The IMF\’s Big Blunder

The international financial system has cracked apart like a smashed eggshell, and all the imp\’s horses and all the IMF\’s men cannot put it together again. That is why President Clinton of the US and Prime Minister Blair of Britain have called for an overhaul of the International Monetary Fund and World Bank. The Asian crisis has spread to Russia and Latin America, with the once-mighty IMF reduced to a helpless spectator.

The scale and sweep of the disaster- few unpredicted, and drives home how little economists really know. Many now tell the crisis-hit countries, \”You should have checked the inflow of hot money in the first place.\” That is rather like telling a man sinking in the quicksand that he should always steer clear of quicksand: it does not help him get out of the morass. Some lay readers feel that financial markets are too complex and daunting for them to understand. I disagree. Discussion of such issues must not be hijacked by a few economists spouting jargon to cloak their ignorance.

So this is the first of a series of columns I propose to write explaining lay readers why the financial terns of countries are so important and so risky at the same time. s will help them understand the \’ate on new solutions.

Money may be the root of all evil, but it is also the root of all prosperity. The challenge is to devise systems that maximise the prosperity while minimising the evil. Business needs a strong financial system to sustain it.

In primitive capitalism, the saver and investor was the same person: a rich man saved his income and invested it. But in modern capitalism, the savers include millions of householders, and a financial system channels their savings to investors.

The development of financial markets, first banks, then insurance companies and stock markets, has been a boon to both savers and investors. Savers have got safety as well as a good rate return. Business has been able to tap the vast savings of households, which was not possible earlier. Thus financial markets have made capitalism a powerhouse. They carry many risks, yet have made capitalism strong enough to beat communism.

The collapse of communism proved the superiority of market systems. Yet it also led to some new illusions on the part of layfolk. One was that successful countries have no controls, and so developing countries should try to abolish all controls. The premise and conclusion were both false. In fact, totally free markets do not exist, and for good reason. If there are no rules or laws, bandits will reign supreme. Competitive markets imply not zero rules but rules to encourage competition and consumer satisfaction, protect against fraud and banditry, ensure health and environmental standards. Even in the US, land of the free, more than 80 regulations (relating mainly to health) govern the manufacture of hamburgers.

McDonalds had to pay compensation to a woman who bought coffee at one of its outlets and spilled it on her legs. She claimed the coffee was hotter than necessary, and the court agreed. Imagine that: in supposedly free US, you are not even free to determine the temperature of the coffee you serve!

How then is the US different from socialist regimes like Nehruvian India? The answer is that in the US anybody is free to enter a business, but must conform to rules that protect consumer interest. Market entry is free, but violators of rules are speedily prosecuted, no matter how rich or powerful they may be.

By contrast, in socialist India, nobody could enter any activity without government permission, so enterprise was strangled. But once you got a licence by hook or crook, you could violate almost any law with impunity, because of lax enforcement and unending legal delays. So, the issue is not of controls versus free markets, but of sensible controls versus stupid ones; of market-friendly controls versus neta-friendly controls. We need rules which nurture and improve markets, not those which substitute markets by government command.

Few layfolk understand that financial markets are the most imperfect of markets, the most prone to panic and euphoria, the most prone to systemic collapse. The financial system is the core of capitalism, and this weakness at the core requires prudential oversight. This is why financial markets are supervised in every country.

Finance is very different from industry. If an industrialist goes bust, his rivals gain from reduced competition. But if a really big bank, financial company or country goes bust, this can spark a chain reaction which causes others to go bust. Readers are familiar with the chain reaction sparked in Latin America by Mexico\’s collapse in 1994, and the one sparked in Asia by Thailand\’s collapse in 1997. They might be surprised to know that US history too is replete with system collapses.

Just this week Long Term Capital Management (LTCM), a major US hedge fund, lost huge sums and was unable to pay creditors. So large was this $ 3.5-billion fund that the Federal Reserve Board arm-twisted the creditors of LTCM to bail it out rather than force its liquidation. Why? Had the creditors tried to get their cash back by selling LTCM\’s assets, they would have further depressed the price of these assets, which might then have bankrupted other investment funds too. The Fed aimed to prevent a chain reaction.

A decade ago, the US suffered a general collapse of Savings and Loan institutions (S and Ls), banks geared to property lending. The S and Ls got into trouble by financing a property bubble that burst. They sought to recoup their losses by funding ever-riskier projects in search of bumper gains, but the gamble ended in mass bankruptcy which cost $ 200 billion to clean up.

The biggest systemic failure occurred in the Great Depression of the 1930s. Runs on banks became the order of the day, with one bank collapse sparking others. By 1933 over 11,000 of the country\’s 25,000 banks had failed, shrinking the money supply by half. To check such systemic failure, the government created the Federal Deposit Insurance Corporation to insure depositors of even failed banks, checking future runs. It created the Securities and Exchange Commission to ensure prudential oversight of the stock markets. And it gave the Federal Reserve Board enhanced supervisory powers over the financial system. Today all countries, including the US, regard prudential supervision of their financial system as a must.

Please remember that when discussing today\’s currency crisis, the IMF has generally opposed controls on forex flows. Yet such flows are capable of causing euphoria and panic, of causing system failures, no less than runs on banks or stock markets. So there is a case for prudential supervision of forex inflows, no less than of domestic financial systems.

Such prudential oversight must not be mistaken for old socialist controls. Yet this is the very blunder the IMF made. The IMF knows the importance of prudential oversight. Yet it failed dismally to see how crucial such oversight might be in the case of forex inflows.

It viewed capital controls as socialist controls to be eliminated, rather than rather than as prudential regulations essential for the health of capitalism.

It had before it the example of Chile, which is not socialist but the main free-marketer in Latin America. Chile has long welcomed long term foreign investment but discouraged short-term flows through stiff taxes.

Yet instead of holding Chile up as a good model, the IMF chose to go the other way. The consequences have been disastrous. That is why it has lost credibility. That is why IMF itself is now going to be subjected to structural adjustment.

Why was the IMF so blind? One reason is that the developed counties were able to lift capital controls over the last two decades without suffering systemic failures.

The IMF assumed, wrongly, that developing countries could do something similar. It failed to note some critical differences in developing countries. That will be the theme of next week’s column.

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