Economist John Maynard Keynes, the intellectual godfather of the IMF who worried about the massive unemployment during the Great Depression, knew that when countries face a downturn, monetary policy often would not suffice to restore the economy to full employment—something the United States has witnessed in the last two years. Keynes argued that governments should increase expenditures (or cut taxes), but he also recognized that due to capital market imperfections, some countries would have difficulty getting access to the funds needed to finance such an expansionary fiscal policy. Because what happened in one country has effects on its neighbors—a slowdown in one can bring on a downturn in others—good macromanagement is an issue of global concern. That is why there needs to be an international fund to provide money to countries facing a downturn.

As I explained in my book, Globalization and its Discontents, Keynes would be turning over in his grave if he were to see what has happened to his creation. Rather than enabling countries to pursue expansionary policies to resolve economic crises, the IMF has instead forced countries into contractionary policies, which has only exacerbated economic downturns, just as economic theory predicted—predictions which have been confirmed by the cases of East Asia and Argentina. Note the contrast between what the IMF and the US Treasury insist on abroad, and what almost everyone thinks is the right US domestic policy —in the recession of 2001, both US parties agreed that there was a need for economic stimulus. Of course, the United States can easily borrow to finance the needed stimulus, but that is exactly the point: the IMF was supposed to provide the needed funds.

There were other market failures the IMF should have addressed to enhance global economic stability, such as the market failures associated with risk which results in poor countries bearing the brunt of exchange rate and interest rate fluctuations. There are a variety of ways this can be resolved, but the IMF does not even seem to recognize the problem, let alone address it. Meanwhile, it has pushed policies like capital market liberalization, actually increasing the risk to which developing countries are exposed.

The Global Reserve System

At the center of the failures of the global financial system is the global reserve system. Every year, countries around the world have to set aside substantial amounts of money into reserves against a variety of contingencies such as decreases in foreign investor confidence, or dropoffs in international demand for the country’s exports. Substantial amounts of global income are thus not translated into global aggregate demand. There are roughly US$2.4 trillion held in reserves around the world. Countries like to keep reserves growing in tandem with imports and foreign denominated liabilities. If these grow at 10 percent per year, then countries need to set aside US$160 billion every year. Today, states hold these reserves in a variety of forms, including gold and US Treasury bills. While the United States may benefit from the resulting increased demand for US Treasury bills, the cost to the developing countries is high. Today they receive a return of 1.25 percent—a negative real return rate—even though investments yield high returns within their own counties. This is the price developing states have to pay to insure against unpredictable market events.

To see what this implies, consider a poor country in which a firm borrows US$100 million from a US bank, paying 18 percent interest. Prudent reserve policy requires that country to set aside US$100 million in reserves, normally held as US Treasury bills. In effect, it must increase its low interest loans to the United States. The country is both borrowing and lending the same US$100 million from the United States—a complete wash, except that when it borrows, it pays US$18 million a year, and when it lends, it receives US$1.25 million a year, for a net transfer from the poor country to the United States of US$16.75 million. This is great for the United States and the US Treasury, but it is hard to see how this promotes growth in the developing country.

The high costs of the global reserve system to developing countries can be seen in another way. For instance, a country with an import-GDP ratio of 30 percent that holds reserves equal to the cost of six months of imports has to hold reserves equal to 15 percent of GDP. If it holds these in the form of US treasury bills, yielding a real two percent return when the return on the marginal investment inside the country is 12 percent, then the opportunity cost to the country is 1.5 percent of GDP. For many developing countries this is an annual amount substantially greater than the entire amount of foreign assistance received.

But matters are even worse. The arithmetic of global trade implies that the sum of all trade deficits equals the sum of all trade surpluses. This means that one country’s deficit is another country’s surplus. If some countries, like Japan and China, insist on running surpluses, then other countries must run deficits. Thus deficits are as much the fault of surplus countries as they are of deficit countries. These deficits are like hot potatoes: if one country manages to get rid of its deficit, it must show up elsewhere. That is one of the reasons why the world, under current arrangements, has faced a succession of crises. When Korea suffered a crisis and converted from a deficit to a large surplus, other countries around the world wound up with larger deficits.

The global economic system has been able to work only because the United States has acted as a “deficit of last resort”—meaning that the richest country in the world is the only one able to spend well beyond its means. The global financial system ought to channel global savings to the poorest countries so they can use it to invest and grow; instead, it is channeling global savings to the richest country, so that its citizens, whose living standard is already beyond the wildest dreams of those in the developing world, can consume even more. But the world’s willingness to lend to the United States as it finances these deficits may be limited, even given foreign countries’ desire to hold US dollars as reserves. If every country tried simultaneously to cut back on their trade deficits, but no pressures were imposed on the surplus countries, earlier fears of a deflationary bias in the global economy would be realized.