Lagarde on the Prerequisites for a Strong Global Economy

Extracts from a Speech to the Washington Foreign Law Society by Christine Lagarde, Managing Director, International Monetary Fund (June 4^th 2013).

I should start with a brief update on the global recovery, which is uneven and in fact suffering from an unfinished agenda of critical legal and institutional reforms. We are seeing now a three-speed global economy, where some economies are growing nicely, like the emerging markets in Asia; some are experiencing a rebound, like the U.S.; and others that continue to see weak or even declines in growth, like in parts of Europe. Our projection for global growth remains at 3.3 percent, not much higher than last year, though recent data on manufacturing and industrial production suggest we could be entering a softer patch. This state of affairs is not optimal: we need to move to a “full speed” global recovery with strong economic performance for all countries.

1. Strong legal and institutional frameworks for a strong economy

Turning to my first area of focus: legal and institutional reforms are a critical component of the unfinished agenda for global recovery.

The current crisis has played out most aggressively in advanced economies ─ ironically the economies that previously were assumed to have the strongest legal and institutional architecture. Instead, their regulatory and institutional weaknesses were the source of the crisis, and they are now the economies in third, or at best, second gear. To recover from their current relatively weak position, these economies need to implement a range of legal and institutional reforms in areas such as banking, fiscal policy and corporate/household debt restructuring, as well as tax policies.

But at the current economic juncture, even those economies that are on the mend or that are doing relatively well, are not immune. They too need to continue to adopt robust legal and institutional reforms, for example, in the fiscal area and financial sector, to address remaining vulnerabilities and strengthen their growth trajectories.

“So, what then is the nature of these strong laws and robust institutions that are necessary for a lasting, ‘full speed’ global recovery?”

They have two essential components:

First, there need to be laws underpinned by an unwavering respect for the rule of law. As James Madison wrote in the Federalist papers: “you must first enable the government to control the governed; and in the next place oblige it to control itself”. This is the essence of the rule of law – the law must apply equally to all citizens, including those who make the law.

Secondly, and just as importantly, there must be strong institutions that are capable of implementing and enforcing the law in accordance with its terms. It is a common saying that a “chain is only as strong as its weakest link”. Well, in the same way, laws are only as strong as the weakest institutions that enforce them.

Above all, this requires a competent and independent judiciary to implement the law consistently, predictably and transparently. “Il faut que, par la disposition des choses, le pouvoir arrête le pouvoir” (Montesquieu). It also requires strong fiscal institutions, and a credible and well-equipped financial sector regulatory framework. These are key pillars of a robust and inclusive institutional framework.

There is a large body of evidence that confirms the importance of a strong legal and institutional framework, with the core features I have described, for sustainable economic growth. This is recognized by political scientists and economists alike, and above all by history: countries that have developed strong legal and institutional frameworks have performed better in terms of sustained growth and human development. The recent book “Why Nations Fail” by Daron Acemoğlu and James Robinson made a very convincing case for this.

Let us take as an example the system of property rights. The economist Hernando De Soto has long argued that the lack of a system of formal property rights is the main cause of under-development. Among other things, it prevents individuals and enterprises from using their assets to secure credit; more generally, weak enforcement frameworks raise borrowing costs significantly. This creates what De Soto famously described as “dead capital” – a large informal economy in which assets are undervalued, unreported and untaxed.

Imagine transferring a title when institutions are not strong, when boundaries and reported properties are vague, at best, or not accounted for at all because there has never been a cadastre.

The underground economy is estimated at 30-40 percent of GDP in developing countries, and about 15 percent in advanced economies like the U.S. Think of the lost productive potential in an economy where almost half of activity is unreported and almost half the population is beyond the reach of public services.

2. The IMF: strengthening laws and institutions

This brings me to my second area of focus: the IMF’s role in this area. Given the general points I have just made, it will not surprise you to hear that strengthening legal and institutional frameworks is central to the IMF’s work, particularly as we aim for a “full speed” recovery from the global financial crisis.

Because the IMF is often involved at crisis or near-crisis junctures, we can serve as a catalyst for countries to enact legal and institutional reforms that they otherwise lacked the political will or urgency to undertake. As I have mentioned, much of the IMF’s efforts in this area are currently focused on advanced economies, particularly in the euro area. But we also continue to do a good amount of work with our emerging market and low-income members, who too have unfinished reforms in this area.

“It is important to note though that this type of reform takes time. The IMF therefore focuses on putting in motion the process of reform. But member countries must sustain these reforms over time to be effective.”

Let me give you three important and topical examples of how sound legal and institutional frameworks are essential for the design and implementation of our policy advice: first, in the area of fiscal frameworks; second, in the area of debt restructuring; and third, in the area of combating economic crimes. These areas have taken centre stage in the IMF’s response to the global financial crisis.

  (1) Strengthening fiscal frameworks

Since the early days, the IMF has been involved in the design of legal and institutional frameworks for fiscal policy. Today, we are seeing the importance of strong fiscal frameworks to underpin the credibility and quality of planned fiscal consolidation, particularly in response to the global financial crisis. As you know, the appropriate pace of consolidation has been at the top of the global economic agenda in recent months.

An important area is tax reform. We have found in many of our member countries that weaknesses here are as much about enforcement as they are about the laws themselves. Tax enforcement requires an efficient and independent judiciary, competent and un-corrupt tax officials. Tax reforms have featured in many of the recent IMF-supported programs, including for Greece for instance.

