The IMF and Moral Hazard
J. Bradford DeLong
First, it seems to me that the moral hazard problem is
not just a
matter of neoclassical theory, but as Robert Rubin himself
conceded a couple of years ago, a material phenomenon. So,
without an IMF bailout fund, there would be less risk-free
NY/London/Tokyo/Frankfurt portfolio capital flowing into the
emerging markets (we call this hot money in South Africa, as
come in very fast three times -- 3-12/95 after exchange controls
were dramatically relaxed, 1-6/98 and 3-11/99 -- but twice left
faster, over periods of a few weeks on largely spurious grounds,
like a rumour Mandela was ill in 2/96, causing enormous real-
sector dislocations due to 30% currency collapses, rapid depletion
of forex reserves, massive interest rate increases, stock market
crashes, etc). So, if the portfolio-K inflow doesn't arrive because
IMF isn't there to do bailouts, then we don't get the disastrous
Ummm... Yes we do. Back before World War II, back before there
was an IMF, there were *lots* of disastrous outflow episodes.
The absence of a moral hazard-creating IMF did not keep there
from being a disastrous outflow episode in the U.S. in 1873,
in the U.S. in 1893, in the U.S. in 1907, in Argentina in 1890,
in Austria in 1931, in Germany in 1931, in Britain in 1931, and
in a bunch of other places. To claim that financial markets will
be "rational" and not overspeculate in the absence
of a lender of last resort is just naive. Only those who have
vast confidence in the rationality of financial markets make
such confident assertions.
The live questions are: (a) How much in the way of additional
capital flows are generated by confidence that there will be
an international lender of last resort? (b) How much smaller
are the financial panics that do come made because of the existence
of an international lender of last resort? The Asian financial
crisis was, a year before it happened, seen as roughly a 1% probability
event (and the Mexican financial crisis was, a year before it
happened, seen as roughly a 10% probability event). So I have
to think that in the most recent financial crisis factor (a)
was small: few who invested in East Asia in 1996 were thinking
at all about the potential benefits of an IMF bailout in 1998.
Claims about how long the East Asian depression would have lasted
in the absence of the IMF are inherently speculative, but my
use of analogies from the 1870s and 1890s (which are, I admit,
extremely weak evidence) suggests that a lot of good was done
by keeping East Asian banking systems liquid.
Second, the IMF should be shut down because their lead
bureaucrats retain enormous power, and are opposed to capital
controls which would halt the capital flight you worry about.
Say, rather, that they're scared that capital controls lead
to large-scale corruption. And that they are attracted (as am
I) by the idea that open capital markets (if they can be properly
managed) allow for large-scale capital flows from Japan and Europe
to the periphery that promise to cut as much as a decade off
the time it takes to go through an industrial revolution.
Look: I like taxes on short-term capital inflows. I like the
idea that developing countries should twist their relative price
structures to make it extremely *expensive* to import foreign-luxuries
and extremely *cheap* to import machine tools. But I am also
fearful: the rhetoric behind India's anti-developmental-state
policies of the past fifty years is very close to the rhetoric
behind Korea's policies of state-led development. I don't think
that the U.S. state has the power and competence to successfully
use tariffs and capital controls as part of an industrial policy--and
the U.S. state is, in broad perspective, one of the most autonomous
in the world.
So I think that the neoliberal bet is the best one open. And
I am pretty damn sure that getting rid of the IMF--without putting
anything else in its place--moves us from a world in which developing
countries have bad options when first-world (and third-world)
investors pull the plug on their economies to a world in which
developing countries have no options at all...
Sorry, I overstated my case and you're right, the moral
argument is ahistorical. What I should have emphasised was that
this is not, at the end of the day, about institutions, but rather
about a cyclical phenomenon (global banking panics and crashes
during the 1820s, 1870s, 1930s and in recent/current years, each
following an overaccumulation buildup). Institutionally, JP Morgan
was the IMF and Fed rolled into one for a long time, early on
century, but even he couldn't hold the line from 1929-33. So
the institution that can or can't prevent the disastrous outflow
episodes, it's in the nature of the accumulation process. Perhaps
we'd agree to agree on this.
I think that central banking privately provided by plutocrats
is a poor second best to government-provided central banking.
And I'm more skeptical about J.P. Morgan-as-central-banker than
many. But you have a good point.
What the IMF does so very well (and differently) today,
police the outflows so that nearly all of it actually flows out,
of during the earlier periods when a good chunk of it got caught
sovereign debt defaults (1/3 of all countries refused to pay,
True. But it also provides resources in times of crisis. And
*if* the crisis is successfully surmounted those resources may
ex post appear to have been extremely valuable. Stan Fischer
likes to compare Mexico after 1982 and Mexico after 1994, and
attribute a large part of the difference to the fact that sovereign
debt defaults are extremely costly to both sides.
Two absolutely "live"
(and death) questions in emerging markets remain, why do we
need "additional capital flows" given what they entail,
degree of whoring is sufficient to generate confidence by portfolio
managers and the IMF cop?
Well, back at the end of the last century the U.S., Canada,
Australia, Argentina, and some others were able to use their
access to international capital markets to accelerate their economic
development. It seems a shame to pass up one possible channel
through which developing countries can rapidly add to their capital
stocks. (Note, however, that both Harry Dexter White and John
Maynard Keynes thought that international capital flows were
too dangerous to be prohibited.)
Wait a minute. As I understand it, the IMF directly ordered
East Asian banking system contraction (and hence foreclosures
plenty of going concerns),
I had thought that the IMF sought the closure of too few East
Asian banks, not too many. You do have to shut down insolvent
(but not illiquid) institutions, after all. But I haven't looked
at it closely enough to have an informed opinion...
As for the rest, you have a lot of good points. But alas!
I have to go grade...
>I commend to you Stan Fischer's address on the IMF
and the Asian Crisis,
>March 20, which discusses this and other aspects of the IMF's
role. It can
>be found at http://www.imf.org/external/np/speeches/1998/032098.htm.
