The first half of the twentieth century was marked by two world wars and a global depression. The European continent suffered greatly in both wars, and the United States was devastated by the Great Depression. From these conditions arose a desire to create a new international monetary system that would (1) reduce the frequency, severity, and financing cost of balance-of-payments (BOP) deficits, (2) stabilize exchange rates without being wholly reliant on gold to back currencies, and (3) eliminate 1930s-style "beggar-thy-neighbor" trade policies, such as competitive devaluations and foreign exchange restrictions, yet substantially preserve each nation's ability to conduct independent economic policies. Multilateral discussions led to a gathering of forty-four nations in July 1944 in Bretton Woods, New Hampshire, to design a postwar international monetary system. Conference delegates drafted the Articles of Agreement for the International Monetary Fund (IMF or fund), which was created to supervise the new "Bretton Woods monetary regime."
Under the original Articles of Agreement ratified in December 1945, the IMF supervised a system of pegged exchange rates. After joining the fund, each member country declared a value for its currency relative to the U.S. dollar. The U.S. Treasury, in turn, tied the dollar to gold by agreeing to buy and sell gold to other governments at $35 an ounce. A country's exchange rate could vary only one percentage point above or below its declared par value. The IMF permitted rate movements greater than 1 percent only for countries in "fundamental balance of payments disequilibrium" and only after consultation with, and approval by, the fund. Countries with temporary, moderate BOP deficits were expected to finance their deficits by borrowing currency from the IMF rather than imposing exchange controls, devaluations, or deflationary economic policies, which could spread problems elsewhere. Member governments were expected to keep their national currencies fully convertible for current account transactions.
By maintaining convertible currencies at stable exchange rates, thereby eliminating currency risk, the framers of the Bretton Woods regime hoped to promote world trade, investment, and economic growth. BOP deficits resulting from misaligned exchange rates were expected to be temporary and readily financed by IMF resources. In reality, the framers created an unsustainable international price-fixing arrangement that eventually ended the par value system and the fund's original mission. Looking for a new mission, the IMF quickly evolved into a financial medic for developing countries. In this capacity, the fund has lent billions of dollars to member countries with detrimental effects: reductions in economic growth, long-term IMF dependency, riskier global investments, and mismanaged domestic economies. This essay describes the fund's original mission, explains its transformation into a financial medic for developing countries, and details its many failures. As an alternative to the IMF, key market-based institutions would promote an orderly and efficient international monetary system.
Balance-of-Payments Deficits, Exchange Rates, and International Monetary Fund Adjustment Programs
Balance-of-payments accounts are a statistical record of the economic transactions during a given period, usually a year, between the residents (individuals, businesses, and governments) of one country and the residents of all other countries. BOP accounts consist of the current account, capital account, and international reserves (primarily foreign currency reserves). The current account, which primarily records a country's net exports of goods and services, is the cash flow element of the BOP accounts. If a country exports more than it imports, the current account is in a surplus position and the country has a positive cash flow. If a country imports more than it exports, the current account is in a deficit position and the country has a negative cash flow--the country's residents are not earning enough foreign currency through their exports to pay for what they buy from other countries.
Countries, like consumers, can spend more than they take in only if they draw down their savings or borrow funds. A current account deficit, therefore, must be financed either by drawing down a country's foreign currency reserves or by borrowing foreign exchange from abroad. The capital account records a country's net foreign borrowing. When a bond is sold to a resident of another country, the payment, a capital inflow, is entered as a credit in the capital account. If a country's foreign currency receipts (exports plus capital inflows) fall short of its foreign currency payments (imports plus capital outflows), it has a BOP deficit in terms of total currency flows and must draw on its international reserves to pay its remaining obligations. The amount of exported reserves equals the "balance for official financing." Persistent current account deficits typically exhaust a country's credit and foreign currency reserves, just as a persistent negative cash flow for a consumer eventually exhausts their credit cards and savings accounts.
If a country, say Brazil, has a BOP deficit--for example, U.S. dollar receipts from abroad are less than U.S. dollar payments due abroad--Brazil can, for a time, draw on its dollar reserves. Alternatively, Brazil can borrow dollars, with interest, from the IMF by exchanging Brazilian reals for U.S. dollars. The IMF uses an analytic framework known as financial programming to determine the amount of the loan and the macroeconomic adjustments needed to eventually reestablish BOP equilibrium. Typically, the amount of the loan is equal to a country's upcoming foreign currency obligations, and the macroeconomic adjustments are intended to reduce imports and increase exports to enable the country to earn sufficient foreign exchange in the future to pay its bills, including the newly incurred IMF debt.
IMF loans, therefore, come at the price of conditionality, the policy adjustments that IMF officials prescribe to correct a country's BOP deficit. The usual strategy is to reduce the country's aggregate demand, and thus imports, using such policies as tax increases, monetary contractions, and government spending reductions. Additionally, the IMF encourages exports by dismantling export barriers. Currency devaluations are used to promote net exports but only for countries with "fundamental BOP deficits." For example, reducing the exchange rate for one Brazilian real from $4 to $2 reduces imports by making U.S. goods twice as expensive in local real prices and increases exports by making Brazilian goods half as expensive in U.S. dollars. It is important to note that if a country's exchange rate floats freely, the BOP is self-equilibrating in a total currency flow sense and there is no need for official financing using international reserves or for IMF loans.1 In other words, international reserves and IMF loans are unnecessary if government officials are completely indifferent to the value of the exchange rate and the balance on the current account.
The framers of the Bretton Woods regime hoped to promote world trade, investment, and economic growth by maintaining convertible currencies at stable exchange rates. BOP deficits resulting from misaligned exchange rates were expected to be temporary and readily financed by IMF resources. Political realities soon exposed the weaknesses of the Bretton Woods regime.
