IMF irony - entirely unintentional

Asia medicine still wrong

In the face of criticism from within the ”mainstream” of economics, most notably by Joseph Stiglitz in “Globalization and Its Discontents”, the IMF has admitted it may not have administered the right medicine in the 1997 Asia crisis. I come to the same conclusion, by way of an issue at once less deep and more focused than the one Stiglitz works from.

The IMF prescribed monetary and fiscal tightness. This standard remedy has logic behind it. It includes very high interest rates - like 30%. It also advises fiscal tightness, but the IMF position on that part changed reasonably quickly as the nature of the crisis became clearer. Fiscal deficits were accepted and remain “correct” in its retrospective views of the situation. However, it still defends the high interest rates (tight monetary policy) that was the heart of its advice. In fact, the program remains defensible -- but wrong.

What the point was

The situation they were addressing was a plummeting currency, caused by hot money trying to get out the door first because the devaluation was eroding the value of their investments. Although the reasoning behind the prescription of high interest rates is more complicated, think of it for the moment as a program of offering high enough interest rates to attract foreign investors to stay in the market. You might think of it as trying to stop a stampede with the smell of gourmet cattle food.

Of course, the panicked exit did not start without reason. The devaluation of the Thai baht that set off the entire crisis caused a self-perpetuating drain on the baht’s value. An excessively large number of Thai borrowers had taken out dollar loans (generally the only kind available on international capital markets), and were struggling to make their loan payments as these were getting more and more expensive in baht terms. Since their income was generally in baht – from rental property, department stores or hotels catering mainly to Thais, or even just taxicabs – they were broke but reluctant to admit it. They were hoping to get by until conditions improved.

The international investors in Thai stocks and bonds knew better, and wanted out. Somehow the downward pressure on the baht needed to be arrested, and the IMF demanded the only steps it feels it can justify. Unfortunately for Thailand, the IMF interest hike was seriously undermining the fundamental health of the economy, but the IMF felt confident that it was more important to send a signal – that the country was willing to bear pain.

More pain, more gain?

This has the effect of making the problem worse. Investors can easily see that the country’s economy is being further damaged, reducing the “fundamental” value of the currency further. Not only is the damage scaring them with the prospect of further devaluation, it is also undermining the confidence that any new loans will actually be repaid, so adding to the “risk premium” of additional interest needed.

The risk of adding to the risk premium is known. In fact, a long history of financial analysis has recognized that one simply does not lend at usurious interest rates, in large part because high rates damage the borrower’s means as much as they compensate for high risk. Unless you can credibly threaten to break the thumbs of the borrower, high interest rates are simply pointless.

Except that the IMF had tried them before and found that they worked, when the borrower is a government and the time frame is limited. The secret was the signal – high interest rates could show government resolve to follow responsible policy. To understand why this was the basic tool in its kit, we need to think about both the underlying IMF mission and the two most recent financial crises before 1997.

The nature of the IMF

The IMF was constructed after the Second World War as a fund to make stable exchange rates possible. The competitive devaluations of the 30s were seen as part of the crisis that brought Hitler to power, and stable exchange rates were one key to the orderly world of economic progress foreseen for the West. The point of a currency fund was to allow a country to stave off a speculative attack on its currency, by borrowing foreign exchange from the fund. In the meantime it might decide to devalue anyway - at a time and pace dictated by prudent judgement rather than market anticipation.

Over the next decades, the 60s and the 70s, the IMF also took on another role. By negotiating conditions for deep loans, it could in effect impose good policy on the countries. This was needed because a country in a payments crisis was almost always itself responsible for the pressure on their currency. The fundamental underlying pressure was nearly always inflation, generated by loose credit as a method of stimulating the country’s domestic economy. The last time an OECD country needed an IMF loan was Britain shortly before the Thatcher years began. With loose money but no willingness to allow the currency to devalue, the Labour government created an irresistible attack on the pound. IMF conditions included devaluation.

The mindset of the IMF has this problem deeply ingrained in it. A payments crisis is interpreted through a filter that almost assumes the problems to be excess liquidity. “Good policy” is therefore seen primarily as conservative monetary and fiscal policy. A disciplined monetary policy avoids inflation, and a (relatively) balanced budget avoids the need to print money. Bad policy, of which the fund has seen more than its critics usually admit, consists of spending money the government doesn’t have and “debauching the currency” to pay the bills. Under pressure to give immediate results, or to postpone pain in hopes that something will turn up, a large majority of countries have gone down this road at least once.

