Capitalism Unhinged: The IMF and the Lessons of the Last Financial Crisis

Lael Brainard
Lael Brainard National Economic Advisor - National Economic Council

January 1, 2002


The Chastening: Inside the Crisis that Rocked the Global Financial System and Humbled the IMF. by PAUL BLUSTEIN. New York: PublicAffairs, 2001, 448 pp. $30.00.

In what many observers termed the first crisis of the twenty-first century, a completely unanticipated attack from a faceless enemy shattered the worlds of countless families as they went about the normal course of their lives. Nearly four years have since passed. In some places, many people whose only culpability was to invest their savings or take jobs in the wrong places are still fighting to escape the poverty and economic insecurity that attacked without warning or mercy.

The Chastening reminds us of the chaos and confusion that swept through the world’s financial system from July 1997 to April 1999. Interrupting a decade of unparalleled economic prosperity and promise, the crisis revealed the precariousness of the system that channels investment through much of the globe. From his vantage point as The Washington Post’s chief correspondent covering the international financial crisis, Paul Blustein recognized that he “had the makings of a good yarn about economic phenomena of great significance.” He applies the craft of great storytelling to a highly deserving subject that is normally the province of technocrats, academics, and financial wizards. The result is an accessible account of one of the most significant financial episodes of our generation from the perspective of the International Monetary Fund (IMF)—an institution that is as little understood as it is important.

Blustein aptly names the decision-makers at the IMF and the key economic agencies of creditor nations “the High Command,” hinting at the warlike nature of the crisis they navigated. In sharp contrast to the world we entered on September 11, 2001, the enemy that stalked the global economy in 1997 was impersonal: the herd psychology of financial markets. Although it has been with us for centuries, financial panic takes on a sufficiently novel twist in each new crisis to challenge key assumptions and policies adopted in response to the last. The Chastening applies skillful investigative journalism to reveal just how much the fabled financial guardians of the 1990s relied on trial-and-error, finger crossing, and guesswork in fighting the crisis—in sharp contrast to the image of elite technocrats dispensing monetary medicine with scientific precision.

The Chastening follows the IMF’s managers from the early days of the Thai crisis in May 1997 through the contagion that beset Indonesia, South Korea, and eventually Russia, then to the gyrations that swept through U.S. financial markets and brought down Long Term Capital Management, and ends with Brazil’s financial stabilization in April 1999. Blustein succeeds not only in telling a riveting story populated by interesting characters, he also offers an informative account of the economic complexities they confronted.

This approach brings to life the deliberations and assumptions underlying key decisions as the crisis unfolded. But it also tempts the reader to identify as heroes those who got it right, and as villains those who pursued actions that turned out in retrospect to be futile or even counterproductive. Rather than taking that route, postmortems are far more useful and appropriate when they evaluate the quality of decision-making in the context of what was known or knowable at the time. Our goal should be to improve the evaluation of financial developments under uncertain conditions and to identify current policy changes that could lower the likelihood and severity of future crises.


The 33-month crucible of the crisis was a fertile period for policy experimentation, offering a wealth of experience from which to draw lessons about the international financial architecture. Virtually every decision taken along the way can be criticized with the benefit of hindsight. Critics also charge that the evolution of policy was incremental, but it was “galloping incrementalism,” in the words of economist Peter Kenen, unfolding at a pace unimaginable in the absence of a crisis. Despite the generally conservative bias of the IMF’s specialist staff, substantial policy innovation took place on a trial-and-error basis, reflecting not only interaction among the IMF and financial authorities in the crisis-stricken and creditor nations, but also market dynamics and political developments within these countries. Just as national security decisions driven by short-term exigencies today may come back to haunt us, key decisions during the financial crisis implicitly made tradeoffs between the immediate imperative of stabilizing the system and the future consequences of cushioning investors from risk, confirming expectations of large bailouts, and postponing the day of reckoning for countries pursuing unsustainable policies.

What are the enduring lessons and where has financial reform fallen short? Greatest agreement exists on the importance of enhancing transparency and disclosure standards and strengthening financial supervision and regulation. Tremendous work has been done to develop codes of best practices for macroeconomic policy and for supervising financial services ranging from banks to securities. But these efforts will fall short without official involvement in making them operational. History suggests that markets alone are unlikely to translate the current efforts at defining best practices into effective mechanisms for evaluating country performance.

