Mervyn King: Reform of the International Monetary Fund
Speech by Mr Mervyn King, Governor of the Bank of England, at the Indian Council for Research on
International Economic Relations (ICRIER), New Delhi, 20 February 2006.
* * *
Sixty years ago delegates from around the world were gathering on Wilmington Island in Savannah,
Georgia, to celebrate the baptism of the Bretton Woods twins, the International Monetary Fund, or,
simply, "the Fund" and the World Bank, "the Bank". India was represented by Sir Chintaman
Deshmukh, Governor of the Reserve Bank of India, and Britain by John Maynard Keynes, Lord
Keynes as he had become. The two men got on well, as can be seen from their official reports on the
Savannah Conference. As Sir Chintaman wrote later:
"this meeting remains memorable mainly as the occasion when the Indian delegation worked in
effortless accord with the British delegation under Lord Keynes and there were many occasions when
there happened to be agreement between us on the need to take some steps which would increase
the utility, independence and creativity of the international bodies".1
In his speech at this first meeting of the Fund, Keynes drew an analogy with the christening-party in
The Sleeping Beauty, which, as Chairman of Covent Garden, he had seen danced at the reopening of
the Garden only two weeks earlier. He hoped that the Bretton Woods twins, Master Fund and Miss
Bank, would receive three gifts from their fairy-godmothers: first, a many-coloured coat "as a perpetual
reminder that they belong to the whole world"; second, a box of vitamins to encourage "energy and a
fearless spirit, which does not shelve and avoid difficult issues, but welcomes them and is determined
to solve them"; third, "a spirit of wisdom ... so that their approach to every problem is absolutely
objective". Keynes warned the delegates that this was asking a great deal: "there is scarcely any
enduringly successful experience yet of an international body which has fulfilled the hopes of its
progenitors". So he hoped that the malicious fairy would not bring its curse upon the twins: "you two
brats shall grow up politicians; your every thought and act shall have an arrière-pensée; everything
you determine shall not be for its own sake or on its own merits but because of something else". And if
the IMF were to become politicised then, Keynes said, it would be best for the twins "to fall into an
eternal slumber, never to waken or be heard of again in the courts and markets of Mankind".2
Sixty years on, the wisdom of Keynes's position at Savannah is clear. In recent years, the critics have
charged that all three of the virtues of universalism, energy and wisdom have been lacking in the IMF.
And if not in a deep slumber, then the Fund has appeared drowsy. It is an institution, it is said, which
has lost its way. What is the truth of these allegations? Certainly, the Fund's remit is unclear. Its
lending activities have waned, and its role in the international monetary system is obscure. The tasks
given to it by the conferences at Bretton Woods in 1944 and Savannah in 1946 need to be adapted to
the financial circumstances of the 21st century. That was attempted in 1976 with the Second
Amendment to the Fund Articles. But 30 years later it is evident that there is still more to do.
We have an opportunity to return to first principles and ask some basic questions. Do we need an
IMF? Is there a role for a multilateral institution in the management of the international monetary
system? If so, what is it? Not before time are those questions now being asked in the corridors, if not
the main floor, of international meetings which rotate endlessly around the world from one windowless
room to another. Belatedly, the G-7 has started to discuss the future role of the Fund, and the IMF has
initiated its own strategic review. Last October, the ministers and governors of the G-20 countries said
that "more work is needed to develop a 'roadmap' for the future strategic reform of the Bretton Woods
institutions". And speeches by several G-7 ministers and governors, and as recently as ten days ago
from the Managing Director himself, show that the debate on the role of the IMF is live. Too often in
the past, as on the fiftieth and sixtieth anniversaries of the Bretton Woods conference, the debate has
simply faded away. But if the mission of the Fund is not examined and the institution revitalised, it
could slip into obscurity. Just as in Savannah, the responsibility for the ideas and impetus for radical
change lies firmly with all the shareholders around the world.
It is encouraging that the Fund and member countries are putting forward concrete proposals for
reform. But unless we consider the fundamental question of what the Fund is for, then any such
suggestions risk being piecemeal and ineffective. That is the issue I want to discuss with you this
afternoon, and I shall try to answer three questions. First, in what way is the world of today different
from that of Bretton Woods? Second, what role, if any, do we want an international monetary
institution to play in today's world? Third, what changes are needed to enable the IMF to play that
role?
