Unlucky Number Sleven: G7 and Beyond

I was walking through Central Park the other day. I came across some old guys playing chess. There was also this young kid trying to kibbitz—offering unsolicited advice to the players. It made me think about the G7. Those that will be doing the talking won’t be taking action and several key actors in the important geo-political and economic dramas are not going to be attending. The old men who do attend will be proffering advice to those who are not. China should let allow a more flexible currency, in apparently a unilateral direction. Oil producers should also allow their currencies to appreciate and do more to contain the increase in oil prices. Iran, whom the Israeli Prime Minister said, along with Syria, was behind recent suicide bombing in Tel Aviv, faces a month-end UN deadline to cease its uranium enrichment program. It is under international pressure not to acquire the weapons that at least three of the G7 countries posses.

The important point though is not the obvious and cynical point that there will not be a fresh new policy initiative from the G7. Rather the reasons why this is the case may help shed light on important developments whose impact will exceed this G7 meeting. There are three major reasons why the G7 and IMF meetings over the next few days are not going to lead to any significant policy initiatives. The main challenges confronting the major industrial countries are not amenable to greater coordination. The G7 already have a strategy in place for addressing the global imbalance. And even if there were a need for a new bold initiative, there is a power vacuum that is not fully appreciated.

The economic challenges that the G7 face are largely of a domestic nature. The major countries are enjoying a rare synchronized expansion cycle. It is synchronized, not coordinated. The euro-zone and Japan are engaged in the normalization of monetary policies and need to have the latitude to control the timing and pace. The US and Canada are further along in their tightening cycles and need the flexibility to respond to growth and price impulses as capacity constraints are neared.

The impact of the oil price shock illustrates why there cannot be much policy coordination at the present. In the US, research and comments by Federal Reserve officials indicate that the rise in energy prices is curbing growth but is having little impact on the general price level of goods and services (inflation). In contrast, for example, The European Central Bank seems more concerned about the secondary impact of higher energy prices. Japan, for its part, seems to still be wrestling with at least some residual deflation impulses and may actually welcome the inflation potential of higher energy prices.

There is a widespread understanding that the global imbalances pose a significant risk to the world economy. The G7 have already devised a strategy to address there imbalance. First, the US has to boost savings. Second, Europe and Japan are to make structural reforms to boost domestic demand. Third, Asia and oil producing nations should adopt more flexible capital markets. That the strategy has not been fully implemented by any party does not mean that the G7 are prepared to abandon that strategy in favor of an alternative, such as a mini-Plaza like agreement that would have the currency market bear the burden of the adjustment. Indeed US Treasury Secretary’s Snow’s op-ed piece in today’s Washington Post that addresses the global imbalances does not even cite the dollar.

Although a stronger euro might help blunt the inflationary impact of higher oil prices, it would risk undermining an important leg on which the current economic recovery remains heavily dependent upon, namely exports. For a relatively closed region, currency movement may not have much impact on inflation in any kind of reasonable time period. Consider that on a real trade-weighted basis, the yen is near 15-year lows, and yet Japan has hardly experiences inflation.

Even if a new strategy to tackle the global imbalance was desired, the constellation of political forces argues against it. As nature abhors a vacuum so too does politics and yet there seems to be a vacuum of sorts at the G7. Look who the players are. Germany has a new Chancellor. Canada has a new Prime Minister, as does Italy. Japan’s Koizumi is expected to step down in the fall. Many people, including ourselves recognize the possibility that the UK’s Blair also steps down in the fall. French President Chirac is frankly a lame duck and the government is terribly unpopular. An election is about a year away.

Ironically, that leaves US President Bush as elder statesman. And even there, his low level of domestic support and persistent talk that Treasury Secretary Snow will be replaced shortly undermines the ability of the US to propose bold measures.

Behind the scenes there does seem to be one area in which holds out the possibility of a significant reform, but it is unlikely to reach fruition until the September IMF meeting at the earliest. Essentially what is involved are long over due reforms at the IMF. There are two tracks that reform appears to be moving. The first is the governance of the IMF and the second IMF’s mission or mandate.

At its origin at Bretton Woods, the IMF was established to provide short-term assistance to primarily European countries that were experiencing current account imbalances that were pressuring their currencies in a regime of fixed exchange rates. After Europe rebuilt, the IMF turned its attention to developing countries.

However, rising commodity prices and better fiscal and monetary policies have provided the wherewithal for several countries to pre-pay its IMF loans and serves to reduce the likelihood that others will have to go hat in hand to the IMF. At the same time, that its raison d’etre may not longer be required, some officials have suggested that the IMF return to its initial focus on foreign exchange. One practical difficulty though is that mechanisms of enforcement are nearly non-existent. Imagine a situation like this past week, when the IMF called for US dollar depreciation. With the Federal Reserve still in the process of raising interest rates and price pressures on near the upper end of various Fed officials self-declared comfort zone, it is difficult to see how it is in the US interest to purposely drive the dollar lower.

Yet the US is backing this and other IMF reforms, apparently confident that surplus countries would be under pressure to adjust their currency policies. And in order to make such reforms more palatable, the US has signaled that it is willing to discuss the current quota system upon which the voting system is based. Canada also appears willing to discuss a change in the distribution of votes. Europe has been more tight-lipped.

Specifically the US has 17% of the votes and this is important because decisions require the approval of 85% voting shares, so the US has an effective veto. Theoretically what determines voting shares is a combination of GDP, account transactions and reserves. After the US, Japan, the world’s second largest economy, has a 6.16% voting share, followed by Germany, the world’s 3rd largest economy with a 6.02% voting share. The UK has a 4.97% voting share and Canada’s share is 3.72%. China, which is now the world’s 4th largest economy has 2.95% of the IMF voting shares. According to a Bloomberg report, Belgium, with its roughly $350 bln economy, has more voting shares than Brazil, Mexico, India and South Korea, all of whose economies are each significantly larger.

Emerging market countries are obviously keen to acquire greater influence at the IMF. Recall that during the Asian financial crisis in 1997-1998, an idea was floated for an Asian IMF. It was summarily shot down by the US. Undeterred, thirteen Asian countries in 2000-including China, Japan and South Korea, launched a regional effort (Chiang Mai Initiative) to create the framework of a parallel fund to the IMF. As the chief economist of the Asian Development Bank noted in an interview on Bloomberg that these countries have essentially created a firewall and “will not got to the IMF for anything.” Redistributing the voting quotas to give emerging markets in general and Asian countries in particular more of a say might be required to keep the IMF relevant.

It is of course in the US interest to get some concession for that change. And of all that the US produces, it excels in creating a virtue of a necessity. That said, it is still difficult to envisage this Administration from surrendering its veto for nearly anything