Capital Ideas: The IMF and the Rise of Financial Liberalization - Softcover

Chwieroth, Jeffrey M.

Softcover

ISBN 10: 0691142327 ISBN 13: 9780691142326

Publisher: Princeton University Press, 2010

Synopsis

The right of governments to employ capital controls has always been the official orthodoxy of the International Monetary Fund, and the organization's formal rules providing this right have not changed significantly since the IMF was founded in 1945. But informally, among the staff inside the IMF, these controls became heresy in the 1980s and 1990s, prompting critics to accuse the IMF of indiscriminately encouraging the liberalization of controls and precipitating a wave of financial crises in emerging markets in the late 1990s. In Capital Ideas, Jeffrey Chwieroth explores the inner workings of the IMF to understand how its staff's thinking about capital controls changed so radically. In doing so, he also provides an important case study of how international organizations work and evolve.


Drawing on original survey and archival research, extensive interviews, and scholarship from economics, politics, and sociology, Chwieroth traces the evolution of the IMF's approach to capital controls from the 1940s through spring 2009 and the first stages of the subprime credit crisis. He shows that IMF staff vigorously debated the legitimacy of capital controls and that these internal debates eventually changed the organization's behavior--despite the lack of major rule changes. He also shows that the IMF exercised a significant amount of autonomy despite the influence of member states. Normative and behavioral changes in international organizations, Chwieroth concludes, are driven not just by new rules but also by the evolving makeup, beliefs, debates, and strategic agency of their staffs.

About this title

About the Author

Jeffrey M. Chwieroth is senior lecturer in the Department of International Relations at the London School of Economics and Political Science.

From the Back Cover

"Chwieroth gives us an in-depth and fair account of what the staff of the International Monetary Fund came to believe about freedom of capital flows and, more importantly, why the IMF holds those beliefs and how its views have evolved over the past six decades. Capital Ideas will be a valuable source for researchers studying one of the key economic policy issues of our time."--James M. Boughton, author of Silent Revolution: The International Monetary Fund, 1979-1989

"This is a fascinating and important book that every student of the International Monetary Fund should read and absorb. Chwieroth buttresses his argument with impressive interview and archival research and poses a serious challenge to previous scholarship about the liberalization of global finance."--Randall Stone, University of Rochester

"What works so well about Capital Ideas is Jeffrey Chwieroth's commitment to understanding historical change and to the very challenging task of getting inside the 'black box' that is the International Monetary Fund. Chwieroth convincingly knocks down some cherished assumptions about international financial institutions and international organizations more broadly. This is a most interesting book and it is likely to be widely read and become a standard work in the field."--Timothy J. Sinclair, University of Warwick

Excerpt. © Reprinted by permission. All rights reserved.

Capital Ideas

THE IMF AND THE RISE OF FINANCIAL LIBERALIZATIONBy Jeffrey M. Chwieroth

PRINCETON UNIVERSITY PRESS

Copyright © 2010 Princeton University Press
All right reserved.
ISBN: 978-0-691-14232-6

Contents

List of Figures and Tables...................................................................................................ixPreface......................................................................................................................xiList of Abbreviations........................................................................................................xviiChapter One Introduction....................................................................................................1Chapter Two Normative Change from Within....................................................................................23Chapter Three Capital Ideas and Capital Controls............................................................................61Chapter Four Capital Controlled: The Early Postwar Era......................................................................105Chapter Five The Limits and Hollowness of Keynesianism in the 1960s.........................................................121Chapter Six Formal Change and Informal Continuity: The Reform Negotiations of the 1970s.....................................138Chapter Seven Capital Freed: Informal Change from the 1980s to the Mid-1990s................................................147Chapter Eight Capital in Crisis: Financial Turmoil in the Late 1990s........................................................187Chapter Nine Norm Continuity and Organizational Legitimacy from the Asian Crisis to the Subprime Crisis.....................226Epilogue A Subprime "Crisis" for Capital Freedom?...........................................................................255Index........................................................................................................................301

Chapter One

Introduction

Few issues have attracted as much controversy as the removal of controls on international capital flows—a process known as capital account liberalization. The International Monetary Fund has been at the center of this controversy. The formal rules of the IMF provide member states with the right to use capital controls, and these rules have not changed significantly since the organization was founded in 1945. But informally, among many staff within the Fund in the 1980s and 1990s, capital controls, once part of economic orthodoxy, became identified as an economic heresy. Although liberalization was not encouraged indiscriminately, the belief that the free movement of capital was desirable—what I call the norm of capital freedom—became the new orthodoxy.

