Rev Int Organ (2011) 6:443452 DOI 10.

1007/s11558-010-9097-y

The IMF returns

Allan H. Meltzer

Received: 31 May 2010 / Revised: 1 September 2010 / Accepted: 2 September 2010 / Published online: 18 September 2010 # Springer Science+Business Media, LLC 2010

Abstract The IMFs role in world financial markets increased following the credit and housing market crises. One good change was the acceptance of a proposal made by the Meltzer Commission to adopt a flexible credit line that grants responsible borrowers a line of credit to use in emergencies. Some mistaken changes gave the IMF a large increase in lending resources, relaxed the requirements for reform imposed on borrowers, and increased loans to risky borrowers such as Ukraine. Borrowing should be used to prevent the spread of financial crises, not to bailout imprudent borrowers that mismanage their economy. Keywords Global Financial Crisis . IMF JEL codes F53 . O19 . F35

1 Introduction It was like a scene from a bad movie. To cheers, the International Monetary Fund (IMF) and the European Union rode in to rescue the Euro, Europe, and Greece in time for the market opening on Monday. Alas, the IMFs analysis was wrong, and the rescue did not occur. By Tuesday, markets saw that the analysis was flawed, the main problems remained, and the IMF and EU loans would not solve the problems in Greece, Portugal and Spain. Public sector wages in Greece are far above productivity (Meghir et al. 2010). IMF and EU loans do nothing to change that fact. When Greece joined the European Central Bank (ECB), it abandoned its domestic money. In a fixed exchange rate system, the solution for wage rates above productivity are either lower wages or, less
A. H. Meltzer (*) Carnegie Mellon University, Pittsburgh, PA, USA e-mail: am05@andrew.cmu.edu A. H. Meltzer The American Enterprise Institute, Washington, DC, USA

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likely, emigration. When Greece joined the ECB, it also accepted a rule for fiscal discipline that restricted budget deficits to 3% of GDP. Greeces deficit reached almost 14% of GDP. New loans can delay fiscal adjustment, but they add to the debt. New loans prevented a current default on Greek debt, but increased the excessive debt. Holders of Greek debt now find their claims made subsidiary to IMF and EU loans. The prospects for a haircut increase. Greece has a large, informal private sector. Wages and incomes adjust downward rapidly as demand falls. The problem is in the very large state sector, where organized workers resist downward adjustment. The IMF and the EU did not require the Greek government to sell state-owned firms and use the proceeds to retire debt. Restoring firms to the private sector facilitates wage adjustment. Asset sales and debt reduction was the proper policy. If asset sales did not reduce outstanding debt sufficiently, default in the form of debt restructuring would be required. Why is the IMF part of the Greek loan? Greece is part of a monetary union, just as California is part of the dollar system. Should the IMF lend to California? Greece is, and California is not, an IMF member. But the main reason for IMF involvement is that it shifts some of the costs to the United States, Canada, the U.K., China, Japan and other IMF members. I dwell on the Greek crisis because it shows much of what is wrong with the IMF. It avoided privatizing and selling assets, and it provided no means of assuring that the Greek government would fulfill its budget promises. Markets are properly skeptical of promises about the next three years made under current circumstances and in the face of strong and strident demands from public sector employees. In 2003 the IMFs Independent Evaluation Office issued a report on fiscal adjustment in countries operating under IMF programs (IMF 2003). The report found that countries often fail to follow commitments made in the loan negotiation. The explanation: countries are unwilling or politically unable to make many of the required structural adjustments. The report recognizes that most fiscal reform programs do not last into the second year. The Independent Evaluation report also recognizes the main reason for failure to reform. Reform occurs where there is strong leadership of a political faction that favors reform. Europeans or Americans need not look beyond their own countries to understand the political dynamics that make reform difficult. IMF exhortation without strong domestic support will not succeed (Vreeland 2006; Dreher 2009). Mexico, Peru, Chile and Brazil are examples of countries where, after many false starts, local support for reform reduced fiscal deficits and inflation.

