IMF: Abandoning some sacred cows?

After decades of criticism, the IMF seems at last to be shifting its ground on inflation and capital controls, although this reversal of position may have been made more with the developed countries' interests in mind.

Humberto Campodonico

AT the beginning of February, the International Monetary Fund (IMF)'s chief economist, Olivier Blanchard, said in an IMF Staff Position Note1 that they were mistaken in recommending that countries seek to attain  low inflation, at rates near 2%. He now says that a little more inflation would not have been bad, maybe around 4%.

Blanchard said that if the inflation target had been higher, the same would have happened to nominal interest rates. But the already low interest rates at the time  the current financial crisis broke out left central banks with almost 'no bullets' or possibility of substantially reducing the rates:

'When the crisis started in earnest in 2008, and aggregate demand collapsed, most central banks quickly decreased their policy rate to close to zero. Had they been able to, they would have decreased the rate further: estimates, based on a simple Taylor rule, suggest another 3 to 5 percent for the US. But the zero nominal interest rate bound prevented them from doing so. One main implication was the need for more reliance on fiscal policy and for larger deficits than would have been the case absent the binding zero interest rate constraint'. (Blanchard et al., page 8).

The conclusion is simple: 'It is clear that the zero nominal interest rate bound has proven costly. Higher average inflation and thus higher nominal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions' (Blanchard et al., page 8).

The change in the IMF's position is significant because for decades it had fought any hint of high inflation rates, which was translated into recommendations to reduce fiscal deficits and to give short rein to monetary emission.

Having said this, however, some critics affirm that this somersault on the part of the IMF is anything but 'theoretical'. It so happens that, given the enormity of the national and external debts of the industrialised countries, the IMF is looking for a policy of 'damage control'. Hence the return to the very old recipe which prescribes that you can liquefy debts with high rates of inflation.

This is what scholars Joshua Aizenman and Nancy Marion2 say: 'Between 1946 and 1955 the debt/GDP ratio was cut almost in half. The average maturity of the debt in 1946 was 9 years and the average inflation rate over this period ... was 4.2%. Hence, inflation reduced the 1946 debt/GDP ratio by almost 40% within a decade' (Aizenman and Marion, page 4).

They add that the temptation to erode the debt burden through inflation is greater than it was after World War II, because at that time foreign creditors only had 5% of the total of the debt, whereas that proportion now is near 50%, due to the liberalisation of capital flows. 'Mainland China and Japan each held about 10% of US public debt at the end of 2008' (Aizenman and Marion, page 7) (see graph next page).3

Aizenman and Marion's conclusion is: 'A government that has lots of nominal debt denominated in its own currency has an incentive to try to inflate it away so as to decrease the debt burden' (Aizenman and Marion, page 5).

'We're all pro-capital controls now'

Another IMF Staff Position Note in February4 also created quite a stir, because it says the IMF has 'rethought' its opposition to the use by emerging markets of restrictions on capital inflows. These are controls against speculative short-term capital flows that wreak havoc in emerging-market economies.

The authors of this paper conclude that capital controls are sometimes 'justified as part of the policy toolkit' for an economy seeking to deal with surging inflows. Really? And what about then IMF Managing Director Michel Camdessus' support in 1997 for a change in the IMF statutes in order to make capital account liberalisation one of the Fund's mandates?

Let's not forget that the Asian crisis of 1997-98 erupted, according to the economists Joseph Stiglitz and Paul Krugman, exactly because of IMF recommendations for capital account liberalisation, starting in the early 1990s. Free capital inflows created an enormous asset market bubble that burst in June 1997 with the devaluation of the Thai baht.

And when the Malaysian Prime Minister, Dr Mahathir Mohamad, imposed capital controls in September 1998, he was ridiculed by the IMF establishment 'for not understanding the modern financial system and for trying to divert blame for the crisis away from domestic policies'. They said he was 'irresponsible'. But capital controls worked for Malaysia, despite the criticism.

Some critics say that this change of position by the IMF, like its turnaround on inflation, has been made with the industrialised countries' interests in mind. These countries need capital to relaunch credit (loans) markets, the chain of payments and mobilise investment to reduce unemployment. But, because of near-zero interest rates, capital is flowing out of the industrialised countries to emerging markets, something that is not conducive to the former's interests.

For that reason, the IMF is now encouraging capital controls in emerging countries. According to Stanford University economist Ronald McKinnon, with near-zero US interest rates sending 'hot money' to developing countries, they are justified in re-imposing controls to maintain monetary control ('IMF reconsiders capital controls opposition', Financial Times, 22 February 2010).

Having said this, many emerging markets around the world, like China, India, East Asian countries, Brazil, Chile, Colombia and Peru, have employed different types of capital controls to defend their currencies against speculative attacks.

If they had relied on earlier IMF policy directives forbidding capital controls, they would have been in serious trouble, as asset market bubbles would have formed.

As for the IMF - which had not foreseen the current economic crisis until it flared up right in front of them - we can appreciate that they continue to criticise their own economic foundations.  Let us say that we think this is all motivated by pure convenience. When the needs of the industrialised countries change, they will again 'surprise' us with new and strange shifts in position, that they will label as 'theoretical'.

We already know them. For that reason, the solution is to think with our heads and follow economic policies according to our realities.     

Humberto Campodonico is a senior researcher at the Peruvian NGO DESCO and Professor at the Economics Faculty of San Marcos National University in Lima. A consultant to the United Nations Conference on Trade and Development (UNCTAD) and the Andean Community of Nations, he is also an economics columnist with the Peruvian daily La Republica.

Endnotes

1)      'Rethinking Macroeconomic Policy' by Olivier Blanchard, Giovanni Dell'Ariccia and Paolo Mauro. IMF Staff Position Note SPN/10/03, February 12, 2010 http://www.imf.org/external/pubs/ft/spn/2010/spn1003.pdf

2)      'Using Inflation to Erode the US Public Debt' by Joshua Aizenman and Nancy Marion. November 2009, http://econ.ucsc.edu/faculty/aizenman/Using_Inflation_to_Erode_Debt_Nov27_09.pdf

3)      Aizenman and Marion also say that shorter maturities of the debt (it was 3.9 years in June 2009 instead of the 9 years in 1946) reduce the temptation to inflate. Nevertheless, their model 'predicts that a moderate inflation of 6% could reduce the debt/GDP ratio by 20% within 4 years' (page 17). 

4)      'Capital Inflows: The Role of Controls' by Jonathan Ostry, Atish Ghosh, Karl Habermeier, Marcos Chamon, Mahvash Qureshi and Dennis Reinhardt. IMF Staff Position Note SPN/10/04, February 19, 2010, http://www.imf.org/external/pubs/ft/spn/2010/spn1004.pdf

*Third World Resurgence No. 235, March 2010, pp 3-4