G20-IMF-FSB Update – March 12, 2010
By Adam S. Hersh
Soul Searching at the IMF: Whither Financial Liberalization and Inflation Targeting
It seems the latest global financial crisis is deflating the IMF hubris bubble. Two recent IMF Staff Position Notes offer serious re-thinks to past IMF policy stances and are causing stirs in official circles. In particular, the papers highlight some of the ways that IMF policies have contributed to macroeconomic and financial instability; the papers also recommend some policies that not too long ago the IMF sought to ban through amendments to its founding Articles of Agreement.
The first paper (pdf), from IMF Research Director Olivier Blanchard, and others, assesses conventional (and IMF) thinking on macroeconomic policy and what that might have gotten wrong in light of the current crisis. What stands out most here is the suggestion that the level of inflation targeted by macroeconomic policy might have been too low. At a two percent inflation rate target, monetary policymakers hoping to prime economic activity and to supply liquidity to capital markets don’t have too much room to maneuver before bumping up against the lower bound of zero percent nominal interest rate. The authors conjecture that maybe having a four percent target would be better, giving monetary policy more wiggle room for managing economic volatility.
The admission about inflation levels itself is striking and controversial, particularly given the near-zero-tolerance for inflation pursued by the European Central Bank and the singular focus on inflation management as the goal of monetary policy pursued in so many other countries. But where does this new four percent inflation target come from? In fact, it is entirely arbitrary. Empirical evidence from economists Michael Bruno and William Easterly and Robert Pollin and Andong Zhu (pdf) shows that there are no observable detrimental effects of inflation up to about the range of 20-25 percent annually. This means, there is no discernible difference between stable inflation at two percent, four percent, or twenty percent. Below this threshold, inflation does not spiral out of control, and economic growth is not impeded. In fact, developing countries with higher inflation rates (within this threshold) actually experience faster economic growth.
This begs the question, why should monetary policy exclusively target inflation? Increasingly, the forces determining price changes are global in nature, meaning exogenous from national economies and beyond the direct control of national policymaking. Yes, monetary policies targeting low, stable inflation succeeded in achieving these targets, however inflation targeting has not yielded benefits that raised employment or led to sustained higher economic growth performance (doc). The deflationary bias inherent in inflation-targeting monetary policy has also led to unforeseen problems in constraining the ability of monetary policy to address (and perhaps contributing to) systemic financial instability.Instead, monetary policy might target full-employment (with stable inflation) or the prevention of wasteful bubble economies (pdf) with the use ofcyclical regulatory tools
The second paper deals specifically with the role that capital controls–regulations on inflows and outflows of financial capital from national economies–can play in promoting financial and macroeconomic stability. Capital controls were once a central feature of the Bretton Woods international monetary order. But for many years, the IMF has encouraged countries to eliminate capital controls through financial liberalization, arguing that restrictions on free financial flows are detrimental to development of financial markets and distort prices impeding development, among other effects. Whatever the theorized benefits of liberalization, unregulated capital inflows can lead to volatile exchange rates, excessive foreign borrowing, and bubble economies. Virtually every country that has undergone financial liberalization experienced a severe financial crisis not too long after.
The impossible trilemma in international economics states that a country can have at most two of the following three features: independent monetary policy, free flows of capital, and a managed exchange rate. With the IMF urging countries to liberalize capital flows, countries are left to choose between a managed exchange rate, good for promoting development of export industries and management of external debt service, or policy autonomy to be growth-oriented (though in practice the threat of capital flight from foreign investors can pressure against expansionary monetary policy).
The issue of capital controls has been on the development agenda for a long time, and capital controls have played a starring role in the experience of many late developing countries. Malaysia famously instituted capital controls amid the 1997-98 Asian financial crisis, helping it to recover from the crisis and China’s capital controls helped it largely steer clear of the Asian crisis altogether. In the current financial crisis, once again capital controls are coming back into play as low interests rates in developed countries are creating a wave of international capital seeking higher returns in developing country markets. Brazil, Colombia, Croatia, Thailand, and Taiwan, among others, have all implemented some forms of capital controls in the current crisis.