2 The New IMF Before the credit and housing crisis exploded in 2007, the IMF had become a much smaller and less important institution. Most of its borrowers had repaid their debt, so IMF loans had fallen from a peak of about SDR 65 billion in 2004 to less than SDR 10 billion in 2007 (IMF 2007). At that point, IMF budget outlays had to be reduced. The IMF discussed gold sales to pay for expenditures (IMF 2008). Several of its former clients had adopted stabilizing policies. Asian countries had accumulated about US $4 billion in foreign exchange holdings to protect against sudden

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economic shocks. The Chiang-Mai initiative established a US $120 billion fund to assist Asian countries, if a crisis returned. The purpose was to avoid recourse to IMF loans and crisis management. Even Turkey, one of the IMFs frequent borrowers announced publicly in the fall of 2009 that it preferred to manage without IMF support and interference. Throughout the world, the IMF was seen as a surrogate for policies the United States espoused but did not practice at home. Many argue that the major shareholders exercise their power to pursue international political goals. While the Board certainly must contend with the Funds internal rules, and all studies of the determinants of IMF lending show that economic variables guide IMF lending, a growing body of literature indicates that international politics matter as well.1 Argentina made the largest debt default that had ever occurred. Holders of Argentina bonds included many individuals in Europe and Japan as well as financial institutions, especially emerging market funds. The large number and widely dispersed creditors made settlement difficult. The IMF had no role. The market arranged a settlement acceptable to 75% of the creditors that was mainly the work of Adam Lerrick who organized the individual creditors and negotiated with the Argentine government (Cooper and Momani 2005). This experience suggests that, without official interference, market solutions can work. At about the same time, borrowers were encouraged to include collective action clauses that make settlement of defaults and debt restructuring easier. Again, the IMF remained sidelined. The energy behind collective action clauses came from John Taylor, U.S. Treasury Undersecretary at the time. The debt settlement and the successful introduction of collective action clauses diminished the IMFs role as the agency responsible for managing international debt problems. When IMF Managing Director Strauss-Kahn repeated the IMF is back, after the London Summit of 2008, he acknowledged that the IMFs role had diminished (IMF 2009). The crisis revived the IMF. At the London meeting in 2008, countries voted to increase IMF resources by US $500 billion. Much of the increase had been agreed before the meeting. Countries also voted to issue US $280 billion in new SDRs. Since the IMF issues SDRs in proportion to countrys quotas, more than two-thirds of the additional SDRs will go to rich countries. Impoverished countries will exchange their SDRs for currencies they can spend. Since Zimbabwe, Iran, Sudan and Venezuela are members of the IMF, they, too, will receive an allocation of SDRs. Actual lending gives a different picture of IMF activity during the financial crisis. Between the end of 2007 and April 2010, the IMF increased loans outstanding by SDR 35 billion, about US $57 billion at the current exchange rate. In 2009, the IMF issued SDR 280 billion, the full US dollar amount agreed in London. The new IMF made fewer demands on borrowers. Critics of its Asia policy in 199798 and new management changed procedures. It offered stand-by agreements for countries with conservative fiscal and monetary policy (Flexible Credit Line),

See Steinwand and Stone (2008) for a recent review. For in depth consideration of international political factors, see Thacker (1999), Stone (2002, 2004), Dreher and Jensen (2007), McKeown (2009), Dreher et al. (2009).

