Remodeling the Multilateral Financial Institutions.

Bird, Graham ; Joyce, Joseph P.

Since the International Monetary Fund (IMF) and the World Bank were first established in 1946, the world economy has changed in a number of important ways. [1] Not only have the volume, composition, and pattern of world trade changed, but capital flows have come to dominate the global balance of payments, as has been underlined by the financial crises of the 1990s (Europe in 1992-1993, Mexico in 1994-1995, and East Asia in 1997-1998).

At the same time, the roles originally envisaged for the multilateral financial institutions have also changed. The IMF no longer oversees an adjustable peg exchange rate regime through which it effectively sought to coordinate macroeconomic policy globally, nor does it attempt to control the quantity of international reserves. Instead, it has taken on a new role in clearing up the debris from financial crises involving developing countries and countries in transition--a role for which it was not originally designed.

Meanwhile, the World Bank, which was established to fill the financing gaps left by private capital markets, has over the years found that in many instances these gaps are fewer than they used to be because private capital flows have increased; the Bank has therefore tended toward supporting softer areas of investment where it is still difficult to raise private money, and focusing, via its International Development Association, on the poorest developing countries.

The response of the multilaterals to a changing world economy has been to evolve in an incremental fashion rather than to embark upon fundamental reform. The reasons for this are easy to see. First, the problems that the world encountered up until the mid-1990s were not sufficiently pronounced or universal to warrant fundamental reform. In many respects, the world continued to perform satisfactorily in terms of conventional macroeconomic indicators. Second, crises, when they did occur, seemed to be temporary rather than prolonged, and primarily regional rather than global. Third, political economy considerations made piecemeal reform much easier to bring about, since not all members of the global community agreed on the need for fundamental reform or on what shape it should take. [2]

However, incrementalism has its dangers. Changes that may make sense when taken individually may make less sense when taken together. The whole may end up being less than the sum of the parts. The multilaterals may have modified and, in some respects, extended their activities by means of a series of relatively small steps that perhaps would have appeared unacceptable if taken in one big step. On top of this, there is the question of whether the individual steps have all been in the same direction or whether we have been moving three steps forward and two (or even four) steps back!

The East Asian financial crisis brought about a sea change, or so it seemed. First, following hard on the heels of the Mexican peso.crisis, and in turn being followed by the Russian and Brazilian crises, the question became, "At what point do crises become a global phenomenon?" Certainly, according to some observers, the crises represented a crisis of global capitalism. [3] Second, the East Asian crisis contained strong elements and even stronger threats of contagion, such that advanced economies worried that they would not escape the recessionary spillover effects. In these circumstances, calls for more fundamental reform rapidly started to appear on the global policy agenda. The Group of 7 (G-7) countries, for example, began to talk about a "new international financial architecture," with this phrase suggesting a broader and deeper perspective than had existed before. [4]

But, although this is an interesting catchphrase, what does "a new international financial architecture" mean, exactly? Broad phrases are frequently difficult to define precisely and the new international financial architecture is no exception. While it incorporates the dissemination of more information on policies and performance and increased recognition that the volatility of international capital flows needs to be addressed, these changes may be seen as merely a continuation of the previous evolutionary trend. The establishment of new lending windows in the IMF may be presented in a similar light. Moreover, strengthening IMF conditionality does not really sound like new architecture. Indeed, one of the least precise aspects of many of the new architecture proposals relates to the roles of the multilateral financing institutions in general and the role of the IMF in particular. When does tinkering with the existing international financial system become fundamental reform? Not simply by dint of being calle d a move toward a new international financial architecture.

This article, at least initially, tries to break away from ad hoc incrementalism. Instead, it adopts a zero-based approach to consider how the IMF should be reformed. By examining the deficiencies of private capital markets and analyzing how they might be rectified, we can design institutions to accomplish this aim and establish the best route for getting from where we are now to where we want to be. While a complete teardown and reconstruction may not be feasible, a blueprint can serve to guide future incremental reforms and ensure that changes are mutually reinforcing and consistent. Establishing an overall design seems to be what a new international financial architecture should be all about, but this seems to be precisely what is missing in much of the current "architecture debate."

In the second section of the article, we examine the deficiencies of private capital markets that in an important sense delineate a role for the multilateral financial institutions. Having discussed in general terms what this role should be, we go on in the third section to assess the institutions that we have (the IMF and the World Bank) and endeavor to isolate a number of areas where the existing institutions fall short. In addition, the experience of these institutions and their program countries allows a number of lessons to be learned. These need to be factored into the reform process. In the fourth section, we are more specific about ways in which the IMF and World Bank should be remodeled. And in conclusion, we offer some remarks about the political economy of the reform process and contrast our ideas about reform with some other proposals for reform that have been made.

What's Wrong with Private Capital Markets?

