[stop-imf] IMF Strikes Back (Foreign Policy, Jan/Feb 2003)

[Robert Weissman]

The IMF Strikes Back
By Kenneth Rogoff
Economic Counsellor and Director of the Research Department
International Monetary Fund
Reproduced with permission from FOREIGN POLICY 134 (January/February
2003)  www.foreignpolicy.com
Copyright 2003, by the Carnegie Endowment for International Peace

  Slammed by antiglobalist protesters, developing-country politicians,
and Nobel Prize=96winning   economists, the International Monetary Fund
(IMF) has become Global Scapegoat Number   One. But IMF economists are
not evil, nor are they invariably wrong. It=92s time to set the record
straight and focus on more pressing economic debates, such as how best
to promote global   growth and financial stability.

  Vitriol against the IMF, including personal attacks on the competence
and integrity of its staff,  has transcended into an art form in recent
years. One bestselling author labels all new fund  recruits as
"third-rate," implies that management is on the take, and discusses the
IMF's role in  the Asian financial crisis of the late 1990s in the same
breath as Nazi Germany and the  Holocaust. Even more sober and balanced
critics of the institution=97such as Washington Post  writer Paul
Blustein, whose excellent inside account of the Asian financial crisis,
The  Chastening, should be required reading for prospective fund
economists (and their  spouses)=97find themselves choosing titles that
invoke the devil. Really, doesn't The  Chastening sound like a sequel to
1970s horror flicks such as The Exorcist or The Omen?  Perhaps this race
to the bottom is a natural outcome of market forces. After all, in a
world of  24-hour business news, there is a huge return to being
introduced as "the leading critic of the  IMF."

 Regrettably, many of the charges frequently leveled against the fund
reveal deep confusion  regarding its policies and intentions. Other
criticisms, however, do hit at potentially fundamental  weak spots in
current IMF practices. Unfortunately, all the recrimination and finger
pointing  make it difficult to separate spurious critiques from
legitimate concerns. Worse yet, some of the  deeper questions that ought
to be at the heart of these debates=97issues such as poverty,  appropriate
exchange-rate systems, and whether the global financial system
encourages  developing countries to take on excessive debt=97are too
easily ignored.

 Consider the four most common criticisms against the fund: First, IMF
loan programs impose  harsh fiscal austerity on cash-strapped countries.
Second, IMF loans encourage financiers to  invest recklessly, confident
the fund will bail them out (the so-called moral hazard problem).
Third, IMF advice to countries suffering debt or currency crises only
aggravates economic  conditions. And fourth, the fund has irresponsibly
pushed countries to open themselves up to  volatile and destabilizing
flows of foreign capital.

 Some of these charges have important merits, even if critics (including
myself in my former life  as an academic economist) tend to overstate
them for emphasis. Others, however, are both  polemic and deeply
misguided. In addressing them, I hope to clear the air for a more
focused  and cogent discussion on how the IMF and others can work to
improve conditions in the global  economy. Surely that should be our
common goal.

 The Austerity Myth

 Over the years, no critique of the fund has carried more emotion than
the "austerity" charge.  Anti-fund diatribes contend that, everywhere
the IMF goes, the tight macroeconomic policies it  imposes on
governments invariably crush the hopes and aspirations of people. (I
hesitate to  single out individual quotes, but they could easily fill an
entire edition of Bartlett's  Quotations.) Yet, at the risk of seeming
heretical, I submit that the reality is nearly the  opposite. As a rule,
fund programs lighten austerity rather than create it. Yes, really.

 Critics must understand that governments from developing countries
don't seek IMF financial  assistance when the sun is shining; they come
when they have already run into deep financial  difficulties, generally
through some combination of bad management and bad luck. Virtually
every country with an IMF program over the past 50 years, from Peru in
1954 to South Korea  in 1997 to Argentina today, could be described in
this fashion.

