The future role of the International Monetary Fund (IMF) is today in
doubt. Former Treasury Secretaries George Shultz and William Simon
have urged that it be closed. President Clinton wants the IMF to
devote more attention to preventing crises rather than responding to
them. Even the IMF criticized its own recent operations in Asia for
protecting foreign lenders at great cost to borrowing countries and
their citizens. Protestors in the Asian countries and elsewhere
complain that the IMF is a lackey of the United States, doing the
U.S. government's bidding to the detriment of local populations.
Before agreeing to provide more money for the IMF as part of the 1998
budget agreement, Congress insisted on greater transparency in
decision making and higher interest rates on IMF loans. These changes
are first steps toward reform of international lending institutions.
Still, more fundamental reforms are needed to reduce the risks of
destabilizing crises that have become more frequent and more costly.
Even the losses suffered by bank depositors during the Great
Depression pale by comparison to recent losses in Mexico, South
America and Asia.
Five factors go a long way toward explaining why there have been so
many large financial and foreign exchange crises in developing
countries during the current period of sustained growth and
development in the world economy: weak banks; government interference
and direction of lending (part of crony capitalism); a large volume
of misdirected bank lending; domestic government and IMF bailouts to
protect foreign lenders and domestic oligarchs; and fixed,
unsustainable exchange rates.
The proposal for reforming the IMF that we shall make in this article
seeks to restore international lending while avoiding the excessive
risk-taking that leads to financial bailouts and severe depressions,
as in Mexico, Thailand, Indonesia, Korea and Russia. The new IMF
would avoid both the problem of excessive risk-taking, followed by
collapse, and the risk of a protracted reduction in capital flows to
developing countries. The challenge is to reduce the costs of the
present system while retaining the benefits for economic development
of international lending and capital movements.
A Record of Failure
The IMF and the World Bank were created at the end of World War II to
foster long-term economic growth and stability in an environment of
weak international capital markets. The World Bank's role was to
boost capital flows to promote long-term growth. The IMF's role was
to provide short-term assistance to facilitate the maintenance of
fixed exchange rates. The presumptions underlying the creation of
these Bretton Woods institutions were that, first, countries would
maintain fixed exchange rates tied to gold and the dollar and,
second, that private international capital flows would be rather
Both presumptions proved to be wrong. The fixed exchange rate system
ended in 1971, when President Nixon devalued the dollar and closed
the gold window. All major currencies--the dollar, yen and
deutschemark--soon began a managed float. And instead of a dearth of
private lending, large-scale lending to developing countries has
coincided with all of the major financial crises of the past twenty
Why have these institutions, intended to foster growth and promote
stability, failed so badly in the Eighties and Nineties? Many reasons
have been offered. Two aspects of private financial arrangements are
of central importance: the form of international capital flows and
the structure of domestic banking systems in emerging market
Under current arrangements, corporations and bankers in the
developing countries borrow from financial institutions and markets
abroad. The loans are made at fixed exchange rates and denominated in
dollars, marks or yen, so the lender is paid in his own currency and
the borrower therefore bears the full risk of devaluation.
At present, banking systems in many developing countries are poorly
capitalized and, therefore, unable to withstand heavy withdrawals.
Bank depositors and stockholders are protected against loss by local
governments. Banks often act either as agents of their government's
development plans, or as captive financial arms of local industrial
firms, lending at below-market rates to favored enterprises without
careful screening for credit worthiness. Unlike prudent lenders, they
do not diversify loans over borrowers in many different industries.