>Department of Economics
Two long selected excerpts from Stanley Fischer:
The charge that, by coming to the assistance of countries
in crisis, the IMF creates moral hazard has been heard from all
points of the political compass. The argument has two parts:
first, that officials in member countries may take excessive
risks because they know the IMF will be there to bail them out
if they get into serious trouble; and second, that because the
IMF will come to the rescue, investors do not appraise -- indeed
do not even bother to appraise -- risks accurately, and are too
willing to lend to countries with weak economies.
It would be far-fetched to think that policymakers embarking
on a risky course of action do so because the IMF safety net
will save them if things go badly.
All the evidence is many countries do their best to avoid
going to the Fund. Nor have individual policymakers whose countries
end in trouble generally survived politically. In this regard,
Fund conditionality provides the right incentives for policymakers
to do the right thing -- indeed, these incentives have been evident
in the preemptive actions taken by some countries during the
present crisis. These incentives may even be too strong, and
I agree with Martin Feldstein that it would generally be better
if countries were willing to come to the Fund sooner rather than
later. But I do not believe countries should have too easy access
to the Fund: the Fund should not be the lender of first resort;
that is the role of the private markets.
The thornier issues arise on the side of investors. Economists
tend to point to the problems of moral hazard and the inappropriate
appraisal of risks; others are more concerned that some investors
who should have paid a penalty -- and typically they refer to
the banks --may be bailed out by Fund lending. These are two
sides of the same coin: if investors are bailed our inappropriately,
then they will be less careful than they should be in future.
First the facts. Most investors in the Asian crisis countries
have taken very heavy losses. This applies to equity investors,
and to many of those who have lent to corporations and banks.
With stock markets and exchange rates plunging, foreign equity
investors had by the end of 1997 lost nearly three quarters of
the value of their equity holdings in some Asian markets -- though
to be sure, those with the courage to hold on, have done better
since the turn of the year. Many firms and financial institutions
in these countries will unfortunately go bankrupt, and their
foreign and domestic lenders will share in the losses.
Some short-term creditors, notably those lending in the inter-bank
market, were protected for a while, in that policies aimed to
ensure that these credits would continue to be rolled over. In
the case of Korea, where bank exposure is largest, the creditor
banks have now been bailed in, with the operation to roll over
and lengthen their loans having been successfully completed earlier
this week. Further, we should not exaggerate the extent to which
banks have avoided damage in the Asian crisis: fourth-quarter
earnings reports indicate that, overall, the Asian crisis has
been costly for foreign commercial banks.
None of this is to deny the problem of moral hazard. It exists,
and it has always to be borne in mind, and we need to find better
ways of dealing with it. But surely investors will not conclude
from this crisis that they need not worry about the risks of
their lending because the IMF will come to their rescue. Investors
have been hit hard. They should have been, for they lent unwisely.
But there remains the question: if it was not mainly moral hazard
that led to the unwise lending that underlies the Asian crisis,
what was it? The answer is irrational exuberance.
Financial crises based on swings in investor confidence --
on irrational exuberance, and also on irrational depression,
not really irrational in lacking some foundation in fact, but
sometimes representing an excessive reaction -- far predate the
creation of the IMF, and would not be avoided even if the IMF
did not exist. This is not something to applaud. Rather we have
to do everything we can to provide the information and incentives
that will encourage rational investor behavior. We do need, as
I will discuss shortly, to find better ways to bail in the private
sector more systematically. But we cannot build a system on the
assumption that crises will not happen. There will be times at
which countries are faced by a massive reversal of capital flows
and potentially devastating loss of investor confidence. Thus
we need in the system the capacity to respond to crises that
would otherwise force countries to take measures unduly "destructive
of national or international prosperity".
The IMF is part of that system of response, to help countries
when markets overreact. Here I would like briefly to discuss
the role of IMF lending -- and I emphasize that the IMF lends
money, and gets repaid, it does not give it away -- and the issue
of bailouts on a more fundamental level.
When the IMF lends in a crisis, it helps moderate the recession
that the country inevitably faces. That means that the residents
of that country, its corporations, and some of the lenders to
that country, do better than they otherwise would have. That
is not in any meaningful sense a bailout, provided lending of
this type can be sustained in future crises. Rather, if properly
designed to avoid as far as possible creating the wrong incentives
for the private sector, it represents rational lending -- not
grants or handouts -- in conditions when markets appear to have
To ensure that lending of this type can be sustained in future
crises, we have to be surethat the required size of Fund loans
does not keep rising, which means that in seeking to improve
the architecture of the international system, we will have to
find ways of discouraging unwise private lending -- that is to
help ensure that risk is properly priced, and to limit the required
scale of official lending, in part by finding ways of sharing
the burden between the official and private sectors.
The alternative proposed by those who would abolish the IMF
is to leave countries and their creditors to sort out the countrys
inability to service its debts. That sounds simple, but it has
rarely been so in practice. That is one reason that the IMF assisted
the Asian crisis countries to avoid defaults or debt moratoria.
In the absence of an accepted bankruptcy procedure for dealing
with such cases, given that the debts involved generally involve
both sovereign and private obligations, and given the free rider
problem, the experience -- from the inter-War period and the
1980s -- is that workouts have been protracted, and that countries
have been denied market access for a long time, at a significant
cost to growth. By contrast, in the Mexican crisis of 1994-95,
market access was lost for only a few months, and Mexico returned
within a year to impressive growth assisted by its ability to
tap the international capital markets. Similarly, in the present
Asian crisis, it is quite likely that both Korea and Thailand
will be back to the international markets within a few months.
That surely bodes well for their recoveries, which it is reasonable
to expect will begin later this year.
The second reason that the IMF tried to help countries avoid
a standstill was the fear of contagion. We believed, and continue
to believe, that a standstill by one country, at a time when
markets were highly sensitive, would have spread to other countries
and possibly other continents. That nearly happened in October,
but due to prompt and courageous action by Brazil, did not.
Of course, we cannot know what would have happened had there
been no official lending in the Asian crisis. But we do know
that the crisis has been contained, and it is reasonable to believe
that, deep and unfortunate as the crises in individual countries
have been, growth in those economies can resume soon.
