The International Monetary Fund

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My name is Ian Vásquez and I direct the Project on GlobalEconomic Liberty at the Cato Institute. I would like to thankChairman Bachus for inviting me to testify before the U.S. House ofRepresentatives. Let me note, in keeping with the truth intestimony requirements, that the Cato Institute does not receivegovernment money of any kind.

Usually, the International Monetary Fund takes a low profileexcept when there are riots in the major cities of clientcountries, national currency crises, or when the IMF is asking formore money. Unfortunately, all three factors explain the currentlyhigh profile of the Fund. The emergency atmosphere of the ongoingAsian financial crisis and the resulting bailout packages theretotaling about $117 billion should not serve as an excuse toapprove urgent requests for a massive increase in the IMF'sresources. The IMF has made matters worse in Asia by establishingmoral hazard, hindering rapid and widespread reforms, andundercutting superior, less expensive market solutions. These areserious charges that require public debate rather than theunquestioning financial support of U.S. taxpayers that the IMF hascavalierly come to expect.

I am encouraged, therefore, that the Congress is interested inexamining the IMF's performance and the ability of thatorganization to comply with the congressional intent of promoting amore stable and prosperous global economy. Evaluations of the IMF,however, should not concentrate on reform efforts if those effortsdo little or nothing to address the fundamental flaws of the IMF.For the most part, current proposals to reform the IMF and itsrelationship with the United States seem to fall under thatcategory.

The IMF suffers from a set of internal tensions in its functionsand operations that additional funding from the United States andother donor nations will not resolve and that will be difficult, ifnot impossible to resolve even without new funding. Those strainsinclude the IMF's demands that countries be more open versus itsresistance at efforts to increase its own transparency; the IMF'sdual role as an international surveillance body versus its role asan agency to prevent the outbreak of crises; the IMF's bailoutfunction versus its claims to minimize or eliminate moral hazard;and the Fund's insistence on conditionality to recipient nationsversus its reluctance to accept any conditions on its ownperformance when asking for more money from donor countries.

Those are relatively new concerns that build on the criticismsthat free-market economists have long had about the IMF. Indeed,Mexico-style crises may have brought much attention to the Fund inrecent years, but the lending agency's record over the past 50years has been dismal. The IMF does not appear to have helpedcountries either achieve self-sustaining growth or to promotemarket reforms. Despite its poor performance, the IMF has proven tobe a remarkably resilient institution. When the system of fixedexchange rates ended in the early 1970s, so did the agency'soriginal mission of maintaining exchange-rate stability by lendingto countries experiencing balance-of-payments problems. Instead ofclosing down, however, the Fund has created new missions for itselfwith each new crisis, each time expanding its economic influence orresources or both. Those episodes included the oil crises of the1970s, the Third World debt crisis, the collapse of communism, andnow, Mexico-style crises.

The IMF in theory makes short-term loans in exchange for policychanges in recipient countries. This has not, however, helpedcountries move to the free market. Instead the Fund has createdloan addicts as review of its lending reveals. Eleven nations havebeen relying on IMF aid for at least 30 years; 32 countries hadbeen borrowers for between 20 and 29 years; and 41 countries hadbeen using IMF credit for between 10 and 19 years. That is notevidence of either the success of the Fund's so-calledconditionality or the temporary nature of the Fund's short-termloans.

Transparency and ReliableInformation

The International Monetary Fund is now demanding transparency onthe part of Asian governments, whose concealment of financial dataand outright deception helped cause the region's economic crisis.But even as the IMF insists on full and accurate information, itremains one of the world's most secretive bureaucracies. Theagency's opacity undermines its credibility and allows the fund tododge accountability.

Openness would surely help to answer the most basic questionabout the fund's performance: How successful is the IMF in helpingcountries reform their economies and achieve self-sustaininggrowth? Numerous independent studies have found that the IMFcreates long-term aid dependency, that its credit slows the processof reform and that it has a bureaucratic incentive to lend. Ofcourse, IMF officials claim otherwise, but they continue to keepmany of the agency's documents, economic evaluations and policyprescriptions confidential.

The fund, for example, has never publicly produced a thoroughassessment of its own effectiveness as has the World Bank.Harvard's Jeffrey Sachs has derided the agency for making it"extremely difficult for outside observers to prepare a seriousquantitative appraisal of IMF policies." Even after the IMFgrudgingly began to publish the stipulations of some of its loanpackages, the head of the Institute of International Finance,Charles Dallara, complained that the information the fund providesis woefully inadequate for the needs of market participants.

