The G20 and the International Monetary Fund May Need a Divorce By Brent M.

Eastwood, PhD (2012)

The G20 and the International Monetary Fund (IMF) are now in an informal partnership that may be premature and unwise. The G20 wants the IMF to be its staffing, research, and policy formulation arm. I will explain why this is a bad recipe and how unelected IMF financial technocrats are creating flawed and misleading research and imprudent policy recommendations for the worlds most powerful leaders. As the G20 grows in importance, these unaccountable IMF technocrats are rising in power and G20 policy makers should recognize the downside of this arrangement and correct it quickly. Over the last few years the G20 has become a more powerful entity. Since 1999, it was originally used as a forum exclusively for finance ministers and central bank leaders from 20 of the worlds largest economies; it has now morphed into something different. The financial panic and meltdown of 2008 forced the G20 into a new era. President George W. Bush and French President Nicolas Sarkozy started down a new path in November, 2008, with the advent of the G20 Leaders Summit on Financial Markets and the World Economy, in Washington, DC. All world leaders were invited to this summit and it resulted in cultivating a star chamber of global power. Four other meetings ensued in the following two years with a highlighted summit in Cannes, France in November, 2011. According to authors James Rickards (2011) and David Rothkopf (2008), the G20 maximum power concept came primarily from Treasury Secretary Tim Geithner. Geithner saw the G20 as an example of what the former Federal Reserve Bank governor called a convening power. In other words the G20 could serve as a borderless, collaborative process (Rothkopf, 2008). Geithner saw the G20 as a critical mass of the right players, that could implement his vision of convening power (Rickards 2011). Under this construct, the convening power of the G20 would bring together world leaders, not just financial ministers, from 20 of the worlds largest economies to mitigate financial crises. This convening power would not have to answer to individual countries legislative bodies or bureaucracies and in theory, could work rapidly to achieve consensus on policy options and executive decisions (Rothkopf 2008, Rickards 2011). There was an immediate problem with the G20s convening power arrangement. There wasnt really an existing staff of economists and policy analysts to do all the work that was needed. Someone or some entity was needed to plan the meetings, set the agenda, formulate policy options, communicate with the media, etc. Another thorny issue was the economic policy ace card that Geithner, Federal Reserve chief Ben Bernanke, and other members of the Obama administration wanted to play with the G20.

This policy option was a new idea they called rebalancing (Rickards 2011). Simply put, rebalancing was about sticking it to China and making China lose a currency war that would be won by the U.S. If the rebalancing worked according to plan, the Chinese consumer would quit saving so much and start buying American goods and the U.S. could create jobs by increasing exports to China. This of course would be Chinas loss because the Americans wanted the Chinese government to spend more on its social safety net (healthcare and retirement pensions). Therefore, the average Chinese consumer would have more in his pocket to spend on the new U.S. consumer goods flowing into the country. If the Chinese did not have to worry as much about saving for old age, the thinking went; the Chinese would have more discretionary income for consumption (Rickards 2011). If you know anything about Chinese culture, you would immediately spot the flaw in this reasoning. The average Chinese consumer will not change his spending habits overnight. Hundreds of years of Confucian ideals that encouraged the merits of a simple life meant most Chinese will still cling to the Confucian ideal and wind up saving their money not spending it on conspicuous consumption. And there is no guarantee that they would spend it on American goods anyway (Rickards 2011). This did not stop the Obama administration from trying to double down on U.S. export growth as a part of this rebalancing strategy. They needed the Chinese to devalue the RMB further against the dollar so U.S. goods were cheaper. After more devaluation the Chinese would theoretically start opening up their wallets to buy American brand names with new found robust consumer spending. How would the U.S. make this happen? Heres where the new empowered G20 entered the picture. If the U.S. could get other countries on board with the rebalancing plan, they would have a better chance to get the Chinese to cooperate. The G20 forum could produce allies for the plan and put the Chinese on the defensive. This is also where the International Monetary Fund (IMF) emerged as a partner in a marriage of convenience or shotgun marriage with the G20. The IMF was becoming irrelevant in the decade leading up to the 2008 financial crisis. It needed a new mission with some gainful employment and it needed it fast. Historically the IMF has functioned as an emergency provider for balance of payments, foreign exchange solutions, and as a rapid responder to currency crises in many countries. The IMF had its share of successes and failures in this role. However, as Rickards (2011) explains, in the latter part of the decade beginning in 2006, the IMF was running out of things to do. Sovereign wealth funds were piling up huge foreign currency stores mainly in U.S. Treasuries. Many countries were running a managed float of their currencies and the U.S. was waging currency wars with its quantitative easing policy. The IMF was left in the dust without an obvious role.