The Collapse of Bretton Woods
The Bretton Woods regime envisioned by the framers, of fully convertible currencies and pegged exchange rates, lasted only thirteen years, 1958-71. From 1947, when IMF operations began, to 1958, many member governments maintained exchange restrictions. After 1971, foreign currencies were no longer pegged to a gold-backed dollar. Simple economic analysis could have predicted its rapid demise. The Bretton Woods regime was essentially an international price-fixing arrangement enforced by the IMF. As in any market, including foreign exchange markets, price controls create rigidities and inefficiencies that increase over time. Price-fixing arrangements contain the seeds of their own destruction.
Pegged exchange rates invariably create a conflict between exchange-rate and monetary policy. This conflict was never more apparent than during the Bretton Woods era. By the late 1960s, the inflationary excesses of the Great Society and the Vietnam War exerted tremendous stress on the gold exchange standard of Bretton Woods. Foreign central banks, awash with dollars, saw gold at $35 an ounce as an irresistible bargain and began to exchange dollars for gold. The United States could either watch its gold reserves flee the country or close the gold window. On 15 August 1971, President Richard Nixon closed the gold window, effectively uncoupling the dollar from gold and ending the Bretton Woods regime. Today, each of the 182 member countries of the IMF can choose the method it uses to determine its exchange rate: a free float, a managed float, a pegged exchange arrangement, or a fixed exchange arrangement.
The International Monetary Fund Rises from the Ashes
The abandonment of the par value system in the 1970s marked the end of the fund's original mission to stabilize international monetary arrangements. According to Milton Friedman, Nobel laureate and Hoover Institution senior research fellow, "the IMF lost its only function and should have closed shop. But few things are so permanent as government agencies, including international agencies. The IMF, sitting on a pile of funds, sought and found a new function: serving as an economic consulting agency to countries in trouble--an agency that was unusual in that it offered money instead of charging fees."2
In its new role as financial medic to developing countries, the IMF skillfully used a series of global economic crises to increase its capital base and financing activities. Responding to the oil crisis of the 1970s, the debt crisis of the 1980s, the transformation of former communist countries in the early 1990s, and the Mexican, East Asian, and Russian financial crises in the mid to late 1990s, the IMF created new financing facilities, increased its loan commitments and capital base, and lengthened the maturity of its loan portfolio. From 1972 to 1999, the fund's capital base, in constant 1999 dollars, rose 127 percent. During this same period, IMF loan commitments under its standby facility rose 254 percent. Did this expansion of IMF financing activities alleviate the BOP problems of member countries and encourage prudent, progrowth economic policies and investment decisions? The evidence, much of it supplied by the IMF, demonstrates that the fund does more harm than good.
The Operations of International Monetary Fund Financing Programs
IMF financing programs are governed by a twenty-four-member executive board headed by the managing director, who also supervises the fund's staff of twenty-six hundred people. From IMF headquarters in Washington, D.C., the executive board approves loans from its $281 billion capital base. The United States provides the largest capital contribution or quota--$50 billion, or roughly 18 percent of the total. Quotas also determine voting rights; thus, the United States controls about 18 percent of all votes--or three times the votes of any other country. The executive board, however, rarely conducts formal votes; its decisions are usually based on consensus.3
Member countries with BOP problems are eligible to borrow from the fund. The IMF has many financing facilities, each with its own access limit, disbursement plan, maturity structure, and repayment schedule. The typical IMF loan, known as an upper-credit tranche arrangement, features an annual access limit of 100 percent of a member's quota, quarterly disbursements provided performance targets are met, a one- to three-year maturity structure, and three- to five-year repayment schedule. Loans are disbursed to the borrowing government's central bank or treasury department, and the government can spend the money as it pleases with no oversight.4 The IMF charges the same interest rate to every country that borrows from a particular financing facility. Most loans currently carry annual interest charges of about 4.5 percent.
A country borrows from the fund's regular lending facilities by using its national currency to buy (purchase) the currency of another member country at an exchange rate denominated in special drawing rights (SDRs), the fund's own unit of account. A drawing on the IMF by a country raises the fund's holdings of that country's currency but lowers its holdings of other currencies by an equal amount. The composition of the fund's resources changes but not the total amount as measured in SDRs. The country repays the drawing over a specified period by using member currencies acceptable to the fund to repurchase its own currency at the prevailing SDR exchange rate. Only about twenty currencies are borrowed during a typical year, and most borrowers want only the major convertible currencies: the U.S. dollar, the Japanese yen, the German deutschemark, the British pound sterling, and the French franc. Countries whose currencies are borrowed by other member governments receive remuneration, currently about 3.5 percent of the amount borrowed. Notice that this "rate of remuneration" is less than the borrowing cost for the U.S. Treasury.
The IMF uses an analytic framework known as financial programming to craft its loan programs. Financial programming, first fully expressed in a 1957 journal article by IMF staff economist Jacques Polak, consists of a set of simple equations that relates the monetary sector of an economy to the BOP.5 Ideally, the model tells the IMF what macroeconomic adjustments and financial assistance is needed to eventually reestablish a country's BOP equilibrium. IMF adjustment programs seek to eliminate BOP deficits within one to three years.
A confidential "letter of intent" accompanies each financing program and details the macroeconomic adjustments and other structural reforms that IMF officials prescribe as conditions for assistance. Since September 1968, the Articles of Agreement have explicitly authorized the IMF to impose conditionality. Typical loan conditions require borrowing governments to reduce their budget deficits and rate of money growth; eliminate monopolies, price controls, interest-rate ceilings, and subsidies; deregulate selected industries, particularly the banking sector; lower tariffs and eliminate quotas; remove export barriers; maintain adequate international reserves; and devalue their currency if faced with a "fundamental BOP deficit." Most programs specify quarterly targets for key variables that, in theory, must be satisfied before receiving the next loan disbursement. The objective of conditionality is to reduce imports and increase exports to enable the country to earn sufficient foreign exchange in the future to pay its bills.
