It is not an understatement to say that the IMF—and indeed the entire world economy—is currently facing its stiffest challenge since the Fund was created after World War II. Many speakers at this conference have already addressed the crisis, the IMF’s role in addressing it, and steps the Fund should take in the future to prevent future crises.
In these remarks, I take on a higher-level issue: what should be done about the IMF itself. Does it have a future, and if so, what should it be?
Two years ago, such questions wouldn’t even be asked in polite company. It was taken for granted that one of the world’s largest international institutions, and certainly one of its most important, would forever be part of the economic and political landscape. Now, this isn’t the case. The Congress has refused thus far to approve the Administration’s request for $18 billion to help replenish the IMF’s resources, which have been severely depleted by the various Asian rescue packages the Fund arranged earlier this year. A shortage of resources is one reason (but certainly not the only one) why the Fund didn’t offer to provide Russia more money during late summer (after arranging a package in July). Even if the Congress eventually approves the $18 billion for this country’s contribution to the quota increase, the acrimonius debate over the IMF’s funding and future this time does not augur well for approval of additional funding in the future.
I won’t hold you in suspense. My bottom line is that the world has an important stake in giving a meaningful future to the IMF, not as a “lender of last resort” but as the “crisis and prevention manager” that it more realistically has been and should continue to be. In what follows, I address a number (but not all) of the recent criticisms of the Fund. Some of the attacks are on target, but in my view, they justify reform of the Fund, not its elimination. Nonetheless, at this writing, because limiting the Fund to its current resources appears to be a possible near-term option, I attempt to guess what the world would be like if that outcome should come to pass. I conclude with a recommendation that the Fund facilitate the rapid workout of the debt overhang in Southeast Asia in particular that is impeding economic recovery in the region.
Is The IMF A Lender of Last Resort? Should It Be? Can It Be?
It is common to talk of the IMF as being an international lender of last resort (LLR), playing a role akin to the one played by central banks in a domestic context. I myself have used this analogy at times and I suspect many of those in this room have done so as well.
But the more I have thought about the subject, the more I have realized that the analogy falls short. In reality, while the IMF performs some functions that look like an LLR, it also differs from a domestic LLR in a number of important respects. Indeed, the differences are so fundamental—and so unlikely ever to be eliminated—that it is time we change the terminology of what the Fund really does and should do in the future, assuming it should continue to exist.
Central banks within countries typically have three characteristics that enable them to function as lenders-of-last-resort:
- They can flood a troubled market with liquidity by printing money (which ordinarily lowers interest rates on government securities and thereby makes investments in riskier assets, such as loans, bonds and equity securities, relatively more attractive).
- They can provide temporary loans to specific solvent institutions, typically banks, that may find themselves short of liquidity in a crisis.
- They limit moral hazard by regulating potential borrowers (banks), and if they are following Walter Bagehot’s rules, only provide loans at a penalty rate backed by good collateral.
The IMF differs from a domestic LLR, however, in the following important respects:
- First, although it has created a small amount of a kind of “world money” for central banks, or SDRs, the Fund cannot act as the world’s provider of liquidity. The resources of the Fund are limited by the amount of currencies deposited by members. The Fund cannot print money to lend to any worthy borrower like a central bank, but increasingly must husband its scarce resources, a topic I address in greater detail shortly.
- Second, while the Fund can and does lend to individual countries in need of liquidity, its loans often have effective maturities that last for years.
- Third, I do not believe the distinction between “illiquidity” and insolvency” is useful in the international context. It is hard enough for a central bank, in the heat of a crisis, to distinguish whether any particular bank is illiquid or insolvent. But what would it even mean to say that a country is insolvent and not merely illiquid?. Sure, governments can and do default on their obligations. But are the countries “insolvent” when they do so, or are political leaders simply unwilling to pay the political and economic price of honoring the country’s debts? Take Russia, as an example. Even though the government there has effectively defaulted on its loans, and caused the banks to do likewise, Russia remains very rich in resources and so is hardly “insolvent”.
