The International Monetary Fund (IMF) is an international organization created for the purpose of working with member countries to achieve global macroeconomic stability. The IMF facilitates 186 members (as of June 29, 2009) with ambitions to ‘foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth whilst maintaining steady inflation and reduce poverty around the world’ (International Monetary Fund).
The IMF uses three key processes to ensure correct identification and mitigation to any acknowledged or evolving risks. These include surveillance, lending and technical assistance. Surveillance is used as an observation tool to view how economies are functioning. Lending serves three main purposes; to amend difficulties arising from short term shocks, ability to unlock other financing and a loans issuance service which can help prevent another crisis forming. As one of the IMF’s core activities, technical assistance provides expertise knowledge and practical guidance in many areas, including central banking, monetary and exchange rate policy, tax policy and administration and official statistics.
My study will review the effectiveness of the International Monetary Fund’s stabilisation programs. I will consider a model characterising the effects of seignorage on inflation. This model will be expressed from ‘Development Macroeconomics’ by Agenor, P. and P. Montiel. Using various analysis including model simulations and before-after analysis, I will examine country specific crises’ to evaluate and conclude the role of the IMF towards each country. The Agenor and Montiel model describes how circulating new money leads to the depreciation in value to holders of existing money balances.
The country specific example I will build my study around is the Argentine economic crisis which arose in the 1970’s when seignorage caused hyperinflation whilst considering the most recent crisis in 2001. The IMF’s intervention caused headlines across the globe. Methods of evaluating performance of the IMF and the effectiveness of their policies include answering the following question; did performance improve as a result of the IMF intervention?
THE INFLATION RATE AND SEIGNORAGE
Seignorage is the concept of governments increasing money supply, through the ‘creation’ of money given its worth exceeds the economic cost of producing it. In 1923 Keynes expressed government’s ability to raise finances through “printing paper money” leading to its ability to “live for a long time”. By inflating their currencies, the government can continue to serve public demand. However the ability to create money was always undertaken at a cost to the public; “what is raised by printing notes is just as much taken from the public as is a beer duty or income tax. What the government spends the public pays for. There is no such thing as an uncovered deficit.” (John Maynard Keynes).
Seignorage revenue can be defined as the amount of real resources that can be supplied by the government through means of base money creation. Agenor and Montiel define seignorage revenue as:
Equation (1) defines seignorage in three expressions. The first expression is defined as the change in base money stock divided by the price level. The second expression is defined as the product of the rate of nominal money growth and real money stock or the product of the tax rate and tax base.
The third expression is defined as the sum of the change in real money stock and the ‘inflation tax’. The inflation tax is a proportion of real money stock. The tax acts as a disadvantage to holders of cash due to the effects of seignorage, which is essentially the revenue to the government of printing money.
In a steady state, the change in real money stock remains constant, i.e. a proportional change in nominal money stock is matched with an identical proportional change in the price level. Therefore, in steady state, seignorage revenue is equal to the inflation tax. A disproportionate change in nominal money stock and price, will lead to a change in real money stock if the change in nominal money stock is different to the change in price level, therefore it is likely to affect the private money holdings. Because the additional money generates inflation, it acts as a hidden tax that subtracts value from cash.
Governments have relied on inflation tax as a source of revenue; however Phelps (1973) later realised, that there is a determined optimal level of inflation that would maximise revenue, known as the Laffer curve.
1/a is the optimal inflation rate that will maximise inflation tax. When inflation is equal to zero, the inflation tax is also equal to zero. Using equation 2 and 3, suppose the monetary base is about $1000 billion at steady state, then at an annual inflation rate of 20%, the revenue gained would be a maximum of $200 billion. (Greg Mankiw, Harvard Economist)
‘The consensus among economists that high inflation is often caused by the government’s need to raise seignorage in order to finance high budget deficits’ (Sargent 1982; Dornbusch and Fischer 1986; Van Wijnbergen 1989; Buiter 1990; and Easterly and Schmidt-Hebbel 1994). Looking at the IMF’s role within the global economy, what strategies do they play?