Critics of the Fund have subsequently charged it with encouraging governments to liberalize their controls prematurely, thereby precipitating the wave of financial instability that swept much of East Asia in 1997–1998 before moving on to Russia and Latin America. Critics also used this wave of financial instability to renew charges that the Fund was promoting "one size fits all" policies that ignored the different circumstances of its member states. Without a careful examination of the evidence, many critics of the Fund have jumped to the conclusion that the IMF staff uniformly advocated capital account liberalization. In examining a critical case of how international organizations (IOs) work and evolve, this book shows that many of these criticisms are unfounded.

While the staff shared a belief that capital freedom was desirable in the abstract long run, they conducted a vigorous internal debate about how to proceed toward this goal. To put it differently, though the staff adopted the norm of capital freedom in the 1980s and 1990s, they disagreed about how this norm should be interpreted and applied. As I discuss more fully below, this finding not only has important empirical implications for critics of the IMF, it also has important theoretical implications for scholars seeking to understand the behavior of IOs. Existing scholarly accounts of IOs, as well as critics of the IMF, devote insufficient attention to the possibility that a norm, once adopted, can be subject to a struggle over its interpretation and application. This book seeks to strengthen our understanding of IOs in general and the IMF in particular by bringing these important battles over norm interpretation and application into sharper focus.

Within the halls of the IMF these debates over norm interpretation and application took the form of a struggle between "gradualists" and supporters of a "big bang." Gradualists emphasized sequencing (i.e., ensuring that certain supporting policies and institutions are in place before additional liberalizing measures are undertaken), while big-bang proponents argued for a rapid move to liberalization. In addition, though both groups generally agreed that controls on capital outflows were inappropriate, gradualists viewed temporary controls on inflows as legitimate in some circumstances, whereas big-bang proponents saw even selective restraints on capital mobility as outside the boundaries of legitimate policy. As a result, though the staff collectively shared a belief in the long-run desirability of liberalization, they often offered conflicting analyses and recommendations on how to proceed toward it.

In the mid-1990s, big-bang proponents gained the upper hand within the Fund, and their informal advocacy of liberalization converged with an initiative to amend the IMF Articles of Agreement to give the Fund the formal mandate to promote liberalization as well as fuller jurisdiction over the capital account policies of its members. In granting the Fund fuller jurisdiction over the capital account, the initiative would have prohibited governments from imposing virtually all types of controls without Fund approval and would have committed governments to liberalizing existing controls. The amendment also would have enabled the IMF, for the first time in its history, to include capital account liberalization as a condition for accessing its financial resources.

In the event, the initiative failed. Proponents of the big-bang approach and the amendment saw their efforts undermined by the financial crises in Asia and beyond. Although the financial crisis that struck Mexico in 1994–1995 had moderated support for the big-bang approach, it was the Asian crisis, which many attributed to "disorderly liberalization" undertaken without regard to sequence, that played a decisive role in discrediting this interpretation and application of the norm of capital freedom. Since the Asian crisis the IMF has been much more cautious in encouraging liberalization, emphasizing sequencing and bestowing greater legitimacy to selective restraints on capital mobility.

Nonetheless, in the decade between the Asian and subprime crises, a period of norm continuity within the Fund, the tacit presumption was that the main risks to financial stability lay with poor fundamentals and institutions within emerging markets, thus placing the onus largely on these countries. Among emerging markets this norm interpretation and application generated much resentment. Emerging markets were encouraged to adjust their policies and implement structural reforms in line with universalist standards and codes that were largely Anglo-American in content, even though emerging markets had little, if any, input into the design of these standards and codes. Within the Fund scant attention was given to "supply-side" regulatory measures aimed at financial market participants based in the financial centers of developed countries; a prescription consistent with an alternative interpretation, often advocated by emerging markets and developing countries, that stresses factors intrinsic to the operation of international capital markets as contributing to financial instability and sees supply-side regulatory measures as intergal to capital account management.

But there are signs that the subprime crisis that erupted in developed countries in summer 2007 is stirring changes within the Fund. Following the partial nationalization of many of their leading financial institutions, developed countries have launched a number of initiatives to reregulate international financial markets. During the subprime crisis the Fund has also come out strongly in favor of regulatory measures aimed at financial market participants in developed countries. However, even though capital inflows played an important part in fueling housing bubbles in the United States and other countries, there has yet to be any significant efforts to overturn the norm of capital freedom.

