Since the outbreak of the Asian financial crisis, it has been open season for attacks on the International Monetary Fund. We have been told that the prospect of IMF bailouts caused the crisis and that the IMF's existence, if continued unchanged, will result in many more financial disruptions. Distinguished former cabinet officials, writing on this page, have asked "Who Needs the IMF?" And this newspaper has added its editorial voice to the chorus.
Here's a more balanced perspective: In a globalized economy, everyone needs the IMF. Without the IMF, the world economy would not become an idealized fantasy of perfectly liquid, completely informed, totally unregulated capital markets. Investors and lenders would still make decisions on the basis of imperfect information, and they would have to take into account the absence of an international lender of last resort. This would be a serious, perhaps devastating, defect. In fact, we got a good sense of life without the IMF in the 1920s and 1930s. The results included widespread competitive devaluation and trade wars in response to balance of payments problems, followed by a plunge into global depression and world war.
Without a guarantor of international liquidity, many good loans would not be made. Fundamentally sound private investment projects in emerging markets can be dragged down by decisions external to the businesses involved. Even prudent government policies can be waylaid by unforeseeable shocks. Either way, fundamentally good investments will run into temporary liquidity problems. In a world of flexible exchange rates, such temporary problems can be magnified by accompanying drops in the value of the domestic currency. IMF programs finance the adjustment necessary to give these countries and firms time to let their fundamentals pay off.
Credit Union
Thus, the IMF is the sovereign nations' credit union. It imposes strict conditions on countries' policies for bridge loans to get through hard times. Only a multilateral institution like the IMF could exert the discipline required without causing an unacceptable affront to a country's sovereignty. The benefits to the borrowing nation are that the adjustment program will be less painful and any resulting contraction less severe. The benefits to the lending countries are not only the availability of those credits to themselves, if and when they need them (as even the United States has), but a smaller contraction of world demand associated with the borrowing country's adjustment.
Some have claimed that these IMF conditions have been misapplied in the Asian crisis, demanding either too much austerity or unjustified structural reform. But IMF conditionality is highly pragmatic. Since the current crisis was not caused in large part by macroeconomic policies but by financial fragility and lack of transparency, the conditions were designed to respond to those causes. The fund has been ready to renegotiate its programs and to loosen austerity (such as the inflation target for South Korea) as matters stabilized. There always is room for improvement in individual IMF programs. But attacks on the basic idea of IMF conditionality are thoroughly misguided.
Events in emerging markets have spillover effects on the world economy as a whole, including the United States. Growing economies provide greater opportunities for investment and exports, so an institution that sustains productive capital flows to developing countries also sustains our own economic growth. More important, countries that run into significant balance of payments problems would have only two policy options without the IMF: default or devaluation. As seen in the interwar years, either can induce reactions by other countries that make a bad situation worse; together, they can make the global economy rapidly spiral downward. This chain of events is precisely what the IMF was created to prevent.
A cycle of competitive devaluations is the most dangerous potential chain of events the IMF prevents. Imagine that an emerging market in trouble over its balance of payments decides that it must export its way out and so devalues or depreciates its currency. Economies with similar exports and markets find themselves competitively disadvantaged, so they too devalue, hoping to offset the first country's currency gambit. Yet, if many countries pursue this strategy simultaneously, none of their positions improve significantly, while their purchasing power drops along with their currencies. It must be considered a triumph of the IMF's rapid response to the recent Asian crisis that no ongoing spiral of competitive devaluation has arisen despite the pressures on Hong Kong and China and even on Brazil and Russia.
All these virtues of the IMF have been forgotten in the rush to condemn one of its inherent costs: the creation of moral hazard. Moral hazard exists whenever insurance is provided against any kind of risk. Anyone who has worked in the banking industry knows that government guarantees, or even the perceived possibility thereof, can create perverse incentives for financial risk taking. The prospect of a rescue can encourage investments that otherwise would not be made. This increases the herdlike behavior of global capital since financial firms often watch what other investors do more than they watch the performance of the actual investments. This tendency certainly contributed to the surge of capital flows into South Korea, Indonesia, and their neighbors, and the subsequent drain of that capital.
It is a huge exaggeration, however, to suggest that the so-called bailout guarantee played more than a minor role in creating the Asian crisis. It is absurd to believe that any country would risk a national currency crisis simply because the tender mercies of the IMF were waiting to rescue it from its follies. The pain imposed by IMF programs deters crises rather than bringing them on.
As for private investors who put money into these economies--in the form of foreign direct investment, equities, commercial paper, and even many foreign currency loans to nonbank businesses--significant losses have been taken in every single country. Market discipline has in fact hit all domestic investors and their intermediaries in these countries hard. Many government and financial officials who contributed to the problem have had their careers ended as well.
Too Much Protection
There was indeed too much protection for the loans of some foreign banks. Here the IMF needs to move toward greater reliance on private financial workouts than excessively large rescue programs. Substantial burden sharing by all foreign creditors must also become an integral part of all future IMF programs. But saying that there is room for increasing the degree of market discipline is not the same as saying that market discipline is entirely lacking, let alone that its absence caused the Asian crisis.
In any event, such a moral hazard cost hardly outweighs all the benefits of IMF programs. The relevant comparison is between the explosive growth and macroeconomic stability we have experienced in the postwar decades, with the IMF in existence, and the much slower growth in the developing countries and far greater worldwide instability we saw in the interwar years or in the late nineteenth century. Only part of the differences can be attributed to the IMF, but it is illogical to ignore its contribution while attributing to it total responsibility for the few short financial crises of the past decades.