- Fourth, the Fund does not regulate countries preemptively in the same way that central banks (or national supervisors) regulate their potential bank borrowers. To be sure, the Fund has a carrot—money—to persuade countries that want to avoid a crisis by reforming their policies. But until countries ask for money, either in the absence or in the middle of a crisis, the Fund has no ability to regulate their activities.
- With some exceptions, the Fund does not charge a penalty rate on its loans, and in this sense the IMF looks very much like our Fed. At the same time, the Fund’s conditions on its loans seem to entail more micomanagement of its borrowers than would be the case even for a national bank supervisor of a troubled institution. But the Fund imposes tough conditions because it cannot seize assets of countries, as can private creditors; or overthrow their leaders, as even U.S. regulators can now do in the case of weakly capitalized banks under the new “prompt corrective action” regime (to be precise, U.S. regulators can assume control of a weak, but still solvent bank, and sell it to others who can recapitalize and manage it).
- Sixth, unlike central banks that have an interest in immediately supplying such funds as may be necessary to stop a deposit run (consistent with prudent lending practices), the Fund dribbles out the disbursement of its assistance in small doses. It does this because the prospect of handing over more money is its only real leverage to ensure that borrowing countries adhere to the Fund’s conditions. But gradualism has its costs as well, since countries can find it hard to stop a currency run when they are short of reserves on hand.
- Seventh, the IMF is governed by many different countries with different interests and must work by consensus. Its director does not have the power of, say, an Alan Greenspan to move the entire body, although recently the U.S. government (through the Treasury) has been well out in front in leading the IMF. However, the U.S. still only has an 18% vote, and our influence inevitably must wane if we are not willing to provide the IMF with the additional resources it has requested.
In short, while I disagree with her recommendation that the IMF be dissolved, I could not agree more with Anna Schwartz when she concludes that the IMF is not like a domestic LLR. Furthermore, even when it had more funds to lend out relatively freely, the IMF’s policy was to lend to any of its members willing to accept its conditions. The Fund did not try to make a determination whether the country is merely illiquid rather than insolvent (nor, for reasons I have already outlined, would it have made sense to try). As the first Article of the Fund’s Articles of Agreement makes clear, one of its major purposes is to “give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity” (emphasis added). In plain English, this means that the Fund is there to help ensure that governments of countries don’t do stupid things either that may precipitate a crisis that has spillover effects to other countries, or in the midst of a crisis, take steps to aggravate a crisis, to their own detriment and to the detriment of other countries.
It is more accurate, therefore, to say that the Fund—it its emergency lending activities—is in the “crisis prevention and management” (CPM) business than to claim it is the international equivalent of a lender-of-last resort. The question the Asian-cum-Russia-cum potential Latin American crisis has put on the table, therefore, is whether the IMF should continue in this role, have its operations refined, changed, constrained or eliminated. It is useful to begin with the arguments for elimination first, for if the Fund can’t survive those, it doesn’t make much sense to address the other options.
The IMF And Flexible Exchange Rates
One alleged argument for dismantling the Fund is built around the claim that it was created to support the Bretton Woods system of fixed (and only occasionally adjusted) exchange rates. Now that fixed rates are largely dead, it is said: it is time to sunset the IMF.
This argument is misplaced on several levels. As a threshold matter, even in the wake of the Asian crisis, not all countries have abandoned fixed rates, or their close cousins, currency bands or managed floating regimes. But more fundamentally, the main purpose for which the Fund was created—to discourage countries from adopting economic policies in the heat of a balance of payments crisis that harm other economies in the process—is independent of the exchange rate regime that may be in place.