This book thus explores the inner workings of the IMF to understand the evolution of the staff's approach to capital controls and why it changed so dramatically. In doing so, it offers an important investigation of how IOs operate and change over time. Much of the focus is on intraorganizational processes that gave rise to debates among the Fund's staff over the legitimacy of controls and their liberalization and on how these internal debates shaped the organization's behavior. While not discounting the importance of formal rules and the significant influence of member states, this book shows that the IMF staff exercised significant autonomy in developing their approach. Normative and behavioral changes in IOs, this book demonstrates, are driven not just by new rules or the influence of member states but also by the evolving personnel configurations, beliefs, debates, and strategic agency of their staffs.

Motivation

The IMF's approach to capital account liberalization is not simply a matter of historical interest. Capital account liberalization continues to be an important concern of the IMF, scholars, and the official and private financial communities. The issue remains, as Barry Eichengreen suggests, "an oldy but a goody." Indeed, a recent IMF strategy paper identifies "understanding capital account liberalization" as one of nine vital "responses" to the contemporary "challenge of globalization." Attesting to the ongoing importance of the issue to the Fund, the strategy paper observes: "There is no solid body of analysis on how best to proceed. This is a challenge to which the Fund must rise." In rising to this challenge, the IMF staff continue to strengthen and tailor their advice on liberalization and the use of controls.

Capital account liberalization also remains an important concern of some governments. The European Union (EU) and the United States view liberalization as one of their top policy priorities; with Brussels pushing for it in the context of accession negotiations, and Washington insisting upon it in recent trade agreements with Chile, Singapore, and South Korea, as well as in its ongoing "strategic dialogue" with China. But the EU and U.S. positions have, on occasion, diverged from the IMF's approach, thus revealing important aspects of the political economy of the organization. For instance, in the context of Bulgaria's and Romania's accession negotiations, the IMF recommended the maintenance of selective controls, while EU officials opposed them. Similarly, the United States and the IMF have clashed over the need for China to liberalize its capital account. While the United States, in seeking to intensify pressure on the Chinese currency to appreciate, argues that China should liberalize more rapidly, some IMF staff members claim that China should slow down its liberalization until it strengthens its financial system and achieves greater exchange rate flexibility.

The subprime crisis has also brought renewed attention to the regulation of international capital flows. The recycling of savings and trade surpluses from Asia and oil-exporting countries stirred "capital flow bonanzas" into the United States and other developed countries that generated abundant liquidity and, when channeled through poorly regulated financial systems, housing bubbles of historic proportions. These bonanzas are not unique to the subprime crisis; in fact, both the 1980s debt crisis and the Asian financial crisis were preceded by massive capital inflows and the recycling of trade surpluses that created asset price bubbles that eventually burst. Because the risk-taking behavior of financial market participants cannot be regulated perfectly, a few prominent academic economists have advocated taxes on capital inflows, along with a coordinated agenda to tackle global macroeconomic imbalances, as a way of reducing the size of these bonanzas. Others point to controls on outflows as a means to manage "sudden stop" disruptions in capital flows, such as those faced by many emerging markets when the contagion from the subprime crisis spread from developed economies. Indeed, as a number of emerging markets have turned to restrictions on outflows to manage pressures from the subprime crisis, some prominent observers have suggested we are perhaps witnessing "the return of capital controls."

The subprime crisis has also opened up space for greater consideration of regulatory measures aimed at financial market participants in developed countries. One prominent issue for capital account management has been the procyclicality of regulatory policies and industry practices, which amplify the "boom and bust" cycle in financial markets by contributing to the expansion of lending during economic upturns and the collapse of lending during downturns. The Group of Seven (G-7) leading developed countries, though initially slow to come around to the idea, now solidly supports introducing greater countercyclical tendencies through the development of new principles and regulations. The Group of 20 (G-20) leading developed and emerging economies—which has recently replaced the G-7 as the principal forum for leaders to discuss key issues in the global economy—also has directed regulators and standard setters to develop recommendations to mitigate procyclicality. The procyclicality of regulatory policies and industry practices will likely remain a priority for policymakers for the near future.

Current efforts to reform the IMF are also linked to its approach to capital account liberalization. Much of the resentment felt by emerging market countries toward the Fund stems from critical perceptions of its handling of the Asian financial crisis. Officials from emerging markets blame the Fund not only for pushing countries to liberalize prematurely but also for its general failure in the 1990s to warn of crises that were on the horizon. The Fund's response to the Asian crisis, which placed the burden of adjustment on emerging markets by mandating austerity, deep structural reforms, and the implementation of standards and codes, generated additional criticism and resentment.