As a way of dealing with the need for short-term balance-of-payments finance and long-term development finance, there is a lot that is right with private capital markets. They mobilize huge amounts of finance and generally show an ability to adapt quickly to market opportunities by devising new instruments. While official, long-term resource flows to developing countries shrank during the 1990s, private flows grew from approximately $44 billion to over $200 billion (see Table 1). There can be little doubt that private capital markets have made a massive positive contribution to world economic welfare by intermediating globally between savers and spenders and by relieving financial constraints.

However, there is a downside, and in analytical terms it is a fairly conventional one. Reliance on markets in any situation opens up the possibility of "market failure." The principal sources of market failure include concentration among producers (monopoly, oligopoly), negative and positive externalities, the nonproduction of public goods, the overproduction of "bads" (such as addictive drugs), inadequate coordination, informational deficiencies, instability, and inequality. Some of these failures, as well as others, can be shown to appear in the context of private capital markets. [5]

First, private markets will generally find it unattractive to lend to low-income countries when the lenders make decisions with a short-term horizon or the countries have not established a record of borrowing. Either because of their lack of resources or because of economic mismanagement of one sort or another, the poorest countries of the world lack creditworthiness. In one sense this may create an incentive for their governments to improve economic policies, but the world community has generally responded to this financing gap by providing foreign aid either bilaterally or via multilateral agencies, in particular the World Bank.

Second, lending decisions made by private lenders seeking a risk-adjusted commercial rate of return may be inappropriate where they are made with inaccurate or partial information. Because of asymmetric information, markets will never know for sure what the policy intentions of governments are. Moreover, it may be very expensive or simply not feasible for individual market operators to collect and interpret all the economic data that they might ideally wish to have before making lending and investment decisions. In any case, if they were to collect it individually, this would represent a tremendous waste of resources. Working on partial information, however, there are dangers of adverse selection. Should markets, for example, ration their lending exclusively on the basis of the rate of interest that borrowers are prepared to pay? Perhaps a willingness to sign loan contracts with relatively high interest rates is an indicator of a government's willingness to default. How do markets then assess the risks of re pudiation when information is partial? Although they will have mechanisms for assessing country risk, experience shows that these are far from perfect.

Imagine that borrowing countries do encounter problems in meeting their outstanding debt obligations. How will markets respond? Individually, the best outcome for any single creditor is that all other creditors grant the borrower debt relief, thus ensuring that the borrower is able to meet its full obligations to the remaining creditor. But if all creditors pursue this strategy, no relief will be given and everyone will end up worse off. In this situation, debt relief may be Pareto-improving. But, at the same time, it is unlikely to be adopted by markets because each creditor will ideally prefer to get a free ride on the back of the debt relief provided by others. In principle, this free-rider problem may be overcome by coordination, but who within the context of private capital markets carries the responsibility for providing this function?

Similarly, in the midst of a financial crisis, where a borrowing country is experiencing extreme illiquidity, the incentive for each individual creditor will be to withdraw funds as quickly as possible. However, if all creditors do this, it will merely exacerbate illiquidity and make it more likely that everyone--creditors and debtors alike--will lose. The conventional analogy is with a fire in a building. An organized evacuation is likely to save more lives than a disorganized stampede by individuals in a state of panic. But who is responsible for organizing fire drills, identifying emergency exits, and so on? This is, in essence, a public good that will not be provided by individuals in isolation. Again, there is a coordination failure.

Financial crises flamed by investor panics may also have spillover and contagion effects, which individual creditors do not take into account when making their decisions. There can then be a domino pattern. In part, contagion may be an economic phenomenon, because recession, interest rate hikes, and currency depreciation in one country adversely affect export performance and the overall balance of payments elsewhere. But there may also be an important psychological or bandwagon effect as the predominant market sentiment changes. In other words, there will be externalities that are not internalized into the decisions made by private capital markets. Individual market operators will not see it as part of their role to deal with systemic risk, of which contagion is a part.

Even in dealing with individual country risk, private markets will be largely unable to enact measures that reduce risk other than by their own portfolio diversification. What measures might there be? An important risk-reducing mechanism is conditionality, by which loans are made contingent on a borrowing government pursuing an agreed range of economic policies designed to strengthen economic performance. Why will private markets find conditionality difficult to organize? First, and yet again, conditionality has to be a coordinated activity. Clearly, individual creditors cannot negotiate separate and possibly mutually inconsistent conditions. Apart from anything else, the transactions costs would, in all likelihood, be prohibitively high. Second, individual creditors have neither the information nor the expertise to devise appropriate conditions. They would have to start at the bottom of what would be a steep learning curve. Third, given the relatively poor data that creditors are likely to have, it would be difficult for them to monitor progress. Fourth, it would be equally difficult for private markets to enforce conditions and ensure that appropriate penalties were applied where countries lapsed.

Experience confirms the above. On the only occasion that private banks endeavored to put together a loan based on their own conditionality, they ended up saying never again. Creditors complained of at least as many problems dealing with each other as they did dealing with the borrowing government. [6]

In addition to the systemic risk discussed earlier, there will be systemic issues that lie outside the sphere of private capital markets on which decisions need to be made. These relate to the generalized exchange rate regime, international macroeconomic policy coordination, and the regulation of both domestic and international financial systems.