What has changed since Bretton Woods?
Following the collapse of the Bretton Woods system in the early 1970s, the IMF came increasingly to
be seen not as the guardian of the international monetary system but as the international lender of last
resort. It hit the headlines as the initiator of large support packages to emerging market economies -
so much so, that until the recent repayment of their loans by Argentina and Brazil, 70% of the Fund's
outstanding lending was accounted for by loans to three countries. In turn, the growth of private capital
flows and the build-up of massive foreign exchange reserves by many Asian economies have made
redundant the idea that the primary function of the Fund is to be an international lender of last resort.
The Asian economies, including Japan, have increased their foreign exchange reserves over the past
fifteen years so rapidly that they are now nearly ten times as large as the combined reserves of the
rest of the G-7. So the Fund urgently needs to ask what its main purpose is.
In 1944, when the Bretton Woods system was created, it was understood that sharp changes in capital
flows were costly. Changes in capital flows can induce changes in trade flows. And to bring about
large changes in trade flows often requires not only a reallocation of resources, which itself can be
costly, but also in some cases sharp falls in national output. The international monetary system was
built around fixed exchange rates and controls on capital movements. Each country met its
international responsibilities by running a balanced current account. When 'imbalances' arose and
countries were depleting or building their official reserves, a key feature of this system was supposed
to be that both the creditor and debtor countries were obliged to adjust their imbalances. In practice,
the obligations on creditor and debtor countries were asymmetric, and in part that explains why the
system proved unsustainable.
One drawback of the system was that it did not allow countries to smooth their expenditure in the face
of fluctuations in their income. The role of the IMF was to facilitate some smoothing, by lending pooled
reserves. Alternatively, changes in exchange rates would be sanctioned by the IMF for those countries
judged to be in "fundamental disequilibrium". In doing this, the IMF fulfilled its purpose to help achieve
orderly world growth. The history of the United Kingdom illustrates these features of the Bretton
Woods system. Britain faced repeated challenges in achieving external balance during the Bretton
Woods era. Sterling was devalued twice and four IMF lending programmes were necessary. Yet in 11
of the 17 years between 1955 and 1971, the UK ran a current account surplus, and its current account
deficit peaked at around a mere 1% of GDP in 1964.
Over time countries realised that restricting their ability to save and invest overseas was a significant
limitation on their wellbeing. Opening up capital accounts broke the link between current income and
current expenditure, and enabled countries both to smooth consumption and to diversify risk.
The openness of capital accounts means that the world today is very different from that of the Bretton
Woods era. Capital flows - both public and private - are very large. And, for many countries, private
capital flows now dwarf official flows. Because domestic demand is no longer constrained by current
national output, a current account deficit does not necessarily indicate any "fundamental
disequilibrium" nor require any official help to finance. For example, New Zealand received the largest
annual disbursement of any industrialised country as a share of GDP during the Bretton Woods era:
1.9% in 1967. That was associated with a current account deficit of 3.7% of GDP. Since 1990, New
Zealand's current account deficit has averaged more than that, but it has had no need of an IMF
programme to finance these deficits. Indeed, the need for official financing for industrialised countries
has become redundant.3
Many of the "imbalances" that reflect private decisions to save and invest are desirable because they
improve the efficiency with which capital is allocated throughout the world. Since it is difficult to
measure "equilibrium" flows of capital from one country to another, it is equally difficult to define
meaningfully "fundamental equilibrium" exchange rates. As Alan Greenspan has pointed out, current
account deficits and surpluses are now the norm rather than the exception.4
Moreover, even if a country is not today running a current account deficit or surplus, past flows of
capital mean that domestic residents have assets and liabilities in a wide range of overseas countries.
