A Watchful Eye

In the wake of the Dec. 9 debt crisis summit, European politicians face the challenges of restoring confidence in the European Union and implementing credible economic reform. An essential element in this plan is a renewed commitment to fiscal discipline in the form of hard limits on debt and deficits. But this deal, like the Stability and Growth Pact that preceded it, is certain to unravel without diligent external monitoring to ensure that EU countries are meeting their pledges.

While the exact mechanism guaranteeing that EU countries meet their fiscal targets is still to be determined, the International Monetary Fund (IMF) can play an important role through its mandate for global economic surveillance outlined in Article IV of the Articles of Agreement. In accordance with this mandate, IMF officials meet with member countries on an annual basis to make sure that each country’s economic policies are contributing to global economic stability. As Managing Director Christine Lagarde has emphasized, the IMF is uniquely positioned to be an indispensible policy advisor. Its expertise has allowed the IMF to inculcate trust among member countries, and the private sector regards it as a provider of high-quality information. The IMF can therefore provide an impartial assessment of EU countries in a way that the European Union itself certainly cannot.

But before the IMF can save Europe, it must improve its surveillance mechanisms. Prior to 2007, IMF surveillance did not warn U.S. policymakers about the potential for a collapse in housing prices, nor did it suggest that the banking system was unstable. The IMF Independent Evaluation Office’s recent review of the Fund’s surveillance record in the pre-crisis period attributed these failings to an internal culture marked by groupthink and an unwillingness to pay attention to mounting risks. The report suggested ways for surveillance to emphasize vulnerabilities and risks rather than uncritically endorse country policies.

We therefore face a conundrum. Surveillance has become a much-needed tool for the world economy at a time when the very effectiveness of surveillance has been called into question. Open markets require open dialogue about the state of the economy and recommendations that can lead to results. The IMF needs to use surveillance constructively to raise its influence in both crisis and non-crisis countries. Recent reforms suggest that the Fund may be rising to meet this challenge, but there’s more that can be done.

IMF surveillance became a more public process in the wake of the East Asian financial crisis in the late 1990s. It became clear that knowing the true state of a country’s economy would help the private sector make better decisions, which in turn would make the IMF’s advice more influential. Since then, countries have had the option of releasing information about their respective consultations with the Fund. In 2010, 89 percent of the countries that had an Article IV consultation released the staff report (the document that the consultation team prepares for the Fund’s executive board). Thankfully, the stresses of the global economic downturn have not reversed this trend. Countries now get more attention for failing to be transparent.

While greater transparency increases the Fund’s influence over member countries, there is still more that the IMF can do to use transparency to its advantage. While publishing the findings of consultations on the IMF website can help inform audiences about the institution’s views, the Fund is forfeiting an opportunity to enhance its influence by not revealing information about the process of the consultations themselves. More media outreach is essential for the Fund, especially in developed countries. In developing countries with Fund-backed adjustment programs, frequent statements by IMF resident representatives to the media are a fact of life. During the July 2011 debt-ceiling debate in the United States, by contrast, hardly any information surfaced about America’s Article IV consultation, let alone what its findings were.

A second surveillance challenge is for the IMF to add real value. Politicians in advanced economies are looking for innovative solutions to the fiscal policy challenges that they face which boil down to a growing burden of entitlements coupled with publics weary of higher taxes and weak job growth. These are problems that an organization with the nickname "It’s Mostly Fiscal" should play a prominent role in fixing.

The narrowness of the Fund’s surveillance mandate (to focus on the linkages between fiscal and monetary policy and the exchange rate) limits both the nature of its advice and its effectiveness. One of the key recommendations of an External Advisory Group that evaluated the Fund’s recent Triennial Surveillance Review was that the IMF should offer more recommendations aimed at job creation. If surveillance only provides politicians with uncomfortable truths rather than creative solutions, it is no wonder that the Fund has little influence in the OECD countries. A discussion of mandate reform is already underway at the Fund, but one reform that could be implemented in the short term for European countries is to synchronize Article IV consultations with national budget-making processes. This would not only ensure that the Fund reveals information in a timely fashion about EU country commitments to new debt and deficit ceilings, but also provide an entrée for further dialogue about how politicians can work to boost employment in a time of fiscal restraint.

Shifts in global power have led to a new and revitalized IMF. Years ago, the noted political economist Susan Strange referred to IMF surveillance as a "pantomime."  In her view, a dialogue between the Fund and its most powerful members could not be consequential because the IMF would not say anything to upset its patrons. But in the past five years, we’ve seen a real democratization within the IMF, reflecting the growing influence of emerging markets. As these countries have transitioned from IMF borrowers to creditors, they’ve acquired a commensurate amount of voice. This is a welcome development, because it will make the IMF more accountable. The Chinese and Brazilians will push for the Fund to "talk tough" to the indebted European countries whose bonds they are purchasing so that these countries honor their new commitments to fiscal austerity. Changes in the global distribution of power suggest that surveillance can become more influential.

European leaders are now racing to build EU-wide institutions to address the European debt crisis. Greater monitoring of EU country fiscal policies is essential given the move toward fiscal union, and the IMF is uniquely equipped to provide that function. Enhancing the transparency of the consultation process, focusing more on job creation, and synchronizing the surveillance process with national budget cycles will help to calm jittery markets and strengthen the Fund’s influence over developed countries. These needed reforms of IMF surveillance will help us avoid the next economic crisis even as we work to exit this one.