To answer this question, I will use before-after analysis to examine IMF policies that followed after the detrimental effects of seignorage within Argentina. In this case, increases in inflation have been closely linked to government’s attempt to raise seignorage to generate public sector revenues. Argentina has limited access to domestic and foreign credit and therefore has been forced to print money.
Before the intervention of the IMF, we can see that seignorage as a percentage of GDP exceed 3% for the majority of the period. There are two periods of marked increases; both periods saw an increase in inflation (calculated using the Consumer Price Index). Within the 16 year period, inflation peaked at approximately 250% and seignorage exceeded 20% of GDP. Between 1975 and 1990, inflation averaged 325% and hit 5000% in 1989. The problem did not affect only inflation, but started to target other economic indicators. Due to high inflation real wages fell to approximately ‘half of their 1974 peak’ and from the period of 1980 to 1989, income poverty rates increased from 27% to 47%. (Argentina: From Insolvency to Growth. The World Bank Press, 1993.)
In a study by Kiguel and Neumeyer, they looked at the Laffer curve effect with respects to Argentina. They found that at revenue-maximising rate of inflation, the government can get seignorage of about 7.5% of GDP in steady state. As shown in figure 1, the Laffer curve shows, that for inflation rates below 1/a, the inflation tax increases. This mirrors Argentina, as there was a clear positive relationship between inflation and inflation tax for inflation below 18%. To reach maximum level of steady state seignorage, government set an inflation of roughly 20% a month. Increasing inflation above or below 20% does not give the government any additional inflation tax revenue. Revenue falls at an increasing rate after 22%. During the first half of the 1980’s, inflation tax was probably the most important source of revenue for the government, however they concluded that to sufficiently stabilise the economy governments needed a source of revenue to replace the inflation tax. (Report: Inflation and Seignorage in Argentina, Miguel Kiguel and Pablo Andre Neumeyer)
So, how did the IMF respond? In 1991, the IMF introduced Argentina to the Convertibility Regime, and over the following decade, continuously worked closely with Argentina through five successive financial arrangements and in 1990’s, they introduced the Regime as a device to stabilise inflation. The Convertibility Regime was a segment of a larger Convertibility Plan with its main function to promote efficiency and increase productivity.
As part of its exchange rate policy, the Argentine Currency Board pegged the Argentine peso to the US Dollar, between 1991 and 2000, in an attempt to eliminate hyper inflation and stimulate economic growth.
At first there was a debate as to which currency they should peg the peso to. Arguments against pegging to the dollar was that the peso should be pegged to a basket of currencies from the countries that were Argentina’s main trading partners whilst arguments for included the ability to provide greater international credibility and the promise of increased trade with US. The effect of their decision had both positive and negative consequences.
The convertibility regime was initially viewed as a stabilisation device; however authorities lost sense of thought towards long term implications on growth. Once the economy had stabilised, the IMF focused their resources to ensure Argentina did not face a similar crisis. Due to higher relative inflation in Argentina to US, the Argentine currency saw a real appreciation which lead to a current account deficit. However, as inflation fell, this became less of a worry.
As it can be seen from the graph, the convertibility plan was initially successful. Argentina saw a marked improvement in economic performance, as inflation fell from 27% in February 1991 to 2.8% in May 1991. On an annual basis, the inflation rate only fell and remained low from the summer of 1993 onwards. Some board members argued that with a small difference in the interest rates between the US and Argentina, 1996-1997 was the optimal opportunity to leave the peg however this did not make sense politically or economically. The IMF was heavily criticised for failing to persuade authorities of not removing the peg.
The role of the Fiscal Policy played an ever more important role. Due to the restricted use of the monetary policy, the remaining economic tool was the main focus. It was vital that fiscal discipline was maintained as it played a role in increasing confidence with the certainty amongst agents that pesos could always be exchanged for US Dollars at par.
