Reforming the International Monetary and Financial System

Comments: Would Reforming the IMF Stabilize Global Finance?

Alexander Swoboda, and Peter Kenen
Published Date:
December 2000
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Charles W. Calomiris

Does redesigning the IMF’s mechanisms for providing assistance offer part of the means—possibly even the proverbial “silver bullet”—for ending the roller coaster of booms and crises that are the central concern of the papers at this conference? Many observers, including David Lipton, view IMF reform as an essential ingredient for stabilizing the global financial system. Yet, would-be reformers of the IMF disagree about which reforms are desirable. The disagreements often reflect differences in opinion about the sources of instability that motivate reform. To be effective, silver bullets—reputed to be the most effective means of destroying werewolves—must be aimed at the right targets. The question, then, is who, or what, is the “werewolf” of global instability?

Clearly, the participants at this conference have different views on that question, and one cannot help noticing that where one stands on that issue seems to depend somewhat on where one sits. On the one hand, some regard market participants (especially international banks) as the werewolves of the drama. According to this view, when the moon is full, they cannot help lending enormous sums at paper-thin spreads to Thai and Korean banks, which they know are insolvent, as in 1996 and early 1997. These werewolves are morally innocent victims of contagion (having become werewolves by being bitten themselves), and are deserving of our pity, not to mention our financial support. This is the view of werewolves I take Michael Mussa and William Cline to endorse. The silver bullet, according to this view, would be placing limits on international financial flows (a very costly cure). Thus, the recommendation typically endorsed by adherents to that point of view is to avoid any dramatic change in financial architecture; an imperfect world of innocent financial werewolves is the best we can manage.

Of course, there is another view of the enormous volume and thin spreads on loans to Asia in 1996 and 1997. Here the werewolf is the political economy (domestic and global) that supports predictable bailouts, and the destructive incentives for risk-taking produced by those bailouts. According to this view (which is also my view), the reason international banks lent enormous sums at low spreads to Korean and Thai financial institutions, which they knew were insolvent, was that lenders believed those debts were effectively guaranteed by the governments of the borrowing institutions. And they further believed that those governments would receive bridge assistance, if necessary, from the IMF to avoid defaulting on their implicit guarantees. Accordingly, the requisite silver bullet would be a set of policy changes that would undermine the insidious political economy that subsidizes excessive risk.

Will a refocusing of the IMF along the lines David Lipton is suggesting do the trick? I believe some of his proposed reforms would help to reduce IMF facilitation of bailouts, although I would not view Lipton’s proposals (or my own related efforts) as silver bullets. The IMF influences, but does not control, the domestic political economy of emerging market countries. Financial sector bailouts have been occurring at great cost to emerging market taxpayers for twenty years, with or without IMF assistance. Fixing the IMF may reduce their incidence, but it will not make them go away.

Still, IMF reform could significantly reduce the magnitude of such crises, and their transmission across countries, by discouraging unwarranted capital flows from foreign investors whose actions are influenced by the perceived presence of IMF protection. The Asian financial crises reflected first and foremost an absence of market discipline in domestic banking. These crises likely would have occurred with or without IMF involvement. But their costs to domestic taxpayers, and their international fallout, would have been far less without the precipitous foreign inflows and outflows of short-term dollar-denominated funds just before the crises. And without an IMF safety net, foreign participation in those debacles would have been more limited.

I largely agree with David Lipton’s agenda for refocusing the IMF, which has three main parts. First, he proposes an end to large-scale bailouts. Anyone who still doubts the importance of government-cum-IMF protection for encouraging excessive risk-taking should consider the investment advice provided in December 1997 by a prominent emerging-market newsletter to its clients:

The combination of increased Japanese capital inflows over the year, a “dip-buying” investor psychology which is spreading from U.S. retail to emerging market investors, and the massive Asian-crisis-inspired injections of high-powered global money by the IMF, will combine to ensure support. Add in the clear moral hazard caused by IMF bailouts—two investors last week told me that they were planning to put on large Brazilian positions (even though they were very unhappy with the currency regime) because they were convinced that a Brazilian crisis would result in an immediate IMF bailout—and it is hard to see why fundamentals should matter.

