Joseph E. Stiglitz
Columbia University
June 2005

• ENHANCING GLOBAL FINANCIAL
STABILITY
• AND THE FLOW OF FUNDS TO
DEVELOPING COUNTRIES

• FOR ECONOMIC STABILITY
• AND ECONOMIC STABILITY IS
IMPORTANT FOR
– GROWTH
– AND POVERTY ALLEVIATION

• 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

• 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

• 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

• 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

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

• 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

• 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

• 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

• 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

• 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)

• 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

• Essential for global stability
• But it has not been working well—growing dissatisfaction
– Stability
– Equity
– 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

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

• 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

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?

• 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

• 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

• 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

• 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”

• 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

• 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

• 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

• 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

• 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

• 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

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