My name is Ian Vásquez and I direct the Project on Global Economic Liberty at the Cato Institute. I would like to thank Vice Chairman for Oversight Crapo for inviting me to testify before the U.S. Senate. Let me note, in keeping with the truth in testimony requirements, that the Cato Institute does not receive government money of any kind.
Dissatisfaction with the way the International Monetary Fund has handled financial crises in Asia and Russia led Congress to attach conditions to the increased funding it rewarded the IMF last fall. Those conditions are intended to address legitimate concerns about transparency, accountability, IMF conditions and advice, and the overall effectiveness of IMF bailouts. In assessing the extent to which IMF programs in crisis countries have been consistent with congressional intent, it is important to also identify the extent to which we can expect Congress’s measures to address the fundamental problems of the lending agency. There is unfortunately little reason to believe that the IMF today does not still suffer from the flaws that plagued it before Congress attempted to make the Fund more effective. The IMF continues to make matters worse in Asia and elsewhere by perpetuating moral hazard, hindering rapid and widespread reforms, and undercutting superior, less expensive market solutions.
Moral Hazard Is Still A Problem
A major and widely recognized problem with IMF intervention — that it establishes moral hazard — has not been resolved or adequately addressed by the new legislation. As long as the IMF bails out countries, nations will continue to slip into crises in the future because the bailouts encourage risky behavior on the part of governments and investors who fully expect that if anything goes wrong, the IMF will come to their rescue.
The Fund has played a large role in creating the financial turmoil of recent years. With every election cycle since 1976, for example, Mexico has experienced a currency crisis caused by irresponsible monetary and fiscal policy. Each episode has been accompanied by U.S. Treasury and IMF bailouts, each time in increasing amounts. In Mexico, everybody has come to expect a financial rescue at the end of each presidential term.i And although IMF and U.S. officials had since 1995 claimed the last Mexican bailout a success, its legacy has been the Asian crisis of today — at least in its degree and severity. Indeed, the bailout of Mexico was a signal to the world that if anything went wrong in emerging economies, the IMF would come to investors’ rescue. How else can we explain the near doubling of capital flows to East Asia in 1995 alone?
Governments in Asia were not discouraged from maintaining flawed policies as long as lenders kept the capital flowing. Lenders, for their part, behaved imprudently with the knowledge that government money would be used in case of financial troubles. That knowledge by 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 investment calculations of lenders. Thailand, Indonesia, and South Korea, after all, shared some common factors that should have led to more investor caution, but didn’t. Those factors included borrowing in foreign currencies and lending in domestic currency under pegged exchange rates; extensively borrowing in the short term while lending in the long term; lack of supervision of borrowers’ balance sheets by foreign lenders; government‐directed credit; and shaky financial systems.ii The financial crisis in Asia was created in Asia, but the aggravating effect of moral hazard was extensive.
Efforts to “promote policies that aim at appropriate burden‐sharing by the private sector so that investors and creditors bear more fully the consequences of their decisions“iii may help chasten investors and promote greater prudence. However, there is no reason creditors should not bear the full consequence of their decisions or why the IMF should be in the position to determine what those consequences should be. If the IMF continues its bailout function, moral hazard will still exist and the Fund’s efforts to make lenders pay for their bad judgement will merely amount to a sloppy approximation of a penalty that the market would have imposed in the absence of IMF intervention.
Moral hazard — which is difficult, if not impossible to measure before a crisis erupts — has likely been reduced somewhat by Russia’s debt default. However, that outcome has resulted from the failure of IMF lending there, not from an IMF policy of burden sharing. In the Russian episode, the IMF unwittingly showed investors that it could be an unreliable bailout agency, thus creating a greater incentive for market participants to play by market rules. Evidence for this was provided by the devaluation of the Brazilian real, which also occurred after an IMF bailout but had no dramatic effect on international financial markets. International investors may be more cautious today, but they are still insulated from full exposure to market forces.
The IMF’s Credibility Problem Continues To Plague Economies In Crisis
The second major problem with IMF bailouts is that they are expensive, bureaucratic, and fundamentally unjust solutions to currency crises. The Fund’s approach helps explain why the Fund’s conditionality lacks credibility and why reform efforts are unlikely to improve its performance. In the first place, the financial aid cuts investors’ losses rather than allowing them to bear the full responsibility for their decisions. Just as profits should not be socialized when times are good, neither should losses be socialized during difficult times. “The $57 billion committed to Korea,” Jeffrey Sachs observes, “didn’t help anybody but the banks.“iv Unfortunately for the ordinary Asian citizens who had nothing to do with creating the crisis, they will be forced to pay for the added debt burden imposed by IMF loans.
