Critical Dialogues

Guiding the Global Economy

Photo by Matthew Gilson

By Melissa M. Bernardoni
Published: February 1, 2007

Professor Raghuram Rajan tells dean Edward Snyder about his tenure as chief economist at the International Monetary Fund during its most "revolutionary" period since 1973.


Snyder: Tell us about the inception of the IMF.
Rajan: It was conceived in 1944 by John Maynard Keynes of the United Kingdom with Harry Dexter White, a U.S. Treasury official, to deal with economic problems that emerged during the Great Depression. The problem was "excessive" competition between countries, depressing their exchange rates to try to get a competitive advantage over other countries.Particularly problematic were countries who could not borrow to finance imports, so they had to devalue to export more and get the necessary foreign exchange.When everybody did this, nobody got a competitive advantage and everybody went down together. So the founders thought, "Let's create a fund that lends to countries with balance-of-payment problems (that is, difficulty financing imports) so they don't need to devalue.And let's maintain a system of relatively fixed exchange rates and monitor the process so countries don't sneak an advantage by trying to devalue."

Snyder: How is the IMF funded?
Rajan: Countries put money into the fund that other countries can borrow. Each country has a quota that tells them how much the fund can borrow from them,how much voting power
they have in the fund,and how much they can borrow from it.

Snyder: Was it clear early on that the IMF was successful at eliminating the phenomenon you described, where countries would chase a lower exchange rate without achieving a more favorable balance of trade?
Rajan: Absolutely.The postwar years were characterized by very strong growth worldwide, and the prewar competitive devaluations didn't recur, partly because of the IMF's funding and monitoring. It worked until 1973, when the Bretton Woods system of fixed exchange rates broke down. The imbalances had built up sufficiently that the system could no longer handle it with minor changes in exchange rates. Flexible exchange rates help you deal better with certain kinds of changes that can roil a system with fixed exchange rates. So we went toward a system of floating exchange rates that were allowed to be determined by the market.

Snyder: Were you surprised you were asked to become the IMF's chief economist?
Rajan: Yes, because my specialty is corporate finance. I know what fixed and floating exchange rates are,what lending is, but it is all knowledge acquired during my graduate school days. But the IMF is changing, and this period in its history is as revolutionary as 1973. Then the raison d'être of fixed exchange rates broke down, and now another raison d'être is breaking down: lending to countries. To some extent we abandoned lending-except to the poorest countries-in 2003 to 2005. What should the fund do now? Should it close shop? I think there's a need for it. That's what we've been discovering, and a lot of it is new terrain for the fund, and it's a terrain on which I felt very comfortable.

Snyder: Fill in the blanks: "I wanted to help the IMF move from x toy."
I went in without knowing where the IMF was, so I didn't know the "from." Early on, Argentina and Brazil were still borrowing; there were still countries in trouble. But moving into 2004,the world economy was strong,Asia was building huge reserves, Latin America was running large surpluses and also starting to build reserves.A new paradigm started emerging. We hear about India and China, but many more emerging markets-Mexico, Brazil, Russia-are now of a sufficient size that they need to be brought in to the international dialogue. They used to listen closely to the large countries and the IMF because they were dependent on them for funding. But now, with their reserves, they're less dependent. Old organizations, such as the G7, are becoming less central to the discussion.The international discussion needs to bring together parties who may differ based on the issues-not the same set of seven every time-and an organization that can bring them together. This is where the fund is finding its new métier. It's a universal organization with the membership of the entire world that can bring the right members to the table on an issue-by-issue basis. We call the device by which we bring together these ad-hoc groups a multilateral consultation. Globalization inevitably will bring greater frictions. To deal with increased friction points, we need an organization that can be impartial, identify the problem, and gather the people with some responsibility toward the solution to resolve it. To my mind, that is the primary new goal of the fund.

Snyder: Is the move away from lending a permanent shift? Or is it that these countries can handle their economies now, but lending could return as an important role for the IMF?
Rajan: I think it's temporary in the five- to ten-year sense.We're seeing the reaction to the crises in the 1990s.Because countries got into trouble, many have become a lot more circumspect about investment and how they manage their economies. They've cut fiscal deficits, reduced government spending, and reduced excessive bank lending. Emerging market countries are investing far less, even while not saving much less. The net difference is being invested in reserves. These reserve positions are making them less dependent on foreign financing. This phenomenon will reverse at some point, when investment starts picking up in these countries and when they start consuming more. As a result, eventually, they'll start needing external finance. We're in a very peculiar episode in history now when poor countries are substantially financing the rich ones. Clearly the poor countries have no vulnerabilities at this time because they're net lenders as opposed to creditors, at least on a flow basis.