And anyone who believes that the financial collapses in Asia were unforecastable events in which the risk of collapse was unknown to the market should read the April 13, 1997, “Survey of Banking in Emerging Markets” by The Economist, which stated that:

Many analysts are beginning to wonder if the next emerging-market banking crises are not already erupting in the east…. A surfeit of lending to overstretched property developers, state-owned smokestacks, politicians’ cronies and other poor risks has left banks’ balance sheets riddled with holes…. Banks in Thailand and South Korea are lurching towards full-blown crisis. Unless regulators act quickly, one of these two might become the next Mexico or Japan.

Second, Lipton argues that shifting financial risks from governments to the private sector will require a greater reliance on flexible exchange rates and on private debt workouts. I agree that flexible exchange rates would be helpful in many cases, although I would emphasize that the feasibility and desirability of flexible exchange rates may be greater in countries like Mexico and Brazil than in other, smaller developing economies.

I also agree that private workouts should become the primary means of resolving debt crises. The Mexican debt crisis of the 1980s—one of the most protracted and difficult workouts in history—has had too great an effect on thinking about workouts. The protracted delays and lost output associated with that workout, I believe, help explain why the IMF began taking a greater role in debt resolution in the late 1980s. But the costs of the Mexican workout (which reflect peculiar legal and political circumstances in that country) are not representative of what can be expected in other countries in the years to come, particularly if basic reforms of commercial and bankruptcy law in developing countries are encouraged by international investors.

David Lipton’s paper is short on details about the best means of achieving greater private market involvement. I would argue that ex ante involvement of private market participants in clearly assuming the risk of default by emerging market banks is the single most important way of enhancing private sector involvement.

Banks in developing countries—typically protected by their governments, and often allied with nonbank domestic borrowers—are the central players in emerging market financial crises. Market discipline to limit their ex ante risks would go a long way toward reducing the frequency and magnitude of crises. If banks were required to issue some minimum fraction of their financing in the form of truly uninsured debt, held at arm’s length, with a publicly observable risk spread, then banks would be constantly subject, on the margin, to the discipline of the marketplace. Moreover, the risk of bank insolvency would be far more transparent, and thus weakness in the banking sector would be much harder for governments not to recognize or to deal with.1

Furthermore, effective commercial laws, accounting standards, and bankruptcy procedures (all of which significantly enhance ex post workouts) will develop if, and only if, market discipline is present in domestic banking systems to encourage those developments. The recent IMF emphasis on disclosure and transparency is laudable, but disclosure will not be meaningful or useful unless market participants who are at risk of loss help to devise the rules for disclosure, and make proper use of information when allocating funds.

Third, Lipton argues that the IMF should restructure its assistance to support global liquidity, thus short-circuiting the transmission of crises across countries. I very much agree with that view, and similar ideas underlie the proposed changes in IMF structure that Allan Meltzer and I have been advocating.2 Is the IMF’s new Contingent Credit Line facility a promising means of restructuring IMF assistance to provide greater liquidity support without continuing to bail out the insolvent? I agree with Lipton that it is not.

There are several fundamental design flaws in the new facility. First, it is not automatically available to countries that have prequalified for it. Rather, access depends on the IMF’s subjective, ex post evaluation that the request reflects a legitimate liquidity problem. Before gaining access to liquidity, countries must prove that they are innocent victims. Furthermore, “A-list” status is not clearly specified as a function of a small number of important and verifiable standards of behavior (e.g., the presence of market discipline in banking), as Meltzer and I have argued it should be. These two design flaws mean that assistance through the CCL will be delayed (not a good feature of a credit line) and politicized, as has been the norm for IMF assistance. Additionally, the CCL does not follow the financing and collateralization recommendations Meltzer and I have advocated, which would help ensure that adequate funds are available when needed, and that they would be used only for genuine liquidity problems.

