Recession, inflation and the international monetary system

W’orldDe~elopnzent, Vol. 9, No. 11/12, Printed in Great Britain.

pp. 1115-1128,

1981.

0305-750X/81/111115-14902.00/0 o 1981 Perpamon Press Ltd.

Recession, Inflation and the International Monetary System ARIEL BUIRA SEIRA*

International Monetary Fund, Washington. D.C. Summary. - The difficult circumstances being faced by the world economy and its uncertain prospects for the 1980s make it necessary to take a new look at the present financial mechanisms and international institutions for monetary cooperation, with a view to adapting them to current needs and to developments in the near future. The industrial countries will have more modest rates of growth than in earlier decades, and this will have significant consequences for the developing countries: (a) stagnation of official development aid flows: (b) possible intensification of protectionist trends; (c) slow growth of producers of raw materials whose export markets will be seriously hmited; (d) gradual shift of world economic and political activity toward oil-producing developing countries and, to a lesser extent, toward the exporters of manufacturers; (e) industrial countries and raw materials producers will become increasingly interdependent; (f) oil-producing and other higher income developing countries will increase their participation in regional economic cooperation and official development aid efforts. Some of the more specific problems which require attention from the international community are inflation and recession; structural disequilibria, recycling and external debt; adjustment process; creation of liquidity and transfer of resources; and participation of the developing countries in the monetary system.

1. INTRODUCTION The difficult circumstances being world economy and its uncertain

faced

by

prospects for the 1980s make it necessary to take a new look at the present financial mechanisms and international institutions for monetary cooperation, with a view to adapting them to current needs and to developments in the near future. This essay briefly outlines the likely course. of the world economy during the decade now beginning and notes the principal aspects of the international monetary system which must be reformed if that system is to fulfil its mission of facilitating the expansion and balanced growth of world trade, and to contribute thereby to the development of the productive resources of all countries and to the promotion and maintenance of high levels of income and employment. the

economic sphere and by political instability, giving rise to serious international tensions. This results from the conjunction of several economic, political and even religious factors. In the economic area, the energy crisis and the growing transfer of wealth from oil-importing to oilexporting countries are aggravating the inflation and stagnation problems already facing the industrial countries, while the political weakness of many governments makes it difficult for them to solve the social conflicts that cause and perpetuate inflation. Internationally, the 1980s are likely to be a decade of retrenchment, in which the industrial nations will try to protect their interests and their way of life; the pursuit of immediate gain will become more widespread, and it will become increasingly difficult to sustain collective efforts. Moreover, the course of events is likely to become increasingly harder to control even for the main industrial countries. International economic forces will influence if not

2. THE INTERNATIONAL ECONOMIC ENVIRONMENT: A DANGEROUS DECADE’ It appears by relative

that the 1980s will be characterized stagnation and disorder in the

* The author is presently an Executive Director at the international Monetary Fund. Responsibility for the opinions expressed in this paper is exclusively his. 1115

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WORLD DEVELOPMENT

determine their foreign policy management and much of their domestic economic and social policy as well. Domestically, the 1980s may be thought of as a decade of weakened social cohesion, greater self-centredness, and lessened sacrifice and tolerance, with the associated risks of confrontation and conflict.

(a) The industrial countries in the 1980s We should recall that during the post-war period the industrial countries experienced unprecedented economic expansion and rapid growth in the volume of world trade. Their economic growth can be attributed to a series of factors, noteworthy among which are the liberalization of trade and international payments, strong and widespread technological progress, expansion of the labour force, and international migration of labour. Also contributing to this period of growth were high rates of capital formation, stability of the supply of raw materials and energy inputs, a slight improvement in the terms of trade for manufactures, and a general climate of confidence arising from the idea that economic knowledge made it possible to eliminate cyclical problems and to maintain high rates of employment and capacity utilization. In recent years, however, a series of mostly structural changes have occurred in the industrial countries, altering their medium-term growth prospects. Among these changes are a slow down in the growth of labour productivity,2 a decrease in the profit rate, an increased natural unemployment rate, increased inflation rates and a loss of confidence in government ability to maintain simultaneously low rates of unemployment and inflation. Several of these economic and social factors combine to produce greater rigidity in national economies, hindering the adjustments made necessary by the changing international division of labour. But the most important change was perhaps the increase in oil prices, which for decades had been kept at low levels. The increase not only had a significant impact on price and income levels in the industrial countries but also discouraged investment and capital utilization, since capital is generally associated with increased energy consumption. In addition, it also rendered obsolete an appreciable portion of energy-intensive industrial plant and technology and much of the existing economic and social infrastructum3 This affected primarily

those countries that had oriented their develop ment toward an economy of high personal consumption based on an ample supply of energy, mineral and other resources at low prices. In such countries, the recent awareness that our planet’s non-renewable physical resources are finite, and that access to them is subject to increasingly narrow limits (political as well as economic), has been accompanied by an environmental conservation movement that imposes restrictions on industry and raises its costs by regulating environmental pollution and underlining the need to preserve a certain measure of ecological equilibrium. As a result of these factors, it seems reasonable to expect that the industrial countries as a whole will have lower average growth rates during this decade than in the past, of the order of only 2 to 3% a year.

