Too much, too soon: IMF conditionality and inflation targeting

A Ghana case study

In a recent report with my colleague at the Political Economy Research Institute, James Heintz, we studied the evolution of this conditionality and its impact in Ghana. In Ghana, monetary policy has been strictly limited by macroeconomic stabilisation agreements made with the IMF and World Bank in conjunction with IMF loans, the Heavily Indebted Poor Countries (HIPC) initiative and the Poverty Reduction Strategy Paper (PRSP) process. In addition to the typical IMF requirements to limit credit to the government and increase foreign reserves, the Bank of Ghana has also been encouraged to focus on reducing inflation into the "low single digits." This focus on inflation fighting and the other limitations imposed by IMF conditionality has reduced the prospects for rapid economic growth and broad-based employment generation.

Monetary policy has been strongly influenced by the IMF Poverty Reduction and Growth Facility agreements and commitments undertaken by Ghana as well as commitments made in conjunction with the development of the Ghana Poverty Reduction Strategy, as part of the HIPC debt-relief initiative, and the Multi- Donor Budgetary Support initiative. According to documents associated with these initiatives: "The focus of macro-stability in the medium term is to ensure prudent fiscal and monetary policy management to achieve price stability, maintain interest rate levels that are conducive to both savings and investments, and to ensure stable yet competitive exchange rates and a fiscally sustainable debt burden."

Financial programming has been used since the 1970's as part of the IMF's lending programmes to least developed countries. This programming has now been folded into the PRSP and HIPC processes without much alteration. The programming uses extremely simple models (at best, a set of assumptions about the structure of the economy) to establish a set of targets that the IMF will monitor and the government will have to meet in order to receive the next installments of IMF loans, or qualify for HIPC relief and other donor support.

The typical programme connects balance of payments constraints, the government fiscal deficit, and central bank policy in order to attempt to reduce indebtedness to a sustainable level, primarily by keeping economic growth in line with likely available foreign resources from export receipts, aid and capital inflows. Increasingly, reducing inflation into the low single-digits has become a central focus. Therefore, two key assumptions of these programmes are (1) that inflation rates between 10 and 20 per cent are bad for economic growth and reducing inflation below that level will not reduce economic growth; and (2) that reducing government spending is good for the economy, because more government spending crowds out private investment. Under the standard financial programming methods implemented by the IMF, target ceilings are set for central bank monetary and credit expansion and floors are established on net foreign reserves. The original motivation for these restrictions was to ensure the ability of countries to reduce their foreign debt and remain solvent, including protecting the ability of the IMF to get repaid. Recently, other goals, such as reducing inflation, increasing foreign exchange reserves and "creating room for private investment," have been emphasised.

A troubling implication of this approach is that there is no clear set of conditions under which expansionary monetary policies are called for, even in a situation of slow growth and high unemployment. This is because there is no explicit operational target for economic growth, employment creation, or poverty reduction. The bias of financial programming is therefore highly contractionary.

Traditional financial programming did not incorporate explicit inflation targets. Now, however, there are new commitments commitments made by central banks to the IMF and associated organisations to reduce inflation. This adds an additional restriction on central bank policy along with the traditional commitments with respect to domestic credit ceilings and reserve floors.

Alternatives do exist

Alternatives to this destructive approach to central bank policy do exist. Erinc Yeldan from Bilkent University in Ankara, Turkey and I directed a series of country studies undertaken by a team of researchers working on a project on alternatives to inflation targeting. The countries covered in this project are Argentina, Brazil, Mexico, India, The Philippines, South Africa, Turkey, and Vietnam. I also worked with a UNDP-sponsored study of economic policy which targets employment for South Africa.

A range of alternatives were developed in these papers, all the way from modest changes in the inflation targeting framework to allow for more focus on exchange rates and a change in the index of inflation used, to a much broader change in the overall mandate of the central bank to a focus on employment targeting, rather than inflation targeting. Some of the alternative policies focus exclusively on changes in central bank policy, while for other countries, changes in the broad policy framework and in the interactions of monetary, financial and fiscal policy are proposed.

Some incorporate explicit goals and targets, while others prefer more flexibility and somewhat less transparency. But all of the studies agreed that the responsibilities of central banks, particularly in developing countries, while including maintaining a moderate rate of inflation, must be broader than that, and should include other crucial real variables that have a direct impact on employment, poverty and economic growth, such as the real exchange rate, employment, or investment. They also agree that in many cases, central banks must broaden their available policy tools to allow them to reach multiple goals, including, if necessary, the implementation of capital management techniques.

The major lesson of these case studies and auxiliary materials is that there are well thought out and plausibly viable alternatives to inflation targeting that can focus more on important social, real sector outcomes such as employment generation, poverty reduction, export promotion and investment enhancement. If inflation targeting is resilient as the 'big idea' of modern central bank policy because many perceive that there is no alternative, these case studies can provide an antidote by showing that viable alternatives are plausible and can be further developed and put into practice. In fact, doing so would be consistent with long-standing historical practice.