The IMF, Now More than Ever: The Case for Financial Peacekeeping

David D. Hale

From Foreign Affairs, November/December 1998

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Summary:  Global economic chaos has made the International Monetary Fund a popular scapegoat, but the crisis shows just why the world needs a financial peacekeeper.

David D. Hale is the Global Chief Economist for the Zurich Group and a consultant to the Defense Department.

Would the world need an International Monetary Fund today if it did not already exist? As the outlook for the world economy becomes increasingly gloomy, the answer is an urgent yes. After Russia defaulted on its debt in mid-August, interest rates in emerging markets have skyrocketed so high that half of the world economy is courting recession next year. But precisely this turbulence in global financial markets demonstrates why the world needs the IMF: no other organization can serve as lender of last resort to buffer extreme economic turmoil during market stress.

The IMF failed to stem the Russian collapse not because its reform package was flawed but because Russia's domestic woes -- combined with its sensitivity to the global slump in oil and commodity prices -- were too severe to prevent market panic. Had the $22 billion IMF package for Russia been as large as its $40 billion bailout of Mexico in 1995, investors would probably not have fled. Instead, Russia's fiscal position was so delicate that investors decided $22 billion was not enough to guarantee success.

Beyond Russia, however, the IMF has successfully tempered the Asian financial crisis. Indeed, the fund's performance in Asia has highlighted the three roles it needs to play in today's economy. First, the IMF offers macroeconomic policy advice that politicians can sell to voters as their own; although the fund remains heavily influenced by the United States and other G-7 countries, it still offers a semblance of autonomy that makes its policy proposals more politically acceptable for borrowers. Second, the IMF acts as a global lender of last resort during a liquidity crunch, similar to the role played by national central banks during domestic banking crises. In this capacity, the fund can step in when market panic prevents a troubled economy from receiving necessary credit. Third, the IMF promotes microeconomic reforms that might otherwise be politically unacceptable. Such reforms have generally helped promote noninflationary economic growth.

RUSSIAN ROULETTE

The Russian default was the third stage in the global financial contagion that began with the devaluation of the Thai baht in July 1997. In the first stage, Thailand's currency depreciation triggered a sudden collapse in other Asian exchange rates, causing a rash of bankruptcies among corporations and financial institutions that had borrowed heavily in U.S. dollars in the first half of the 1990s. In turn, the devaluations contributed to a slide in world commodity prices, leading currencies of other commodity producers such as Australia, Canada, New Zealand, Chile, and Mexico to plummet as well. During these two stages, Russia escaped a ruble devaluation thanks to previously pledged IMF support and investor demand for high-yield Russian Treasury bonds. But when the IMF failed to help sustain the ruble in the spring and early summer as it came under pressure from Russia's large budget deficit and first postcommunist trade deficit, investors panicked. The resulting capital flight out of Russia and other emerging markets produced a $2 trillion to $3 trillion decline in the value ...

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