Introduction

Since the mid-1990s, the incidence of financial crises among emerging-market countries appears to have increased (Hoggarth and Saporta, 2001). In response, governments and international financial institutions have worked intensively on ways to reduce the likelihood and virulence of crises. This is the debate on the so-called ‘international financial architecture’ (see, for example, Eichengreen, 2002, for an overview).

There is now a fairly widespread consensus within the official community on appropriate crisis-prevention measures (King, 1999; Eichengreen, 2002). For example, the best defence against financial crises is to establish sound macroeconomic fundamentals and to have a credible policy framework in place to deal with economic and financial shocks. A broad international consensus has also emerged on the importance of prudent balance sheet management, with a particular focus on the balance sheet positions of governments and the financial system. Considerable work has also been done by international groups to establish codes and standards of best public policy practice. The official community should not be prescriptive about the adoption of standards. But it should promote transparency about the degree of country compliance with them (see Drage and Mann, 1999).

Even with such prevention measures in place, however, crises will still occur from time to time. Moreover, there is less consensus among policy-makers on appropriate crisis-resolution measures in these circumstances. This fact is well recognised by, among others, the IMF (Krueger, 2001). The IMF has responded to crises by providing often large-scale lending packages, conditional on the implementation of macroeconomic and structural reform.

Introduction

In the sad economic history of Argentina since the 1950s, the 1990s encompassed a remarkable transition. Rising from the ashes of yet another episode of economic chaos and hyper-inflation at the end of the 1980s, the surprisingly orthodox policies of the new Perónist President, Carlos Menem, brought a decisive end to decades of monetary instability and launched the Argentine economy into four years of unusually rapid expansion. Those economic policies featured a hard peg of the Argentine peso at parity to the US dollar, backed by the Convertibility Plan, which strictly limited domestic money creation under a currency board-like arrangement. Many doubted whether the new policy regime would survive, especially as tensions rose during the ‘tequila crisis’ initiated by the Mexican devaluation of December 1994. But it did survive; and after a sharp recession in 1995, the Argentine economy resumed rapid growth from late 1995 until the spillover effects of the Brazilian crisis hit Argentina in late 1998. Indeed, with most of the economies of emerging Asia collapsing into crises from mid-1997 to early 1998, Argentina became the darling of emerging-market finance – able to float large issues of medium- and longer-maturity debt on world credit markets at comparatively modest spreads over US Treasuries. And, in the official international financial community, especially the International Monetary Fund (IMF), many of Argentina's economic policies were widely applaudedand suggested as a model that other emerging-market countries should emulate – international approval that was dramatised by President Menem's triumphant address to the IMF/World Bank Annual Meeting on 4 October 1998.

Introduction

IMF lending to countries is generally conditional on the government and Central Bank carrying out specified policies and achieving specified outcomes. Some of these conditions might be prerequisites for an initial disbursement, while others will be requirements for subsequent drawings on a standby arrangement. In discussions of the appropriate conditions, IMF and country officials often disagree, sometimes diametrically. Economic programmes supported by IMF resources usually are negotiated compromises between the policies initially favoured by the Fund and those favoured by the country's authorities. In some cases, having gone through this process of negotiation, the authorities might be reasonably happy with the outcome and may be said to ‘own’ the programme even though it was not their original preference. In other cases, they might be swallowing a bitter pill simply because it is the only way to get the IMF to cough up the money. This chapter tackles two questions raised by the distinction between ‘owned’ and ‘imposed’ outcomes. Is the distinction empirically meaningful? If so, what can be done to operationalise it?

First, it is necessary to define ‘policy ownership’. Several definitions have been offered in the literature, but it is not easy to devise a definition that is empirically relevant. For a government to own a set of policies does not require that officials think up the policies by themselves, nor that the policies be independent of conditionality.

Introduction

There are several different strands in the current economic literature regarding the role of IMF. In this chapter, I develop one particular theme, namely the role of the IMF in assisting countries that have serious international payments difficulties. One characterisation of this debate is that between the ‘moral hazard’ school and the ‘liquidity’ school. The former stresses the classic perverse incentive problem created with insurance-type interventions in capital markets leading lenders to bet on being ‘bailed out’ at some future date if things go wrong – especially in countries that might be considered ‘too big to fail’.

