This is sad, because if you don't urge system reform, nobody will
“The financial system can work if each of its members follow the right principles for their economy”
M Lagarde has had a successful year at the Fund but this statement at the G20 meeting in Moscow yesterday shows the Fund has not learnt the key lesson of the economic disaster.
The mistaken belief that if each country does the right thing – or what seems to it to be the right thing – in its own interests for its own economy, then the global economic and financial system can take care of itself was a big cause – even the main general cause – of the financial and economic crash that began in 2007.
Remember what the IMF said in its appraisal of the World Economic Outlook in April 2007 just before the collapse:
“Notwithstanding the recent bout of financial volatility, the world economy still looks well set for continued robust growth in 2007 and 2008. While the U.S. economy has slowed more than was expected earlier, spillovers have been limited, growth around the world looks well sustained, and inflation risks have moderated. Overall risks to the outlook seem less threatening than six months ago but remain weighted on the downside, with concerns increasing about financial risks.”
Eminent economists – most recently for example Kenneth Rogoff and Barry Eichengreen – have acknowledged that economists have not had a good crisis. The discipline of economics is ony beginning to absorb the lessons. But it seems that the same observation has to be made of the IMF, despite all the heart searching and external evaluations it has gone through. The IMF is sorely neglecting its main function, the care of the international monetary system in the interests of all its members.
We have lost – the Fund has lost – the old language of international monetary cooperation. Hence it has no defence against the politicisation of international monetary relations. It is a free for all, in which might is right. Lacking the language to develop a systemic analysis, it has to act merely as an honest broker between strong political and national interests. It tries to avoid finger-pointing; this time, it tried to avoid putting Japan in the dock. Let’s calm down. Talk of currency wars was “overblown”, according to Madame Lagarde:
“I welcome G-20 resolve to achieve a lasting reduction in global imbalances through joint actions to avoid persistent exchange rate misalignments, and the group’s commitment to refrain from competitive devaluation, to resist protectionism in all forms, and to keep markets open. It was heartening to see the G-20 reaffirmed its commitment to move more rapidly toward more market-determined exchange rate systems and exchange rate flexibility to reflect underlying fundamentals.”
“We think that talk of currency wars is overblown. People did talk about their currency worries. The good news is that the G-20 responded with cooperation rather than conflict today.”
The story of the years leading up to 2007 is precisely that each country did what it deemed the right thing. The IMF repeatedly examined the policies of major countries and found them, well, OK. So it is left without any convincing explanation of why the crisis blew up despite all the major countries doing the right thing and its own laughably optimistic forecasts.
The old language would have talked about adjustment and liquidity – using impersonal terms to identify and press for the adjustment of policy in each country needed to promote the objective of the common good. But the dogma of market-determined exchange rates has destroyed the language of international cooperation that facilitated orderly adjustment of policies. There is nothing to replace it. Hence the repeated outbreak of – yes – competitive currency depreciations. So the Fund approves whatever the big boys, above all the US, want to do – the Conally defence (see below).
How can businesses plan and equity appetite recover in such chaotic conditions? How can cross-border flows be stabilising when they are dominated by short-term capital movements that persistently drive exchange rates away from long-term values? How can “putting your own house in order” be an adequate policy prescription when central banks’ attempts to use their balance sheets to stimulate expansion merely cause surges of what used to be called hot money, mainly from developed to emerging markets, driving up currencies and asset prices and fuelling unsustainable booms in many countries around the world?
A good international monetary system can accommodate huge and persistent global imbalances without causing the collapse of banking and financial systems every few years. It does so by inducing countries to follow policies that are in the general interest and thus in their own long-term interests by being constrained by agreed, common and universal rules.
Without such rules, there are too many easy arguments for currency manipulation – which is always in the interests of local politicians. An amusing typology of such counter-arguments has been drawn up by Simon J Evenett . He distinguishes between five responses:
1. The ‘just following orders’ defence.
This defence was put well by Philipp Hildebrand, the former head of the Swiss National Bank, in the Financial Times. In his view, central banks haven’t declared war on trading partners. Rather they’ve sought to revive their national economies taking steps that are entirely consistent with their legal mandates.
2. The ‘no malice’ defence.
In their statement this week the G7 implicitly proffered this defence (G7 2013). No harm was intended, so what’s the problem?
3. The omelette defence.
If “you can’t make an omelette without breaking a few eggs”, and assuming the developed countries want an omelette, then the EM eggs must accept their fate.
4. The ‘grabbing headlines’ counter-attack.
Accusations of beggar-thy-neighbour acts by trading partners are merely a smoke screen for failed domestic policies.
5. The Connally defence.
“The dollar is our currency, but your problem.” On this view, the rest of the world needs to adjust to the reality of monetary easing and live with its consequences.
Another way of looking at it is to assert that rules are needed to keep policy focussed on the medium to long term. If national policies could be focussed on such a longer-term horizon under current global financial system, then they might work.But that is not politically possible, They are hostage to political imperatives. Thus it becomes unthinkable for central banks to raise short-term interest rates even when some are convinced that is in their country’s long-term interest.
It is in practice impossible to rein in excessively expansionary monetary and fiscal policies just because they produce international spillovers – even if those spillovers return to damage you.
I argue in The Money Trap that the result in the longer term will be a collapse of confidence in central banks and government credit – including that of the US itself. There is nothing that would benefit the US more than being constrained by a good international system. But it is now late. This collapse is on-going. Increasingly, the pathetic response of governments is to suppress finance and markets. That won’t work either.
Policy-makers need rules to allow them to pursue adjustment policies that are in the general interest and thus, in the end, in the interests of their own economies. As the late Jacques Polak once said to me, “it’s very difficult for the Fund to get the international interest taken into account in the absence of fixed exchange rates”.
What is the money trap? It describes how policy-makers in each country are ensnared by the delusion that they can realise their aims by acting in what seems to be their country’s own interest in the absence of a true international monetary system. “Let us eat the forbidden fruit while nobody is watching” they say, “we can afford it.”