What would be the implications of leaving these various deficiencies of private capital markets unattended? In short, global economic welfare would be lower than it need be. Capital would be inefficiently allocated throughout the world. Capital movements would tend to be unstable and volatile, and there would be a high incidence of balance-of-payments crises. Governments might be effectively forced to pursue excessively strict deflationary (counterinflationary) policies in an attempt to impress private capital markets, so that while private capital markets might relax financing constraints in one way, they might impose an additional constraint in another. Because there would, in any event, be a high degree of contagion of financial crises, some governments would lose the ability to pursue macroeconomic policies based on domestic needs. Poor countries would find themselves starved of external finance, and living standards for many millions of people would therefore be adversely affected.

How can the deficiencies of private capital markets be overcome while retaining their undoubted advantages? To some extent, bilateral aid may help by providing external finance to low-income countries. But bilateral aid donors might be little better than private markets in collecting and interpreting data and in organizing conditionality.

The Role of Multilateral Financial Institutions

If there is a conventional list of market failures, there is also a conventional way of trying to deal with them. Market failure provides an analytical justification for government intervention, and domestic governments regulate domestic financial markets. But we do not have a global government. An alternative therefore has to be found in dealing with the failures of private capital markets, and this is where multilateral financial institutions fit in.

But just as markets may fail in certain ways, so too may governments. There are government failures, and costs associated with policy interventions, that need to be considered. These include poor information and slow decision and implementation processes. Partly as a consequence, there may be gaps between what policymaking governments intend and what actually happens. People may, for example, second-guess what policies governments will pursue and adjust their own behavior in such a way that the policies are no longer effective (the Lucas critique). Government intervention may encourage rent-seeking behavior, which wastes resources, and there may be little incentive for the public sector to be efficient (a common justification for privatization). Finally, governments are run by politicians and bureaucrats who, according to public choice theory, are likely to be self-serving. [7] Pursuing their own interests is unlikely to result in maximizing some social welfare function. In order to minimize these problems, governments need to be open, accountable, and democratic.

In designing multilateral financial institutions, it is therefore as important to bear in mind possible sources of government failure as it is to seek to overcome the sources of market failure. From the above analysis, the comparative advantage of multilateral financial institutions is likely to be in the areas of collecting information and interpreting it, negotiating policy conditionality, internalizing global externalities, coordinating behavior to offset free riding, dealing with systemic risk and other systemic issues, and providing finance (in appropriate circumstances) to countries that are shunned by private capital markets. However, they also need to ensure that their interventions are effective and efficient and that their organizational structures enable them to avoid the public choice critique. As part of this they need to discipline any bureaucratic tendency to grow in size and in sphere of activity. As a general guideline, the multilaterals should not seek to do things that private capital mark ets can do better.

How Do the IMF and World Bank Score?

While this section accentuates the negative in order to focus on areas where reform is necessary, this approach tends to misrepresent the contribution of the multilaterals to global economic welfare. One of the problems, however, is that it is difficult to measure their contribution with any great precision. To look at the flows of finance that they have provided and adjust these according to some "reasonable" rate of return gives one indication. Anne Krueger carries out such an exercise and concludes that World Bank lending alone has probably contributed to economic growth in the countries receiving its support by about .2 percent of GDP. [8] However, to the extent that the multilaterals have also exerted a positive effect on the quality of economic management via technical training and policy dialogue, their contribution overall is almost certainly very significantly greater than this.

Any cost-effectiveness study or cost-benefit study would, with little doubt, show that the IMF and the World Bank have played a useful and constructive role in the world economy. [9] This implies that draconian proposals to close them down are misplaced. However, to say that the multilaterals have played a constructive role is not to deny that they might be able to do better. Where have they fallen short?

The IMF may be assessed in terms of its adjustment role, its financing role, and its role in systemic management. As far as adjustment is concerned, the principal modality through which it has attempted to exercise this role has been conditionality. Incrementalism has witnessed an expansion in conditionality. Over the years, low conditionality finance (historically available via the Compensatory Financing Facility) has been abandoned and the number of conditions involved in Fund programs has increased. [10] Conditionality now covers not only demand-side instruments such as fiscal policy, monetary policy, and exchange rate policy, but often also detailed microeconomic and supply-side policies. Does the expansion in Fund conditionality reflect a track record of success that the Fund has been anxious to build upon? No; in many respects conditionality has become less effective, with the majority of Fund programs remaining incomplete." But why might governments fail to implement Fund programs? Clearly, there can be a range of reasons, including external shocks that blow programs off course and overambition in design. However, the Fund tends to blame a lack of commitment to reform by governments, although this is oversimplistic because it fails to go on to analyze why governments may be uncommitted and the complex political economy that underpins implementation. [12]