The IMF also works extensively with countries rich in natural resources, such as Liberia, Mozambique, Malawi, Sierra Leone and Myanmar to help set up sound, transparent institutions and fiscal regimes for extraction that can ensure fairness to all parties and, especially, long-term fiscal sustainability.

  (2) Restructuring debts

Let me turn to my second example: A pervasive theme of the current crisis has been the problem of over-indebtedness – we saw this during the Asian financial crisis and again today. It will not surprise you that strong legal and institutional frameworks are central to addressing this problem.

In the corporate and household sectors, the IMF has helped countries revise insolvency laws, though we found, once again, that implementation and enforcement of the law was the key fault-line. In Greece and Portugal, for example, the IMF is helping put in place more effective procedural rules, fast-track court approval procedures and out-of-court debt restructuring frameworks. These and other measures are needed to optimize the efficiency of court proceedings, and in particular to reduce the large backlogs of cases that are overburdening the system.

In the financial sector on the other hand, the main issue is finding a way to efficiently resolve global financial institutions that took on excessive debts in the lead-up to the crisis. Large international financial groups operate on an increasingly global and integrated basis; however the legal and institutional frameworks to resolve these groups in times of distress are distinctly national in scope. As the Governor of the Bank of England, Mervyn King, famously said: “Banks have an international life, and a national death”.

What has become abundantly clear is that we need a way to encourage cooperation and coordination between national authorities in the resolution of these institutions. The IMF has therefore worked closely with the Financial Stability Board to develop a set of international standards for effective resolution regimes, which includes measures for cross-border cooperation.

“In Europe, the IMF has also strongly supported efforts to create a European banking union – a key pillar of which is a single resolution authority, backed by a common resolution fund.”

Without the necessary legal and institutional framework in place, countries may be pushed to “bail-out” those institutions perceived to be systemic for their financial systems – but this can be hugely detrimental for sovereign balance sheets.

This brings me to the issue of the sovereign itself. We must recognize that, at a certain point, a country’s public debt level may become unsustainable. And while this should be the last resort, a strong legal framework is needed to support any debt restructuring process. The ongoing litigation related to Argentina’s debt restructuring highlights the legal vulnerabilities that remain to be addressed in this area.

The IMF Executive Board met recently to discuss the IMF’s legal and policy framework regarding sovereign debt restructuring. We will be looking at these issues more closely in the coming months. Amongst other areas, we will focus in particular on ways in which the contractual, market-based approach to facilitate sovereign debt restructuring can be improved.

  (3) Combating economic crime

So after tax law, bankruptcy and resolution, coupled with debt restructuring, another area in which sound legal and institutional frameworks are crucial to the IMF’s role is in combating financial fraud, tax evasion, corruption, and the money laundering that accompanies it.

These activities can severely undermine national and global financial stability and eat into a government’s revenue stream, with severe fiscal consequences. To give you a few examples, there is no doubt that tax evasion has been widespread in Greece. In Cyprus, weaknesses in the anti-money-laundering framework may have contributed to the attractiveness and unsustainable growth of its financial sector. Financial fraud was at the centre of crises in a number of other countries in which the IMF has been involved.

Our efforts in this area thus work to address the vulnerabilities in legal and institutional frameworks that allow these activities to flourish. In particular, this involves strengthening frameworks for tax administration, financial supervision and public financial management.

In addition, it requires mobilizing the anti-money laundering and counter financing of terrorism framework to clamp down on economic crimes, for example, by increasing the monitoring of suspicious fund flows, and ensuring that related assets can be frozen to support tax debt collection.

Ultimately, left unchecked, these activities allow criminals to amass wealth, power and influence. This undermines the rule of law and erodes the social fabric, hindering prospects for growth and human development.

3. Conclusion: Governance, inequality and long term prosperity

Let me conclude by stepping back a bit. The examples I have identified often arise in the context of a crisis – and this should not be surprising given the fact that crisis resolution is a critical area of our work. But it is not the only area of our work. We also have a mandate to prevent crises and to promote sustainable growth for the future.

In that context, we have realized that perhaps we need to spend more time identifying and reflecting on those factors that, over the longer term, may have an impact on economic prosperity. I have discussed the importance of strong laws and institutions, underpinned by the rule of law, for long term economic prosperity. Those countries whose legal and institutional frameworks are particularly weak are likely to pay for those weaknesses over time.

But there are also other long-term trends that can have a major impact on economic prosperity. For example, there is significant evidence that, over time, growing inequality can adversely affect both growth and stability. Equally, we need to take into account trends such as climate change and resource scarcity, and reconcile our aspiration for growth with the constraints of a finite planet – sustainable growth is also green growth.

Accordingly, it makes sense to ask whether the need for reforms in these areas should not also form a greater part of our conversation with member countries – even if, in the short term, a crisis does not appear to be on the horizon. Clearly, there will be other international organizations that are also well-placed to play a leading role in this area. But I think the IMF can do more to identify this as an issue – and this is an area that we will be exploring further.

Thomas Aquinas defined law as “an ordinance for reason for the common good, made and promulgated by him who has care of the community.” The IMF is a public economic institution with a higher purpose of promoting the common good and the best interests of the global community.  We need to foster strong laws and institutions, and think about the longer term consequences of the decisions we make today, if we are to achieve the sustainable economic growth that is central to the IMF’s mandate.