The crisis also provoked institutional innovation. The IMF is better funded and somewhat more transparent. It has a new department dedicated to capital markets and new facilities designed to provide expanded financing in extraordinary circumstances, though now at higher interest rates to mitigate the problem of moral hazard. Moreover, the governance of the international financial system has been strengthened by the creation of a new steering group: the g-20, a collection of 20 nations that includes important emerging markets along with the largest advanced economies (an innovation noted only in passing by Blustein). And several key creditor governments are seeking to narrow the IMF’s focus to crisis prevention and response, with continued modest involvement in financial support for the poorest nations. Such a step would decrease the medium-term balance-of-payments financing that has made too many countries chronically dependent on the fund. But substantial work remains in aligning IMF representation and voting more closely with present-day economic realities, further narrowing the central missions of the IMF and especially the World Bank, and remedying the perceived deficit in their democratic accountability. Moreover, one of the most vaunted innovations, the Contingent Credit Line facility, intended to help strong economies ward off contagion by “prequalifying” for crisis finance, has yet to be tapped because borrowers are concerned about inadvertently sending distress signals to the financial markets.


The financial crisis contributed to the debate surrounding capital controls—without providing a definitive resolution. Since the now infamous recommendation of the IMF in 1997 to make capital-account liberalization one of its core purposes, antipathy to capital controls of any stripe has been substantially undermined.

But while taxes on short-term inflows, such as those pioneered by Chile, are now generally accepted as either neutral in effect or even modestly helpful, Malaysia’s experiment with short-term controls on capital outflows remains controversial. And the evidence is equivocal. Although it is difficult to prove that capital controls were detrimental to Malaysia, there is deep disagreement on whether they may have helped that nation escape a deeper crisis.

The financial crisis also sorely tested the prevailing wisdom regarding exchange-rate regimes, and again it provided no easy answers. The virulent spread of the financial crisis throughout Asia was integrally related to the initial misalignment of pegged exchange rates and the perceived linkages among the region’s currencies. Similarly, it is impossible to comprehend the initial failure of financial stabilization in Russia and Brazil without looking to the absolute determination displayed by these nations to defend their fixed exchange rates, which had been the lynchpins of hard-fought victories over hyperinflation.

Over the course of the crisis, there was a breathtaking change in thinking about the sustainability of pegged exchange rates. Normally cautious policymakers recommended restricting future financial assistance to countries adopting currency regimes on either of two extremes: completely floating exchange rates, or the surrender of monetary sovereignty either through a currency board or the outright adoption of a major currency, such as the dollar. The debate rages on today in both academia and policy as unrelenting financial pressure pushes Argentina ever closer to abandoning its once-celebrated currency board in favor of either a float or full-fledged dollarization.

Possibly the most consequential and least conclusive debate surrounds the question of massive financial bailouts relative to “bailing in” private investors by suspending debt payments. Between the Mexican financial crisis of 1995 and the Brazilian stabilization of 1999, a host of different approaches to such “private-sector involvement” were pursued, mostly driven by desperation rather than design, after other policy measures and substantial sums had been exhausted.

During this time, unsustainable debt dynamics appeared in a variety of guises, depending on whether the debtor was a sovereign state or the private sector (in some cases guaranteed by the government) and on whether the bulk of debt was held by a limited set of foreign commercial banks or a broadly diffuse set of bondholders. The bail-ins ran the gamut from purely “voluntary” exchanges (which failed) to “concerted” rollovers, orchestrated by financial authorities, to unilateral exchanges dictated by debtor governments without an international seal of approval. As the crisis ran its course, private-sector involvement became broadly accepted as a vital lever in crisis resolution—showing a recognition that official resources are increasingly outgunned by private capital and concern about moral hazard.

But institutionalizing a greater private-sector role has proven complicated. It is genuinely difficult, given the absence of an international bankruptcy regime, to develop a set of general rules that would help investors make better risk assessments while minimizing creditor panic at moments of financial weakness. A variety of useful proposals, such as mandating provisions in bond contracts for collective action or automatic rollover, do go some of the way in facilitating a suspension of debt payments, known as a “standstill.” But basic questions remain unanswered, such as what should trigger a standstill and how to determine how much of a hit the private sector should take. Since 1999, private-sector involvement has been a part of most stabilization programs, and it is playing out today in the touch-and-go context of Argentina’s stabilization. IMF Deputy Managing Director Anne Krueger’s proposed creation of a Chapter 11-style international bankruptcy procedure would institutionalize a fundamental shift in this direction, but it remains to be seen whether countries such as the United States and the United Kingdom will approve laws permitting such sweeping changes in creditors’ rights.


Blustein originally sought to write about the IMF, and the financial crisis provides a fascinating window into this normally sheltered, technical international bureaucracy. But he skimps on many of the important stories behind the crisis: geostrategic imperatives, domestic politics in both crisis-stricken and key creditor countries (such as congressional brinkmanship over U.S. funding of the IMF), bureaucratic turf fights, and market players’ calculations about when to run and when to stick around.

