In early June 2011, shortly after the governor of Mexico’s central bank had officially entered the contest to succeed Dominique Strauss-Kahn as the managing director of the IMF, Kevin Gallagher, professor at Boston University and co-director of the Global Economic Governance Initiative, published an article entitled "Why Agustín Carstens should not be the next head of the IMF".
Gallagher (a professor of international relations, rather than economics) welcomed an emerging markets candidate, but argued forcefully against Carstens’ candidacy on his economic record, which "epitomizes what is wrong with global finance", and he argued that Carstens had "not been able to learn from the [2007/08] crisis and has been stuck to outdated thinking ... [holding] Mexico to tight inflation targeting and shunned capital controls".
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Gallagher was writing as liquidity driven by quantitative easing was flooding into emerging markets and countries such as Brazil were frantically constructing sandbags of capital controls. Central banks in advanced economies and emerging markets had moved to new macro-prudential monetary policies, either to promote domestic growth or manage the fallout from externalities that others’ zero-lower-bound strategies were having on their own economies. The article went on to label Carstens a "Chicago Boy", given his training at the economics department of the University of Chicago, which Gallagher characterized as a promoter of "discredited theories of rational expectations and efficient markets". It’s not a view shared by many. And bankers in Mexico would argue that the IMF’s loss was their country’s gain.
Two years later, having lost out on the IMF job to France’s candidate, Christine Lagarde, Carstens is still governor of the Banco de México – presiding over one of the most open economies in the world – certainly among emerging nations. With the Brics slowing, Mexico’s future looks bright. Although economists have been shaving 2013 forecasts for a plethora of largely one-off, short-term factors very few were lowering their growth projections for 2014, and the proposed energy reforms have many forecasting long-term trend growth of between 5% and 6%.
Inflation is low and expectations are anchored; FX depreciation over the past few months has been lower than the peso’s peer group as money flowed out of emerging markets; fiscal reform is planned; and Mexico is attracting inward investment – both foreign direct investment and capital flows – at strong levels. All this contrasts starkly with some other areas of the emerging world.
Facing a changing global macroeconomic environment, this year some emerging market central banks have been trying to convince markets that inflation-targeting is really their primary function (not an easy job to do quickly) to re-anchor expectations of inflation. In the developed world, the belief in the newly adopted theories of forward guidance is being shaken in practice, especially since September’s Federal Reserve decision not to begin tapering quantitative easing has highlighted the difficulties in weighting linguistic nuances to such an extent.
So, does Carstens feel that the argument about central banking policy has swung back to orthodox, inflation-targeting? "It’s a good question," he says. "My beliefs in terms of what the role of the central bank should be are deeply anchored – not so much by orthodoxy but by having been involved for over 30 years, in different shapes and forms, with central banking. I started my career here, I had 10 years outside the bank [Carstens was deputy director of the IMF between 2003 and 2006 and Mexico’s finance minister between 2007 and 2010] and I have seen policy from different angles. And I think the best way that the central bank can help any economy is by keeping inflation under control."
Carstens is also keen to nuance Euromoney’s depiction that he is a pure economic rationalist, for example by expounding his stance on capital controls. He says: "We have been facing unprecedented times in the last three of four years where there have been massive capital flows coming into the emerging markets – and more recently a reversal – and I think that framed as part of macro-prudential policies [and] under [certain] circumstances, capital controls could be an adequate policy to follow. Given the capacity to absorb capital in some emerging markets some of the inflows can be very distortionary and [capital controls] to prevent those distortions are adequate." This approach puts Carstens, theoretically at least, in line with the IMF’s measured but controversial backing of capital controls in 2011.
However, one wonders what exceptional conditions would lead Carstens to introduce them. He says Mexico has not been close to using capital controls since the 1980s ("we didn’t have a very good experience"), and he believes the experiences of some of his colleague countries show that "oftentimes capital controls or macro-prudential policies can themselves introduce distortions to the market and subtract from clarity and I think it has worked for us to have a stand-off approach". Carstens also uses discussion about the Chicago School to cite Ronald Coase, a Nobel prize-winning member of that particular establishment, whose eponymous theorem contends (summarized crudely) that regulatory responses to externalities are ineffective, certainly less so than the free market.
