Time to Terminate the IMF

cato.org

by Anna. J. Schwartz

Anna J. Schwartz is a research associate at the National Bureau of Economic Research and author of Time To Terminate the ESF and the IMF, a new study by the Cato Institute.

Added to cato.org on October 6, 1998

The bailout model of the International Monetary Fund and the U.S. Treasury is an abject failure. Instead of rescuing the financially distressed Asian and Russian economies, the bailouts have worsened their situations.

When the IMF was created in 1944, its well-defined purpose was to enforce the rules in a fixed exchange rate system about altering a country’s exchange rate when fundamental adjustment was needed, as well as to provide temporary resources to deal with a country's balance-of-payments problems. With the collapse of that system in 1971, the IMF lost its purpose. The switch to floating exchange rates eliminated its exchange-rate regulatory role and changed the character of balance-of-payments problems. Since the early 1970s, the IMF has been seeking to reinvent itself. Until the 1995 Mexican bailout, it had pretty much decided that it would promote its purpose as providing advice and information to its members, which number more than 180 countries. That, however, proved to be only an interim stop on the road to acquiring a new identity.

The IMF's role in the 1995 Mexican bailout planted the idea that the fund should serve as an international lender of last resort. The problem with this program is that its advocates have little understanding of the meaning of a lender of last resort.

Anna J. Schwartz is a research associate at the National Bureau of Economic Research and author of Time To Terminate the ESF and the IMF, a new study by the Cato Institute.

Central banks have the capacity to serve as their banks' lenders of last resort. They can create high-powered base money (currency in circulation plus reserves), they can act quickly, and they can decisively stem a banking panic. The IMF lacks each of those features. It cannot create high-powered money. It can issue Special Drawing Rights to central banks that can monetize the SDRs in their national currencies. But the IMF cannot issue SDRs without authorization by its membership. It cannot act quickly. The decisions of its executive board are subject to the votes of executive directors who consult their national authorities. To provide money to a borrowing country, the IMF first engages in lengthy negotiations of a reform program. A national central bank can promptly provide liquidity to the money market without prior external approval. Moreover, a national lender of last resort rescues solvent banks temporarily short of liquidity. It does not rescue insolvent institutions. The IMF has no such inhibition.

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When the IMF was created in 1944, its well-defined purpose was to enforce the rules in a fixed exchange rate system...With the collapse of that system in 1971, the IMF lost its purpose...[and] has been seeking to reinvent itself.

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The IMF reinvented itself again after the Mexican bailout in 1995. The lesson the fund took from the bailout was that it needed a stockpile of money if it was to act as a lender of last resort in the next financial crisis, given that it lacks the capacity to create high-powered money. In early 1997 the IMF announced a plan to raise cash to rescue a country in distress by creating a special $28 billion fund. By 1998 that proposed line of credit was increased to $47 billion. In addition, the IMF decided to increase the quota that each member contributes. For the United States, the total contribution amounts to $18 billion. That amount is what the administration is now asking Congress to appropriate. Since mid-1997, the appeal to Congress to allocate funds to the IMF has been based on the plight of the Asian countries.

Short-term renewable loans denominated in foreign currencies were the undoing of Mexico in 1994; yet the Asian countries welcomed the same form of credits two years later, and the lenders came off scot-free in 1995 as the banks probably will in 1998, because of the IMF. A big pot of IMF money is clearly the wrong response. Bailouts are not needed, especially in today's world of deep capital markets that are ready to lend to liquidity-constrained countries at interest rates that reflect credit risk.

As the financial turmoil in Russia this summer proves, money infusions have not bought Russia's compliance with pledges to convert a command economy into a market-oriented one.

Within Congress the IMF faces two groups of opponents: liberals who seek labor and environmental reforms in the countries to which the IMF is prepared to lend as a quid pro quo for supporting the increase in funding, and conservatives who seek concessions related to abortion legislation or the way in which the IMF operates. Congressional opponents of whatever stripe should not demand a quid pro quo but should reject the increase in IMF funding on principle.

The countries in Asia that are experiencing financial problems will either adopt measures to reform their banking systems, to eliminate political domination of credit allocation, and to earn restoration of their creditworthiness in international capital markets, or they will not. To do so requires political resolve, not the IMF. Not to do so means those countries will fail to grow out of their problems. The world financial system will not be undermined if the IMF does not bail out those countries. Low-income countries have gotten into trouble financially many times in the past two centuries. Investors who lost money in ventures in those countries were hurt, and the countries involved had setbacks. The world did not collapse.

The IMF is weak on crisis prevention. It says it warned Asian countries and Russia against bad policies, but they rejected its advice. If the moral authority of the IMF as a source of sound advice cannot win the rewww.cato.org spect of its client members, it is in the wrong business. Reform of the IMF is not the answer. It should be shut down.