Countries now have asset positions quite distinct from their official reserves. The single most important
difference between the old world and today's world is that in the former the financial position of a
country was captured by the size of its current account surplus or deficit; now the financial position is
best measured by the size and composition of its national balance sheet. The ratio of the sum of
overseas assets and liabilities to GDP for major industrialised countries rose from around 70% in 1983
to around 250% in 2003.5
The willingness to hold those assets and liabilities depends on expectations of the economic
"fundamentals" such as productivity growth and demographic change. It also depends on expectations
of future economic policy - both at home and abroad. If any of those expectations change, desired
international investment positions will alter, possibly leading to sharp movements in asset prices and
capital flows. News about economic fundamentals and about economic policy decisions leads to
fluctuations in world inflation, output and employment. To understand the transmission mechanism
requires a study of national balance sheets. They tell us three things.
First, they tell us about the claims of one country on another. That will help to reveal how international
capital flows respond to news. For example, as expectations about productivity growth in the United
States have changed, so have the composition of capital inflows. Equity inflows into the United States
were twice as large as debt inflows in 2000. By 2004, debt flows were nearly four times as large as
equity inflows.
Second, balance sheets contain information about the potential speed of any likely adjustment. That
speed is crucial in determining the intensity of the resulting changes in capital flows and hence, the
costs associated with reallocating resources. For example, currency and maturity mismatches in the
banking sector created the scope for a liquidity run on Korea in 1997.
Third, balance sheets contain information about how changes in relative prices will affect the values of
both assets and liabilities. For example, both Australia and the Philippines were affected by the crises
in Thailand, Indonesia and Korea. Between 1996 and 1998, their exchange rates fell by 20% and 35%
respectively. Both had high ratios of external liabilities to GDP. But whereas a significant proportion of
Australia's obligations were denominated in local rather than foreign currency, the obligations of the
Philippines were largely in the form of foreign currency debt. Australia was able to cut official interest
rates, run a larger current account deficit and grew faster in 1998 than 1997. The Philippines, on the
other hand, could not and went into recession with its current account swinging by 7.5% of GDP, from
deficit in 1997 to surplus in 1998.
These balance sheet linkages have altered the risks we face but they are an inevitable consequence
of the free movement of capital, which has brought with it new opportunities for us all. Any answer to
the question of what role the IMF should nowplay must recognise these balance sheet linkages. The
size and composition of balance sheets is crucial for determining how shocks are transmitted across
national borders. And surprises about economic policy and news about economic fundamentals can,
by generating changes in desired balance sheet positions, have large impacts on capital and
expenditure flows.
Is there a need for an international monetary institution?
In the post-Bretton Woods world, do we need an international financial institution, and what would be
its role? Or has the international capital market replaced the need for such a public institution by
providing both finance to, and discipline on, countries?
National economic policies are - or should be - trying to create stable monetary and fiscal frameworks
to condition expectations of future economic policy. Policy surprises should not add noise to the news
about economic fundamentals. It is in each of our national interests to avoid sudden or large changes
in capital flows induced by volatile or unpredictable changes in economic policy. We want the
monetary and fiscal decisions not only at home, but also in other countries, to be boring.
Although domestic economic policies seem to have become increasingly boring over the past decade
or two, their interaction has not. Consider two, related, examples. First, the rise in the US current
account deficit to more than 6% of national income has raised fears of how the inevitable correction
will eventually be achieved. Second, for much of the past twenty years, as evidenced by the Asian
crisis of the late 1990s, we have worried about emerging market countries accumulating excessive
dollar liabilities. Now we seem to be worried about their accumulating excessive dollar assets.
Capital has flowed "uphill" from poor to rich countries. The invisible hand of international capital
markets has not successfully coordinated monetary and exchange rate policies.
Many countries are no longer the atomistic entities of textbooks whose policy choices have no effect
on global prices: whether an exchange rate, a real interest rate, or the prices of particularly sensitive
commodities such as energy. Rather, the actions of all major countries have sufficient spill-over effects
on other countries that they will then react in turn. The international economic system is better seen as
a "game" in which there are many players of varying sizes, each adopting their own strategy. This has
important implications. A world of atomistic countries requires no assumptions to be made about the
objectives of others. The impersonal prices that we face contain all the information relevant to our own
decisions. But in the international economic "game" it is important to know about the objectives,
strategies - "policy reaction functions" - and policy decisions of other countries. In as much as these
reaction functions are not well understood, the consequences of policy choices may not be reliably
priced by markets. Policy makers, therefore, are more likely to make incompatible choices if they make
decisions independently relying solely on international prices as their guide for the consequences of
their actions.