Better to defend against excessive currency appreciation or depreciation through liquidity, says Carstens. "Just a few weeks ago the tri-annual BIS survey about activity in the FX market was published and the peso is now eighth [most liquid], up from 14th in the last three years, and the most liquid in the emerging market, and it has allowed us to deal with the swings in capital in a really efficient way."
According to Carstens, the internationalization of the Mexican currency is in line with the economy: "For at least two decades now we have had this commitment to be a very open economy in Latin America – trade is a very important part of our activity and the integration with the US makes it inevitable to have a well-designed and well-established FX market. We have a very good settlement process, the peso is [traded] 24 hours a day, it is Euroclearable; so we have pretty much ensured that people who want to take or reduce peso positions can do it in a very agile way."
Carstens says that this and the strong economic fundamentals have stabilized the currency. "If you see how the peso has been behaving, it has been trading in a more or less stable range – and what is anchoring the value of the peso is fiscal policy, the health of the financial system and monetary policy," he says, adding that one of the very important developments in Mexico during the last six years is that the link between exchange rates and prices has improved. "Price setters in Mexico have got accustomed to the volatility of the peso and they also know it is a two-way bet," he says. "If the peso depreciates and they adjust prices upwards, but then the peso appreciates, they may end up with very high prices and that would hurt their bottom line."
Carstens says that in Mexico the relationship between the exchange rate and price is comparable to the relationship seen in Australia, Canada and advanced economies. "That has been a very important achievement from a macroeconomic point of view because it gives us an instrument of adjustment. The exchange rate adjusts to different developments in the external sector. It helps our stabilization process and it doesn’t affect the anchoring of inflationary expectations – and I think to have that instrument is very valuable."
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| Agustín Carstens makes his point to the press about reforming the IMF |
It is fair to say that Carstens’ approach to economics didn’t cost him the IMF job – whether his school of thought was in vogue or not. The IMF directorship went to a French citizen for the fifth time in eight appointments. The European grip on the position was never under threat. Despite commentary that the emerging market nations’ failure to coalesce around Carstens weakened his chances, the fact that Europe and US were not prepared to open the European domination of the IMF – or the reciprocal US ownership of the headship of the World Bank – ended the contest. Carstens all but admits that he had no chance from the outset: "I always had it in my mind that it was a very long shot," he says diplomatically. "First of all, Christine Lagarde was a very solid candidate – that by itself represented a challenge – but I think the most important challenge was to try to break the status quo. More than anything my objective was to make it clear to the world that this arrangement is completely outdated and to show that there are candidates from emerging markets that could be a good managing director."
Although Carstens didn’t break the status quo, he did manage to shine a spotlight on the cosy carve-up of the IMF and World Bank that the US and Europeans agreed at the Bretton Woods conference in 1944. Alejandro Valenzuela, CEO of Banorte-Ixe, is not alone in saying that Carstens’ candidacy will have repercussions for the IMF.
"With regard to the IMF, [Carstens] did something very good and people will be grateful to him over time," Valenzuela told Euromoney in August. "He knew his chances were very low – if not almost impossible – but I think he saw something fundamental. It is very difficult to go through a process when you know that the dice are loaded against you, but he did something that was right and he should be commended for it."
Valenzuela is far from alone – especially in the emerging markets – in seeing the leadership arrangement for the IMF and the World Bank as anachronistic. "All the Bretton Woods institutions were built in 1944. China didn’t declare [itself a socialist republic] until 1949. India got its independence in 1947 – and so here you have two of the biggest economies [in the world today] that weren’t even considered at that time," says Valenzuela. "Today Belgium has a weight [in the IMF] similar to China and India. Bretton Woods needs to be redefined, and I think Agustín [ran] to say we need to redefine this equilibrium. The new world order was generated by the winners [of the Second World War] but today in a peaceful period of time you need to understand and reflect the importance of China, India, Brazil – even of Mexico."