(b)

The developing countries

To analyse the prospects for the developing countries, it is necessary to classify them into three groups: (a) oil-exporting countries; (b) manufacturesexporting countries and new industrial countries; (c) raw-materials-exporting countries. As we shall see, the paths of these three groups of countries now tend to diverge appreciably, and many of the common elements that gave these countries a certain homogeneity in the past are being lost. (i) The oil-exporting countries This group of countries is a new actor on the international economic stage. Its emergence as a power centre may be dated arbitrarily from 1973-1974, when the member countries of OPEC, acting together, quadrupled the price of oil, while a majority of them imposed an oil boycott on the United States and the European countries that supported Israel in the Yom Kippur War. As a result of this increase, the current account surplus of the oil-exporting countries rose from 7 billiondollars in 1973 to 70 billion dollars in 1974; it then decreased gradually over the succeeding years to only 5 billion dollars in 1978. Subsequent oil price increases led to a surplus of 68 billion dollars in 1979 and 115 billion dollars in 1980. The wide fluctuations of these countries’ surpluses result in part from the stagnation of their oil export volume, the gradual deterioration of their terms of trade and their rapid absorption of real resources from the rest

RECESSION, INFLATION

AND THE INTERNATIONAL

of the world. Nevertheless, these factors have been offset by the new increases in oil prices; these factors can be expected to continue in effect during the coming years. More recently, the growth in investment income as a result of higher interest rates on accumulated surpluses, strengthen the tendency toward continuing current account surpluses in these countries. The volume of petroleum exports will be determined by international demand, which is expected to grow only slightly over the decade as a result of the slow growth of the industrial economies, the increasing adoption of conservation policies, and the gradual development of other energy sources.4 Having discovered that petroleum in the ground is a better investment than most financial assets, it is reasonable to suppose that the oil countries will uphold a production policy enabling them to extend the life of their oil fields and obtain larger real income in the future. The experience of several of the large oil exporters - with their growing but still limited absorptive capacity arising from the lack of administrative capacity in the public sector and from the constraints imposed on the use of oil revenues by the transportation system and other infrastructural factors - points to the same conclusion. One further argument is provided by the inflationary pressures and social stresses that are often caused by very high rates of expansion of oil exports. Although the absorptive capacity of most of these countries has increased rapidly as their physical infrastructure has been expanded in the course of a few years, the training of their technical and administrative corps has generally been slower, representing a ,less apparent but perhaps more lasting constraint on the efficient absorption of oil export revenues. For these reasons, and also because several of the oilexporting countries have already attended to their most pressing needs to the extent demanded by their political systems and realized the most obvious development projects (subject to the limitations imposed by geography), a half-dozen oil exporters can be expected to accumulate large surpluses during the next decade, increasing their holdings of financial assets despite their high expenditure. This process will lead to a growing concentration of financial power - and in some cases military power as well - in those countries, which will try to obtain an ever-increasing role both in the large international banks and in international financial organizations. In the countries of the Middle East, the resurgence of Islamic fundamentalism and the

MONETARY

SYSTEM

1117

growing awareness that national and Arab interests do not necessarily coincide with those of the superpowers could limit the ability of their governing elites to guide their oil policy in a manner consistent with their close relations with those countries. They will increasingly have to demonstrate some national advantage beyond the mere accumulation of international reserves, which have already reached extremely high levels in some of these countries. The future oil policy that can be deduced from the foregoing is one of conservation, with no substantial increases in output and occasional production cutbacks aimed at maintaining or raising real oil prices. The relationship between the principal oil exporters and the major industrial countries rests on a basic tension arising from the wish for assured, plentiful and lowcost energy supplies on the part of the industrial countries, as opposed to conservation tendencies in the oil-exporting countries. Since neither side would benefit from heightening the risks inherent in this tension, one may expect a compromise around a gradually rising oil price trend congruent with the gradual exhaustion of this energy resource. The exact form this understanding will take cannot be foreseen, but its basic features could well resemble those of the Mexican proposal for a global energy plan designed to provide for an orderly transition from an economy based on hydrocarbons to one based on renewable energy sources. For the surplus oil countries, the loss of value of their financial assets resulting from exchange rate fluctuations and international inflation, coupled with the political risk associated with their investments in other countries, represents a cause for concern. Conany long-term energy agreement sequently, must consider financial aspects which might alleviate this concern, and will therefore have profound implications for the international monetary system. For the world economy, the persistence of significant structural surpluses increasingly concentrated in a group of oil-exporting countries would represent an appreciable deflationary pressure that would be unacceptable to all participants. Hence the need for the recycling to which we shall refer below. (ii) Manufactures-exporting countries and new industrial countries There is an identifiable group of 10 to 12 developing countries which have maintained high rates of capital formation (22-25s of GDP), achieved an intermediate stage of industrialization, and developed a significant export

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capacity in manufactures. These countries include several of the largest, such as Argentina, Brazil, India and Mexico, and some of the smallest ones, such as Hong Kong, Singapore, Israel, South Korea and Taiwan, which have oriented their economies toward foreign trade.5 The structural characteristics of this group of countries enables their exports to increase at rates faster than those of international trade as a whole, so that their relative shares in world trade also increase. These countries export a wide variety of products, ranging from clothing and footwear to steel products, machinery, chemicals, electronic equipment, automobiles, aircraft, and - increasingly - arms and capital goods. In recent years their high rates of economic growth, which exceed those of the world economy, and the protectionist trends prevailing in most industrial countries, have combined to cause large current account deficits, especially in those countries which import a high proportion of their energy requirements. To finance these deficits, these countries have increasingly resorted to the international capital markets, particularly the international commercial banks. This process has in turn entailed growing external indebtedness and a more than proportional increase in the debt service burden, since bank credit generally is granted for shorter terms and at higher interest rates than apply to credit provided by official development financing sources. The manufacturesexporting countries those with the highest incomes in the developing world if one excludes the large oil exporters - could become another dynamic element in the world economy. Although these countries’ productive capacity and more flexible economic structures enable them to adapt better than other developing countries to the changing circumstances of the world economy, and although they have appreciable economic potential, their sustained growth is clearly jeopardized by the stagnation of the industrial economies, the new protectionism and their lack of energy resources, all of which impose a heavy burden on the balances of payments of several of them and will continue to require significant financial inflows from abroad. The high external debt and the debt service levels reached by several of these countries, the restrictions imposed on international banks by the monetary authorities of some of the principal financial centres, and the constraints imposed on these same banks by their low capitalization and by the large amounts they have committed in several of these countries, all suggest that this mechanism - which in the past