* * * * * * * * * * * *
Despite its other activities -- surveillance, information
provision, and technical assistance -- the IMF is best known
for its lending. The Fund operates much like a credit union,
with countries placing deposits in the Fund, which are then available
to loan to members who need to borrow and who meet the necessary
conditions. Members' quotas in the Fund determine both the amount
they have to subscribe, and their voting shares. The size of
a member's quota reflects, but typically with a lag, the size
of its economy and its role in the world economy. 4
Total quotas now amount to a bit under $200 billion. Countries
have to pay in 25 percent of their quota (the so-called reserve
tranche) in any of the five major currencies in the SDR; the
remainder can be paid in the country's own currency.
This means that not all the quotas can be used for lending. Countries
can have virtually automatic access to their reserve tranche,
and the U.S. has drawn on its reserve tranche more than twenty
times, most recently in defense of the dollar in 1978.
In September 1997 the members agreed to increase quotas by
45 percent, about $90 billion, with the United States' share
of the increase amounting to nearly $14.5 billion. The Congress
has before it at present both the Administration's request
for the quota increase, and a request for $3.5 billion for the
United States contribution to the New Arrangements to Borrow
(NAB). The NAB will allow the IMF to borrow from a group of 25
participants with strong economies in the event of a risk to
the international monetary system. 5 It would thus provide backup
financing that could be available if the Fund runs short of regular
quota-based resources. The NAB doubled the resources available
to the Fund under the
General Arrangements to Borrow established in the 1960s.
When a member in crisis approaches the Fund for a loan, the
Fund seeks to negotiate an economic program to restore macroeconomic
stability and lay the conditions for sustainable and equitable
growth, paying careful regard to the social costs of adjustment.
The decision whether to support the country will be taken by
the Executive Board, based largely on the strength of the reform
program the country is willing to undertake. The loan is typically
tranched, paid out in installments, each conditional on the country's
meeting the conditions to which it has agreed. These procedures,
especially conditionality, constitute the adequate safeguards
required by the Articles of Agreement.
The policies agreed in a Fund-supported program typically
include fiscal and monetary policies, designed to restore viability
to the balance of payments, help restore growth, and reduce inflation.
Where appropriate, they also include
structural policies designed to remedy the problems that led
to the need to borrow from the Fund. When a country's problem
is purely balance of payments related, and can be expected to
be reversed in a short time, the Fund loan will
typically cover policies for a year, with repayment starting
after three years and concluding within five years. When the
country's economic problems are more deep-seated and will take
longer to deal with, the arrangement will last longer,
covering policies for up to three or four years. In these cases,
the program will contain, along with monetary and fiscal policy
changes, more structural measures, such as reform of the financial
system, the pension system, labor markets, agriculture, and the
energy sector. Such extended arrangements typically include reforms
that will be financed during the period of the program by World
Bank loans. Such is also the case with the financial sector and
other structural reforms in Asian countries.
Despite the common usage, "IMF program", the Fund
itself is careful to speak of a "Fund-supported program".
Ideally the program should be that of the country, and one that
its government is committed to carry out. Of course, in the loan
negotiations, the Fund will usually ask the government to do
more than it initially wanted. But because a program is unlikely
to succeed unless those who have agreed to it intend to carry
it out, a key element in the evaluation of any
agreement is the degree of the government's commitment to the
economic program which it has signed -- a conclusion which is
reinforced by the recent Asian experience, in which the Korean
and Thai financial markets both turned around
when new governments, strongly committed to carrying out the
programs, came into office. The government's commitment may be
difficult to judge, especially if it is divided, and if, as happens
not rarely, the program is being used
by those who favor reform as a vehicle to implement changes that
some of their colleagues oppose. Although a Fund-supported program
is often seen in the press as the international community's way
of imposing changes on a
country's economy, it is more often the international community's
way of supporting a government or a group within the government
that wants to bring about desirable economic reforms conducive
to long-term growth.
But why then are programs so often unpopular? The main reason
is that the Fund is typically called in only in a crisis, generally
a result of the government's having been unwilling to take action
earlier. If the medicine to cure the crisis had been tasty, the
country would have taken it long ago. Rather the medicine will
usually be unpleasant, in essence requiring the country to live
within its means or undertake changes with short-term political
costs. Probably the government knew what had to be done, but
rather than take the reponsibility, finds it convenient to blame
the Fund when it has to act. Similarly, when structural changes
have to be made, the losses are often immediate and the gains
some way off. Despite all this, there are countries where the
Fund is popular, among them transition economies that have seen
hyperinflation defeated and growth begin during Fund-supported
The secrecy that until recently has often attended Fund-supported
programs may well have contributed to their unpopularity. A public
that does not know what is being done, nor why, is less likely
to support measures that are difficult in the short-run but that
promise longer-run benefits. Governments have often been reluctant
to publish their agreements with the Fund, disliking to give
the impression that their policies were in any way affected by
outsiders. Recently, in the Korean, Thai and Indonesian programs,
the government's Letter of Intent, its letter to the management
of the Fund describing its program, has been published --another
change welcomed by the management of the Fund...
>After reading your Mexico article, I wondered how you
>would respond to Greider's assertion, apparently drawn largely
>economists, that most countries following the neo-liberal
model are failing,
>and that rapidly developing countries have generally taken
>approach (Greider emphasizing the importance of capital controls).
The most rapidly growing countries have taken a "Japanese"
approach. Unfortunately, the *least* rapidly growing countries
have taken a "Japanese" approach to...
If you have a government strong enough, independent of elites
enough, and interested enough to undertake fundamental land reform
to ensure a relatively egalitarian distribution of income; a
bureaucracy *honest* enough to carry out the missions the central
government assigns it (rather than using its leverage to extort
bribes and reward its relatives); subsidy policies that promote
industrialization while quickly withdrawing support from industries
that are too poorly-led or poorly-positioned to generate significant
exports; tariff policies that do not hinder attempts to boost
exports by making it difficult for export industries to get the
stuff that they need--if you have all these things, then you
can follow the "Japanese" model of state-led development,
and be very successful.
