The IMF: learning from its mistakes, or too soft?

The International Monetary Fund has always been subject to criticism for its hard line on desperate countries. It is a fund that was set up at the end of WWII in order to insure monetary stability in North America and Western Europe. It soon took on that role for the rest of the world as well. At first, it was designed to help countries maintain fixed exchange rates by assisting them in handling balance of payments problems. These occur when a country's current (mostly trade, but also things like aid and interest payments on loans and investments) and capital accounts (mostly loans in or out) do not balance. With floating exchange rates, such a "problem" would simply cause the currency to rise or fall to adjust. In the world of fixed exchange rates from the end of WWII to around 1973, this was not possible. The IMF was meant to lend between countries to help them adjust. It's success was limited.

The IMF has arguably been much more successful in its later role as a lender of last, last resort (the lender of last resort is a country's central bank, the IMF then comes when the country itself needs help). When a country gets into a nasty crisis, generally because of too much debt, so that the country is be unable to pay the interest on debt from foreign creditors, the IMF loans the country money at a discounted rate to help it out of the crisis.

This aid is not without cost, however. There are strings attached: the countries must balance their budgets and pay down debt by cutting spending and raising taxes. They must also fix the imbalances (usually current account deficits, mostly made up of trade deficits) that led to the crisis by lowering wages and prices to make their goods more competitive and to curb demand. The name for this is retrenchment, and it means a lot of suffering for everyone in the economy, but is a necessary move to make the country run better and make it sustainable. It is the only way the IMF could be (fairly) certain it gets its money back.

The other good reason to be tough: it discourages lax behavior in the first place by making sure no one turns to the IMF unless absolutely necessary. Governments do everything else in their power first. Otherwise, governments might run bad policies and then just wait to be bailed out.

Or so the theory.

The Asian debt crisis of 1997-98 changed the perspective for many. The Asian governments generally did not have terribly high debt. Their countries were suffering from a different kind of crisis, much like the one the rich world (and now everyone else) is suffering from now. The answer should have been more government spending to boost flagging demand, not less. The argument is that the austerity measures forced by the IMF actually made the recessions in Asia much more severe than they had to be.

The IMF learned from this. It is now lending almost no-strings-attached to a number of weaker countries hit by the current economic crisis. Is this a rational response to a crisis where boosting demand could help bridge the recession? Or is this niceness coming at the risk of being too soft, causing countries to become too reliant on the IMF in the future?

The new, friendly IMF is probably only a temporary response to the current crisis. But even if it isn't, the old criticisms of the IMF were valid. The prescription of currency devaluation, tax hikes, spending cuts, privatization, and deregulation is not always the best answer. For governments who get themselves into a mess via their own profligacy, though, it really is. I would hope the IMF remains tough on them in the future. Most of the Asian countries, however, were not profligate, but rather suffered from currency speculation and a rather heavy indebtedness of the private sector, not the government (largely due to financial market deregulation at the behest of Washington-based organizations like the IMF!). Had their currencies been free-floating (as they are now), this likely would not have happened (the currency speculation would not have occurred and there probably would have been less borrowing in foreign currencies with the expectation that the fixed exchange rate would hold).

Hopefully, the new IMF is one that differentiates, rather than having a standard set of one-size-fits-all prescriptions that obviously don't fit all. One thing this crisis has shown: the world still needs the IMF, and it still has a critical role to play in world financial stability. Previously, the IMF's nastiness almost did it in, as countries wouldn't turn to the IMF no matter what, and countries like China contemplated making their own pooled funds as an alternative to the IMF's (western/U.S. dominated) meanness. Let's hope it contributes to stability and doesn't encourage profligacy, and that it remains the only lender of last-last resort. A competition among lenders could lead to destabilization as they all get friendlier. It would also be a waste of money, hording cash with IMF-like funds around the world rather than using that cash for something else. As is so often the case, it's all about balance.