The IMF had several problems with enforcing discipline. In 1999, due to biased political decision making, the increase in public spending led to further problems by restricting the use of expansionary fiscal policy needed to bring Argentina out of recession when it deepened. The IMF was left handicapped, when analytical weaknesses and data limitations restricted accurate decision making and advice. In addition to this, the sustainability of the level of public deficit was overestimated. Lack of professional knowledge and available tools controlled IMF’s ability to make informed decisions, though were criticised for not exploring risks in greater depths. The critical error of the IMF was their weak enforcement of fiscal conditionality; even during periods where growth exceeded expectations, the targets for deficits remained modest. From 1994, every annual target was missed; however the IMF failed to enforce discipline and repeatedly granted waivers.
Several factors were involved behind the crisis that emerged from 1998-2000 including the appreciation of the US Dollar relative to the Euro, which lead to a reduction in international competitiveness. As Argentina turned to the IMF in March 2000, the IMF advised Argentina of two policies including higher taxes which sent Argentina into deeper recession. The IMF were criticised for encouraging higher taxes but not lower spending. The second policy was to devalue the Peso, however trying to make the Peso worthless lead to investors bailing out. Everyone began to raise prices and the economy went into further tailspin. The devaluation had a detrimental impact because 80% of Argentines private and government debt is denominated in US Dollars. A devaluation meant that borrowers pay more Pesos for every Dollar they owe. (www.capmag.com)
In 2000, a total of $22 billion of financial support was provided by the IMF as Argentina continued to struggle and were no longer able to raise finances through voluntary methods. As of 2001, authorities changed the exchange rate system from being pegged to the US Dollar to being pegged equally to an equally weighted basket of the dollar and the euro. Inflation and Unemployment began to deteriorate further with 2002’s monthly inflation peaking in April at 10.4%. In 2005, Argentina began to repay debts to the IMF from their fiscal surplus which they paid on a tight schedule. Argentina has returned to high and steady growth and by 2007, unemployment had been reduced to less than 10%. Inflation hit double figures in 2005 and 2006, which prompted the government to increase tariffs for exporters to stabilise prices.
To conclude my study, I will look at the role of the IMF together with specific objectives in relation to the Argentine crisis, to verify if they have achieved what they claim to do. I will look at how the IMF have applied their resources towards making decisions and suggest improvement in their ability to make correct policy choices effectively. These recommendations are based on evaluations conducted by the Independent Evaluation Office of the International Monetary Fund.
Firstly, as one of the three main roles of the IMF, careful and accurate surveillance of a country is vital. In Argentina’s case, the while the IMF considered pegging the Peso to the Dollar, they failed to realise the risks and problems of how this may conflict with other policies. The IMF also wrongly estimated a sustainable public deficit among developing countries. Converting an exchange rate or reforming a fiscal policy is always a complex task and therefore it is essential that the IMF constantly works closely with countries to help such a shift.
Secondly, the IMF must consider long term implications of their short term objectives. The IMF must use resources available to consider the impacts to each decision whilst considering contingency plans. As the IMF only considered annual fiscal deficits (short term objective) and not on the accumulation of public debt (long term objective), Argentina’s economy was lured into a deeper recession. A recommendation would have been to encourage lower public spending, rather than increase taxation.
Finally, the IMF must improve in their ability to make quick decisions. “Delaying the action required to resolve a crisis can significantly raise its eventual cost, as delayed action inevitably lead to further output loss, additional capital flight and erosion of asset quality in the banking system.” (IEO Report) The IMF had several occasions in which to prevent the crisis of 1999 occurring by simply removing the peg. Failure to react when economic conditions were optimal was strongly influential in leading the economy into tailspin. Though it is not the IMF’s role to undertake specific economic policy decision making, they must be more influential when providing technical assistance.
The IMF received large amounts of condemnation for their role within Argentina. Nestor Kirchner, President of Argentina between 2003 and 2007 was a member of these critics. He said, “An urgent, tough and structural redesign of the IMF is needed, to prevent crisis’s and help in [providing] solutions.” He emphasised the IMF’s need to “change that direction, which took it from being a lender for development to a creditor with demanding privileges”. (http://www.mundoandino.com/Argentina/Argentine-economic-crisis-1999-2002)