If not--well then, as Lant Pritchett of the World Bank puts
it, there's nothing worse than state-led development carried
out by an anti-developmental state. Restrictions on imports and
exports--capital controls, import licenses, and so forth--become
ways in which segments of the bureaucracy can reward the politically
powerful or their relatives; subsidy policies prop up employment
of factions that the government wishes to keep in its corner
rather than assist industrialization; corruption spreads throughout
the whole government; and the fact that the government is daily
making thousands of decisions that alter the distribution of
wealth means that the distribution of wealth gets more unequal
because only the elites have access to the levers that the government
uses to redistribute the stuff.
The economy stagnates.
Look at Wole Soyinka's _Nigeria:_Open_Sore_of_a_Continent_,
at Robert Bates's _Markets_and_States_in_tropical_Africa_, or
Carlos Diaz-Alejandro's _Essays_on_the_Economic_History_of_the_Argentine_Republic_
to get an idea of how catastrophically wrong the "Japanese"
model of state-led development has gone in much of the third
world (and in parts of the first world: Argentina in 1929 was
a first world nation).
The "neo-liberal model" is, at some level, an admission
of defeat: a bet that if you cut back on the government's role
in the economy, you are likely to destroy more of the rent-seeking,
corruption-causing, growth-retarding actions of the government
than you are likely to hinder the pro-growth, pro-development
programs (if there are any).
How this bet is going to turn out is still unclear. It looks
like a good bet to me. But it would be far, far better to get
a proper Japan-style developmental state up and running--neo-liberal
policies are for countries where such a successful developmental
state is simply not an option.
>Greider also predicts a coming global supply crisis similar
>to the Depression. Krugman rather glibly mocks him, saying
there are no
>supply crises, only liquidity problems solved by monetary
Central banks do not always act properly: they could blow
it, and we could have another great depression. But Krugman's
right. We don't have--we never have--an "oversupply"
problem: we have an "underdemand" problem.
Global productive capacity today is something like 60 times
what it was a century ago; something like 200 times what it was
two centuries ago; something like 300 times what it was three
There are always people talking about how the economy is "too
productive", and how "technological unemployment"
and "secular stagnation" because of over-productivity
is inevitable. (In fact, if you read _Brave_New_World_, most
of the social control exercised by the elite over the population
is an attempt to artificially stimulate consumption to avoid
such a "supply crisis."
After hearing "wolf" cried for two centuries, I
understand where Paul is coming from. And I think that this part
of Greider's argument simply cannot be taken seriously--because
he doesn't make even a feeble attempt to say why this time the
prophets of a supply crisis are correct.
Now corporate economists have something to worry about: high
capacity in their industries and low demand means low prices
in their industries--good for consumers, but not for the continued
employment of corporate economists.
I think that there are actually two things to worry about--and
Greider's book is not helpful for thinking about either one of
(I) So far, the past two generations have seen U.S. income
inequality widen sharply, but increasing trade has played little
if any role in the widening. What is going to happen in the next
two generations, because globalization certainly has the potential
to inflict massive changes on the U.S. income distribution?
(II) We have no reason to feel confident that the IMF and
the world's central banks are up to the task of avoiding another
Great Depression. Even a relatively small international financial
panic like Mexico 1995 was contained by only the narrowest of
margins. (No thanks to William Greider, I might add.) And it
was contained over the objections of the government of Britain,
the government of Germany, the Republican caucus in the House,
the Democratic caucus in the Senate, and Banking Committee Chair
Brad De Long
>No, they were significant. Significantly worse if I
>correctly, in that the IMF will charge HIGHER rates and demand
>SHORTER repayment period in the wake of the congressional
>Enlighten me if I'm mistaken, please.
No, you are not mistaken. I know that I want (and Joe Stiglitz
wants) a kinder, gentler IMF, willing to loan more money for
longer periods of time at lower interest rates with less conditionality;
and willing to broker debt-forgiveness deals.
That's not what we got. We got an IMF that is going to loan
at higher interest rates in the future. I don't think *that*
much damage was actually done--the IMF does have more resources,
after all, and is able to loan more for longer terms--but some
damage was done.
An IMF that is out of money is not a kinder, gentler IMF--willing
to loan more money for longer periods of time at lower interest
rates with less conditionality; and willing to broker debt-forgiveness
deals. If you wanted a nastier, rougher IMF, you voted against
recapitalization. Credit to the AFL-CIO for recognizing this.
>Does anyone (Doug?) have any information of what is
actually going on in
>Indonesia. The official transmission belts (aka media) are
>unreliable, and they focus thier coverage along the lines
of "angry mob
>looting the sacred cow of capitalism - private property."
I think it was
>Noam Chomsky who graphically demonstrated the media bias
>reporting by actually measuring the volume of the Mossad
>(aka New York Times) [Note: why the antisemitism?] coverage
and juxtaposing it with their coverage of the
>alleged "communist attrocities."
I think that the New York Times is still *way* *behind* on
its coverage of Stalinist atrocities. Recall their lines during
the 1930s on Stalin's Russia and during the 1970s on Mao's China...
Suharto. Tyrant seated on a throne of skulls. Killed 500,000
Communists, suspected Communists, ethnic Chinese-Indonesians
who it was to someone's advantage to claim was a Communist, random
ethnic Chinese-Indonesians, and so forth--plus another 200,000
dead in East Timor over the past two decades. Supported by the
United States in one of our not-very-smart exercises in realpolitik
on the grounds that someday Indonesia might be a useful ally
against China should China turn expansionist and imperialist.
Suharto. Corrupt as Mobutu. The line in expatriate circles
in Jakarta for decades was that his wife's name, Tien, was short
for "Tien percent."
Suharto. Who has presided over a quadrupling of Indonesian
real GNP per capita. Some of this was the result of the OPEC
oil boom of the 1970s--but in other high-population OPEC producers
like Venezuela and Nigeria, the political dynamic set in motion
by the oil boom ended up making the country poorer than had it
never had any oil at all. Suharto deserves some "objectively
progressive" points for not following the path that has
in Nigeria led to General Abacha.