The Effect of International Monetary Fund Financing Programs
As of 31 May 1999, the IMF had fifty-six financing programs with fifty-three countries--nearly a third of its membership and more than a quarter of all countries in the world. Loan commitments totaled $65 billion. Do fund financing programs benefit borrowing countries? IMF staff economist Mohsin Khan examines this question in a journal article titled "The Macroeconomic Effects of Fund-Supported Adjustment Programs"6 in which he conducts a comprehensive assessment of the impact of fund programs on borrowing countries' BOP, current account deficits, inflation, and economic growth. After reviewing thirteen statistical studies covering fund activities from 1963 to 1982, the best that Khan could say was "first, there is frequently an improvement in the balance of payments and the current account, although a number of studies show no effects of programs. Second, inflation is generally not affected by programs. Finally, the effects on the growth rate are uncertain, with the studies showing an improvement or no change being balanced by those indicating a deterioration in the first year of a program."7 Khan thus demonstrates that there is no professional consensus that IMF programs benefit borrowing countries. In fact, the broad historical record indicates a negative impact.
Bryan Johnson and Brett Schaefer, research fellows at the Heritage Foundation, looked at the relationship between IMF loans and economic growth in less-developed countries from 1965 through 1995.8 According to their study, of the eighty-nine loan recipients, forty-eight (54 percent) were no better off in 1995, as measured by real per capita wealth, than before they accepted their first loan; thirty-two of those forty-eight countries were poorer; and fourteen of those thirty-two countries had economies that were at least 15 percent smaller than before their first loan. The economic performance of Nicaragua and Zaire were particularly poor: Between 1968 and 1995, Nicaragua received $185 million from the IMF, yet its economy contracted 55 percent. Zaire received $1.8 billion between 1972 and 1995, and its economy contracted 54 percent. These results should be expected, argues Alvin Rabushka, senior fellow at the Hoover Institution, since loans from multilateral institutions
put governments in the business of power generation and distribution, telecommunications, shipping, railroads, and other ventures that charge monopoly prices and lose money. These ventures are not productive for their countries, and they also tax economically productive enterprises to cover their losses. Thus international lending institutions stall economic progress by favoring government over private enterprise.9
The fund's dismal record debunks the dominant "aid equals development" doctrine.
Long-Term IMF Dependency
The more likely outcome of IMF financing programs, according to Doug Bandow, senior fellow at the Cato Institute, is that "aid equals dependency." Bandow examined financing activities from 1947 through 1989 and discovered that six countries relied on IMF assistance for more than thirty years, twenty-four countries for twenty to twenty-nine years, and forty-seven countries for ten to nineteen years.10 Of the eighty-three developing countries that used IMF resources for at least 60 percent of the years since they started borrowing, more than half, forty-three nations, have relied on the IMF every year. Graham Bird, professor of economics at the University of Surrey in England, concludes that "the image of the fund coming into a country, offering swift financial support, helping to turn the balance of payments around, and then getting out, is purely and simply wrong."11 Rather than providing infrequent and temporary BOP assistance as envisioned by the framers, the IMF has become a continuous source of heavily subsidized aid for a growing number of countries, many of whom are the world's economic basket cases. This record of addiction supports the observation of Leland Yeager, professor emeritus of economics at the University of Virginia, that "self-important international bureaucracies have institutional incentives to invent new functions for themselves, to expand, and to keep client countries dependent on their aid."12
Wealth Transfers through Interest-Rate Subsidies
One incentive used by the IMF to keep client countries dependent on their aid is interest-rate subsidies. The IMF currently charges about 4.5 percent on its regular lending facilities. This uniform interest rate is well below alternative market rates and is available to all member governments regardless of their credit risk. For example, at the time that South Korea was negotiating its record-breaking $21 billion IMF loan in December 1997, the Korean government was offering interest rates of 14.5 percent to attract buyers for its three-year dollar-denominated debt. The IMF gave Korea a 10 percent interest-rate rebate. David Sacks and Peter Thiel, research fellows at the Independent Institute, calculate that East Asian governments will receive a $35 billion subsidy over three years from such rebates.13 This represents a direct wealth transfer from mostly U.S. and West European taxpayers to Asian governments. Uniform, below-market interest rates--designed to increase the fund's loan demand, discretion, and bureaucracy--provide the largest subsidies to the riskiest borrowers and encourage "moral hazard."
Eligibility for IMF credit depends on a country's BOP--primarily the level or trend of its foreign currency reserves--and governments are primarily responsible for their BOP problems.14 A government can induce a fall in its currency reserves by maintaining an overvalued exchange rate or an excessive rate of money growth. Neither policy indicates an emergency situation, but each can prompt IMF assistance. An unpublished 1981 IMF study concludes that overexpansionary fiscal and monetary policy is the primary cause of BOP problems in borrowing countries; exogenous factors are least important.15 Unsound domestic economic policies, not temporary external shocks, explain the persistent demand for IMF assistance. Furthermore, the fund's implicit guarantee of subsidized bailouts reduces the cost of fiscally irresponsible, yet politically rewarding, policies, which encourages even greater recklessness. Economists call this behavioral response moral hazard. In private insurance markets, moral hazard is constrained by deductibles. In private credit markets, moral hazard is constrained by market interest rates and loan conditions such as pledging adequate collateral. Neither interest rates nor loan conditions effectively constrain moral hazard in IMF financing programs.
Government Moral Hazard: The Russian Experience
Moral hazard was evident in July 1998 when Russia promised to implement key economic policies in exchange for an $11.2 billion IMF loan commitment. Even though Russia had reneged on several previous agreements and IMF staff in Moscow advised against additional assistance, the executive board approved the loan. Less than one month after receiving the first installment of $4.8 billion--which was wasted propping up the ruble long enough, in the words of one fund official, "to let the oligarchs get their money out of the country"16--the Yeltsin government abandoned its commitments, devalued the ruble, defaulted on its debt, began printing money with abandon, fired virtually every reformer in the government, and failed to enact many of the promised reforms.