Approving policy

When the debt crisis of the 80s hit, the IMF’s role as policy judge came to the fore. Creditors insisted on an IMF loan before they were willing to accept write-downs, and, even more crucially, to resume short-term lending such as the trade credit that gets goods through the no-man’s land between jurisdictions. If a country got an IMF loan, it was demonstrating that it was sincerely trying to follow sound policy. (The thing that makes most criticism of the IMF from the left so ludicrous is that it makes out the IMF as some kind of international bully, nearly ruling over poor countries, while in fact the only enforcement mechanism it has is the threat of withholding new credit. If a country wants to go its own way, even to renouncing its debts, Cuba style, no one will come after it with gunboats. But it will certainly notice the lack of trade credit, among other carrots withheld by the folks with the money. Essentially, they don’t like to play with someone who makes up their own rules as they go along.)

The payments crises in the 80s were caused mainly by external factors: falling commodity prices, slowing exports, a rising dollar and rising interest rates. But profligate, over-optimistic investment and unwillingness to absorb the pain of higher oil prices had certainly contributed. Many countries needed debt forgiveness and new credit both, and they had not given creditors reason for confidence. The IMF used its conditionality power to push these debtors toward monetary and fiscal policy that would reduce inflationary pressure. It also asked for “structural adjustments” to reduce the role of government in allocating scarce resources, rationed foreign exchange being high on its list. By the time the mid-90s rolled around, the IMF knew a thing or two about what would inspire confidence among creditors.

As the debt crisis dragged on through the late 80s and early 90s, the IMF repeatedly dealt with floods of flight capital in Latin America. The stage was set for the 1995 peso crisis, and the standard medicine had appeared to work very well. If a country had truly repented its sins of the past, and took steps to convince creditors that it would not stumble into the bar again for another round of deficit spending and cheap money, its own economy had generally gotten better (after a painful adjustment period) and lenders had re-opened the credit lines.

(To cut short the period of pain necessary to convince investors, various methods of guaranteeing their good behavior have been proposed, notably the gold standard and Estonia’s “currency board”, which contributed mightily to the wrecking of the Argentine economy when its inflexibility made it impossible to deal with hard knocks of the late 90s. The IMF flirted with these guarantees, acknowledging the benefits of quick credibility. To its credit, it never fully bought in.)

It seemed to work

What was used instead was the rigor of high interest rates, sustained over a substantial period such as six months to a year. If a government had the political moxie to stick that out, the bond buyers were ready to trust them. In the peso crisis, a crisis of confidence par excellence, the pain got so bad that there was talk of its banks going under, and the government had to make real sacrifices to shore them up. But the medicine worked and the $40 billion bailout loans from the US were paid back early. Real interest rates were down to reasonable levels in about six months, and the economy was basically healthy within a year and a half, (due in part to NAFTA).

Unfortunately, the lesson learned by the IMF was that flight capital can be turned around by short-term pain, consistent with its previous experience but lifted completely out of its inflationary context. If it works in two different contexts, it must be a law of nature, right?

Ya gotta be tough. . .

So two years later, when the baht devaluation kicked off a similar spiral of capital flows out of the country, the same medicine was prescribed. Again giving due credit, the IMF did relent on fiscal deficits, perhaps in part because they were dealing with a country that did not have regular oil income to tap. But it maintained the fiction that high interest rates would staunch the capital exit, in the face of continuing evidence to the contrary. Congratulating itself that the currency stabilized with only market incentives, by contrast with the capital controls imposed by maverick Malaysia, the IMF treated the pain created by 30% interest rates as inevitable medicine that must be endured.

To be fair, the crisis in Southeast Asia would have been a tough time for ordinary people anyway. Malaysia’s experience was not much more pleasant, and the return of foreign investment took noticeably longer there, as the IMF had predicted. But the truth is that Malaysia had only imposed capital controls because the IMF medicine was such a bad prescription. Had the Fund simply recognized that the problem was not inflationary policy in the first place, it could easily have put its stamp of approval on a much more moderate program and had approximately the same effect on world confidence. To do this would have required giving up the “trial by fire” approach that had evolved to deal with governments accustomed to saying one thing and doing another.

