David Dodge: The evolving international monetary order and the need for an
evolving IMF
Lecture by Mr David Dodge, Governor of the Bank of Canada, to the Woodrow Wilson School of
Public and International Affairs, Princeton, 30 March 2006.
* * *
Yesterday, I was in New York City, where I had the opportunity to talk to the New York Association of
Business Economics about global current account imbalances, and about the pressing need to allow
market-based mechanisms to resolve these imbalances. Most of my remarks dealt with what
policymakers should do to allow market-based mechanisms to work. But at the end of my speech, I
mentioned that there is also an important international aspect to this issue. The world needs an
international institution to promote a new monetary order-a well-functioning, market-based global
financial system. This will be the subject of my remarks today.
Recently, Martin Wolf of the U.K. Financial Times used his column to pose an interesting question: If
the International Monetary Fund did not exist, would we invent it?1 His answer, if I may oversimplify,
was no, because today's world does not have the courage and vision to create powerful multilateral
institutions. I'm not sure that I agree with his answer or with his reasoning for it. But I am sure that this
is exactly the kind of fundamental question we need to be asking.
Today, I'd like to take a slightly different approach to Wolf's question. Let me put it this way: If the IMF
did not exist and we set out to create it from scratch, what would be its fundamental role in the global
economy? What should an ideal IMF do, and what should it not do?
Some might suggest that these very questions are being asked and answered right now within the
IMF, in the context of the internal strategic review initiated by Managing Director Rodrigo de Rato. Mr.
de Rato is to be commended for taking on this task. The Executive Board of the IMF will discuss the
internal review next week. But it seems to me that the review, while important and useful, has been
focused on finding better ways for the existing institution to do what it already does. I want to approach
this issue from a more basic level and ask what is required for the IMF to evolve into the best possible
institution, designed for the global economy of the 21st century. For that evolution to take place, the
key shareholders of the institution need to show leadership and vision.
To set the stage for my remarks today, I will briefly review how and why the current IMF came into
being, and then I will consider how the global economy has evolved since the founding of the IMF. I
will next elaborate on what I see as the fundamental role for the IMF in today's global economy, and
then discuss the changes that would need to take place in order for the institution of today to evolve
into the "ideal" IMF. I hope that my remarks will then lead to a vigorous discussion in the time
remaining.
The rise and fall of Bretton Woods
So let me begin by going back 60 years to the original United Nations Monetary and Financial
Conference at Bretton Woods, New Hampshire. The delegates-representing 45 nations-were
nothing if not ambitious. They ended up creating two, almost three, international institutions. There
was the International Bank for Reconstruction and Development-now known as the World Bank-
charged with providing aid for the rebuilding of Europe. Delegates also came close to creating the
International Trade Organization, which was to be dedicated to keeping protectionism in check and
facilitating freer international trade in goods and services. This organization eventually came into being
a couple of years later as the General Agreement on Tariffs and Trade, which subsequently morphed
into the World Trade Organization. And, of course, the third institution was the International Monetary
Fund.
The IMF was meant to create an international monetary order that would allow trade to flourish again
and post-war reconstruction to take place. The institution that these delegates created was very much
a creature of its time, and its roles and responsibilities reflected the experience of the Great
Depression. The great policy failure of the 1930s was the competitive "beggar-thy-neighbour" currency
devaluations to which nations resorted. The Bretton Woods delegates sought to prevent countries
from adopting such policies. The first of the Articles of Agreement that govern the IMF called on it "to
promote international monetary co-operation through a permanent institution which provides the
machinery for consultation and collaboration on international monetary problems." Exchange rates
were to be fixed, and were to be adjusted only in the case of "fundamental disequilibrium." The
delegates also correctly identified liberalized trade in goods and services and the development of
economic specialization as crucial for the creation of wealth.
Permeating the Bretton Woods conference was a vital sense of co-operation, identified as the "spirit of
internationalism" by Raghuram Rajan, the current Director of the IMF's Research Department in a
recent lecture.2 The Bretton Woods delegates were able to see how their own country's interest was
clearly wrapped up in a collective interest. All represented nations understood that their own countries
might sometimes need to shun politically expedient policies and, instead, "play by the rules of the
game," thus promoting the common good of a well-functioning international monetary and financial
order. Delegates also saw that the Fund could act as an impartial arbiter or umpire to call out countries
that violated the rules by pursuing policies that impeded the free flow of goods and services.
