Working Paper No. 11

Independent but Accountable: Walsh Contracts and the Credibility Problem
Ali al-Nowaihi, Paul Levine

Walsh (1995) addresses the government-central bank principal-agent problem where there exists a severe information extraction problem. This is solved by a ‘Walsh contract’ which links the income of the central bank to observed macroeconomic variables, output and inflation. However, the contract does not solve the time-inconsistency problem. There will be circumstances where renegotiation of the contract benefits all parties involved and non-renegotiation-proofness destroys its credibility as a commitment device. But the contract’s strength is that renegotiation can be very visible and this facilitates a reputational solution to the problem, set out in this paper.

Working Paper No. 12

Financial Market Integration, Global Capital Mobility and the ERM Crisis 1992–5
Geoffrey R D Underhill

This paper argues that there is a close relationship between the enhancement of short-term capital mobility and volatility through regulatory changes in the financial market framework, on the one hand, and the growing constraints on state macroeconomic policy autonomy, on the other. One example of such macroeconomic difficulties, not to say instability, was the crisis of the European Exchange Rate Mechanism (ERM) which erupted in mid-1992 and continues to threaten the future of the EMS and the prospects for the Maastricht Economic and Monetary Union/Single Currency project.
This paper demonstrates, however, that although the two policy issues, financial market regulation and macroeconomic policy-making, are interdependent, the policy communities involved in each are effectively separate. Thus regulatory changes, which have a considerable impact on the capacity of democratically-elected governments to chose and manage their macroeconomic policy options, are made on the basis of financial market liquidity and efficiency criteria and without reference to their undoubted impact on the wider economy. This constrains the ability of these governments to maintain their domestic political legitimacy in the face of exchange rate instability and other aspects of economic volatility.
In addition there is little public debate about the highly complex issues of global financial market regulation, which remains the preserve of specialized agencies with very close connections to the financial services industry. In contrast, governments face a wide array of interests, many in conflict with each other, in the making of macroeconomic policy. In sum, closed and increasingly transnational policy communities dominate the making of regulatory policies, constraining the capacity of governments to foster exchange rate stability, employment, growth and social policies. This constitutes a ‘legitimacy deficit’, and the risk is that states might react by flexing their jurisdictional muscles in ways which are not always either cooperative or pleasant in terms of the international community.

Working Paper No. 13

Can Delegation be Counterproductive? The Choice of ‘Conservative’ Bankers in Open Economies
David Currie, Paul Levine, Joseph Pearlman

This paper provides a comprehensive assessment of the open economy aspects of the ‘delegation game’ in which the operation of monetary policy is delegated to independent and ‘conservative’ central bankers, with a greater dislike of inflation than the public. When all countries optimally and independently choose the conservatism of their bankers a highly inefficient Nash equilibrium can result. This inefficiency increases as the number of countries increases, the correlation of shocks increases, and if there is unemployment persistence. Delegation can be counterproductive in the sense that the non-cooperative equilibrium of the delegation game results in a lower welfare than that of the representative bankers game.

Working Paper No. 14

Testing for the Symmetry of Shocks Amongst the G3 Economies
Hong Bai, Stephen Hall

The question of the optimal form of cooperation between countries and the right form of delegation within countries has received enormous attention over the last few years. This literature stems originally from the work of Barro and Gordon (1983) although it has now grown to include a number of interrelated concepts such as time inconsistency, the nature of solutions and without precommitment, reputational equilibria and ways of setting up punishment strategies to ensure cooperative or time consistent solutions. The more recent work in this literature has focused on optimal forms for delegation and optimal structures for policy coordination in a more realistic setting. Much of this work focuses on deriving optimal behaviour for a range of stylized descriptions of how the world might be. One of the key assumptions has turned out to be the degree to which shocks which hit different countries in the game are correlated. Yet though we understand the general importance of the degree of correlation of shocks across the international system, very little empirical work has been undertaken to document the real relationship which exists in actual fact. The purpose of this paper is to help fill this gap in our understanding. We apply a new technique which assesses the extent to which time series data have various different properties. The intuition here is that shocks will be generally have certain time series properties and that these properties will be reflected in the data we observe. If two series are found to exhibit common behaviour then the underlying stochastic process which generated them must have an important correlation structure which will have implications for the structure of economic cooperation.

Working Paper No. 15

The World Bank: Its Functions and its Future
by Christopher L Gilbert, Raul Hopkins, Andrew Powell and Amlan Roy

July 1996

The World Bank has evolved over its 50 years of operation so that it simultaneously exercises a number of different functions. We identify four: the Bank as a bank, as development agency, as credit-ranking agency, and as a development research institution. The first two of these are central. The banking function is premised on the existence of capital market imperfections, of which that arising from sovereign risk is the most important. Acting as a development agency, the Bank provides finance for development purposes, often on concessional terms, which over the past 15 years has generally been combined with policy conditionality.

We argue that the role of conditionality is crucial to understanding the World Bank’s operations. The Bank imposes conditionality as part of its development mission – structural adjustment has resulted in policy reforms taking priority over projects as a justification for lending. But the ability to impose conditionality gives the Bank a comparative advantage in enforcement of debt service. This generates a complementarity between the Bank ‘s development agency and banking functions. But because successful conditionality will also result in improved service of private debt, there is an externality. The Bank is concerned with development and not simply profits, and is therefore willing to allow the gains from conditionality to be shared with private sector banks. This results in a superior lending equilibrium than would exist in the absence of a strong multilateral institution.

All of this would be lost by privatization of the bank either as a whole or split into functional groups. We see privatization as a distraction from the main issues facing the Bank. Most important is that there should be a shift in emphasis from provision to facilitation. This implies a shift from public sector to private sector funding, and an institutional shift from the IBRD to the IFC. The Bank should also lend less and guarantee more with the consequence that borrowing countries may be encourage back to the private capital market. This implies increased prominence for MIGA. Bank involvement in a country should evolve from provision to facilitation to exit. Direct provision of development assistance is now only essential in the LDC group of least-developed countries, and in eastern Europe and the ex-Soviet Union. Retreat in other areas, in favour of the IFC and the private sector, will create a leaner and less diffuse World Bank.