Assuming for a moment that conditionality is appropriately designed and identifies the right policies, it still appears to be a less than effective means of ensuring that these policies are adopted. Much the same can be said for World Bank conditionality in the context of policy-based structural adjustment lending. [13]

But has conditionality been well designed? There are concerns that by using conditionality, the multilaterals have encouraged governments to pursue policies about which there is legitimate debate. [14] These concerns cover the routine items of interest rate policy, fiscal policy, and exchange rate policy, as well as specific measures of economic liberalization and the speed and sequencing of liberalization in general. If there are things in economics that we know and things that we do not know, or at least are uncertain about, it may be sensible for conditionality to concentrate on the former and downplay the latter, allowing governments to retain more discretion in these areas. [15] This would limit the scope of conditionality. Moreover, given the uncertainties surrounding economic policy, it may be unjustifiable to be too precise quantitatively. While, because of the difficulties alluded to earlier, the multilaterals have a comparative advantage in conditionality as compared with private markets, it is a m istake to squander this by designing it in such a way as to make it relatively ineffective.

There is another point here that links the multilaterals' conditionality to private capital markets. In principle, conditionality should have a catalytic effect on private flows by signaling that governments are committed to economic policy reform. However, poor implementation and the rather weak overall effects of conditionality on economic performance undermine potential catalysis. Since countries turn to the Fund only when they are in severe economic distress and have no alternative source of finance, and since there are strong elements of recidivism in borrowing from the IMF and the World Bank, a program with the multilaterals may well be interpreted by the markets as an indicator of economic difficulties ahead. The evidence on catalysis suggests that overall the effect is weak, and in a sense this reflects the markets' judgment on conditionality. [16]

Another thing that may get in the way of the multilaterals maintaining a strong financial reputation is where their lending becomes influenced by external factors, with some major shareholding countries such as the United States putting pressure on the IMF and World Bank to make loans in circumstances where they would otherwise have said no. If multilateral lending is allowed to become affected by politics, its part in overcoming the failures of markets will become constrained. Indeed, it is possible that the failures will be magnified.

Turning to the Fund's financing role, how much lending should it do? To take criticism to the extreme, an argument can be formulated that the Fund has lent too little to the many and too much to the few. In recent years there has been a large dispersion in the amount of funds committed to various countries. A few large countries have accounted for significant proportions of the total amount of IMF financing (see Table 2). What does this mean for the many smaller countries that divide up the remaining funds? Low-income countries that form the majority of the Fund's clients often encounter structural balance-of-payments problems that are likely to take a lengthy period of time to correct. Relatively slow adjustment implies relatively high financing in the short term (although lower financing in the long term). But what if external financing represents a binding constraint? Countries will have to change their adjustment strategies and opt for the quicker elimination of their current account balance-of-payments deficits. However, rapid adjustment will imply adjustment based on deflating domestic aggregate demand and, to the extent that the problems are structural, demand deflation will fail to correct them.

Although deflating aggregate demand will tend to reduce the current account deficit in the near term, the deficit will reemerge in the longer run when deflationary policies lapse. Indeed, to the extent that next period's aggregate supply is positively related to current period aggregate demand, deflationary policies will make the long-run situation worse. [17]

Inferior adjustment may therefore reflect inadequate financing. There is some evidence to suggest that the success of IMF programs is positively related to the amount of financing that is provided by them. [18] Moreover, countries will be keen to escape Fund conditionality as soon as possible, and this may help explain why so many programs break down.

But what about the idea of lending too much to the few? By this is implied the recent critique that the Fund has bailed out private capital markets and thereby created a moral hazard problem, in the sense that the prospect of bailouts encourages private markets to overlend. In a similar vein, the argument was made during the 1980s that the presence of the IMF and its unwillingness to lend to countries in arrears with private banks served to discourage banks from offering debt relief--the very relief required to provide a systemic solution to the debt crisis. The Fund was sometimes portrayed as a debt collector for the banks.

The general point is that intervention by the multilaterals designed to deal with a particular problem associated with private capital markets, such as the volatility of private capital flows, may itself have undesirable side effects. In both the 1980s debt crisis and the East Asian crisis of 1997-1998, the solution is that the lending role of the multilaterals may need to be replaced by an enhanced coordinating role, with creditors being encouraged to share a larger proportion of the burden. Coordination is the mechanism through which private creditors can be prevented from attempting to secure a free ride. Excessive lending by the multilaterals may therefore reflect inadequate coordination.

