Global Policy Forum

By Hossein Askari

In 1944, as the end of World War 11 was coming into view and in the aftermath of financial disorder following the Great Depression, the two Bretton Woods institutions, the World Bank and the International Monetary Fund (IMF), were created. The World Bank was mandated with financing the reconstruction of Europe and with long-term economic development projects in developing countries; the IMF was mandated to be the guardian of international monetary stability.

They now duplicate each other to a point that many ministers of finance and heads of central banks do not know the difference between the World Bank and the IMF. As a result, a number of academics and politicians have called for the fusion of the two institutions. Both institutions have incurred financial losses: the World Bank had to downsize in the 1980s, and the IMF had to do so recently. Both institutions have also played havoc with the development process of many developing countries, pushing them deep into debt and economic decline for a number of years.

As the world economy has been recently shaken by unprecedented financial, food and energy crises, resulting in the socialization of the financial system of many advanced countries, the media, politicians and academics have naturally wondered whether the two Bretton Woods institutions have carried out their mandates efficiently. Unfortunately, the performance record of both institutions has been deeply disappointing.

Both institutions have been criticized by many leading figures for their ill-designed policies. Over more than three decades, the World Bank has concentrated on policy lending in privatization, demobilization of armies and downsizing of countries' civil services, while neglecting agriculture development in many potentially agriculture rich countries as well as infrastructure. Such diminished emphasis on agriculture has undermined food security in many developing countries facing rapid population growth.

The IMF has over the past decade renounced its monetary role. Dominated by political slogans, it has portrayed itself, instead, as a poverty fighter. Both institutions wanted to promote good governance and fight corruption in Africa, as if corruption existed only in Africa and nowhere else. Although fighting corruption has no clear or measurable meaning, most likely turning humans into angels, such demagoguery shows how far removed both institutions have been diverted from their Bretton Woods mandates.

While intransigent and dictating policies to developing countries, the IMF has always been congratulatory of US policies. Staunchly supporting former Federal Reserve chairman Alan Greenspan's bailing out of hedge funds and excessive monetary and deregulation policies, the IMF has urged the European Central Bank to lower interest rates and pursue the same policy stance as the US Fed. In contradiction with its mandate to stabilize exchange rates as well as take an orthodox monetary approach to the balance of payments, the IMF was strongly, and at the same time wrongly, supportive of a deep depreciation of the US dollar through very low interest rates, as called for in its past World Economic Outlook documents, to solve external imbalances.

Of the Group of 20 meeting in Kleinmond, South Africa, in 2007, Reuters reported "The view of the IMF is that the move in the dollar depreciation is in the correct direction," Evidently, fast depreciation of the dollar contributed to an acceleration of commodity price inflation, food riots and crippling energy prices. As a result of the explosion of food and energy prices, real incomes have fallen sharply, economic growth has slowed and unemployment has started to rise.

Unlike natural disasters (such as floods, tsunamis and earthquakes) that cannot be predicted, financial crisis have never been random events. They were fully documented by classical economists in the 19th century and were shown to be an unavoidable result of speculative credit boom. Irving Fisher (1933) ruled out all causes for a financial crisis except a sustained speculative credit boom and over-indebtedness. Did the IMF predict the present financial crisis when it was in the stage of incubation? No.

Even after the financial crisis broke in August 2007, the IMF continued to be supportive of present Federal Reserve chairman Ben Bernanke's aggressive monetary policy, which has precipitated economic recession and downfall of giant financial institutions. Recently, the IMF has fully endorsed gigantic bailouts proposed by US Treasury Secretary Henry Paulson and European authorities and socialization of the banking sector, without explaining reasons for such endorsements and their economic, financial, and social implications.

While Bernanke has recently confessed to the US Congress concerning the failure of monetary policy and suggested a stimulus program to cope with recession, the IMF has remained in a passive position. There is no plan that can be authentically called an IMF plan put forward by IMF for dealing with the financial crisis. The world community cannot afford two big institutions being the vested interest of highly paid officials and failing to achieve their basic mandates. World leaders should consider reshaping these two institutions according to the type of organization they were in the 1950s and 1960s.

A major cause of the present crisis is that financial institutions refuse to deal with their basic mandates and want to extend their role to areas that do not fall under their jurisdiction. In this respect, central banks in many countries, most notably the US Federal Reserve, do not want to manage liquidity and regulate the banking system; instead, they want to promote full employment and growth, based on the Taylor rule (which stipulates how nominal interest rates should be changed in response to divergences of actual GDP from potential GDP and divergences of actual rates of inflation from a target rate of inflation) or inflation targeting.

Similarly, the IMF does not want to deal with monetary issues; it wants to fight poverty and corruption. In doing so, it has recruited anthropologists and social workers and has lost over the years its monetary know-how, as new generations of staff are no longer familiar with IMF practices as they existed. The World Bank does not want to specialize in financing growth projects; it wants to promote democracy, fight corruption and promote good governance and civil society.