Perhaps the Fund had itself been burned too many times – getting an IMF deal signed was usually the critical step for easing international credit, and many countries had then failed to meet the agreed “targets.” In addition, foreign investors looking into the soundness of Southeast Asian economies suddenly claimed to discover “crony capitalism” that had somehow escaped their notice before, and the violent change of regime in Indonesia made everyone face the turbulence following strongman government as a sobering prospect they had overlooked.

But that ain't enough. . .

Nevertheless, the IMF had in its power the possibility of asserting the expertise that supposedly gave it the authority to certify policy as sound. If it had done so, the countries could have avoided punitive levels of interest and capital controls. It is entirely possible that the help to the economy would have given more confidence than the attempt to demonstrate resolve.

It is not too much exaggeration to say the IMF behaved as if its own credibility and resolve were the issue. Its defensiveness in the face of Stiglitz’ broad attack is still on display in the “views and opinions” on its website. At least three of the 2002 responses are still there, including two rather wounded and rather personal in tone (in fairness, Stiglitz provoked it with the nature of his attacks, which were unfocused to the point of getting in each others’ way, and themselves included some personal innuendo.) The point at which its defensiveness is most obvious is when they allege that Stiglitz’ vocal dissent at the time of the negotiations undermined the confidence they were trying to establish. As if pointing out the devastating effects of sky-high interest rates would take Wall Street by surprise. As if proof of toughness was the only issue that mattered.

The causes of this single-mindedness should be given careful thought by pundits such as those at Fred Bergsten’s Institute for International Economics. They need to ask: how did the IMF get into a situation where it could not recognize an adequate macroeconomic plan and certify it, but instead resorted to the voodoo of outguessing foreign investor reaction? Or was it even worse – did the Fund know what was really needed and insist on more pain anyway, to shore up its own credibility? One of the things that ought to be told, when Stanley Fischer’s memoirs recount the events of the time, is how much effort went into actually checking with Wall Street.

The IMF quotes the neo-Keynesian

Another telling piece of the puzzle can be found in the reply to Stiglitz posted by Thomas Dawson, director of external relations at the Fund. He quotes Larry Summers (a favorite voice for replies to Stiglitz because of his own sound credentials as a Democrat and neo-Keynesian) saying that there is always a dilemma in a payments crisis, between long term credibility priorities and short-term “financial repair”. “It's a classic problem of a single instrument and multiple targets. Confidence is widely recognized as essential in combating financial crises," said Summers.

Summers had slogged through months of negotiations to line up the lending that tided Mexico over its 1995 liquidity crisis, and credibility was a very familiar problem for him. But in the classic fashion of generals re-fighting the last war, he and the other Washington officials who hammered together the policy for Southeast Asia seemed unable to recognize the differences in the situation they faced in 1997. (And it is sad that current IMF thinking is still willing to interpret his nuanced phrases as an endorsement of putting all the weight on credibility issues.)

I will name just a few crucial differences.
1. Mexico got into trouble by, in effect, lying to its creditors: it hid dollar loans it owed, using an ingenious approach in which the government indexed peso bonds to the dollar, making them “dollar” debts without the formal requirement of reporting them internationally as agreed in negotiations to resolve the 80s debt crisis;
2. It did so at the end of president Salinas’s term, to help ensure the re-election of the PRI, thus putting the credibility of the new Zedillo government squarely in the center of the issue;
3. Thailand’s problem was solvency, not liquidity, as it had taken on dollar loans to earn baht income at an unrealistic exchange rate (though one that had looked realistic before the dollar began its long rise in the mid to late 90s); and
4. Thailand had no large stream of oil income (or prospect of NAFTA) to bank on for long-term solvency, but rather needed the viability of the local economy to pay its bills internationally and to enable the continued progress up the value chain that investors had anticipated.

What could they be thinking?