But what if countries began providing the fund with the data itdemands? Could the IMF at least be expected to detect ominousfinancial developments and offer timely warnings? Treasurysecretary Robert Rubin and others suggest that the world badlyneeds better economic surveillance. The fund, says IMF chief MichelCamdessus, should fill that role. It is useful to recall that theagency was already charged with that mission and utterly failed toalert the world to problems in Thailand, South Korea, Indonesia orthe PhilippinesCa task at which it had promised to do a better jobafter failing in Mexico in 1994. Instead, the IMF praised all ofthose economies right up to the outbreak of crisis. Rather thanacknowledge negligence or inattentiveness to the impending Asianfinancial crisis, the IMF has refused to accept responsibility.When asked if the fund's performance in Asia and Mexico was notevidence of failure, Camdessus responded: "This is a joke. It istrue that Mexico revealed the importance of transparency. . . . Butthe fact is that we are not suppliers or producers of statistics.These are produced by each individual country." William Keegan ofthe London Observer put it aptly: "Bycalling for >transparency,' [the World Bank and the IMF] admitthey did not know what was going on."

Not only has the fund shifted blame for its obvious lack ofvigilance; it is asking for $18 billion in U.S. funding and makingthe superficially appealing recommendation that the IMF strengthenits role as a watchdog agency that provides an "early warning"system in case of potential financial troubles. Congress should ofcourse deny support to any bureaucracy that responds to requestsfor transparency with smugness. Yet even if the IMF somehowtransformed itself, it is unclear how a warning mechanism wouldwork. As economist Raymond Mikesell asks, "Who would be warned andwhen? As soon as the financial community receives a warning that acountry is facing financial difficulty, a massive capital outflowis likely to occur, in which case crisis prevention would be out ofthe question."

On the other hand, if the IMF perceives serious financialdifficulties in a country and does not disclose that information,then it undermines its credibility as a credit-rating agency forcountries. That appears to have been the case in Thailand, wherethe IMF now claims it issued warnings about the economy before thecrisis erupted but kept those concerns confidential. The fund'scredibility is further undercut by inherent conflicts of interest:in many cases, it would be evaluating countries in which it has itsown money at stake; in all cases, it would be evaluating countriesthat, as member-owners of the IMF, have contributed to the fund'spool of resources. Only by ceasing to lend could the agencyincrease its integrity. At that point, however, its evaluationswould merely replicate a service already available.

Moral Hazard

Another problem with IMF intervention is that it establishesmoral hazard, a problem U.S. Treasury Secretary Robert Rubin hasrecognized as significant, but, like other advocates of increasedfunding for that institution, has failed to resolve.(1)

The more the IMF bails out countries, the more we can expectcountries to slip into crises in the future because it encouragesrisky behavior on the part of governments and investors who fullyexpect that if anything goes wrong, the IMF will come to theirrescue.

We've seen the moral hazard problem in the past and we areseeing it today. With every election cycle in the past 20 years,for example, Mexico has experienced a currency crisis caused byirresponsible monetary and fiscal policy. Each episode has beenaccompanied by U.S. Treasury and IMF bailouts, each time inincreasing amounts. In Mexico, everybody has come to expect afinancial rescue at the end of each presidential term.(2)

And although IMF and U.S. officials had since 1995 claimed thelast Mexican bailout a success, its legacy has been the Asiancrisis of todayCat least in its degree and severity. Indeed, thebailout of Mexico was a signal to the world that if anything wentwrong in emerging economies, the IMF would come to investors'rescue. How else can we explain the near doubling of capital flowsto East Asia in 1995 alone?

Governments in Asia were not discouraged from maintaining flawedpolicies as long as lenders kept the capital flowing. Lenders, fortheir part, behaved imprudently with the knowledge that governmentmoney would be used in case of financial troubles. That knowledgeby no means meant that investors did not care if a crisis erupted;but it led to the mispricing of risk and a change in the investmentcalculations of lenders. Thailand, Indonesia, and South Korea,after all, shared some common factors that should have led to moreinvestor caution, but didn't. Those factors included borrowing inforeign currencies and lending in domestic currency under peggedexchange rates; extensively borrowing in the short term whilelending in the long term; lack of supervision of borrowers' balancesheets by foreign lenders; government-directed credit; and shakyfinancial systems.(3)

The financial crisis in Asia was created in Asia, but theaggravating effect of moral hazard was extensive. As Michael Prowseof the Financial Times commented after theMexican bailout, "Rubin and Co. wanted to make global capitalismsafe for the mutual fund investor. They actually made it farriskier."(4)

As long as the IMF provides bailouts, the moral hazard problemwill be prevalent. The only way to eliminate moral hazard is forprivate sector institutions to feel the full consequenceof their investment decisions; that will only happen, however, ifthe IMF ends its bailout function.