IMF bailouts pose another burden on ordinary citizens because they don’t work very well. 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. Rather, a suspension of loans will tend to concentrate the minds of policymakers in the various troubled countries. The reason, after all, that there is any talk today of market‐reform is not because the IMF has shown up and suggested it is a good and necessary thing. That is fairly obvious. Economic reality is forcing the long‐needed change. To the extent that the IMF steps in and provides money, those reforms will not be as forthcoming. Thus, the citizens of recipient nations suffer the added burden of IMF intervention. Not only do they have to pay a greater debt; but they also have to suffer prolonged economic agony that is produced by the Fund’s bailouts.
That has certainly been the experience of Mexico since becoming a recipient of IMF aid in 1995,v and appears to be the case as well in Korea, another country in which the Fund is claiming success. Although progress has been made there, backtracking in important areas such as bankruptcies and privatization has occurred. After having promised to quickly privatize state‐owned monopolies, the Korean government has put off such moves for the energy, telecommunications and tobacco industries until 2003.vi As the Economist Intelligence Unit reported in February 1999, banks are more tightly controlled by the government today than when the crisis began and the chaebol, or Korean conglomerates, dominate the economy even more.
“The bottom line is that the chaebol virtually are the economy. In 1998 the top seven accounted for more than half of all South Korean exports. The biggest are too big to fail; they know it, and they know the government knows it too. Indeed, chaebol dominance means they can continue to joust with the government over reforms. These basic truths of the balance of power limit Kim Dae-jung’s ability to impose change. In the final analysis, state and business in Seoul remain as intertwined as they have ever been. Their interdependence will and must adapt to a changing world. But a truly free market is a chimera.” vii
In Thailand the story is much the same. Progress has occurred, but more would have likely occurred without IMF lending. Critical bankruptcy legislation has been postponed until the second half of 1999 after the Thai government had agreed with the IMF that it would be implemented by October of 1998.viii The Fund’s money in Indonesia has allowed the government to halt progress on reform, forcing the IMF to delay its flow of credit there. Earlier this month the government postponed a plan to restructure the banking system, which would have closed dozens of bankrupt banks, many of which have close political connections to the government. One market‐oriented Indonesian economist, Rizal Ramli, noted, “With the fall of Suharto, you might have expected that Suharto‐isms would be reduced. But it hasn’t worked out that way. The game is the same, only the players have changed.“ix
But what about the Fund’s “strong conditionality”? Don’t the strict conditions of IMF lending ensure that important policy changes will be made? It has become clear that domestic factors, not outside aid agencies, tend to determine whether a country reforms or not. In one study on multilateral lending, Oxford University’s Paul Collier explains that “some governments have chosen to reform, other to regress, but these choices appear to have been largely independent of the aid relationship. The micro‐evidence of this result has been accumulating for some years. It has been suppressed by an unholy alliance of the donors and their critics. Obviously, the donors did not wish to admit that their conditionality was a charade.“x
The IMF’s own record — 86 countries have been relying on IMF credit for more than 10 years — shows that the conditionality of the Fund’s “short term” loans has not worked well in the past. But besides the Fund’s poor record, there is good reason why the IMF has little credibility in imposing its conditions. As we have seen with Russia over the past several years, a country — especially a highly visible one — that does not stick to IMF conditions risks having its loans suspended. When loans are cut off, recipient governments tend to become more serious about reform. Note that the IMF encourages misbehaving governments to introduce reforms by cutting loans off; it is the cut off of credit that induces policy change.
Unfortunately, when policy changes are forthcoming, the IMF resumes lending. Indeed, the IMF has a bureaucratic incentive to lend. It simply cannot afford to watch countries reform on their own because it would risk making the IMF appear irrelevant. The resumption of financial aid starts the process over again and prolongs the period of reform. The Fund’s pressure to lend money in order to keep borrowers current on previous loans and to be able to ask for more money is well documented.xi The IMF’s bureaucratic incentive to lend is also well known by both recipient governments and the IMF itself, making the Fund’s conditionality that much less credible.
Just this week, the IMF agreed to release the second installment of its $41.5 billion package to Brazil despite every indication that the government will continue to resist long‐overdue reforms. The IMF bailout package for Brazil, which came after the U.S. Congress passed the Foreign Operations Act of 1999 urging reforms at the IMF, shows that the Fund’s program there has been flawed from the beginning.
