In the last two decades, large crises in Latin America, Mexico, Asia, and Russia heightened interest in the structure and functioning of international financial institutions. Calls for additional capital for the International Monetary Fund to respond to these crises raise questions about how the Fund uses resources, whether its advice increases or reduces the severity of crises and its effect on living standards.

Growth in private lending and capital investment, and the expanding objectives of the international development banks, raise questions about the adequacy and effectiveness of these institutions. Repeated commitments to reduce poverty in the poorest nations have not succeeded. A large gap remains between promise and achievement.

Disputes about the functioning of the World Trade Organization have increased as its role in service industries expanded. Concerns for the environment and the welfare state clash with concerns elsewhere to maintain open trading arrangements, avoid protection, and spur development.

Frequent, large banking crises focus attention on financial fragility, inadequate banking regulation, and the role of the Bank for International Settlements and its affiliated institutions. Are financial standards inadequate? How should they be improved? What should be done to reduce the role of short-term capital in international finance?

In November 1998, as part of the legislation authorizing approximately $18 billion of additional funding by the United States for the International Monetary Fund, Congress established the International Financial Institution Advisory Commission to consider the future roles of seven international financial institutions:

the International Monetary Fund,

the World Bank Group,

the Inter-American Development Bank,

the Asian Development Bank,

the African Development Bank,

the World Trade Organization, and

the Bank for International Settlements.

The Commission was given a six-months life. It held meetings on twelve days and public hearings on three additional days. All Commission meetings and hearings were open to the public. And, to make its work accessible to a broad public, the Commission established an interactive web site. All papers prepared for the Commission and unedited transcripts of all meetings and public hearings are available on the Commission's web site; http://phantom-x.gsia.cmu.edu/IFIAC. All documents will be published as a permanent record of the Commission's work.

The Commission did not join the council of despair calling for the elimination of one or more of these institutions. Nor did it decide to merge institutions into a larger multi-purpose agency. A large majority agreed that the institutions should continue if properly reformed to eliminate overlap and conflict, increase transparency and accountability, return to or assume specific functions, and become more effective. These changes are most important for the International Monetary Fund and the multilateral development banks, so the report directs most attention to those institutions.

Since it had a short life, the Commission relied heavily on people with expertise gained through years of research or experience working with or for the seven institutions we were asked to consider. We are grateful to all who assisted us by writing papers, on very tight deadlines, to inform us and help us understand the functioning, roles, and responsibilities of these institutions, and the effects and effectiveness of their programs. We are grateful, also, for their suggestions for changes. Many of the authors of commissioned papers contributed further by testifying before the Commission and by answering questions. Other witnesses at Commission meetings and public hearings brought a broad spectrum of opinions that illuminated areas of public concern or supplemented the information in the commissioned papers. A list of the witnesses and authors is included at the end of the report.

The members of the Commission benefited also from the opportunity to meet informally with the Managing Director of the International Monetary Fund, the Presidents of the World Bank and the Inter-American Development Bank, the U.S. Executive Directors of the Fund and the Bank, the Secretary of the Treasury, and their staffs. We are especially grateful to Dr. Stanley Fischer, Acting Managing Director of the International Monetary Fund, and President James Wolfensohn of the World Bank who presented their views and responded to questions at one of our hearings.

The Commission operated under Treasury Department rules. We had the pleasure of working with Mr. Timothy Geithner, Ms. Caroline Atkinson, Mr. William McFadden, Ms. Lauren Vaughan, and many other Treasury personnel.

The Commission's report recommends many far-reaching changes to improve the effectiveness, accountability, and transparency of the financial institutions and to eliminate overlapping responsibilities. These proposals should not be taken as criticism of the individuals who work in and guide these institutions. We have been impressed repeatedly not only by the dedication and commitment of many of the people we met but also by their willingness to assist us, inform us, and supply the information that helped us complete our task.

The Commission depended on the work of a dedicated staff that arranged meetings, organized material, and prepared research reports and drafts of the final report. Their names are listed in the report. Mr. Donald R. Sherk, though not a member of the staff, helped us in numerous ways, improved our understanding of the development banks and allowed us to benefit from his long experience and deep knowledge of their problems and prospects.

I am personally grateful to the members of the Commission who worked together in a spirit of comity and harmony, who gave willingly of their time and counsel, and never complained about the heavy demands placed on them. It has been my great pleasure to work with them. Each of them recognized the important contributions that the international financial institutions have made and can make in the future. They joined enthusiastically in this bipartisan effort to suggest reforms and restructuring that the majority believes will improve the functioning of financial markets, the stability of the world economy, and the incomes of people in rich and poor countries.

