raison d’être of managing the international monetary regime.

Conclusions

At its recent summit in Naples, the heads of government of the Group of Seven asked, How can we adapt existing institutions and build new (international economic) institutions to ensure the future prosperity and security of our people? They inscribed the issue on the agenda for their meeting in Canada next year.

A number of changes are needed in both categories (for a comprehensive review, see Bergsten, 1994). But international monetary reform is surely the place to start. The international monetary system lies at the heart of the world economy just as national monetary policies lie at the heart of individual national economies. The present regime is clearly inadequate. A viable alternative is available. There is growing support for such reform, as indicated by the widespread and prestigious participation in the Bretton Woods Commission and the expression of personal views on the topic by the Managing Director of the Fund (Camdessus, 1994, pp. 31–32).

Yet neither the Executive Directors of the Fund, nor the Board of Governors, nor the Group of Seven have made any serious proposals in recent years to improve the system. The fiftieth anniversary of Bretton Woods would be an apt moment to begin the process of creating an effective and stable monetary regime for the years, and even decades and half century, ahead. Installation of a central monetary role for the IMF should be an integral element of any such systemic reform. There would be no more suitable time to launch the effort than at this annual meeting of the Fund.