When problems arise in a developing country or the world economy as a
whole, the financial position of banks in emerging market economies
weakens. Because governments protect domestic banks from failure,
banking losses become a fiscal burden on government and, therefore,
on domestic taxpayers. To pay for these losses, governments borrow
more from domestic and foreign lenders. The additional foreign
borrowing strains their ability to repay, increasing the risk of
devaluation, default and a foreign exchange crisis. Instead of
renewing or increasing short-term loans, some foreign banks demand
repayment in their own currency, further draining the borrowing
country's reserves of dollars, marks and yen. Other lenders, seeing
the loss of reserves, also demand repayment at the fixed exchange
rate. As foreign reserves decline and the country can no longer honor
its commitment to repay foreign borrowers at a fixed exchange rate,
it must default, resulting in devaluation and a currency crisis. The
crisis deepens the insolvency of domestic banks that have borrowed
abroad in foreign currency and have assets priced in domestic
currency. The currency and the weak domestic banking system collapse.
The economy goes into recession, or deep depression, triggering
additional bankruptcies, inability to repay domestic banks, and thus
more bank failures and defaults on foreign loans.
To prevent such defaults, the IMF has taken on the role of lending to
governments of developing countries in times of crisis. Much of the
money that the IMF supplies is used to pay off foreign banks and to
maintain the appearance of solvency at domestic financial
institutions. Local taxpayers must repay these debts to the IMF in
the future, so the banks' rescue is also at taxpayers' expense. The
countries are often left in deep depression. Mexico in 1995 and
Thailand and Korea in 1998 are the clearest examples.
Banking system insolvencies and improper government policies, not
unwarranted speculative attacks on exchange rates, are among the
principal reasons behind currency instability and financial failure.
The IMF adds to the problem by fostering the belief that it will bail
out the banks, however imprudent or insolvent they may be. The
ultimate cost is then borne by local taxpayers.
The Orchestrator of Bailouts
Prior to 1987, the IMF would not lend until borrowers worked out
agreements with private foreign creditors. This forced debtors to
negotiate in good faith with their creditors. Since 1987, the IMF has
often been a lender not of last but of first resort, offering loans
before private debtors and creditors reach agreement.
Why has the IMF undertaken the role of bailout agency for
international lenders? First, the IMF is not independent of its
member governments. Rather, its decisions are the direct result of
votes by its member governments' representatives, and voting power is
concentrated in the hands of a few nations. Accounting for 18 percent
of these votes, the U.S. Treasury has used its considerable power to
push through some IMF programs even over the objections of senior
staff and country experts within the IMF. Thus, political objectives
of one or more powerful members, rather than sound economic
reasoning, often guide IMF intervention.
Second, to the extent that IMF staff are able to determine policy,
they do not represent a reliable source of independent judgment.
Indeed, many espouse the views of the borrowing governments they
monitor. One reason is that their performance and promotion are much
affected by the quality of their relations with foreign officials.
Unfriendly actions by IMF staff members restrict their access to
these officials. The finance minister or central bank president
becomes "unavailable." Foreign officials use such subtle pressures to
restrict criticism and avoid unwanted recommendations for reform.
One consequence of the IMF's new role as orchestrator of bailouts is
that its programs are now much larger than before. Since foreign
banks did not suffer losses in Mexico, they did not believe they were
taking big risks in Asia and Russia. Bankers reasoned that if Mexico
was important enough to the U.S. Treasury and the IMF that the banks
had to be spared, Korea and Russia were at least as important.
In December 1997, for example, a prominent emerging-market
investments newsletter told its clients that anticipated IMF
protection would promote continuing inflows of funds to Brazil,
despite its poor fundamentals:
"The combination of increased Japanese capital outflows over the
year, a 'dip-buying' investor psychology which is spreading from U.S.
retail to emerging market investors, and the massive
Asian-crisis-inspired injections of high-powered global money by the
IMF, will combine to ensure a market in which there is tremendous
technical support. Add in the clear moral hazard caused by the IMF
bail-outs--two investors last week told me that they were planning to
put on large Brazilian positions (even though they were very unhappy
with the currency regime) because they were convinced that a
Brazilian crisis would result in an immediate IMF bail-out--and it is
hard to see why fundamentals should matter [emphasis added]."