Allan H. Meltzer

Chair

March 2000

Votes of the Commission

The Commission approved the following report by a vote of 8 to 3. Voting affirmative were: Messrs. Calomiris, Campbell, Feulner, Hoskins, Huber, Johnson, Meltzer and Sachs. Opposed were: Messrs. Bergsten, Levinson and Torres.

The Commission voted unanimously that (1) the International Monetary Fund, the World Bank and the regional development banks should write-off in their entirety all claims against heavily indebted poor countries (HIPCS) that implement an effective economic and social development strategy in conjunction with the World Bank and the regional development institutions, and (2) the International Monetary Fund should restrict its lending to the provision of short-term liquidity. The current practice of extending long-term loans for poverty reduction and other purposes should end.

Executive Summary:

General Principles and Recommendations for Reform

In November 1998 as part of the legislation authorizing $18 billion of additional U.S. funding for the International Monetary Fund, Congress established the International Financial Institution Advisory Commission to recommend future U.S. policy toward seven international institutions: the International Monetary Fund (IMF), the World Bank Group (Bank), the Inter-American Development Bank (IDB), the Asian Development Bank (ADB), the African Development Bank (AfDB), the Bank for International Settlements (BIS), and the World Trade Organization (WTO).

The economic environment in which the founders expected the IMF and the Bank to function no longer exists. The pegged exchange rate system, which gave purpose to the IMF, ended between 1971 and 1973, after President Nixon halted US gold sales. Instead of providing short-term resources to finance balance of payment deficits under pegged exchange rates, the IMF now functions in a vastly expanded role: as a manager of financial crises in emerging markets, a long-term lender to many developing countries and former Communist countries, an advisor and counsel to many nations, and a collector and disseminator of economic data on its 182 member countries.

Building on their experience in the 1930s, the founders of the Bank believed that the private sector would not furnish an adequate supply of capital to developing countries. The Bank, joined by the regional development banks, intended to make up for the shortfall in resource flows. With the development and expansion of global financial markets, capital provided by the private sector now dwarfs the volume of lending the development banks have done or are likely to do in the future. And, contrary to the initial presumption, most crises in the past quarter century involved not too little but too much lending, particularly short-term lending that proved to be highly volatile.

The frequency and severity of recent crises raise doubts about the system of crisis management now in place and the incentives for private actions that it encourages and sustains. The IMF has given too little attention to improving financial structures in developing countries and too much to expensive rescue operations. Its system of short-term crisis management is too costly, its responses too slow, its advice often incorrect, and its efforts to influence policy and practice too intrusive.

High cost and low effectiveness characterize many development bank operations as well. The World Bank’s evaluation of its own performance in Africa found a 73% failure rate.1 Only one of four programs, on average, achieved satisfactory, sustainable results. In reducing poverty and promoting the creation and development of markets and institutional structures that facilitate development, the record of the World Bank and the regional development banks leaves much room for improvement.

The Commission's Aims

In 1945, the United States espoused an unprecedented definition of a nation's interest. It defined its position in terms of the peace and prosperity of the rest of the world. It differentiated the concepts of interest and control. This was the spirit which created the International Financial Institutions and which has guided the Commission's work. Global economic growth, political stability and the alleviation of poverty in the developing world are in the national interest of the United States.

The Commission believes that performance of the IMF, the Bank, and the regional banks would improve considerably if each institution was more accountable and had a clearer focus on an important, but limited, set of objectives. Further, the IMF, the Bank, and the regional banks should change their operations to reduce the opportunity for corruption in recipient countries to a minimum.

Accountability, accomplishment, effectiveness, and reduction in corruption will not be achieved by hope, exhortation, and rhetoric. Programs must be restructured to change incentives for both recipients and donor institutions. Each institution should have separate functions that do not duplicate the responsibilities and activities of other institutions. The IMF should continue as crisis manager under new rules that give member countries incentives to increase the safety and soundness of their financial systems. For the Bank and the regional banks, emphasis should be on poverty reduction and development not, as in the past, on the volume of lending.

IMF

The IMF should serve as quasi lender of last resort to emerging economies. However, its lending operations should be limited to the provision of liquidity (that is, short-term funds) to solvent member governments when financial markets close. Liquidity loans would have short maturity, be made at a penalty rate (above the borrower’s recent market rate) and be secured by a clear priority claim on the borrower’s assets. Borrowers would not willingly pay the penalty rate if financial markets would lend on the same security, so resort to the IMF would be reduced. It would serve as a stand-by lender to prevent panics or crises. Except in unusual circumstances, where the crisis poses a threat to the global economy, loans would be made only to countries in crisis that have met pre-conditions that establish financial soundness. To the extent that IMF lending is limited to short-term liquidity loans, backed by pre-conditions that support financial soundness, there would be no need for detailed conditionality (often including dozens of conditions) that has burdened IMF programs in recent years and made such programs unwieldy, highly conflictive, time consuming to negotiate, and often ineffectual.