What about systemic management? With the demise of the Bretton Woods system, much of the scope for systemic management disappeared. The world will not return to the 1950s and 1960s. To the extent that there is a systemic role for the Fund to play, it is not therefore in terms of managing a quasi-fixed exchange rate regime. Instead, it is in terms of the coordination role described above, and in terms of collecting, disseminating, and interpreting data and ensuring that countries comply with financial regulatory requirements. Although it may not immediately be apparent why the Fund needs to get involved in domestic banking standards, there is evidence to suggest that currency crises, in which the Fund has an unambiguous interest, often follow on domestic banking crises. This implies that the Fund needs to take an interest in domestic banking arrangements in its member countries just as much as it takes an interest in their domestic macroeconomic policies. [19]

Much of what has been said could also apply to policy-based lending by the World Bank. The Bank, however, focuses mainly on project lending, which it finances by mobilizing international capital either by its own direct borrowing, in which context it acts as a financial intermediary, or by contributions in the case of its soft loan arm, the International Development Association. The rationale for these activities again hangs on informational failures (with the Bank having better information than markets), monitoring and enforcement, public goods, and inequality. Private capital markets may fail to support worthy projects for reasons similar to those that mean domestic governments often have to take on the responsibility for public/infrastructural investment, such as the existence of public goods or the need for a longer time horizon to evaluate the benefits of the project. The principal area of criticism of the Bank tends to be in terms of whether it has defined this activity sufficiently narrowly, or whethe r it has carried on financing projects for which private capital would be directly available. To the extent that low-income countries continue to encounter a gap between the external finance they need for developmental projects and the finance they can raise on private capital markets, there will be a role for a multinational agency such as the World Bank.

The broad principle behind designing multilateral financial institutions must be the idea of filling gaps or making good deficiencies left by private provision but without creating additional problems as a consequence of their intervention.

An alternative way of approaching the task is to group member countries of the multilaterals into a range of classifications. Because of their unimpaired access to private capital markets, advanced countries are unlikely to need multilateral financial institutions. Middle-income developing countries and countries in transition usually have access to private capital markets but at other times may experience impaired access. Here the multilaterals need to support these countries and private capital markets--not in terms of providing a guaranteed and costless safety net, but by endeavoring to ensure that private lending decisions are well informed and that sound economic policies are pursued. This may imply occasional lending by the multilaterals, but the emphasis needs to be on helping to shift these economies across the margin of creditworthiness.

Low-income countries, by contrast, face longer-term financing problems, and here the lending role of the multilaterals is more important on an ongoing basis, or at least until these countries graduate into the category of better-off developing countries.

In both low- and middle-income developing countries, the multilaterals need to see external financing as part of a package of services they offer, with their adjustment input being an important part of the package. However, multilaterals need to ensure, as best they can, that they support appropriate policies and create an incentive for countries to pursue them. This almost certainly implies a flexible approach to conditionality.

To be effective, the multilaterals also need to carry the support of the world community as a whole. While quota-weighted voting systems may facilitate efficiency, the multilaterals need to avoid becoming dominated by their more powerful shareholders. This may be difficult to achieve if they rely heavily on subscriptions, reviewed by a political process, to finance their activities.

In the next section, we go on to examine some more specific proposals for remodeling the IMF and World Bank to comply with the blueprint laid out above. Our conclusion is that these institutions do not need to be rebuilt from scratch. Demolition is unnecessary.

Remodeling: Design Features

In terms of a new international financial architecture, the IMF will continue to be the premier multilateral financial institution. The role of the World Bank, however, should not be overlooked. It will continue to be important as a source of development finance for low-income countries. As far as its policy-based lending is concerned, many of the comments made below about IMF conditionality could also be applied to that of the Bank.

While some observers have seen reform of the Fund as a relatively small component of the new international financial architecture, we present it as much more central. After all, the very word architecture suggests some overall plan, and it is unwise to assume that this will somehow satisfactorily emerge from private capital markets. Taking the design lead is precisely what the Fund should be doing. But what items should be on the IMF remodeler's checklist?

First, and fundamental, is the reform of conditionality. The aim should be for consensus and commitment. This will require more flexibility than in the past. The Fund should adopt as light a touch as possible and seek to minimize its interventions. There should be a greater distinction between low- and high-conditionality lending, reflecting the distinction between liquidity and solvency problems. The Fund should also distinguish between balance-of-payments crises that are the product of poor domestic macroeconomic management and those due to volatile capital markets. Conditionality might be reformed to follow a sliding scale; governments with a good track record of economic policy and in possession of their own economic reform agenda might expect to receive light conditionality, with this becoming heavier only in cases where governments are reluctant to formulate their own programs or where past promises have not been kept. The Fund in the future needs to work harder to avoid the accusations of excessive an d misdirected intervention, a classic source of "government failure," and arrest and reverse the trend toward more conditionality.

Second, reforming conditionality would be an important element in improving program implementation and success, which is a function of "ownership." Countries would then be encouraged to turn to the Fund earlier, when their economic situations were not so dire. At the same time, slippage should be more heavily penalized. There should be sticks as well as carrots. Countries that have failed to keep their policy promises would find that it becomes harder to negotiate a new program, not least because the degree of conditionality would be greater. At this stage, the Fund would become more hands on than hands off.

