*EPF313 06/27/01
Text: Treasury Secretary O'Neill on IMF, World Bank Reform
(Each loan should raise productivity, he says) (3340)

Secretary of the Treasury Paul O'Neill says lending by the multilateral development banks (MDBs) must be focused "intently and solely" on projects that raise productivity in the poorer countries.

"In the case of each new loan, each new grant, each new project, each new program, we have to ask: 'How is this flow of funds going to raise productivity or raise income per capita?'" O'Neill said in a June 27 speech to the Economic Club of Detroit.

The World Bank and the other MDBs should concentrate on assisting the factors that will improve productivity, O'Neill said. First, the MDBs should place greater emphasis on funding education, which now is only 7 percent of total World Bank lending, he said. Second, the MDBs must encourage countries to invest in sectors to "make real products for real customers in competitive markets" and avoid those sectors that "are already over-supplied." Third, "to spark innovation, you need the rule of law, enforceable contracts and a stable government process with a minimum amount of corruption," he said.

O'Neill added that the World Bank and the other MDBs should start making more grants rather than loans that will not be repaid. "If their intent is not to get the interest and principal back, then they should call it a grant," O'Neill said. "MDBs should adopt a bolder, more aggressive stance on the use of grants for the poorest countries," he said.

The International Monetary Fund (IMF) also needs to be more focused, O'Neill said. "The core objectives of the IMF are to (1) promote sound monetary, fiscal, exchange rate, and financial sector policies, (2) carefully monitor economic conditions, and (3) deal with critical problems in the international financial system as soon as they are detected," he said. In the 1990s, the IMF went "well beyond" these core objectives, he said.

While seeking to make institutional changes, O'Neill said it was not possible to "just stop everything and start over." In the case of Turkey, O'Neill said, the new administration "inherited a crisis and set of expectations surrounding the crisis." Nonetheless, the new administration, in dealing with the crisis in Turkey, has been able to take certain steps that present a "different pathway for the future," he said.

"First, we did not provide additional bilateral financial assistance to Turkey. Rather, we said that the IMF should be the instrument of choice when there is a need to deal with financial instability, or crisis conditions," O'Neill said. Since the IMF's resources are limited, this decision was a statement that "there are indeed limits on what the official sector will do in such situations," he said.

Second, in moving ahead with assistance to Turkey, the United States insisted on "a firm commitment" from the top leaders of the country, O'Neill said. "Going forward, Turkey's success will depend on that government following through on its commitments," he said.

Following is the text of O'Neill's speech as prepared for delivery:

(Note: In the text "billion" equals 1,000 million.)

(begin text)

EXCELLENCE AND THE INTERNATIONAL FINANCIAL INSTITUTIONS
REMARKS BY PAUL H. O'NEILL
SECRETARY OF THE TREASURY
TO THE ECONOMIC CLUB OF DETROIT
DETROIT, MICHIGAN
June 27, 2001

Thank you for inviting me to speak to the Economic Club of Detroit. You are one of the premier venues for important economic discussion and I welcome this opportunity today to pull together in a more complete form some of the things I have been saying and acting on since I became Secretary of the Treasury last January.

Many of you know me from past business associations or from our work together in helping non-profit organizations. None of you will be surprised to know that I have brought my devotion to the idea of excellence to my new pursuits in the government. I am questioning every practice I encounter to see if there is a way to create more value for the American people who pay the bills. A companion part of this quest is to improve the sense of satisfaction for the people in the government who do the work.

My particular focus today is the International Financial Institutions. I will talk to you in the familiar terms of economics and process and public policy, but before I do that I want you to know that my passion for these subjects comes from forty years of traveling and working in the world -- seeing first hand what it means for an individual human being to have a life without hope. Many of you have seen what I have -- babies born in the dust, young children afflicted by diseases that are caused by the absence of clean water and sanitation, young adults who have no education. Putting an end to these conditions is why we need to care about the performance of the International Financial Institutions.

Since their inception the international financial institutions -- the IMF, the World Bank and the regional development banks -- have spent hundreds of billions of dollars to reduce poverty and address financial crises around the globe. The World Bank group alone has lent $470 billion since its inception, and $225 billion in just the last decade. Visit some of the poorest nations in the world, and you will see that we have too little to show for it. It's time for a new approach to eliminating poverty.

Today, more than 1.2 billion people around the world live on less than $1 a day. In the United States, the average income is nearly $90 per day. Virtually all of those differences can be explained by differences in productivity. Poor countries are poor because productivity is low. And higher productivity translates directly into higher incomes. The best way to alleviate poverty is to increase people's incomes.

That is our challenge -- raising productivity to raise living standards around the world. It's a challenge that we in the world's wealthiest and most innovative and optimistic nation should relish. The people of the world can achieve better living standards the way we have -- through the constant improvement of and rewarding of skills and ideas.

To spread the principles that have made America prosperous, we must continue to promote more open trade around the world and we must focus the international financial institutions on nourishing the seeds of market economics.