For example, events have shown that having a flexible exchange rate does not make it any easier for a country to manage a large “supply shock”, such as a major jump in oil prices for oil importing nations or a sharp drop in commodity prices for exporting countries. In the former case, a jump in prices of a key import has a direct inflationary impact which is compounded by the drop in the exchange rate, which also makes other imports more expensive. The sharp currency depreciation that can follow a drop in world prices of important commodity exports can have a similar impact on exporting countries. If the affected countries also have sizeable foreign currency debts, then the sudden currency depreciation can generate a wave of bankruptcies that can further damage the economy, which may already be weakened by any attempts to fight the depreciation-induced inflation through restrictive macroeconomic policies.
By themselves, these familiar events may not justify IMF assistance. But as recent events have shown, foreign exchange markets are subject to contagion, which means that any initial currency depreciation can easily be magnified when domestic and foreign investors “run” to safe havens. If countries cannot borrow foreign currency to stop the run on their own reserves, then they may adopt any number of measures that restrict trade and capital in an effort to halt the inflationary impacts of their falling currencies. If only one or two countries take such counterproductive measures, the damage to the world may not be significant. But if many similarly situated countries follow a similar course, then the world economy suffers from a “tragedy of the commons” and many economies spiral downward together. This is what happened in the 1930s. And it was what the IMF was created to prevent.
More sophisticated critics of the IMF may nonetheless respond that while the purposes of the Fund theoretically may be appropriate in a world of flexible exchange rates, the availability of Fund financing creates a kind of moral hazard—not the typical one I will discuss shortly—that discourages countries from adopting floating rates. These critics will (or should) point out that a major reason for the Asian crisis was that the countries in the region pegged their currencies to the dollar, encouraging local borrowers to engage in a massive arbitrage play: borrowing dollars at low interest rates with the aim of using the funds to earn much higher rates of return in local currency. Critics may point out that had the IMF not been in existence, and thus unavailable to provide liquidity in the event of a run on the currency, it is possible that the Asian countries never would have adopted the currency pegs that encouraged this arbitrage game.
It is impossible to know, of course, whether this would have been the case. But even if it were true, the “currency moral hazard” argument does not justify eliminating the Fund. Although I personally believe that flexible rates should be the norm for most countries, fixed or managed rates may be useful in ending a hyper-inflation by constraining the ability of centrals banks to pursue an overly expansionary monetary policy. Once inflation has been brought under control, then the case for pegging weakens. That should be a main lesson of the recent financial turmoil that the Fund should be preaching to its members rather than any of the members calling for the downsizing or elimination of the Fund.
The IMF And Its Warts
The criticisms of the Fund extend far beyond issues about exchange rate regimes, of course. As I am about to briefly summarize, some of these attacks are partly valid. But to paraphrase the Clinton Administration’s approach to affirmative action, the far better course is to “mend the Fund, not to end it”.
Moral Hazard: Let’s begin with the better known “moral hazard” problem: that because IMF funds recently have been used to stabilize domestic banking systems, IMF rescues have the effect of insulating creditors of banks in borrowing countries against loss. This distorts the pricing of loans and encourages too much borrowing and lending at artificially suppressed interest rates.
IMF officials have acknowledged this problem, have urged attention be devoted to solving it, but at the same time, either have implicitly or explicitly suggested that this is a price that may have to be paid in order to prevent contagion. This view is far too pessimistic. In the United States, we heard similar objections to curtailing the ability of regulators to protect uninsured depositors during the 1980s and yet a law was enacted in 1991 (FDICIA) that does precisely that. In the international arena, the objective should be to establish a similar system, or at the very least, to adopt measures that have the effect of providing more market discipline. I will briefly discuss two steps that would move policy in this direction.
