With the advent of floating exchange rates in 1973, in the face of calls for its abolition as an irrelevant institution with no clear mission, it transformed itself into a international aid agency, partly usurping the function of the World Bank (WB), but distinguishing itself from the WB in terms of the controversial conditionality of its loans to developing countries in economic crises. This conditionality consisted of macro and micro-economic performance requirements imposed on borrowers as a quid pro quo, referred to as the Washington Consensus.
After coming under attack from both the right and left for its, what was considered to be, largely ineffective and even harmful interventions in the 1997-1998 Asian financial crisis, the IMF began to move away from the Washington Consensus. In 2001 it also established a self-review process through its Independent Evaluation Office to learn from and rectify its policy mistakes, which I discussed in a previous column (“The IMF’s ineffective exchange rate policy advice,” May 21, 2007).
Before the onset of the global financial crisis in 2008, however, the IMF had begun to face fiscal problems of its own as its revenues kept shrinking but its expenditures continued to rise. Its existing customers had been paying back their loans, and new customers were failing to materialize to generate interest income. The troubled IMF was thinking about selling some of its gold stock to generate additional revenues instead of cutting down on its expenditures, finding it hard to practice what it had for years preached to developing countries that had come to it hat in hand for advice and support. But the global financial crisis became a golden opportunity for the IMF to shine again as a relevant and forceful institution, with strong support from the G-20, as I discussed in several columns on the G-20 summits.
Especially under its assertive managing director, Dominique Strauss-Kahn, a former French socialist finance minister who is now believed to be aspiring to become France’s next president, the IMF is once again dominating the global economic and financial agendas and headlines. But the new revisionist IMF, with its continuing policy makeover led by the neo-Keynesian, French-born academic Olivier Blanchard, whom Mr. Strauss-Kahn hired in 2008 from MIT as his chief economist and research department head, now supports policies that would have been anathema to the old orthodox IMF. The new iconoclastic IMF advocates the continuation of the fiscal stimuli in developed countries to combat the Great Recession against calls for fiscal consolidation amid gaping budget deficits and ballooning public debts, caused by higher spending and lower tax revenues (See my column, “Confronting the challenge of fiscal consolidation,” Nov. 9, 2009).
The IMF’s research department released two working papers, each with multiple co-authors, in the last two weeks that shed light on the IMF’s evolving policy makeover, whose institutional and political motives are open to speculation. The first paper, titled “Rethinking Macroeconomic Policy,” appeared on Feb. 12 and the second, titled “Capital Inflows: The Role of Controls,” appeared on Feb. 19. Although both papers contain the disclaimer that they express the views of their authors, and not those of the IMF, its executive board, or its management, they indicate the direction in which the IMF’s position on macroeconomic and foreign exchange policies might be evolving amid the recent global financial and economic crises. The first paper addresses monetary and fiscal policy issues, inflation target levels in particular, which are relevant primarily for developed countries, whereas the second one deals with the foreign exchange policies, in particular controls over foreign capital inflows of developing countries, especially emerging market economies (EMEs). These papers belong to a series of IMF policy papers written in the wake of the global financial and economic crises, several of which will be presented at a conference in Seoul, South Korea, this month.
The main message of both papers is a continuation of the IMF’s tilting to the left in economic policies by calling for higher inflation rates as well as greater financial regulation in developed countries and for capital controls in developing countries. In both papers, however, this message is skillfully hedged and repeatedly qualified, reflecting the theoretical complexities and the controversial empirical evidence concerning the relevant issues. I will focus in this column on the first paper, co-authored by Professor Blanchard. The paper argues that the 2 percent inflation target of most developed countries is too low because it is too close to the zero nominal interest rate bound at which the liquidity trap is triggered, rendering monetary policy impotent to fight deflationary recessions. (Inexplicably, the paper does not discuss simulating negative nominal interest rates as an alternative to higher inflation to beat the liquidity trap. Last July, Sweden’s Riksbank became the first central bank to simulate negative nominal rates when it made banks pay interest on their central bank deposits.) When monetary policy becomes impotent, fiscal policy is overused, the paper argues. That causes worsening fiscal imbalances, shrinking the “fiscal space” to combat future recessions. So, the paper proposes 4 percent as an inflation target as one of its several, but most contentious, policy proposals. This proposal, which has ignited a heated debate, is supported by some economists as a radical departure from the IMF’s orthodoxy as well as a proven way to ease public and private heavy debt burdens. It is rejected, however, by others who believe that it would cause ratcheting, ultimately runaway inflation as it destroys the anchoring of inflationary expectations. For me, The Economist put it best: “As an intellectual exercise, Mr. Blanchard’s idea is intriguing. As a policy proposal, it is reckless.” Next week, I will discuss the second paper, which has much more relevance for the Turkish economy than the first one.
