The IMF's Unreasonable External Balance Benchmarks

Methodological flaws encourage persistent imbalances and discourage some reasonable responses by governments to protect their citizens.

The International Monetary Fund’s (IMF) latest External Sector Report has plenty of interesting material, including welcome attention to some suspicious discrepancies in China’s balance of payments that I and others have been highlighting for the past three years. But like its predecessors, it is also marred by some methodological flaws that undermine the entire exercise. The net effect is that the IMF understates the severity of existing imbalances, encourages the buildup of ever-larger imbalances (in both directions), and promotes an unwelcome combination of private borrowing and fiscal rectitude that undermines both financial stability and global demand.

What is the IMF For?

The IMF’s website does not have a clear description of why it exists and how its activities contribute to its mandate.¹ This issue is not just one of web design, as the IMF’s board had a meeting about the lack of clarity last summer. So I will first provide my own thoughts on what the organization is supposed to do, based on the history surrounding its founding. This matters for understanding why it even does External Balance Assessments, and why the current methodology should be improved.

World War I left the main European belligerents saddled with excessive debts and unreasonable exchange rates. The U.K. and France had borrowed extensively from the U.S., as well as from their empires, while Germany owed massive reparations payments. None were able to service their obligations without borrowing even more from abroad, mainly the U.S.

Their difficulties were compounded by their inability to earn enough foreign currency through trade, which was ultimately the fault of the U.S. Federal Reserve’s decision to effectively establish a domestic inflation target in the context of the interwar gold exchange standard. Interest and principal payments to the U.S. denominated in gold should have loosened U.S. financial conditions, thereby boosting U.S. spending on goods and services while also raising U.S. prices. That would have made it easier for Europeans to sell to Americans while also making European goods more competitive in both European markets and third countries.

Instead, the gold—and the associated purchasing power—effectively disappeared in vaults without any commensurate increase in dollars, or was recycled via new loans abroad. Debtors were forced to borrow more and more just to sustain current levels of spending. Something similar also occurred within the U.S. as rising inequality shifted purchasing power towards entities more likely to buy financial assets rather than goods and services. The impact was magnified, in the second half of the 1920s, by the actions of the Banque de France, which had responded to the challenges posed by high debt and the deflationary policies of the U.S. by depreciating the franc to regain competitiveness, sterilizing the resulting inflows by buying pounds and dollars in size, and then eventually converting those fiat claims into gold.

By the end of the 1920s, the global financial system had become increasingly fragile. Losses in one place were quickly transmitted into credit constraints somewhere else, which then led to spending cuts, lower incomes, defaults, further losses, and a downward spiral. While this was exacerbated by policy mistakes, the global rise in indebtedness and the skewed distribution of purchasing power were the big drivers.

The collapse in worldwide spending meant that businesses could only grow—or maintain—their sales by taking market share from competitors. Many governments chose to protect their local companies through tariffs and currency devaluations. The zero-sum approach made the world as a whole worse off, while empowering chauvinists and demagogues. The collapse of the (relatively) open system was not the cause of WWII, but people at the time believe that it was a contributing factor. As Keynes put it in 1936 in the conclusion to his General Theory:

There was no means open to a government whereby to mitigate economic distress at home except through the competitive struggle for markets…if a rich, old country were to neglect the struggle for markets its prosperity would droop and fail.

But if nations can learn to provide themselves with full employment by their domestic policy…there would no longer be a pressing motive why one country need force its wares on another or repulse the offerings of its neighbour, not because this was necessary to enable it to pay for what it wished to purchase, but with the express object of upsetting the equilibrium of payments so as to develop a balance of trade in its own favour.

International trade would cease to be what it is, namely, a desperate expedient to maintain employment at home by forcing sales on foreign markets and restricting purchases, which, if successful, will merely shift the problem of unemployment to the neighbour which is worsted in the struggle, but a willing and unimpeded exchange of goods and services in conditions of mutual advantage.

The challenge is that, under certain conditions, some of the policies countries might use “to provide themselves with full employment by their domestic policy” could encourage capital flight. Unwelcome depreciations in the exchange rate and tighter financial conditions would exacerbate whatever problems were supposed to be solved. In other words, the basic constraints of the pre-WWI gold standard and the 1920s gold exchange standard would return, albeit in a different form. Since local business cycles do not perfectly align in timing and magnitude across countries, something had to be done to make the world safe for Keynesian domestic policies—without returning to the 1930s attempts at autarky.

This was why the allies decided to create the IMF (along with what would become the World Bank) at the Bretton Woods conference in 1944. Keynes was one of the most important representatives at that conference, and while the IMF that was eventually created was different from what he had wanted in several important ways, the purposes of the organization laid out in the first of its Articles of Agreement make a lot more sense in this context.

In that document, the IMF exists to promote “monetary cooperation”, “the expansion and balanced growth of international trade”, “exchange stability”, as well as “the elimination of foreign exchange restrictions which hamper the growth of world trade”. More specifically, the IMF was created to “give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity”. The overarching goal: “shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members”.

In other words, the IMF is supposed to be an international lender of last resort that helps societies suffering from capital flight and/or sudden stops of financing from abroad. When people in a country suddenly lose the ability to pay for foreign goods and services, the IMF is supposed to come in and cover the difference.² At one level, it is supposed to do this because these crises are extremely destructive recurring features of the global economy. But the even more important reason that the IMF is supposed to be a reliable safety net is because efforts by individual societies to protect themselves from balance of payments crises in advance are incredibly harmful when enough countries try them at the same time.

IMF Surveillance and the External Sector Report

Understandably, the IMF’s founders recognized from the beginning that the institution needed to actively monitor what was happening both across individual countries and the global economy as a whole. The best way to avoid making lots of emergency loans is to reduce the risk of crises before they occur. But it was not until the 1970s that the IMF institutionalized any form of macroeconomic surveillance, and when it did, it was only on a country-by-country basis through the Article IV process.

Even then, most of the analysis focused on government borrowing, hence the joke that IMF is an acronym for “It’s Mostly Fiscal”. This was why the IMF missed so badly on the Asian Financial Crisis and the euro crisis, neither of which were preceded by budgetary excesses.³ Embarrassingly, there was no attempt to look at the world as an integrated system until 2012.

The IMF’s 2008 Triennial Surveillance Review warned that its “surveillance did not deliver on its potential to help the authorities understand better their country in the global context” and “that there appears to be a large unmet demand for cross-country analysis informing the policy dialogue”, while “market participants considered that this was among the areas where the Fund’s contribution was the weakest”. That was published on September 2, 2008.

By the time of the 2011 Triennial Surveilance Review, the conclusion was that those issues were now paramount: “the overarching theme of this review is making Fund surveillance as interconnected as the global economy itself”.⁴ One official recommendation was amending the IMF’s Articles of Agreement to establish “obligations that recognize the contributions of all policies to the stability of a member and, globally to the effective operation of the IMS [international monetary system]”.

This was the context in which the first “pilot” External Sector Report was published in 2012. It opened by providing its reason for being:

Global external imbalances (current accounts different from those warranted by fundamentals and desirable policies) add to vulnerabilities by exacerbating domestic booms and busts and amplifying spillovers…global external imbalances have also been accompanied by financial instability and volatile capital flows which has complicated policies for many economies.

While that was a marked improvement from the IMF’s prior work, the report suffered from some serious flaws.