First, the Shadow Financial Regulatory Committee, of which I am a member, proposed last May and has just reiterated in September that future IMF emergency lending (or at the very least the interest rate on those loans) should be made conditional on borrowing countries having a mechanism that, with one caveat I am about to mention, imposes some kind of a haircut on foreign currency creditors of banks when such rescues are announced. The caveat is that the haircut not apply if the creditors keep their money in the banks—if they roll over their deposits or interbank loans (at no higher rate of interest) and keep their money in until the IMF loan is paid back. Furthermore, governments would be prohibited from guaranteeing any more than the principal amount of the interbank credits minus the haircuts. Such a system would promote stability because it penalizes lenders only if they withdraw their funds. It would also curtail moral hazard by encouraging lenders in the future to price their loans to reflect the possibility that they might have much longer effective maturities than anticipated or may suffer a haircut (lenders may also then be induced to purchase “catastrophe” insurance in the private market to protect them against suffering such losses).
I have heard it said that such a conditional haircut regime nonetheless would be destabilizing because it could encourage lenders who fear that an IMF rescue package is imminent to mount anticipatory runs on banks. I do not see this is as a drawback, but as a plus, provided the IMF has adequate funds to respond to crises when it is called upon to do so. As it is now, precisely because of the policy conditions the IMF imposes on its loans—the subjects I will turn to next—governments tend to put off going to the IMF until their currency reserves are nearly exhausted. If a conditional haircut system causes governments to adopt policy reforms sooner, then this is a clear advantage of the idea.
Another criticism of haircuts is that once they are imposed they allegedly would redline a country out of the international credit markets. The recent events in Russia might be cited as “proof” of this danger: it has been widely remarked within the financial community that, having effectively defaulted on its government debt and essentially wiped out the positions of foreign creditors of its banks, Russia has cut off itself off from foreign credit for years, if not decades. The Russian example is an extreme one, however: the Russian government didn’t impose haircuts, but rather, decapitation (creditors will be lucky if they get 10 cents on the dollar). Furthermore, given that Russia does not have anything close to a functioning market economy—nor is there a prospect that it will have one any time soon—it is hardly surprising that the financial community is saying that Russia has dealt itself out of world credit markets. A much better example for haircut critics to look at is the experience in Latin America following the issuance of Brady Bonds, which effectively guaranteed only the written-down portion of the original sovereign debt. This plan didn’t redline Latin America out of credit markets; to the contrary, as economies in the region subsequently recovered, foreign capital returned.
Second, markets function best when all actors have up-to-date, accurate information, a condition that it is widely agreed was lacking before the Asian crisis and remains less than fully fulfilled today. Of course, even the best information will not be helpful if creditors know they will be bailed out of their mistakes, and that is why there is a need for some kind of conditional haircut for foreign currency creditors of banks. At the same time, if a haircut system is not to have the unintended side-effect of promoting contagion, it is vital that all financial actors have access to the best information about the financial condition of all countries—especially their currency reserves, net of forward obligations, and the amounts and maturity schedules of foreign currency debt (including debt of affiliates abroad)—so that they can distinguish the good from the not-so-good credits.
Fairly complete banking data are already published by the BIS, while the World Bank and the OECD provide other relevant financial information. Nonetheless, up-to-date, reliable information about net international reserves (gross reserves minus forward commitments) is still not available. The IMF should encourage all its member countries to collect and report data on net reserves and foreign currency debt (although even developed countries, including the United States, do not currently tabulate foreign currency debt of foreign affiliates, so this particular job will be a challenging one). The IMF can then post all of the information on its own Web site.
A more controversial question is whether the Fund should provide to the public its Article IV staff evaluations of the economies of member countries (the official Article IV evaluations for many countries are currently made public but these often read like committee-produced documents that are not as blunt as the staff reports). The case for doing so is that the IMF staff may be in a better position than outsiders to assess the real condition of a country’s finances and the quality of its financial supervision, and that disclosing this information would enable the market to do what the Fund as an institution may not be able to accomplish: to induce governments to follow constructive policies that avoid crises. The familiar arguments against release of the staff evaluations are that it could impede the Fund’s ability to gain confidential information from its client countries and may precipitate crises when none may be warranted, arguments that bank supervisors have long made about disclosing CAMEL ratings of the banks they supervise.