Suharto. Who has presided over a *sharp* rise in income and
wealth inequality--but even so, estimates I have seen suggest
that the average working-class Indonesian today has about twice
the material standard of living of his or her counterparts forty
years ago (and the average upper-class Indonesian today has perhaps
ten times the material standard of living of his or her counterparts
forty years ago).
Suharto. Who lacked sufficient control over his country last
year to fulfill the promises he had made about stopping the burning
and deforestation that created the southeast asian smog of 1997.
The IMF. Which is trying to *loan* Indonesia $43 billion so
that the sudden wave of domestic and international capital flight
does not send the economy into a deep depression, but only into
a shallow recession. The problem is that the IMF is not a grant
but a loan-making organization, so that it wants its $43 billion
back *with* *interest* in time for it to loan it out again to
someone else facing a panic wave of speculative capital flight
in two or three years when the next international financial crisis
Thus as a result the IMF's policies--the conditions that it
imposes on you if you want to borrow $43 billion--are crafted
with an eye toward, first, making sure that the borrower country
will repay its loan in two or three years. This means that the
IMF wants to see, first, an export surplus against which loan
principal and interest payments can be charged--and thus needs
to see a fall in domestic demand (and a rise in domestic unemployment)
and a fall in the exchange rate (and thus a sharp rise in the
domestic-currency price of internationally-traded staple goods
like rice) in order to diminish imports and boost exports and
create the export surplus to repay the loan.
Only after it is sure that the recommended policies will be
sufficient to guarantee repayment does the IMF turn its attention
to trying to make sure that economic growth in the borrower country
resumes as fast as possible.
If you ask Stanley Fischer why the IMF thinks that loaning
$43 billion to Indonesia for two years would do any good--or
would do more good than simply having Indonesia suspend payments
and repudiate its debt--he will point to the contrast between
Mexico after its 1982 debt crisis and Mexico after its 1994 exchange
crisis. After the first suspension of payments and partial repudiation,
it took seven years before GDP per worker reattained its old
levels and began to rise. After the second IMF loan and Exchange
Stabilization Fund loan rescue, it took only one year for Mexican
economic growth to resume. The distributional consequences of
both crises were bad--but I have seen nothing to suggest that
the distributional consequences were worse the second time than
I think we would live in a better world if the IMF worried
less about getting its money back. I think an IMF with four times
the resources willing to loan twice as much for twice as long
with half of the conditions imposed on domestic economic policies
would do a lot more good in allowing countries to cope with the
aftermath of policy disasters or of international capital panics.
But that's not the way the political winds are blowing. Both
Lauch Faircloth and Ralph Nader appear to want not a larger,
kinder, gentler IMF but no IMF at all--in which case there is
no one to loan $43 billion on any terms at all to developing
countries that suddenly see their balances of payments go completely
haywire because of international capital panics. Stanley Fischer
and Michel Camdessus have bet the future of the IMF on successful
resolution of this East Asian crisis. Indonesia's spiral suggests
that their bet is not at all a sure thing.
>So if Bhagwati took you out of context, what is your
position on capital
My position is massively confused and inconsistent...
I like the idea that the industrializing periphery can borrow
on a large scale from the industrial core in order to cut perhaps
a generation off of the time needed to go through the industrial
revolution (and--perhaps more important in the very long run--the
I'm not very scared that the (successfully) industrializing
parts of the periphery will wind up enserfed in a form of global
debt peonage. Leland Stanford and Jay Gould did a wonderful job
at making sure that British investors who loaned to American
railroads wound up owning not high dividend-paying enterprises
but instead overcapitalized shells on the point of bankruptcy.
I think that this process will be repeated...
I am scared that (unsuccessfully) industrializing parts of
the periphery may get into bad trouble as kleptocrats skim off
the foreign loans to live on the Riviera and leave the country's
taxpayers to repay. When Erich Honecker wanted to redistribute
wealth to himself from the East German people, all he could get
was a big house, a few imports, and a deer park. By contrast
modern capital financial markets allow Suharto and family to
skim off 3 billion? 10 billion? 20 billion? Enough to be worried
I do believe that *if* we are going to go the global-capital-mobility
route, we need a kinder, gentler IMF: one that makes bigger loans
at lower interest rates for longer periods requiring less conditionality
when we have an episode like Europe '92, Mexico '94, or East
Asia '97 when industrial core investors panic and flee. Thus
I am depressed at seeing my options for change reduced to either
Lauch Faircloth (who thinks that 30 million people in East Asia
need to be thrown out of work because East Asian borrowers who
overborrowed *must* be punished)or Ralph Nader (who thinks that
30 million people in East Asia need to be thrown out of work
because New York lenders who "overlent" *must* be punished).
There's a depressing symmetry here.
Here's a first-draft response to Bhagwati, by the way:
I open my May/June _Foreign Affairs_ to discover myself pilloried
in an article by Jagdish Bhagwati between Paul Krugman and Roger
C. Altman (excellent company to be in, by the way: much better
than I am used to) as a banner-waving proponent of international
capital mobility, guilty of "assum[ing] that free capital
mobility is enormously beneficial while simultaneously failing
to evaluate its crisis-prone downside."
I rub my eyes in surprise. I had not thought of myself as
a banner-waving proponent of international capital mobility.
I wish that Jagdish Bhagwati's research assistants had shown
him the sentence from my January 28 Los Angeles Times op-ed after
the two he quotes (it reads: "But the free flow of financial
capital is also giving us one major international financial crisis
every two years"); or shown him my evaluation of the causes
of the crisis a paragraph but one above where he quotes (it reads:
"the sudden change in [market] opinion [toward East Asia]
reflects not a cool judgment of changing fundamentals [of East
Asian growth] but instead a sudden psychological victory of fear
If I am the the point man waving the banner, all I can say
is that the ranks of the army of international capital mobility
must be thin indeed.
But since I have apparently been elected, let me pick up the
banner and wave it around a few times, for on this issue I am
what Jagdish Bhagwati calls a "liberal"-- someone who
believes that we should neither encourage governments to choke
off international flows of saving and investment (as Bhagwati
thinks), nor look with schadenfreude on and discourse on the
long-run salutory effects of the great depressions caused by
international financial panics; but instead try to have our cake
and eat it too: to reap the benefits of international capital
mobility, and to minimize the human costs of recurrent crises
through appropriate and well-funded international central banking
institutions and practices.