Four of the proposed pre-conditions for liquidity assistance that we recommend are: First, to limit corruption and reduce risk by increasing portfolio diversification, eligible member countries must permit, in a phased manner over a period of years, freedom of entry and operation for foreign financial institutions. Extensive recent history has demonstrated that emerging market economies would gain from increased stability, a safer financial structure, and improved management and market skills brought by the greater presence of foreign financial institutions in their countries. A competitive banking system would limit use of local banks to finance "pet projects," or lend to favored groups on favorable terms, thereby reducing the frequency of future financial crises.

Second, to encourage prudent behavior, safety and soundness every country that borrows from the IMF must publish, regularly and in a timely manner, the maturity structure of its outstanding sovereign and guaranteed debt and off-balance sheet liabilities. Lenders need accurate information on the size of short-term liabilities to assess properly the risks that they undertake.

Third, commercial banks must be adequately capitalized either by a significant equity position, in accord with international standards, or by subordinated debt held by non-governmental and unaffiliated entities. Further, the IMF in cooperation with the BIS should promulgate new standards to ensure adequate management of liquidity by commercial banks and other financial institutions so as to reduce the frequency of crises due to the sudden withdrawal of short-term credit.

Fourth, the IMF should establish a proper fiscal requirement to assure that IMF resources would not be used to sustain irresponsible budget policies.

To give countries time to adjust to these incentives for financial reform, the new rules should be phased in over a period of five years. If a crisis occurred in the interim, countries should be allowed to borrow from the IMF at an interest rate above the penalty rate.

Maintenance of stabilizing budget and credit policies is far more important than the choice of exchange rate regime. The Commission recommends that countries avoid pegged or adjustable rate systems. The IMF should use its policy consultations to recommend either firmly fixed rates (currency board, dollarization) or fluctuating rates. Neither fixed nor fluctuating rates are appropriate for all countries or all times. Experience shows, however, that mixed systems such as pegged rates or fixed but adjustable rates increase the risk and severity of crises.

Long-term structural assistance to support institutional reform and sound economic policies would be the responsibility of the Bank and the regional banks. The IMF should cease lending to countries for long-term development assistance (as in sub-Saharan Africa) and for long-term structural transformation (as in the post-Communist transition economies). The Enhanced Structural Adjustment Facility and its successor, the Poverty Reduction and Growth Facility, should be eliminated.

The IMF should write-off in entirety its claims against all heavily indebted poor countries (HIPCs) that implement an effective economic development strategy in conjunction with the World Bank and the regional development institutions.

In keeping with the greatly reduced lending role of the IMF, the Commission recommends against further quota increases for the foreseeable future. The IMF’s current resources should be sufficient for it to manage its quasi lender of last resort responsibilities, especially as current outstanding credits are repaid to the IMF.

The Development Banks

At the entrance to the World Bank's headquarters in Washington, a large sign reads: "Our dream is a world without poverty." The Commission shares that objective as a long-term goal. Unfortunately, neither the World Bank nor the regional development banks are pursuing the set of activities that could best help the world move rapidly toward that objective or even the lesser, but more fully achievable, goal of raising living standards and the quality of life, particularly for people in the poorest nations of the world.

Collectively, the World Bank Group and its three regional counterparts employ 17,000 people in 170 offices around the world, have obtained $500 billion in capital from national treasuries, hold a loan portfolio of $300 billion and each year extend a total of $50 billion in loans to developing members.

There is a wide gap between the Banks' rhetoric and promises and their performance and achievements. The World Bank is illustrative. In keeping with a mission to alleviate poverty in the developing world, the Bank claims to focus its lending on the countries most in need of official assistance because of poverty and lack of access to private sector resources. Not so. Seventy per cent of World Bank non-aid resources flow to 11 countries that enjoy substantial access to private resource flows.

The regional institutions overlap with the World Bank in several ways. They compete for donor funds, clients and projects. Their local offices are often in the same cities. The regionals repeat the World Bank’s organizational structure, which focuses on subsidized loans and guarantees to governments, zero-interest credits to the poorest members, and loans, guarantees and equity capital for private sector operations. Recently, the World Bank expanded its field offices, increasing duplication and potential conflict in the regions. The Commission received no reasonable explanation of why this costly expansion was chosen instead of closer cooperation with the regional banks and reliance on the regional banks' personnel.

All the Banks operate at the country level, defining their objectives within the nation-states instead of the region or the globe. Their patterns of lending over the past 3 years are very similar: to the same countries and for the same purposes. Four to six of the most credit-worthy borrowers, all with easy capital market access, receive most non-aid resource flows: 90% in Asia; 80-90% in Africa; 75-85% in Latin America.