It is important, however, that the Fund recognize more fully that economic growth may be a constraint on the balance of payments and not simply constrained by the balance of payments. For low-income countries this almost certainly means that the Fund needs to increase the amount of finance it provides to such countries. This in turn would further encourage countries to design and implement sensible programs of economic reform. Moreover, given the absolute volume of finance involved, it would not have a significant effect on the Fund's resource position.

Of course, improving the track record of conditionality and strengthening the commitment to economic reform would also have the benefit of reinforcing the Fund's catalytic effect on other capital flows, such that an increased proportion of the financing could be met from private sources. Low-income countries could also be assisted by means of a special allocation of special drawing rights (SDRs) to them, an idea that has been around for some time. [20]

In the case of better-off developing countries and countries in transition, the Fund needs to avoid, as far as possible, getting into the situation where it is making large loans in crisis conditions. This is what puts pressure on the Fund's resource base and threatens to perpetrate a moral hazard problem. Even if it were to be politically feasible, the Fund should resist invitations to develop in the direction of becoming a formal international lender of last resort; it lacks many of the characteristics of an international central bank and could become exposed to moral hazard problems. It should attempt to play down its crisis lending role and play up its crisis management role. The emphasis should be on coordinating creditors at a time of crisis in a way that ensures that they are unable to pass the cost of the crisis on to the Fund. This will almost certainly impair the willingness of private capital markets to lend, but currency crises often reflect excessive lending in the past more than deficient lendi ng in the present. The details of strengthening the Fund's coordinating role are complex but not insurmountable.

In terms of dealing with capital volatility, the logic of proposals that the Fund should collect and disseminate fuller amounts of data almost goes without saying. To the extent that there are informational failures of one sort or another, these need to be corrected. However, more doubts exist about what should be expected from the Fund in terms of interpreting data and drawing appropriate policy conclusions. Like other institutions, the Fund's forecasting record has not always been strong.

In the context of capital volatility, it is perhaps more important that the Fund should not make countries liberalize their capital accounts as part of conditionality. There are strong arguments that if anything should be open, it should be the Fund's mind about capital account liberalization. In order to help avoid their destabilizing effects, many developing countries may need to retain the option of imposing some sort of tax on capital movements. The Fund often likes to see itself as a doctor diagnosing country illnesses and prescribing appropriate medicines (which, of course, may be unpleasant to take). The Fund also needs to recall that the doctor's first objective is to do no harm. Premature capital account liberalization may harm developing countries. [21]

While attempting to minimize its role as a crisis lender to better-off developing countries, the Fund also needs to avoid becoming itself resource constrained. The use of IMF credit has more than doubled in the years 1994-1998 (see Table 3). It therefore needs to break away from the system of periodic quota reviews by which its resource base is increased at discrete moments in time. Instead, its resources need to be determined with a higher degree of automaticity by, for example, maintaining a ratio between Fund quotas and world trade within a specified range. A formula could be devised that also endeavored to capture the importance of the capital account in causing overall balance-of-payments difficulties, which will remain the primary focus of the Fund. An automatic formula-based approach would also overcome some of the accusations that have been made against the Fund's management--including, that it engages in hurry-up lending prior to a quota review. [22] It would also serve to protect the Fund from dire ct political influences over its lending capacity. More radical proposals to use additional SDR allocations as a way of financing the Fund would, however, probably encounter substantial resistance from the Fund's principal shareholders, who may wish to keep the institution on a short leash.

This may also rule out the option of the Fund following the lead of the Bank and financing itself by borrowing directly from private capital markets. However, in many ways this is an attractive option, because by using this mechanism the Fund would be able to directly catalyze private capital. [23] To private capital markets, lending to the Fund could be an appealing complement to direct country lending since, while it might offer a lower return, it would also carry less risk. In this way the Fund would be able to offer a safety net to private capital markets. The Fund would, of course, need to continue to receive subscriptions and other contributions to finance its concessionary activities. Where the Fund's major shareholders insist on the short-leash approach, however, the task is to ensure that the leash is not so short as to cause strangulation.

Insulating Fund decisions from political considerations represents a substantial challenge, since it is in many ways a fundamentally political institution. But its remodeling needs to take into account that it will lose an important part of its financial reputation if its decisions become too heavily influenced by the political preferences of its major shareholders. This is a case for allowing the Fund's own staff more executive discretion. But then, who checks up on them? The Fund often comes over as a rather closed, opaque, and self-defensive institution. If Fund staff is to be granted more decisionmaking power, this has to be accompanied by greater openness and accountability. Either the Fund has to become more self-critical or expose itself formally to the criticisms of others. [24] At the same time, depoliticizing the Fund should not exclude the borrowing countries from the sense of partnership with the Fund, which they require if they are to undertake fundamental policy reforms.

