May 24, 2000 | Commentary on Foreign Aid and Development

Taming the IMF

Never in its history has the International Monetary Fund (IMF) faced such strong criticism on so many fronts. Liberals and conservatives alike are accusing the IMF of mishandling recent financial crises, aggravating poverty in developing nations, and encouraging bad policies and decisions by governments and investors. Even Treasury Secretary Lawrence Summers, a staunch supporter of the IMF, supports dramatically reforming the institution.

That the critics have had some impact is obvious from statements made by the IMF's new Managing Director, Horst Köhler. In April, for instance, Köhler acknowledged that the "IMF is not a god that knows everything." It is unlikely that Torquemada could have wrung a similar admission from former IMF Director Michel Camdessus.

But other statements by Köhler are less encouraging and should cause concern. Proclaiming that "the state must provide a 'crash barrier' for the economy" and that opening a country's economy is "highly risky" could be seen as advocating an IMF role in governing capital flows or as skepticism about liberating financial markets in developing countries.

There was no mandate for such activities in the IMF's original charter, which charged the institution with overseeing a complex system of exchange rates tied to gold. On a day-to-day basis, the Fund's role was to observe the economies of its member states and recommend policy changes to maintain stability. IMF financing originally was restricted to short-term loans to countries experiencing temporary current account deficits. If a country was experiencing persistent imbalances, the IMF could approve an exchange rate adjustment, recommend policy changes, or both.

This system worked relatively well until the late 1960s, when the United States experienced a sustained deterioration in its balance of payments. Foreign central banks and private traders began to doubt America's ability to honor its dollar liabilities in gold at the current exchange value. To forestall demands of gold for dollars, President Richard Nixon suspended convertibility of the dollar into gold in 1971, effectively pulling the U.S. out of the Bretton Woods system. The entire system collapsed in March 1973, effectively ending the primary mission of the IMF.

The lack of a central mission did not lead the IMF to reduce its activities. On the contrary, the IMF increased lending at the very time when such activities could most reasonably be expected to decrease. The volume of IMF lending more than doubled in real terms from 1970 to 1975 and increased by another 58 percent from 1975 to 1982.

The oil shocks of the early 1970s occurred at an opportune moment for the IMF. Dramatic increases in oil prices simultaneously brought financial windfalls to oil-producing countries and severe hardship to oil-dependent developing countries. The IMF stepped in to "recycle" petro-dollars from surplus countries to those requiring loans to finance oil purchases.

Following the oil shocks, the IMF lent to nations during the Latin American debt crisis - a fig leaf to cover the fact that most of the debt was unrecoverable. IMF intervention came at a cost to living standards in Latin America. It was not until the Brady plan in the late 1980s that banks accepted some losses, debt arrangements were hammered out, and growth resumed.

Beginning in the 1980s and accelerating in the 1990s, the IMF cast itself as a financial firefighter. The Fund and the United States led a bailout of unprecedented size in 1994 to "rescue" Mexico. Though touted as successful, Mexico's real external debt was higher in 1998 than in 1994, nearly a third of private businesses between 1995 and 1997 declared bankruptcy, and GDP per capita remains below its 1980 level.

The IMF also assumed a greater role in advising developing countries on economic policies and development - a role redundant with that of the World Bank. Worse than duplication, however, is the IMF's frequent failure to help these countries. Indeed, an IMF-World Bank study found that the Fund's development loans were largely negative in reducing deficits and inflation and indeterminate in promoting economic growth.

The IMF should be trimming its activities, not expanding them. As noted by the bipartisan Meltzer Commission, the IMF should serve as a quasi-lender of last resort for countries meeting pre-established conditions that reduce the possibility of crisis, such as adopting international accounting standards and permitting foreign competition in the financial sector. Assistance should be restricted to rare instances when the market truly closes, i.e. when it refuses to lend.

The IMF should also change its loan practices to increase transparency, shorten maturity, and charge a penalty interest rate. It should also eliminate development lending, allowing the IMF and World Bank to respect their traditional roles. This reformed mandate would halt most of the Fund's current financial activities, but it would complement the modern economy, not impair it.

To a great extent, success depends on how seriously Köhler implements changes in coordination with a few reform-minded member states. Reformers should hope Köhler, who assumes office this month, overcomes institutional inertia and transforms an institution too long left unsupervised.

Brett D. Schaefer is the Jay Kingham fellow in international regulatory affairs at The Heritage Foundation, a Washington-based public policy research institute.

About the Author

Brett D. Schaefer Jay Kingham Senior Research Fellow in International Regulatory Affairs
The Margaret Thatcher Center for Freedom

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