An international financial institution might, therefore, help in two ways. First, even if countries are not
willing to cooperate in the formal sense that they agree jointly on macroeconomic policies, a forum
which improves knowledge and understanding of other countries' objectives and policy reaction
functions may lead to more compatible policies. Second, such an institution might provide the public
good of a dispassionate and independent analysis of the spill-over effects of one country's policies on
others. Some of the more idealistic aspirations for Bretton Woods - such as the creation of an
international central bank and new currency - were never likely to be adopted and look impossible
absent a world government. But an arbiter of the international monetary system can play a more
limited role - not so much the referee brandishing the yellow and red cards of the football pitch, more
the cricket umpire warning the players not to attack each other verbally and making it clear publicly
when they believe the players are not abiding with the spirit of the game. Invoking the MCC's "spirit of
cricket", when a country knows that a policy such as an exchange rate regime requires modification,
the player should walk. Indeed, the players might in time come to realise that most games benefit
when played according to a clear and agreed set of rules.
So although it is not an international central bank, and the SDR is not a currency, the IMF still has a
role to play. Given that most systemically important countries allow their exchange rates to float, the
Fund cannot have an independent remit for global monetary stability. Hence, the Fund's role should
be to support national policy makers by providing expert analysis about external risks to their domestic
monetary policy objectives. National policies which appear sustainable in terms of countries' own
objectives may interact and, through the resulting balance sheet effects, create risks to those same
countries further ahead. The Fund should be a forum in which countries can discuss these risks. It
should also hold countries to account. In these ways, it can indirectly support global monetary stability.
With countries naturally reluctant to cede any control over their own monetary and fiscal policies, it is
likely that the IMF will have as instruments only the powers of analysis, persuasion, and, in Keynes'
own favourite words, "ruthless truth-telling". That phrase does not conjure up many memories of any of
the many international meetings I have attended. But unless the IMF has the self-confidence to play
that role, its deliberations and statements will carry little weight. The Fund requires an independent,
respected and clear voice.
The Fund should focus its work on the international monetary system around three tasks. First, it
should provide and share information about the balance sheets of all major countries, their
composition and size, and the links between them. The Fund has been in the forefront of the analysis
of balance sheets for emerging market economies, and it needs to extend this approach to its
surveillance of the industrialised world. In conducting this analysis, the Fund must look at countries'
exchange rate choices. But no one price is a sufficient statistic for the effect of one country's policies
on the rest of the world - even one as important as the exchange rate. Balance sheet analysis should
be at the heart of the surveillance process. That analysis should lead to an assessment of the risks to
the world economy as a whole.
The second task is to encourage countries to abide by their commitments to each other by promoting
greater transparency about national policies. In agreeing the Second Amendment of the Fund's
Articles, all member countries made a general commitment to each other to pursue policies consistent
with the objectives of stable global growth and low inflation. Only in relation to exchange rate
arrangements were members asked to specify what framework they would follow to be consistent with
this commitment. As Tim Adams, Under Secretary for International Affairs at the US Treasury, has
noted recently, the nature of those commitments was left unhelpfully vague and should be clarified. In
doing this, we should not lose sight of the fact that the policies of all significant members have
spillover effects and all should be required to be more precise about their policy making frameworks.
Clarity about the objectives of policy of member countries should make it easier for all countries to
formulate their own policy. And by making their national policy frameworks sufficiently transparent,
countries will be making it possible for the IMF to hold them to account and to fulfil its role as an
umpire.
The third task is the provision of a forum for national authorities to discuss risks to the world economy.
To build a common analysis of balance sheet positions and a shared understanding of the implications
of that analysis for the world economy, a trusted, independent and expert secretariat is needed to
facilitate those discussions. Only if countries are willing to share confidences with each other - discuss
their "policy reaction functions" - will international meetings justify their cost.