made it possible to recycle efficiently the oil surpluses - will not be able to play the same role in the future as it did in the second half of the 1970s. This gives rise to the need to design new financial procedures or mechanisms to channel toward these countries the resources required to sustain their development. (iii) Raw-materials-producing countries This group of countries, which comprises the majority of the developing world, will be faced with a particularly difficult situation in coming years. Their low capital accumulation rates (of the order of lo-IS% of GDP) and the expected slow growth of the industrial economies tend to indicate that they also will perform poorly. The expected weak demand for their principal export products suggests a more or less sustamed deterioration of their terms of trade. The dependence of most African and Asian primary producing countries and several Latin American ones on the industrial countries’ markets is undeniable. When the latter are expanding, the former can attain high rates of growth; but when the industrial countries experience recessions, the developing countries are faced with economic stagnation. It is worth recalling that exports of commodities normally grow more slowly than the output of industrial countries; consequently, slow growth in the latter will significantly limit the development possibilities of exporters of primary products. Most of these countries have high rates of population growth (2 to 3% annually) and, although the rate can be expected to decline in some of them, the levelling off of per capifa income may give rise to increasing social stress and political instability. A few, however, may enjoy strong demand for their exports; this is true especially for producers of some minerals. Others may alleviate this difficult situation by more closely linking their economies - perhaps by means of regional integration agreements with those of the new growth centres of the world economy, namely the oil countries and the new industrial countries. The specific arrangements for linkage with these new dynamic centres will vary; those countries that choose to become linked with oil exporters will tend to specialize in providing services, while those that become more closely tied to the new exporters of manufacturers will concentrate on exporting goods, particularly raw materials. The new analysis suggests that the international economy will experience serious stress and profound changes in the next few years. Industrial countries will have modest rates of growth as several of the factors that enabled

RECESSION. INFLATION AND THE INTERNATIONAL MONETARY SYSTEM them to maintain high rates in earlier decades become exhausted. For developing countries as a whole, the weakening of the industrial economies will have significant consequences, among which are the following: (a) Stagnation of official development aid inflows. (b) Possible intensification of protectionist trends. (c) Slow growth of producers of raw materials, whose export markets will be seriously limited (except in the case of some exporters of minerals). In these countries, the extreme poverty that today characterizes most of Asia and of Africa south of the with the consequent Sahara will persist, political instability and increasing radicalization. (d) A gradual shift of world economic activity toward the oil-producing developing countries and, to a lesser extent, toward the exporters of manufactured goods, which will gain increasing importance in the international economy. In the monetary and financial sphere, these countries will have the largest surpluses, the largest deficits and the largest external indebtedness. This should lead to greater participation by these countries in political and economic decisionmaking and will favour reform of the main financial institutions and of trade and development organizations. (e) The traditional dependence of developing countries on the industrial world will exhibit signs of a turnabout, with industrial countries and raw materials producers becoming increasingly interdependent with exporters of oil and manufactures, which may lead to closer political ties among certain developing countries and the industrial economies. (f) The stresses resulting from the slow growth of the industrial countries and from the stagnation of most of the developing world will be a factor behind increasing instability and political concern, leading the oil countries and some other high-income developing countries to increase their participation in regional economic cooperation and official development aid efforts.

3. INTERNATIONAL MONETARY SYSTEM: TOWARD AN AGENDA FOR REFORM The last 10 years have witnessed worsening of the various monetary

a gradual ailments

1119

that afflicted the system established at Bretton Woods in 1945. The recent changes in the world economy and the tensions that can be foreseen for the next few years make it necessary to reactivate the reform process. Reform is needed to promote the recovery of economic activity at satisfactory rates and contribute to economic growth both in industrial countries and in developing countries. The strong push given to consideration of monetary reform by the Group of 24 is worth noting. Under the chairmanship of Mexico, this group proposed basic ideas for reforming the policies of the International Monetary Fund and the World Bank,‘j together with a programme for immediate action. In the opinion of the Group of 24, developing and developed countries alike share the goal of a viable international monetary system having the following characteristics, among others: (a) An effective, symmetrical and equitable adjustment process consistent with the of high employment and maintenance growth rates and with a dynamic expansion of world trade. (b) A flexible exchange rate system that also promotes an adequate degree of stability (c) Creation of international liquidity through Joint measures consistent with the demands of an expanding world economy and the needs of developing countries, with safeguards to ensure that the volume and distribution of international liquidity are not unduly influenced by the balance-of-payments position of any particular country. (d) Improvement in the net flow of real resources to developing countries as an integral part of the system, with establishment of a linkage between the allocation of special drawing rights and development aid. (e) Increased participation of developing countries in the process of making decisions concerning the international monetary system.’ With this framework in mind, the following may be put forth as some of the principal problems requiring attention from the international community: (a) inflation and recession; (b) structural disequilibria, recycling and external debt; (c) adjustment process; (d) creation of liquidity and transfer of resources; (e) participation of developing countries in the monetary system.

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WORLD DEVELOPMENT (a) Inflation

and recession

The industrial countries have indicated that among the difficulties currently facing the international economy, the fight against inflation must be the primary objective of economic policy.s This priority has been assigned to reducing inflation despite the short-term risks it represents for growth and employment, since it is believed that halting inflation is an essential prerequisite to achieving better investment performance and reattaining a satisfactory growth rate over the longer term. This constitutes a major change in the orientation of the industrial countries’ economic policies. In comparing the new policy with the one adopted in 1974 and 1975 in the wake of the oil price rise, it becomes apparent that there has been no attempt to use fiscal policy to compensate for the expected decline in aggregate demand and economic activity. In contrast to the situation at that time, the industrial countries have now decided that no attempt should be made to soften the impact of oil price increases on their economies; in other words, real income and economic activity must decline, and unemployment rates -- already high in many countries - must rise even further. This policy has had considerable impact on the level of output, although it is expected to have only a modest effect on prices.9 According to OECD estimates, the combined result of oil price increases and the restrictive fiscal policies adopted since 1978 will be to reduce the GNP of its industrial member countries to 6.5% below the level they would otherwise have reached, implying a loss of 550 billion dollars in 1981 alone. The OECD also estimates that unemployment in the industrial countries will rise from its December 1980 level of approximately 23 million to 25.5 million, or 7.5% of those countries’ labour forces in the same period, before possibly levelling off during the first half of 1982. lo These projections rely significantly on the assumption of continuing business confidence and on the usual technical assumption that no change will occur in current policies, prevailing exchange rates, or real oil prices. The use of demand-restricting policies as the only response to the current account deficits arising from oil price increases seems to set aside the awareness gained in 1974 that the rest of the world will inevitably show a deficit vis-rivis the oil-exporting countries, and runs the risk of worsening the deflationary impact of those increases and prolonging the international econ-