One would have thought that the fall of the Russian ruble in August 1998 would have put to rest the notion that the IMF can prevent financial crises by providing bailouts before turmoil erupts. Nevertheless, the Fund provided just such aid to Brazil last fall with similar consequences. The Brazilian government has had years since the Mexican peso devaluation to put its house in order and get its spending under control. Only after investors began to lose confidence in the real in the fall of 1997 did President Fernando Henrique Cardoso react by announcing tax increases and spending cuts worth $20 billion. Tax increases of about $9 billion were implemented, but most spending cuts never were. Revenues have increased, but spending has gone up at a faster rate leading to a growing budget deficit of 8 percent of GDP.
Higher spending and higher taxes have been the norm in Brazil during the Cardoso years. Public spending has increased from 30 to 40 percent of GDP since 1994, while the tax burden has gone from 26 to 31 percent of GDP during that time. The IMF’s new austerity plan agreed to in the fall of 1998 promised $11 billion in new tax increases and proposed tax cuts amounting to only 6.3 percent of the total budget for 1999.xii
With the budget out of control, Brazil has relied on disciplined monetary policy to maintain stability. But monetary policy alone cannot save Brazil. Brazil’s pegged currency, high interest rates, issuance of short‐term, dollar‐denominated debt and lack of urgency about reform created an environment that inhibited self‐sustaining growth and eventually led to the devaluation of the real after the IMF came to the rescue. Brazil’s central problem of too much government spending is essentially a political problem, one that the IMF is ill‐suited to address and appears to be enabling. Those problems are severe. For example, the percentage of states’ revenues spent on salaries in Brazil range from a low of 40 percent to a high of 85 percent (for the states of Minas Gerais, Rio de Janeiro and Sao Paulo the figures are 80, 79.7 and 62.3 percent respectively). At the heart of the government’s uncontrollable spending is the bankrupt state‐run pension system. Two thirds of the budget deficit is due to that program, yet the Brazilian Congress has postponed its reform for years and the “reform” agreed to under the IMF package does little to address this structural problem. Although the state pension system had a 1998 deficit of around $40 billion, the so‐called pension reform finally passed by Brazilian lawmakers will collect $2.6 billion dollars generated from new taxes on pensions. The measure neither deals with fundamental flaws in government spending nor qualifies as reform.xiii
Brazil is a clear example of a country in which IMF credit is performing as poorly as it traditionally has despite it being made available after the U.S. Congress took steps to improve the Fund’s performance. New IMF lending has served as a sort of financial morphine for the Brazilian political system, allowing it to continue postponing reforms. There is no reason to believe that the latest installment of IMF money will increase the Fund’s credibility in terms of its ability to push Brazil toward significant policy change. A more effective approach would rely on the market.
The IMF Should Stand Aside
IMF bailouts, however, undermine superior, less expensive 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 what creditors and debtors always do in cases of illiquidity or insolvency: they renegotiate debt or enter into bankruptcy procedures. In a world without the IMF, both parties would have an incentive to do so because the alternative, to do nothing, would mean a complete loss. Direct negotiations between private parties and bankruptcy procedures are essential if capitalism is to work. As James Glassman has stated, capitalism without bankruptcy is like Christianity without Hell. IMF bailouts, unfortunately, undermine one of the most important underpinnings of a free economy by overriding the market mechanism. As Catherine Mann put it
“In the current situation, the more difficult, drawn‐out, ad hoc, and therefore costly are the financial disaster workouts, the greater are the incentives for investors to demand and institutions to offer instruments ex ante that will help to generate a market‐oriented solution to the workout process. So rather than intervening more frequently, official institutions must stand aside.” xiv
There is simply no reason why international creditors and borrowers should be treated any differently than are lenders and debtors in the domestic market.
Governments would also react differently if no IMF interventions were forthcoming. There would be little alternative to widespread and rapid reforms if policymakers were not shielded from economic reality. Lawrence Lindsey, a former governor of the U.S. Federal Reserve opposed to bailouts, has noted, for example, that, “All of the ‘conditions’ supposedly negotiated by the IMF will be forced on South Korea by the market.“xv Of course, there is always the possibility that a government would be reluctant to change its ways under any set of circumstances; but that is a possibility that is larger, and indeed has become a reality, under IMF programs.
