IMF Abandons Its Theological Belief In Neoliberalism, Bats For Ideas That Work

After World War II, the need for a new international monetary framework and financial system was felt. The destruction of cities and countries called for their reconstruction and development after the war was over. For these purposes, scores of representatives from allied nations gathered for the Bretton Woods Conference in New Hampshire. The International Monetary Fund (IMF) and the World Bank were two institutions that resulted from this conference, and the policies they advocated came to be known as the Washington Consensus.

The aim of these institutions was to improve monetary cooperation, enhance international trade and promote liberalisation among its member countries. The IMF in particular had sold a set of economic policies that championed these objectives as a tonic to its members or outsiders facing an economic crisis and wanting to resolve it.

The election of Ronald Reagan in the United States and Margaret Thatcher in the United Kingdom saw these countries implement neoliberal policies that led to massive wealth creation. Communist China’s decision to replace Marxist economics with the same neoliberal policies lifted millions of Chinese out of poverty. India, Chile, Brazil also benefited from similar policies.

However, barely any economist worth his or her salt would say that these policies have been good for all. Despite that, the elites of this financial order have brushed away even mild criticisms of their system.

The rise of Donald Trump, Bernie Sanders and the Brexit vote are being seen as a protest against such arrogance of the financial elites. These economists are also now realising that they probably oversold the neoliberal agenda, and need to step back a little and acknowledge the losers, as well as find ways to incorporate and compensate them.

Economists Jonathan D Ostry, Prakash Loungani, and Davide Furceri, all of who work at IMF’s Research Department, acknowledge in this paper that some neoliberal policies have increased inequality and, in turn, jeopardised durable expansion.

But what is this neoliberal agenda anyway? They write that this agenda rests on two main planks:

1) Increased competition: By opening up domestic markets to foreign goods and services, and thereby increasing competition.

2) Shrinking government: This means either limiting the role of the government in some sectors by privatisation of the firms run by it, or disinvestment. It can also mean putting limits on the ability of governments to run fiscal deficits and accumulate debt.­

These policies have undoubtedly done a lot of good around the world. The IMF trio acknowledges that the expansion of global trade has lifted millions out of poverty, Foreign direct investment (FDI) has led to technology transfer to developing countries and privatisation of state-run enterprises has led to a more efficient provision of services and lowered the fiscal burden on governments.­

But these policies haven’t delivered on expected lines. To prove their point, the economists focus on two polices of the neoliberal agenda in their paper:

First, the liberalisation of financial markets, i.e., free flow of capital across borders. The trio notes that this can allow the international capital market to channel world savings to their most productive uses across the globe, and developing economies with little capital can borrow to finance investment, thereby promoting their economic growth. But there are hazards.

The economists write that while FDI does help in boosting long-term growth, “the impact of other flows—such as portfolio investment and banking and especially hot, or speculative, debt inflows—seem neither to boost growth nor allow the country to better share risks with its trading partners.”

In fact, these inflows add to economic volatility and result in a financial crisis. The IMF trio digs out the evidence to prove it. They write:

Below is the chart depicting the same.

Many in the recent past have called into question the utility of short-term capital flows since they may lead to a financial crisis. The consensus for more controls on such short-term capital flows is emerging.

Second, shrinking government by fiscal consolidation (reducing debt levels or fiscal deficits). Apart from privatisation and disinvestment, this is the tool recommended by the IMF to keep a tight leash on big government. Do not spend what you don’t have is the common refrain.

But what is an optimal debt target for a country? The answer to this question cannot be a fixed one for obvious reasons. Nonetheless, the IMF in its fiscal policy advice, the trio notes, has been ‘concerned mainly with the pace at which governments reduce deficits and debt levels.’ It has also argued for paying down debt ratios in the medium term as an insurance against future shocks, they write.

These recommendations rest on two notions: Countries should use quiet times to pay their debts so that all hell doesn’t break lose when they are faced with a financial crisis; and high debt is bad for growth.

But these ideas fall in a “one-size-fits-all” category. While it is useful for developing or poor countries to focus on fiscal consolidation, for their credit-borrowing capacity is poor, for countries which are fiscally responsible, there is a very low probability of a debt crisis, even with very high levels of debt.

The trio writes that for such countries the cost of moving from a debt ratio of 120 percent of GDP to 100 percent of GDP over a few years could be much larger than the benefit. Why? Because to lower the debt, taxes have to be increased or productivity spending cut, which may not be worth the reduction in the crisis risk.

So, what is the option? Live with the high levels of debt? That’s what the IMF trio recommends. The governments with ample fiscal space should choose this path and allow the debt ratio to decline organically through growth.

The IMF economists admit that the rise in inequality caused by liberalisation of financial markets and reducing government size by putting limits on fiscal deficits might itself undercut both the level or the durability to growth - the central focus of neoliberal policies.

Considering the damage that inequality can cause to the growth prospects, the IMF trio advise their fellow economists that they should take the case of redistribution more seriously. According to them, the focus should be on increasing the spending on education and training which expand the quantity of opportunity.

In their paper, the economists note how the IMF has also changed its stance over the years on the two issues of financial openness and austerity. Consider these statements noted down by the trio in their paper:

In 2010, IMF’s former chief economist Olivier Blanchard said that, “what is needed in many advanced economies is a credible medium-term fiscal consolidation, not a fiscal noose today.”

In 2013, IMF Managing Director Christine Lagarde said the institution believed that the US Congress was right to raise the country’s debt ceiling “because the point is not to contract the economy by slashing spending brutally now as recovery is picking up.”

Last year, the IMF advised that countries in the euro area “with fiscal space should use it to support investment.”

On the financial liberalisation front also, the IMF has come around to supporting the utility of putting more controls to deal with the volatility of capital flows.

To sum up, the Washington consensus is changing. Its subscribing economists had better catch up.

Read the complete research paper here.

Also Read:

G-20: West Abandons Its Theological Belief In Unbridled Free Markets.