omit recession. Such policies are often presented as intended to abate inflationary pressures, but in fact seem to pose the risk of shifting deficits from one country to another. Nevertheless, as pointed out by Professor James Meade as he accepted the Nobel Prize in Economics, it would be hazardous to transform price stability into the goal of demand management so long as increases in import costs exert an upward pressure on prices, as the maintenance of price stability would then require an offsetting decrease in domestic wage costs. And who knows what -levels of pressure and unemployment would be needed to attain this goal?” Several explanations have been proposed for this change-in economic policy priorities on the part of the industrial countries. Various analysts agree that the lessened desire to sustain employment and domestic demand is related to the decline in confidence perceived in those countries in * their government’s ability to manage their economies so as to simultaneously achieve growth, price stability and high employment rates. Another explanation - which has not been put’forth publicly - suggests that the industrial countries feel that recession or slow economic growth suits their interests better than a vigorous increase in output, since the latter alternative would raise the demand for oil and thus might give excessive power to the oilwhile exporting countries also causing appreciable increases in the prices of oil and certain other primary products. It must be acknowledged that traditional policies, whether Keynesian or monetarist, have achieved scant results in the fight against inflation in recent years, or rather, in the struggle against the present combination of inflation and stagnation. Although it is true that the timely adoption of restrictive demand policies may well be effective in the few countries where inflation has not become entrenched (such as Germany and Switzerland), the results of such policies in many other countries are less favourable. Experience suggests that the impact of demand cutbacks on price levels becomes noticeable only after output and employment have declined considerably; in the case of those which have extensive industrial countries unemployment insurance systems, this result cannot occur until unemployment levels have remained extremely high for long enough to weaken the upward pressures on prices. Moreover, a policy of severe demand containment has already been shown to have an adverse impact on investment levels and long-term growth prospects, aggravating the trend toward

RECESSION, INFLATION AND THE INTERNATIONAL MONETARY SYSTEM low productivity growth observed in recent years. Furthermore, policies that concentrate exclusively on restraining demand run the risk - particularly severe in developing countries of becoming politically unsustainable as they give rise to rising unemployment and increasing social pressures, which can force a change in economic policy orientation and cause this costly strategy to be abandoned before its first results are in. It therefore appears that the fight against inflation and. recession requires policies that attack not only the structural problems that limit the growth of the economy’s productive potential, but also excess demand and the psychological problem of inflationary expectations. Changes in expectations are an essential factor in the success of the fight against inflation. A decade of inflationary experience has deeply rooted such expectations, making them an autonomous factor, to such an extent that it is virtually impossible to reduce prices by managing demand policy without cutting output, increasing urnemployment and restricting demand to a much greater degree than would have been necessary at another time. Therefore, unless the power of such expectations can be successfully broken, they will continue to feed price and wage increases, and inflationary pressures will persist. Solutions to the current structural problems of the world economy must be sought in policies that go beyond mere demand management. What is needed is a combination of policy measures that, in addition to preventing excessive demand, will stimulate investment and supply in the various areas where problems can be perceived or anticipated. This suggests a need for promoting the mobility and efficient allocation of production factors, encouraging investment, developing energy conservation policies, and otherwise making it possible for national economies to make the changes required by the transformation of the world economy. In the external sphere, such measures should be accompanied by international cooperation agreements in various fields monetary policy, energy, food, commerce, development - which can help not only to solve substantive problems but also to modify Increased economic policy expectations. coordination among the principal industrial and developing countries in attacking these problems will obviously be more desirable than an essentially deflationary approach and will conto sustaining domestic economic tribute activity and the growth of international trade.

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(b) Structural disequilibria, recycling, and external debt

As mentioned above, the oilexporting countries will continue to have large balance-of-payments surpluses and to accumulate international financial assets, since their limited absorptive capacity will not enable them to use their high incomes domestically. In fact, the increase in the relative price of oil and the surpluses of certain oil-producing countries suggest the problem of the transfer of real resources from developing to exporting countries; that is, they imply that the exporting countries are willing to transfer real resources to the develop ing countries and the latter are willing to accept them. According to the classical theoretical framework, the monetary counterpart of the transfer of resources would be an automatic expansion of demand in the receiving countries and an equivalent reduction of demand in the transferring countries. The process by which this retrenchment is supposed to take place has rarely been explicit, however, except under the gold standard. Under the present monetary system, a country incurring a deficit must cover it in one of three ways: (a) by reducing its international reserves; (b) by borrowing abroad; and (c) by transferring goods and services, i.e. a portion of its current output. Obviously, if such transfers are large and sustamed, a country’s international reserves are likely to be insufficient to cover its indebtedness; this makes it possible only to postpone the problem for a while by shifting the resource transfer burden to a third country. That is, payment will take place only when there is a flow of goods and services from the debtor to the surplus country. But for this to occur the debtor country must release a portion of its output by reducing its consumption or investment level, of which it will be necessary to increase the tax load or restrict credit so as to reduce domestic demand. For the transfer to take place, however, it is also necessary to have a simultaneous increase in the external demand for the goods and services thus made available, which have to be absorbed by either the surplus country or some third country so that the higher external demand will complement the debtor country’s lower domestic demand. Due to the low absorptive capacity of some of the principal oil exporters, the danger arises that they will only be able to take up very gradually the goods and services made available in the importing countries. This implies a risk that external demand will not increase as much