While the IMF has long opposed capital controls, the authors of this new paper write that use of capital controls "is justified as part of the policy toolkit." This conclusion has been simmering at the IMF for some time now. In 2003, anIMF Occasional Paper wrote that "a systematic examination of the evidence, however, suggests that it is difficult to establish a robust causal relationship" between financial liberalization and economic growth, but there is evidence of a relationship between financial liberalization and macroeconomic volatility. (Maurice Obstfeld, who literally wrote the book on international macroeconomics, reaches much the same conclusion). Despite such admissions, economist Ilene Grabel documents continued tepid and begrudgingly passive-agressive relationship between the Fund and capital controls. As recently as November 2009 Dominique Strauss-Kahn was saying that capital controls are not a policy recommendation the IMF would recommend to countries. The IMF’s newfound detente so far extends only to controls on capital inflows, and they remain more ambiguous about controls on capital outflows.
The IMF also opened a consultative process with civil society organizations on financial sector taxation, including on the idea of a financial transactions tax, or so-called [James] Tobin Tax or the Robin Hood tax. Chairman of the UK’sFinancial Services Authority last year floated the idea of a financial transactions tax to help recoup public bailout funds and dampen unproductive speculation.British Prime Minister Gordon Brown and French President Nicolas Sarkozy are both publicly calling for a global bank levy. The EU’s Commissioner for Development and Humanitarian aid also proposed a Tobin Tax idea, and the idea is gaining legs in Germany, France, Australia, and Japan
New Rules for Hedge Funds…or Maybe Not
The International Organization of Securities Commissions issued new guidelines for requiring hedge funds to report data to national regulatory and supervisory officials. Guidelines for hedge fund reporting (pdf) suggest that regulators collect data on:
- Fund general manager, principals, and advisers
- Fund performance, investor information, and marketing activities
- Assets under management
- Gross and net asset exposures and asset class concentrations
- Gross and net geographic exposures
- Trading, turnover, and clearinghouse issues
- Balance sheet liquidity
- Value and distribution of borrowing
- Risk assessments
- Counterparty risk exposure
- Asset complexity and concentration.
The underlying premise of the new guidelines is that more information will help investors make better decisions in choosing hedge funds and monitoring their investments, and will help regulators better assess systemic risks created by hedge funds. For investors, more information may or may not improve their investments (certainly many investors failed to heed apparent warnings from some regulated financial institutions that disclose even more information). For financial regulators without any regulatory authority over hedge funds, it is unclear to what use such information can be put in securing systemic stability.
In 2000 the Financial Stability Forum–which became the Financial Stability Board in 2009–balked at proposing direct regulation of hedge funds, instead promoting reliance on "market discipline" and voluntary codes of conduct. In one survey, less than ten percent of hedge funds reported intention to adopt voluntary standards
After circulating a draft report for comment from hedge fund industry representatives in mid-2009, IOSCO’s final June report on Hedge Fund Oversight (pdf) " agreed that some proposals received were not to be taken forward" (p. 23). In particular, commenters objected to proposals for prudential regulation of hedge funds and registration of fund managers.IOSCO’s review of current national regulations on hedge funds found that although many jurisdictions require registration, funds may often receive exemptions from those requirements. How big a deal is registration? According to Richard H. Baker, President of the Managed Funds Association, more than half of fund managers in the United States are already registered (pdf) with the SEC.
Even seemingly innocuous regulations like requiring registration of hedge fund managers have sparked contention. The European Union is pushing a modest plan, but US Treasury Secretary Tim Geithner (pdf) and UK financial services minister Paul Myners are going to bat for the hedge funds. Myners vowed to fight “line by line and minute by minute” against EU attempts at rein in hedge funds with even this modicum of regulation. At issue is whether a hedge fund authorized to operate in one EU country should be allowed to operate under a "passport" in every country. In opposing the EU’s proposal, Geithner and Myners are fighting to keep open a back door for hedge funds to register operations in off-shore tax havens.
While Secretary Geithner is fighting for hedge funds in Europe, back in the United States the House of Representatives passed "Wall Street Reform and Consumer Protection Act of 2009," passed in the House of Representatives on December 11, 2009, would force hedge fund managers to register with the SEC (though would not otherwise regulate hedge fund activities).