Adherents to this school point to the sheer size of IMF-led packages to emerging economies, the very low emerging-market spreads after the assistance to Mexico in 1995 and the ‘lending boom’ to emerging economies, including the Asian economies, that then followed as evidence of the potential importance of moral hazard. In figure 13.1, we plot the EMBI spread from 1994 as an illustration.

Some have labelled this as a ‘theory of plenty’: a theory of too much private lending, on the one hand, and too little discipline on the other. This lack of discipline might result in countries contracting large amounts of debt (either in the public or private sectors or in the private sector with implicit or explicit guarantees) while, at the same time, failing to address structural weaknesses or not adjusting quickly enough to negative shocks as they arise.

Introduction

The subject of this chapter is macroeconomic policy coordination among developed countries. The chapter covers both the findings of theoretical models of policy coordination and the historical experience of coordination between policy-makers in different countries. Most importantly, the chapter assesses the extent to which models of policy coordination capture the key features of practical experience. For areas where the models and experience diverge, we attempt to draw some lessons for both modellers and policy-makers.

The past few decades have seen the development of theoretical and empirical models designed to explore the benefits of international macroeconomic policy coordination. The models highlight the fact that macroeconomic policy actions in one country affect economic welfare in other countries; that is, they have externalities for other countries. The key insight of the models is that coordination of policies among countries that takes into account these externalities may lead to higher welfare for all countries. Starting with this key insight, the modelling of international policy coordination has moved in many different directions addressing such issues as the types of problems that coordination is best suited to address, which policies are best suited to address which problems, the means of enforcing international agreements, the roles that uncertainty and information sharing play in the coordination process and the measurement of the gains from policy coordination.

When the US Congress approved $18 billion of additional funding for the International Monetary Fund (IMF) in November 1998, it authorised a study of international financial institutions. Congressional concerns included the growing frequency, severity and cost of financial disturbances, the fragility of the international monetary system, the ineffectiveness of development banks, and corruption in Russia, Indonesia, Africa and elsewhere. But Congress also expressed concern about whether international financial institutions (IFIs) had adapted appropriately to the many changes since the Bretton Woods Agreement in 1944.

In July 1999, Congress completed appointment of the members of the International Financial Institution Advisory Commission (usually called the Meltzer Commission). Between 9 September 1999 and 8 March 2000, the Commission met twelve times and, in addition, held three days of public hearings. On 8 March 2000, it presented its Report to the Speaker and the Majority Leader of the House of Representatives (International Advisory Commission, 2000). The Report stimulated active discussion of issues that might have been addressed at the fiftieth anniversary of the Bretton Woods Conference, in 1994, but were not.

Discussion was overdue. As the US Congress recognised, the world economy and the international financial system are very different from the world envisioned at Bretton Woods in 1944. The principal international financial institutions responded to many past changes and crises by expanding their mandate and adding new facilities and programmes. New regional institutions opened to serve the needs of regional populations.

Introduction

In mid-1997, the IMF's Interim Committee issued a statement announcing that the time had come ‘to add a new chapter to the Bretton Woods agreement’. The statement called for the establishment of a ‘multilateral and non-discriminatory system to promote the liberalization of capital movements’. The Committee invited the Executive Board to complete work on a proposed amendment of the IMF's Articles that would make the ‘liberalization of capital movements one of the purposes of the IMF’ and extend the IMF's jurisdiction to enforce those obligations on its members.

The timing of this statement was not propitious. The massive reversal in capital flows to East Asia that followed the floating of the Thai baht on 2 July 1997, and which accelerated in the months after the IMF statement was issued, turned out to be unprecedented in its speed and scale. Although the crisis initially centred on the East Asian economies, the turbulence in emerging markets was much more widely felt. In June 1998, Russia was added to the critical list when its announcement of a debt moratorium prompted an unwinding of positions in Russian and other emerging markets. And in January 1999 the Brazilian government abandoned the peg on its exchange rate, a move which was prompted by rapid capital flight and which precipitated a large currency depreciation and further capital withdrawal. These crises prompted economists once again to take a harder look at the risks as well as the benefits of an open capital account.

