In trying to find their way toward growth and economic and social development, policymakers in developing countries face multiple uncertainties. For most, the major sources of advice of external financial assistance are the Bretton Woods institutions. With large financial resources at their disposal, and their support conditional on the adoption of certain policy prescriptions, the influence of the International Monetary Fund (IMF) and the World Bank (WB) can hardly be exaggerated.
Their influence on economic policy has undoubtedly contributed to the strengthening of the macroeconomic framework of member countries, reducing public sector deficits and public debt accumulation, improving monetary control and reducing the distortions and misallocation of resources brought about by high rates of inflation. In addition, by fostering trade liberalization and privatization of state enterprises, the Bretton Woods Institutions (BWIs) have generally contributed to the growth of exports and the attraction of foreign direct investment. In the face of a number of recent challenges, however, these institutions’ neoliberal paradigm would seem insufficient, and needs to be complemented by other elements.
The first of these challenges is posed by the explosive growth of capital markets and their extraordinary volatility, with the consequent potential for the emergence of multiple equilibria in exchange markets – and also for devastating financial crises. While the BWIs recognize these risks, and are trying to improve their capabilities to predict crisis, efforts at crisis prevention have not been successful. As for crisis resolution, the IMF's approaches to in Asia, Russia and Argentina have been controversial. In fact, one of the more successful responses to the challenge posed by the volatility of capital flows has been the introduction in Chile and Colombia, for example, of market-based controls on capital movements, which had been resisted by the IMF for years. These responses illustrate the practical relevance of the ‘theory of the second best’ by which, when an economy suffers a distortion, welfare may be improved by the judicious introduction of another distortion through some form of government intervention.
A second, related, challenge, which is yet to be addressed, is posed by the massive reversals of previously large capital flows, from the developed to the developing countries.