The prime focus of delegates was to encourage trade flows, rather than to rebuild or develop
international capital markets. This is understandable when you recall that as a legacy of World War II,
governments controlled international capital flows tightly, and private capital flows were a tiny fraction
of what they are today. Capital controls were symptomatic of the enormous faith that delegates had in
the power of the state to direct economic activity and to control economic variables, including the
correct exchange rate values among the world's major currencies. The controls were also
symptomatic of the fact that outside the United States, capital markets had either atrophied because of
the war, or simply were not yet well developed. Because of the stresses brought on by the war, the
allocation of capital was much more state directed than market directed. These controls stayed in
place for some years after the war, persisting longer in Europe than they did in the United States or
Canada.
The Bretton Woods system of fixed exchange rates did not work all that smoothly, and its framework
led to several crises along the way. During the quarter century that the system operated, Canada
developed a reputation as the "bad boy" of the international financial system when we "temporarily"
opted out of Bretton Woods in 1950. By that time, strong capital inflows into our resource sector, as
well as sharply higher commodity prices, led to upward pressure on the Canadian dollar. In addition,
there were speculative short-term capital inflows, which added to the pressure on the currency. To
maintain the fixed exchange rate, Canadian authorities first intervened on a massive scale. Foreign
exchange reserves rose by 40 per cent in less than three months, and the money supply grew rapidly
at a time when the domestic economy was already operating at capacity. Ultimately, Canadian
authorities decided that the best way to resolve these emerging imbalances was to let the Canadian
dollar float. The alternative would have been higher inflation.3
One of the key lessons the Canadian authorities learned was that in an open economy, a
marketbased floating exchange rate was not at all incompatible with the goal of free international markets for
goods and services. Indeed, we came to realize that allowing the relative price of the currency to be
set in the market meant that we could concentrate on conducting monetary policy in our own best
interest, rather than being preoccupied with aiming for balance in our external current account. In a
rapidly changing global economy, it did not make sense to assume that the "correct" exchange rate
could ever be known in advance. And even if the correct exchange rate could be identified at a point in
time, the economic situation would soon change, and the level of the pegged exchange rate would no
longer be appropriate. A market-based exchange rate proved to be useful as a "shock absorber,"
helping the economy react to shocks more efficiently than a fixed exchange rate.
The evolution of the world economy and the role of the IMF
In 1971, the Bretton Woods system collapsed. Domestic capital markets in many countries had been
restored and modernized. As well, there was recognition by some major industrialized economies that
the Bretton Woods paradigm wasn't working. But the alternative was not yet clear. Just as central
banks around the world spent much of the 1970s and 1980s searching for a monetary policy anchor,
much time was spent searching for a new framework for the international financial system. By the
1990s, policy-makers-particularly in the OECD countries-started to come around to the idea that a
framework of market-based policies was best both for national economies and for the global economy.
This shift in paradigm, from the distrust of markets to the primacy of markets, set the stage for the rise
of economic globalization.
If we held a new Bretton Woods Conference today, it is clear that delegates would design a different
IMF, because both attitudes and circumstances are fundamentally different than they were at the end
of World War II. International trade flows now constitute a much greater share of most countries' GDP.
The transfers of goods, services, and technology, and the existence of supply chains across national
borders, have brought enormous benefits in terms of growth and efficiency. As well, financial markets
have become vastly larger and deeper-in economists' words, more complete. Private capital flows
are now dominant, dwarfing the size of official flows.
Today, we need an international monetary order that does more than just facilitate trade. We need a
system predicated on the idea that markets-not just for goods and services but also for capital-need
to be free and open. And so let me now go back to my original question: What should the fundamental
role of the IMF be in today's economy? The answer is that the role of the IMF must be to promote a
well-functioning, market-based, international financial
system. By "well-functioning," I mean a financial
system that is both efficient and stable, so that markets can do their job in allocating savings to
investments through the pricing of capital, and in smoothing economic adjustments through
movements in relative prices.
Sixty years after the original Bretton Woods conference, now is the time for policy-makers to agree
once again on the fundamental objective of the IMF. We need to agree that its role should be to
promote a well-functioning, market-based, international financial system. We need to agree that the
IMF should be the forum where we as shareholders collectively develop the appropriate framework-
the rules of the game-to support the international financial system. And we need to agree that the
IMF should be an independent, impartial umpire, ready to call out countries that are breaking the rules
by imposing policies that distort trade flows, or policies that inhibit capital flows unnecessarily.