Even worse, the new CCL is not a substitute for existing IMF loan programs, but rather it is an add-on program. Thus countries have scant incentives to qualify for the CCL, since bailouts will still be available through regular channels. The only way to end bailouts is for the IMF to forswear such activities institutionally, by limiting the means through which it provides assistance. Doing so would lead to better decisions by international investors, greater market discipline, and thus improvements in emerging market countries’ policies. It would also encourage adoption of “A-list” conditions to gain access to real liquidity insurance through an improved CCL.

I found the last part of Lipton’s paper hard to interpret, but easy to criticize—the part of his analysis that calls for a new “trust fund” of core members to create increases in global money supply, as needed. I have grave doubts about the desirability, in general, of monetary coordination among Europe, America, and Asia. On political economy grounds, I would prefer to see the United States, the European Union, and Japan pursue their own monetary policies without the mischief of IMF facilitation of coordination. I see the Lipton trust fund as an unwitting means to drag the IMF and its members into supporting undesirable monetary policies.

For example, suppose that some of the European Union member governments wished to engineer a depreciation of the euro, against the wishes of the European Central Bank (ECB), possibly to avoid politically painful reductions in pension fund benefits or other fiscal expenditures. To be concrete, suppose five years from now Italy or France were to suffer a balance of payments outflow associated with a collapse in confidence in its pension policies (or other influences on its deficit). If the IMF had the power to create “global money,” European Union members might use the IMF as a means to force ECB capitulation.3

Not only do I see the Lipton trust fund as a vehicle to undermine the independence of central banks, I can think of no plausible economic argument to justify it. Clearly, central bankers in the United States, Europe, and Japan have a vested interest in global economic growth and do not need the IMF to advise them when monetary expansion would be desirable to stabilize the global economy. Central banks, of course, make mistakes (as does the IMF), but they already weigh global concerns alongside domestic price stability or other domestic objectives when setting their monetary policies (witness the Fed’s actions in 1998).

In embracing constructive ambiguity as a (non) policy to guide the implementation of this trust fund, David Lipton strikes a tone opposite to his own wise argument about the need to make IMF policies predictable: “… market participants, in evaluating potential crisis outcomes, should have a clear idea of the bounds of IMF support so that investment decisions are not subject to undue moral hazard.”

The same logic applies to his proposed trust fund. Ambiguity is not constructive, but rather is an invitation to the usurpation of monetary powers by fiscal authorities in the guise of international coordination. Just as politically motivated bank bailouts produce more and worse crises, IMF involvement in monetary policy would raise average inflation, and make monetary policy more volatile and less predictable. In monetary policy, as in the management of bailouts, the last thing the world needs is to place more discretionary power in the IMF.


    CalomirisCharles1997The Postmodern Bank Safety Net: Lessons from Developed and Developing Economies (Washington: American Enterprise Institute).

    CalomirisCharles1999Blueprints for a New Global Financial Architecture (Washington: American Enterprise Institute).

    CalomirisCharles and AllanMeltzer1999“Fixing the IMF,”The National Interest No. 56 (Summer) pp. 8896.

    CalomirisCharles and DavidWheelock1998“Was the Great Depression a Watershed for American Monetary Policy?” in The Defining Moment: The Depression and the American Economy in the Twentieth Centuryed. byMichaelBordoClaudiaGoldin and EugeneWhite (Chicago: University of Chicago Press).

    MeltzerAllan1999“What’s Wrong with the IMF? What Would Be Better?”Independent ReviewVol. 4 (Fall) pp. 20115.

    U.S. Shadow Financial Regulatory Committee2000Reforming Bank Capital Regulation (Washington: American Enterprise Institute Press).

See Calomiris (1997, 1999) and U.S. Shadow Financial Regulatory Committee (1999).

For a similar story of how the U.S. Treasury used its monetary powers to pressure the Federal Reserve to expand the money supply historically, see Calomiris and Wheelock (1998).

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