We should try to have our cake because the potential benefits
of international capital mobility truly are mammoth. Between
1994 and 1996 some $200 billion of international capital flowed
into Malaysia, the Philippines, South Korea, and Thailand. In
all of these countries the private return on investment is high--higher
than in the industrial core. In all of these countries the social
return on investment is higher still: if the economic history
of the past two centuries teaches us anything, it teaches us
that investments in modern machine technologies are a very good
if not the best way to upgrade the skills of the labor force
and gain the organizational expertise necessary for high total
This inflow of capital to these four countries was worth at
least $15 billion a year and perhaps as much as $40 billion a
year in higher GDP to the receiving countries even after taking
account of the interest, dividends, and capital gains owed to
investors from abroad. Just as the flow of finance from the British
core to the periphery in the late nineteenth century played an
important role in producing the Australian and North American
economies that have had the world's highest standard of living
in the twentieth century, so the flow of finance from today's
industrial core to the NIC periphery has every prospect of cutting
a generation or so off of the time needed for East Asian workers
and consumers to achieve industrial core levels of productivity
and economic welfare.
Calculations of the effect of international capital mobility
welfare are considerably more complicated and uncertain than
calculations of the effect on growth, but they carry the same
message: the ability to attract international capital to boost
development or cushion
the costs of macroeconomic policy mistakes can be very, very
We should try to eat our cake too because the costs of unmanaged
international financial crises are horrific. Because of the Latin
American debt crisis of 1982 the decade of the 1980s was lost
to Latin American development--leaving the typical Latin American
country between five and ten percent poorer at the beginning
of the 1990s than it would have been in a counterfactual world
in which borrowing from abroad had not financed oil imports and
elite consumption in the late 1970s. The financial crisis of
1873 saw the share of the U.S. non-agricultural labor force employed
in building railroads fall from perhaps eight to perhaps two
percent. And international financial crises turned the global
recession of 1929-1931 into the Great Depression, generating
not only a decade of relative poverty but the rise of the Nazi
regime and the fifty million dead from World War II in Europe.
If there were no reasonable prospect of successfully managing
international financial crises, then I would agree with Professor
Bhagwati: the risks of an 1873 or a 1982 or--worst of all--a
1933 would then significantly outweigh the benefits of capital
mobility. But there is every reasonable prospect of successfully
managing international financial crises. The much-larger-than-anyone-anticipated
Mexican crisis of 1994-1995--successfully handled--saw Mexican
economic growth resume after a single year of recession. The
East Asian crisis of 1997 may not even generate an absolute recession:
as of this writing it looks as though East Asian GDPs will not
decline, but instead that growth will pause in 1998 and resume
But successful handling of international financial crises
requires political and economic skill. It requires rejecting
the arguments of the Wall Street Journal's editorial page that
East Asia "needs" a deep, prolonged recession with
mass unemployment to punish entrepreneurs and banks in NICs who
overborrowed. It requires rejecting the arguments of Ralph Nader
that East Asia "needs" a deep, prolonged recession
with mass unemployment to punish New York financiers who overlent.
And it requires rejecting the arguments of Jagdish Bhagwati that
international capital mobility--good enough to finance the industrialization
of the NICs of Australia, Canada, and the U.S. a century ago--is
too risky for the NICs of today.
On Thursday, January 16, a $3.5 billion electronic funds transfer
reached the Federal Reserve Bank of New York: the government
of Mexico repaying the last piece of the more than $13 billion
that it borrowed from the United States during the peso crisis
of the winter of 1995.
President Clinton saw nothing but sunshine: "The United
States is being repaid more than three years ahead of schedule.
We have earned more than half a billion dollars on our loan.
Our exports to Mexico are at an all-time high and the Mexican
economy is back on track... The Mexican economy grew by over
four percent.... The exchange rate has stabilized. Inflation
has been cut nearly in half. Close to one million new jobs have
been restored to Mexico since the crisis bottomed out. And Mexico
has regained the confidence of international investors. This
is a remarkable turnaround."
Clinton praised his own policies, that he said had successfully
protected "a strong and growing market for American products
that supports 700,000 jobs here. We helped Mexico to sustain
its program of democratic reform and economic growth. And we
helped to give the Mexican people renewed hope for a more secure
Reading this, I winced. I did not wince because the U.S. policy
of loaning Mexico lots of money at usurious interest rates during
the winter 1995 peso crisis was a mistake--it was not a mistake,
but the more-or-less successful carrying out of the standard
governmental role of preserving the liquidity and functioning
of the financial system during an irrational financial panic.
I winced because, once again, President Clinton was overpromising.
There is a lot that is not sunshine in Mexico's economy, and
in U.S. economic relations with Mexico. Very bad things are likely
to happen to Mexico's economy, and in Mexico's political system,
in the next few years. Whether the Mexican government's decision
to open its economy to foreign competition and privatize state-owned
industries will be a success is still not clear: it ain't over
'til it's over--and it ain't over.
When the next big setback to Mexican economic growth or to
Mexican political democratization occurs the yahoos, who think
that we should (i) ban trade with Mexico (ii) build a big electric
fence along the border (iii) close our eyes and (iv) hope Mexico
goes away, will be stronger. They can ask what happened to the
"remarkable turnaround" and to the "sustained
program of democratic reform and economic growth."
Moreover, Clinton was overselling the success of U.S. government
policies as well. He talked as though the U.S. government deserved
an A for its actions in the Mexican peso crisis. But in fact
the U.S. and other governments deserve, at most, a C+. The Executive
Branch and the Federal Reserve deserve better grades, but the
Congress and the governments of other leading industrial nations
deserve worse. To paper over the history by which government
actions during the peso crisis fell short of the mark is to make
it more likely that we will repeat the same mistakes--and more
likely that the next such crisis will have a much more unhappy
It is safe to say that virtually no economists saw the peso
crisis of early 1995 coming.