Introduction

The decade of the 1990s saw a series of international financial crises on a scale and frequency unprecedented in the post-war period. The economic costs were high, spillover effects were widespread and the political and social consequences were severe. Not surprisingly, calls for the reform of the international financial architecture mounted.

Since 1998 there has been a plethora of international conferences devoted to this general theme. To those who expected them to result in a new ‘system’, comparable in its coherence and comprehensiveness to the Bretton Woods arrangements, the outcome of these deliberations is no doubt a disappointment.

But this would be to set the wrong standard. There is no brand new ‘system’ waiting to be discovered. What has been achieved (inter alia through programmes such as the one sponsored by the ESRC), however, is a better understanding of the strengths and weaknesses of current arrangements. From this flows an agenda of incremental reforms that, if carefully pursued, should result in a stronger and more efficient international monetary system.

There is no realistic alternative to an economic system based on decentralised market forces. This has been virtually universally accepted at the national level since the collapse of centrally planned economic systems in the late 1980s. And it applies equally at the international level. When governments attempt to control decisions about the allocation of real resources, they typically introduce rigidities and inefficiencies that outweigh any benefits stemming from the pursuit of social objectives in economic decisions.

Introduction

This chapter is a substantially revised version of Gilbert, Irwin and Vines (2001) in which the focus is on the implications of capital account liberalisation for the poorest developing countries.

The articles of agreement of the IMF, first drafted in 1945, include among their primary purposes the achievement of current account convertibility and trade liberalisation. In April 1997, the IMF announced its intention to alter its articles of agreement to widen its mandate to include capital account liberalisation. Since then a succession of financial and currency crises worldwide have led some to call into question the desirability of free international capital mobility and to advocate restrictions on capital flows (Rodrik, 1998). In this chapter, we assess how the IMF should view capital controls.

First, we discuss the extent to which countries should move towards capital account liberalisation. The focus is on developing countries as full capital account convertibility already exists in the developed countries. Our argument – in line with the climate of opinion since the crises in East Asia and elsewhere – is one in favour of caution. The reasons are partly sequencing (or ‘second-best’) ones, and partly that liberalisation can increase the vulnerability to financial crisis. Second, we discuss what role the IMF should play in facilitating the policy and institutional development identified in the first part of this chapter as necessary for the successful liberalisation of the capital account.

Introduction

The 1990s was a tumultuous decade for the international financial system, especially for emerging-market countries. Capital flows to those countries increased dramatically in the first few years of the decade. But from 1994 to 1999, the world economy was shaken by a series of financial crises in Mexico, East Asia, Russia and in a number of other emerging markets. These crises caused major recessions in the affected countries. But they were a wake-up call to policy-makers that the existing international financial architecture must be reformed.

The surge in capital inflows to emerging-market economies during the first half of the 1990s was driven by high rates of investment relative to saving in these countries and associated high expected returns, financial liberalisation and innovation and lower transactions costs. Simultaneously, investors in the industrial countries increased their supply of financial capital in the belief that international diversification, the explicit or implicit guarantees offered by the governments of developing countries and the prospect of international bailouts if things went wrong had mitigated the risks of increased exposures to emerging markets. In retrospect, it is evident that many of the same structural changes that facilitated large capital inflows to these economies also exacerbated outflows when expectations shifted. In such circumstances, pegged exchange rate regimes collapsed and weak banking systems imploded. The international financial architecture failed to forestall these crises or limit contagion. As a result, economic expansions in many emerging-market countries were suddenly thrown into reverse.

Introduction

As originally envisaged, the International Monetary Fund (IMF) had three functions. It was an adjustment agency providing advice on balance of payments policy, a financing agency providing short-term liquidity to countries encountering balance of payments problems and finally an agent for managing the Bretton Woods international monetary system, which was based on an adjustable peg exchange rate regime. However, after the early 1970s, the Fund lost most of its systemic role. As flexible exchange rates replaced fixed ones, the Bretton Woods system as originally conceived broke down. Private capital markets began to provide balance of payments financing and regional monetary arrangements – particularly in Europe – began to shift attention away from the Fund. With these developments the dominant theme of the 1960s – the global adequacy of international reserves – diminished in significance and the Fund was effectively marginalised.