Why did the IMF have such blinkers on? Stiglitz sees excessive trust in markets at the core of the problem. It is true that the economics profession overreacted to the macroeconomic lessons of the 70s, and that an exaggerated faith in markets (or at least distrust of governments) had taken root in international institutions during the 80s and 90s. The lessons of Enron should help provide some corrective, and economists (who tend to be American and therefore insulated from the real world) are gradually taking on board the spectacular failures of monetarist theory in Japan and, in most direct practice, Argentina. Stiglitz gets it right, I think, when he argues for proper attention to short-term dynamics and demand stimulus.

(Unfortunately he and the other neo-Keynesians have not given the world a solid enough version of how their “market failures” work, or a set of econometric tests that will demonstrate their point. They are too often left with one vague, hand-waving version of the world to counter the vague, hand-waving version of Milton Friedman and his fellow travelers, the neoclassical, competitive equilibrium, market-clearing, Rational Expectationists who pretend that math is an ideal substitute for understanding. “Globalization and its Discontents” reads like a case study in the Big Think Vagueness approach that I would consider even more fundamentally at fault than monetarism per se.)

Yes, I personally think the “market worship” version is too glib. Much of the rhetoric of the right is true, and much is motivated by genuine humanitarian concern, rather than by trying to feather a nest with right-wing think tanks or Wall Street firms. I am more inclined to blame simple human frailty in the form of a tendency to look for facts that confirm your current beliefs. Abetted, I must say, by a deep divide between policy and academic economics.

The academe ought to provide a reservoir of wisdom and a calibration of its advancement, as it would in biology or chemistry. Instead academic economists solve theoretical problems whose main interest is the career enhancement available for impressive displays of mathematical firepower. When it comes time to bridge the gap between theoretical and real issues, trained economists are almost as much at sea as lay persons, and far more likely to wander down the wrong path out of devotion to their theoretical compass. Indeed, Robert Rubin’s performance in government looks better in retrospect than either Stiglitz’ or Summers,’ despite the sincere efforts and incredible intelligence of the latter pair.

I would recommend Alan Greenspan as the rare example of someone who can bridge the worlds, and he has every reason to be proud of the eclectic approach of the Fed on his watch. Because they did not make the mistake of slavishly re-fighting the previous policy issues, we learned that unemployment can indeed go below 6 percent without inflation taking off. That Wall Street has the temerity to blame Greenspan for the bubble of the 90s, and the high tech crash that followed, is a good index of how much their views are to be trusted.

Uncle Milton is betrayed

As a final note on this rather rambling analysis, one of the richest ironies in the 1997 experience is apparent to a neo-Keynesian, but not to those who still have on the international version of monetarist blinkers. The policy dictates out of Washington were derived fairly directly from the ideas of Milton Friedman, most especially the supposed long-run macroeconomic impotence of monetary policy that justifies focusing only on inflation control. This view has never come to grips with the question of what to do when Aggregate Supply is contracting (see most recent blog). The closest I have seen was in a pre-Clinton textbook by neo-Keynesian (more or less) Alan Blinder, who plods through the story as if it is a mere classroom exercise and fails to demonstrate insight into the nature of the assertions being made and assumed.

Friedman, with confidence at least the equal of Stiglitz’, did face up to the question, in the context of explaining the Great Depression. His conclusion (a sort of monetarist mental backflip) is very instructive: that the Great Depression would have been avoided if only the Federal Reserve had actively increased money supplies in the face of the monetary contraction that was setting in as the margin buying unraveled. The Fed, it should be noted, was concerned with its credibility and a need for sound money, at the time. At least Friedman brought in the use of a proxy for Aggregate Demand, in the form of a falling money supply, and allowed as how it might matter.

Yet today’s international monetarists at the IMF, intellectual descendants though not disciples, came out advising tightening of credit in a contraction. Like the Fed in Hoover’s day, they could see the credibility issue all too clearly, and found that other business to be just too murky to be concerned with.

Of course if you believe that the “real” economy is impervious to financial variations, as monetarists supposedly do, then Summers’ trade-off is an illusory one, mattering only in the short term. But if you believe that, then the Great Depression was an unfortunate series of negative shocks, and Friedman’s view should be ignored (as, incredibly, it was.) I suppose we should take some comfort from the fact that the IMF is quoting neo-Keynesian Larry Summers to argue that their side was at least one horn of a dilemma. Perhaps next they will take on board the lesson that the other horn is just as real.