Snyder: Ten years ago, many people said IMF might lead countries to be more reckless. It's what economists call moral hazard: you provide the backup, and the backup changes the behavior of the countries. The IMF hasn't gone bankrupt, and there aren't indicators of reckless behavior by these emerging countries, so you could say it looks like the IMF did a good job. An alternative explanation is that it's been a good period for overall economic growth and some countries have benefited from that. Do you think the IMF figured out how to lend appropriately without having reckless behavior, or would you say we didn't see a real problem from the backup role because of things more external to the IMF, such as a good run for the world economy and for emerging markets in particular?

Rajan: The truth is somewhere in between. I don't think the moral hazard problem, in the sense that leaders would lend recklessly because the fund would bail them out was ever that strong. Similarly, borrowers were also unlikely to take excessive risk.Many of them lose their jobs in a crisis-I think Argentina had three presidents in the span of a few months. There was tremendous pain in the country soon after the crisis.No politician wants to go through that.Of course, at the margin,backup does create some incentives for misbehavior, but I am not sure it is that big. Where it truly becomes problematic is when in staving off a really bad crisis, the fund removes the urgency to undertake the reforms post-crisis. I think it's after the fact that the pressure gets weakened. By having lended, we've removed the pressure that the markets would otherwise impose on the governments. That is why we have started emphasizing the need for governments to have ownership of the reform process post-crisis, so that they do the right thing even when the pressure is off. Also,we've been talking a lot about how we can keep pressure on governments to do the right thing, even outside of a crisis. Why wait for a country to collapse? Can we apply steady pressure beforehand? Can you give a "Good Housekeeping Seal of Approval" to governments? Tell governments that follow the right policies that we'll back them up with immediate insurance without a ton of conditionality. Tell them, "You've been doing the right thing; if you get into trouble it's due to factors beyond your control, and we know that we don't have to come tell you what to do.You can ask us for advice, but you'll do the right thing." Let's flip moral hazard over and ask: Can we give incentives for good behavior by saying, "The more you do the right things, the more protection you get"? That's a second theme in what the fund is trying to do now.

Snyder: So in terms of what the IMF is moving to, I'm hearing selective actions to address multilateral issues, and being a neutral party aimed at resolving things in a way that's consistent with the IMF's overall mission. And the second component is working with a country to give it incentives to make steps in a positive direction.

Rajan: Absolutely. Then there's a third pillar, which is: for the fund to be able to do these things in a reasonable way, it should be seen as legitimate. It has 184 members, but those members are not equally represented on the fund. Different countries have different quotas. The problem with all these changes in the world economy is that a number of countries have become much bigger but have miniscule quotas. The classic example is China, which is bigger on a [purchasing power parity] basis than every economy in the world except the United States, but until recently had a lower quota than any of the G7.You need to get quotas to be more representative of the economic power because then they will feel this organization represents them legitimately.

Snyder: Hence the idea you raised of allowing countries to earn an IMF "Seal of Approval." That would provide them an incentive to up their quota if, along with the seal, came funding in certain states of the world that would be dependent on the size of that contribution.

Rajan: For sure.The quota would more represent the economic weight better and therefore the need for financing,but it would also give a sense that when decisions are made by the fund, they are legitimate.They are not decisions made by a cabal, controlling the world economy because of its power in 1944. Instead, it would be the current world economy, essentially, sitting at the table, making these decisions.

Snyder: On this issue of quota sizes and a country's relative size, if you were to just take a very simple construct, and say, on a scale of 1 to 10, 1 means this is very out of whack, to 10, this makes sense, where is the situation today?

Rajan: I'd say 6 or 7. It's reasonable, but there are some significant aberrations that need to be corrected.The problem is that if we don't correct those aberrations, like the example of China I just gave you, it looks totally crazy. Furthermore, there is a sense in which a democratic deficit also has to be remedied. The vote in the fund is based on economic power, but there's also a vote just for being a member. So there are two bits to it. We're trying to up the worth for the members so the democratic deficit is alleviated, so to speak, even while we realign the economic weighted component as well, so that decisions make sense from the perspective of the larger economy.Why not go all the way towards one country–one vote?It doesn't make sense for the largest economy in the world-the United States-to have as much of a vote as, say, an island in the Pacific, because their import to the world economy is very different. So if you weight voting power partly by how much a country means to the world economy, you can get decisions that make some sense. I think there will always be a combination, but the IMF is trying to become more democratic-for example, trying to let the poorer countries in Africa have more of a say.