What does this mean in concrete terms? Before getting into detail, there is a complication that we
need to deal with. We live in a world where all industrialized economies now profess to accept the
market-based paradigm for the international financial system. But today's global economy consists of
more than just the industrialized economies. There are emerging-market countries that are
systemically important. These countries, particularly China, have the clout to influence the entire world
economy. So, in developing the appropriate framework for the international financial system, in setting
out the rules of the game, we need to make sure that everyone is at the table. We also need to
recognize that some emerging-market countries are, and have, just that: markets that are emerging.
And so while the principle of a market-based international financial system should be accepted by all,
we need to recognize that some economies are in transition, and that until their markets fully develop,
the rules of the game need to take this into account. For example, the removal of capital controls
needs to be done with proper sequencing.
An ideal IMF: what would it do?
So, if we were to create the IMF from scratch today, we would want it to have as its ultimate objective
the promotion of a well-functioning, market-based international financial system. But how should we
turn that objective into concrete action? What would this ideal IMF actually do? How would it operate?
And how would that differ from what the IMF does now? I will discuss four related issues here:
surveillance, lending, representation, and governance.
First, let me talk about how surveillance can support a market-based international financial system.
There are several points to be made here.
It is absolutely critical that surveillance take into account the growing interdependence of the global
economy in order to maintain the stability of the international financial system. When policy errors in
one country can lead to a financial crisis halfway around the world, we need to better understand the
linkages between countries. Therefore, the IMF should use its surveillance, not just nationally but
internationally, to identify externalities and potential policy spillovers. This would be invaluable in
helping policy-makers to understand the implications of their actions. I am pleased to see that there
has been progress in this area. Indeed, IMF staff have been working to develop GEM-the Global
Economic Model-that can help to model spillover effects in the global economy. This work is
tremendously valuable in that it provides authorities with a broader, multilateral perspective on their
own policies. Policy-makers can see how their actions affect the global economy and, in turn, how
these global repercussions will be felt back at home. This is a good start. But it is critical that greater
emphasis be placed on this type of work in the future, to help us better identify spillovers.
A few minutes ago, I said that the IMF should be the forum where shareholders gather to collectively
develop the appropriate rules of the game. I also said that it should be an independent, impartial
umpire, ready to call out countries that break the rules. In other words, the IMF should have a
secretariat umpire
function and an function. IMF surveillance can, and must, do a better job of
supporting both of these functions.
Let me start with the so-called umpire role. This is one area where the IMF has consistently fallen
short of the mark. Too often, surveillance has shied away from the "ruthless truth-telling" that
Keynes-one of the main architects of Bretton Woods-called for.4 Instead of making the tough calls
about the rules of the game, the IMF has sat in the umpire's chair and simply asked the players
whether they thought that their shot was in or out. This needs to change. The IMF needs to be able to
make calls impartially about whether countries are playing by market-based rules of the game. This
would help policy-makers sitting around the table to decide what actions should come next. It would
also help the market to apply the appropriate discipline to a country not playing by the rules.
all
Like any good umpire, the IMF should apply the same judgment to players in the global economy.
Much has been said about the way China and other countries continue to operate with a fixed
exchange rate. I have previously argued that while greater exchange rate flexibility would be good for
China, its citizens, and the global economy, the Chinese authorities must be allowed to choose the
exchange rate regime they feel is best for them. But what the authorities should not do is frustrate
market forces by thwarting the adjustment of real exchange rates through sterilization of their foreign
exchange interventions. By "sterilization," I mean offsetting the effect of those interventions on the
domestic money supply. Last month, U.S. Treasury Undersecretary Tim Adams called on the IMF to
put more emphasis on exchange rates in its surveillance activities.5 I certainly agree that the IMF
needs to put greater emphasis on the interdependencies in the system, and exchange rates are
clearly a part of those interdependencies.
But we have also seen examples of industrialized economies choosing to break the rules of the game.