It is surprising that Blustein downplays these dimensions, since he does not wear the intellectual blinders of many economists. In the Asian crisis, politics really did matter. In episode after episode, the financial guardians quickly discovered that investors bet as much on the management team as on the strength of its business plan. The success of South Korea’s second stabilization program owed a great deal to President Kim Dae Jung’s electoral victory and his forthright commitment to accept responsibility for the reform plan; Indonesia’s prolonged instability stemmed from President Suharto’s determination to distance himself from IMF reforms, his reluctance to address the corruption of his friends and family, and lingering questions surrounding his succession.

How should the political commitment to reform be taken into account in designing financial stabilization packages? The experience from 1997 to 1999 clearly suggests that stabilization packages are likely to succeed only amid a strong domestic commitment to reform that commands political legitimacy. But does that mean financial support should be denied in cases where favorable political conditions do not hold? Economists and financial experts do not have good answers to this type of question, and it is difficult for the ostensibly neutral IMF to address this issue directly.

The crisis was also influenced by domestic politics within the IMF’s major shareholders. Like any good storyteller, Blustein focuses in depth on some dramas and necessarily gives short shrift to others. He brings to life, with nuanced descriptions of internal debates, how the IMF and the U.S. Treasury Department battled financial markets. But the involvement of other key actors such as Congress is most often overlooked or bears little resemblance to reality. For instance, congressional restrictions on U.S. bilateral support for stabilization, enacted during the Mexican crisis, largely determined the initial U.S. decision not to aid Thailand in 1997. Moreover, subsequent U.S. commitments to provide bilateral assistance elsewhere were due more to the lifting of these restrictions and a growing recognition of the systemic nature of the crisis than to competition with a flawed Japanese proposal, as Blustein suggests. In addition, U.S. priorities on some of the financial programs were crafted with a view to the ongoing congressional debate over increased funding for the IMF.

Blustein also described heads of state of the G-7 group of advanced industrialized nations “as wanting to get more personally involved” as late as the autumn of 1998, when the crisis was sweeping financial markets in most of the world. This statement ignores more than a year of intensive diplomacy among these leaders and their counterparts in crisis-affected countries, as well as important policy innovations they drove, such as the creation of the g-20. Finally, the geostrategic dimension demands greater attention than it receives here in explaining the United States’ activism on South Korea, its increasing desperation over the Suharto question, and its ambivalent intervention in Russia.


What lessons—if any—should we draw for the present moment? The 1990s were characterized by a confluence of forces that brought international economics to the fore. The end of the Cold War, the sustained, productivity-driven growth achieved by an increasingly internationalized U.S. economy, and the relative decline of Japan afforded the United States the luxury of revisiting its commitments to international trade, aid, and financial assistance. In Washington, economic agencies such as the Treasury and the Office of the U.S. Trade Representative were as important, if not more so, in shaping international relations as were the State and Defense Departments. On the international scene, the IMF rivaled the U.N. in importance. And, when contrasted with the Cold War, U.S. policy in the 1990s, with some important exceptions, was made with a greater eye to economic imperatives and domestic politics relative to geostrategic considerations.

The tragic events of September 11 could prove pivotal not only to U.S. security policy and relations with the Islamic world but also to the relative importance of international economic and national security imperatives. Indeed, the 1990s could prove to be a unique period rather than a herald of the new century. The question is whether we will continue to follow the economic logic of the decade, when the international community recognized that it takes more than throwing money alone to address financial problems, or whether international financial institutions will be pushed back toward their former role as underwriters for our geostrategic goals. Although The Chastening does not address these questions directly, it provides a compelling account of what the IMF does well and badly. It reminds us that the unresolved complexities of preventing and responding to financial crises should not be neglected as we breathlessly shift focus to fighting the newest “twenty-first-century crisis.”

Although the nation is properly focused on the immediate danger, the guardians of the international financial system must sustain their focus on reform. The IMF and financial authorities around the world would be well advised to make The Chastening required reading within their organizations, along with Charles Kindleberger’s Manias, Panics, and Crashes. The crisis that raged in the late 1990s suggests that the curriculum for new recruits at the IMF should focus less on the niceties of accounting and lecturing foreign financial authorities and more on preparing to handle the next crisis. That approach means discerning troubling linkages in the minds and portfolios of international investors, unearthing hidden sources of danger such as unfunded liabilities on central-bank balance sheets, and examining the soundness of domestic financial systems with a view to macroeconomic vulnerability. History suggests that it is only a matter of time before we again confront a financial crisis of potentially worldwide proportions. Blustein reminds us how perilously close to the edge we came in the midst of remarkable prosperity—and warns us to remain vigilant.