Performance is one of the Commission's principal concerns. Ending or reducing poverty is not easy. The development banks cannot succeed in their mission unless the countries choose institutions and government policies that support growth. Developing country governments must be willing to make institutional changes that promote improved social conditions, reward domestic innovation and saving, and attract foreign capital. To foster an environment conducive to economic growth, the development banks must change their internal incentives and the incentives they offer developing countries.

The project evaluation process at the World Bank gets low marks for credibility: wrong criteria combined with poor timing. Projects are rated on three measures: outcome, institutional development impact and sustainability. The latter, central to progress in the emerging world, receives a minimal average 5% weight in the overall evaluation. Results are measured at the moment of final disbursement of funds. Evaluation should be a repetitive process spread over many years, including well after the final disbursement of funds when an operational history is available.

The Banks seldom return to inspect project success or assess sustainability of results. After auditing 25% of its projects, the World Bank reviews only 5% of its programs 3 to 10 years after final disbursement for broad policy impact. Though the development banks devote significant resources to monitoring procurement of inputs, they do little to measure the effectiveness of outputs over time.

Recommendations for the Development Banks

To function more effectively, the development banks must be transformed from capital-intensive lenders to sources of technical assistance, providers of regional and global public goods, and facilitators of an increased flow of private sector resources to the emerging countries. Their common goal should be to reduce poverty; their individual responsibilities should be distinct. Their common effort should be to encourage countries to attract productive investment; their individual responsibility should be to remain accountable for their performance. Their common aim should be to increase incentives that assure effectiveness. The focus of their individual financial efforts should be on the 80 to 90 poorest countries of the world that lack capital market access.

All resource transfers to countries that enjoy capital market access (as denoted by an investment grade international bond rating) or with a per capita income in excess of $4000, would be phased out over the next 5 years. Starting at $2500 (per capita income), official assistance would be limited. (Dollar values should be indexed.) Emergency lending would be the responsibility of the IMF in its capacity as quasi lender of last resort. This recommendation assures that development aid adds to available resources (additionality).

Performance-Based Grants

For the world’s truly poor, the provision of improved levels of health care, primary education and physical infrastructure, once the original focus for development funding, should again become the starting points for raising living standards. Yet, poverty is often most entrenched and widespread in countries where corrupt and inefficient governments undermine the ability to benefit from aid or repay debt. Loans to these governments are, too often, wasted, squandered, or stolen.

In poor countries without capital market access, poverty alleviation grants to subsidize user fees should be paid directly to the supplier upon independently verified delivery of service. Grants should replace the traditional Bank tools of loans and guarantees for physical infrastructure and social service projects. Grant funding should be increased if grants are used effectively.

From vaccinations to roads, from literacy to water supply, services would be performed by outside private sector providers (including NGOs and charitable organizations) as well as by public agencies. Service contracts would be awarded on competitive bid. Failure to perform on earlier projects would weigh heavily against participation in future bids. Quantity and quality of performance would be verified by independent auditors. Payments would be made directly to suppliers. Costs would be divided between recipient countries and the development agency. The subsidy would vary between 10% and 90%, depending upon capital market access and per capita income.

Institutional Reform Loans

Institutional reforms lay the groundwork for productive investment and economic growth. They provide the true long-term path to end poverty. Reforms are more likely to succeed if they arise from decisions made by the developing country.

Lending frameworks, with incentives for implementation, should be redesigned to fit the needs of the poorest countries that do not have capital market access. The government of each developing economy would present its own reform program. If the development agency concurs in the merit of the proposal, the country would receive a loan with a subsidized interest rate. The extent of the interest rate subsidy would range from 10% to 90%, as in grant financing of user fees. Lending for institutional reform in poor countries without capital market access should be conditional upon implementation of specific institutional and policy changes and supported by financial incentives to promote continuing implementation. Auditors, independent of both the borrowing government and the official lender, would be appointed to review implementation of the reform program annually.

Division of Responsibility

To underscore the shift in emphasis from lending to development, the name of the World Bank would be changed to World Development Agency. Similar changes should be made at the regional development banks.

Development Agencies should be precluded from financial crisis lending.

All country and regional programs in Latin America and Asia should be the primary responsibility of the area's regional bank.

The World Bank should become the principal source of aid for the African continent until the African Development Bank is ready to take full responsibility. The World Bank would also be the development agency responsible for the few remaining poor countries in Europe and the Middle East.

Regional solutions that recognize the mutual concerns of interdependent nations should be emphasized.