 Policymakers in distressed economies know the fund will intervene where
no private creditor  dares tread and will make loans at rates their
countries could only dream of even in the best of  times. They
understand that, in the short term, IMF loans allow a distressed debtor
nation to  tighten its belt less than it would have to otherwise. The
economic policy conditions that the  fund attaches to its loans are in
lieu of the stricter discipline that market forces would impose in  the
IMF's absence. Both South Korea and Thailand, for example, were facing
either outright  default or a prolonged free fall in the value of their
currencies in 1997=97a far more damaging  outcome than what actually took
place.

 Nevertheless, the institution provides a convenient whipping boy when
politicians confront their  populations with a less profligate budget.
"The IMF forced us to do it!" is the familiar refrain  when governments
cut spending and subsidies. Never mind that the country's
government=97whose macroeconomic mismanagement often had more than a
little to do with the  crisis in the first place=97generally retains
considerable discretion over its range of policy  options, not least in
determining where budget cuts must take place.

 At its heart, the austerity critique confuses correlation with
causation. Blaming the IMF for the  reality that every country must
confront its budget constraints is like blaming the fund for  gravity.

 Admittedly, the IMF does insist on being repaid, so eventually
borrowing countries must part  with foreign exchange resources that
otherwise might have gone into domestic programs. Yet  repayments to the
fund normally spike only after the crisis has passed, making payments
more  manageable for borrowing governments. The IMF's shareholders=97its
184 member  countries=97could collectively decide to convert all the
fund's loans to grants, and then recipient  countries would face no
costs at all. However, if IMF loans are never repaid, industrialized
countries must be willing to replenish continually the organization's
lending resources, or  eventually no funds would be available to help
deal with the next debt crisis in the developing  world.

 A Hazardous Critique

 Of course, in so many IMF programs, borrowing countries must pay back
their private creditors  in addition to repaying the fund. Yet wouldn't
fiscal austerity be a bit more palatable if troubled  debtor nations
could compel foreign private lenders to bear part of the burden? Why
should  taxpayers in developing countries absorb the entire blow?

 That is a completely legitimate question, but let's start by getting a
few facts straight. First,  private investors can hardly breathe a sigh
of relief when the fund becomes involved in an  emerging-market
financial crisis. According to the Institute of International Finance,
private  investors lost some $225 billion during the Asian financial
crisis of the late 1990s and some  $100 billion as a result of the 1998
Russian debt default. And what of the Latin American debt  crisis of the
1980s, during which the IMF helped jawbone foreign banks into rolling
over a  substantial fraction of Latin American debts for almost five
years and ultimately forced banks to  accept large write-downs of 30
percent or more? Certainly, if foreign private lenders  consistently
lose money on loans to developing countries, flows of new money will
cease.  Indeed, flows into much of Latin America=97again the current locus
of debt problems=97have  been sharply down during the past couple of years.

 Private creditors ought to be willing to take large write-downs of
their debts in some instances,  particularly when a country is so deeply
in hock that it is effectively insolvent. In such  circumstances, trying
to force the debtor to repay in full can often be counterproductive. Not
 only do citizens of the debtor country suffer, but creditors often
receive less than they might  have if they had lessened the country's
debt burden and thus given the nation the will and means  to increase
investment and growth. Sometimes debt restructuring does happen, as in
Ecuador  (1999), Pakistan (1999), and Ukraine (2000). However, such
cases are the exception rather than  the rule, as current international
law makes bankruptcies by sovereign states extraordinarily  messy and
chaotic. As a result, the official lending community, typically led by
the IMF, is often  unwilling to force the issue and sometimes finds
itself trying to keep a country afloat far  beyond the point of no
return. In Russia in 1998, for example, the official community threw
money behind a fixed exchange-rate regime that was patently doomed.
Eventually, the fund cut  the cord and allowed a default, proving wrong
those many private investors who thought Russia  was "too nuclear to
fail." But if the fund had allowed the default to take place at an
earlier stage,  Russia might well have come out of its subsequent
downturn at least as quickly and with less  official debt.