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WORLD DEVELOPMENT

as the decrease in domestic demand in the countries attempting to transfer goods and services outwardly giving rise to a downward multiplier effect. Moreover, it is evident that balance-of-payments deficits can exist only to the extent that countries obtain credit to sustain them. Therefore, it is necessary to internationalize the structural surpluses of the large oil exporters with low capacities through absorptive monetary recycling mechanisms that will channel them toward the deficit countries. In the absence of such mechanisms, the surpluses wilI represent a deflationary factor in the international economy, as well as a potential instability factor in the monetary system, given that they can be shifted among countries and among currencies at great risk to the international economy. Nevertheless, the growing external indebtedness of the non-oil-developing countries limits the capacity of some of them to procure new credit and, in conjunction with the high debt service burden (see Table 1 below), reduces net capital flows to these countries, thereby restricting their import capacity, their development rate, and their share in world trade. As the above suggests, the external indebtedness of the developing countries must be looked upon not as an isolated problem but as a result of the profound changes in the world economy during the last decade. Its increase has been largely a consequence of factors outside the control of these countries, such as the slow growth of their export markets, the growing protectionism in those markets, and the deterioation of their terms of trade resulting from international inflation and oil price increases. By occasioning the appearance of structural surpluses in some countries, these factors necessarily also gave rise to the emergence of deficits in others. Consequently, the problem of external indebtedness must be placed within the framework of the world economic adjustment process. Recognizing it as a problem of the international community, and not simply one of the debtors, would lead us to a re-examination of

the mechanisms for recycling and real resource transfers to developing countries, as well as of the adjustment process itself, with a view to ensuring that they operate in an orderly manner and contribute to the sustained expansion of international trade and to the growth of the world economy. As noted earlier, the growth of the external indebtedness of numerous developing countries suggests that in the future commercial banks wiIl not be able to continue to perform the role of financial intermediary in the recycling process which they have played in the recent past; in other words, they will not be willing to continue indefinitely to expand their credits to deficit countries, particularly the oil-importing developing countries. Consequently, a need arises for designing new financial mechanisms for recycling, or what may be simpler - to expand and modify existing institutions such as the IMF and the World Bank so that they can play a much larger role.12 Because of their integration, these institutions constitute a means of sharing the risk among their member countries - that is, the international community - and have the added of promoting adjustment and advantages channelling resources to a broader range of countries. not just to those with access to international financial markets. As for the World Bank and the regional development financing banks, their low-cost, longer-term credits are more suited for financing the infrastructural investments normally required for structural adjustment. It must be recognized, nevertheless, that very high levels of external financing to deficit countries cannot be sustained indefinitely; that is, an adjustment must be effected to achieve current account _ deficits sustainable over the medium term. Such an adjustment, which implies structural modifications in the economies of oil-importing countries, will require several years, during which external financing flows must remain sufficiently large to prevent these countries from having to adopt policies that would severely and needlessly restrain their growth.

Table 1. Foreign public debt of developing countries (billion US dollars)

Total Debt service Source: IMF. (e) = estimated. (p) = projected.

1975

1978

1979

140 19

255 40

299 51

1980 (e)

1981(p)

3.53 64

418 80

RECESSION, INFLATION AND THE INTERNATIONAL MONETARY SYSTEM (c) Adjustment

process

Traditionally, the primary goal of IMFsupported adjustment programmes has been to correct external disequiiibria, with a secondary objective of reducing inflation. Per Jacobsson, a former IMF Managing Director, used to say that the Fund-supported stabilization (standby) programmes could be reduced to three basic elements: (a) sector (b) supply (c)

balancing the government or public budget ; reducing the growth of the money ; and establishing a realistic exchange rate.

A frequent result ~of such measures has been a strengthening of the balance o.f payments accompanied by a levelling off or decline in production resulting from a reduction in aggregate demand exceeding that needed to permit expansion of the output of export goods. At least in the short term, therefore, a conventional adjustment programme contains a deflationary bias that tends to strengthen the balance of payments at a high cost to economic activity. This suggests the presence of a serious imbalance in the design of such programmes, inasmuch as the absolute priority given to the external sector makes more sense from the point of view of foreign creditors interested in the timely payment of debt service obligations than from that of the authorities of t.he countries that have to implement the programmes, whose economic policy objectives normally are much broader. This suggests that there are differences between the objectives or priorities of the Fund and those of its members’ authorities. Furthermore, this essentially deflationary approach clearly is unsuitable in the present world economic conditions. It would appear that the main conclusion to be derived from a critical review of the Fund’s conditionality is that it should be adaptable to the circumstances of each specific case. The intention of stand-by arrangements is to improve the balance of payments and reduce the rate of inflation in order to attain or reattain a stable growth rate. It must be acknowledged, however, that the disequilibrium between supply and demand can be corrected by (a) reducing aggregate demand (i.e. generally applying deflationary methods), (b) increasing overall supply (i.e. increasing output), or (c) a combination of these approaches. The Fund’s adjustment method today is based primarily on reducing aggregate demand.

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It is put into practice by restricting credit and government expenditure and by imposing an incomes policy, often accompanied by devaluations as a means of reducing the domestic absorption of goods and services. This method may be unobjectionable if the economy is suffering from excess demand, but it is obviously not the best policy in all cases, particularly when there is widespread unemployment. Consequently, it should be asked whether it is generally appropriate to rely above all on restricting demand or whether it might not be advisable in many cases to try to restore equilibrium through a combination of measures designed not only to restrict excess demand but also to give as much importance as possible to encouraging production and investment. The Fund’s policies often overlook the fact that excessively rigid financial stabilization proeconomy’s sources of growth. The first problem is to determine whether a gradual stabilization approach is more effective than a ‘shock treatment’. At least as far as developing countries are concerned, there are very sound arguments for believing that a gradual adjustment process may be much more effective than a programme concentrated in an extremely short period of time. Thus, for example, the devaluation analysis implicit in the Fund’s financial programme incorporates serious deficiencies when applied to a context of underdevelopment, the obligatory frame of reference for most such programmes. The Fund assumes that devaluation leads to an expansion of demand in the importsubstitution and export-production sectors, and that this increased demand is accompanied by a parallel process on the supply side. In this view, the composition of supply will change automatically as factors of production shift among sectors. Devaluation thus has an expansionary impact that helps to mitigate the contractionary effects of a stabilization programme. On the demand side, there is little doubt that a devaluation has a deflationary impact on domestic absorption. A devaluation directly increases the price level of trade goods in terms of domestic currency, thereby deflating the real values of financial assets and nominal factor incomes. So the impact effect of a devaluation on domestic expenditure is clearly negative. As far as the supply side is concerned, the Fund’s view is that a devaluation tends to have a stimulative effect on the productive sector,.since the shift of relative prices in favour of traded goods tends to expand the production of exportables and import-competing goods, thus improving the trade balance. Therefore, the Fund con-