Snyder: Are you getting progress on quota sizes?

Rajan:We made a major improvement in Singapore in the fall, when the governors voted to increase the quotas for four grossly under-represented countries, including China. It's a step in the right direction with the aim of changing the quotas significantly more over time. This is an issue not just for the IMF-it pervades all our international organizations. There's been debate about the UN,for example-why isn't Japan in the Security Council on a permanent basis, let alone having a veto, or isn't in the Security Council on a permanent basis? Or take the Organization for Economic Cooperation and Development (OECD), for example- what's its composition? If it's truly an economic organization, how can it discuss economics without China present? The problem is that this rapid, relative growth of the emerging markets has created a change in actual economic power around the world, translating eventually into military power and so on. International organizations need to accommodate that change. It's very difficult because you can't just make organizations bigger-that makes them less relevant sometimes.You can't shrink them-nobody who's a member of the club wants to leave and give their place to someone else. So how do you get the right groupings to discuss the right problems?

Snyder: Let's shift to the future. I think it may get harder to measure the IMF's impact. People used to say, "Thank God the IMF stepped in and solved this crisis." It seems that the value of the IMF will be manifest in ways that won't be crises as much as holistic, global improvement. How will the IMF and people who care about it see and measure its value?

Rajan: When you're a maintenance organization, the absence of crisis is what really reflects good performance. But it creates an issue: How do you get more public legitimacy when you're doing things that primarily the finance ministry or the central bank recognizes as good,but everybody else criticizes, including outsiders who have less knowledge? Sometimes you can't respond because you can't share specific information. The answer is to be much more transparent and try to enlist a wider audience in support of what you're doing. We need countries to talk to each other in mediated discussions, to cooperate, to sometimes do something that's not in their shortterm interest that will benefit them in the long term because of the global interest.We increasingly see resistance to globalization fostered by people who haven't benefited. Organizations such as the fund have a greater problem because what they do and how they benefit the global economy are going to become less obvious, while the downsides of cooperation will become more obvious. Transparency and communication are going to become more important.But it's a tough package.

Snyder: You grew up, in terms of your academic career, here at Chicago. How did that influence your work? Were your Chicago values in play as you took on these responsibilities?

Rajan: I think Chicago's values are always with you. In the traditional Chicago sense it forces you to ask the questions,"Tell me why people wouldn't think of this and work to resolve it? Why do we have to come in with a heavy hand and deal with this problem?"More generally,Chicago also means competition for ideas. I see my role in the fund as one of throwing out ideas and pushing them forward.You have to fight the internal and external battles to get them accepted.You're not the only source of ideas out there, and you've got to fight in the marketplace for ideas. Chicago also means the idea that there's a role for government, and a role for the market, and you have to find out how to combine the two well.There's always a tendency for the government to stifle the market, and you have to understand how you can prevent that while recognizing the government's legitimate role.

Snyder: I'd like you to reflect on how you see your role as an academic, an expert in finance and economics, trying to influence policy for the good. I'll give you three thumbnails and ask you to reflect on whether you're closer to one or in a different place altogether. George Stigler was very skeptical of the idea that good economic analysis could influence public policy. He didn't like to go to Washington. He was very influential in developing the view that political forces determine policy, and that's certainly one of the reasons he won the Nobel. Yet he was very good friends with Milton Friedman (see story on page 9), who believed in the advocacy of ideas, and fighting for ideas. You could make the case that Milton had a huge impact not by just throwing out ideas, but pushing them in an unrelenting fashion. He was committed to the fight, not just the development of ideas. And then there's Keynes. As you noted, he had an important role in the IMF's development. In your book with fellow faculty member Luigi Zingales, Saving Capitalism from the Capitalists, you talk about this issue of ideas versus economic forces, or political forces, and you quote Keynes: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else." That's a third view, that some ideas become so powerful they get traction in the minds of political leaders and take on a powerful dynamic. Those three don't cover the whole potential spectrum, but they're very different. Comments?

Rajan: I think I believe a bit of all three approaches. I do think the political structures matter. I always am struck by how closely Stigler resembles Karl Marx, that it is the political dynamic, not individuals, that matters. The two just differed in the role of government and business.