The IMF's Credibility Problem and the Failureof Conditionality

IMF bailouts of Asian countries are expensive, bureaucratic, andfundamentally unjust solutions to currency crises. The Fund'sapproach helps explain why the Fund's conditionality lackscredibility and why reform efforts are unlikely to improve itsperformance. In the first place, the financial aid cuts investors'losses rather than allowing them to bear the full responsibilityfor their decisions. Just as profits should not be socialized whentimes are good, neither should losses be socialized duringdifficult times. "The $57 billion committed to Korea," JeffreySachs observes, "didn't help anybody but the banks."(5)

Unfortunately for the ordinary Asian citizens who had nothing todo with creating the crisis, they will be forced to pay for theadded debt burden imposed by IMF loans.

IMF bailouts pose another burden on ordinary citizens becausethey don't work very well. The Fund's money goes to governmentsthat have created the crisis to begin with and that have shownthemselves to be unwilling or reluctant to introduce necessaryreforms. Giving money to such governments does not tend to promotemarket reforms, it tends to delay them because it takes thepressure off of governments to change their policies. Rather, asuspension of loans will tend to concentrate the minds ofpolicymakers in the various troubled countries. The reason, afterall, that there is any talk today of market-reform is not becausethe IMF has shown up and suggested it is a good and necessarything. That is fairly obvious. Economic reality is forcing thelong-needed change. To the extent that the IMF steps in andprovides money, those reforms will not be as forthcoming. Thus, thecitizens of recipient Asian nations suffer the added burden of IMFintervention. Not only do they have to pay a greater debt; but theyalso have to suffer prolonged economic agony that is produced bythe Fund's bailouts.

But what about the Fund's "strong conditionality"? Don't thestrict conditions of IMF lending ensure that important policychanges will be made? Again, the record of long-term dependency ofcountries shows that conditionality has not worked well in thepast. But besides the Fund's poor record, there is good reason whythe IMF has little credibility in imposing its conditions. As wehave seen with Russia over the past several years, acountryCespecially a highly visible one--that does not stick to IMFconditions risks having its loans suspended. When loans are cutoff, recipient governments tend to become more serious aboutreform. Note that the IMF encourages misbehaving governments tointroduce reforms by cutting loans off; it is the cut off of credit that induces policy change.

Unfortunately, when policy changes are forthcoming, the IMFresumes lending. Indeed, the IMF has a bureaucratic incentive tolend. It simply cannot afford to watch countries reform on theirown because it would risk making the IMF appear irrelevant. Theresumption of financial aid starts the process over again andprolongs the period of reform. The Fund's pressure to lend money inorder to keep borrowers current on previous loans and to be able toask for more money is well documented.(6)

The IMF's bureaucratic incentive to lend is also well known byboth recipient governments and the IMF itself, making the Fund'sconditionality that much less credible.

The IMF Versus the Market

It is worth noting that IMF bailouts undermine superior, lessexpensive market solutions. No amount of IMF reform in that area,short of an end to its bailout function, can change that reality.In the absence of an IMF, creditors and debtors would do whatcreditors and debtors always do in cases of illiquidity orinsolvency: they renegotiate debt or enter into bankruptcyprocedures. In a world without the IMF, both parties would have anincentive to do so because the alternative, to do nothing, wouldmean a complete loss. Direct negotiations between private partiesand bankruptcy procedures are essential if capitalism is to work.As James Glassman has stated, capitalism without bankruptcy is likeChristianity without Hell. IMF bailouts, unfortunately, undermineone of the most important underpinnings of a free economy byoverriding the market mechanism. There is simply no reason whyinternational creditors and borrowers should be treated anydifferently than are lenders and debtors in the domesticmarket.

Governments would also react differently if no IMF interventionswere forthcoming. There would be little alternative to widespreadand rapid reforms if policymakers were not shielded from economicreality. Lawrence Lindsey, a former governor of the U.S. FederalReserve opposed to bailouts, has noted, for example, that, "All ofthe 'conditions' supposedly negotiated by the IMF will be forced onSouth Korea by the market."(7)

Of course, there is always the possibility that a governmentwould be reluctant to change its ways under any set ofcircumstances; but that is a possibility that is larger, and indeedhas become a reality, under IMF programs.

Reform Proposals

Because the Fund suffers from an array of inherent tensions inthe way it operates, causes more harm than good once a crisiserupts, and undermines superior market solutions, we should notallow superficial reform proposals to serve as a distraction fromthe Fund's fundamental flaws and to lead us into believing that itssevere shortcomings will somehow be overcome. If Congress wishes tocontinue supporting the IMF, the most important reform it canpursue -- but one which may only make a marginal difference inFund's effectiveness -- is that of increased transparency at thelending agency. The U.S. government and the U.S. public areentitled to know what advice the IMF is giving countries, when itis giving that advice, under what financial and policy conditionsis the Fund providing support, and what exact criteria the IMF willuse to measure whether a country is successfully reforming ormerely delaying comprehensive market reforms. The Fund should alsopublicly identify those institutions, public and private, inrecipient nations that are receiving its subsidized finance. Inpractice, that means that IMF documents including economicevaluations, policy prescriptions, letters of intent, and othermemoranda be made public. The Fund should also allow outsideauditors to assess the quality of IMF loans and to conduct fullevaluations of the IMF's lending record.