The final "design feature" strongly follows on from a zero-based strategy. The Fund now possesses a mind-boggling array of lending facilities, including standbys and the Extended Fund Facility (EFF), the Poverty Reduction and Growth Facility (PROF), formerly known as the Enhanced Structural Adjustment Facility (ESAF), the Compensatory Financing Facility (CFF), and the Supplemental Reserve Facility (SRF). The Fund's response to the East Asian crisis was to add to this an extra swift disbursement window. There is considerable scope for rationalizing this range of lending facilities and concentrating on maybe two that emphasize the analytical distinctions that were made earlier. [25] One could involve short-term loans where the principal problem is a lack of liquidity. The second could be longer term and would deal with problems of insolvency and structural adjustment. The degree of concessionality could be determined by the per capita income of the borrowing country. To some extent, this would be a matter of r egularizing the current situation, since in reality some of the Fund's existing lending windows are little used. There is little chance that if the Fund were being built from scratch it would be designed with as many windows as it currently has.

Conclusion

The East Asian financial crisis has led to claims that a new international architecture is needed. But what does this mean? Most accounts of it are rather imprecise. It is usually seen as involving only limited reforms to the IMF, the world's premier international financial institution. The accent, where reform to the Fund is envisaged, is placed on either expanding its role in providing information and in "strengthening" conditionality or abandoning conditionality altogether in favor of preconditions. The Fund itself has favored increasing its jurisdiction to cover capital account liberalization, while others have suggested an increased supervisory role as important, particularly in terms of domestic financial systems. To us, some of these ideas are good and largely uncontroversial, although perhaps of more limited benefit than is sometimes assumed; others, however, are bad and potentially damaging.

In any case, our view is that the Fund is central to the concept of a new international financial architecture and therefore requires much closer fundamental examination. The Fund should be designed to make good the deficiencies of private capital markets, while bearing in mind the potential dangers of intervention. Following on from this analytical approach is a "job specification" that delineates a clear role for the Fund. Reform of the Fund should cover its adjustment role, its financing role, and its role in systemic management. At the same time, the World Bank needs to adopt a similar orientation in dealing with the deficiencies of private capital markets.

Is this a task that can be achieved? It can if there is sufficient political will. Failure to agree on and implement a program of reform will indeed, in this case, reflect a lack of political will (irony intended). In previous years, and even at the time of the fiftieth anniversary of the Bretton Woods institutions, there was little enthusiasm for fundamental reform. But the severity of the East Asian crisis along with its contagion effects may have created a global environment that is conducive to reform. The hope is that political leaders grasp the opportunity to undertake the necessary institutional remodeling and refurbishment. The worry is that as the global economy recovers and memories of the crisis fade (until the next one), the temptation will be to settle for marginal incremental reform. As a consequence, the reality will lag behind the rhetoric and the new international financial architecture will end up becoming just another empty phrase.

Notes

Graham Bird is professor of economics at the University of Surrey and director of the Surrey Centre for International Economic Studies. He is the author of IMF Lending to Developing Countries (1995). Joseph P. Joyce is professor of economics at Wellesley College.

(1.) See Harold James, international Monetary Cooperation Since Bretton Woods (New York: Oxford University Press, 1996), for a history of the international monetary system; and A. F. P. Bakker, International Financial Institutions (London: Addison Wesley, 1996), for a survey of multilateral financial institutions.

(2.) For a more detailed and structured discussion of the circumstances under which fundamental reform to the international monetary system may and may not take place, see Graham Bird, "From Bretton Woods to Halifax and Beyond: The Political Economy of International Monetary Reform," World Economy 19, no. 2 (1996): 149-172.

(3.) For example, Jeffrey Sachs, in The Economist (12 September 1998), writes about the shortcomings of global capitalism and the reforms necessary to make it work better.

(4.) Barry Eichengreen discusses many of the proposals that have been offered in the wake of the Asian crisis to reform the international financial institutions in Toward a New International Financial Architecture (Washington, D.C.: Institute for International Economics, 1999).

(5.) The benefits and risks of international capital flows are examined in IMF Occasional Paper No. 172, Capital Account Liberalization: Theoretical and Practical Aspects (Washington, D.C.: IMF, 1998).

(6.) The experiences of commercial lenders in trying to organize their own conditionality in the case of Peru in 1976 are nicely summarized in Dani Rodrik, "Why Is There Multilateral Lending?" in Michael Bruno and Boris Pleskovic, eds., Annual World Bank Conference on Development Economics 1995 (Washington, D.C.: International Bank for Reconstruction and Development, 1996), pp. 167-193.

(7.) See, for example, Roland Vaubel's use of the public choice approach in "The Political Economy of the International Monetary Fund: A Public Choice Analysis," in Roland Vaubel and Thomas D. Wilett, eds., The Political Economy of International Organizations (Boulder: Westview, 1991), pp. 204-244.

(8.) Anne O. Krueger, "Whither the World Bank and the IMF?" Journal of Economic Literature 36, no. 4 (1998): 2016. Krueger derives this estimate for Bank lending to areas outside of Africa.

