Joseph E. Stiglitz Columbia University June 2005

1. IMF STRATEGIC REVIEW:Risks for Emerging Market Economies Amid Increasingly Globalized Financial Markets Joseph E. Stiglitz Columbia University June 2005

2. BASIC OBJECTIVE • ENHANCING GLOBAL FINANCIAL STABILITY • AND THE FLOW OF FUNDS TO DEVELOPING COUNTRIES

3. FINANCIAL STABILITY IS OF CRITICAL IMPORTANCE • FOR ECONOMIC STABILITY • AND ECONOMIC STABILITY IS IMPORTANT FOR • GROWTH • AND POVERTY ALLEVIATION

4. PRO GROWTH AND PRO POOR STABILIZATION POLICIES • WE HAVE LEARNED THAT GROWTH DOES NOT NECESSARILY REDUCE POVERTY • TRICKLE DOWN ECONOMICS DOES NOT WORK • SOME POLICIES INTENDED TO PROMOTE GROWTH MAY ACTUALLY INCREASE POVERTY • IMPLICATION: WE HAVE TO HAVE PRO POOR GROWTH POLICIES • SO TOO, WE HAVE TO DESIGN STABILIZATION POLICIES IN WAYS THAT PROMOTE GROWTH AND REDUCE POVERTY

5. RISK, GROWTH, AND POVERTY • LONG BEEN RECOGNIZED THAT ECONOMIC POLICIES SHOULD • REDUCE VOLATILITY (reduce likelihood of crises, “vulnerability) • RESPOND TO CRISES IN WAYS THAT MINIMIZE DEPTH AND DURATION OF DOWNTURNS • ENSURE THAT ADVERSE EFFECTS ON MINIMIZED

6. IMPACT OF POLICIES • BUILT IN STABILIZERS (LIKE WELFARE PROGRAMS) REDUCE VOLATILITY AS WELL AS PROTECTING POOR • SOME POLICIES (CML) EXPOSE COUNTRIES TO MORE RISK AND REDUCE CAPACITY TO RESPOND • And therefore policies may not even accomplish primary objective of improving efficiency of resource allocations and pace of economic growth • SOME REGULATORY FRAMEWORKS (CAR) WHILE THEY REDUCE LIKELIHOOD OF CRISES EX ANTE, CAN INCREASE DEPTH OF DOWNTURN ONCE IT SETS IN • And therefore may not even accomplish original intent of having a sound banking system

7. COUNTERCYCLICAL LENDING CAN REDUCE MAGNITUDE OF FLUCTUATIONS • WELL DESIGNED BANKRUTPCY REGIMES CAN BE AN IMPORTANT PART OF RESPONSE • NEED FOR BETTER WAYS OF RESOLVING SOVEREIGN DEBTS

8. GENERAL POINTS: 1. POLICIES WHICH MAY HAVE BENEFIAL EFFECTS IN REDUCING LIKELIHOOD OF A CRISIS MAY HAVE ADVERSE EFFECTS ON THE CONSEQUENCES OF A CRISIS WHEN THEY OCCUR, POSING COMPLICATED TRADE-OFFS WHICH HAVE TO BE CAREFULLY ASSESSED 2. POLICIES ADOPTED FOR WHATEVER PURPOSE HAVE IMPLICATIONS FOR THE STABILITY OF THE NATIONAL ECONOMY AND THE GLOBAL ECONOMIC SYSTEM • These effects may undermine ability of policies in achieving original objective • Global impacts particularly import in the new era of globalization • And paying attention—and calling attention—to these global impacts is especially the responsibility of the IMF

9. TWO MAJOR GLOBAL PROBLEMS • DEVELOPING COUNTRIES BEAR RISK OF INTEREST RATE AND EXCHANGE RATE FLUCTUATIONS • GLOBAL RESERVE SYSTEM CONTRIBUTE TO MAGNITUDE OF GLOBAL VOLATILITY AND IMPACT OF THIS VOLATILITY ON DEVELOPING COUNTRIES

10. RISK BEARING • IN WELL FUNCTIONING CAPITAL MARKETS, RISK WOULD BE SHIFTED FROM THOSE LESS ABLE TO THOSE MORE ABLE TO BEAR IT • BUT DEVELOPING COUNTRIES STILL BEAR MOST OF THE RISKS OF INTEREST RATE AND EXCHANGE RATE FLUCTUATIONS

11. CONSEQUENCES • THE CONSEQUENCES CAN BE ENORMOUS • THE DEBT CRISIS OF THE 80S • LATIN AMERICAN COUNTRIES BORE THE RISKS OF INTEREST RATE INCREASES • WHEN US RAISED INTEREST RATES TO UNPRECEDENTED LEVEL COUNTRIES THESE COUNTRIES WERE FORCED INTO DEFAULT • LEADING TO THE LOST DECADE OF THE 80S • INTEREST RATE INCREASES OF LATE 90S HAD MUCH TO DO WITH CRISES AND POOR PERFORMANCE