As I said yesterday in New York in the context of global imbalances, we now see examples of
industrialized countries following policies that impede market forces-for example, restrictive labour
policies in Europe. We have also seen unsustainable fiscal policies here in the United States. In
Canada, we still have restrictions on foreign ownership of firms in certain sectors. And recently, we
have seen legislators in the United States and Europe propose new restrictions on foreign investment
flows. Again, the IMF as umpire should not shy away from making tough calls whenever they see the
rules being violated, be it with respect to trade, capital flows, or other policies that distort financial
markets. Making these calls loudly and forcefully could, as I said, help IMF members apply pressure
for policy reform, and could certainly help the market to apply its own pressure, thus maximizing the
chances that welfare-enhancing, market-based policies would be adopted.
In a world where stability can be easily threatened by capital flows, we need to have a better sense of
national balance sheets, a point that Bank of England Governor Mervyn King recently made.6
Surveillance needs to answer questions such as: What is a country's net foreign asset position? How
is it being financed? What are the currency and maturity mismatches? The goal is to better integrate
financial sector surveillance into country reviews so that potential risks are identified earlier. This
would also help the IMF in its secretariat role, allow national authorities to address problems early on,
and give capital markets more information to help them price risk appropriately.
Earlier, I spoke about the need for capital markets in emerging-market economies to fully emerge.
Ultimately, we hope that all countries will develop capital markets and the infrastructure to allow them
access to global private investment flows. But in the transition period, we need to bear in mind that
these markets work imperfectly at best, and are susceptible to overshooting and sudden reversals of
capital flows. The IMF, therefore, has a role to play in furthering financial market development through
its surveillance, through its advice and technical assistance, and through appropriately structured
lending activities. I'll return to this point in a minute.
Let me make one more point about surveillance. We all know that markets work less efficiently, and
can even fail, in the absence of the right policy framework. Markets can fail when they are impeded by
information asymmetries or by a lack of proper transparency. The IMF has an important role here in
helping to support markets so they can work at peak efficiency. The talented staff of the IMF certainly
have a long history of expertise in this area from years of conducting surveillance, and this expertise
should be used to maximum potential. Currently, it is not. The IMF could be a key supplier of an
important public good: reliable information on, and judgment about, the performance of national
economies. In addition, as I said, the IMF has a very important role to play in providing analysis of
spillovers and interdependencies. The IMF has taken a good step in this direction through its Financial
Sector Assessment Program and its Reports on the Observance of Standards and Codes. But it needs
to do more-not to duplicate what markets provide, but to supplement it.
Having discussed surveillance, I will now turn to the second issue, which is lending. In a world where
countries have unprecedented access to international capital flows, and where those who have
borrowed from the IMF are doing everything they can to repay their loans early, some have argued
that an ideal IMF should do no lending whatsoever. I certainly agree that the prime purpose of the IMF
is not to make loans. In particular, long-term lending for development clearly falls outside of its
mandate. Until such time as all countries can develop their own capital markets, it is the World Bank
that should play this role, just as the European Bank for Reconstruction and Development recently
helped many Eastern European countries make the transition to market economies.
However, as I mentioned earlier, a number of emerging markets do not have robust financial systems.
And so there may still be a role for the IMF to maintain stability by providing temporary liquidity in
extreme cases. But this very limited lending must take place only when it can be shown that the
borrower is illiquid but not insolvent. And I would stress that there must be clear rules as to when this
liquidity can be accessed, as well as clear lending limits that are known by all parties in advance.7
In terms of "emergency" lending, it would be far preferable to have the IMF focus on helping countries
avoid problems in the first place, rather than lending funds to help them resolve balance-of-payments
problems. The IMF could best support a market-based international financial system by working with
countries to put mechanisms in place that help resolve problems before they turn into crises. In this
regard, the institution has taken some steps in the right direction by stressing the use of
collectiveaction clauses and encouraging parties to adhere to basic principles during debt restructurings.8
By restricting its lending role, the IMF can make a much greater contribution to a market-based
financial system. Too often in recent years, Fund lending has impeded the very same market-based
adjustments that the IMF should be encouraging. There are three important points to be made here.