Carstens is at his most candid during the interview when talking about his desire to see reform at the IMF. "Europe should learn to compete [for the managing director position]," he says. "There is substantial talent in Europe and if they really wanted to have the best managing director I am sure they would be able to stand the competition. They probably wouldn’t win every single case but I think they should have the confidence to open up the process and, at the end of the day, if they don’t win they would have the satisfaction that at least the best possible person is heading such an important institution. For me it was more of a quest to try to level the playing field in this type of process – and a reflection of my concern with the IMF, because the IMF is an extremely important institution, but it faces many, many challenges. The IMF, as lender of last resort, always has the huge challenge of imposing conditionality on a country. That by itself is a huge challenge [and if you] add to that [the fact that] some of the member countries don’t feel that the fund is a legitimate institution – because there is uneven representation – then that adds to the challenge of the fund."
Does Carstens think the IMF will reform? "I hope so," he says. "And the control is not only a European issue – it is also an agreement with the World Bank and the US. After the crisis there was a big push in the G20 to reinforce the fund – and there was the 2010 quota review – that generated a shift in contributions towards increasing the part of the emerging markets and developing economies. So that was a move in the right direction. But regrettably it hasn’t been possible to implement this because we don’t have the vote of the US and the US has veto power. It’s not that they disagree, but they haven’t had the political environment to get their vote cast. I think movement in that direction would be important. All the members should do their best to preserve the legitimacy and the efficacy of the fund, and if we don’t do that it would be regrettable. We would have a less effective leader of last resort."
However, his response to a question about redistribution of the IMF’s voting rights to the emerging markets is less diplomatic, and more telling. "Very fundamental decisions that would fully recognize the importance of emerging markets have not been made," he says. "There is a quota review of 2010 in the fund. It is time to start another quota review, but it hasn’t started because the previous one hasn’t been completed. And in terms of governance not much has changed in the fund. We are still waiting."
Carstens’ IMF candidacy not only presented a possible opening-up of the leadership. There were clear differences between Carstens and Lagarde on the IMF’s approach to the overwhelmingly big problem facing it: Greece. Carstens’ backers said his experience in Mexico – which has recovered slowly but surely from its 1994 Tequila crisis – would give him the (outsider’s) perspective that, combined with his economics training, would have been a preferable option to Lagarde, a European with a background in law. At the time, Carstens said that the IMF should work to ensure that Greece could restructure its debts in a way that enabled it to reaccess the international markets as swiftly as possible. Looking back, if he had been managing director of the IMF, what would he have done differently?
"Given my experience of emerging markets crises – and the Greek crisis had many similar elements to an emerging markets crisis – I think you need to make a very quick effort to break the negative dynamics," he says. "And my sense is that in the case of Greece it took them many years to get a convincing package. I mean, when things started to look bad in 2010 until it stabilized it took a very long time and all through that time the debt situation deteriorated. So a much quicker response would have been better. I would say that the country would have gotten far better mileage out of early austerity than to wait, and also [the delay] allowed time for a debt crisis to become a banking crisis and everything escalated at that point. So I think a more prompt response would have been better. Now, at the same time Europe didn’t have the institutional arrangements that we needed to face that situation and those institutional arrangements have [now] been formed or are now being formed so I think a situation like Greece can be managed in a more effective way in future."
Carstens’ perspective also gives him an interesting insight into the current debate in Europe – and in other advanced economies – about the relative merits of austerity versus stimulus to restart and rebalance these economies. Carstens believes keeping the markets onside is crucial. "It is fundamental in any recovery process to have healthy public finances – if you don’t have that well anchored and you don’t get the recognition of the markets that the level of debt is sustainable then it is very hard to achieve a sustainable recovery," he says. "If the debt is not deemed to be sustainable then interest rates will start increasing, and that can affect the health of the banking system – which in turn can affect investment and consumption and therefore you don’t get traction in the efforts to achieve a sustainable recovery."
Carstens says it is very hard to know at what level the markets will consider a country’s debt to be unsustainable. The widely quoted study by Reinhart-Rogoff has been supplemented by research by the Bank for International Settlements and the IMF, but "there are different thresholds for advanced economies and emerging markets, and those thresholds are not like gravity," says Carstens, who has a clear warning to those advocating the use of even greater fiscal stimulus.