12. SIMILAR PROBLEMS ASSOCIATED WITH EXCHANGE RATE CHANGES • IMPEDES PRUDENTIAL LEVELS OF CAPITAL FLOWS • WITH LESS CAPITAL AND MORE VOLATILITY GROWTH IS LOWERED AND POVERTY INCREASED

13. MAKING MARKETS WORK BETTER • WHAT COULD THE IMF DO TO SHIFT MORE OF THE RISK BURDEN TO THE ADVANCED DEVELOPED COUNTRIES? • IN WAYS THAT DID NOT CREATE “MORAL HAZARD” (WITH EXCHANGE RATE FLUCTUATIONS)

14. REDUCING RISK • AT THE VERY LEAST, MORE OF THE FUNDING FROM IFI’S SHOULD ABSORB MORE OF THE RISK IN THEIR OWN LENDING • COULD BE DONE BY HAVING REPAYMENTS BASED ON BASKETS OF SIMILAR CURRENCIES • ESSENTIALLY ELIMINATING MORAL HAZARD PROBLEM

15. GLOBAL RESERVE SYSTEM • Essential for global stability • But it has not been working well—growing dissatisfaction • Stability • Equity • Deflationary bias

16. Deflationary Bias • Every year, several hundred billion dollars of “purchasing power” are buried in ground • Under gold system, gold buried in ground gave rise to employment—though hardly productive • Previously, profligate governments and lose monetary policies made up for deflationary bias • Now US has played the role of “consumer of last resort” • Offsets deflationary bias • But causes problems of its own

17. Inequity • Allows U.S. to have access to cheap credit • Net transfer from developing countries • Adversely affecting their growth

18. Instability • Reserve currencies need to be good store of value • Which is why inflation has always been viewed so negatively by central bankers • But the credibility of a currency as a reserve currency depends also on exchange rates • For foreign holders of dollars, weakening of the exchange rate is as bad as an increase in inflation • Even true for domestic wealth holders, because of opportunity costs

19. DOLLARS HAVE BEEN USED AS RESERVE CURRENCY • But can the current system continue? • Negative dynamics—as confidence erodes, people move out of currency, weakens currency • Now there are alternatives to dollar • Problem is partly inherent—reserve currency country gets increasingly in debt as others hold its currency; ease of selling debt entices borrowing; but eventually, debt gets so large that credibility is questioned • Is this happening today?

20. Major shift in thinking among central banks • Don’t need dollar as reserves • What matters is value of reserves • Reserves have to be managed like any other portfolio • With due attention to risk • With multiple hard currencies, prudent to hold reserves in multiple currencies • And as dollar appears more risky, to shift out of dollar • This process is already well under way

21. Implications for medium and long run • During transition an extra source of weakness for the dollar—posing problems for Europe • In the long run, increased potential instability, as changes in expectations can lead to more shifting in portfolios

22. The Hot Potato of Global Deficits • Deficits long recognized as contributing to instability • But sum of trade deficits must equal sum of trade surpluses • Surpluses are as much a part of the problem as deficits • But it is in the interests of each country to run surplus—to avoid consequences of crisis • And well managed countries actually succeed in doing so

23. But if there are some countries that persist (prudentially) in having a surplus, the rest of the world must have a deficit • If some country succeeds in eliminating its deficit, the deficit will appear somewhere else in the system (hence the term, deficits as hot potatoes) • The current system “works” because the US has been willing to be “deficit of last resort”

24. But even the United States has a problem in being “the deficit of last resort” • With imports exceeding exports, creates deflationary bias in U.S. • Requires huge fiscal deficits to offset • It is not a solution for there to be a two-reserve currency system • Europe too would then face a deflationary bias • Given its institutional structure, Europe would not be able to respond effectively

25. A Simple Proposal • Annual issue of global greenbacks (SDR’s, bancor) • In amounts equal to amount of additions of reserves • Would not be inflationary—would just undo deflationary bias of current system • Allocation could be done in ways which promote global equity, help finance global public goods

26. A Simple Proposal • Would enhance stability • By eliminating the inherent instability from the reserve currency • And countries would face risk of crisis only if the trade deficit exceeded their Bancor allocation—hence the “hot potato” problem would be reduced

27. Global Reserve System • At the very least, there is a worry that the current global reserve system is not working well, that it is contributing to high level of exchange rate volatility, that this volatility has adverse effects on the global economic system • It is essential for the functioning of the global economic system that the global financial system function well

28. The global financial system and the global reserve system are changing rapidly • But are they changing in ways which will enhance global economic stability? • This should be one of the key questions being addressed by the IMF

29. Concluding Remarks • The developing countries have experienced enormous instability • At great cost to the people in their country • Some of that instability is a result of instabilities in the global financial system • And of the failure of markets to shift risk to those in the developed countries who could bear it better

30. THE IMF NEEDS TO THINK CAREFULLY ABOUT • THE IMPACT OF EACH OF ITS POLICIES ON THE “RISK” PERFORMANCE OF NATIONAL ECONOMIES AND THE GLOBAL ECONOMIC SYSTEM • HOW TO IMPROVE THE RISK PERFORMANCE • AND WHAT ROLE THEY CAN PLAY IN REDUCING THE ADVERSE IMPACTS ON THE DEVELOPING WORLD