First, a lack of clear rules about when the IMF would lend-and in what amounts-has caused
uncertainty and unnecessary delay, thus making the timely and efficient resolution of crises more
difficult. Second, there is nothing inherently wrong with the IMF providing financing which, if it occurred
in the private sector, would be called "debtor in possession" financing. In those circumstances, the IMF
can expect to be treated as a "preferred creditor," standing at the head of the line with respect to
subsequent debt servicing. However, as in the private sector, this should only occur when this action
would preserve or increase the value of outstanding claims. This brings me to my third point. Too often
in the past, assistance was provided to countries that were assumed to be suffering only from
temporary illiquidity, but which later proved to be insolvent. IMF lending in these cases simply added to
an already unsustainable debt burden, placing additional costs on both debtors and creditors. As I said
before, emerging-market economies may occasionally face problems for which timely financial
assistance from the Fund would help. But this lending needs to be clearly delineated and constrained
if it is to do more good than harm. All of this is to say that we need a fundamental review of the IMF's
lending activities. Lending should not be the major focus of the IMF's mandate. Instead, it should play
only a supporting role.
Next, let me talk about representation. For the IMF to successfully promote a well-functioning,
marketbased international financial system, it must be an effective forum, where global economic issues are
discussed and solutions are found.9 The IMF should be the place where national authorities gather
around the table for a frank exchange on policy issues common to all. We need to rekindle the "spirit
of internationalism" seen at Bretton Woods 60 years ago, and also seen at the OECD during the
1960s and 1970s, as that organization did its part to build a liberal economic order and a framework
for freer trade. But it is difficult to build a shared sense of trust and responsibility if key players feel that
they don't have an adequate voice. In this respect, it is clear that the IMF needs to give a larger voice
to China and some other emerging-market economies, as they become more systemically important.
But as my colleague at the Bank of Canada, Deputy Governor Tiff Macklem, said recently, "with a
larger voice comes greater responsibility."10 Membership in the IMF carries with it a responsibility for
supporting the goals of the institution. Members must have a shared understanding of how the
international financial system should function, and of the IMF's role in supporting that system. So it
seems to me that there really is no point for countries to demand, and receive, greater quota and
voting power unless they believe in, and actively support, a market-based international financial
system. It is absolutely true that Asian nations need to have greater quota and voting power to make
the institution more legitimate in their eyes. But this should happen only if it will lead to an increased
willingness among all countries to respect the rules of the game that are developed.
Having discussed surveillance, lending, and representation, the final issue I want to talk about is
governance. Good governance begins with clear objectives. So, after establishing the IMF's
fundamental objectives, the institution must improve its governance structures.
The IMF must ensure that it has clear lines of responsibility internally, and that it is transparent with
respect to the reasons for its decisions. In other words, the IMF needs a governance structure that
helps it achieve its goals and that holds its officials accountable. Currently, decision-making
responsibilities are divided among the Board of Governors, the Executive Board, and the Managing
Director and staff. But in practice, the division of responsibilities among these groups is not always
clearly defined. Accountability is dispersed, and decision making lacks transparency. The IMF would
be more effective if the Executive Board focused on setting strategic direction, and ensured that
policies are sound and that objectives are met, rather than focusing on the day-to-day business of the
institution. The Managing Director would be accountable for the secretariat and surveillance functions
and be responsible for policy implementation. This framework would help to clarify that the
responsibility for policy formulation rests with the Executive Board, and that the responsibility for
implementation rests with the Managing Director. Towards this end, Mervyn King recently suggested
establishing a non-resident Executive Board that meets periodically, rather than almost continuously,
and that focuses on strategic direction and oversight.11 This suggestion certainly merits consideration.
We also need to consider how to enhance the vital role of the IMFC-the International Monetary and
Financial Committee-within the institution. As well, we should think about whether there could be
some useful role for various working committees to deal with specific issues as they arise.
Conclusion
Ladies and gentlemen, let me conclude. I've argued today that there is a role for the IMF in today's
global economy. We need an institution to promote a market-based international financial system that
works efficiently and is stable. This ideal IMF would have a sharper focus and a more international
aspect to its surveillance, with clear rules governing a greatly reduced lending role. It would also be
more representative than the current IMF, and would have an overhauled governance structure.
The prescription I have outlined today may sound radical. But we cannot afford to be put off by the
size of the task. Progress may come only over time, but it does need to happen. The first and most
important step on the path is to have all players in the global economy agree on the fundamental
objective of the IMF. As IMF members gather next month in Washington for the institution's spring
meetings, my great hope is that we will have a real discussion of these fundamental issues.
Let me close by recalling Martin Wolf's column in the Financial Times. Ultimately, Wolf agreed that the
world needs to create a tough and independent IMF. But Wolf said it could not be done. It is up to us
to prove him wrong. It is up to us to show that we do have the courage and the vision to build this
important institution.