The World Development Agency should concentrate on the production of global public goods and serve as a center for technical assistance to the regional development agencies. Global public goods include treatment of tropical diseases and AIDS, rational protection of environmental resources, tropical climate agricultural programs, development of management and regulatory practices, and inter-country infrastructure.

In its reduced role, the World Development Agency would have less need for its current callable capital. Some of the callable capital should be reallocated to regional development agencies, and some should be reduced in line with a declining loan portfolio. The income from paid-in capital and retained earnings should be reallocated to finance the increased provision of global public goods. Independent evaluations of the agencies' effectiveness should be published annually.

Debt Reduction and Grant Aid to the Poorest Countries

The World Bank and the regional development banks should write off in entirety their claims against all heavily indebted poor countries (HIPCs) that implement an effective economic development strategy under the Banks’ combined supervision. Moreover, bilateral creditors, such as the U. S. government, should similarly extend full debt write-offs to those HIPC countries that pursue effective economic development strategies.

More generally, the United States should be prepared to increase significantly its budgetary support for the poorest countries if they pursue effective programs of economic development. This support should come in several forms: debt reduction, grants channeled through the multilateral development agencies, and bilateral grant aid. The current level of U. S. budgetary support for the poorest countries is about $6 per U.S. citizen ($1.5 billion total), so there is scope for a significant increase in funding if justified by appropriate policies and results within the developing countries.

The Bank for International Settlements

During its 70-year history the BIS has adapted well to large changes in the financial industry and central banking practices. Its ability to adapt was due largely to its limited and homogeneous membership. An example of such adaptation is the way the BIS quickly rose to the challenge of meeting regulatory deficiencies at the international level. The BIS has also demonstrated its ability to convince the most financially important countries to adopt its standards.

The Commission recommends that the BIS remain a financial standard setter. Implementation of standards, and decisions to adopt them, should be left to domestic regulators or legislatures. The Basel Committee on Bank Supervision should align its risk measures more closely with credit and market risk. Current practice encourages misallocation of lending.

The World Trade Organization

The WTO has two main functions. First, it administers the process by which trade rules change. Trade ministers (or their equivalent) negotiate agreements that national legislative bodies can approve or reject. Second, the WTO serves as a quasi-judicial body to settle disputes. Part of this process involves the use of sanctions against countries that violate trade rules.

Quasi-judicial determination, when coupled with the imposition of sanctions, can overwhelm a country's legislative process. As WTO decisions move to the broader range of issues now within its mandate, there is considerable risk that WTO rulings will override national legislation in areas of health, safety, environment, and other regulatory policies. The Commission believes that quasi-judicial decisions of international organizations should not supplant national legislative enactments. The system of checks and balances between legislative, executive and judicial branches must be maintained.

Rulings or decisions by the WTO, or any other multilateral entity, that extend the scope of explicit commitments under treaties or international agreements must remain subject to explicit legislative enactment by the U.S. Congress and, elsewhere, by the national legislative authority.

Chapter 1

Introduction

The postwar financial institutions established at Bretton Woods in 1944 are unique in many ways. The mission of the Bretton Woods institutions was to promote monetary and financial stability, to reconstruct countries devastated by war, and to expand the reach of the market system by offering open trade and market access to all countries. Never before have the victors in war established a framework to promote growth, development, and global prosperity.

These institutions, and the U.S. commitment to maintain peace and stability, have had remarkable results. In more than fifty postwar years, more people in more countries have experienced greater improvements in living standards than at any previous time. With the help of our allies, we have avoided global war. Our former adversaries are now part of the expanding global market system. They seek to achieve the benefits of freer trade and exchange in a system based on growth of personal liberty and increased ownership of private property.

The postwar economic order permitted countries to adopt a strategy of export-led growth. This policy required imports of technology, services, and raw materials that spread prosperity to other countries. The international framework provided a sufficient degree of financial stability to absorb costly oil shocks, regional wars, and occasional financial disturbances.

Expansion of trade, capital flows, and economic activity permitted improvements in health care, longevity, education, and other social indicators. Growth provided resources to solve old environmental problems and address new ones. Peace, economic and social progress, and stability contributed to the spread of democratic government and the rule of law to many countries.

The Congress, successive administrations, and the American public can be proud of these achievements. The United States has been the leader in maintaining peace and stability, promoting democracy and the rule of law, reducing trade barriers, and establishing a transnational financial system. Americans and their allies have willingly provided the manpower and money to make many of these achievements possible. The benefits have been widely shared by the citizens of developed and developing countries.

The dynamic American economy benefited along with the rest of the world. Growth of trade spread benefits widely. Per capita consumption in the United States tripled. As in other countries, higher educational attainment, improved health services, increased longevity, effective environmental programs, and other social benefits accompanied or followed economic gains.