IMFs Dominique Strauss-Kahn needed to fill a void in the IMFs core mission and he looked to hitch its star to the G20. It was pretty good timing. The Obama Administration needed help with its rebalancing plan, Geithner wanted to execute his vision of a convening power, and the IMF sought relevancy. And dont forget that Geithner used to work for the IMF. So the marriage between the G20 and IMF was born. The courtship started during the G20 Summit in Pittsburgh, PA in late 2009. The G20 leaders put out a statement after the meeting that included the foundation for the new relationship between the G20 and IMF, Our collective response to the crisis has highlightedthe need for a more legitimate and effective IMF. The Fund must play a critical role in promoting global financial stability and rebalancing growth (Rickards, 2011, pg. 132). Moreover, in a March, 2011, conference in Nanjing, China, Sarkozy claimed, Greater supervision by the IMF appears indispensable (Rickards 2011, pg. 140). Rickards (2011) described the relationship as the IMF serving as the policy referee for the G20, including the G20 using the IMF as an outsourced secretariat, research department, and statistical agency (Rickards, 2011, pg. 132). I will tell you why this policy referee role for the IMF is dangerous and why the IMF needs to go back to the sidelines as an irrelevant observer. I will first examine an IMF report from the last G20 Meeting of Deputies in Mexico City in January of 2012. This report, entitled Global Economic Prospects and Policy Changes, and prepared by staff members of the IMF, draws questionable conclusions and policy recommendations as a result of IMF meddling in the G20. The G20 Mexico City policy paper first calls for deeper fiscal and financial integration across Europe. However, deeper integration is the main problem with the European Union experiment. The countries in the EU have already given up too much of their sovereignty to Brussels. The EU is an idea hatched by technocrats and academics more integration should not be a policy option. If anything, the EU needs less integration. As Margaret Thatcher said at the beginning of the EU, "The EU is the result of plans...a classic utopian project, a monument to the vanity of intellectuals, a program whose inevitable destiny is failure: only the scale of the final damage is in doubt." Then the IMF authors really step in it by calling for more government spending by emerging economies in the G20. Thats right. After Greece, Italy, Ireland, Portugal, and Spain have already gone on an unprecedented spending spree that has wrecked their economies, these IMF technocrats are calling for more government spending by everybody in the G20. The following comment from the report is the most telling and it appears to have been customized for Geithner and Bernankes benefit. Social spending can be increased in economies where inflation is low, public debt not high, and external surpluses are large (e.g. China) (Stavrev 2012, pg. 2). Those are the authors words linking China to this messy policy. And it

clearly shows that IMF technocrats are shilling for the rebalancing that the Obama administration wants. The next paragraph recommends emerging countries invest more in enhanced pension, healthcare, and education systems (Stavrev 2012, pg. 2). Again, more words aimed at China to encourage them to spend more on U.S. imports. And who says this is a good idea anyway? China is a sovereign state that can and will do what it wants. Wishful thinking by IMF technocrats wont change anything in China. The IMF is also giving other emerging economies bad policy advice. They seem to want more cradle-to-grave socialist systems throughout the world. This is the rationale for the same government spending that got the EU in so much trouble. The other problem with the IMFs attempts at policy formation for the G20 is that they take on a western bias in their policy development. I doubt the IMF has many researchers from South Africa, Thailand, Brazil, or other emerging countries outside Washington, DC or Brussels. There is another 2012 IMF report that even won an international award. Good Financial Regulation: Changing the Process is Crucial, oozes big government regulatory statism written by a Duke University academic named Conell Fullenkamp and an IMF economist named Sunil Sharma. These two authors won best paper of the year from the International Centre for Financial Regulation (ICFR) for their efforts. Their paper calls for even more burdensome and damaging regulations. The authors believe that financial regulations are a product that can be subject to a quality control process. They want to re-think the production process that creates new financial regulations (Fullenkamp and Sharma 2012. pg. 2). Good financial regulations, in their words, have three tasks. First they believe all market participants should understand their financial risks and not take on more risks than they can bear. Second, financial regulations should protect the consumer by the abuse of informational advantage and fix the lack of financial literacy in all literacy. Third, they believe that good regulations maintain systemic stability. Let me start by discussing the systemic stability aspect. I actually agree with this assertion. Market clearing mechanisms that are consistent, effective, predictable, and transparent are integral to efficient financial markets. So I concur that there is a real need for systemic stability in financial markets that encourages beneficial international capital flows. But let me take on that first task and disagree with it vehemently. The authors believe that financial regulations determine efficient credit allocation. I am not a strict adherent to the efficient market hypothesis but I do believe that capital should follow the best yield and the best