(9.) Mohsin Khan summarizes the evidence on the impact of Fund-supported adjustment programs in "The Macroeconomic Effects of Fund-Supported Adjustment Programs," IMF Staff Papers 37, no. 2 (1990): 195-231; "Do IMF-Supported Programs Work? A Survey of the Cross-Country Empirical Evidence," with Nadeem Ul Haque, IMF Working Paper No. 98/169, 1998.

(10.) The increase in conditionality is explained in Jacques J. Polak, "The Changing Nature of IMF Conditionality," Essays in International Finance, No. 184, Princeton University, 1991.

(11.) Tony Killick, Moazzam Malik, and Marcus Manuel examine the reasons for noncompletion of IMF programs in "What Can We Know About the Effects of IMF Programmes?" World Economy 15, no. 5 (1992): 575-597.

(12.) Graham Bird analyzes the political economy of policy reform in "The Effectiveness of Conditionality and the Political Economy of Policy Reform: Is It Simply a Matter of Political Will?" Policy Reform 1, no. 1 (1998): 89-113.

(13.) An excellent analysis of policy-based lending by the World Bank is provided by Paul Mosley, Jane Harrigan, and John Toye in their Aid and Power: The World Bank and Policy-Based Lending (London: Routledge, 1998).

(14.) For an analysis of IMF programs, see Tony Killick, IMF Programmes in Developing Countries: Design and Impact (London: Routledge, 1995).

(15.) For a fuller discussion of this general theme, see Graham Bird, "How Important Is Sound Domestic Macroeconomics in Attracting Capital Inflows to Developing Countries?" Journal of International Development 11, no. 1 (1999): 1-26.

(16.) Graham Bird and Dane Rowlands, investigating whether involvement with multilateral institutions has a positive catalytic effect for a country, find evidence for such an effect only in the case of official lending. See Bird and Rowlands, "The Catalytic Effect of Lending by the International Financial Institutions," World Economy 20, no. 7 (1997): 917-991.

(17.) For a more detailed discussion of these ideas, with supporting evidence, see Graham Bird, "External Financing and Balance of Payments Adjustment in Developing Countries: Getting a Better Policy Mix," World Development 25, no. 9 (1997): 1409-1420.

(18.) See Killick, IMF Programmes in Developing Countries, for evidence on this issue.

(19.) See, for example, Jeffrey D. Sachs, Aaron Tornell, and Andres Velasco, "Financial Crises in Emerging Markets: The Lessons from 1995," Brookings Papers on Economic Activity, no. 1 (1996): 147-198; and Graciela L. Kaminsky and Carmen Reinhart, "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," American Economic Review 89, no. 3 (1999): 473-501. Barry Eichengreen, Toward a New International Financial Architecture, provides further jutification for this point of view.

(20.) For recent examination of this idea, see Graham Bird, "Economic Assistance to Low Income Countries: Should the Link Be Resurrected?" Essays in International Finance, No. 193, Princeton University, 1994.

(21.) For a brief analysis of capital account liberalization, see Graham Bird, "Convertibility and Volatility: The Pros and Cons of Liberalizing the Capital Account," Economic Notes 27, no. 2 (1998): 141-156.

(22.) See Roland Vaubel, "The Moral Hazard of IMF Lending," World Economy 6, no. 3 (1983): 291-303.

(23.) Adam Lerrick presents the case for IMF borrowing from the private sector in Private Sector Financing for the IMF: Now Part of an Optimal Funding Mix (Washington, D.C.: Bretton Woods Committee, 1999).

(24.) The Fund has moved to greater use of external evaluators. See, for example, External Evaluation of the ESAF (Washington, D.C.: IMF, 1998).

(25.) U.S. treasury secretary Larry Summers recently advanced his own proposal for reforming the IMF, which included a reduction in the number of the Fund's lending facilities (The Economist, 18 December 1999), p. 123.

 Net Long-Term Resource Flows to Developing Countries, 1990-1998
 (U.S.$ in billions)
 1990 1991 1992 1993 1994 1995 1996 1997 1998 [a]
Official flows 56.9 62.6 54.0 53.3 45.5 53.4 32.2 39.1 47.9
Private flows 43.9 60.5 98.3 167.0 178.1 201.5 275.9 299.0 227.1

Source: World Bank, Global Development and Finance. Analysis and Summary Tables (Washington, D.C.: World Bank, 1999), p. 24.

Note: a. Signifies provisional.

 Major Borrowers from IMF
 Total Program Program Commitment
 Commitment as % of All
Year Country (U.S.$ in billions) Commitments in Year
1995 Mexico 17.8 53
1996 Russia 10.1 58
1997 South Korea 21.0 53
Source: IMF, Annual Reports.
 Total Use of IMF Credit
 (U.S.$ in millions)
Year Credit
1994 44,144
1995 61,101
1996 60,106
1997 70,798
1998 95,459
Source: World Bank, Global Development and
Finance: Country Tables (Washington, D.C.:
World Bank, 1999), p. 14.