The IMF was established at the Bretton Woods conference in 1944. However, recent financial crises and the failure of those in the international financial framework to adequately respond to these economic collapses, has resulted in repeated cries for the need to restructure both the organisation and policy strategy of the IMF. Ed Healy, Leonora McConville, James Ruane and Alexis Murphy examine the issues surrounding these calls for reform and also suggest how the opportunity to restructure could be best exploited.
The onset of the Asian crisis has placed the issue of IMF reform to the fore. However, this is not a new issue; since the collapse of the Bretton Woods system in 1971, and the subsequent floating of the dollar, the IMF has been searching for a new identity. As an institution designed in the late 1940s to guarantee the fixity of exchange rates, the IMF clearly needs to redefine its role in the global economy, which today faces a severe crisis.
In this essay, we seek to analyse the critical issues related to intervention in the global economy. Firstly we discuss the issue of moral hazard. This is a fundamental problem to any organisation which aims to provide insurance, as does the IMF. We then discuss the informational problems facing the global economy and their effects. Is the private market capable of providing satisfactory information for the global economy, or is there a need for international standards of information? Can an international organisation such as the IMF ensure that data relevant to the global economy are both available and accurate? We then analyse the issue of market efficiency: why are there market failures, and how can these be remedied? Finally we look at the political implications of intervention in the global economy.
Having discussed these normative issues and identified their relevance with respect to the IMF, we draw up a positive policy proposal for a reformed IMF. This draws on the issues and solutions discussed in the prior sections.
Moral hazard exists when banks or governments, protected by a lender of last resort or deposit insurance, engage in deliberately risky activity. The existence of the IMF may encourage nations to engage in such risk-taking in the knowledge that they have IMF protection in the form of emergency loans. This risk taking may take the form of either deferred political and economic reforms or excessive international borrowing by domestic governments for investment in high-risk projects. Similarly, commercial banks may be more prone to engage in foreign lending, investment banks will underwrite risky bond issues, and investors will be more likely, to invest in risky emerging markets if such markets are at least partially insured by the IMF.
Many authors object to the IMF precisely because of this problem. Schwartz (1998) criticises the IMF for a number of reasons. She says that it has lost its initial purpose and is therefore without a clear role in today’s economy; she attacks its anti-democratic nature and the slow speed with which it administers funds; she criticises attempts by the IMF to act as an international central bank whilst lacking the ability to create high powered money; finally, she focuses on the problem of moral hazard. Here she cites the Mexican crisis of 1995 and draws parallels with the more recent Asian crisis:
"Short-term renewable loans denominated in foreign currencies were the undoing of Mexico in 1994; yet the Asian countries welcomed the same form of credit two years later and the lenders came off scot-free in 1995 as the banks probably will in 1998, because of the IMF".
Sachs advocates an end to the lender of last resort function on the grounds that it promotes moral hazard. Similarly, Calomiris notes that
"the explanation for the new epidemic of worldwide banking instability is the roller coaster of risk produced by the choices of banks in developing economies – choices that are a by-product of government subsidies for risk-taking".
Even Stanley Fischer, Deputy Managing Director of the IMF, concedes that although governments try to avoid contact with the IMF,
"the thornier issues arise on the side of investors. Some point to investors who take excessively risky positions on the back of an IMF safety net".
Vasquez cites Mexico as an example of moral hazard, where US government and IMF bailouts have failed to provide an incentive for political and financial reform. He notes that "everyone has come to expect a bailout at the end of each presidential term" as Mexican leaders deliberately pursue imprudent policies in the pre-election period. The figures bear this out, with a bailout every 6 years coinciding with a Presidential election.
IMF/ESF Bailouts of Mexico
Similarly in Russia essential (but politically painful) reforms were deferred due to the expectation of an IMF bailout. This illustrates the problem referred to by Vasquez that:
"The Fund’s money goes to governments that have created the crisis to begin with and that have shown themselves to be unwilling or reluctant to introduce necessary reforms. Giving money to such governments does not tend to promote market reforms, it tends to delay them because it takes the pressure off of governments to change their policies."
There is an argument that the moral hazard problem does not exist in sovereign states because of co-insurance. If governments are interested in the general economic well-being of the country, in staying in power, and remaining popular, it is not in their interest to take risks which would render the country insolvent. However, given that governmental terms are of a limited time horizon (especially in developing countries) responsible and far-sighted policies are rarely heeded. Political business cycle theorists may even argue that outgoing governments may deliberately engage in irresponsible actions to ‘tie the hands’ of the incoming rival party.