"Obviously the risk when you demand more on fiscal policy for recovery is that at some point you might be hit with the verdict of the market that your debt is unsustainable – and then this very pervasive dynamic can be unleashed. I think the advanced economies were, in part, very aggressive in providing fiscal stimulus and when they started many of these countries had this fiscal space so in a way it was appropriate to use [this strategy]," he says. "But they are getting closer and closer to the levels where an adverse reaction by the market can be expected. Therefore I think it is adequate for many of these governments to be more prudent in their fiscal expansion and I think it is good policymaking for them to be mindful of the progress of their debt and also very good for them to delineate multi-year plans on how they will assure the sustainability of their debt."
However, nor does Carstens view ingenious innovations beyond zero-bound monetary policies to be a panacea. Speaking on September 17, the day before the Federal Reserve surprised some with its decision to delay taper of its programme of quantitative easing, Carstens spelt out the problems that central banks can have when changing their approach to the reaction function (the upward-sloping relationship between the inflation rate and the unemployment rate). "A very important component of monetary policy is how you, as a central bank, can affect the formation of expectations – and the formation of expectations is, in a way, influenced by the reaction function of the central bank and how the central bank has reacted to different scenarios in the past," he says. "We face a situation when the markets are used to a certain reaction function, but that reaction function is not necessarily a good guidance [for the future] because of the situation we are facing today, partly because of the lower zero bound but partly because advanced economies face an unprecedented situation in terms of growth."
The changing reaction function therefore puts greater pressure on the markets to use the forward guidance, with all its conditionality. Another challenge is that where recovery is appearing, monetary looseness might be generating the wrong kind of recovery, with the UK, for example, seeing growth in the price of real estate assets, hinting at a return to the credit-driven growth that caused the crisis in the first place, rather than a de-leveraging and a rebalancing of the economy that many prescribe as necessary for a more stable economic recovery. "Monetary policy is not almighty," says Carstens about the nature of recoveries in advanced economies – while declining to discuss any specific case studies. He then advocates that countries should consider using macro-prudential measures to temper a credit-fuelled expansion.
"That’s why you need other instruments and that’s why this field of macro-prudential policies is adequate. For example, where there has been a housing bubble fed by credit expansion in the local financial system some countries have decided to request banks to have a lower loan-to-value ratio – which means people buying a house would depend on less leverage, they would have to make higher upfront payments or they would have to finance it – they would basically have to make higher down-payments. There are other restrictions in terms of – for example – the level of debt to income that a borrower has to hold. If you tighten that in the sense people should have a lower percentage of their income to debt that should help stabilize things too. In other cases, financial market regulators have requested higher capital levels. So there are instruments other than monetary policy where you can sort of put some gravel in the process of credit extension that – at some point in time – might be generating financial stability risk."
It is clear that Carstens’ approach to central banking is a mix of theory, experience and pragmatism. Unusually, this central banker has also been finance minister, which many in Mexico say gives him an appreciation of the growth agenda to which many other central bankers are not as sensitive. Does Carstens agree with that assessment? "Well, first I think being minister of finance was an extraordinary opportunity," he says. "I think, especially here in Mexico, the reach of the minister of finance is very broad. It gave me a very good perspective of the overall economy and I think that I now understand much better how the different policy instruments work, and it also makes it very clear that it is essential for there to be policy coordination."
He dodges a question about whether he would be prepared to be a candidate for managing director of the IMF after Lagarde’s tenure ends. He says he is very happy at Banxico: "Here in the central bank it is very exciting and you have more institutional support [than at the ministry of finance] and also you have a very clear mandate, and you also have a longer horizon, and I think this is very helpful. That allows you to make more contributions to the economic policymaking in your country."
So does he prefer his current role to his time as finance minister? "I was very glad to be minister of finance," he replies dryly. "But being minister of finance is like buying a boat. The best day is when you are confirmed as minister, and the second-best day is when you reach the end of your term. It is the same as buying a boat; the best day is when you buy it and the second-best day is when you sell it."