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eludes from this that the net effect of a devaluation on total output is expansionary. This seems to me a questionable conclusion. Without quantification of the opposing effects, the best one can say is that the outcome is indeterminate. Indeed there are also grounds on which a reasonable presumption may be established that the net effect of the devaluation is contractionary, particularly in developing countries. First, there are a number of factors by which a devaluation can induce a contraction in output, thereby giving rise not only to stagnation but also to stagflation in the short run as a result of the upward shift of the aggregate supply schedule. They can be summarized by saying that in the absence of money illusion or when factor incomes are indexed to the general price level, a devaluation might induce stagflation. In today’s inflation-conscious world these are probably the rule rather than the exception. It is necessary to recall that the prices and incomes of all imported inputs and factors of production are fully indexed to the devaluation, thereby contributing to making the absence of money illusion in factor incomes the rule rather than the exception even in the short term. Secondly, the usual Fund analysis of the impact of devaluation on aggregate supply often neglects the consideration of elasticities.13 What happens, for example, if the increase in the price level of traded goods in terms of domestic currency, caused by devaluation, does not lead to an increase in the output of traded goods? In other words, what happens when, as is frequent, the price elasticities of the supply of exportable and import-competing goods is very low in the short run? The results would be that imports would not decline much in the short run in response to a devaluation, given the absence of adequate home-produced substitutes. In fact, imports will decline largely due to declines in income rather than as a result of relative price changes induced by the devaluation. Taking into account that exports of LDCs are often inelastic in the short run, the final impact of devaluation on the balance of trade is uncertain, while it is clear that it can induce contractionary effects on output and employment. The results of a devaluation will, of course, vary with the assumptions made. A positive output effect of the devaluation may result from a smaller rise in factor prices than in commodity prices and assuming the absence of rigidities towards the shift in resources away from the non-traded goods sectors towards the traded-goods sector. While it is clear that there

is a change in the composition of the aggregate output of the economy, whether total output or levels of employment increase is in no way clear. It is therefore necessary to look more closely into this matter so that policy prescriptions may be determined not by preconceptions but by the situation to which the model is intended to apply and by the questions asked about the situation. It would therefore appear that the sequence generally followed - namely, to improve the balance of payments and lower the rate of inflation in order to lay the foundations for achieving or resuming growth - is one possible strategy, but not the only one or necessarily the best one in every case. Many examples from experience demonstrate that one must not simply assume that the measures taken will result in growth and investment. These results have not followed in numerous cases, even though the traditional method takes it for granted that the expected growth will eventually become evident. Experience shows that the traditional strategy commonly gives rise to many problems such as an output decline, regressive redistribution of income, insufficient capital formation, underemployment of labour and underutilization of installed capacity and other forms of waste, none of which is essential for restoring financial balance. Moreover. this approach does not facilitate and often hinders the structural adjustments necessary to adapt the economy to the new relative prices of energy and other goods prevailing. Traditional stabilization programmes do not consider what policies will be needed to maintain economic activity and the growth tate at acceptable levels: in other words, they do not contain explicit analyses of savings and investment levels consistent with the desired objectives, their domestic and external sources, or the policies required to achieve them. Such programmes normally also fail to recognize that when full employment does not exist (the case of most countries that negotiate arrangements with the Fund), income adjusts to monetary demand and factors of production can be shifted more readily in a period of expansion than in a recession. When designing adjustment programmes, the various possibilities available should be considered carefully in order to find the path that minimizes the costs of the adjustment. In most cases this will mean that the objective of growth must be considered on an equal footing with those of controlling inflation and restoring external equilibrium. Any adjustment based on

RECESSION. INFLATION AND THE INTERNATlONAL MONETARY SYSTEM sacrificing production and employment is, and probably will continue to be, questionable to the vast majority of Fund members. In the present circumstances, the process of adjustment of an economy entails structural transformations (particularly in the case of oilimporting countries) and will therefore take several years to accomplish, during which time substantial investments will be required. External financing flows should be maintamed at a volume sufficient to prevent such countries from being forced to adopt policies that would severely and unnecessarily restrain their growth. As a result of the efforts made by the Group of 24, the Executive Board and management of the Fund have accepted some of the ideas on the adjustment process which are discussed here but their implementation is only beginning. There is still far to go along this road. Moreover the Fund’s resources today represent about 4% of the total value of world trade, compared with 12% in the mid-l 960s; they are thus clearly inadequate to make sufficiently high volumes of external financing available to deficit countries to enable them to adjust gradually until they achieve current account deficits that can be sustained in the medium term. A very substantial increase in the Fund’s resources is therefore essential, and should be effected basically by means of increases in members’ quotas. Nevertheless, the Eighth General Review of Quotas, and the redistribution of quotas that is to take place along with it, will not take effect for several years, probably not before 1984. In the meantime, the IMF is obtaining credit from among the principal surplus countries that will enable it to add to its resources. The future importance of the Fun’d and its contribution to the adjustment process and the maintenance of international economic activity will depend, in my view, on the speed of its progress in the direction pointed out here.