Morris Goldstein has suggested one possible way out of this box: allow countries themselves to publish their IMF staff evaluations, and hopefully a process of “competitive transparency” may induce other countries to follow. Countries that don’t take this route would be pleading the financial equivalent of the fifth amendment from which the markets would draw adverse inferences. I don’t know whether any countries would follow Goldstein’s suggestion, but it certainly seems worth a try.
I am more dubious, however, of calls for the IMF or some other institution to become an “unber-regulator”, or regulator of the national financial regulators. For one thing, I’m not sure what such an international organization would or could actually do to countries that don’t meet some kind of minimum standard, other than publicize that fact. But this then gets back to the question of whether the uber-regulator will sacrifice its access to national regulators if it at the same time becomes a regulators’ rating agency. I’ll return to what I just said: let’s try Goldstein’s suggestion for voluntary disclosure first and hope that a process of “competitive transparency”, as he calls it, will ensue.
Macro Policy Conditions Too Tough: The IMF has been attacked from both the right and the left for forcing too much macroeconomic austerity down the throats of the Asian countries, most of which were generally perceived to be following prudent macroeconomic policies before the crisis. In retrospect, the critics appear to be right about fiscal policy tightness and the IMF has since relaxed its deficit targets. Given the continued downward spiral of the Asian economies at the heart of the crisis, additional fiscal expansion—further tax cuts and selected infrastructure projects (schools, highways and the like)—seems warranted. (The same advice is not warranted for countries like Brazil that already have large fiscal deficits).
The IMF’s prescription for tight money has been even more controversial. The conventional wisdom—which the IMF routinely follows in its rescues of countries experiencing currency runs—is that high interest rates are necessary to stabilize the currency. Things haven’t worked out so neatly in Asia, however, because as World Bank Chief Economist Joseph Stiglitz has persuasively argued, applying the tight money remedy to economies with high initial levels of leverage can strangle the patient, sending the currency down even further. With 20/20 hindsight, this criticism looks persuasive, but in all fairness, it was not unreasonable for Fund officials at the time when the crisis first appeared to have insisted on tight money, since without higher interest rates there was a real danger that the suddenly depegged currencies would have fallen even more sharply than they did. And there was no way of knowing at the time, back in the summer and fall of 1997, that the Asian crisis would be as severe and contagious as it has turned out to be.
In a recent piece in The New Republic, Paul Krugman argues otherwise, claiming that even in a crisis tight money runs counter to textbook wisdom, pointing to the decline of the U.S. dollar in 1985 as an example. Better he suggests to “roll with the punches”, let the falling currency buoy exports and even cut interest rates to support aggregate demand. But as Krugman himself acknowledges, this “textbook” advice is not easily generalized to developing countries with large foreign currency debts that may be highly dependent on imports. As I have already suggested, in this situation, a sharply falling currency can trigger both uncomfortably higher inflation and a wave of domestic bankruptcies. Under these circumstances, it was not unreasonable at the time of the initial crisis (although it may subsequently have proved counterproductive) for the IMF to have insisted on tight money policies to stabilize falling currencies.
Nonetheless, given where the Asian economies now find themselves—flat on their backs—it may be appropriate for the countries there (with the IMF’s permission) to run a Stiglitz-Krugman experiment by letting interest rates fall modestly and then watching what happens to both the economies and to the currencies. If Krugman and Stiglitz are right, then by stimulating the domestic economies, lower rates might help restore confidence in the currencies and not only brake their fall but perhaps give them a boost. If the experiment fails, then it is always possible to return to tighter money. At the very least, if the IMF is not willing to run the risks of doing this, it then ought to encourage the countries to move rapidly to reduce indebtedness of their private sectors along the lines I outline shortly so that their economies would be better positioned to withstand any tight money policy that may be necessary to maintain the values of their currencies.