Serious challenges remain. The beneficiaries of globalization must include the poorest members of the world economy. Instability of the world economy must be mitigated.

The Institutions

The principal Bretton Woods Institutions are the International Monetary Fund (IMF) and the World Bank Group (Bank). The initial role of the IMF was to smooth balance-of-payments adjustment in a system of fixed but adjustable exchange rates. The Bank's original charge was to foster postwar reconstruction in war-devastated regions and to encourage economic development by lending to developing countries. Initially, neither institution had the resources or the experience to make major contributions. The Marshall Plan and other assistance from the United States, and the prodigious efforts of people in the war-devastated countries, achieved postwar reconstruction.

Beginning in the 1960s, countries created regional development banks to supplement the Bank's work. The Inter-American Development Bank (IDB, 1959), the African Development Bank (AfDB, 1964) and the Asian Development Bank (ADB, 1966) provide loans and grants for development in their respective regions.

The General Agreement on Tariffs and Trade (GATT) joined the IMF and the Bank in 1948. Through successive rounds of multilateral negotiation, GATT reduced most tariff barriers to negligible values. Nontariff barriers remained. In 1995, GATT ended, replaced by the World Trade Organization (WTO) with broader powers and expanded responsibilities to settle trade disputes. The U.S. economy continued to benefit greatly from the expansion of world trade and participation in the WTO.

New Conditions, New Challenges

The economic environment in which the founders expected the IMF and the Bank to function no longer exists. The pegged exchange-rate system, which gave purpose to the IMF, ended between 1971 and 1973, after President Nixon halted U.S. gold sales. Instead of providing short-term resources to finance balance-of-payment deficits under pegged exchange rates, the IMF now functions in an expanded role as a manager of financial crises in emerging markets, as a long-term lender to developing economies and former Communist countries, as a source of advice and counsel to many nations, and collector of economic data on its 182 member countries.

Building on their experience in the 1930s, the founders of the Bank believed that the private sector would not furnish an adequate supply of capital to developing countries. The Bank, joined by the regional development banks, intended to make up for the shortfall in resource flows. With the development and expansion of global financial markets, capital provided by the private sector now dwarfs any volume of lending the development banks have done or are likely to do in the future. And, contrary to the initial presumption, most crises in the past quarter-century involved not too little but too much lending, particularly short-term lending that proved to be highly volatile.

Beginning with the Latin American debt problems of the 1980s, followed by Mexico's crisis in 1994-95, and the Asian financial and economic problems of 1997-98, parts of the world economy have experienced the largest financial traumas and recessions of the postwar years. Liabilities of bank failures in crisis countries often reached 20% of annual income, a far greater financial collapse than occurred in any developed country, including the United States, during the depression of the 1930s or the banking and U.S. savings-and-loan failures in the 1980s.

The crises in developing countries destroyed large parts of the wealth of their citizens. In an interrelated global economy, financial flows and trade declined, particularly U.S. and European exports and inter-regional exports and imports. The effects spread to other developing and developed countries. The frequency and violence of these crises, and the weakness of many emerging countries' financial systems show the need for a new framework and new policies to restore and strengthen economic stability, growth and development.

The Commission recognizes that financial crises have occurred throughout history and cannot be eliminated entirely. However, the frequency and severity of recent crises raise doubts about the system of crisis management now in place and the incentives for private actions that it encourages and sustains. The IMF has given too little attention to improving financial structures in developing countries and too much to expensive rescue operations. Its system of short-term crisis management is too costly, its responses too slow, its advice often incorrect, and its efforts to influence policy and practice too intrusive.

High cost and low effectiveness characterize many development bank operations also. The World Bank's evaluation of its own performance in Africa found a 73% failure rate.[1] Only one of four programs, on average, achieved satisfactory, sustainable results.

In reducing poverty and promoting the creation and development of markets and institutional structures that facilitate growth, the record of the World Bank and the regional development banks leaves much room for improvement. Six principal reasons for the development banks' poor record in poverty reduction and institutional reform are:

(1) by far the largest share of the Banks' resources flows to a few countries with access to private capital;

(2) the amount of funds provided by development banks to their largest borrowers is small compared to the private-sector resources received;

(3) the host government guarantee, required by all Bank lending, eliminates any link between project failure and the Bank's risk of loss;

(4) money is fungible so that any linkage between development bank resources and specific projects or policy changes is difficult to trace and often nonexistent;

(5) countries do not implement reforms unless they choose to do so, and they rarely sustain reforms imposed by outsiders; and

(6) development projects typically succeed only if the recipient country has a significant interest in the project and directs its efforts to achieve success.

IMF and Bank Assistance

In the past, the Fund has worked to achieve growth and economic stability by making loans conditional on changes in monetary, fiscal, exchange rate, trade or labor-market policies. The World Bank has added other conditions. Countries often face a long list of conditions that, if followed, would restrict the role of national political institutions and the development of responsible, democratic institutions.