Those three tasks do not exhaust the responsibilities of an international financial institution. From time
to time, there may well be financial crises when it would be appropriate for the international community
to provide temporary financial assistance to mitigate the costs of sharp adjustment in trade flows and
output. But such a role should not be the principal focus of international monetary co-operation, and,
as I have pointed out, it has not been the role for the IMF vis-a-vis any developed economy for many
years. Moreover, nor is it likely to be true of many important emerging market economies in the future.
As I argued in my K.B. Lall Lecture in 2001, following the Asian crisis of the late 1990s it was likely that
countries might choose to build up large foreign exchange reserves in order to be able to act as a "do
it yourself" lender of last resort in US dollars. It is now clear that this is exactly what many Asian
countries have done. Nevertheless, it is sensible to provide the Fund with the capability to act when
necessary.
How should the IMF be reformed?
The treaty creating the Fund made clear that its founding purpose was "to promote international
monetary co-operation through a permanent institution which provides the machinery for consultation
and collaboration on international monetary problems". In reality, though, the Fund is not playing that
role at present. Its surveillance lacks focus. Its lack of day-to-day independence hampers its ability to
comment effectively on divergences between stated objectives and actual policies at the national level.
And it lacks the legitimacy to be an effective secretariat. Despite strenuous efforts by its Chairman,
Chancellor of the Exchequer Gordon Brown, to promote discussion, there is little genuine interaction
between members of the IMFC (or the Interim Committee as it was) about the international monetary
system.
I welcome the Managing Director's recent statement that he intends to examine Fund surveillance.
One symptom of the Fund's decreasing effectiveness has been the proliferation of "G" groups - the
G -5 that became the G-7, the G-22 that became the G-33 and then the G-20; the G-10; the G-24 and
the G-77. All of these were attempts to create opportunities for serious discussions among countries in
the international monetary system. But as the world economy, and hence the relevant issues, have
changed so it has been necessary to set up new "G" groups. Such groups are perceived as exclusive
and lack legitimacy, and their meetings have increasingly become communiqué-driven events. In
February 2004, the G-7 met in Boca Raton in Florida. A key issue for discussion was the challenge
posed by large current account imbalances and the role of exchange rate adjustment in any unwinding
of the imbalances. As we looked around the table it was obvious that some of the key players, such as
China and India, were not present. Since then a rather informal and ad hoc arrangement has ensured
that the G-7 engages in discussion with a broader group. We need to take a multilateral approach to
the key issues but that does not mean that every country needs a seat at the table to discuss every
issue.
If the Fund is to make this possible, reform is necessary. Realistically, only meetings with a small
number of participants can encourage the level of frankness needed to resolve the challenges in the
international monetary system. All member countries will need to accept that the big players in the
international monetary game must be able to meet at a relatively small table. But the membership of
the top table must change with circumstances - the group of big players is no longer an exclusive
group of rich countries. Low and middle income countries can now affect the global economy. India
and China have to be at the table.
Reducing the size of the IMF Board itself to achieve this aim is likely to be problematic. An enlarged
Board has been one way of providing a platform for smaller and poorer members. One solution could
be to create more flexible groupings within the Fund to discuss particular topics. For example, the
Managing Director's powers to initiate bilateral consultations about the policy choices of individual
members could be expanded to cover multilateral issues discussed by the relevant group of members.
If this does not prove practicable, other mechanisms will need to be found to introduce the requisite
flexibility in how countries come together under the auspices of the Fund.
The institution itself, though, also needs to change. The IMF has the great merit of being a universal
institution. But it needs greater focus, independence and legitimacy. In terms of focus the members of
the Fund, through the IMFC, could usefully restate the Fund's mandate in terms of global economic
and monetary stability. If it is to be able to meet its remit then surveillance should focus at least as
much on balance sheets as on exchange rates. The mandate should make clear both what the IMF is
responsible for and what it is not responsible for.
But producing more focussed surveillance cannot be achieved in isolation from more fundamental
reforms of the Fund. In terms of independence the responsibility for the delivery of a new mandate
should be placed more firmly in the hands of the management of the IMF. At present, the Board
involves itself in every aspect of the Fund's activities. In 2004, for example, the Board met for about
500 hours, an average of over three hours for each of the three days a week on which the Board
normally meets. Board members were given about 70,000 pages of material by IMF staff and
produced another 10,000 or so of their own in written statements and other documents - equivalent to
300 pages of reading for each and every working day. The direct costs of supporting the Board
account for around 10% of the Fund's net administrative budget. And the indirect costs, in terms of
staff time spent writing and reviewing papers, attending and following up meetings and so on, are
much higher.
