How to Replace the IMF

Saturday, October 30, 1999

Reforms advanced by the Group of Seven nations, the International Monetary Fund, and the Clinton administration to design a “new global financial architecture” give the IMF and other multilateral organizations greater regulatory control over the international monetary system. This is the wrong approach. International financial markets work best when market participants, not government “architects,” determine prices, contracts, and oversight mechanisms. The historical record demonstrates that international financial markets suffer and ordinary citizens pay the price when IMF intervention grows.

THE FUND’S ORIGINAL MISSION

The IMF was created at the Bretton Woods Conference in July 1944 to supervise a system of pegged exchange rates and to provide temporary, low-cost financing of balance-of-payments deficits resulting from misaligned exchange rates. In reality, the framers of the Bretton Woods regime created an international price- fixing arrangement enforced by the IMF. 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. As with all price-fixing schemes, the Bretton Woods regime contained the seeds of its own destruction. The inflation of the 1960s made the U.S. commitment to sell gold at $35 an ounce unsustainable. To preserve U.S. gold reserves, President Richard Nixon closed the gold window in August 1971, effectively uncoupling the dollar from gold and ending the fund’s original mission of supervising a system of pegged exchange rates. At this point the IMF should have closed shop; instead, it assumed a new, expanded role as financial medic for developing countries. In this capacity, the IMF has lent billions of dollars, at heavily subsidized interest rates, to governments that, ironically, are largely responsible for their countries’ economic problems.

THE FUND’S CURRENT MISSION

Beginning in the early 1970s, the IMF skillfully used a series of global economic crises—the oil crisis, the debt crisis, the transformation of former communist countries, and the Mexican, East Asian, and Russian financial crises—to increase its capital base and financing activities. Increased IMF intervention in world financial markets has done more harm than good. A cogent example is the recent IMF programs for Mexico and East Asia. In response to balance-of-payments deficits caused by the Mexican government’s overexpansionary fiscal and monetary policies and its overvalued peso, the IMF committed $17.8 billion to Mexico in February 1995 with the understanding that all foreign creditors would be kept whole. This arrangement signaled to international lenders that they needn’t worry about future investment risks—the IMF will bail them out if their loans go bad.

By removing the risk of default, the IMF encouraged riskier global investments, which contributed to the East Asian crisis that erupted in 1997. The fund’s implicit guarantee in 1995 contributed 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 a record-breaking $21 billion to South Korea in December 1997. Thanks to IMF bailouts, foreign lenders ignored basic principles of sound banking such as determining how many loans borrowers had outstanding, how much money had been borrowed short to lend long, and how much currency risk had been assumed. Under the current bailout regime, lenders don’t care because the IMF will rescue them if they roll the dice and lose. IMF financing programs encourage riskier global investments and unsound domestic economic policies that contribute to global financial chaos.

WHO PAYS THE PRICE?

Ultimately, it is Western taxpayers and citizens of borrowing countries that pay the price of IMF loan programs. Western taxpayers provide the bulk of the fund’s $287 billion capital base, and citizens of borrowing countries pay off the IMF debt through “adjustment programs” that seek to reduce imports and increase exports. 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. 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.

This pattern of massive IMF bailouts, inappropriate economic policy prescriptions, insufficient institutional reforms, and declining standards of living was repeated in East Asia and Russia. The IMF incorrectly diagnosed the East Asian crisis as a fiscal crisis rather than a banking crisis. Its policy prescriptions of monetary contraction and higher interest rates strangled Asian economies. In Russia the IMF has lent billions of dollars on the empty promise of institutional reform; the money has gone largely to finance the oligarchs’ capital flight. The IMF has done more harm than good. It cannot be fine-tuned, as many officials in Western governments claim. By its very nature, the IMF impedes the efficient operation of international financial markets. It is time to abolish the fund and strengthen market-based alternatives.

MARKET-BASED ALTERNATIVES TO THE IMF

Several key market-based institutions would ensure an orderly and efficient post-IMF international monetary system:

  1. FLOATING EXCHANGE RATES. Countries with pegged exchange rates routinely experience balance-of-payments problems and currency crises. In contrast, as Milton Friedman has observed, “under a floating rate, there cannot be and never has been 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.” The recent foreign exchange crisis that hit Indonesia, Malaysia, South Korea, and Thailand did not spread to Australia or New Zealand because they have floating exchange rates. Floating exchange rates preclude balance-of-payments deficits, foreign exchange crises, and the “contagion effect.” There would be no need for IMF balance-of-payments financing if countries maintained floating exchange rates.
  2. INTERNATIONALLY ACCEPTED ACCOUNTING AND DISCLOSURE PRACTICES. The adoption of internationally accepted accounting practices by foreign businesses would allow lenders to assess more accurately the true credit risk of potential borrowers. Free capital markets encourage “transparency” and the adoption of uniform standards by providing better terms to borrowers that use accepted accounting practices. The current lack of transparency in foreign markets, cited by many pundits as justification for greater international financial regulation, 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 lending mistakes. The greater incentives 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 would also, in the words of Alan 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.” Concern over these “hot money” flows has prompted some economists to propose a 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.
  3. UNFETTERED FINANCIAL MARKETS. The IMF was not designed to be an international “lender of last resort.” Unlike a true lender of last resort, the IMF cannot create high-powered money (currency held by the public plus bank reserves) and cannot act quickly to stem a banking panic. The fund’s cumbersome, bureaucratic decision-making process is suited to financial markets of 1944, not 1999. 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 balance-of-payments 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, and with collateral, that reflect true credit risk.
  4. FUNDAMENTAL INSTITUTIONAL REFORMS. Economic development requires the accumulation of physical, human, and financial capital. A secure and predictable environment attracts capital, whereas capital will flee countries with excessive taxation, inflation, regulation, trade and investment barriers, government intervention, and 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 legal, political, and constitutional ingredients for self-sustaining economic growth.

CONCLUSION

The IMF is obsolete, unnecessary, and counterproductive. It is time to scrap the fund and strengthen market-based alternatives that would forestall future financial crises. An unfettered international monetary system would provide the appropriate incentives for governments to implement the sound macroeconomic policies and market-based institutional reforms needed for self-sustaining economic growth, and it would improve the efficiency and coordination of global capital flows. It is time for the “architects” to step aside and let markets coordinate the international monetary system.