At the very least, more transparency would provide for a moreinformed public debate and, in theory, would make the IMF moreaccountable. There is, however, no reason to believe that the IMFwould noticeably improve its performance or significantly changeits behavior even if much damning evidence came to light. Afterall, Washington's other major multilateral lending agency, theWorld Bank, already conforms with many of the stipulations some aresuggesting for the IMF. The Bank's Operations EvaluationsDepartment and other internal reviews have for years consistentlyturned up self-admitted dismal performance. These have resulted inreforms and promises of reform, but no noticeable improvement inperformance. Congress should expect the same experience from theIMF bureaucracy if it attaches demands for transparency in exchangefor continued or increased financial support.

Congress, moreover, may ask the U.S. Treasury Department toreport whether the IMF is complying with Congressionalstipulations; but Congress should not rely on the TreasuryDepartment to provide adequate assessments. Because the TreasuryDepartment, through the U.S. executive director at the IMF, hasinfluence over the use of IMF funds, it is in its bureaucraticinterest to maintain and even increase those resources under itsinfluence. Treasury has long supported the prerogatives of the IMF,regardless of whether U.S. administrations have been conservativeor liberal. Treasury's recent and disingenuous claims that fundingthe IMF does not cost U.S. taxpayers a dime is only the most recentexample of its virtually uncritical endorsement of IMF lendingactivities.

Another proposal which has been made -- to explore alternativesources of IMF funding such as the issuance of bonds -- is alsounlikely to change the Fund's performance and may even make theagency even less accountable than it is today. As long as theUnited States maintains its membership in the IMF, and by so doingguarantees the agency's financial soundness, the Fund should notmove to such a system. In case the Fund experiences any financialdifficulties, its bondholders would be repaid using additional U.S.taxpayer money. Again, such a system already exists at the WorldBank; while it has increased U.S. taxpayer liability there, it hasnot improved the Bank's performance.

Finally, it is worth noting that the global financial systemcould improve in a number of ways. Countries do need to increasethe transparency of their financial institutions and discloseeconomic data. Financial deregulation and openness to foreigninvestment in that and other sectors would also reduce instabilityand promote prosperity in developing nations. That would imply anend to policies of directed credit and the crony capitalism thatsuch policies often engender. The establishment of bankruptcyprocedures and the rule of law are requisite to encourage sustainedinvestment, both foreign and domestic. Free exchange rates anddisciplined monetary and fiscal policy are also necessary to helpavoid crises. Currency boards as an alternative to floatingexchange rates have also been consistent with stability andeconomic growth in the countries that have adopted that exchangerate mechanism. In general, economic liberalization will helppromote prosperity and stability in the global economy. But all ofthose reforms can be unilaterally introduced by developingnations. Such policy change does not require IMF intervention.Reforms at the IMF, which promise little, are thus a distraction tothe important tasks developing countries are more likely toundertake without IMF money and advice. The conditionality thatCongress attaches to increased funding of the IMF is in any eventlikely to be about as effective as IMF conditionality itself.

Notes

1. See David Wessel, "Rubin SaysGlobal Investors Don't Suffer Enough," Wall StreetJournal, September 19, 1997.

2. W. Lee Hoskins and James W.Coons, "Mexico: Policy Failure, Moral Hazard, and MarketSolutions," Cato Policy Analysis no. 243, October 10, 1995. Theauthors claim that the result of the Mexican bailout Ais a set ofperverse incentives for Mexican officials and foreign investorsthat ensures the >crisis' will reappear on an even largerscale.

3. Some of these points were madeby Allan H. Meltzer at a Cato Policy Forum, "Why We Should Say NoTo the IMF," Washington, D.C., February 12, 1998. See also Allan H.Meltzer, "Danger of Moral Hazard," FinancialTimes, October 27, 1997.

4. Michael Prowse, "The Rescuers,"New Republic, February 27, 1995.

5. Quoted in Peter Passell,"Economic Scene," New York Times, February12, 1998.

6. See, for example, JohnWilliamson, The Lending Policies of theInternational Monetary Fund (Washington: Institute forInternational Economics, 1982); Roland Vaubel, "Bureaucracy at theIMF and the World Bank: A Comparison of the Evidence," The World Economy, March 1996; and Peter B. Kenen,Ways to Reform Exchange Rate Arrangements(Princeton, N.J.: Princeton University Press, 1994).

7. Lawrence B. Lindsey, "The BadNews About Bailouts," New York Times,January 6, 1998.

Ian Vásquez

Subcommittee on General Oversight and Investigations
Committee on Banking and Financial Services
United States House of Representatives