The Board should step back from much of this expensive micro-management, for example by ceasing
its involvement in the day-to-day reviews of Article IV reports, and concentrating instead on holding
management accountable for the delivery of the mandate. The Independent Evaluation Office,
reporting on the Fund's lending to Argentina, pointed to the difficulty of knowing who was responsible
for those decisions: management, the Board, or the national shareholders. The Fund is an institution
with exceptionally high quality staff which is not best served by its current governance arrangements.
At Savannah, the main issue that divided the Americans and the British was the role of Executive
Directors. Keynes argued that the Fund should be under the control of the Managing Director with
oversight carried out by part-time Executive Directors. The latter should comprise people who help to
formulate the policies of their countries in national capitals, and so could not be full-time in
Washington. The main function of the Executive Directors was not to manage the Fund, but to act as
an essential link between the Managing Director and the national treasuries and central banks from
which they were drawn. In retrospect, Keynes's position seems sound. Given the ease of modern
travel - at least in comparison with 1946 - serious consideration should be given to a non-resident
Board, meeting some six to eight times a year with directors comprising senior finance ministry or
central bank officials.
The process of shifting to a non-resident Board would bring the issue of the division of responsibilities
to the fore. Member countries might conclude, for example, that they wanted to retain control of
decisions to lend under the exceptional access framework. But in other areas, such as surveillance, it
would make sense to delegate responsibility to the Managing Director in the context of a clearly
defined remit. Moves in this direction would need to be accompanied by reforms to strengthen the
accountability of the Managing Director. A first step in this direction would be to instigate regular IEO
assessments on the effectiveness with which the Managing Director and staff had discharged their
surveillance responsibilities.
Finally, in terms of legitimacy, its members must feel that the ownership of the Fund is shared and
that all have a voice. In practical terms, that means reaching a deal on quota shares and seats at the
Board with all regions of the world appropriately represented. Such a deal will be extremely difficult to
reach. Nevertheless shareholders should recognise that the collective benefits of reaching a deal
would justify compromise on each of their parts. But even if an agreement is reached what would be
the purpose if the Fund remained unreformed and the larger questions I have posed today were
unanswered?
Conclusions
The extraordinary changes in global patterns of trade and production, in which India is playing a major
part, have the potential to raise living standards around the world by exploiting the division of labour
which, as Adam Smith told us many years ago, is the foundation of our prosperity. As those real
economic changes unfold, it would be quite extraordinary if the institutions required to sustain and
support that new open trading and financial system were not to adapt. After a decade of discussions
on the "international financial architecture", it might be sensible to pause and ask what we are trying to
build.
The world needs a strong and effective IMF to make us conscious of our responsibilities as members
of the international economic system, and to provide a clear and cogent analysis of the challenges
ahead. In the end, it is ideas that change the way people think and then act.
Those who founded the Bretton Woods institutions did so after a time of crisis, war and economic
disaster. They had the vision to put in place international institutions that might help prevent the
disintegration of the open trading system that they saw as necessary to a revival of economic
prosperity. We have not had to go through a time of economic disaster. We have had the opportunity
to experience an extraordinary flowering of the international trading system, and the entry into that of
the world's two largest populations. The expansion of trade, the rise in the number of qualified people
entering the world's labour force, and the growing realisation that we can all benefit from trade has
raised living standards and provided us with opportunities to reduce poverty around the world. That
should make it easier, not more difficult, to design international institutions to sustain those
developments. We will have only ourselves to blame if we fail to live up to that challenge and simply
allow the IMF to evolve through a series of ever more bland communiqués and meaningless
statements.
Today, I have tried to challenge the thinking behind the slow progress in reforming the IMF. But that
should not be interpreted as any criticism of the extraordinarily talented and committed people who
work for the Fund. On the contrary, the responsibility for reform lies fairly and squarely with the
shareholders - the member countries.
Nor are the issues an arcane exercise in interna