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Professor of Economics, Tel–Aviv University and University of Maryland, NBER, and CEPR. I would like to thank my discussants, Jeffrey Frieden and Mohsin Khan, conference participants, and especially Jeromin Zettlemeyer for insightful comments. Shir Raz provided excellent research assistance. Some of the research for this paper was conducted during a visit to the IMF’s Research Department, which I wish to thank for its hospitality. Financial support from the Yael Chair in Comparative Economics, Tel Aviv University, is gratefully acknowledged.
See the IMF website http://www.imf.org under “conditionality” for a number of papers on aspects of this debate.
One could argue that conditionality is meant as a form of technical assistance: a country may agree with the overall program objectives set out by the IMF, but be unsure how to implement the program. This is not a really satisfactory answer, however, and is recognized as such. If this were the problem, the solution would be one of technical assistance rather than conditionality, a point widely recognized (see, for example, IMF, 2001).
For example, Khan and Sharma (2001) argue that the analogy with private bank lending is useful in understanding IMF lending. Tirole (2002) presents a similar argument reconciling conditionality and ownership. Analogous to the commitment arguments made above, he argues that by giving up certain control rights or otherwise constraining himself ex ante, a borrower can commit himself not to take specific actions ex post that a lender would see as detrimental to repayment prospects. (See also Federico (2001).) In this approach, structural conditionality can be partially justified by the argument that a credible promise of loan repayment requires sustained medium–term improvement in economic performance.
This essential tension in terms of what conditionality means about the “political” status of borrowers has long been recognized. It was well stated by Diaz-Alejandro (1984) and forms the basis of recent critiques, such as Killick ((1997).
“…conditionality is often viewed as an attempt of international financial institutions (or aid donors) to use financing to ‘buy’ policy reforms that are not desired by authorities. [This] interpretation of conditionality is often reflected in the use of a principal–agent model, in which the Fund (the principal) establishes a mechanism intended to ensure that reforms will be undertaken by the authorities (the agent), in a setting in which the objectives of the Fund and the authorities do not fully coincide and there are informational asymmetries associated with the fact that the Fund cannot directly observe some aspects of the authorities’ actions, objectives, and/or circumstances. This presentation of the Fund as “the principal” in this framework is inconsistent with that of country ownership of the program.” (IMF, 2001, paragraph 16.)
Many references could be given. See, for example, Haque and Khan (1998). Dollar and Svensson (2000) present convincing evidence that political conditions in the receiving countries are much more important than conditionality in explaining the success or failure of World Bank programs.
One should note that IMF (2001) explicitly acknowledges the importance of heterogeneity within a country, for example, in paragraph 38.
For example, the behavior by an agent that can be induced by an optimal contract will depend on the extent to which the interests of the principal and agent are aligned.
There is now a growing body of work on multiple–principal, multiple–agent, and multiple–task models, though the application of existing formal models to the specifics of IMF programs is not immediate. It has been suggested that models of “moral hazard in teams” (Holmstrom (1982)) may be relevant. In these models, the outcome is a function of the actions of several agents (and perhaps also a random component), where individual actions are unobservable, so that there is a “free rider” problem. The design of an IMF program would be finding a scheme that induces optimal actions by each agent. On the one hand, team behavior captures the notion that many agents must “sign off on a program. On the other, the team setup does not seem to describe very well the nature of the economic problem an IMF program is meant to address nor the nature of policymaking.
Dixit (2000b) provides some suggestions on how conditionality and other aspects of IMF programs may be better understood in terms of formal principal–agent theory.
The type of conditionality may also demonstrate commitment. For example, structural conditions may more effectively demonstrate the government’s commitment to sustainable macroeconomic stability.
As Khan and Sharma (2001, p. 15), “in pluralistic societies, does ownership refer to the views on program design of and objectives held by key ministers and central bank officials that negotiate the program with the IMF, or to the views of the entire domestic bureaucracy that has to approve the necessary legislation, or to the beliefs of civil society at large?“
An IMF program would have no structural component (that is, no reliance on τ) to the extent that the Fund targets Y, and τ has little or no effect on Y. This would represent the case in which the IMF’s performance target is narrowly defined so that it is a function only of macroeconomic variables such as e, so that the IMF’s narrowly defined objectives imply no role for structural conditionality.
The term “status quo” may be slightly misleading, since this could be the state after the economy has suffered a large shock. The idea is that once the economy finds itself in this position, domestic interests may oppose any reform, hence the term “status quo.“
The authorities’ indifference curves are horizontal along e+(S), since this is a reaction function in which e is chosen optimally for each S
The discussion at the beginning of Section I, whereby conditionality may mean higher welfare for borrowers relates to the case of comparing conditional lending to no lending, the unavailability of lending reflecting problems of moral hazard, etc. In this discussion, in addition to the absence of such considerations, the lender is assumed to extract all the benefit of conditionality (equation (5b)), so that the borrower is only weakly better off.
Vreeland (1999, 2001) has used this type of model to study the possible effects of conditionality in a framework where policy has a single dimension (in his case, the size of the government budget deficit). Other papers that consider conditionality from a political economy perspective include Drazen (1999), Jeanne and Zettelmeyer (2001), Martin (2000), Mayer and Mourmouras (2002), Svensson (2000), and Willett (2000).
There is a slight “catch” in that a conditional lending program itself must be assumed not to make the domestic political constraint binding.
Condition (9a) is basically equivalent to the first–order condition derived in Mayer and Mourmouras (2002) in the absence of IMF lending (using a Grossman-Helpman (1994) menu-auction model) when τ, interpreted as a political contribution, enters linearly and of opposite sign and there are many interest groups. The difference is in equation (9b), where a menu–auction model with political contributions has a reservation utility constraint given by the requirement that the government’s utility with positive contributions under the policy it chooses is the same as what it would get if it ignored the contributions of the interest groups. In terms of Figure 3, the equilibrium in the menu–auction model may represented by the point on the contract curve giving the same utility to the government (for a linear formulation for τ) as the case where τ = 0.
In the politically constrained case, e is higher (suggesting aid may be more effective), but there are both structural distortions and political constraints (suggesting aid may be less effective). Hence, the difference in the numerator is ambiguous and may be second order relative to the difference in the numerator.
Since (e0, x0) is feasible for S < 0, any other point chosen must yield higher welfare than (e0, x0), which yields higher welfare when S is positive than when it is zero.
The assumption that Y τs = 0 does not mean that changes in τ do not affect Y, but rather that a change in S does not change the effect of τ on Y.
In the case of different objectives (such as an IMF financial constraint), a strong distortion due to the political constraint in the sense of ep(S) being very much above e+(S) means that the unconditional and conditional lending solutions will generally be farther apart in the politically constrained case than in the economically constrained case. In this very limited sense one might argue that political constraints in themselves give a role for conditionality, but it is a weak argument given our interest in the case where authorities and the IMF agree on objectives.
In presenting a case for selectivity in lending, Drazen and Fischer (1997) and Drazen (1999) argue that conditional lending may be ineffective in addressing appropriation because of problems of asymmetric information and nonobservability. For example, suppose not only that the use of loans cannot be observed, but also that neither policy actions nor the connection between policies and outcomes is fully observable. Coate and Morris (1997) suggest that poorly designed conditionality may make things worse if it induces appropriation in especially inefficient ways.