IMF takes a Major Step without Fanfare

Yesterday, the IMF announced its first update of its foreign exchange surveillance mechanism in three decades. Aside from some media coverage, which was generally descriptive in nature, there was little fanfare. Yet there seems to be potentially far-reaching implications that have yet to be grasped.

Previously the IMF had three principles three points about currency regimes. Countries should not manipulate the foreign exchange market to prevent balance of payment adjustments and give an unfair competitive advantage. Intervention can be undertaken if markets are disorderly. When countries do intervene, they should take into account the impact on the currency they are intervening against.

To these, the IMF has added a fourth principle: Members should avoid exchange rate policies that result in external instability. This is not inconsequential. Rather than simply be another principle, the IMF is placing it at the center of its surveillance efforts.

It is a long-time coming. The US has been pushing in this direction for the last couple of years and perhaps less formally since the end of the Asian financial crisis that is about to celebrate its 10th anniversary.

It turns orthodoxy on its head in two important respects. First, traditionally the burden of the adjustment has fallen on the deficit or weaker country. At Bretton Woods, Keynes argued that the surplus country should also have a responsibility, but the US, the main surplus country at the time, insisted on the traditional approach. It wasn’t until after Bretton Woods collapsed and Europe was seeking to avoid the dramatic exchange rate movement within Europe that the surplus countries like Germany, had a responsibility to keep defend currency bands, such as against Italy.

This new principle clearly shifts the burden away from the US and deficit countries to surplus countries and especially, China and to some extent, Japan, and the oil exporters.

Second, the new principle also breaks from the past insofar as it gives greater saliency to “external stability”. Realism and realpolitik has meant that in lieu of a world government, countries would pursue their own self-interest. Now sovereigns are being told that the systemic needs (external stability) are of greater importance. Of course, there are ways to square the circle. It is not necessarily zero-sum. Proper national policies and balanced growth on a domestic level will help foster external stability.

However, this runs against the main current of market-based economics and liberty. Adam Smith argued it is precisely by individuals pursuing their self-interest that the general interest will be achieved. The “invisible hand” turned private vices (e.g. greed) into public virtues (prosperity).

That said, this change at the IMF reflects an important evolution in the thinking of policy makers. The Great Depression and WWII convinced many policy makers that the dramatic swings in the business cycle could threaten democracy and liberty. Viola, as Nixon quipped, “we are all Keynesians”—counter-cyclical government action has not ended the business cycle but can mitigate the downturn and make the business cycle longer and flatter.

The liberalization of the capital markets helped absorb the shocks created by modern economies so that the economies themselves could be more stable. However, then there were the series of emerging markets crises beginning with Mexico in 1994-1995 and extending through the Asian financial crisis and Argentina 2001-2002. Among the lessons that policy makers drew from that period was that the volatility of the capital markets themselves could create feedback loops and undermine not only the underlying economies, but also threaten democracy and liberty.

Consequently, there was recognition, perhaps among the highest echelons of policy makers, of the importance of fostering international financial stability. At the same time, emergence of China, which was bound to be disruptive in any event given its size and vast pool of cheap labor, is sparking anxiety of all sorts, even though the world economy is set to grow around 5% for the fourth consecutive year and unemployment in the major industrialized countries—from the US to the UK to the euro-zone and Japan are also posting multi-year lows in unemployment. If these anxieties are not addressed, the danger is a protectionist political backlash, which is understood by top policy makers as putting the global economy at risk.

Yet the IMF may be over-playing its hand. Given the significance of China to the whole debate, even though of course the IMF did not cite it per se, it is a shame that a greater effort was not done to win it over. China (along with a couple of other countries) opposed the new measures, understanding it was aimed at them.

Moreover, it seems disingenuous to make these changes, broadening the scope of the IMF’s surveillance without first making the IMF more reflective of economic realities. The weighted votes are supposed to be re-jigged in a preliminary fashion late this year before more thorough reform is implemented.

But officials have put the cart before the horse. The IMF has a credibility issue that has not been addressed. Perceptions, only enhanced by the 1997-1998 Asian financial crisis, that the IMF does Washington’s bidding may be strengthened by these new reforms. Although policy makers may have been trying to make the IMF more relevant, the risk is that it becomes more marginalized. For at least 10-years many Asian countries wanted to develop their own regional IMF. Although an institutional framework has not crystallized, the creation of an extensive network of swap lines and possibly pooling reserves are preliminary steps in that direction.