Economists divide countries into two groups: those with governments
that are solvent--that are balancing or could easily balance
their spending and their revenues--and those with governments
that are not solvent--that have no way to balance their budget,
and next to no ability to raise taxes in the future to pay off
what they might borrow today.
Those in the first group are vulnerable to small-scale speculative
attacks on their currency, should international investors think
that the exchange rate is too high. For example, the fall of
1992, for example, speculators made a lot of money by betting
that the British pound's exchange rate was too high, and selling
pounds back to the British government as fast as they could.
When the cost of buying back all these pounds became too high
the British government cracked, devalued its currency, and the
exchange rate settled into a new value roughly twenty percent
lower. Such a small-scale speculative attack is an embarrassment
for a government but not an economic disaster.
Those in the second group are vulnerable to much worse crises:
crises in which not only do speculators bet that the currency
is going to lose value, but in which virtually all domestic and
foreign investors decide that they need to pull their money
out of the country immediately. Such a large-scale crisis sees
the currency lose more than half its value in a matter of days,
sees interest rates rise to levels that bankrupt businesses and
banks, sees a spiral of high inflation take hold, and sees a
depression. Such a large-scale flight of capital is an economic
disaster for the country.
Before 1995 Mexico was in the first group of countries. Its
government budget was balanced. International investors had ample
confidence in its long-run development prospects, and funnelled
large sums of investment capital into Mexico--in spite of the
political risks associated with the corrupt and authoritarian
ruling Institutional Revolutionary Party. It would violate the
canons of financial market rationality if--without very bad news
about Mexico's government finances--the same investors eager
to pour money into Mexico in 1993 were to suddenly decide that
they had to stampede out, no matter how much of their investment
they were to lose.
So much the worse for the canons of financial market rationality.
The same investors who had been eager to stampede into Mexico
in 1993 stampeded out in the winter of 1995. And economists--including
me--were left dumbfounded at the spectacle of a complete currency
collapse and liquidity panic in a country that (our models had
told us) should have been vulnerable only to a small-scale devaluation.
In a matter of weeks Mexico became a country that could not borrow
to refinance its government debt from anyone in the private market,
at any price.
The consequences for the Mexican economy? Think of an upper-middle-class
American family with a rolling balance of -$5,000 on its credit
cards, no other liquid assets, and no prospects for a home equity
loan. Think what would happen to it if suddenly its credit card
company cut off further purchases and demanded immediate repayment.
That's what happened to the Mexican economy in the winter of
1995. Perhaps one in ten jobs in Mexico disappeared.
When financial markets fall into such a panic where no one
will lend because no one else is lending, the right thing is
for some very large authority--some government, central bank,
or international organization--to act as a "lender of last
resort": put its own money up or guarantee repayment in
order to keep the flows of capital going until the panic passes.
When the panic passes, people are happy to make the loans and
hold the securities that they would not touch before--just as
private sector investors are happy to lend to the Mexican government
So when the Mexican panic hit in the winter of 1995, the Federal
Reserve and the Executive Branch came up with a plan to provide
loan guarantees to calm and reassure the panicked market. The
United States government would say that should for any reason
the Mexican government not repay its debts, the United States
government would step in. So President Clinton introduced and
Chairman Greenspan backed a bill for Congress to authorize guarantees.
Such a law should have slid through the Congress quickly: both
the new Speaker of the House Newt Gingrich and the new Majority
Leader of the Senate Robert Dole had been strong supporters of
the policy of economic engagement with Mexico. Their political
fortunes were at stake should the Mexican economy collapse into
chaos as well.
But then Gingrich's chief lieutenant, Majority Leader Armey,
started dragging his feet. Right-wing Republicans like Patrick
Buchanan began calling any assistance to Mexico "Goldman-Sachsanomics."
Ex-consumer advocate Ralph Nader demanded that Congress vote
against the loan guarantees. One House Republican, Zach Wump,
came out of a briefing by Chairman Greenspan on the rationale
for assistance crowing that this was "an issue made for
talk radio." California Senator Feinstein, whose constituents
stood to suffer the most from a severe depression in Mexico,
complained to Treasury Secretary Robert Rubin that she did not
see why she should vote for it. Even the--usually staunchly internationalist--core
of the establishment media, the New York Times and the Washington
Post, ran incoherent op-ed pieces denouncing loan guarantees.
Gingrich and Dole were soon missing in action: if President
Clinton wished to provide assistance to Mexico by loaning out
the Treasury's Exchange Stabilization Fund (never mind that that
Fund had never been used in such a way before), they would not
stand in his way. But they were not going to spend any of their
political capital rallying support.
Such rapid erosion of support was horrifying. The United States
government had been undertaking lender-of-last-resort operations
to calm markets in financial crises since at least the Gold Panic
of 1870. When such operations have not been undertaken--as when
the Federal Reserve failed in its mission at the end of the 1920s,
at the start of the Great Depression--the consequences have been
disastrous. Yet this one-hundred and twenty-five years of historical
experience did not register on the minds of the Congress, even
though the seekers of the loan guarantees were the head of the
Democratic Party, President Clinton, and the senior Republican
in Washington, Chairman Greenspan.
So when U.S. assistance did materialize in the Mexican panic
of 1995, it came later than it should have because several weeks
had been wasted in the search for Congressional approval. And
it came on a smaller scale than it should have, because it was
limited to the amounts the Executive Branch could claim it could
commit without Congressional authorization.
It is true that late is better than never, and that some is
better than none. But late is still late. And some is not as
good as more: the support package as implemented probably turned
the Mexican Great Depression of 1995-1997 into merely a recession,
but a somewhat larger package might well have saved another million
jobs in Mexico, and turned the depression we had into a mere
Perhaps the World War II battle of Dunkirk is a good analogy.
At the Battle of Dunkirk it looked as though the Germans were
going to capture 300,000 British soldiers and all their tanks,
artillery, vehicles, and equipment. Instead the 300,000 soldiers
got away across the channel, and all the Germans captured was
their equipment, vehicles, artillery, and tanks. The British
House of Commons cheered. But Prime Minister Winston Churchill
pointed out that "wars are not won by evacuations."