But at the same time as it was losing its systemic role, the Fund was gaining another one as it became heavily involved with lending to developing countries, and then countries in transition (CITs). Indeed, the Fund ceased lending to industrial countries altogether. Particular episodes saw it lending to highly indebted developing countries – especially those in Latin America – in the aftermath of the 1980s Third World debt crisis, to CITs as they embarked on the move to market-based systems at the beginning of the 1990s, to Latin America again during the Mexican peso crisis in 1994–5, and to Asian economies, Brazil and Russia during the financial crises of 1997–9.

East Germany used to be considered as the model economy of the socialist bloc. Yet, after unification, little of that economy seemed worth preserving. But the East Germans seemed to be luckier than their eastern neighbours, for reform and reconstruction there would have West German support of a magnitude unavailable to any other former socialist country. Overnight, unification provided the framework and the institutions needed to operate as a market economy and gave access to the financial and managerial resources of West Germany. East Germany thus obtained the necessary legal framework at the stroke of a pen when the unification treaty came into effect on 3 October 1990. Moreover, monetary union (1 July 1990) brought an untrammelled price system, a stable and convertible currency and an efficient capital market. Privatisation was also quickly begun under the management of the Treuhand Agency (THA).

Seen against this backdrop, which combined conditions ideal for a big-bang reform and considerable financial support, East Germany's subsequent vicissitudes are incomprehensible to many. Are the disappointing results due to avoidable policy errors, or was the initial collapse of the East German economy a normal consequence of a big-bang reform that should have been anticipated from the outset? Most observers will acknowledge that the difficulties of restructuring the economy of East Germany may have been underestimated, but they all have their own theories as to the policy errors that may have been made.

Ever since the socialist takeover in Russia a debate has been raging about the profundity of the changes imposed on Russian society. However, looking back on Russia's history since Peter the Great, we find that many features of Russian pre-revolutionary society survived, and indeed were sometimes reinforced, after the Revolution. The Soviet Union remained an empire with its border problems and nationality conflicts, and continued to police its population severely. Democracy was as absent and repression as regular after as before the Revolution. State organisation remained highly centralised and the problems of the periphery were, as always, ignored, misunderstood or repressed. Within the imperial borders the conflict between town and country was as acute in the 1930s as in the seventeenth century. The leadership remained divided between imperial expansion eastwards or westwards, and between opening up to or closing off foreign, mostly Western, influences. The empire invariably rooted its strength in strong ideological grounds: in pre-revolutionary days in absolute monarchy and religion and afterwards in the Marxist framework. Both regimes, each claiming to pursue a superior mission, had expansionary goals for which a strong and influential military was necessary. The need to equip the military, more than the desirability of improving the welfare of citizens, was in each case the driving force behind industrialisation.

As chapter 3 made clear, economists could not agree on a detailed optimal blueprint for reforms. Different countries opted for different approaches. Now, more than ten years later, one can attempt an evaluation of how successful different approaches to reform have been.

We start this chapter with the question in section 1 whether rapid or slow reforms were more successful. Here the evidence is unambiguous: it paid to reform quickly and comprehensively.

One experience common to all transition economies and not anticipated by Western economists was the initial collapse of output. Was the depth or duration of the output collapse avoidable?

Most countries liberalised the price system as one of the first (and administratively easiest) reform measures. The combination of relative price adjustments, lower production and a monetary overhang propelled inflation, in some countries degenerating into hyperinflation. Macrostabilisation became important and urgent, as argued in section 2.

All transition economies liberalised their foreign trade early on and, to varying degrees, capital movements. The rapid reorientation of trade to Western markets is a salient result; foreign direct investments were initially much more modest. The Russian crisis of 1998 was a dramatic reminder that liberalising capital flows is altogether a different matter from liberalising trade. With the opening up, the choice of exchange rate regime became important. From currency boards to ‘dirty’ floating, all regimes were tested somewhere. Section 3 asks whether there are conclusions to be drawn.