Section 1
The International Economic System
International Economic Governance: Where We Are and How We Got There
MANMOHAN AGARWAL
Centre for Development Studies, India Research and Information Systems for Developing Countries, India
There are many different levels of institutions for international economic governance, three of them are especially important after the Second World War. They are the World Bank, the International Monetary Fund, and the World Trade Organization. We discuss the rationale for the establishment of these three institutions and how they have operated. We analyze the development of these institutions and how currently there is growing dissatisfaction with their working as they do not seem to successfully manage the world Economy. Reform of these institutions is urgently required.
Keywords: International Economic Governance, World Bank, International Monetary Fund, World Trade Organization.
Introduction
A set of institutions were established at the end of the Second World War to help manage the world economy and to prevent a repetition of the Great Depression. There are many institutions that form the international economic governance structure and whose actions influence the working of the international economy, and more particularly the developing countries. There are aid agencies at the international level, e.g., the World Bank (WB), regional development banks such as the African Development Bank, bilateral aid agencies in the traditional donor countries, and now those in the emerging economies are also becoming important. These aid agencies mainly affect the developing countries. They provide loans for specific projects, for sector investments and reforms, and also general purpose loans usually tied to policy reforms, but which can also be used for a broad range of activities. Then there are the many specialized agencies of the UN, e.g., Food and Agricultural Organization, the World Health Organization etc. We shall concentrate our discussion on the three major economic organizations established at the end of the Second World War, viz., the WB, the International Monetary Fund (IMF) and the World Trade Organization (WTO).1 These institutions were established to mainly manage the macro aspects of the world economy, rather than specialized sectors which was the role of the UN agencies.
In Section âThe Post-Second World War System for International Economic Governanceâ we discuss the rationale for the establishment of these three institutions and how they have operated. We then discuss in Section âThe Evolution of the System in the 1950s and 1960s: The Role of Developing Countriesâ whether these institutions, as currently established, are adequate for the purpose of managing the world economy. Subsequent sections deal with the evolution of the system since 1973, p. 8, and the current situation, p. 21.
The post-Second World War system for international economic governance
The rationale for the post-Second World War system of economic governance: The economic collapse in the 1930s
The 1930s had seen a collapse of international finance and trade and the interaction between the two had resulted in a severe aggravation of the economic chaos caused by the financial woes.2 As the credit worthiness of countries collapsed, they could not borrow to finance current account deficits. Inability to finance a deficit forced a country, say, the home country, to devalue its currency and to impose quantitative restrictions (QRs) on imports, in order to ensure that the import payments equaled its export earnings. But as it cut back on its imports, the exports of its partners were adversely affected and these were forced to devalue their currencies and impose QRs to manage their balance of payments (BOP) leading to a further fall in the exports of the home country. A vicious cycle of competitive depreciations and tightening QRs set in. This resulted in a much greater decline in exports and activity in export industries than what had occurred in the initial stage. This decline of activity in the export industries, in turn, aggravated the fall in economic activity in countries and increased the level of unemployment. The trade policies adopted, resulted in a much greater decrease in export activities, both in agriculture and manufacturing, and in the level of overall economic activity and employment, than what would have occurred because of the reduction in demand resulting from the financial crisis.
The Reciprocal Trade Agreements Act of 1934 passed in the US tried to reverse the process of diminishing trade by liberalizing trade.3 It was believed that if a countryâs exports could somehow be increased, then the country would reduce its import restrictions and this would encourage exports of its partners who in turn would reduce their restrictions. So a virtuous cycle of increasing trade, and increasing level of economic activity fostered by expanding exports and higher employment would be set in motion. An initial spurt was sought to be given to exports by the US government through the Reciprocal Trade Agreements Act of 1934, which authorized the US president to cut tariffs by up to a half if the other country did the same. The agreements signed under the Act started a process of liberalizing trade and expanding exports, but the overall effect on economic activity was limited by the circumstances of the 1930s. However, policy makers continued to believe in the effectiveness of the process of trade liberalization.
The planners for a post-Second World War world economy sought to build a process of trade liberalization. But they also sought to set up a system to finance current account deficits that a country might have, so that a country would not resort to trade restricting policies which would lead to adoption of restrictive trade policies by other countries with all the trade restrictions resulting in reduced economic activity and employment. The positive act of trade liberalization was to be achieved by the General Agreement on Tariffs and Trade (GATT), the replacement for the International Trade Organization (ITO), and the negative task of preventing adoption of trade restricting measures, when a country was faced by BOP deficits, was to be performed by the IMF.4 It was also recognized that considerable amounts of money would be required to repair the damage inflicted by the war and this was to be provided through the WB. In many respects the system has evolved beyond its original conceptualization to deal with the problems thrown up by the evolution of the world economy.
The establishment of the post war system of international economic governance
International Monetary Fund
In the negotiations to establish the IMF, a fundamental question was whether the IMF was to provide loans to countries experiencing BOP problems or whether it was to act more as a central bank trying to manage the level of world economic activity.5 In the latter case, it would issue its own currency and determine the amount of international money required for a high level of world economic activity.6 Both deficit and surplus countries would be required to adjust.7 The US, which had expectations of being the main creditor country after the Second World War, preferred that the IMF be merely a lender (Strange, 1976). Later, the US wanted the loans to be accompanied by conditions (Babb and Carruthers, 2008; Buira, 2003; Gould, 2006). The preferences of the US carried the day. But many of the issues raised at that time remain relevant â the question of having adequate international reserves, whether there should be an international currency or reserves should consist of strong national currencies, the distribution of the burden of adjustment between debtor and creditor countries, etc.