While it is always difficult to know what would have happened in the absence of the IMF's or Bank's conditions, their research, as well as considerable research by outsiders, finds no evidence of systematic, predictable effects from most of the conditions.[2] A recent summary of conditional lending concludes:

"[I]t is now well-accepted that Fund-supported programs improve the current account balance and the overall balance of payments. The results for inflation are less clear…In the case of growth, the consensus seems to be that output will be depressed in the short-run as the demand reducing elements of the policy package dominate."[3]

A main reason for the IMF's modest success is that countries come to the IMF mainly when they have serious problems, often when they are in crisis. The IMF's relatively standard advice includes reducing domestic spending and permitting the country's currency to depreciate. Reducing spending lowers incomes. Reduced spending and a depreciated currency typically improve the current account and may reduce inflation.

If the IMF did not exist, the market would force a country in crisis to follow similar policies. Perhaps the IMF's assistance cushions the decline in income and living standards. Neither the IMF, nor others, has produced much evidence that its policies and actions have this beneficial effect. One reason may be that IMF loans permit some private lenders to be repaid on more favorable terms, so the benefits have gone mainly to those lenders. Or, the IMF's loans may permit governments to maintain spending that remains politically attractive despite its low social value.

The last possibility receives support in recent work at the World Bank. Assessing Aid summarizes the results of experience and research:

"Foreign aid has at times been a spectacular success…

"On the flip-side, foreign aid has also been, at times, an unmitigated failure…

"Financial aid works in a good policy environment.…

"Improvements in economic institutions and policies in the developing world are the key to a quantum leap in poverty reduction….

"Aid can nurture reform even in the most distorted environment--but it requires patience and a focus on ideas, not money."[4]

The Commission believes that the effectiveness of foreign aid and progress against poverty would increase and financial crises would be reduced in number, frequency and severity, if current programs of the IMF and the development banks change to focus attention on institutional reform, incentives for improved domestic arrangements and policies, greater transparency and accountability, reduced opportunities for corruption in developing and restructuring countries, and the provision of global public goods. These improvements will yield maximum benefit only if governments continue to foster open markets and further reduce barriers to trade in goods, services, and long-term capital.

The Role of the Commission

The international financial institutions have made signal contributions to prosperity and the spread of democratic government. These institutions have not adapted appropriately to the changes in the economic environment of the past quarter century. A majority of the Commission agrees that the main problems of the international financial institutions are:

--- overlapping missions and mission creep;

--- lack of transparency and accountability;

--- failure to prevent the increasing depth and severity of international financial and economic crises;

--- ineffectiveness, corruption in developing countries, and waste of resources;

--- commandeering of international resources to meet objectives of the U.S. government or its Treasury Department;

--- failure to develop successful regional and global programs to confront transnational problems in agriculture, transportation, forestry, environmental, and health care;

--- overuse of conditional lending and the imposition of multiple conditions;

--- inability to enforce commitments on borrowers unwilling to meet them; and

--- reluctance to reduce lending to countries that do not honor their obligations.

Recognizing that international financial institutions have often achieved results at extremely high cost to the citizens of the crisis countries, or failed to achieve their missions, and that the rhetoric of their leadership is often distinctly different from the institutions' accomplishments, Congress established the International Financial Institution Advisory Commission. Its mandate was to examine:

--- the effects of globalization, increased trade, capital flows, and other relevant

factors on these institutions;

--- the adequacy, efficacy, and desirability of current policies and programs at such

institutions as well as their suitability for the beneficiaries of such institutions;

--- cooperation or duplication of functions and responsibilities of such institutions;

and

--- other matters the Commission deems necessary to make recommendations

pursuant to the preparation of its report.

Congress asked the Commission to report on:

· changes in policy goals set forth in the Bretton Woods Agreements Act and the International Financial Institutions Act;

· changes in the charters, organizational structures, policies and programs of the international financial institutions;

· additional monitoring tools, global standards, or regulations for, among other things, global capital flows, bankruptcy standards, accounting standards, payment systems, and safety and soundness principles for financial institutions;

· possible mergers or abolition of the international financial institutions, including changes in the manner in which such institutions coordinate their policy and program implementation and their roles and responsibilities; and

· any additional changes necessary to stabilize currencies, promote continued trade liberalization and to avoid future financial crises.