At the end of the day, however mistaken the IMF may have been in imposing its macroeconomic conditions in Asia—and there certainly is room for debate on that score—the presence of mistakes themselves does not justify dismantling the Fund. The Federal Reserve made big mistakes in the 1930’s, too, when it failed to fully discharge its role as a lender of last resort, but no one seriously considered abolishing the Fed. I realize I have earlier drawn a sharp distinction between the CPM role played by the Fund and the LLR functions of domestic central banks. But the same logic holds. Mistakes don’t justify execution.
Attacks on the IMF’s Micro Conditions: The IMF has taken on a new role during and since the Asian crisis, defining conditionality to include not just macroeconomic belt-tightening but also a series of what can best be labeled “micro” reforms aimed at converting crony capitalism to something closer to Western-style capitalism, such as: improvements in financial regulation, adoption of bankruptcy regimes, cancellation of showy infrastructure projects, and improvements in disclosure. Critics have mounted three challenges to this new style of conditionality have mounted. Before considering each, I want to repeat in this context what I just suggested with respect to the Fund’s macro conditions: even if you believe that the conditions are unwise, it does not follow that the appropriate remedy is to eliminate the Fund.
The first critique is that the micro fixes were not necessary to restore investors’ confidence in the battered currencies; appropriate macro policy alone, it is asserted, would have done the trick. We’ll never know whether this would have been true. Indeed, one of the best lessons from this crisis is that once confidence in a currency is lost, it is very difficult to know what can bring it back. In any event, even the critics must concede that financial supervision in these countries was weak and that too much money was allowed to chase the wrong projects. If the IMF had ignored these problems and handed out the money without addressing them, at the very least it would have been attacked for pouring good money after bad. After all, this in essence is the argument that has been leveled against the Fund’s loans to Russia. It seems to me to be equally valid with respect to the Asian economies.
Martin Feldstein and others have argued that a second major flaw of the IMF’s micro conditions is that they intrude too strongly into the domestic affairs of borrowing countries and run the risk of exposing not only the Fund, but the West as a whole, to a severe political backlash in the affected countries. In fact, even putting aside Malaysia, which didn’t receive IMF assistance, evidence of a backlash has already surfaced, although it is difficult to sort out to what extent the complaints are made about IMF-directed micro-management in particular or whether they represent deep (and understandable) frustration with the declining condition of the economies in the region. The truth is that we won’t know for some time whether the political risks that imposing the conditions entailed ultimately outweighed the benefits of attempting to fix some of the underlying problems in these economies when the IMF’s leverage was at its maximum.
Nonetheless, one way to minimize the political risks is for the IMF and the World Bank to encourage or even require borrowing countries to introduce Western style social safety nets, notably unemployment insurance, to cushion the deep pain now being felt in these countries. I recognize that the Bank is giving attention to this subject; it may need more resources and much higher priority among the Bank’s many objectives.
A third attack on the micro conditions is that they require such a major change in the way borrowing country economies work that the IMF cannot reasonably expect the reforms to really “stick” within the time frame when the Fund has leverage—that is, until the assistance it promises is fully delivered. This is a fair objection. We in the West should not expect entire cultural traditions to be overturned in a year or two, or even a decade. All we can reasonably expect is for the process of reform to begin and to hope it gradually seeps into the way the affected economies are run. But to claim that reform is not even worth trying because many years may pass before it takes hold is to give up before the game is even played.
A Constrained IMF?
Although the Congress may provide this round of extra money for the Fund, it is entirely possible that this could be the last time. In the future, therefore, the Fund could be significantly constrained. How might this effect the way it conducts business?
The most obvious implication is that much like an infantryman who is down to his last few bullets and doesn’t want to waste any ammunition, a constrained Fund will have to decide very carefully how it wants to use its limited resources. To some extent, of course, that is not a decision for the Fund to make. Member countries have the right under the Articles of Agreement to take back a limited part of their quota. Only fo