The IMF's misplaced priorities.
Flawed Fund
By JAMES TOBIN and GUSTAV RANIS
The New Republic
Issue date: 03.09.98
Post date: 04.05.00
They did it in the 1930s, and now they're threatening to do it again. "They" are the lords of world finance--international bankers, central bankers, finance ministers, and, since 1945, the International Monetary Fund. Faced with currency crises that endanger both financial systems and whole economies, they invariably give priority to finance. Their standard remedies, fiscal stringency and punitive interest rates, are devastating to economic life. They destroy jobs and bankrupt enterprises. But their authors assure the world that restoring the confidence of lenders and investors worldwide in the soundness of governments' financial policies is essential for prosperity and growth. Prime ministers and presidents have to go along.
The trouble is that the resulting recessions themselves undermine the credit-worthiness of businesses and governments. During the 1930s, financial soundness meant sticking stubbornly to the established gold values of currencies. The attempt led to the Great Depression, and the gold standard ultimately collapsed anyway. The recent IMF bailout packages for Thailand, Indonesia, and South Korea, true to form, demand austere fiscal and monetary policies along with drastic structural reforms. But the announcement of these packages did not inspire the hoped-for confidence in financial markets. The runs on the countries' reserves continued, and their currencies and stock markets continued to slide. This episode will not end in world depression, but it will doom Asian tigers, accustomed to six to eight percent growth, to severe slowdowns.
In the 1930s, Weimar Germany's Chancellor Bruening ignored his country's 20 percent unemployment rate and succeeded only in paving the way for Hitler's accession. Britain, having endured depression since returning to the gold standard in 1925, was finally forced off in September 1931 to the immediate benefit of its economy. In 1932, as the depression worsened, the Hoover administration and the Federal Reserve were desperately defending the gold value of the dollar. Roosevelt let the dollar depreciate in 1933, and recovery began at last.
An important purpose of the IMF was to tide countries over during temporary shortages of international liquidity, giving them time to make adjustments to their policies and exchange rates. The architects of the IMF, unlike their latter-day successors, did not presume that currency difficulties were the victims' fault.
Originally, the IMF reestablished a sort of gold standard. Each member made its currency convertible into dollars at a fixed rate, and the dollar was convertible into gold. This system lasted until 1971, when the United States ceased to guarantee conversion of dollars into gold. Since 1973, exchange rates among the dollar, the mark, and the yen have floated freely with no official parities, though central banks occasionally buy or sell in the currency markets. This system has the great virtue that exchange rates can adjust without precipitating financial and political crises. For example, there was no crisis from 1995 to 1997 when the yen gradually lost about 40 percent of its dollar value.
Other countries generally adhere to semifixed exchange rates. They promise to keep their currencies within a band relative to one of the three "hard" currencies or to a mixture of them. The band itself usually is nudged up or down in response to persistent market trends. Crises occur when a currency's dollar value gets stuck at the lower limit of the band and speculators become sure it will fall further. They sell, and the hapless central bank has to buy, using up its reserves. A pretty obvious lesson of the recent crises is that most countries would do better to abandon fixed or semifixed exchange rates in favor of freely floating rates.
The IMF's Asian packages are based on its experiences with Latin America, in particular with Mexico in 1994. Mexico had appeared to be in fair shape by IMF standards. Its budget was close to being balanced; its inflation was single-digit; wages were stabilized with the help of a pact with organized labor; and Mexico was deregulating its economy and opening itself further to foreign trade and investment. Nevertheless, from 1993 to 1994, Mexico allowed the peso to become overvalued. Dollars poured into Mexican financial markets, bidding up the peso on the way. At the same time, commodity prices were rising faster than they were in the United States. Consequently, Mexico ran a trade deficit that was financing a consumption binge rather than productive investment. The government itself was borrowing dollars short term, but the inevitable lowering of the exchange-rate band was too little and too late. Lenders took flight.
At that point, the IMF and the U.S. arranged a $50 billion bailout. The familiar prescription was to float the peso, tighten the budget, restrain the money supply, and raise interest rates. Mexico's real GDP fell six percent in 1995, but growth resumed the following year. The 20 percent fall in the peso's real value in dollars sufficed to restore trade balance, and the accompanying bulge in inflation subsided. Mexico repaid its bailout loans.
In 1997, the IMF and the U.S. Treasury responded to Asia's currency crises in the same way that central banks and governments had responded to the gold crises of the 1930s. They diagnosed Asia as a victim of the "Latin American disease" and prescribed the usual medicine. Yet, prior to 1997, the Asian tigers appeared to be model economies by IMF criteria. They were generally running budget surpluses, and money growth was moderate. Inflation rates were low, and saving rates high. Some countries, notably South Korea, had incurred large volumes of mostly short-term foreign debt. Unlike Mexico's dollar-guaranteed debts, these were almost all private debts. As the IMF noted, these countries were running trade deficits. But, unlike Mexico, they were not importing for consumption. It is quite legitimate for developing economies to borrow abroad for investments at home, though some of South Korea's recent investments apparently were ill-advised prestige projects in heavy industry, land, and real estate. The key problem was misallocation of private credit, not governmental profligacy.
