The 2007-2010 crisis offered the International Monetary Fund an unexpected opportunity to demonstrate that it was serious about changing its emergency lending practices, heavily criticised for being unnecessarily contractionary and drawing on outdated economics (Easterly, 2004). The new conditionality policies promised increased flexibility, minimal structural conditions and mainstreaming inflation targeting as the new economics of crisis (Gabor, 2010a).
An increasingly popular monetary policy framework, inflation targeting works as follows: the central bank establishes (together with the government) a target for inflation that is consistent with the economy producing at full potential. The central bank commits to achieve this inflation target over a time horizon (typically one to two years) by manipulating its interest rate, to the exclusion of achieving other targets such as level of employment or an exchange rate. The theoretical framework informing inflation targeting regimes offered the IMF an avenue for reforming the economics of its conditionality (known as financial programming) without altering its underlying principles:
1. Economic stability is best achieved through price stability (rather than employment or growth), a view also promoted by financial programming. The new policy framework envisages that price stability can and must be pursued through the central bank's influence over aggregate demand: changes in interest rates bring the economy back to its potential and inflation to target.
2. Economic policy, particularly during crisis times, can only be formulated 'rationally' if insulated from political interventions (Woods, 2006), in other words assigned to politically independent central banks. In fact, inflation targeting supporters contrasted the sophisticated monetary 'science' of modelling dynamic individual behaviour with the 'alchemy' of inevitably politicised fiscal decisions (Leeper, 2010). Thus, by embracing inflation targeting models, the IMF could claim "scientific foundations" for its (criticized) insistence that low inflation should be the policy priority.
3. Fiscal policy not only lacks theoretical foundations but is ineffective: rational agents recognise future tax burdens created by fiscal activism, and reduce present consumption/investment accordingly.
4. Markets, and not central banks, are best placed to set exchange rates. Neither concerns with competitiveness nor precautionary accumulation of reserves are necessary as monetary policy credibility ensures access to international financial markets.
Even before the crisis, critical voices questioned the wisdom of instituting a policy more concerned with inflation than unemployment as the framework for addressing crises, particularly since it suited the financial sector rather than development agendas (Epstein, 2006). The IMF dismissed such concerns, instead providing countries with technical assistance to help speed up the transition. However, it had limited opportunities to test how conditionality might work under inflation targeting (only in Colombia, Brazil and Peru), because emergency lending was concentrated in low-income countries yet to adopt this policy regime. The collapse of Lehman Brothers in September 2008 changed this, bringing crisis to Eastern Europe.
Eastern Europe problems
Eastern Europe's impressive growth performance pre-crisis relied on a consumption-driven model enabled by short-term capital inflows and appreciating exchange rates (Fabrizio et al, 2009). As in high-income countries, the prevailing model of banking sharpened vulnerabilities. The foreign-owned banks dominating banking sectors (an outcome of post-socialist privatisations) would borrow short-term in international money markets or from Western European parent banks to lend long-term in foreign currencies, resulting in housing and consumption booms and growing current account imbalances. By September 2008, over 50 per cent of housing loans were denominated in foreign currencies (euro or Swiss francs) in most countries in the region. Consumers accepted the exchange rate risk for two reasons: (relatively) lower interest rates and expectations that their national currencies would continue to appreciate (similar to expectations that US housing prices would continue to rise). However, the post-Lehman convulsions in international money markets saw regional currencies quickly depreciating and suddenly raised the possibility that parent banks might refuse to roll over the short-term debt of their Eastern European subsidiaries (Gabor, 2010b). Faced with such a 'sudden stop' in capital inflows, three European Union members, two with inflation targeting regimes already in place (Hungary and Romania), turned to IMF emergency assistance.
At a first glance, what is striking about the IMF's conditionality is the small difference between targets designed under the traditional financial programming (for Latvia, given its fixed exchange rate regime) and those for inflation targeters. As Table 1 shows, an inflation band replaced the financial programming criterion for central bank credit (and only as an indicative target for Romania). In fact, the design of monetary conditionality conformed to traditional IMF programming, giving the impression that fiscal misbehaviour rather that private banking practices had forced countries to seek the IMF's help; fiscal targets dominated conditionality.
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