Both institutions have been advocating reform in member countries; now, they have to admit that they themselves need reform. The IMF should remodel itself into the organization it was in the 1950s and 1960s, basically deleting its poverty, social and structural mission, and closing its resident representative missions that number over 90 in developing countries. It is clear that more than a decade since the IMF decided to fight poverty in Africa, it has impoverished itself by going deeply into the red and has only increased poverty and destabilized a number of African countries.

Often, the IMF was told that poverty reduction was the prerogative of the World Bank and a large number of regional development banks. Yet, the IMF never accepted this truth and kept on insisting on its poverty fighter role. Its poverty reduction and growth facility (PRGF) amounts to a pure budgetary loan disbursed every six months to a country to finance pure government expenditures, namely large increments in salaries of the army and civil service. Such use of IMF money makes a country indefinitely dependent on the IMF to meet its military and civil service salaries. The PRGF resources and the huge operational costs for running PRGF programs should instead be added to the resources of regional development banks and finance only development projects (such as in health, infrastructure, education, agriculture, energy and so forth).

The world needs an IMF that is in charge of macroeconomic policies, namely fiscal, monetary and exchange rate policies, leaving trade policies to the World Trade Organization and economic development and its financing to the World Bank. The IMF has to deploy its resources and recruit experts in central banking and in the financial sector, and put in place programs for rebuilding sound and safe banking sectors in every member country, most importantly in major industrial countries. The IMF has a long way to go to fill up the regulatory gap in the financial sector, banking, securities, and futures and derivatives. It should not underestimate this important task.

The IMF has to be a lender of last resort only to central banks, or monetary authorities, of a country, using one facility for all countries, and on a temporary basis. Keeping a country for several years under a program will be totally damaging to the country as the country cannot regain control of its economic development policies and will remain forever under an IMF program.

Gold used to be an anchor for central bank's issuance, and used to be, par excellence, the settlement means for international balances that cannot be settled with securities and claims. Now, we have an environment with a fiat money (paper) standard with flexible exchange rates. The IMF has to control monetary and credit aggregates in such an environment in order to establish monetary stability. For each country, the IMF should establish a benchmark monetary program against which monetary performance can be evaluated periodically. Such an indicative monetary program should be consonant with exchange rate and price stability and external sector viability.

The IMF should monitor credit aggregates by sector and by maturities, and regularly evaluate the soundness of the banking system. Fast expansion of credit can only fuel speculation and deteriorate creditworthiness in a country and lead to a financial crisis when profits starts diminishing rapidly. Distorted maturities can be a cause of instability. The IMF should discourage factor and product-price distortions. Most importantly, the IMF should discourage the use of interest rates as a policy tool, as this instrument has turned out to cause instability, distort prices and create a highly unpredictable monetary framework.

The World Bank should concentrate on fighting poverty and speeding up economic growth in developing countries. It has to channel International Development Association resources (low-cost funding for poorer countries) unconditionally to eligible countries and direct these resources only to long-disbursing development projects and not to quick-disbursing budgetary aid. The poorer countries need much more funding for health, education and infrastructure and for private-sector growth. World governments should also understand better the mandates of the Bretton Woods institutions. Such understanding would help both institutions remain confined to their true mandates.

In recent days, the major concern with both of these institutions has been the unfolding sex scandal involving the head of the IMF, managing director Dominique Strauss-Kahn. The IMF board at the weekend cleared Strauss-Kahn of harassment, favoritism and abuse of power after it hired a Washington DC law firm to investigate his affair with an IMF economist. The board's statement on October 25 nevertheless noted that "the incident was regrettable and reflected a serious error of judgment on the part of the managing director".

That scandal followed on the heels of another involving the former head of the World Bank (resulting in his resignation). And in the past, rumors have been rife throughout the institution about impropriety on the part of board members themselves. These institutions are in need of serious management overhaul.

At the same time, the management of these institutions is dominated by the US, a handful of European countries and Japan. While the institutions preach good governance and management, they have been unable to adapt themselves. China is arguably the most important economic power in the world after the United States. Yet Britain and France dwarf its influence. Latin Americans are similarly under-represented. The list goes on.

Will the present financial crisis shake up the Bretton Woods institutions and make them rise up to the challenges facing the world economy? This will be answered in the months to come. Nonetheless, drifting further away from initial Bretton Woods mandates and not improving their management will be costly for the world economy. Resources will be squandered. Frustration among politicians and bankers will increase. There have already been calls in many quarters and reputable newspapers (such as London's Financial Times) for a world central bank to take charge of world monetary affairs and stabilize financial markets. It's time to act ahead of the curve.

About the authot: Hossein Askari is professor of international business and international affairs at George Washington University.