Grassroots Economics

Grassroots Economics

Mini Teaser: The IMF has become little more than an abettor of bad policymaking. To avoid the next meltdown, the IMF must become a global advocacy group. Diplospeak is out; punchy prose and clear policy recommendations are in.

by Author(s): Raghuram Rajan

THE INTERNATIONAL Monetary Fund is back in business. And how! The volume of its emergency lending, meant to tide countries over when private markets are no longer willing to lend to them, is at an all-time high. It is taken seriously once more at the tables of high finance. Perhaps this is no more clearly evidenced than in its central role in the recent discussions on stabilizing the euro area. No longer is the IMF only the lender of last resort for the poor, weak and struggling nations of the world; to prevent the Greek debt crisis from spreading throughout the eurozone, the IMF stepped in with 30 billion euros worth of financing (far greater than any individual national contribution) to help shore up Athens’s balance sheet.

By the metrics of how much its emergency lending and its programs for troubled countries are needed, the Fund is indeed a successful organization—much in demand. But this very demand is a measure of its failures in preventing the kinds of policies that lead to crises—especially ones of the global variety.

 The IMF was set up in 1944 to help revive global trade while averting the “beggar-thy-neighbor” exchange-rate policies that characterized the interwar years. During that time, one country after another devalued its currency and raised tariffs in order to gain a competitive trade advantage over its neighbors, only to see its neighbors respond in kind. The result: the world spiraled downward into depression. The founders of the IMF resolved that the body would maintain surveillance over country policies so that such devaluations did not take place. As well, in case a state became uncompetitive (for instance, because the government overspent and pushed up wages too rapidly—as in the case of Greece today) and unable to raise financing from the markets or other governments, the IMF would lend it money on a temporary basis, so that it could have the time to make the adjustments needed to regain competitiveness. This emergency lending was meant to limit the pain the country and its people faced as its policies adjusted.

The IMF has honed its lending procedures, and in many ways it is very effective at putting out fires. And, as an international bureaucracy, it not only has the ability to demand policy changes that are politically unpalatable in the country that needs to adjust, but it can also serve as a convenient scapegoat. Politicians love to blame the IMF for dictating policies that they themselves know are necessary to get their country’s finances back in order. The IMF has been perfectly willing to serve in this role and rarely challenges politicians.

But even as its ability to restore stability to a country’s finances has improved (of course, there are a number of countries like Argentina and Pakistan whose policies and politics have resisted all attempts at change, and are repeat, albeit reluctant, clients of the IMF), the Fund’s ability to influence more stable policies in normal times, especially policies that will lead to greater global economic stability, is small. This is because its primary means of leverage is the money it can dole out. For recovering countries, the first order of business is to repay the IMF and gain “independence,” a popular objective since the IMF is blamed for the pain the citizenry has had to undergo. Once a country repays the Fund, no domestic politician wants to be seen as heeding its advice—until bad policies drive the country back to the IMF. With limited influence over fragile countries when all is largely well, and a willingness to hand out money when all is not (often to rescue irresponsible banks), the IMF ends up encouraging bad policies. Perhaps equally problematic, it has no influence over large countries that will never need its money, even if those states’ policies have an adverse global impact.

This is a dangerous weakness at a time when the world is becoming more integrated. Countries are agenda setting with only their domestic interests at heart, even though the negative spillovers to the rest of the world will eventually come back to haunt them. The question is: how can the IMF change domestic policymaking to take into account the global good, even while respecting the sovereignty of nations? The only feasible answer may be to turn itself into more of a grassroots advocacy organization.


TO SEE why, consider perhaps the most pressing international economic problem today: global trade imbalances. After World War II, a number of countries focused on exports as the key to rapid growth. First, Germany and Japan, followed by Korea and Taiwan, Chile, Malaysia and Thailand, and now China, Vietnam and the oil exporters have generated large production surpluses that have to be absorbed elsewhere. This would not be a problem if countries, once rich, were able to become more balanced. But both Germany and Japan continue to pump out surpluses, suggesting the path back to balanced growth is not an easy one.

If some countries produce more than they can spend, of course other countries have to spend more than they produce, financing the difference by borrowing from international private-capital markets. Recent history suggests that large-scale spending financed through foreign borrowing has not turned out well. In the 1990s, it was the emerging markets that got into trouble, whether it was the overconsuming Latin American economies or the overinvesting Asian ones. In both cases, countries found that private foreign finance tended to be undiscriminating in boom times, funding irresponsible governments and unviable projects, only to cut and run when the weight of past mistakes proved overwhelming. Frequently, foreign investors did not suffer the full consequences of their mistakes, especially when they had lent to domestic banks or well-connected firms, and the domestic government stepped in, backed by the IMF, to bail them out.

In the wake of these disasters, many of these countries decided to behave more wisely, cutting their spending to fit available savings (and some even put aside a little extra in the form of foreign-exchange reserves for future emergencies). The result: these countries only added to the global trade surpluses looking for a home.

Industrial nations, especially those that had limited discipline on government or household spending, stepped up to provide that destination. The countries that ran large deficits—Iceland, Hungary, Latvia, Greece, Portugal, Spain, the United Kingdom and the United States—now look like a rogues’ gallery of nations that are in trouble. Prudent macroeconomic management suggests that these countries should be more careful about spending and save more. Indeed, the bond vigilantes (financial speculators who sell the bonds of profligate governments, thus pushing up bond yields and making it more difficult for those governments to finance themselves) seem to be insisting as much by betting against big spenders like Greece and Spain.

As much as the industrial world might like, the solution to these imbalances is not to get poorer emerging markets or developing nations to step up their spending once more, so that they again run large trade deficits and pull the industrialized countries out of their economic slump. If there is one thing we have learned, large, sustained debt-financed trade deficits are a source of instability. Even more so, what we do not want is the IMF to change its rules to permit more risky borrowing, encouraging foreign private financiers to lend indiscriminately to these countries. In the same way Greece spent its way into trouble, bolstered by the implicit guarantees on its debt from the euro area, foreign lenders are apt to ignore the uses their loans are put to, if they know the domestic government, backed by the IMF, will come to their rescue when the loans go south. Irresponsible foreign lenders get bailed out, and because the IMF always recovers the loans it has made, the country’s taxpayers eventually have to foot the bill. The answer instead lies in everyone avoiding a sustained trade surplus or deficit—especially as they grow rich.


ALAS, SUCH a shift in trade balances will be politically painful in the short term for all nations. For those running trade deficits—the United States being the most egregious offender—the policies to bolster household consumption (many of which led to the crisis in the first place) continue apace. The U.S. Federal Reserve is holding interest rates artificially low (especially in loans to the housing market) in the hopes that consumers will start buying more again. After all, that has been the primary source of growth on these shores in recent years.

Certainly as Herbert Stein, the chairman of Richard Nixon’s Council of Economic Advisers, once so sagely commented, “If something is unsustainable, it will stop.” Thus far, the United States has been fortunate—it has continued to attract capital on easy terms from the rest of the world. But foreign investors have become increasingly wary about the amount of debt the U.S. government has had to issue to finance its deficits. One way to escape this spiral is for Washington to seek new sources of revenue (read: taxes). Yet as a majority of U.S. citizens think that they benefited little from the boom years of the mid-2000s, they will likely consider this yet more unnecessary punishment.

Image: Pullquote: Politics is always local; there is no constituency for the global economy.Essay Types: Essay