Global Policy Forum

By Larry Elliot

The International Monetary Fund is confused. That's a surprise in itself, because the IMF is a body that thrives on certainty. It has firm views about everything, even if most of them are wrong. Still, it's worth finding out exactly what the Fund is confused about, because that goes to the heart of the way the global economy is being governed. Or rather, not governed.

Stuck away in its half-yearly document, the world economic outlook, the Fund has a section called "macroeconomic stability and the forces of globalisation: lessons from the 1990s". You might expect a paean to the values that the IMF has championed, namely that freeing up capital flows has led to a more efficient use of resources and therefore aided global growth and stability. However, as the Fund admits, the 90s have been marked by "unstable macroeconomic conditions", with global output growing by 3% a year on average, against 3.5% in the 80s and 4.5% back in the bad old 70s.

"The instability has included a large number of currency crises; substantial swings in exchange rates among the major currencies, especially the yen/dollar rate; run-ups in asset prices followed by pronounced asset price deflations; and banking crises in almost all regions of the world- often, though not always, linked to asset price collapses."

Well, yes, absolutely. Couldn't put it better myself. But there's more. "It is unclear whether macroeconomic instability generally has been increasing. However, the mere fact that it has remained pervasive may be considered surprising given the general improvement in macroeconomic policies in most countries compared with the two preceding decades - suggested, in particular, by declines in inflation and better containment of fiscal imbalances - and the substantial progress worldwide with structural reforms that have increased the scope for market forces to guide the allocation of resources within and across countries."

The report then lists four recent developments in the global economy. First, there is the trend towards lower inflation, which the IMF believes is largely due to trade liberalisation, privatisation, and the conduct of monetary and fiscal policy.

Second, there is the rapid integration of financial markets in the 90s following the liberalisation of the 70s and 80s. This has resulted in "private capital flows to emerging countries unprecedented in scale at least since the first world war". The IMF says the large flows into developing countries in the build-up to the recent crisis in part reflected "unsustainable developments in the recipient countries".

Third, economic and financial linkages and policy transmission mechanisms across countries have become more complex in the 90s, with a tendency for capital to flow into dynamic countries and regions. "However, as experience shows, large net capital flows into strongly expanding economies may exacerbate risks of overheating and asset market bubbles, while reversals of such flows can severely strain weak financial systems and lead to destabilising currency movements."

Finally, flexible exchange rates have become increasingly prevalent. "In the 90s, short-term exchange rate volatility has remained high with no clear trend, which is somewhat surprising in view of the decline in worldwide inflation." Surprising? There are trillions of dollars zipping around the world every day without let or hindrance so is it surprising that there is exchange rate volatility?

The IMF sums things up like this: "Taken together, developments in the global economy in 90s and the hypotheses to which they give rise are not particularly reassuring. They point to a global economic and financial system with great potential for allocating resources more efficiently within and among countries, but also with a potential for excesses to develop in asset markets and the private sector, and therefore for recurrent macroeconomic instability even when macroeconomic policies are reasonably well disciplined."

So, there you have it. The economic system so cleverly constructed over the past 25 years has resulted in lower levels of growth, asset price bubbles, foreign exchange volatility and permanent macro-economic instability. But inflation is lower, so what the hell. Of course, not everybody has been surprised by these developments. Keynes argued that flexible exchange rates and free international capital mobility are incompatible with global full employment and rapid economic growth in an era of free trade.

Professor Paul Davidson, the keeper of the sacred Keynesian flame, says the problem was that Keynes's analytical system was not incorporated into orthodox theory. Instead, the idea was implanted that either markets were efficient, which was the view of people such as Milton Friedman, or were only temporarily inefficient and could be made efficient, which was the view of a group known as neo-Keynesians.

Davidson argues that the logic of true Keynesianism is that the primary function of financial markets is to provide liquidity. "Since a liquid market must be an orderly one, rules and institutions must be developed to guarantee orderliness," he says. "If Keynes's liquidity preference theory of orderly financial markets is relevant, then financial markets can never deliver, in either the short or long run, the efficiency promises of efficient market theory. In the real world, efficient markets are not liquid and liquid markets are not efficient."

In strategic terms, Davidson argues that there needs to be a complete overhaul of the international financial system along the lines that Keynes wanted at Bretton Woods. However desirable that might be, the reality is that there is no political constituency - even among the parties of the left - for such reforms. However, one thing that could be achieved is to ensure that the development strategies of poorer countries are not jeopardised by a continuation, and even an intensification, of the policies which have failed in the past. Caning the speculators

In a study of the Asian crisis, Jeffrey Henderson of the Manchester Business School found that there were distinct differences between those nations which felt the full heat of the meltdown and those - like Taiwan and Singapore - which emerged relatively unscathed. "Taiwan and Singapore have so far remained largely outside the web of the crisis because they continue to have effective (though very different) developmental states. "As a consequence they have been able to construct more robust economies than the others, partly by withdrawing property and stock markets as foci for speculative investment, partly by maintaining the institutional capacity and bureaucratic skill to - in the Singaporean phrase - 'cane the speculators', and partly by continuing to practise strategic economic planning."

Henderson's point is that there is something inimical between the long-term capital commitments and the patience needed for "late industrialisation", and the speculative and short-term portfolio flows induced by the sort of capital-market liberalisation traditionally urged on developing nations by bodies such as the IMF. This is what bodies such as Oxfam have been saying for some time. Debt relief, they say, is not an end in itself, but should be channelled into laying the foundations for development through investment in the basic social infrastructure.

What this means is a more restricted role for the IMF, which should advise on the right conditions for macro-economic stability, but should do so within a framework that makes poverty reduction a priority. What it does not mean is countries being force-fed structural adjustment programmes and being bullied into ill-timed and self-defeating capital liberalisation.

The Fund says that structural adjustment programmes are to be given an anti-poverty focus, with even the name being changed from Esaf (enhanced structural adjustment facility) to the "poverty reduction and growth facility". But, as we found with Sellafield, changing the name is one thing, changing the way things are done is quite another. Gordon Brown and Clare Short believe that the IMF can be changed, that it can be weaned off neo-liberalism.

It is encouraging that, inside the IMF, people are having second thoughts about the wisdom of the prevailing orthodoxy. If that means the Fund returns to doing what it was set up to do - creating the macroeconomic conditions for growth and the advancement of human welfare - it will be good news for all of us, even if long overdue.

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