Calomiris has proposed a form of self-regulation to reduce the moral hazard problem. He proposes that banks be required to finance part of their capital base by selling subordinated debt to other institutions, with the stipulation that the yield on this debt be no more than 50 basis points higher than the rate on a corresponding riskless instrument. As subordinated debt is not covered by a safety net, its claimants are the last to be paid in the event of bankruptcy. This fact would give banks a strong incentive to regulate each other due to this possibility of loss. Moreover, this self-regulation may be more effective than that of governments for two reasons:
One problem with Calomiris’ solution is that risky banks may have tacit agreements among themselves to hold each others’ subordinated debt. However, such collusion could be avoided through the international trading of such bonds (thereby creating a large and liquid market) and with appropriate regulation that would prevent such collusion. From another perspective, it could be argued that if there was a financial crisis such colluders would at least have the virtue of wiping themselves out.
Accurate information is required so that economic agents can make correct decisions about investment and form prices correctly. In the international context, information affects both the formation of currency exchange rates (through the role of expectations in the Interest Parity Condition) and the prices of foreign assets (through agents perceptions of risk and return, as formulated by the information available to them).
The role of the IMF in providing this information is linked to one’s beliefs about the efficiency of the market for information: should it be publicly or privately provided? It is our contention that there are significant failures in the information market, with the result that public provision of information is needed.
Because information is a public good and can rapidly be diffused through the marketplace, there is a free-rider problem in the provision of private information. Private agents have little incentive to gather data on countries as others may profit from it. If the information provided freely by governmental institutions is wrong and there is no adequate private market for information, investments may be made incorrectly, based on poor information.
On an international level, there also exists a problem in that sovereign governments have the ability and often the incentive to provide incorrect information. A government which overstates the strength of its economy can attract additional investment (or at least delay a crisis) which may not be justified by its true economic fundamentals. Mexico did not disclose the depletion of its foreign exchange reserves until it was on the brink of a currency crisis in 1995. Another example, albeit in reverse, is Ireland, which understated the strength of its economy in order to gain extra EU funding.
In advocating homogeneous information standards, the IMF can help ensure that investors are not deceived by different national statistical or accounting practices. It has already taken steps in this regard by establishing some common data standards; however, the failure of published data to show the fundamental structural problems of the Asian economies indicates that more work is needed in this area. The IMF also has a role in verifying the accuracy of data released under these standards, much in the same way that an auditor checks a company’s accounts. For example, there is evidence to suggest that Russia has falsified much of its national accounts in an effort to attract extra IMF funds. Fischer notes:
"One possibility would be to encourage countries to adopt common standards in areas such as bankruptcy codes, securities trading, and corporate governance, including accounting. Market participants would then have a clearer basis for making lending decisions. Once again, the international system would need to monitor the implementation of these standards".
The IMF itself has been criticised for not making sufficient information available on its policies and actions. It has a major role in the world economy (especially during periods of crisis) but according to Sachs:
"offers virtually no substantive public documentation of its decisions, except for a few pages in press releases that are short of the technical details needed for a serious professional evaluation of its programmes."
The lack of IMF transparency was also highlighted by the US House of Representatives Joint Economic Committee, which pressed for "a transparency requirement … that mirrors the procedures in place for our own Federal Reserve" (i.e. full disclosure within 90 days). This appears to have been accepted by the IMF, with its Managing Director writing that:
"transparency is the first order of business. Everyone – ordinary citizens, civil society, investors and policymakers – need more timely and accurate data and information about what is happening in economies and how policies are being formulated".
Ethan Kapstein focuses on these issues in his book Governing the Global Economy. In it he highlights the importance of information in providing a transparent and ultimately democratic marketplace. The Basle concordat (1992) set out clear measures that would guarantee private sector banking transparency. Summarised, these stipulate that:
These measures would first of all help combat fraud. Secondly, they would provide the depositor and the home country bank supervisor with accurate information about the bank’s risk-taking activities and solvency. Thirdly, it would mean that domestic governments and their central banks would be fully responsible for banks registered in their own country, both in terms of providing them with short-term liquidity and in terms of ensuring that they remain solvent.
If the IMF insisted that all its members adhere to the measures of the Basle concordat, the banking crises that have been at the root of the currency crises of the last two years may have been averted. This echoes the kind of self-help that Jeffrey Sachs advocates. Central banks should be responsible for private sector banking supervisors and should therefore be able to act as LLRs during banking crises. Given the successful discharge of their functions by domestic central banks there would be no justification for the IMF to act as an international lender of last resort.