Snyder: That's a great observation.

Rajan: However, I think there's a role for ideas and for people. Your version ofMilton Friedman is advocacy-influencing the right people can help, because people can change things. The influence Friedman had over Thatcher, indirectly, through other people he had influenced, and over Reagan, that was very important in giving them a sort of compass. I think ideas work, as in Keynes's story,by influencing the right people. Sometimes communicating directly with the right people can help even more because you convince them and they can influence the process. Obviously the political dynamic must be supportive, or be looking for change at that point.Being the right person at the right place,when the dynamic changes, can help the change go in the direction you want. To give an example, if you had a receptive finance minister who's looking for ideas, there are some ideas that would face tremendous opposition. But there are some ideas that are new enough, that people haven't thought that much about, that don't fit any vested interest. They can be put into place, and over time they create their own constituencies,which can allow those ideas to flourish. Those ideas eventually persist, despite dynamics that would create opposition if it were well known what they'd amount to in the end.I think there are opportunities like this.

Snyder: You have a long ride ahead of you. What lies ahead?

Rajan:Coming back into research.That's really what's important. But I do want to communicate more with a wider audience that I used to in the past,because I think that we economists do too little of it. One of the issues we communicate less about is the big questions. I think we feel far more comfortable with the smaller questions because we work them out precisely. We know the answers.We can do it rigorously.But the big questions haven't gone away. Except now, given the higher standards of academic rigor, we feel far less able to talk about it without revealing oneself as being a little bit of a loosey-goosey economist. I think that's wrong.When we move away from the big questions, we let people who have even less competence take center stage about them. This is where we've lost a little from the generation of Friedman and Stigler and certainly Keynes and Friedrich Hayek. Gary Becker, University Professor of Economics and of Sociology, does some of this, but the younger generation is focused inwardly into the profession, as opposed to outwardly. There are young economists like Steve Levitt still doing it,but we need more.

Snyder: That's a good comment for other academics, because people like Gary have to give an out. How many times have you heard Gary say, "I'm not an expert on this," and then go on to say something extremely important? As you pointed out, if he doesn't make those comments, there'll be other ideas filling that vacuum, and they may be much less instructive or valuable.

Rajan: I think we should cut people slack. The idea is to be as rigorous as possible with everything you do, but also to be able to talk about things based on how much evidence you have without having a complete picture. Offer some conjectures. Don't be completely fazed if occasionally they're proven wrong. Take some risks-at least you have more information in offering those conjectures than maybe others would have.

Snyder: You mention returning to research. What's on your agenda? Has anything from the last three years led you to shift your focus?

Rajan: One of the things I'm working on now is, to some extent, based on the last three years. There's a theory in development economics that countries are a function of their history. Their institutions determine their state of development. I was a believer in that for some time. But going to an organization that's partly developmental in nature, you start asking, what role does that leave us? If you're a function of your history, then what can we do to help you? The bleak answer is,nothing. But are you really a function of your history? Do institutions accompany the process of growth? Are institutions predetermined and forever determined? There's a notion that some countries are poor because they have oppressive political institutions and can never change.But democracies, even imperfect ones, should be strong enough to vote for change, so why don't they? I think it's partly because there are constituencies or interest groups within countries that create an equilibrium that's very hard to break out of. If you can shock that system out of that equilibrium,you could make big changes.

Snyder: Or there are times when there are certain degrees of freedom presented, and countries have choices.

Rajan: Exactly. For example, when opportunities open up, and you can move out of this equilibrium but still give everybody some of the benefits of moving out. The problem in the old equilibrium is that one group moves out, and it hurts the other group. It's like crabs in a bucket-they pull each other down and everyone stays in the bucket. That represents many poor countries. It's not the institutions that are keeping them in the bucket; it's each other. But if the right circumstances arise, you can move out. Sometimes we have to say, "The easy way to fix this thing is to fix the politics. The problem is that these people were suppressed. Let's have elections, and get people to vote." But after the vote, you get the same situation because it wasn't the political environment determining things, it was the internal groupings. I'm much more skeptical of the notion that if you achieve constitutional change, everything will get better. You need to achieve a much deeper change, and then the constitutional change will take place automatically. This is the bigger picture I'm trying to work on.

More Critical Dialogues
In the next issue of Chicago GSB Magazine, dean Edward Snyder talks with professor of economics Randall Kroszner about his first year on the Federal Reserve Board of Governors.