This resentment, and the sustained period of global expansion and macroeconomic imbalances from 2002 to 2007, led emerging markets, the Fund's traditional client base, to "self-insure" by paying off early their outstanding IMF loans, and accumulating massive stockpiles of reserves and developing bilateral and regional liquidity arrangements so as to avoid having to borrow from the Fund in the future. Self-insurance, along with the pursuit of export-led growth strategies, helped create the global imbalances that played a role in generating the underlying conditions for today's crisis. Without adequate reforms to restore the faith of emerging markets in the Fund, the risk is that these countries will continue to opt for self-insurance rather than collective insurance, with the result being that the cycle of inflow bonanzas could repeat itself.

Because the IMF's income model depends heavily on interest charges from outstanding loans, the Fund's legitimacy problems created a budgetary crisis for the organization. In response, it has been forced to adjust its own policies, downsizing staff and developing a new income model. The Fund has also begun a comprehensive overhaul of the way it lends money, which has included the introduction of new, more flexible lending instruments. The Fund's member states have also pursued modest governance reforms by agreeing to a slight increase in the relative voting power of emerging markets and developing countries. At the time of writing, these initiatives were pending approval by various national parliaments, with the subprime crisis prompting the G-20 to accelerate the timetable and scope of governance reform.

The Fund's approach to capital account liberalization is not only an important "cause" of current reform efforts, but an important "effect" of such efforts. One of the core lessons of the Asian crisis was that the Fund must develop a broad agenda in monitoring the economies of its member states (what it calls "surveillance") and subjecting its borrowers to conditionality, that is, setting requirements to obtain loans. Yet this lesson cuts against efforts to "streamline" conditionality and against member states' interests in avoiding intrusiveness on the part of the IMF.

If surveillance and conditionality pertaining to choices about social institutions is to be perceived as legitimate and politically acceptable, the organization itself must be seen as legitimate and accountable to those member states where this advice and conditional lending is extended. Thus, as Eichengreen concludes, "The debate over capital account liberalization leads, as all roads seem to do these days, to the need to reform governance and representation in the Fund." If the interests and experiences of emerging markets are genuinely incorporated into the IMF (and other key international forums), then reform of the organization, which aims to strengthen its legitimacy and accountability, could foster among emerging markets a sense that surveillance and conditionality (as well as standards and codes) are legitimate and politically acceptable, which, in turn, could encourage greater compliance. Genuine participation from emerging markets could also translate into changes to how the IMF approaches capital account liberalization by giving greater weight to measures, such as supply-side regulation, that align with the interests and experiences of those countries. Without this participation, emerging markets may turn their back on the IMF and the universalist standards and codes it promotes through the pursuit of self-insurance as well as the development of alternative regionally defined norms of financial governance, a process that Eric Helleiner calls "regulatory decentralization."

The historical and contemporary relevance of these issues suggests that understanding the process of normative change within the Fund deserves close attention. Moreover, understanding how the Fund works and evolves has become increasingly important. As recently as October 2008 the IMF seemed to be slipping towards terminal irrelevance. For several years, the demand for its loans had been in sharp decline, as emerging markets were awash with private capital flows and many of them pursued self-insurance strategies. Even after summer 2007, as the world sank into financial crisis, there was little demand for its resources. But the intensification and spread of the crisis in autumn 2008 has changed all of this.

The IMF is now no longer at the margins of financial governance. It has been thrust back into lending business and faced with calls for it to play a more central role as a global supervisor of financial regulators. The G-20 has also agreed to treble the IMF's financial resources and to strengthen its mandate to develop recommendations and engage in surveillance. In addition, the staff is also currently engaged in a number of high-profile exercises, such as those concerning global macroeconomic imbalances and sovereign wealth funds. These exercises place the staff at the center of efforts to define "exchange rate manipulation" and to identify "best practices" for government-owned investment funds. All of this suggests that the Fund is positioned to play a central role in defining future norms of financial governance, and thus it is incumbent upon scholars to strengthen our understanding of how it approaches this task.

The evolution of the Fund's approach to capital account liberalization also has important theoretical implications for how scholars understand IO behavior and change. Not surprisingly, the Fund's approach to capital account liberalization has attracted much attention from academics and policymakers. In line with a state-centric approach to IOs, the conventional wisdom for some time, exemplified by Jagdish Bhagwati's and Robert Wade's writings on the "Wall Street–Treasury Complex," was that the Fund's approach resulted from its management acceding to pressure from U.S. officials, who in turn were shaped by demands from the private financial community. But this view has been shown to be problematic.

(Continues...)

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Edition details

• Publisher: Princeton University Press
• Publication date: 2010
• Language: English
• ISBN 10: 0691142327
• ISBN 13: 9780691142326
• Binding: Paperback
• Number of pages: 332