This was originally published in Emerging Markets under the title “ A tale of two crises.”
A speculative real estate bubble inflates over many years. A poorly supervised financial sector misallocates high-risk credits extended on the back of foreign borrowing. Then the bubble bursts, real estate prices decline, financial institutions run into difficulty, rating agencies downgrade creditworthiness, the currency weakens and credit is tightened. Most people would recognize today’s problems in the United States. In response, the Federal Reserve Board and the US Treasury are throwing all but the kitchen sink to try and forestall a recession. Drastically lower interest rates, a fiscal stimulus package, rescue operations for financial institutions, bailouts for distressed home owners and expansionary lending by public mortgage companies are all pursued by an administration that in the past extolled the virtue of unfettered private enterprise and the failings of public intervention. The IMF has applauded the “timely and targeted fiscal stimulus” and the “critical role played by central banks in …providing necessary liquidity”.
For those with longer memories, the sequence of events that has transformed the US sub-prime mortgage problem into a macroeconomic problem with the threat of recession looks all too familiar. Ten years ago, Thailand, Korea, Indonesia and Malaysia faced a financial crisis borne out of very similar circumstances. The major difference from the US today? East Asia could not rely on its own resources to forestall a recession but had to turn to the IMF and the G7 for financial support. The story then unfolded in very different ways from what we see today.
East Asians were told to raise interest rates, cut public spending, shut down banks and investment houses and let asset prices—stocks, real estate and currencies—find their market level. In return, East Asians received modest financing from the IMF and from some advanced economies. The result: their economies collapsed. Thailand, Indonesia and Korea saw falls in 1998 GDP of 11, 13 and 7 percent respectively.
There were voices at the time who argued for a different approach to the East Asia crisis. Joeseph Stiglitz, then Chief Economist at the World Bank, advocated a less deflationary approach and more interventionist policies to prop up the failing economies. Malaysia went its own way in managing the crisis by establishing capital controls and by more expansionary monetary and fiscal policies, spurning an IMF program. But generally, East Asian economists and governments felt bullied and humbled by the stern advice and uncompromising conditionality that was imposed by the guardians of the international financial world – the IMF and the G7.
The IMF and others subsequently concluded that some of the advice and some of the conditions imposed at the time were unduly harsh, that a less deflationary policy stance would have been preferable, and that better communication of the logic of the program with the public and markets would have boosted ownership and credibility. But for the affected East Asian economies, which had been used to growing at over 6 percent per year, the costs were enormous. It took Indonesia 8 years to regain its pre-crisis income level. Meanwhile, most foreign banks escaped with minimal losses thanks to the current account surpluses that were produced by the draconian macroeconomic programs.
The contrast in how the rules-of-game are implemented for different countries is at the heart of today’s crisis of legitimacy and relevance in the IMF. This venerable institution is going through its own deflationary experience, battling organizational budget deficits through drastic cut-backs in staff imposed on it by key shareholders, even as it tries to give greater voice to the dynamic, emerging economies among its membership. Some might get a sense of satisfaction from seeing the IMF, the stern task master of decades past, put through the wringer. But “Schadenfreude” – while perhaps a gratifying sentiment – is not a satisfactory policy response. Instead, reform of the IMF needs to restore the institution’s role as a global lender of last resort.
The first priority is to confirm that rules apply equally to all member countries. The IMF needs to acknowledge explicitly that a less deflationary, more supportive response by the international community is warranted when countries face externally-triggered macroeconomic problems.
A second priority is to act decisively on IMF governance. The East Asians, and more generally the developing countries, have rightly felt that their voices are not adequately represented in the making of the rules. On top of that, they also see the rules applied differently to them as compared to the big boys. As a consequence, many countries have sought safeguards beyond the IMF. The build-up in each country’s foreign exchange reserves has fuelled a mercantilist approach to policy that is inefficient globally and has contributed to global imbalances. As part of its ongoing reform initiative the IMF now has an opportunity to significantly revamp the distribution of quotas and voting shares to give a greater voice to the emerging market economies and to the smaller and poorer potential borrowers. Unfortunately, the current bet is that a compromise will be reached at the IMF-World Bank spring meetings in April which will produce only very small and largely meaningless shifts in this direction— for example, the quota for Luxemburg (population 480,000) will about the same as for Vietnam and the Philippines combined (population 176.3 million).
A key problem blocking more far-reaching reforms of the IMF governance structures is the unwillingness of European countries to give up their control over an excessive share of quotas and votes and of chairs on the IMF’s Board of Executive Directors. A recognition by the Europeans that, by blocking fundamental reform of the IMF, they are in the long-term only harming their own interest in a stable and well managed global financial system, is now of the utmost importance. It is perhaps ironic, but a reflection of our globalized times, that the lessons of the East Asia and the US sub-prime crises for international financial governance need to be heeded most in Europe.