IMF loans to Russia, pushed by the Clinton State Department under the "Too Nuclear to Fail" doctrine, have enabled the Russian government to postpone institutional reforms that are politically difficult but necessary for self-sustaining economic growth. Loans have often been used to subsidize inefficient state enterprises. Absent the bailouts, Russian officials would have been forced to sell assets to the private sector to pay their bills. Meanwhile, Russia's economy continues to sink, pulling the Russian people down with it. Real per capita gross national product has fallen 37 percent since the collapse of the Soviet Union in 1991. Three-quarters of all Russians--with an average monthly income of $100--barely survive. One-quarter of Russia's labor force receives its wages late, in kind, or not at all. Interest rates have reached 150 percent. The life expectancy at birth for males has fallen three years, to sixty-one, since 1990. There is no evidence that IMF loans have helped the Russian people. Instead, bailouts help insulate oligarchs and, more broadly, politicians from the negative consequences of their reckless policies while undermining the natural process of reform that global competition would otherwise promote.
Investor Moral Hazard: The Mexican "Cause" and East Asian "Effect"
IMF financing programs also encourage moral hazard among international investors. Consider, for example, the 1994-95 Mexican currency crisis. In an attempt to create the illusion of a booming economy before the August 1994 presidential election, the Mexican government inflated the money supply, increased deficit spending, and depleted its foreign currency reserves in a futile attempt to maintain an overvalued peso. The Mexican government financed this illusionary expansion by issuing nearly $30 billion in short-term dollar-linked bonds known as tesobonos. Most of this debt was purchased by U.S., Japanese, and European banks.
As a result of the Mexican government's overexpansionary policies, by the end of 1994 Mexico had only $5 billion in reserves to cover $23 billion in tesobono liabilities, which would surely be pulled from Mexico as they matured, and no private investors willing to lend hard currency. In February 1995, the IMF committed $17.8 billion to Mexico with the understanding that all foreign creditors would be kept whole. The loan package rescued Americans and other foreign nationals that invested in tesobonos, cetes (short-term "domestic" government debt), and securities of Mexico's nonfinancial firms. This arrangement signaled to international lenders that they needn't worry about future investment risks--the IMF would rescue them from their imprudent decisions.
The 1995 IMF bailout of investors in Mexico effectively privatized investor profits and socialized investor losses. By removing the risk of default, the IMF encouraged riskier global investments that, Friedman notes, "helped fuel the East Asian crisis that erupted two years later."17 The fund's implicit guarantee contributed in 1995 to a $90 billion capital inflow in 1996 to Indonesia, Malaysia, the Philippines, South Korea, and Thailand. Foreign commercial banks provided the bulk of the private external credit to these countries--$58 billion out of a total $76 billion. By June 1997, foreign bank debt had grown to 25 percent of gross domestic product in South Korea, 35 percent in Indonesia, and 45 percent in Thailand, most of which was short-term liabilities. Korea's short-term debt was three times its foreign currency reserves.
East Asian banks and corporations borrowed short term in foreign currencies--yen, marks, and dollars--to lower their financing costs. Through government-directed bank lending, much of this money was funneled into questionable long-term ventures, often controlled by political cronies, that paid back, if at all, in local currencies. This practice exposed Asian borrowers to three potential risks: (1) an inability to repay creditors due to inadequate investment returns, (2) a refusal by foreign creditors to roll over their short-term loans, and (3) a break in the exchange pegs that would devalue the domestic currency and increase the burden of servicing foreign-denominated debt. All three risks were realized in 1997, yielding widespread insolvency and additional IMF bailouts of foreign investors. The fund committed $3.9 billion to Thailand in August 1997, $11.5 billion to Indonesia between November 1997 and July 1998, and $21 billion to South Korea in December 1997. Allan Meltzer, professor of political economy at Carnegie-Mellon University, observes that, "if [foreign] banks and financial institutions had taken losses in Mexico, they would have exercised elementary judgment about risks in Asia."18 Thanks to IMF bailouts, however, foreign lenders ignored basic principles of sound banking. Meltzer elaborates:
Prudence is the missing element in the Mexican and Asian problems. In its absence, bankers and other lenders have taken excessive risks. They have no incentive to learn about how many loans borrowers have outstanding, how much borrowers have borrowed short to lend long, or how much currency risk has been assumed. The lenders don't care much, because they collect with little or no loss whatever happens.19
Under the current bailout regime, investors and politicians do not bear the full cost of their reckless behavior. IMF loans encourage riskier global investments and overexpansionary domestic economic policies that contribute to global financial chaos.
The Fund's Incentives to Lend
As discussed above, domestic economic mismanagement drives the demand for IMF assistance. Supply-side factors, notably the fund's desire to increase its resources and bureaucracy, also influence its lending decisions. The fund receives fees totaling 1 percent of each loan; thus, it has an incentive to maintain below-market interest rates and approve larger loans.
Also, the fund uses "hurry-up lending" to increase its capital base. Hurry-up lending involves increasing IMF loan commitments before a general quota review to create the appearance of a "liquidity crisis" and the need for larger quotas. The Articles of Agreement state that quotas must be reviewed at least every five years. Roland Vaubel, professor of economics at the University of Mannheim in Germany, finds that in the third year after a quota review, IMF loan commitments relative to total quotas increase, on average, by 26 percent.20 Commitments increase 52 percent in the fourth year. In contrast, loan commitments decrease by 9 percent and 15 percent in the first and second year after a review. Hurry-up lending allows the IMF to "plead poverty" before its member governments, who must approve their respective quota increase. This pattern of hurry-up lending was repeated in 1997-98 when the IMF significantly increased its loan commitments and warned of "dangerously low liquidity levels" before congressional approval, in October 1998, of the United States' share of a 45 percent IMF capital base increase.