 Since restructuring of debt to private creditors is relatively rare,
many critics reasonably worry  that IMF financing often serves as a
blanket insurance policy for private lenders. Moreover,  when private
creditors believe they will be bailed out by the IMF, they have reason
to lend  more=97and at lower interest rates=97than is appropriate. The
debtor country, in turn, is seduced  into borrowing too much, resulting
in more frequent and severe crises, of exactly the sort the  IMF was
designed to alleviate. I will be the first to admit the "moral hazard"
theory of IMF  lending is clever (having introduced the theory in the
1980s), and I think it is surely important in  some instances. But the
empirical evidence is mixed. One strike against the moral hazard
argument is that most countries generally do repay the IMF, if not on
time, then late but with  full interest. If the IMF is consistently
paid, then private lenders receive no subsidy, so there is  no bailout
in any simplistic sense. Of course, despite the IMF's strong repayment
record in  major emerging-market loan packages, there is no guarantee
about the future, and it would  certainly be wrong to dismiss moral
hazard as unimportant.

 Fiscal Follies

 Even if IMF policies are not to blame for budget cutbacks in poor
economies, might the fund's  programs still be so poorly designed that
their ill-advised conditions more than cancel out any  good the
international lender's resources could bring? In particular, critics
charge that the IMF  pushes countries to increase domestic interest
rates when cuts would better serve to stimulate  the economy. The IMF
also stands accused of forcing crisis economies to tighten their budgets
 in the midst of recessions. Like the austerity argument, these
critiques of basic IMF policy  advice appear rather damning, especially
when wrapped in rhetoric about how all economists at  the IMF are
third-rate thinkers so immune from outside advice that they wouldn't
listen if John  Maynard Keynes himself dialed them up from heaven.

 Of course, it would be wonderful if governments in emerging markets
could follow Keynesian  "countercyclical policies"=97that is, if they
could stimulate their economies with lower interest  rates, new public
spending, or tax cuts during a recession. In its September 2002 "World
Economic Outlook" report, the IMF encourages exactly such policies where
feasible. (For  example, the IMF has strongly urged Germany to be
flexible in observing the budget  constraints of the European Stability
and Growth Pact, lest the government aggravate Germany's  already severe
economic slowdown.) Unfortunately, most emerging markets have an
extremely  difficult time borrowing during a downturn, and they often
must tighten their belts precisely  when a looser fiscal policy might
otherwise be desirable. And the IMF, or anyone else for that  matter,
can only do so much for countries that don't pay attention to the
commonsense advice of  building up surpluses during boom times=97such as
Argentina in the 1990s=97to leave room for  deficits during downturns.

 According to some critics, though, a simple solution is staring the IMF
in the face: If those  stubborn fund economists would only appreciate
how successful expansionary fiscal policy can  be in boosting output,
they would realize countries can simply wave off a debt crisis by
borrowing even more. Remember former U.S. President Ronald Reagan's
economic guru,  Arthur Laffer, who theorized that by cutting tax rates,
the United States would enjoy so much  extra growth that tax revenues
would actually rise? In much the same way, some IMF  critics=97ranging
from Nobel Prize=97winning economist Joseph Stiglitz to the relief agency
Oxfam=97claim that by running a fiscal deficit into a debt storm, a
country can grow so much  that it will be able to sustain those higher
debt levels. Creditors would understand this logic and  happily fork
over the requisite extra funds. Problem solved, case closed. Indeed, why
should  austerity ever be necessary?

 Needless to say, Reagan's tax cuts during the 1980s did not lead to
higher tax revenues but  instead resulted in massive deficits. By the
same token, there is no magic potion for troubled  debtor countries.
Lenders simply will not buy into this story.

 The notion that countries should reduce interest rates=97rather than
raise them=97to fend off debt  and exchange-rate crises is even more
absurd. When investors fear a country is increasingly  likely to default
on its debts, they will demand higher interest rates to compensate for
that risk,  not lower ones. And when a nation's citizens lose confidence
in their own currency, they will  require a large premium to accept debt
denominated in that currency or to keep their deposits in  domestic
banks. No surprise that interest rates in virtually all countries that
experienced debt  crises during the last decade=97from Mexico to
Turkey=97skyrocketed even though their  currencies were allowed to float
against the dollar.