Dunkirk was a SNAFU and a disaster--but not as bad a disaster
as it for a time looked like it was going to be.
And Mexico? Mexico's unemployment rate has come down several
points since it peaked in July of 1995. Mexico's exports are
booming. The long-term benefits from the economic policy reforms
remain because tariffs and non-tariff barriers to imports have
been slashed, restrictions on foreign investment have been lifted,
and state-owned enterprises have been privatized.
But many of Mexico's banks are still in danger of bankruptcy.
Mexican inflation is still double-digit. Whatever recovery from
the nadir of the depression in 1995 has been accomplished has
not trickled down to the streets of Mexico City.
Moreover, Mexico's progress toward democracy is not assured.
The Institutional Revolutionary Party is corrupt to the core
and not eager to hand over power. And the underpaid police are
vulnerable to bribery financed by the high prices U.S. consumers
pay for drugs moving north.
Mexico's destiny is its own to make. It is wide open. There
is an apocryphal story that Zhou Enlai was once asked his opinion
of the consequences of the eighteenth-century French Revolution:
his answer was, "It is too soon to tell."
Mexico's destiny is probably a better one as a result of recent
U.S. policies. NAFTA has probably increased the odds that successive
Mexican governments will continue to dismantle the structures
of government control and political influence that have kept
Mexico's growth far below what it might have been. Support for
the peso in the 1995 panic did keep Mexico's liquidity crisis
an economic misfortune, as opposed to an economic disaster. President
Clinton is entitled to be happy that he did the right thing.
But "the Mexican economy... back on track"? "A
remarkable turnaround"? A sustained "program of democratic
reform and economic growth"? Renewed hope for a more secure
future"? Nope. The future remains uncertain, and the risks
immense. It would be more accurate to say that the Mexican reformers--and
their supporters in the U.S.--have not yet crapped out. It ain't
over 'til it's over--and it 'aint over.
Brad De Long
>So if Stanley Fischer is so smart, why did the IMF
respond to Asian
>deflation with austerity packages, and to Russian collapse
>packages? Why is Russia committed to running a budget surplus
I think that the answer to your questions is an expansion
of my point: that "Stan Fischer is a lot smarter than Montagu
Norman... but Lauch Faircloth is not."
I think that our policy toward Russia is insane. I think that
having spent $4 trillion in the generation before 1990 buying
weapons to defend ourselves from the Commies, that any sane U.S.
government would have been willing to spend a tenth that amount--$400
billion--on a Marshall Plan for the former Soviet Union. I think
that a hundred years from now historians will judge that the
greatest crime committed by Ronald Reagan was that his tax-cut
rhetoric robbed the U.S. government of the ability to do the
right thing at the end of the Cold War.
As to why the IMF responded to Asian deflation with austerity
packages, I wish that the IMF had loaned a lot more money to
East Asia on easier terms. But I don't see how it could have
done so, at least not without a mammoth injection of new capital.
And that is nowhere on the horizon.
I asked my patron (and the former chair of my dissertation
committee Lawrence Summers) this same question: why isn't the
IMF loaning East Asian countries twice as much for twice as long
at lower interest rates with less conditionality?
His answer had two parts--
(i) That I must remember Mexico in 1995: how the IMF and the
U.S. Treasury had tried to do more, and had been pulled up short
by others. (I do remember Newt Gingrich trying to make administration
acceptance of the Balanced Budget Amendment a precondition for
even bringing up aid to Mexico for a vote; I do remember the
British and German Executive Directors of the IMF registering
strong opposition to the Mexican loan package; I do remember
Principal Deputy Managing Director Fischer stating at a San Francisco
Federal Reserve conference that most of the 6% fall in Mexican
real GDP in 1995-1996 could have been avoided had the peso support
package been the size that the U.S. Treasury and the IMF had
(ii) That, as he politely put it, "neither your friends
on the left nor your friends on the right want to see a larger,
better-funded IMF. Where is the political coalition to support
increasing the IMF's resources going to come from?"
The IMF is not a central bank: it cannot create large amounts
of purchasing power to pull countries (or the world) out of global
recession. It can provide temporary injections of liquidity to
(somewhat) soften the trauma when the world economy (and its
own government) have just creamed some developing economy. But
a kinder, gentler IMF would need to be a better-funded IMF.
And at the moment we are caught between Lauch Faircloth (who
doesn't want to see a kinder, gentler, refunded IMF because such
an IMF would reduce the amount by which East Asian workers suffer),
and Ralph Nader (who doesn't want to see a kinder, gentler, refunded
IMF because such an IMF would reduce the amount by which New
York-based investors suffer). Moreover, we have people at the
head of the Bank of Japan and the European Central Bank who may
be as clueless as Montagu Norman was...
>broadly, why has the IMF been pushing deflationary policies
- not just
>fiscal contraction, but the encouraging 120 poor countries
to compete for
>the privilege of exporting to 20 rich ones - on the whole
damn world at
>least since Mexico's 1982 default?
Exports to the first world are the best way to get the purchasing
power to buy the industrial capital goods that embody so much
modern technology--and those countries that have exported and
used the proceeds to boost their investment rates have done much,
much better than other developing countries over the past half
Of course, there are those developing countries that have
boosted exports and used the proceeds to pay for elite vacations
in Davos. Those have not done so well...
And most developing countries have not gone for export promotion:
export promotion (usually) requires a relatively low exchange
rate. The elite is much happier with controls on imports that
keep the non-elite from buying from abroad, with the high exchange
rate controls on imports generate, and with the ample ability
to purchase foreign luxuries that a high exchange rate allows...
I agree that if the developing world as a whole actually listened
to what the IMF economists said in their Article IV consultations--that
if all developing countries tried to follow export-led development
strategies--we would see exactly how elastic first-world demand
for third-world imports is. But there are powerful domestic political
reasons why only East Asia and Southwestern Europe undertook
the export-led road to growth in the second half of the twentieth
century. Those reasons remain. There are many places in the world
today where the state is not an executive committee for managing
the affairs of the business class, and there is no reason to
expect economic growth in such places...
Brad De Long