(d) Creation of liquidity and transfer of resources Under the present system, international liquidity is created mainly through the external disequilibria of the United States and, to a much smaller extent, of Germany, France and Japan. As a result, year-to-year changes in international liquidity cannot be forecast and are more a reflection of the outcomes of these countries’ economic policies than of the requirements of the world economy. Moreover, it is evident that the benefits of

1125

liquidity creation accrue mainly to the countries that issue reserve currencies and to the United States in particular, since the dollar is by far the major such currency. In 1968, the international economic community agreed to create (through the IMF) the special drawing right (SDR) as one way of supplementing international liquidity and establishing control over its creation. 1976, IMF members Subsequently, in formally agreed by means of the Second Amendment to the Articles of Agreement to make the SDR the principal international reserve asset. In the words of Article VIII, section 7 : Each member undertakes to collaborate with the Fund and with other members in order to ensure that the policies of the member with respect to reserve assets shall be consistent with the objectives of promoting better international surveillance of international liquidity and making the special drawning right the principal reserve. asset in the international monetary system. To this end, the Fund would periodically estimate international liquidity requirements and make decisions concerning the creation of SDRs. The role of the SDR has been limited, however, both by the unattractive characteristics it has been given and by its small share in total international liquidity. As regards its characteristics, the SDR was made subject to a number of restrictions, the principal ones being: (a) Unlike reserve currencies, SDRs can be held only by central banks and other official agencies, which seriously limits their use by the private sector in international commercial transactions. (b) The interest rate paid on the SDR was set far below market rates, making its yield less attractive than those of the principal currencies. (c)The method of valuating the SDR turned out to be extremely complex, having been set in terms of a basket of 16 currencies, and made it impractical and inefficient to effect SDR operations. (d)There was a difference between the valuation basket (16 currencies) and the interest rate basket (5 currencies), making it possible for the SDR interest rate and exchange rate to move independently of one another, inasmuch as - in contrast to the situation for the principal currencies - a weakening of the SDR rate would not necessarily be offset by an increase in the interest rate.

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(e) Countries receiving S3Rs were required to retain a certain proportion of the SDR allocations received in their reserves and to reconstitute their SDR holdings whenever they fell below that level, paying interest for their use. Obviously, characteristics such as these would seriously limit the attractiveness of the SDR and its role as an international currency and reserve asset, to the advantage of those countries that issue the currencies with which the SDR was to have competed. An equally important restriction followed from the small share of the SDR in international liquidity; its proportion of the total ranged from a maximum of 7.8% of international reserves in 1972 to 3.3% of these reserves in 1978. In recent months, however, some of the features that reduce the attractiveness of SDRs have been modified, primarily by adopting the use of a common currency basket for valuation and interest rate purposes and by abolishing the reconstitution requirement. Other characteristics are expected to be changed in the near future. Notwithstanding these modifications, the SDR will not be able to play a significant role in the world economy as long as restrictions on its use by private parties remain in effect and its volume continues to account for such a small share of international liquidity. Regarding future allocations of SDRs, Article XVIII, Section 1, of the Articles of Agreement provides that they shall seek to meet long-term global liquidity needs, so as .to ‘avoid economic stagnation and deflation as well as excess demand and inflation’. Nevertheless, this has been interpreted so as to assign to the SDR a residual role of supplementing international reserve needs that are not covered by the reserve currencies, in view of which it appears that the goal of making the SDR the principal reserve asset will not be achieved.r4 Furthermore, in recent years the supply of international reserves has become increasingly elastic as a result of several factors, including primarily the growing mobility of capital and the adoption of floating exchange rates for the various currencies, which broke the original linkage between the level of international reserves and the money supply of countries. As a result, it is now more difficult than, say, 10 years ago to believe that the money supply of the major countries (which, in the final analysis, are the ones that determine the world inflation rate) can be controlled simply by of international the creation controlling liquidity. It will be difficult to make progress in

the struggle against inflation so long as control over international reserves - and, moreover, a closer linkage between the volume of reserves and the money supply - is not established, or, in other words, so long as a return to a system of fixed but adjustable exchange rates has not taken place. Another important aspect is that of the distribution of the benefits from the creation of international liquidity among the members of community. the international economic According to Article XVIII, Section 2(b), of the Articles of Agreement of the Fund, SDR allocations shall be proportional to the quotas of members at the time they are decided on. Therefore, because of their larger quotas, the industrial countries receive over 60% of each allocation. The developing countries receive only a smaller share. No reasonable argument has ever been submitted showing that this distribution pattern for the benefits of SDR creation is equitable or desirable from the standpoint of the world economy as a whole. On the contrary, there are clear reasons for noting that the international reserve needs of developing countries are larger than those of the more advanced countries; reference might be made to their larger external indebtedness, their greater vulnerability to commodity price fluctuations, the deterioration of their terms of trade, their lower level of reserves, and the limited access of most of them to external credit. For these reasons, and because of the limited flows of official development assistance, the developing countries insist on the establishment of a link between the creation of international liquidity and ‘the transfer of real resources to the developing countries.

(e) Participation of developing countries in the monetary system When the Bretton Woods system was established just after the Second World War, the United States and England, the main actors in the negotiations, assigned themselves 46% of assuring for themselves a total quotas, dominant role in the newly-formed IMF. Other countries assigned significant quotas were the Soviet Union (which subsequently failed to ratify the agreement) with 13.6% of the total; France, with 5.1%; and Canada, with 3.4%. The developing countries were given a very small minority role, the largest quotas being those of China (6.25%) and India (4.5%), while the 18 Latin American countries together accounted for 5.6% of the total. It is worth recalling that

RECESSION, INFLATION

AND THE INTERNATIONAL

most African, Asian and Caribbean countries had yet to become independent at the time. The distribution of quotas is important because it determines each country’s contribution and access to the Fund’s resources, serves as the basis for determining its voting power in decision-making, and sets its participation in SDR distributions. The major changes that have occurred in the world economy in recent years have altered the relative positions of many countries in that economy. Nevertheless, the quotas have been adjusted only to a minor extent as a result of these changes. Although the developing countries currently account for over 85% of IMF members, the Executive Directors representing them exercise only 35% of total voting power and their quotas account for only 37% of the total. The serious imbalance between developed and developing countries that exists in the management and control of the Fund, the World Bank and several other international financial organizations results from the application of the principle that participation in dec’ision-making should be proportional to one’s financial contribution. This principle, which may well be appropriate in the corporate sector of an industrial society, is not as valid in the framework of international economic relations. It must be acknowledged that there must be a certain balance between debtor and creditor countries to keep policies and decisions from being made essentially by a single group. Although the industrial countries have traditionally been exporters of capital and the developing countries have had deficit positions and thus been importers of capital, the emergence of structural surpluses in some oilexporting countries and of significant external deficits in some industrial countries bring new factors into consideration. This new situation suggests that the surplus oil countries should be counted among the traditional creditors and the rest of the developing countries among the debtors, which would yield a different distribution of quotas. Although the developing countries are the principal users of the Fund’s resources, they have only a minor say in making the Fund’s decisions and formulating its adjustment policies; their role in the Fund bears no relation to their number, their financial needs or their capacity to contribute financially to the Fund and play a positive role in it. Consequently, the Fund’s policies are essentially determined by a small group of industrial countries. Evidently these countries cannot be expected to look after the interests of their minority partners,