 The debate over how far interest rates should be allowed to rise in
defending against a  speculative currency attack is a legitimate one.
The higher interest rates go, the more stress on  the economy and the
more bankruptcies and bank failures; classic cases include Mexico in
1995 and South Korea in 1998. On the other hand, since most crisis
countries have substantial  "liability dollarization"=97that is, a lot of
borrowing goes on in dollars=97an excessively sharp fall  in the exchange
rate will also cause bankruptcies, with Indonesia in 1998 being but one
example  among many. Governments must strike a delicate balance in the
short and medium term, as they  decide how quickly to reduce interest
rates from crisis levels. At the very least, critics of IMF  tactics
must acknowledge these difficult trade-offs. The simplistic view that
all can be solved by  just adopting softer "employment friendly"
policies, such as low interest rates and fiscal  expansions, is
dangerous as well as naive in the face of financial maelstrom.

 Capital Control Freaks

 Although currency crises and financial bailouts dominate media coverage
of the IMF, much of  the agency's routine work entails ongoing dialogue
with the fund's 184 member countries. As  part of the fund's
surveillance efforts, IMF staffers regularly visit member states and
meet with  policymakers to discuss how best to achieve sustained
economic growth and stable inflation  rates. So, rather than judge the
fund solely on how it copes with financial crises, critics should
consider its ongoing advice in trying to help countries stay out of
trouble. In this area, perhaps  the most controversial issue is the
fund's advice on liberalizing international capital  movements=97that is,
on how fast emerging markets should pry open their often highly
protected  domestic financial markets.

 Critics such as Columbia University economist Jagdish Bhagwati have
suggested that the IMF's  zeal in promoting free capital flows around
the world inadvertently planted the seeds of the  Asian financial
crisis. In principle, had banks and companies in Asia's emerging markets
not  been allowed to borrow freely in foreign currency, they would not
have built up huge foreign  currency debts, and international creditors
could not have demanded repayment just as liquidity  was drying up and
foreign currency was becoming very expensive. Although I was not at the
IMF during the Asian crisis, my sense from reading archives and speaking
with fund old-timers  is that although this charge has some currency,
the fund was more eclectic in its advice on this  matter than most
critics acknowledge. For example, in the months leading to Thailand's
currency collapse in 1997, IMF reports on the Thai economy portrayed in
stark terms the risks  of liberalizing capital flows while keeping the
domestic currency (the baht) at a fixed level  against the U.S. dollar.
As Blustein vividly portrays in The Chastening, Thai authorities didn't
listen, still hoping instead that Bangkok would become a financial
center like Singapore.  Ultimately, the Thai baht succumbed to a massive
speculative attack. Of course, in some  cases=97most famously South Korea
and Mexico=97the fund didn't warn countries forcefully  enough about the
dangers of opening up to international capital markets before domestic
financial markets and regulators were prepared to handle the resulting vola=
tility.

 However one apportions blame for the financial crises of the past two
decades, misconceptions  regarding the merits and drawbacks of
capital-market liberalization abound. First, it is simply  wrong to
conclude that countries with closed capital markets are better equipped
to weather  stormy financial markets. Yes, the relatively closed Chinese
and Indian economies did not catch  the Asian flu, or at least not a
particularly bad case. But neither did Australia nor New Zealand,  two
countries that boast extremely open capital markets. Why? Because the
latter countries'  highly developed domestic financial markets were
extremely well regulated. The biggest danger  lurks in the middle,
namely for those economies=97many of which are in East Asia and Latin
America=97that combine weak and underdeveloped financial markets with poor
regulation.

 Moreover, a country needs export earnings to support foreign debt
payments, and export  industries do not spring up overnight. That's why
the risks of running into external financing  problems are higher for
countries that fully liberalize their capital markets before
significantly  opening up to trade flows. Indeed, economies with small
trading sectors can run into problems  even with seemingly modest debt
levels. This problem has repeatedly plagued countries in Latin  America,
where trade is relatively restricted by a combination of inward-looking
policies and  remote location.

