One would think that policymakers would have learned a few lessons from the collapse of the Thai, Korean, Indonesian and Russian economies. The failed bailout of Brazil gives the International Monetary Fund and governments around the world one more opportunity to learn.
The fall of the Brazilian real should finally put to rest the notion that the IMF can prevent financial crises by providing bailouts to countries before turmoil erupts. That idea was discredited by the devaluation of the Russian ruble weeks after the IMF approved a $22.6 billion aid package, but it did not prevent IMF officials from subsequently providing $41.5 billion to the Brazilian government on the same theory. Indeed, last fall President Clinton urged the fund to institutionalize just such a system. But Clinton failed to make clear how the IMF would determine which countries would qualify for such assistance or why the preventive approach had not worked in Russia or Indonesia.
Another lesson is that pegged exchange rates, especially in countries that are liberalizing their economies, are recipes for disaster. This has been clear since at least the outbreak of the Mexican peso crisis, when that country tried to maintain both a pegged rate and an expansionary monetary policy, and the Asian crisis, when the accumulation of malinvestments and government liabilities became a problem too large to ignore.
When the government manipulates both the exchange rate and the money supply, its measures can often work at cross-purposes. Increasing interest rates to defend a pegged rate can induce recession, thus further overvaluing a currency. If a government refuses to cut spending under those conditions, or if it has high debt, as was the case in Brazil, fiscal deficits are bound to grow and continue to undermine the pegged rate. Only exchange rate mechanisms consistent with the free market can keep countries from falling into that trap. Those mechanisms include fully floating exchange rates, under which the market sets the price of the currency; and fully fixed exchange rates, as with a currency board, under which governments essentially abdicate the authority of their central banks. As Brazil discovered, attempts to move from one pegged rate to another under crisis conditions merely result in the government’s subsidizing capital flight.
In Brazil and other client nations, new IMF credit has served as a sort of financial morphine for the political system, allowing it to continue postponing necessary reforms.
A third lesson is that countries have not suffered from “financial contagion.” Each country that has experienced financial turmoil has done so because of a series of home-grown policy mistakes. Brazil’s pegged currency, high interest rates, issuance of short-term dollar-denominated debt and demonstrated lack of urgency in introducing economic reforms created an environment that inhibited self-sustaining growth. Other crisis countries succumbed to similar internal contradictions. In Brazil’s case, one result was a growing fiscal deficit of 8 percent of gross domestic product. Two-thirds of that deficit are due to the government’s bankrupt social security system that politicians have shown no interest in reforming.
It is no wonder that both foreign and domestic investors pulled their money out of Brazil — except perhaps to those who can afford to be generous with other people’s money. One example is President Enrique Iglesias of the Inter-American Development Bank, who remarked that financial markets were behaving irrationally and that he was “very surprised that markets have not appreciated the immense efforts Brazil is undertaking on reform.” Comments like that showcase slow learning in Washington and explain why the IMF is not the only lending agency suffering from credibility problems.
Fourth, IMF money, whether it is disbursed before or after the outbreak of economic crisis, harms the recipient country. In Brazil and other client nations, new IMF credit has served as a sort of financial morphine for the political system, allowing it to continue postponing necessary reforms. The fund is not only incapable of buying political will; its largesse is turning into a gift to speculators at the expense of ordinary Brazilian citizens, who will have to pay the bill in the form of higher debt and prolonged economic turmoil.
In the end, the market will have to resolve the debt problems caused by bad government policies. But it would be less painful and less expensive if the IMF got out of the way and allowed lenders and borrowers to deal directly with each other. Sovereign borrowers would be forced to undertake fiscal policy and other reforms in exchange for future finance, and lenders would be forced to take some losses. That’s exactly what happened in the late 1980s when Citibank set aside enough loan-loss reserves to deal with its Third World debt exposure. Other banks followed suit, and Latin American governments suddenly became interested in policy change. Had the IMF not intervened during that lost decade, the debt problem surely would have resolved itself years earlier.
Thus, the most important lesson from Brazil and previous episodes of financial mismanagement is that recovery will come about only when policymakers in Brasilia and the capitals of other afflicted countries face economic reality and implement policy change — a process that is more likely to occur without IMF “help.”