The Chief Economist of the International Monetary Fund (IMF) is calling for countries to raise their inflation targets and pursue counter cyclical fiscal policies. Why? The current economic crisis has "exposed flaws in the precrisis policy framework." As the Financial Times reports, this runs against what has come to be called economic "orthodoxy," and represents a dramatic shift away from the standard policy advice of the IMF - stretching back decades.
During the East Asian Financial Crisis of the late 1990s, for example, the Fund imposed economic austerity on countries that received IMF loans - raised interest rates and contractionary fiscal policy. During the Latin American Debt Crisis of the 1980s, austerity was also the answer. Not surprisingly, these policies resulted in lower economic growth, but the IMF preached financial stability first, economic growth to follow.
Of course, during these years, the only borrowers from the IMF were developing countries. Indeed, until the recent crisis, the last time an advanced industrial country borrowed from the IMF was the mid-1970s. And as Joseph Stiglitz has observed, the contractionary IMF advice seemed somewhat hypocritical, considering the way advanced industrial countries responded to economic crises - far from following economic austerity, these countries always put together stimulus packages.
The hypocrisy did not go unnoticed by people of the developing world, who grew to hate the IMF, some seeing it as a tentacle of Western imperialism. The debacle that resulted from IMF policy advice during the East Asian Financial Crisis was the last straw. Nearly all emerging market countries and even some poorer countries vowed they would never again borrow from the IMF. During the first decade of the 2000s, the IMF had to go on an austerity program of its own. With few countries borrowing or - importantly - repaying their loans with interest, the Fund did not have the funds to run its operations.
Well, now the shoe is on the other foot. The current economic crisis has driven many countries to borrow from the IMF, and the international organization is back in business. For the first time in a long time, however, its customers include advanced industrial economies. And suddenly, economic austerity isn't looking like the answer.
If one takes a broad historical view of the IMF, this softer IMF does not seem so heretical. The IMF was the brainchild of Lord Meynard Keynes of "Keynsian" economics. As the world emerged from the Great Depression, he advocated the international pooling of resources to be used in times of economic downturns in a counter-cyclical manner. The problem as seen by the United States - the world's largest creditor at that time - was that the promise of liquidity during economic crises would lower the incentives of governments to avoid those crises in the first place, a problem we call "moral hazard." The solution that developed over time was "conditionality": in return for liquidity, the IMF would require governments to adjust their policies.
But how much liquidity in return for how much adjustment? This debate has fueled the historical evolution of the IMF. In the early years - up to the 1970s, the United States was on the harsher side of conditionality, with opposition coming from the borrowing Western European countries. When the United States became a deficit country, the advanced industrial world decided to turn away from IMF solutions, pursuing a radically different way to structure their international economic transactions. (Notably, they moved from fixed to floating exchange rates - see Eichengreen's work.)
The IMF had been lending all along to developing countries, however, and thus it simply shifted its focus to them. During these times, the advanced industrial countries usually favored harsh conditionality, while the developing world often complained that IMF policies were hurting economic development. Of course, the IMF decides most things according to majority rule, and votes are supposed to be pegged to economic weight. So, the developing world was out-voted, and austerity carried the day throughout the 1980s and 1990s. Finally, by the early 2000s, practically no one wanted to deal with the IMF conditionality.
Now with the current crisis, the Washington "Consensus" of tight monetary policy and fiscal austerity is no longer. Those favoring weak conditionality and expansionary policies are now carrying the day at the IMF. Yet, there will be a price to be paid for expansion, and when the dust settles, we will have a very different looking IMF.
The emerging markets have arrived. In the coming decade, we will see increasing vote shares at the IMF for countries like China, Brazil, India, Korea, Mexico, Indonesia, Turkey, Iran (yes, a member in good standing) and South Africa - many of whom were historically spurned by IMF conditionality. Still, the debate over conditionality will persist. Those not hit by a crisis will still worry most about moral hazard and advocate stringent conditionality. Those closely tied to the crisis will advocate the massive provision liquidity, eschewing conditionality (see Lipscy's piece on this). Some will preach stability first, growth thereafter. Others will suggest that by priming the pump, we can grow our way out of crisis and debt.
So where's the real change?
Global economic power has shifted. In their Godfather parable, Hulsman & Mitchell suggest the United States is "slipping." We've moved from a uni-polar world to a multi-polar globe. The United States will remain the "chairman of the board," continuing to hold more IMF votes than any other single country - as the world's largest economy and biggest contributor to the IMF. But it will have to share power, most notably with China. And this will be the real, long-lasting change at the IMF. See, during the bi-polar days of the Cold War, the Soviet countries refused membership in the Fund. So the West dominated the votes. But soon, and for the first time in its history, the IMF will have multiple voices with power. Importantly, they will have different ties to different economies - so preferences over liquidity provision and moral hazard may shift depending on where the next crisis hits. Looking decades ahead, we've got to ask ourselves: How will conditionality feel when the shoe is on the other foot?