There are many questions being raised about the future of the International Monetary Fund. I will argue that it is not that the IMF is faltering in its tasks -- we were just repaid by our largest debtors, a cause for celebration in any financial institution -- but that even while the linkages among countries grow and the need for economic dialogue among nations increases, the spirit of internationalism is ebbing.
There is a belief that IMF reform will somehow restore the quality of the international dialogue. In my view, any proposal that does not focus squarely on reviving the spirit of internationalism is doomed to failure. IMF reform can be part of the solution and, unlike some, I believe the IMF's lending function will be critical to this process. But we must get the diagnosis of the problem right before attempting solutions.
The midwives at the Fund's birth in 1944 were political tragedy and economic despair. During the inter-war depression years, countries, suffering from overcapacity and unemployment, tried to export their way out of trouble by devaluing their currency, even while raising their own tariffs to protect against imports.
Of course, other countries had the same problem, and tried the same solution -- known colloquially as beggar-thy-neighbour policies. The result? Global trade collapsed, while exchange rates and capital flows became volatile.
What the world needed, according to the Fund's founders, John Maynard Keynes and Harry Dexter White, were rules to govern international exchange and flows, and an impartial arbitrator to point out when those rules were being violated.
With the spirit of internationalism reinforced by recent memory, the Fund was conceived at the 1944 Bretton Woods Conference with the prime objective of facilitating ". . . the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income . . ."
It was to do this, in part, by "promoting exchange [rate] stability" and avoiding "competitive exchange depreciation." This required the Fund to "exercise firm surveillance" over the exchange rate policies of members so that they "avoid manipulating exchange rates or the international monetary system" to prevent adjustment or "gain an unfair competitive advantage over other members."
In addition to monitoring country policies through surveillance, the Fund was set up to work as a sort of credit union, lending to countries that suffered adverse external shocks. The availability of this line of credit helped a member in a number of ways.
The IMF could help countries correct balance of payments difficulties by providing temporary financing to smooth the required adjustment and limit the impact on economic activity at home and abroad. Thus the country's incentives to export its problems to the rest of the world were mitigated; in fact, the IMF's financing would be conditional on policies that would limit or avoid such effects.
The importance of Fund financing should therefore not be underestimated -- it was a carrot that gave countries an incentive to play by the rules.
Since the early days of the Fund (leaving out the abnormal post-war lows), world trade has grown, from 10% of world GDP in 1960 to almost triple that in 2005. World GDP itself has grown at an average rate of 3.5% over this period, faster than at any other period in human history.
In short, judging by the Fund's goals at its founding, it has been a great success. (But) even as the world has become more interconnected through trade and finance, even as the Fund's members have become more successful, the spirit of co-operation that prevailed amongst the members at the time of the founding of the Fund, seems to have waned. I believe the trends are not unconnected.
At the risk of simplifying to the point of caricature, in the initial post-war years, virtually all countries with the possible exception of the United States had fragile economies. Given that they might need help, they were
The Fund was a partnership of the heedful, and given that a country could be a creditor one day and a debtor the next, it was also a community of common interests.
Over time, however, industrial countries recovered from their post-war weakness. They rebuilt their capability to undertake policy analysis. And the system of capital controls and fixed but adjustable exchange rates broke down for reasons well described elsewhere. Most industrial countries moved to floating exchange rates.
This move, coupled with their political stability and strong institutions, ensured that private capital markets would be a reliable source of finance. As a result, industrial countries stopped borrowing from the Fund -- as late as 1975, nearly half of Fund lending was to industrial countries, but by the late 1980s, it was zero.
This had two important consequences. The first was that with little to gain from the vetting of their policies by the larger Fund membership, important industrial countries started forming groups outside the Fund, with serious policy discussion and economic co-operation taking place within these groups. The most prominent avatar of this First Circle is now the G-7.
While not denying the global benefits of frank policy dialogue and coordination within the group, an unfortunate consequence has been to diminish the relevance of the multilateral discussion that takes place within the Fund.
The second consequence was that the Fund itself was divided -- between industrial country creditors who would never borrow and held the weight of the shareholding, and potential debtors who had to subject their policies to multilateral advice either within the context of a Fund-supported policy programme or for fear they might otherwise lose access to Fund resources in their times of need.
The tensions between these groups centred on programme conditionality -- the conditions the Fund imposed in lending programmes to ensure repayment, and to ensure that the resources were used to promote, rather than postpone, adjustment and reform.
Most recently, some emerging markets have built up their foreign reserves to such an extent that they are unlikely to need Fund resources at least in the short term. Given the precedent set by the industrial countries, these "advanced" emerging markets are not keen to be seen heeding Fund advice, though many of them value it privately.
This development is particularly pernicious for a number of reasons. Unlike industrial countries, these advanced emerging markets still have structural vulnerabilities.
More important, many of them are now significant players in the world economy, who affect each other, as well as the rest of the world. They could play a valuable role in the multilateral dialogue. Their collective will could be a powerful force in reforming multilateral fora, but it is not being asserted, partly because they have diverse interests.
So even as the linkages among economies grow, the places where dialogue among nations can reasonably take place are diminishing. Multilateralism is in retreat everywhere. As just one example, we see signs every day in the financial press of a revival of beggar-thy-neighbour policies, except it is now also on the capital account. It is amidst this background of diminishing multilateral dialogue that calls are being made to reform the Fund.
Part of the Fund's response to its largest shareholders has to be, "Physician, heal thyself." But the larger part of the Fund's response has to be to find ways to re-engage all of its member countries.
(To be concluded)
Raghuram G Rajan is Economic Counselor and Director of Research, International Monetary Fund . Excerpted from the 2006 Krasnoff Lecture delivered at Stern School, New York University on March 8, 2006.
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