MONETARY

SYSTEM

1127

the developing countries. But then, who can? Leaving aside the argument of equity and political representativeness, which are consistent with the liberal philosophy of the Fund and the political tradition of the industrial countries, it may be argued that the latter countries’ own interests call for a revision of the decision-making processes with a view to making the IMF more effective. The present international monetary system would enter a crisis should several of the developing countries stop cooperating actively with the industrial countries in its management. It is worth recalling that the principal debtors and the principal surplus countries are developing countries and that interdependence is thus a concrete fact in the international monetary sphere. Another aspect of the developing countries’ Fund that must be participation in the corrected is the low proportion of professionals from such countries in the Fund’s technical staff, especially at the higher levels. Latin American personnel, for example, account for approximately 12% of the Fund’s technical staff. At the higher levels, however, they hold less than 1% of the positions at the division chief level and above, and several of the larger countries are completely unrepresented. The difficult international economic prospects for a world with a greater propensity to economic and political instability, less natural resources, and increasing food and energy costs, suggest the need for greater efforts toward international economic cooperation. To be successful, these efforts will require the full participation of all members of the international economic community, including not only the industrial countries but also the oilexporting countries, the new exporters of manufactures, and the producers of raw materials. It should be obvious that these countries will not bring their full cooperation to such collective efforts unless they feel they have a satisfactory level of participation in formulating policies and making decisions.

4. CONCLUSION This article has pointed out the difficult situation and grim prospects of the international economy. The inflation and recession afflicting the world economy, the requirements of adjustment process in a situation of structural disequilibria, the issues related to recycling and external debt in less developed countries, the process of liquidity creation and the transfer of

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WORLD DEVELOPMENT

resources to less developed countries. as well as their participation in the monetary system, present problems whose soluti.on calls for significant reforms to present arrangements, as well as for a higher degree of international cooperation. Despite the complexity of the problems, this conclusion is clear even to the governments and people of the richest countries, which find themselves far from the most of hunger, health and pressing problems unemployment that afflict most of the developing countries. International cooperation in the monetary field and the broader problem of international economic cooperation in general must be regarded not as an antagonistic relationship between North and South but as an imperative for the various members of the family of man in the search for solutions to the problems that afflict it - solutions that will

benefit not just the developing countries but the entire international community. The spirit in which this task must be approached should be that which guided General Marshall’s proposal of 1947, when he stated that the needs of Europe as regards foodstuffs and other essential products in the following years were so far in excess of its ability to pay that it would undergo extremely serious economic, social and political deterioratio if it did not receive help from outside. One of the major challenges to confront the world in this decade will be that of re-establishing the health of the international economy and restoring the growth and the hope of the developing world. This goal cannot be accomplished without the collaboration of all, and, unless it is accomplished, there can be neither domestic social stability nor peace in the world.

NOTES 1. The ideas presented here derive from the study oi trends in the world economy and analysis of its present situation. Like every projection, these ideas are subject to a wide margin of error. The international economic situation may be affected by factors that cannot be easily foreseen and taken into account. Who could have foretold, in 1970, the extraordinary increase in oil prices with alI the consequences it entailed? 2. E. F. Dennison suggests 17 possible reasons for the slowdown of productivity growth since 1972, concluding that none of them can expiain more than a _ small portion of this occurrence but that the present slow growth is likely to persist throughout the next decade, with ail the implications that wilI have for economic growth, inflation, and social conflict. See Challenge (November-December 1980). 3. See D. W. Jorgenson, ‘The answer is energy’, Chullenge (November-December 1980). 4. See OECD

Economic

Outlook (December 1980).

5. Although strong domestic demand and high inflation rates have minimized the growth of Mexican exports of manufactures in recent years, Mexico’s manufacturing potential continues to grow rapidly and may once again - if the sector is competitive - turn toward the export market. 6. The Intergovernmental Group of 24 on International Monetary Affairs represents developing countries in international economic and financial forums. Mexico’s Secretary of Finance and Public Credit held the chair from April 1979 to April 1980. 7. See ‘Outline for a program of action on international monetary reform’, IMF Survey (15 October 1979), p. 3 19.

8. See, for example, the press communiques of the Interim Committee of the IMF Board of Governors of October 1979 and April and September 1980. 9. ‘Domestically-generated inflation . _. seems likely to vary across countries. By mid-1982 it may be lower . . . in a few, but in most it will probably be somewhat higher’. ‘Overall inflation which, measured by consumption deflators, also takes into account the effect of import prices, would seem likely, by mid-1982, to be more rapid than immediately before the oil-price rise in most countries, perhaps by 1 l/2 percentage points for the OECD area as a whole’. See OECD Economic Outlook (1980), p. 6. 10. See, OECD Economic ber 1980).

Ourlook.

No. 28 (Decem-

11. See James Meade, ‘The meaning of ‘internal balance’, Economic Journal, Vol. 88, No. 351 (Sep tember 1978). p. 429. 12. The Mexican Government put forth a proposal along these lines in 1978. See A. Buira Seira, ‘The world economy, external debt and prospects for development financing’, in World Development, Vol. 7, No. 2 (February 1979). for instance, document Supply-Oriented of the International Monetary Fund, No. SM/81/78 (6 April 1981). 13. See,

Policies

14. It is disappointing that it has not yet been.possible to reach agreement on a new SDR allocation for the Fourth Basic Period which starts in January 1982.