Refocusing the IMF

Martin Feldstein

From Foreign Affairs, March/April 1998

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Summary:  Initially devised to maintain a system of fixed exchange rates, the IMF took on a new role during the Latin American debt crisis of the 1980s-providing moderate amounts of credit, facilitating debt renegotiations, and recommending responsible macroeconomic policies. But the IMF is also applying the lessons of Eastern Europe and the former Soviet Union, where a fundamental economic restructuring was necessary, to Asia. So in Korea, for example, the fund called for reform of inefficient conglomerates and inflexible labor laws. However beneficial in the long run, such changes are not needed to resolve the current crisis. By stepping in too far and too soon, the IMF discourages countries from seeking modest help. Even worse, it encourages bankers to undertake more risky loans, making another crisis more likely.

Martin Feldstein is Professor of Economics at Harvard University and President of the National Bureau of Economic Research.

OVERDOING IT IN EAST ASIA

In the Asian currency crisis, the International Monetary Fund is risking its effectiveness by the way it now defines its role as well as by its handling of the problems of the affected countries. The IMF's recent emphasis on imposing major structural and institutional reforms as opposed to focusing on balance-of-payments adjustments will have adverse consequences in both the short term and the more distant future. The IMF should stick to its traditional task of helping countries cope with temporary shortages of foreign exchange and with more sustained trade deficits.

Today's emphasis on structural and institutional reforms has not always been part of IMF programs. The IMF was founded in 1945 to help operate a system of fixed exchange rates, in which all currencies were pegged to the dollar, in turn fixed with respect to gold, that experts then considered necessary to encourage international trade. Although that system succeeded temporarily, differences in inflation between countries forced many to alter their currency values. When the fixed-rate system collapsed completely in 1971, the IMF was forced to find a new raison d'etre.

The fund found a new and important role, which is still appropriate for the current crisis, in the 1980s. Changes in economic conditions led Mexico and other Latin American countries to announce they could not meet the interest and principal payments on their large borrowings from overseas commercial banks. A default on those obligations would have wiped out the capital of many leading banks in the United States, Europe, and Japan, so the U.S. government provided a temporary bridge loan that allowed Mexico to meet its imminent payments. Negotiations then began between the Mexican government and representatives of the lending banks, who agreed to restructure the debts, lengthening maturities and lending additional money with which the borrowers could meet part of their interest obligations. Similar negotiations were later conducted with the other Latin American debtors.

To meet their interest obligations and reduce their outstanding debt, Latin American countries had to earn more foreign exchange by increasing their exports or decreasing their imports. So Latin American governments raised taxes, cut government outlays, and tightened credit to reduce domestic uses of national output. The IMF monitored these adjustments and provided moderate amounts of credit to indicate that it was satisfied with the policy progress that the debtors were making. But the primary provision of credit was left to negotiations between the foreign banks and each of the debtor countries.

Over time the process was successful. The region's economic growth eventually resumed, and the countries were generally able to service their rescheduled debts. The commercial banks wrote off some loans of small, heavily indebted countries. In the end the banks swapped their remaining loan balances for so-called Brady Bonds that had government guarantees but paid less interest or had a reduced principal. This approach succeeded because of a general recognition that the problem of the major Latin American countries was one of liquidity rather than insolvency-that is, ...

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