The heavy private indebtedness of Asian countries clearly aggravated their situation. Once the central bank commits itself to sell hard currency for local currency on demand, its international reserves become hostage to repayment of private foreign debts. Commitment to a fixed exchange rate relieves local borrowers and foreign creditors of risk. The borrowers do take some risk only if the central bank lets the price of foreign currency rise as debtors bid for it in order to repay loans.
The IMF-U.S. package has been criticized for bailing out South Korean banks and industries indiscriminately. Some deserve to be rescued by public funds or mergers. Owners of others should be permitted to take a bath. The worst injustices and worst precedents occur when foreign lenders are guaranteed to get all their money back; having made risky investments in search of profits, they should not be immune to losses. Converting all debts into government liabilities, as some foreign banks have demanded of South Korea in return for lengthening maturities, is another bad precedent. However, some degree of "moral hazard" is inevitable in any system of insurance. That is not a reason for abolishing "lenders of last resort" within nations or between nations. It is a reason for designing bailouts with care.
The IMF-U.S. explanation of the currency crises emphasizes long-standing fundamental defects of economic structure--anti-competitive and corrupt alliances among oligopolistic businessmen, bankers, and politicians. However objectionable this "crony capitalism"may be, it is nothing new. It could hardly have been the main cause of the 1997 financial crisis.
A more likely cause is that Japan's prolonged recession weakened the major export markets of its neighbors. Their trade deficits are counterparts of Japan's surpluses. Yen depreciation, along with China's devaluation in 1994, further contributed to overvaluation of Asian currencies, especially those tied too inflexibly to the dollar. Once foreign lenders suspected that these countries' exchange rates were not sustainable, they dumped them. Adding insult to injury, Japanese banks were among the first to pull out. The creditors' panic, accentuated by the dismal prospects of economies under IMF surveillance, depressed exchange rates much further than necessary to correct their basic overvaluations.
The spectacular growth of the Asian tigers in recent decades was not a mirage. It was based on combining an educated labor force, high saving and rapid capital accumulation, modern technology, and resourceful entrepreneurship--fundamentals which still bode well for the future, and in which, incidentally, East Asia surpasses Latin America.
The Asian tigers do need structural reforms: continuous full disclosure of the size of central-bank reserves and of bank balance sheets and non-performing loans; orderly bankruptcy procedures; substitution of objective risk analyses and arm's-length credit allocations for political favoritism and for government guarantees of private loans; and adequacy of bank capital by international standards. Most importantly, local banks must be forbidden to be net debtors in hard currency.
But these problems do not justify forcing these economies into deep recession, which is bound to be especially painful for the poor, dependent as they are on maintenance of public-health and education expenditures, plus other safety nets. Nor will such a prescription restore the confidence of investors, foreign or domestic.
Finally, the IMF-U.S. doctors insist that these Asian governments open their doors wider to international financial transactions. This is a particularly inopportune time to urge further globalization. Encouraging inflows when exchange rates and local asset values are so depressed creates the image and the reality of arranging bargain-basement deals for foreigners, thus undermining the faith of many residents of these nations in the intentions of the international lenders, public and private. Anyway, entry of foreign capital should not be further eased before domestic banking and financial reforms are in place. That would only attract inflows of nervous funds ready to move out when interest-rate differentials and/or devaluation expectations change, funds of the type that contributed so heavily to the present crisis. To avoid attracting hot money, a Chile-type tax or special deposit could be required of inflows. In the longer run, an internationally negotiated tax on currency transactions might deserve consideration.
Some critics of the IMF's bailouts want to abolish the IMF. Free-market ideologues have faith that completely liberalized international financial markets will handle all shocks optimally, if only governments and international institutions will stay out of the way. No convincing evidence or logic supports this faith. Currencies are not market institutions, and cannot be. Critics from the opposite side regard the IMF as an instrument serving multinational capitalism at the expense of ordinary people throughout the world. We believe that the world needs an IMF, just as nations need central banks, and that the IMF needs loans of hard currencies from its major members. The lesson of current events is that the IMF should stick to its original mission, saving its members from disasters due to short-term illiquidity. The World Bank and other international lenders are better suited to handle long-run structural and developmental issues.
JAMES TOBIN, Sterling Professor of Economics Emeritus, received the Nobel Prize in Economic Science in 1981. GUSTAV RANIS is the Frank Altschul Professor of International Economics and director of the Yale Center for International and Area Studies.(Copyright 2000, The New Republic)
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