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as the Meltzer Commission recommended in 2000 (Meltzer 2006). Mexico became the first country to agree to supplement domestic reserves with the right to draw up to US $47 billion from the IMF. The IMF used its expanded resources to make loans to countries that had borrowed and spent excessively. One of the worst examples is US $16.6 billion lent to Ukraine, a country with an unstable government and a very divided electorate. After its recent election, Ukraines new government increased public sector wages and pensions by 20 percent. The IMFs response: it reduced Ukraines required holding of international reserves. Other large loans to countries with poor prospects include Hungary, where government spends 50 percent of GDP mainly to pay interest and finance current consumption. The budget remains in deficit and the economy continues to decline. Romania has a US $17 billion IMF loan, a projected budget deficit of 9 percent of GDP, and worsening economic prospects because of European turmoil. The government announced additional spending cuts including a 25 percent reduction in public sector wages that was met by strikes and demonstrations. The IMF also has a large (US $10.9 billion) loan to Pakistan outstanding. This, too, seems a risky undertaking given the inability of Pakistanis to form a strong, democratic government and the political instability in the western regions. But it is probably less risky than the US $800 million in credit to Zimbabwe that it offered jointly with the African Export-Import Bank. The 2010 loan to Greece is part of a package of risky loans with weak restrictions on government budgets. In Romania, the new IMF favored less spending reduction than the government because of its concern for the poor and disadvantaged. Unlike the old IMF that many criticized for being unconcerned about the effect of austerity on low income individuals, the new IMF puts much greater emphasis on the effects of policy on income distribution. It has not spoken about whether such concerns are compatible with the program for restoring macroeconomics stability. It is costly to tax the poor or reduce transfers, but there is possibly a larger loss if taxes fall more heavily on investment. Since the IMF has a poor record of enforcing its fiscal and monetary restrictions (Vreeland 2006), there may be little difference in outcomes. Elected governments, and some authoritarian regimes as well, usually choose policies that the public will accept. Stabilization policies seem to work best, if they work relatively quickly. Long drawn out austerity programs are unlikely to succeed. The old IMF urged countries to avoid devaluation by raising nominal and real interest rates. The new IMF accepts currency depreciation and avoids large increases in interest rates. The old IMF preached budget balance and fiscal restraint. The new IMF is eager to endorse government spending to help the poor. To carry out its new programs, the IMF has expanded its authorized spending, but actual spending increased by US $51 billion during the crisis, a small part of the mandated increase in IMF resources. Unfortunately, one critical part of IMF policy operations has not changed. The IMF has always combined large loans with poorly enforced promises to reform (Vreeland 2006). That hasnt changed. Despite internal research showing that most promises are kept for a year or less (IMF 2003), the IMF has not found an ability to sanction countries that violate agreements. At times, the IMF has withdrawn funding

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for a short period, but governments know from experience that the withdrawal is temporary.2 In the mid-1970s, members amended the IMF Agreement to recognize that the era of fixed but adjustable exchange rates ended in 1973. Fluctuating exchange rates were accepted as an authorized approach. The IMFs responsibility shifted from maintaining fixed exchange rates to surveillance of members exchange rate policies to assure that members did not manipulate exchange rates for their own benefit. The IMF failed completely to carry out the assignment. Beginning with Japan, countries chose export-led growth as a development strategy. Combining an undervalued exchange rate and rigid exchange controls permitted countries to run persistent current account surpluses, import capital to finance development and prevent exchange rate appreciation. China followed this strategy to an excessive degree. It accumulated US $2 trillion of foreign reserves by 2010. The United States could get Japan to appreciate its currency from 360 yen per dollar at the end of the fixed exchange rate period to less than 100 yen per dollar by 2010. Neither the IMF nor the United States convinced China to appreciate. There is not much evidence that the IMF had the will or the tools to change Chinas policy. No one in authority ever wonders publicly why countries like Turkey, Pakistan, Argentina, and Ecuador and, earlier Mexico and India had frequent recourse to IMF programs and loans. Could the reason be that these countries did not reform (Easterly 2005)? It is instructive that Turkey began implementing reforms more fully when it had the incentive of possible membership in the European Union. Without reforms, Turkey would have no chance of membership. Indias incentive came when it compared its growth rate to Chinas. Reforms that had been politically impossible could be and were made. Indias growth rate rose.

3 The SDR as International Money The Chinese government proposed to change the role of the US dollar as an international money by proposing that the IMF replace the United States and the SDR replace the dollar (Carbaugh and Hedrick 2009). While problems with the dollar as an international money are of long standing, the SDR is not a plausible substitute for the dollar. The SDR is a unit of account used only at the IMF to value its accounts. It lacks the essential property of money-use as a medium of exchange. The IMF describes the SDR as a reserve asset. On its website (IMF 2010), the IMF writes: The SDR is neither a currency nor a claim on the IMF. Rather, it is a potential claim on the freely useable currencies of IMF members. The SDR began existence in 1969 as a supplement to gold as a reserve asset on the mistaken belief that growth of world trade would be hindered by slow growth of
2

In April 2010, a vice-president of the Czech National Bank told a Czech newspaper that the IMF issued false information about the problems in the Czech financial system. It is difficult to be certain ... that the IMF wanted to harm the Czechs, Slovaks or Poles on purpose. ... More likely it was a combination of panic, lack of expertise, and a desire to see problems everywhere.