The Rich Get Richer and the Poor Repay the International Monetary Fund
It would be difficult to devise a more regressive wealth transfer scheme than IMF financing programs. IMF loans are used to rescue wealthy, politically connected bankers, investors, and financiers at the expense of domestic taxpayers. As predicted by public choice theory, well-organized minorities receive political favors paid for by fragmented majorities. Consider the 1995 IMF loan to Mexico. The so-called Mexican bailout did not bail out Mexico's citizens; rather, it bailed out the foreign financial institutions that made bad loans to Mexico. Mexico's citizens paid the price of "adjustment." One year after the 50 percent devaluation of the peso, which began in December 1994, Mexico's consumer prices had risen 35 percent and interest rates were approaching 60 percent. From 1994 to 1996, Mexico's taxpayers were saddled with an additional $60 billion in external debt--a good portion owed to the IMF. Real per capita gross national product fell 9 percent in 1995. What caused this sharp decline in Mexico's standard of living? IMF loan conditions didn't help. Standard, austere IMF policy prescriptions reduce economic growth rates, deepen and prolong recessions, and affect most severely the poorest people in the borrowing countries, producing a backlash against the West rather than a backlash against their often corrupt, brutal, and kleptocratic governments.
Inappropriate Loan Conditions
The IMF contends that conditionality reduces the frequency and severity of BOP problems and promotes the efficient use of fund resources. This, in turn, ensures prompt repayment, which facilitates the revolving nature of IMF credit. Irrespective of these lofty goals, the evidence demonstrates that, to the extent that loan conditions are implemented, they often exacerbate the problems of borrowing countries.
The fund's Articles of Agreement refer to the maintenance of high levels of employment, income, and economic development as the "primary objectives of economic policy." Unfortunately, its narrow focus on restoring a country's BOP equilibrium through austere loan conditions causes it to neglect the effect of conditionality on the "primary objectives." For example, many financing programs, including the 1995 program for Mexico, call for a reduction in the government's budget deficit.21 In response, the government will raise taxes and increase tariffs, thereby reducing the country's long-run growth prospects. One study of conditionality reports that the fund explicitly prescribes higher tax rates in 74 percent of its programs.22
IMF policy prescriptions are usually "off-the-shelf" remedies that are not adequately tailored to each country's unique circumstances, and traditional austere loan conditions prolong and deepen financial crises. For example, as part of its financing programs for Indonesia, South Korea, and Thailand, the IMF called for currency devaluations and essentially unchanged low inflation rates. This policy combination necessitated massive reductions in Asian money supplies. The accompanying sky-high interest rates did not produce the anticipated net capital inflows since investors feared defaults on dollar-denominated debt, further devaluations, and insufficient foreign currency reserves to accommodate investors that refused to roll over their short-term loans. Between 1997 and 1998, foreign banks reduced their exposure in East Asia by about $60 billion.
The combination of tight money and high interest rates strangled East Asian economies and produced widespread insolvency. IMF policies stunted economic growth by making it extraordinarily expensive for companies and consumers to borrow and aggravated the foreign debt burden. Steven Radelet, an economist at the Harvard Institute for International Development, asks how did "it help Thailand to deprive apparel manufacturers of the working capital needed for exports?"23 Alan Blinder, former vice chairman of the Federal Reserve Board and former Clinton administration economist, concedes that "the IMF probably made the problems worse."24 Steve Hanke, professor of economics at Johns Hopkins University, summarizes the debacle: "The International Monetary Fund failed to anticipate Asia's financial crisis. Then, to add insult to injury, the IMF misdiagnosed the patient's malady and prescribed the wrong medicine. Not surprisingly, the patient's condition has gone from bad to worse."25 The IMF failed to recognize that the East Asian crisis was a banking crisis, not a fiscal crisis; hence, its traditional prescriptions were inappropriate and exacerbated the problem. Perhaps it is best, therefore, that governments seldom honor the terms of their loan agreements.
Conditionality Compliance and Enforcement
It is impossible for outside analysts to monitor conditionality compliance routinely since loan terms and data are confidential and released only voluntarily. Sebastian Edwards, professor of international economics at the University of California at Los Angeles, has examined the degree of compliance using the fund's own data, never before released to outside analysts,26 and finds that compliance is mediocre at best. Looking at the compliance rate for thirty-four upper-credit tranche programs that were approved in 1983 in response to the debt crisis, Edwards examined three "intermediate macroeconomic targets": the ratio of the government deficit to gross domestic product, the rate of growth of domestic credit, and the rate of growth of domestic credit to the public sector. He reports that the median compliance rate with IMF loan conditions between 1983 and 1985 was only 46 percent. The compliance rate for the government deficit never reached this level once and was a paltry 19 percent in 1984. Meanwhile, the median compliance rate for final program targets regarding the current account, inflation, and economic growth was even worse--only 41 percent. Elsewhere, Jeffrey Sachs, director of the Harvard Institute for International Development, has concluded that "the evidence presented in the IMF's 1988 review of conditionality . . . suggests that, since 1983, the rate of compliance has been decreasing sharply, down to less than one-third compliance with program performance criteria in the most recent years."27
When the IMF suspends assistance due to noncompliance, it quickly negotiates a new agreement with the offending party. For example, the IMF negotiated eight separate agreements with Brazil between 1965 and 1972 and seventeen separate agreements with Peru between 1971 and 1977. Despite Russian perfidy in August 1998, the fund agreed in April 1999 to lend the government an additional $4.5 billion over eighteen months. The new loans will enable Russia to repay old IMF loans and service eurobond debt. The Russian government owes more to the IMF than it has budgeted for education, public health, the environment, and the arts combined. The new agreement was reached in the face of allegations that previous IMF loans to Russia were channeled through an offshore company called Fimaco on the island of Jersey, part of Britain's Channel Islands.