Because the Fund suffers from an array of inherent tensions in the way it operates, causes more harm than good once a crisis erupts, and undermines superior market solutions, we should not expect current reform efforts to somehow overcome the Fund’s fundamental flaws, much less to make a noticeable difference in the performance of IMF client countries. The most important reform Congress has advocated — but one which may only make a marginal difference in Fund’s effectiveness — is that of increased transparency and accountability at the lending agency.xvi The U.S. government and the U.S. public are entitled to know what advice the IMF is giving countries, when it is giving that advice, under what financial and policy conditions is the Fund providing support, and what exact criteria the IMF will use to measure whether a country is successfully reforming or merely delaying comprehensive market reforms. The Fund should also publicly identify those institutions, public and private, in recipient nations that are receiving its subsidized finance. In practice, that means that IMF documents, including economic evaluations, policy prescriptions, letters of intent, and other memoranda be made public. The Fund should also allow outside auditors to assess the quality of IMF loans and to conduct full evaluations of the IMF’s lending record.
At the very least, more transparency would provide for a more informed public debate and, in theory, would make the IMF more accountable. There is, however, no reason to believe that the IMF would noticeably improve its performance or significantly change its behavior even if much damning evidence came to light. After all, Washington’s other major multilateral lending agency, the World Bank, already conforms with many of the stipulations some are suggesting for the IMF. The Bank’s Operations and Evaluations Department and other internal reviews have for years consistently turned up self‐admitted dismal performance. These have resulted in reforms and promises of reform, but no noticeable improvement in performance. Congress should expect the same experience from the IMF bureaucracy if it attaches demands for transparency in exchange for continued or increased financial support. And although Section 602 of the Foreign Operations Act calls for the U.S. Treasury Secretary to certify that IMF resources to Korea are not being used to provide financial assistance to certain industries, there is no way such a certification can be reliably made because of the fungibility of money. IMF funds to the Korean government merely free up resources that allow the government to support its favored projects anyway.
Even though Congress has asked the U.S. Treasury Department to report whether the IMF is complying with Congressional stipulations, it should not rely on the Treasury Department to provide adequate assessments. Because the Treasury Department, through the U.S. executive director at the IMF, has influence over the use of IMF funds, it is in its bureaucratic interest to maintain and even increase those resources under its influence. Treasury has long supported the prerogatives of the IMF, regardless of whether U.S. administrations have been Republican or Democratic. Treasury’s disingenuous claims that funding the IMF does not cost U.S. taxpayers a dime is only the most recent example of its virtually uncritical endorsement of IMF lending activities.
Congress’s efforts to prevent the Fund from financing bankrupt institutions are part of a larger effort to make the IMF function as an international lender of last resort. For example, Congress stipulated that emergency finance be made available at “not less than 300 basis points in excess of the average of the market‐based short‐term cost of financing of its largest members“xvii and that such credit be made available for shorter terms. Unlike a true lender of last resort that provides funds at a penalty rate to solvent banks that are temporarily threatened by panic, the IMF has generally provided subsidized funds that bail out insolvent financial institutions. Imposing penalty interest rates alone will not discourage imprudent behavior nor allow the Fund to be an effective lender of last resort. Indeed the agency cannot act quickly nor create money as can true lenders of last resort. Countries that experience threats to their financial systems can already rely on their own central banks as lenders of last resort. That includes the United States, where the Federal Reserve is charged with such a mission.xviii Turning the IMF into an international lender of last resort is both unnecessary and politically improbable.
Another reform urged by the U.S. Congress is for the IMF to promote policies aimed at “strengthening crisis prevention and early warning signals through improved and more effective surveillance of the national economic policies and financial market development of countries.“xix Yet it is unclear how a warning mechanism would work. As economist Raymond Mikesell asks, “Who would be warned and when? As soon as the financial community receives a warning that a country is facing financial difficulty, a massive capital outflow is likely to occur, in which case crisis prevention would be out of the question.”
On the other hand, if the IMF perceives serious financial difficulties in a country and does not disclose that information, then it undermines its credibility as a credit‐rating agency for countries. That appears to have been the case in Thailand, where the IMF now claims it issued warnings about the economy before the crisis erupted but kept those concerns confidential. The fund’s credibility is further undercut by inherent conflicts of interest: in many cases, it would be evaluating countries in which it has its own money at stake; in all cases, it would be evaluating countries that, as member‐owners of the IMF, have contributed to the fund’s pool of resources. Only by ceasing to lend could the agency increase its integrity. At that point, however, its evaluations would merely replicate a service already available.