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gold and dollars. This did not happen, so after an initial allocation, the SDR had no role in subsequent events. The initial issue of SDR 9.3 billion in 197072 was followed by SDR 12.1 billion in 197981 and SDR 16.1 billion in 2009. Initially the SDR was valued at the equivalent of US $1 dollar in gold. After the Bretton Woods system of fixed exchange rates ended in 1973, the SDR was revalued as a basket of four currenciesthe dollar, the pound, the euro and the yen. The US dollar value of an SDR is recalculated daily using fixed weights for the four currencies. Every five years, the IMF adjusts the weights based on the value of exports and external holdings of reserves denominated in each currency. If China, or any other country, decides to value its reserves in SDRs, it can do so. The weights on the four currencies are known, so countries can create SDR equivalent holdings. SDRs cannot be used in payments except in transactions between central banks. Private holdings of SDRs are not permitted. This eliminates their use as a means of payment.

4 Reforming the IMF Discussion of IMF reform almost always refers to changes in the allocation of votes at IMF meetings. Critics note that the allocation of votes has changed very little since the original allocation in 1944. There are now many more countries, and relative sizes have changed. There is no reason to doubt that some countries want more votes to recognize their increased prominence. Shifting control from lenders and creditors to borrowers and debtors is not in the interests of the IMF as a lending organization. Successful lenders follow prudent lending policies. Pressures are strong to lend to some countries that are imprudent. Transferring control to such countries is likely to reduce financial support. Proponents of reorganization claim that a main reason for redistributing votes is to increase acceptance of IMF programs in developing countries. In part, this is a response to the heavy handed way that the IMF responded to the Asian crisis in 1998. As noted above, Asian countries have massively increased their reserves and established their own lending facility. They are unlikely to welcome IMF assistance soon again. Further, the new IMF has eased the terms it requires of borrowers and increased the amounts it lends. It did not require a major change in organization or voting. It remains true, of course, that the distribution of votes reflects circumstances in 1945, not the greatly changed distribution in 2010. As most proponents of reform recognize, the European Union should replace the separate votes of the WWII European allies. Procedures for choosing the IMFs Managing Director is a contentious issue also. From its start, the IMF has always selected a European as Managing Director. The President of the World Bank has always been an American. These traditions will change in the direction of making the process more open and including leaders from all countries in the pool of eligible candidates. These political issues arouse passions, but they seem no closer to resolution than in the past. Small changes in votes are called unsatisfactory (Kelkar et al. 2004).

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Large reallocations that combine the separate votes of Britain, France, Netherlands, and Belgium into a single vote for the euro-area have not been accepted by the countries that would lose influence. Evidence of the belief that the IMF is not effective as recently constituted comes from the large literature on IMF and international financial reform. Before agreeing to increase IMF resources, the U.S. Congress appointed the International Financial Institution Advisory Commission (Meltzer et al. 2000); I served as chair, so the commission was called the Meltzer Commission. Ted Truman (2006) gave a comprehensive discussion of IMF reform proposals in a volume that included recommendations from the then current Managing Director and other knowledgeable experts including Truman. First, developing countries learned that if they do not pay their debts, the developed countries forgive the debts without imposing or enforcing reforms. Debt forgiveness creates a disincentive to reform policy and reduce corruption. The disincentive weakens the already weak incentives to repay debt. Recognizing the problem, the Meltzer Commission proposed to substitute monitored grants for subsidized loans. The proposal was adopted by some of the multilateral lenders. The weakness is the absence of strong enforcement procedures. Many of the reform proposals rely mainly on exhortation to improve outcomes. The report issued by a study group sponsored by Council on Foreign Relations (Truman 2006: 49) urges effective steps to reduce their crisis vulnerability and elsewhere fair burden sharing in workout situations. But the report also urges the IMF to end large rescue packages and keep to its much smaller country limits. In practice, the IMF has gone in the other direction with the relatively large loans to Romania, Ukraine and others discussed earlier. Lawrence Summers, at the time U.S. Treasury Secretary, proposed a flow of better information and told the IMF to be selective in providing financial support (Truman 2006: 50). He also urged the IMF to refocus support of growth and poverty reduction in the low-income countries. (ibid.) These examples are representative of many proposals. Like much regulation of domestic banks and financial institutions, the proposals do not change incentives. Regulation that does not change incentives rarely achieves its objectives (Frey 1984; Vaubel 1986, 2006). My two laws of regulation explain why. First, regulations are drafted by lawyers and bureaucrats. Markets circumvent costly regulations. Second, regulation is static, but markets are dynamic. If markets do not circumvent costly regulation at first, they will later. The Basle Agreement offers an example of circumvention. It required banks to hold more capital if they held risky mortgages. Banks opened off-balance sheet entities that were not subject to the regulation. Circumvention was completely legal. After the collapse of housing prices, the banks had to absorb the losses, but lasting damage was done. Bank deposits are insured against loss de facto or de jure everywhere. The purpose is to protect the payments system from collapse thereby forcing economic activity to stop. With bank deposits insured by a government agency, some regulation of bank risk taking becomes mandatory. Regulation of capital requirements should require banks to hold sufficient capital to absorb losses. A simple incentive scheme would require banks to increase capital reserves more than in proportion to their increases in assets. Instead of the incentive to expand and take

