A Fischer-eye view of meltdowns in the global financial system

IMF Essays from a Time of Crisis
October 15, 2004

Stanley Fischer served as the first deputy managing director of the International Monetary Fund from 1994 to 2001. His was an eventful watch.

In December 1994, a massive devaluation by Mexico precipitated problems not only in other Latin American countries but also in Southeast Asia and Central Europe. In July 1997, the Thai baht was devalued. This was quickly followed by devaluations in Malaysia, the Philippines, South Korea and Indonesia. Subsequently, the five countries went into an economic tailspin. Within a year industrial output in the region had fallen by anything between 5 per cent (Korea) and 20 per cent (Indonesia). In August 1998, the collapse of the Russian rouble and an associated debt default rocked global markets regionally and as far afield as Brazil and Wall Street. For the emerging markets, this was a time of crisis.

On each occasion, the IMF was intimately involved in shaping the policy responses of the countries concerned. It is for this reason that it has been blamed for the subsequent recessions, industrial unrest and food riots that occurred. The critics are much less generous in giving credit for the strong economic recoveries that followed, but that is the nature of political theatre.

This book consists of 16 essays, all but two of which were written during the author's time with the fund. They explore the evolving role of the IMF and the major policy challenges it faced. In view of the sustained fire the organisation has come under, it is perhaps no surprise that there is a defensive air about some of his comments. An example would be his acknowledgement that "the initial fiscal adjustment in Asia had probably been too strong", immediately followed by the judgement that this "cannot have had a significant (overall) impact" due to an early reversal of policy. Perhaps so, but there are many who would agree with the first part of the observation but demur from the second. The patient recovered but was the surgery unnecessarily brutal? It is an issue addressed implicitly by a number of the essays.

The IMF came into existence after the Bretton Woods conference in 1944. It was set up to police the adjustable-peg exchange rate system. In 1971, President Nixon moved the US off the gold standard and two years later the system collapsed, leaving currencies free to float against the dollar. The IMF's policing role within the developed world (though not its surveillance function) ceased. Its last loan to a high-income industrialised country was in 1977.

The IMF's original role was tactical: money was made available to help member countries through balance-of-payments difficulties. It now plays this role in the developing world. Increasingly, it has become a quasi-development agency, some of whose functions overlap with those of the World Bank, leading to turf battles.

While the author is keen to point to the worthy analytical, surveillance and advisory functions the IMF discharges, its role as lender attracts most attention. One of the best essays in the book is on the need for an international "lender of last resort".

It is clearly of benefit to society that assets not needed immediately are available for others to use. For a given level of resources, this maximises output. The banking system achieves this by allowing deposits (assets not immediately needed) to be loaned to others at a price. The process, however, is intrinsically unstable. If the market perceives that a borrower is in difficulty, credit can be removed swiftly. This withdrawal of resources can, in turn, produce a collapse in output, making a payment default all but certain. In these circumstances, investors are like an audience in a theatre when someone cries "Fire": everyone wants to avoid injury by getting out first, but the resultant stampede makes injury certain.

At such times of panic, a lender of last resort is needed. Liquidity is extended to sound borrowers to get them over a market failure. Within a nation, this is the job of the central bank. Between nations, there is no single entity equipped to play this role, although the IMF comes closest.

But, as Fischer notes, the resources required are so great that the IMF alone cannot be equal to the task. It is only when its loans are amplified by other creditors that the amounts involved approach, but rarely achieve, sufficiency.

Another complication is that a pure liquidity crisis is rare. Poor economic policies produce poor investments. The market may exaggerate an underlying problem, but a problem there often is. For outside aid to work, it has to be contingent on a policy change. But it is one thing to demand that a company in trouble close a plant to achieve solvency, quite another to ask a nation-state to rein in its spending - a deeply political act. Fischer justifies the contingent nature of loans on the grounds of necessity. This, in turn, is based on a view of what a healthy economy should look like.

The author has a clear preference for the liberal consensus. Fiscal discipline, deregulation, transparency and trade liberalisation are part of the formula for high-quality growth. The state builds infrastructure and human capital and regulates but, in the absence of natural monopolies, the market leads in the arena of production. This is not a view shared by everyone. The Japanese government financed a study published in 1993 that suggested that state guidance and quasi-mercantilist policies played a large role in the success of the Southeast Asian economies.

I think Fischer's prescription for economic success is generically correct but in application fails to give sufficient weight to culture. Informal as well as formal institutional structures helped to send Southeast Asia, Latin America, the states of Central Europe and the Commonwealth of Independent States on different trajectories despite receiving similar advice.

To give the IMF its due, I would make two observations. The first is that free trade and its big brother, globalisation, are strongly associated with the biggest reduction in poverty in human history. The second is a practical point - that most of those who lend on the coat-tails of the IMF, providing the lion's share of its money, share its view of the world.

Without them there would be no effective aid.

Fischer recognises that the IMF's adjustment-lending leads it, increasingly, into World Bank territory. He provides an excellent analysis of the roles of the two organisations and some possible reforms.

The one he rejects completely is a merger between the two. He is against the idea, first, because the size of such an entity would stretch managerial control, and, second, because the successor institution would be too powerful. I find the arguments uncompelling. There are larger financial institutions in the private sector. Good management should be able to generate considerable efficiency savings that could be ploughed back into lending.

The second point assumes that competition between the organisations is a good thing. This may be true in the provision of analysis and advice, but cannot be the case in structural or adjustment lending. I may be unfair but I think the author suffers from institutional capture.

Two areas in which there appears to have been a shift in thinking are the merits of exchange-rate regimes and the issue of capital account liberalisation. The sequential collapse of soft-pegged exchange-rate regimes throughout the emerging markets has left the author believing that countries must choose between floating and fixed systems of management; there is no scope for an inter-mediate position.

Many countries are like badly wired cottages that cannot handle the "high voltage" of free capital flows - they are in danger of catching alight. The IMF is still devoted to capital account liberalisation, but there is increasing recognition that this requires a stable domestic financial system in place. Electricity is useful only after the house has been rewired - and that takes time.

A rider to this is that in a fixed-rate regime both monetary and fiscal policy can become subservient to the exchange-rate target in the context of free capital flows. As the experience of Argentina shows, the price of currency stability may be too high for most emerging economies to bear. The fashion in Asia for shadowing the dollar is therefore an experiment fraught with danger.

Inflation is a recurring concern with Fischer. There are separate pieces on hyper and high inflation, controlling moderate inflation, modern central banking and the impact of inflation on the poor. That the problem is not new is underscored by the table depicting the persistence of inflation in ancient Rome and in Sung Dynasty China. However, Fischer notes that hyperinflations are a relatively modern phenomenon and associated with the widespread use of paper money. He gives empirical evidence linking persistent inflation to poor economic outcomes and produces clear evidence that people, especially the poor, dislike it intensely. I remember in Brazil how in the period of high inflation, workers would rush to spend their money before it lost value. The better-off, with assets that appreciated, were more relaxed. It is interesting that the theoretical models examined in the book do not measure the strength of the dislike of inflation by policy-makers and citizens alike. This is a subject worthy of more study.

I enjoyed these essays, which are generally non-technical and accessible.

Anyone interested in the workings of the international monetary system from a political or an economic viewpoint should find them a rewarding read.

Arnab K. Banerji is the Prime Minister's economic policy adviser.

IMF Essays from a Time of Crisis

Author - Stanley Fischer
Publisher - MIT Press
Pages - 535
Price - 32.95
ISBN - 0 262 06237 2

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