The ‘Washington consensus’ described by Krugman advocates free trade, free markets, and free capital market flows. This grew out of the demise of the Bretton Woods system and the fall of communism, with the result that there is near unanimity today as to the virtues of the free market economy. This stems from the assumption that markets are efficient. Implicitly the IMF endorses this view, which is reflected in IMF conditionality. For example, in Malaysia recently, the IMF has insisted on the abolition of the rubber and teak cartels and has also pushed for the abolition of import controls.
However the policy of the IMF as regards intervention as a Lender of Last Resort (LLR) reflects a view contrary to this. The IMF ignores market based solutions to financial crises and its very intervention serves to increase market failures.
The IMF intervenes as a LLR when a country faces a currency crisis. A LLR should intervene freely to banks that are distressed but solvent, against collateral and at a penal rate of interest. This does not correspond to the behaviour of the IMF. As a LLR the IMF does not have any clear rationale for its intervention. This has several implications. First of all it increases market uncertainty because the markets have no clear indicators as to why, when, or to what extent the IMF will bail out a country. Secondly the ad hoc nature of the IMF bail outs reveals the subordination of economic considerations to political motivations. The IMF bail out of Mexico in 1994/95 is an example of such favouritism. Mexico shares a border and is a member of a free trade area with the most powerful member country of the IMF. This ensured IMF aid which was swiftly administered and vastly superior to Mexico’s legal quota:
"Under IMF rules, Mexico was able to borrow no more than an additional $3 billion. Under pressure from US officials, the IMF approved a $7.8bn credit anyway and pledged a further $10 billion…The loan is greater than total IMF lending in 1993 and 1994 combined, twice the amount ever loaned to any other country and seven times Mexico’s allocation. European governments…were irked by the way the US pushed the IMF into extending credit without seeking approval from them".
More generally, market imperfections can be categorised under four broad headings:
As discussed above, accurate information is vital for the correct formation of currency exchange rates and asset values. Imperfect information about a country’s policies and its economic circumstances can mean that market psychology rather than fundamental valuations determine market behaviour. Second-generation models of speculative attacks incorporate this notion of expectations and thus show that currency crises may be a by-product of badly functioning markets.
Bandwagon effects explain both the rapid inflow of capital into many areas and its equally rapid exit when expectations change. For example, Latin America experienced a rapid inflow of capital after reforms were implemented in only a few countries; other, non-reforming states benefited from this band-wagon effect. Following the Mexican devaluation in 1994, the rest of Latin America then experienced a ‘tequila effect’ as the process repeated itself in reverse.
Loan contracts are difficult to enforce internationally for legal and political reasons. Firms or banks that default on their obligations to foreign lenders are often treated leniently – if at all – by domestic courts, and are not accountable in the courts of their creditors’ countries. This problem is exacerbated for governments, who are not accountable to any supra-national legal body. Their only downside is a loss of reputation, which may not be permanent (thus increasing the incentive to default).
Finally, according to Masson and Mussa, there are multiple equilibria:
"there may be one equilibrium in which lenders believe the authorities intend to do what they say and in which money is available on reasonable terms that allow policy commitments to be fulfilled, and another equilibrium in which lenders do not believe the authorities and in which investors demand a high risk premium that, in turn, provokes a balance of payments crisis".
A policy that aims to improve the stability of the international financial system should seek to mitigate these market imperfections.
As a powerful international institution, the IMF wields considerable political influence in the world. This stems from its imposition of structural adjustment policies on debtor countries, backed by the threat of withholding loans.
Structural adjustment policies are imposed on countries that face crises that may have exogenous causes. This creates a situation where a politically and fiscally responsible country that has been subjected to a second-generation speculative attack on its currency is forced to adopt policies which may be socially sub-optimal from the perspective of the nation. Moreover, these may often be unsuited to the country’s circumstances: Mankiw claims that the Asian crisis is unlike the ‘traditional’ inflation problem faced by the IMF, whilst Sachs claims that IMF involvement simply creates increased panic among investors.
A factor exacerbating this problem may be the IMF’s lack of resources. At present it has less than 1,000 economists working to perform both the surveillance function and to deal with crises. This has led Jeffrey Sachs to comment that "it defies belief that 1,000 economists in Washington can dictate the economic conditions of life to 1.4 billion people in the developing world."
Another political problem has been highlighted by the Cato Institute: IMF bailouts involve a redistribution of income from richer nations’ tax payers to poorer nations’ leaders (who are often corrupt and undemocratic).
Kapstein notes the instrumental role of the IMF in recycling ‘petrodollars’ in the 1970s, which ultimately led to the 1980s debt crisis. The IMF then conveniently redefined its role as being at the cornerstone of international debt restructuring.