Some doubt the ability of the international financial institutions to meet that challenge. I shared their concern, even before I became Treasury Secretary, that these institutions were too often associated with crisis conditions or failure. When respected elder statesmen and scholars call for closing down the IMF, it is clear that we have a major repair and restoration job before us.

I believe we can focus the vast knowledge in these institutions and help them to be effective in achieving world economic development. We have begun to engage the institutions and all of the other Nations that fund them, to encourage change, step-by-step. As we do so, we are holding up the banner of excellence. For us excellence means: the MDBs clearly associated with improving standards of living in the developing world based on productivity growth and, for the IMF, careful monitoring and prompt decisions before financial crisis conditions threaten economic order in the world.

The Multilateral Development Banks

The work of the development banks has been too diffuse. If we are to accomplish our goal of raising living standards around the world, we must focus intently and solely on projects that raise productivity.

So, here is our approach: In the case of each new loan, each new grant, each new project, each new program, we need to ask: "How is this flow of funds going to raise productivity or raise income per capita?"

How do you increase productivity growth? There are three elements to improving productivity: improvements in human knowledge, new and better physical capital, and ongoing entrepreneurial activity. The recent history of the U.S. makes clear how important improved education and capital are to individual entrepreneurs. One has only to look at the American farmer. As farmers learned new techniques and developed new machinery, farm output per unit of farm labor grew by more than eight times between 1948 and the 1990s. In contrast, agriculture value-added per worker in sub-Saharan Africa is lower now than it was 20 years ago.

Many of the poorest countries are primarily agricultural. It used to be thought that forcing the pace of industrialization was the path to progress. But putting huge uncompetitive industrial plants in poor countries had too little payoff in lives of the general population. Such policies disrupted lives and traditional communities as young men left their families and communities to stream into growing industrial cities. The social and health consequences are all too obvious and deplorable in all too many developing countries. And the huge state-owned industrial firms are now bankrupt or heavily subsidized by the toil of common people.

We now understand that investing in agriculture while creating the environment to diversify into competitive, privately owned manufacturing is the key to development. But there is still more to be done in focusing on productivity.

So how can the World Bank and other MDBs contribute to those three factors underlying productivity? First, expanding human skills and knowledge. One of the most fundamental things -- call it a universal truth -- is that education is inextricably linked to improving living standards. If you want to see higher rates of productivity growth, the people need knowledge and skills. So, I would like to see the MDBs place greater emphasis on education. President Bush has made education a top priority for the U.S. economy. It should be a top priority for Nations around the world. Over the past 5 years, education projects accounted for only 7 percent of total World Bank lending. That must change.

Second, productivity growth requires capital, so you need open trade and stable capital flows from abroad. But not all capital investment is equal. You need to make real products for real customers in competitive markets. As the MDBs provide investment assistance it is important that they take a "whole world" view, and not induce countries to invest in sectors that are already over-supplied.

Finally, the role of the entrepreneur is critical, and almost intangible. How do you invest in idea creation? If we knew that, we'd solve all the world's problems. We do know that some things are necessary, if not sufficient, to create an entrepreneurial environment. To spark innovation, you need the rule of law, enforceable contracts and a stable government process with a minimum amount of corruption. Without these, there is no reward to innovation -- without assurance that you can own a new idea, who will bother?

We must insist that the MDBs reinforce these bedrocks of a market economy. We must establish as a precondition that we will not tolerate corruption. Poverty is not an excuse for corruption. It is not an excuse for not having the rule of law. Poverty is a symptom and it will only go away when these basic conditions for lasting growth are in place.

Within this strategy for setting priorities based on productivity enhancement, let me propose some specific ways to use taxpayer resources more effectively:

I think the World Bank and the other multilateral development banks should be clear about the instruments of assistance they use. When they give a nation money and call it a loan, then I think they should expect they are going to get their money back with interest. If their intent is not to get the interest and principal back, then they should call it a grant. By misusing loans we've allowed many of the poorest nations to become so highly indebted that they cannot service the loans they already have, let alone more. We are making progress cleaning up those situations. They must never happen again. We teach a bad lesson to the recipients when we confuse loans with grants because the message is: obligations may not be real obligations.

I believe that the MDBs should adopt a bolder, more aggressive stance on the use of grants for the poorest countries. How can you make a loan for an already heavily indebted country to provide basic health and education services to its poorest people or to help fight HIV/AIDS and other infectious diseases? How will such economies generate the economic returns with which to pay back funds? Projects like these should be considered for grants, not loans.

As we become clear about the instruments of assistance, we also need to become more rigorous about measuring results. For example, in education it is clear that inputs -- classrooms, teachers -- are a secondary measure. What is really important is the product of education -- an ability to read and write and compute at an appropriate level. When you have achieved that, you have achieved a critical milestone for the prospects of economic development. We need to be hard-minded and demanding that the inputs produce valuable outputs so that people in the developing world can achieve a standard of living that we know is attainable.