At its start, the Commission agreed unanimously to consider the roles and tasks that should be assigned to these institutions if they were created anew in the year 2000. The members recognized that the new or changed roles and assignments might require changes in the institutions' charters, their size and the scope and directions of their activities. It agreed that the economic environment had changed greatly in the more than fifty years since the principal institutions began operations and that the institutions had grown and changed in response to crises and changes in the world economy. Many of these changes were unplanned or opportunistic. Some of the institutions, particularly the World Bank, have become so large and have taken on so many different tasks that effectiveness has been sacrificed. Frequent reorganization and changes of mission have reduced efficiency and wasted resources. Programs that overlap with IMF or regional bank activities have led to conflict and failure to achieve agreed-upon goals.

The Commission believes that to encourage development, countries should open markets to trade, and encourage private ownership, the rule of law, political democracy and individual freedom. Market economies work best when they operate in an environment where national governments and international institutions follow predictable policies that maintain economic stability, protect political freedom and private property, and sustain incentives for efficient, purposeful behavior leading to wealth creation that benefits all members of the society.

The principal role of public-sector institutions is to provide global public goods, create and maintain the framework and rules that permit the private sector to function productively, generating wealth to reduce poverty and pay for social improvements. Effective international financial institutions can contribute importantly to this process.

In drafting its recommendations, the Commission sought to encourage these desirable outcomes by:

(1) assigning specific responsibilities to particular institutions, avoiding overlap

wherever possible;

(2) increasing transparency of aims, decisions, and financial statements, and

accountability for achievements and effectiveness;

(3) relying more on incentives and local decision-making and much less on programs

and conditions imposed by multilateral agencies;

(4) sustaining and expanding opportunities for trade and sustainable, long-term

capital movements; and

(5) increasing incentives for institutional reform, expansion of markets, and prompt

provision of reliable information about economic, financial, and political changes.

The United States has a large role in the world economy. It is a leading exporter and importer of goods and services. U.S. citizens own, directly or through corporations and institutional investors, $2 to $3 trillion of foreign assets.

The U.S. interest is not entirely commercial, financial or mercantile. With the help of other democratic, market economies we have been the leader in spreading democracy, the rule of law, and economic stability. U.S. efforts to restructure international financial institutions should continue this tradition of leadership by fostering arrangements appropriate to the new environment these efforts will create. Reforms are necessary to enable the international financial institutions to play an important role in promoting growth, stability, and responsible, democratic government for the next 50 years and beyond.

Chapter 2

The International Monetary Fund

Near the end of World War II, forty-four nations, led by the United States, met at Bretton Woods, New Hampshire to establish postwar economic and financial arrangements designed to prevent a return to the economic instability of the interwar years. The common diagnosis of interwar problems found the causes in competitive devaluations of principal currencies, exchange controls on current account transactions, protective tariffs and other restrictions on trade and payments. To prevent a reoccurrence of monetary and financial instability, the Conference established the International Monetary Fund (IMF).

The Articles of Agreement state that the IMF seeks to promote international monetary cooperation, facilitate the expansion of international trade, promote exchange-rate stability and avoid competitive depreciation. The agreement established a multilateral system for international payments for goods and services that assisted member states to correct balance-of-payments problems, while avoiding measures destructive of national and international prosperity.

The IMF's early goals reflected three main assumptions that the founding countries believed would, and should, characterize future financial relations:

(1) The world economy would remain on a system of fixed, but adjustable, exchange rates tied to gold or the dollar with the gold price fixed at $35 per ounce.

(2) After an initial postwar economic adjustment, payments for goods and services would be free of exchange controls.

(3) Capital account transactions such as lending, borrowing, investing, and repaying could be subject to exchange controls at the discretion of the home country government.

The founders expected the IMF to make short-term loans to assist countries with payments deficits and to advise countries that failed to remove controls on current account. Over the years, the IMF has increased the frequency and scope of consultations and advice. It now engages all members annually about their economic conditions and policies. These consultations, requiring huge documentation, consume more person-hours than any of the IMF's other activities.

Two of the founders' key assumptions are no longer valid. The fixed but adjustable exchange-rate system ended in August 1971 when President Nixon closed the gold window, ending the U.S. commitment to keep the dollar price of gold at $35 per ounce. In March 1973, major countries agreed that the fixed exchange-rate system would not be restored. Thereafter, currency values would be determined in various ways ranging from freely floating exchange rates at one end to firmly fixed exchange rates at the other.

By 1973, many countries had removed exchange controls on both trade and capital movements. The international economy faced a new challenge--to reconcile growth, low inflation and high employment with open trading arrangements and international capital mobility. The oil shocks of the 1970s and the mistaken economic policies in many countries that produced large deficits and inflation increased the difficulty of achieving these goals and objectives. Nothing in the founding mission or the accumulated experience of the IMF prepared it to deal with these evolving challenges.

Seeking New Roles

The end of the gold/dollar standard meant that the IMF's central mission---supporting a fixed global exchange-r