The Fund was established with subscriptions from countries, these subscriptions reflected their importance in the international economy. The voting rights as well as the rights to borrow from the IMF were both governed by the size of the subscriptions. The subscriptions limited the amount of resources available to the IMF to meet the BOP needs of its members and also limited the amounts that a country could borrow to meet its BOP financing needs. The day to day operations are managed by an executive board of 24; 8 are appointed by individual countries and the others represent groups of countries. The developed countries have more than 50% of the voting rights. But their decision making power is even greater as major decisions currently require 85% of votes. The US alone with about 17% of voting rights wields a veto power, one that it has had for the entire period of operation of the Fund. A small group of European countries could also wield the veto. So could the developing countries. But they would need a much larger coalition. The head of the Fund has always been a European and the second in command, who was initially the Deputy Managing Director and since 1994, the First Deputy Managing Director as the number of deputy directors was increased to three, a US citizen.
Apart from having access to Fund financing for BOP deficits, countries could devalue only with the concurrence of the Fund so that competitive devaluations would be avoided.8 Furthermore, while countries were in general not supposed to impose quantitative restrictions on trade, such restrictions could be imposed if the IMF certified that the country faced a severe BOP problem. But the Fund has become increasingly reluctant to grant such a certification as the belief has grown that exchange rate adjustment rather than QRs are the appropriate mechanism to manage the BOP.9
The international trading system
The planners of the post war international economic governance system sought to reverse the policies that had resulted in a cycle of declining trade in the 1930s. They sought to set in motion a liberalization that would lead to a progressive growth in world trade.10 But the original plan envisaged a broad based organization that would embed trade liberalization within broader economic objectives of full employment and economic development.11 Australia, with the support of India, China, Lebanon, Brazil, and Chile, urged that undeveloped states should be allowed to use import quotas to help promote industrialization.
The charter also dealt with issues such as commodities trade and restrictive business practices. The charter recognized the special problems facing commodities such as pronounced price fluctuations, substantial disequilibria between consumption and production. It recognized that inter governmental agreements may be necessary to handle these special problems. Also any member could ask for studies regarding the conditions affecting a specific commodity. The charter also required members to take measures to prevent any private or public enterprise from adopting restrictive practices or restricting competition.12
The US sought to build a liberal trading system with no special preferences for groups of countries so that the system of imperial preferences would be dismantled. The UK finally accepted the need for a liberal trading system.13 Two of the contentious issues were the compatibility of such a system with the maintenance of full employment and with the development imperatives of developing countries.
The resulting ITO that was negotiated never came to fruition. Instead the part that dealt with reduced barriers to trade came into existence with the first agreement in 1947 as the GATT.14 Subsequent negotiations under the auspices of GATT resulted in a very significant reduction in tariffs on imports of manufactures by the developed countries. These declined from an average of about 40% at the end of the Second World War to about 5% with the implementation of the Tokyo Round agreement. These countries also eliminated QRs on trade in manufactures. Without the ITO, the architecture for post-war economic governance remained incomplete. Keynesâ thinking about the IMF was that it was necessary to undertake the trade liberalization that was essential for post war prosperity. One could almost say that the ITO was the primary objective and the IMF an instrument.15
The World Bank
The WB was set up to help the flow of private capital for mainly the reconstruction from the war damage. It was expected to do so by providing guarantees for private investments (Macbean and Snowden, 1981; Mason and Asher, 1973). This was expected to counteract the fall in private lending during the depression of the 1930s. Its establishment was not controversial as there were few contentious issues.
The evolution of the system in the 1950s and 1960s: The role of developing countries
The reconstruction of Europe proved to be beyond the loan facilities of the WB and as it involved imports from the US, reconstruction resulted in large current account deficits which were beyond the financing capacity of the IMF. The reconstruction needs of Europe were met by the Marshall Plan, grants that amounted to about 1.1% of US GDP for the four years that the programme lasted. The US granted a loan, the AngloâAmerican loan of US$3.75 billion in July 1946 to pay for imports by the UK, after the lendâlease came to an end. One of the conditions of the loan was that international sterling balances became convertible one year after the loan was ratified, on 15 July, 1947 (Rosenson, 1947). Within a month, nations with sterling balances had drawn almost a billion dollars from British dollar reserves, forcing the British government to suspend convertibility and to begin immediate drastic cuts in domestic and overseas expenditure. The rapid loss of dollar reserves also highlighted the weakness of sterling, which was duly devalued in 1949 from US$4.02 to US$2.80 (Kindleberger, 2006). The episode showed that the European economies were not yet ready for current account convertibility.16 It was the late 1950s, before the currencies of the European countries became convertible on the current account.
Another important development was that a number of poorer countries became independent in the 1950s and 1960s and had to be integrated into the world economic governance system. These independent countries sought to improve the living standards of their people and embarked on programmes to increase the rate of growth of their economies. The question for developing countries was how the working of these institutions would or could be adjusted to accommodate the goal of faster economic growth and reduced poverty.17 The consensus among development economists was acceleration of growth required higher investments (Rosenstein-Rodan, 1943; Nurkse 1952; Lewis, 1954; Rostow, 1960), and since domestic savings rates were low, higher investment would require aid. Obviously, the institution most suited to help developing countries meet their objectives was the WB which had the resources which were no longer needed for the reconstruction of the war damaged economies. The main function of the WB became to finance the economic developm...