Graduation of Middle Income Countries. I believe that the MDBs should focus their resources first on countries that do not have access to private financial markets. As the financial conditions of individual countries improve, we should implement a system of loan rates that moves toward the private market interest rate. Then we would not confuse the assistance role of the banks from the point of view of competing with private enterprise.

Better Coordination. I also believe that the multilateral development banks can improve their coordination. More work is needed to bring greater consistency, simplicity and clarity where more than one institution is operating in a particular country. The MDBs need to do a better job of sharing ideas and lessons learned about what works and what does not work.

In addition, it is important that the assisting institutions put themselves in the shoes of the recipient countries as they impose conditions. Is it practical to assume that a President in a country without a well-developed government system can do all of the well-intentioned things we tell them they must do? If the answer is no, we need to reduce the number of things we insist on to those that are measurable and that we mean to enforce.

The International Monetary Fund

Like the World Bank, the IMF needs to focus on core objectives. The core objectives of the IMF are to (l) promote sound monetary, fiscal, exchange rate, and financial sector policies, (2) carefully monitor economic conditions, and (3) deal with critical problems in the international financial system as soon as they are detected. In the late 1990s, the IMF went well beyond these core objectives; putting too many conditions on some loans and putting too much money into some places in the face of dubious economic and political conditions.

Crisis Prevention. Having inherited a few international financial crises when I came into this job, I have spoken often about the need for better crisis prevention at the IMF. Crises strike when there is a failure to detect financial stresses or imbalances, or when there is a failure to make the necessary decisions to reduce the stresses and imbalances that have been detected. The problem in recent years has clearly been the latter. We simply must do better -- and that is why I continue to return to this theme.

Conditionality. In our policy review work at Treasury, we have been arguing that conditionality can be substantially reduced, so that what is left is more enforceable, measurable, and purposeful and in the interest of the people in the recipient countries. For example, in the case of Indonesia, the IMF had a very long list of conditions, none of which were undesirable per se, but some of which went well beyond the IMF's core area of expertise. Some of these things were more properly in the province of people inside the country.

Moral Hazard and Contagion. Another thing that the IMF should strive for is a way to reduce so-called moral hazard. It is a fundamental truth that risk and reward must go hand in hand. Disassociating the two is a recipe for disaster. We need to figure out a way to let people who reap the high returns suffer the consequences of that risk without letting them off the hook with the taxpayers' money.

Understanding contagion will enable us to deal more effectively with this moral hazard problem. Frankly, I don't believe that we should accept the notion of contagion as something that God intended for us to have. I think we should work very hard to develop mechanisms to defeat contagion. If you look at Turkey, Argentina and Indonesia today, you would be very hard-pressed to make a case that they were closely related to each other. We should not accept the proposition that a weakening financial condition in one difficult place inevitably creates a chain reaction of investors withdrawing from other markets.

Exaggerating the possibility of contagion leads to too-frequent intervention because, in effect, we convince ourselves we don't have a choice. That is to say, if we don't act, the consequences will be multiplied in a world-wide rout of the financial system. Making money available on this theory, we promote the idea that we will intervene everywhere on the spur of the moment in order to protect ourselves against the consequences of one nation losing its financial footing.

If we can solve the problem of contagion, we can deal in a much more forthright and forceful way with individual countries and investors. If we do not have to worry about contagion, it is going to be a lot easier to say "you brought this situation on yourself in spite of the best possible advice and we are not going to bail you out."

Recent Financial Crisis

How do we make these institutional changes? Clearly, we don't just stop everything and start over. In the case of Turkey, for example, we inherited a crisis and a set of expectations surrounding that crisis. We could not start from scratch. Nonetheless, the steps we took represent the beginning of a different pathway for the future.

We stressed several principles in our dealings with Turkey. First, we did not provide additional bilateral financial assistance to Turkey. Rather, we said that the IMF should be the instrument of choice when there is a need to deal with financial instability or crisis conditions. In general we should not become engaged in bilateral assistance on top of, or in lieu of, appropriate intervention by the IMF. Since IMF resources are limited -- and this is very important -- this decision was a statement that there are indeed limits on what the official sector will do in such situations.

Second, we stressed the importance of prior actions with a firm commitment from the top political leadership. We feel that a forthright, on the record, very clear position of ownership of the changes that are going to be made should be a condition for the receipt of assistance; and that is what the Turkish government agreed to do. Going forward, Turkey's success will depend on that government following through on its commitment. Modifying the practices and expectations of the past in dealing with such situations will take time, but we have begun to do so.

Conclusion

Next week I will be meeting in Rome with my partners in the G-7 [Group of Seven (G-7) leading industrial countries: Canada, France, Germany, Italy, Japan, United Kingdom, United States], as well as with the Heads of the Multilateral Development Banks. I look forward to this meeting as an opportunity to move forward on the priorities that I have described to you today.

Thank you.

(end text)

(Distributed by the Office of International Information Programs, U.S.
Department of State. Web site: http://usinfo.state.gov)
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