Finally, it is worth noting that the global financial system could improve in a number of ways. Countries do need to increase the transparency of their financial institutions and disclose economic data. Financial deregulation and openness to foreign investment in that and other sectors would also reduce instability and promote prosperity in developing nations. That would imply an end to policies of directed credit and the crony capitalism that such policies often engender. The establishment of bankruptcy procedures and the rule of law are requisite to encourage sustained investment, both foreign and domestic. Free exchange rates and disciplined monetary and fiscal policy are also necessary to help avoid crises. Currency boards or dollarization as alternatives to floating exchange rates have also been consistent with stability and economic growth in the countries that have adopted those mechanisms.xx In general, economic liberalization will help promote prosperity and stability in the global economy. But all of those reforms can be unilaterally introduced by developing nations. Such policy change does not require IMF intervention. Reforms at the IMF, which promise little, are thus a distraction to the important tasks developing countries are more likely to undertake without IMF money and advice. The conditionality that Congress has attached to increased funding of the IMF has shown itself to be about as effective as IMF conditionality itself.
i. W. Lee Hoskins and James W. Coons, “Mexico: Policy Failure, Moral Hazard, and Market Solutions,” Cato Policy Analysis no. 243, October 10, 1995. The authors claim that the result of the Mexican bailout “is a set of perverse incentives for Mexican officials and foreign investors that ensures the ‘crisis’ will reappear on an even larger scale.”
ii. Some of these points were made by Allan H. Meltzer at a Cato Policy Forum, “Why We Should Say No To the IMF,” Washington, D.C., February 12, 1998. See also Allan H. Meltzer, “Danger of Moral Hazard,” Financial Times, October 27, 1997.
iii. Section 610 of Title VI of the Foreign Operations, Export Financing, and Related Programs Appropriations Act of 1999, Congressional Record, October 19, 1998, p. H11104.
iv. Quoted in Peter Passell, “Economic Scene,” New York Times, February 12, 1998.
v. See Ian Vásquez and L. Jacobo Rodríguez, “What To Expect From IMF? Look At Mexico,” Investor’s Business Daily, April 1, 1998.
vi. Evelyn Iritani, “South Korea’s Economy Offers Illusion of Reform,” Los Angeles Times, September 13, 1998, p. A1.
vii. Economist Intelligence Unit, “South Korea: On the leading edge of free‐market reform?” February 17, 1999.
viii. “Crisis Highlights Risks To Investors,” Bangkok Post, January 27, 1999.
ix. Mark Landler, “Bank Reform Issue Hobbles Indonesia,” International Herald Tribune, March 5, 1999.
x. Paul Collier, “The Failure of Conditionality,” in Catherine Gwin and Joan Nelson, eds., Perspectives On Aid and Development (Washington: Overseas Development Council, 1997), p. 57.
xi. See, for example, John Williamson, The Lending Policies of the International Monetary Fund (Washington: Institute for International Economics, 1982); Roland Vaubel, “Bureaucracy at the IMF 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).
xii. See L. Jacobo Rodríguez, “Bailout Will Handicap Brazil,” Journal of Commerce, Novermber 17, 1998.
xiv. Catherine L. Mann, “Market Mechanisms to Reduce the Need for IMF Bailouts,” International Economics Policy Briefs no. 99–4, February 1999.
xv. Lawrence B. Lindsey, “The Bad News About Bailouts,” New York Times, January 6, 1998.
xvi. See Section 601 (2), (3) and Section 610 (13), Congressional Record pp. H11102 and H11105.
xvii. Section 601, (4) (A), p. H11102.
xviii. For more on international lenders of last resort, see Charles Calomiris, “The IMF’s Imprudent Role As Lender of Last Resort,” Cato Journal (Winter 1998) vol. 17, no. 3, pp. 275–294; Anna J. Schwartz, “Time To Terminate the ESF and the IMF,” Cato Institute Foreign Policy Briefing no. 48, August 26, 1998; and Jim Saxton, “An International Lender of Last Resort, The IMF, And the Federal Reserve,” Joint Economic Committee of the U.S. Congress, February 1999.
xix. Section 610, p. H11104.
xx. See, for example, Steve Hanke and Kurt Schuler, “A Dollarization Blueprint for Argentina,” Cato Institute Foreign Policy Briefing, March 12, 1999.