 Perhaps the best evidence in favor of open capital markets is that,
despite the international  financial turmoil of the last decade, most
developing countries still aim to liberalize their capital  markets as a
long-term goal. Surprisingly few nations have turned back the clock on
financial  and capital-account liberalization. As domestic economies
grow increasingly sophisticated,  particularly regarding the depth and
breadth of their financial instruments, policymakers are  relentlessly
seeking ways to live with open capital markets. The lessons from
Europe's failed,  heavy-handed attempts to regulate international
capital flows in the 1970s and 1980s seem to  have been increasingly
absorbed in the developing world today.

 Even China, long the high-growth poster child for capital-control
enthusiasts, now views  increased openness to capital markets as a
central long-term goal. Its economic leaders  understand that it's one
thing to become a $1,000 per capita economy, as China is today. But to
continue such stellar growth performance=97and one day to reach the
$20,000 to $40,000 per  capita incomes of the industrialized
countries=97China will eventually require a world-class  capital market.

 Even though a continued move toward greater capital mobility is
emerging as a global norm,  absolute unfettered global capital mobility
is not necessarily the best long-term outcome.  Temporary controls on
capital outflows may be important in dealing with some modern-day
financial crises, while various kinds of light-handed taxes on capital
inflows may be useful for  countries faced with sudden surges of
inflows. Chile is the classic example of a country that  appears to have
successfully used market-friendly taxes on capital inflows, though a
debate  continues to rage over their effectiveness. One way or another,
the international community  must find ways to temper debt flows and at
the same time encourage equity investment and  foreign direct
investment, such as physical investment in plants and equipment. In
industrialized  countries, the pain of a 20 percent stock market fall is
shared automatically and fairly broadly  throughout the economy. But in
nations that rely on foreign debt, a sudden change in investor
sentiment can breed disaster.

 Nevertheless, financial authorities in developing economies should
remain wary of capital  controls as an easy solution. "Temporary"
controls can easily become ensconced, as political  forces and budget
pressures make them hard to remove. Invite capital controls for lunch,
and  they will try to stay for dinner.

 Striking a Global Bargain

 Should the international community just give up on global capital
mobility and encourage  countries to shut their doors? Looking further
ahead in the 21st century, does the world really  want to adopt greater
financial isolationism?

 Perhaps the greatest challenge facing industrialized countries in this
century is how to deal with  the aging bulge in their populations. With
that in mind, wouldn't it be more helpful if rich  countries could find
effective ways to invest in much younger developing nations, and later
use  the proceeds to support their own increasing number of retirees?
And let's face it, the world's  developing countries need funds for
investment and education now, so such a trade would prove  mutually
beneficial=97a win-win. Yes, recurring debt crises in the developing world
have been  sobering, but the potential benefits to financial integration
are enormous. Full-scale retreat is  hardly the answer.

 Can the IMF help? Certainly. The fund provides a key forum for exchange
of ideas and best  practices. Yes, one could go ahead and eliminate the
IMF, as some of the more extreme  detractors wish, but that is not going
to solve any fundamental problems. This increasingly  globalized world
will still need a global economic forum. Even today, the IMF is
providing such  a forum for discussion and debate over a new
international bankruptcy procedure that could  lessen the chaos that
results when debtor countries become insolvent.

 And there are many other issues where the IMF, or some similar
multilateral organization,  seems essential to any solution. For
example, the current patchwork system of exchange rates  seems too
unstable to survive into the 22nd century. How will the world make the
transition  toward a more stable, coherent system? That is a global
problem, and dealing with it requires a  global perspective the IMF can
help provide.

 And what of poverty? Here, the IMF's sister organization, the World
Bank, with its  microeconomic and social focus and commensurately much
larger staff, is appropriately  charged with the lead role. But poor
countries in the developing world still face important  macroeconomic
challenges. For example, if enhanced aid flows ever materialize,
policymakers  in emerging markets will still need to find ways to ensure
that domestic production grows and  thrives. Perhaps poor nations won't
need the IMF's specific macroeconomic expertise=97but they  will need
something awfully similar.



 IMF EXTERNAL RELATIONS DEPARTMENT Public Affairs: 202-623-7300 - Fax:
202-623-6278       Media Relations: 202-623-7100 - Fax: 202-623-6772

    IMF Home  What's New  Site Map  Site Index  About the IMF  IMF at
Work  IMF Finances  Country Info  News  Publications