The nature of the IMF’s governance is also a cause of concern. The IMF has been US-dominated since its inception: it is headquartered in Washington, DC, and its Vice-President is always American. As a result, it is often seen as operating to support US political and economic interests abroad. For example, the Mexican bailout has been cited by Krugman as being driven more by US desires to keep its neighbour friendly rather than by economic factors.
"As a concern of US economic policy, the debt crisis was not a major issue. The unfortunate fact about poor countries is that they don’t have much money - and so, in purely economic terms, they do not carry much weight. The combined gross national products of all debtors was less than 4 per cent of the world’s GNP. The total value of all loans to troubled nations was less than one per cent of the wealth of the creditor nations; the debt service on those loans less than one-quarter of one percent of the national incomes of those nations".
Kapstein also argues that IMF bailouts do not in fact save nations from financial crises. Instead, they merely act as a way of ensuring that the banks of industrialised countries recoup at least part of their risky loans, thereby averting banking failures in industrialised countries.
Proposal for Reform
Any proposal to reform the IMF must be sensitive to the issues that have been dealt with above (moral hazard, information, market efficiency and political concerns) in order to be successful. We feel that international legislation (i.e. treaties between nations) is essential to the proper functioning of a truly global economy and thus should be the foundation of any reform of the IMF. However, this legislation must have the support of all participating nations rather than being externally imposed – as such legislation would be more likely to succeed both in letter and in spirit if adopted voluntarily by sovereign countries.
The first measure which we would propose for a reformed IMF would be that all members conform to standards laid down by the Basle committee of the BIS for bank capital adequacy. This would involve transparent and homogeneous accounting practices for companies and banks and homogeneous standards of risk evaluation. For international financial institutions, there would be a need for accountability to one ‘home country’ whose Central Bank would be responsible for monitoring the performance and solvency of that institution. Consolidated accounting practices would ensure that the home Central Bank would be responsible for all foreign branches of the bank being monitored.
Similarly, governments should be required to publish national statistical data according to standard conventions. The IMF could verify these data, and publish the results. This would lead to increased stability of international markets due to better investment decisions and more stable expectations.
We would also endorse the suggestions of Charles Calomiris in his article "The Post-Modern Bank Safety Net". As explained above, the issuing of junior debt between banks on an international level could ensure that they regulate themselves, hence reducing the role of the domestic Central Bank as a lender of last resort. These two measures would greatly increase the accountability of banks. This would feed in to the international financial system and have a generally stabilising effect. This would mean that creditors and debtors would be more informed about each other, therefore reducing the problems associated with information asymmetries. This would also mean that economic agents would be responsible for their actions to a greater extent. Countries and banks would therefore be unable to plead ignorance to justify the intervention of a lender of last resort.
We accept the position of the IMF in pushing for market-based reforms and floating exchange rates. However, we also accept Paul Krugman’s contention that in the short term, there is a need for fixed exchange rates or currency boards, combined with capital controls in transition economies that are stabilising after a period of economic turmoil. However, such arrangements would ultimately be replaced by free capital flows and floating exchange rates. The IMF would see a progressive downscaling of its role as an international lender of last resort. It could then redefine its role in the world economy by acting as an international bankruptcy court – the so-called ‘disappearing residual’ argument of Bordo and Eichengreen.
Such a bankruptcy court would be more effective than acting as a lender of last resort. As both creditors and debtors share the pain of adjustment, it would be less one-sided than the current LLR system. In so doing, it would promote responsible decision-making and reduce moral hazard. Such a court is not without precedent – the Brady and Baker plans of the 1980s featured negotiation between creditors and debtors to resolve third world debt problems.
It is clear that there are many issues surrounding reform of the IMF. They include moral hazard, information problems, market inefficiencies and political issues. When combined, these issues make international financial markets unstable and inefficient. Therefore, we feel that reform of the IMF should aim to increase the efficiency and stability of international markets and that international legislation should be introduced to achieve this.
We propose that the IMF be made responsible for ensuring the accuracy of data published by national governments and banks. Furthermore, banks themselves should be made issue subordinated debt to other banks as a form of autoregulation. Finally, the IMF itself should ultimately aim to become an international bankruptcy court. These measures should help stabilise the international financial system, whilst avoiding the inefficiencies associated with statist, non-market solutions.
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Asia Crisis Homepage http://stern.nyu.edu/~nroubini/asia/AsiaHomepage.html
Institute for International Economics http://www.iie.com
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The Cato Institute http://www.cato.org
The International Monetary Fund http://www.imf.org
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