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risk implicit in too big to fail policies, there would be greater disincentive to expand and take large risks. This principle, use incentives to enforce financial discipline, should apply to IMF lending. The Meltzer Commission proposed that financially prudent countries should be granted stand-by credit facilities to protect them against crises coming from external sources. For ten years, the IMF rejected the idea because the staff was concerned that a prudent borrower might undertake imprudent actions once the stand-by credit was in place. That objection has been overcome and loans under the Flexible Credit Line have been approved for Mexico and Poland during the recent crises. None of the loans has been drawn. The IMF and many of the member governments want the IMF to intervene in any crisis or financial problem that occurs. This encourages excessive risk and produces behavior like that of Turkey, Argentina or India before reform. These countries were among those that borrowed from the IMF repeatedly. The Meltzer Commission proposed that the IMF should lend to countries that are harmed by crises in other countries but should not lend or assist financially a country that does not follow prudent fiscal, monetary, and exchange rate policies. This proposal recognizes that countries cannot always protect themselves against events in the countries with which they trade or to whom they lend. An international agency like the IMF can eliminate the externality of a spreading crisis. During the Argentine crises after 2000, Uruguay suffered from a large capital outflow caused by Argentines withdrawing deposits in Uruguayan banks. An IMF loan to Uruguay was appropriate. The late Peter Bauer was one of the few development experts who advocated free markets in place of command and control (Bauer 2009). His message applies no less to the use of command and control techniques when used or advocated by international agencies. A main lesson of development, as Bauer often noted, is that private markets typically find better, more workable solutions to problems than command and control. The same applies to problems in the management of international finance. Unless the citizens want their country to follow prudent policies, support is limited and stabilization efforts fail. That leaves the IMF with tasks that an individual country cannot undertake. The IMF can collect and publish information that efficient markets require and the IMF can keep problems from spreading from troubled countries to their neighbors and trading partners.

5 Conclusion The IMF began when the world operated on fixed exchange rates. Its task was to get surplus and deficit countries to share in the task of maintaining fixed exchange rates by lending and borrowing. Capital accounts in most countries reflected trade imbalances. Very little private capital moved internationally. Capital account imbalances became the principal source of problems in the Latin American debt crises of the 1980s, the Asian crises of the 1990s, and the large creditor position of Asian countries, particularly China. The IMF does not have the resources to manage these problems and it is not able to prevent them. Further, it

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cannot expect to receive an increase in resources of the size that would be needed. The IMF can, perhaps, prevent the spread of crises in China or the United States from hurting neighbors. The new IMF has to recognize this limit on its future role. Current IMF Managing Director Mr. Strauss-Kahn exults that the IMF is back. Can it remain vibrant when its bad loans accumulate? The IMF and other international organizations neglect the main development lesson of the past fifty years. As Easterly (2002) and others have insisted, aid programs are less successful than market opening and competition at fostering economic growth and poverty reduction. A smaller IMF concentrating on improving market information, preventing the spread of crises, and encouraging market opening still seems the right way for the future.

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