In order to reach new agreements, governments pledge minimal policy changes to get the money flowing again instead of implementing major institutional reforms needed for self-sustaining economic growth and development. Borrowing governments frequently fail to implement even minimal changes and likely would have done more to reform without the loans. Boris Fyodorov, Russia's former tax chief, summarizes the Russian experience: "The IMF should learn a lesson from the past five years. The IMF was pretending that it was seeing a lot of reforms in Russia. Russia was pretending to conduct reforms. The Western taxpayer was paying for it."28
Borrowing governments often negotiate soft loan conditions by arguing that particular IMF policy prescriptions would be "politically unfeasible," pointing to civil unrest as evidence. This strategy has become so successful that, according to Kendall Stiles, professor of political science at Bowling Green State University, some governments have, "through their manipulation of the media and the masses, contrived `discontent and instability.' For example, Argentina and Brazil . . . seem to have simply `allowed' riots to take place when negotiations with the IMF became deadlocked."29
All told, the evidence demonstrates that IMF financing programs, which rarely prescribe appropriate economic policies or sufficient institutional reforms, are at best ineffective and at worst incentives for imprudent investment and public policy decisions that reduce economic growth, encourage long-term IMF dependency, and create global financial chaos. It is time to scrap the IMF and strengthen market-based alternatives.
Market-Based Alternatives to the International Monetary Fund
Absent IMF bailouts, politicians would be more likely to pursue sound domestic economic policies and international investors would be more likely to follow basic principles of sound banking. Lenders would charge foreign borrowers interest rates that reflect true credit risk and require proper collateral, prudent investment decisions, and sound domestic economic policies as conditions for cross-border loans. Lenders would also enhance their own internal risk-management systems, which Alan Greenspan, chairman of the Federal Reserve Board, characterizes as "the most effective countermeasure to the increased potential instability of the global financial system."30 The following key market-based institutions would ensure an orderly and efficient post-IMF international monetary system.
Floating Exchange Rates. Countries with pegged exchange rates routinely experience BOP problems and currency crises. In abstract, Friedman notes that "under a floating rate, there cannot be and never has been a foreign exchange crisis, though there may well be internal crises, as in Japan [but not accompanied by a foreign exchange crisis]. The reason is simple: Changes in exchange rates absorb the pressures that would otherwise lead to [foreign exchange] crises in a regime that tried to peg the exchange rate while maintaining domestic monetary independence."31 The foreign exchange crisis that hit Indonesia, Malaysia, South Korea, and Thailand did not spread to Australia or New Zealand because they had floating exchange rates, which preclude international transmission (the so-called contagion effect). A. James Meigs, former chief economist at First Interstate Bancorp, insists that, "if Mexico had adopted market-determined exchange rates in 1988 or soon thereafter, instead of trying to control the peso/dollar exchange rate, there would have been no peso crisis in 1994-95."32 The fact that floating exchange rates preclude BOP deficits and foreign exchange crises explains the fund's long-standing preference for pegged exchange rates. Institutional survival necessitates its stance.
Internationally Accepted Accounting and Disclosure Practices. The adoption of internationally accepted accounting practices by foreign businesses allows lenders to more accurately assess the true credit risk of potential borrowers. Free capital markets reward "transparency" and the adoption of uniform standards by providing better terms to borrowers that use accepted accounting practices. The lack of transparency in foreign markets, cited by many pundits to justify greater international financial regulation as part of a "new global financial architecture," is the result of the present bailout regime. International lenders have little incentive to demand uniform standards and full disclosure from foreign borrowers since the IMF covers their mistakes.
The greater reward for transparency offered by post-IMF capital markets would also apply to governments. Disclosure of more timely, accurate, and comprehensive economic and financial data not only would reduce a government's borrowing costs but also would, in the words of Greenspan, "help to avoid sudden and sharp reversals in the investment positions of investors once they become aware of the true status of a country's and a banking system's financial health."33 Concern over these "hot money" flows has prompted some economists to propose a "Tobin tax" on cross-border capital movements. Post-IMF capital markets, however, would provide greater incentives for the disclosure of information that would improve the efficiency and coordination of private capital flows without an additional tax.
Unfettered Financial Markets. The IMF was not designed to be an international "lender of last resort." Anna Schwartz, research associate at the National Bureau of Economic Research, notes that true lenders of last resort can create high-powered money (currency held by the public plus bank reserves) and act quickly to stem a banking panic. "The IMF," she observes, "lacks each of those features."34 The IMF cannot directly create high-powered money, and its loan packages usually take months to negotiate and approve. Moreover, Schwartz notes that "a national lender of last resort rescues solvent banks temporarily short of liquidity. It does not rescue insolvent institutions. The IMF has no such inhibition."35
The fund's cumbersome, bureaucratic decision-making process is suited to the financial markets of 1944, not 1999. Walter Wriston, former chairman and chief executive officer of Citicorp/Citibank, observes that, "by today's standards, the markets that existed immediately after World War II and for some twenty odd years thereafter were primitive. . . . The marriage of computers with telecommunications has created a truly global market in everything from money to stocks to commodities."36 Today's capital and foreign exchange markets consist of complex global computer networks that move billions of dollars across national borders in the blink of an eye. Foreign currency markets alone exchange about a trillion dollars a day. Millions of investors, ranging from Wall Street brokers to housewives with PCs, can respond almost instantaneously to small differences in risk-adjusted rates of return. The IMF is a dinosaur in this digital world. Its lending agreements normally take months to negotiate and approve, whereas international investors react in seconds.
Unfettered private capital markets can readily finance countries' temporary BOP deficits resulting from unforeseen external shocks. Private capital flows to developing countries have surged in recent years and now dwarf official lending. The World Bank calculates that between 1990 and 1996, net private capital flows to developing countries rose from $44 billion to $244 billion. Deep private capital markets stand ready to lend to liquidity-constrained, yet creditworthy, foreign borrowers at interest rates that reflect true credit risk. Foreign borrowers would also act more responsibly with funds borrowed from private creditors than with funds borrowed from the IMF because potential penalties are greater. Borrowers that default on private loans are often excluded from private capital markets for a decade or more. Market discipline constrains reckless behavior. In contrast, borrowers, such as Russia, that are near default on IMF debts simply receive additional IMF loans to repay old fund obligations.
