The spectacular collapse of the Argentine economy last year, coming after several International Monetary Fund "rescue" packages, seemed to finally discredit the Fund's approach to financial crises. In Russia, Indonesia, and elsewhere, emergency IMF credit failed to avert economic turmoil and added massive debt. As a result, the IMF and the Bush administration promised to do things differently. But now it looks like things haven't changed much.
That was the message the IMF sent this month when it agreed to give Brazil $30 billion. The loan has undermined Washington's credibility, made the global financial system more fragile, and will likely be as unsuccessful as previous loans to Brazil. It was only a year ago, after all, that the Fund awarded Brasilia $15 billion. That money has now been used. In 1998, the Fund backed a $41.5 billion bailout to Brazil. Three months later, the country's currency collapsed. As in all IMF bailouts, investors and the government benefited, while poor citizens picked up the tab.
The Brazilian economy is better run today than it was a few years ago, prompting George Soros to blame the market for its current volatility and claim that "Brazil's problems cannot be blamed on anything Brazil has done." But Brazil's main problem is homegrown. It is suffering primarily from political uncertainty caused by the prospect that a populist government, whose policies are unknown, will be elected in October. An IMF bailout cannot change that political situation.
Markets are already taking note of that reality. The Brazilian real and the country's stock market began to fall within 24 hours of the bailout. Moody's downgraded Brazil's credit rating after the announcement of the bailout. IMF money will be used in an attempt to prop up the currency, a measure that in practice subsidizes capital flight. Noting that perversity, Walter Molano of BCP Securities says "the probability of default is now higher."
Academics and financial policymakers, on the other hand, continue to blame the Brazilian turbulence on contagion and irrational investors. Joseph Stiglitz, former chief economist of the World Bank, proclaims that, "If the markets understand the state of affairs in Brazil . . . Brazil should have no difficulty meeting its commitments."
Really? Brazil's political uncertainty is compounded by its precarious economic situation. The country's budget deficit is 5 percent of gross domestic product, and much of its growing debt, now at 60 percent of GDP, is still short-term. Brazil has enough money to pay its debt this year, but markets are reacting to the real possibility that it may not be able to do so next year when more payment is due.
Indeed, Brazil last year began propping up its currency by increasing interest rates and issuing debt tied to the exchange rate. Some 90 percent of public bonds are now indexed to inflation, the exchange rate or interest rates. That means that an unexpected bump in the road quickly increases Brazil's debt to unmanageable proportions. In its review of the Brazilian economy early this year, the IMF warned precisely about that problem. Political uncertainty has become the bump in the road that is now turning into a crisis.
Until now, the Bush administration had been seeking to move the IMF away from bailouts because of the perverse incentives they create. Those include the encouragement of risky investments and less cautious policies by emerging country governments. Such moral hazard can only be averted with a credible commitment by Washington not to intervene in the homegrown crises of emerging markets. Just weeks before the bailout, Treasury Secretary Paul O'Neill appeared to reinforce that commitment by publicly suggesting that Brazil deserved no such loan.
The administration's policy reversal has eliminated whatever credibility it had on changing the IMF bailout doctrine. Investors and governments can be excused for believing that rescues are now in order for Argentina and future potential trouble spots. The global financial system has been weakened again without resolving Brazil's underlying problems. Superior solutions to debt crises -- whereby creditors and borrowers work together without burdensome, third party intervention -- have been undermined.
Worse, detractors of the market have wrongly interpreted the Bush administration's policy reversal as a vindication of their interventionist tendencies. Once again, the IMF has done much damage to the spread of free markets. Will it take another crisis in Brazil to finally put an end to the era of big bailouts?