yield is usually determined by markets not by regulations in a perfect world. I realize that regulatory systems failed miserably in 2008 financial crisis, but regulators should be careful not to overdo it and allow the pendulum to swing too much in favor of over-regulation. Regulations should usually not determine how much risk an institution, business, or individual should take. Risk managers made some deadly mistakes during the subprime mortgage meltdown, but others took measured risk on the other side of the trade by shorting collaterized debt obligations and other derivatives. You cannot have regulations that overly limit the amount of risk or determine appropriate distribution of risk. These types of punitive regulations eliminate market makers, arbitrage, and certain derivatives that help determine market clearing prices and reduce distortion in financial markets. Some derivatives are indeed financial weapons of mass destruction, according to Warren Buffett, although others serve a more beneficial purpose of increasing market efficiency in some cases. Again, the efficient markets hypothesis does have its faults, but some of its underlying theoretical constructs are still relevant today. Consumer protection is in vogue now with the Dodd-Frank reforms and other political meddling. The media cries out for all these financial victims from the 2008 crisis. But that does not mean regulations should be used to limit informational advantages of one party over another in a financial transaction. This is also called abusing asymmetrical information. Let me explain why this type of consumer protection is wrong. For example, if I sell you a stock based on my superior analytical skills, say I use several stock picking criteria including return on capital, book value per share growth, earnings per share growth, cash flow growth, manageable debt, etc., and I sell it to you at its 52-week high, I am using an informational advantage over you. You buy this stock at a high price without any sophisticated stock picking system; instead you buy the stock because the product is cool. Both parties of the trade have maximized their utility, but one party abused the informational advantage because he is an experienced, disciplined, and systematic stock picker. Our doltish buyer of the stock is the so-called victim. Heres my main point. You do not need financial regulation to eliminate these types of trades. Maybe the owner of the cool stock will still have capital gains as the price keeps going up past its 52-week high. The owner of the cool stock still makes money even though he has no informational advantage or prowess at stock picking. Hes just lucky. Why would you want to legislate luck or good fortune out of the trade in the guise of consumer protection in financial transactions? Financial consumers should always have what Milton Friedman called the freedom to choose. Regulations should rarely interfere in these choices. But that is exactly what these authors want to do in the name of protecting consumers. They want to limit your economic liberty and freedom to choose by blocking an inalienable and very important aspect of capitalism and free markets.

Fullenkamp and Sharma (2012) also want to use regulations to teach financial literacy. They never explain how regulations will accomplish this task. Lack of financial literacy is a problem the whole world faces, but no amount of regulation will solve that problem. Fullenkamp and Sharma (2012) would like financial regulators to have more authority and more independence. They think regulators should be paid more and have more prestige. They want regulators to have different types of compensation accounts and claw back arrangements. These schemes are supposed to improve the regulatory product, but their reasoning is suspect and highly optimistic. This leads the authors to call for a new regulatory academy that educates regulators, as if we need to breed and social engineer more irksome technocrats in some academy in Washington, DC or Brussels. It might be better to close down or shrink university programs that educate these unelected regulators in the first place. These are the types of research and reports that come out of the International Monetary Fund. You should immediately see that IMF research can sometimes be capricious, spurious, and misleading. These are not the type of researchers the G20 should depend on. If the G20 really needs a staff to handle policy analysis and formulation, the solution is simple. Each G20 country should get to provide one policy analyst with a few staff assistants. Each policy analyst from each country would get to vote on proposals with a basic up or down vote. The winning proposals make it into the reports and the silly ideas, such as starting regulatory academies, will hopefully get voted down. This is a very democratic, prudent, and fair solution that reduces the influence of unelected IMF financial technocrats. The IMF should not be associated with the G20 in this current form. The G20 and the IMF should get a divorce to allow the IMF to look for a new mission that fits its strengths and fixes its weaknesses. Both entities would then emerge as stronger institutions and would perhaps get a chance to actually solve some real problems. Let those IMF technocrats find a new path toward relevance and let the G20 coordinate and calibrate global economic policy.

Works Cited Fullenkamp, Connel and Sunil Sharma. 2012. Good Financial Regulation: Changing the Process is Crucial. International Centre for Financial Regulation and the Financial Times. February 7, 2012. Rickards, James. 2011. Currency Wars: The Making of the Next Global Crisis. New York: Portfolio/ Penguin and the Penguin Group.

Rothkopf, David. 2008. Superclass: The Global Power Elite and the World They Are Making. New York: Farrar, Straus, and Giroux. Stavrev, Emil, Shaun Roache, Thomas Helbling, and Eric Bank. 2012. Global Economic Prospects and Policy Changes: Meeting of G20 Deputies, January 19-20, 2012 in Mexico City. International Monetary Fund Policy Paper.