Fundamental Institutional Reforms. Economic development requires the accumulation of physical, human, and financial capital. A secure and predictable environment attracts capital. Wriston writes: "Capital goes where it is wanted, and stays where it is well treated. It will flee onerous regulation and unstable politics, and in today's world, technology assures that that movement will be at near the speed of light. Despite thick tomes of theory on capital movement, that is `all she wrote.'"37 Capital will flee countries with excessive taxation, inflation, regulation, trade and investment barriers, government intervention, political corruption and instability. It will avoid countries lacking creditor, stockholder, and private property rights or well-defined banking, commercial, and bankruptcy laws. Unfortunately, many countries lack these basic institutional ingredients for self-sustaining economic growth. For example, many countries lack U.S.-style bankruptcy laws that provide three major benefits to insolvent companies: a debt standstill, "administrative priority" to attract new lenders, and a forum to negotiate a restructuring agreement that is fair to creditors. U.S. bankruptcy laws protect companies from creditors during reorganization and provide a predictable legal framework to resolve disputes, secure future working capital, and reallocate assets, which speeds recovery from recessions.
Governments could apply bankruptcy provisions to their own operations, giving new private lenders administrative priority in debt repayment. Sachs elaborates: "We need Chapter 11-type procedures to enable countries in restructuring to borrow fresh working capital from the private markets rather than taxpayer dollars under IMF control. The trick would be to assign those new loans priority in the timing of the government's debt repayments."38 In addition, when countries issue sovereign debt they could specify that any future debt relief agreements would require the consent of a certain percentage of bondholders; no single bondholder or minority faction could block an accord. These collective action clauses could be included in private debt issues as well. Inevitably, some creditors would lose money from debt relief, but this burden sharing would "bail in" private lenders and encourage them to assess the credit risk of future borrowers more carefully. Too often in the past, the IMF needlessly delayed debt relief by insisting that private lenders be paid in full.
What is an important catalyst for achieving these fundamental institutional reforms? Joel Hellman, professor of government at Harvard University, examined the experience of twenty-five postcommunist countries and found that "stable constitutions that place constraints on executive, and hence state, power appear to have a positive effect on the process of economic reform, even in this still early stage of the postcommunist transitions."39 Given this result, Russia is a case study on how not to conduct reform.
Financial order in a world of increasing capital mobility requires governments to maintain sound macroeconomic and exchange-rate policies. Countries that fail to maintain sound policies and strengthen market-based institutions in a post-IMF world will predictably experience serious financial problems. Schwartz contends, however, that "the world financial system will not be undermined if the IMF . . . [does not exist to] bail out those countries. Low-income countries have gotten into trouble financially many times in the past two centuries. Investors who lost money in ventures in those countries were hurt, and the countries involved had setbacks. The world did not collapse."40 The world will not collapse without the IMF. In fact, an unfettered international monetary system will provide the appropriate incentives for governments to implement the market-based institutional reforms needed for self-sustaining economic growth, and it will improve the efficiency and coordination of global capital flows. The IMF is obsolete, unnecessary, and counterproductive. It is time to abolish the fund and strengthen market-based alternatives.
1 A useful way to think about the dynamics of IMF adjustment programs is to contrast them to the market adjustment process for an ordinary good. When supply or demand for a good shifts, the good's price changes to equate the quantity demanded with the quantity supplied. When a country has a BOP deficit at a given exchange rate, instead of allowing the exchange rate (price) to depreciate (increase) to eliminate the deficit (excess demand for foreign goods), the fund's preference is to shift the country's aggregate supply and demand curves to synchronize total currency flows at the prevailing exchange rate.
2 Milton Friedman, "Markets to the Rescue," Wall Street Journal, 13 October 1998, p. A22. Reprinted in Lawrence J. McQuillan and Peter C. Montgomery, eds., The International Monetary Fund--Financial Medic to the World? A Primer on Mission, Operations, and Public Policy Issues (Stanford: Hoover Institution Press, 1999), pp. 126-30.
3 According to Karin Lissakers, the U.S. executive director at the IMF, the fund voted on only about a dozen of the more than two thousand major decisions during nearly a five-year period. See House Committee on Banking and Financial Services, Subcommittee on General Oversight, Hearing on the International Monetary Fund, 105th Cong., 2d sess., 21 April 1998.
4 The fund admits that it does not track how governments use IMF loans. There is evidence that since 1995 the Russian government has used IMF loans to finance its military buildup. See J. Michael Waller, "IMF and the Russian Missiles," Washington Times, 23 January 1998, p. A21. Reprinted in McQuillan and Montgomery, International Monetary Fund, pp. 186-88.
5 Jacques J. Polak, "Monetary Analysis of Income Formation and Payments Problems," IMF Staff Papers 6 (November 1957): 1-50.
6 Mohsin S. Khan, "The Macroeconomic Effects of Fund-Supported Adjustment Programs," IMF Staff Papers 37 (June 1990): 195-231. Excerpted in McQuillan and Montgomery, International Monetary Fund, pp. 43-52.
7 Khan, "Macroeconomic Effects," p. 210.
8 Bryan T. Johnson and Brett D. Schaefer, The International Monetary Fund: Outdated, Ineffective, and Unnecessary, Heritage Foundation Backgrounder No. 1113, 6 May 1997. Excerpted in McQuillan and Montgomery, International Monetary Fund, pp. 55-57.
9 Alvin Rabushka, "From Austerity to Growth: A New Role for the IMF," in The Political Morality of the International Monetary Fund, ed. Robert J. Myers (New Brunswick, N.J.: Transaction Books, 1987), p. 151.
10 Doug Bandow, "The IMF: A Record of Addiction and Failure," in Perpetuating Poverty: The World Bank, the IMF, and the Developing World, ed. Doug Bandow and Ian Vasquez (Washington, D.C.: Cato Institute, 1994), p. 19. Excerpted in McQuillan and Montgomery, International Monetary Fund, pp. 78-83.
11 Graham Bird, IMF Lending to Developing Countries: Issues and Evidence (London: Routledge, 1995), p. 105.
12 Leland B. Yeager, "How to Avoid International Financial Crises," Cato Journal 17 (winter 1998): 263.
13 David Sacks and Peter Thiel, "The IMF's Big Wealth Transfer," Wall Street Journal, 13 March 1998, p. A16. Reprinted in McQuillan and Montgomery, International Monetary Fund, pp. 31-34.
14 Several studies have examined the economic characteristics of countries that do and do not borrow from the fund. Borrowing countries have larger BOP problems, smaller foreign currency reserves, and relatively expansionary domestic economic policies. For a detailed discussion see Bird, IMF Lending to Developing Countries, pp. 118-24, and Patrick Conway, "IMF Lending Programs: Participation and Impact," Journal of Development Economics 45 (December 1994): 365-91.
15 Roland Vaubel, "The Political Economy of the IMF: A Public Choice Analysis," in Bandow and Vasquez, Perpetuating Poverty, p. 40. The contention that governments are primarily responsible for their own BOP problems is supported by additional evidence. See Thomas M. Reichmann, "The Fund's Conditional Assistance and the Problems of Adjustment, 1973-75," Finance & Development 15 (December 1978): 38-41; Mohsin S. Khan and Malcolm D. Knight, "Determinants of Current Account Balances of Non-Oil Developing Countries in the 1970s: An Empirical Analysis," IMF Staff Papers 30 (December 1983): 819-42; and Sebastian Edwards, "The Role of International Reserves and Foreign Debt in the External Adjustment Process," in Adjustment, Conditionality, and International Financing, ed. Joaquin Muns (Washington, D.C.: International Monetary Fund, 1984), pp. 143-73.
16 David E. Sanger, "As Economies Fail, the IMF Is Rife with Recriminations," New York Times, 2 October 1998, p. A10. Excerpted in McQuillan and Montgomery, International Monetary Fund, pp. 22-23, 136-37, and 147-48.
17 Friedman, "Markets to the Rescue," p. A22.
18 Allan H. Meltzer, "Asian Problems and the IMF," Cato Journal 17 (winter 1998): 269.
20Vaubel, "Political Economy of the IMF," pp. 49-51.
21 Governments that more fully participate in IMF adjustment programs achieve smaller budget deficits. This is the only policy effect of fund programs found by Conway in "IMF Lending Programs."
22 Sebastian Edwards, "The International Monetary Fund and the Developing Countries: A Critical Evaluation," in IMF Policy Advice, Market Volatility, Commodity Price Rules, and Other Essays, ed. Karl Brunner and Allan H. Meltzer (Amsterdam, Netherlands: Elsevier Science Publishers, 1989), table 2, p. 33. Excerpted in McQuillan and Montgomery, International Monetary Fund, pp. 72-77 and 179-80.
23 Peter Passell, "Critics: The IMF Is Misguided. Skeptics: Too Much Rot in Asia," New York Times, 15 January 1998, p. D2. Reprinted in McQuillan and Montgomery, International Monetary Fund, pp. 131-33.
24 Bob Davis, "Rubin Prescribes Tight Money for Asia," Wall Street Journal, 30 June 1998, p. A2. Reprinted in McQuillan and Montgomery, International Monetary Fund, pp. 133-35.
25 Steve H. Hanke, "How to Establish Monetary Stability in Asia," Cato Journal 17 (winter 1998): 295.
26 Edwards, "International Monetary Fund and Developing Countries," pp. 30-37.
27 Jeffrey D. Sachs, "Strengthening IMF Programs in Highly Indebted Countries," in The International Monetary Fund in a Multipolar World: Pulling Together, ed. Catherine Gwin and Richard E. Feinberg (New Brunswick, N.J.: Transaction Books, 1989), p. 107.
28 Michael R. Gordon, "IMF Urged by Russian Not to Give More Aid," New York Times, 1 October 1998, p. A18.
29 Kendall W. Stiles, Negotiating Debt: The IMF Lending Process (Boulder, Colo.: Westview Press, 1991), p. 31.
30Alan Greenspan, "The Globalization of Finance," Cato Journal 17 (winter 1998): 249.
31 Friedman, "Markets to the Rescue," p. A22.
32 A. James Meigs, "Lessons for Asia from Mexico," Cato Journal 17 (winter 1998): 319.
33 Greenspan, "Globalization of Finance," 248.
34 Anna J. Schwartz, "Time to Terminate the IMF," in Cato Commentaries (on-line), 6 October 1998; available at www.cato.org/dailys/10-06-98.html. Reprinted in McQuillan and Montgomery, International Monetary Fund, pp. 221-23.
35 Schwartz, "Time to Terminate IMF."
36Walter B. Wriston, "Dumb Networks and Smart Capital," Cato Journal 17 (winter 1998): 334-436.
37 Ibid., p. 342.
38 Jeffrey D. Sachs, "IMF, Reform Thyself," Wall Street Journal, 21 July 1994, p. A14. Reprinted in McQuillan and Montgomery, International Monetary Fund, pp. 57-59.
39 Joel S. Hellman, "Constitutions and Economic Reform in the Post-Communist Transitions," in The Rule of Law and Economic Reform in Russia, ed. Jeffrey D. Sachs and Katharina Pistor (Boulder, Colo.: Westview Press, 1997), p. 73.
40 Schwartz, "Time to Terminate IMF."