September 22, 2003

September 22, 2003 | Commentary on Foreign Aid and Development

Put the IMF Out of Its Misery

Pity the poor International Monetary Fund. For the first quarter century of its existence, the IMF had a clear, important mandate. Today it has none.

It was born in the closing years of World War II, when representatives from 44 nations met in Bretton Woods, N.H., to create a new international financial system. Under the rules they established, the dollar was fixed to gold at $35 per ounce, and all the central banks pegged their currencies to the dollar. The banks simply agreed to intervene to sell and buy their currencies for dollars whenever the value of those currencies rose or fell too much. For the next 25 years, inflation was low and stable, and the world economy flourished.

The IMF was the mechanic that kept this system running smoothly. Often, this meant staying out of the way: When a certain nation's currency rose in value, the central bank of that nation would buy dollars and sell its local currency to bring it back into line. When its currency fell, the bank would sell dollars to buy back its depreciating local currency. But sometimes there weren't enough dollars available. The system suddenly was in peril.

Enter the IMF to the rescue. Its lines of credit were the oil that could provide the offending central bank the reserves to stave off financial disaster and keep the system running smoothly. The IMF knew when to intervene (shortage of reserves), how much to intervene (enough to restore confidence that the central bank could stand behind the fixed value of money), and, most importantly, when to stop intervening (when confidence was restored and the currency was near parity).

But in the late 1960s and early 1970s, the wheels began to come off the system that produced monetary stability. The United States, mired in Vietnam and spending to create a Great Society , could no longer hold up its end of the bargain. Ballooning budget deficits led many to believe the United States couldn't maintain the $35-per-ounce gold peg. Nervous dollar holders around the world lined up to convert their dollars into gold.

Neither the cascading deficits nor the dwindling gold reserves did anything to ease the concern about the dollar. The United States had to react, and the path it chose led to the demise of the Bretton Woods System. The dollar peg to gold was loosened in 1968 and discarded completely in August 1971. Then, in early 1973, the last vestiges of pegged currencies were set aside. Suddenly, the IMF found itself with a large bureaucracy, an expensive building, and nothing to do.

But, as with all bureaucracies, self-preservation was paramount. The IMF would re-invent itself and prove its relevancy. So over the last 30 years it has been finding new reasons to intervene. A country can't pay its loans? Send in an IMF team to the rescue. Unfortunately, the "rescues" usually leave countries even more in a lurch.

To see why, consider the post-1973 formula for intervention the IMF developed -- one with perverse incentives that dooms most countries to failure. Want an IMF loan? First you must raise tax rates and devalue your currency. Translated into English, this means destroy incentives for people to work, save and invest, and destroy any remaining confidence in your monetary system.

What are the chances that a country adopting such policies will grow and position itself to pay off the new debt? Probably slim to none. Which is good news for the IMF, because it initiates a new cycle of aid and dependency that will bring the country back again, hat in hand. The IMF has a new client state to add to its existing stable.

Which brings us to today. As the IMF prepares for its Sept. 23-24 meetings in Dubai, UAE, it's fair to ask: Should the IMF still exist? Given its recent history, the answer appears to be no. Some would therefore conclude that the IMF should be abolished outright. After all, its large, luxurious building in the center of Washington would make beautiful condominiums. What a marvelous way to relieve the city's housing shortage.

But here's a more compassionate proposal: Simply give IMF employees the proper incentives in deciding where and when to impose their pre-conditions for loans. Require that, henceforth, the pensions of all IMF employees be invested exclusively in the bonds of the countries in which they choose to intervene. In no time, such a plan would bring the optimal number of interventions -- and the optimal number of IMF employees.

Marc Miles is director of the Center for International Trade and Economics at The Heritage Foundation.

About the Author

Marc Miles, Ph.D. Senior Fellow
The Kathryn and Shelby Cullom Davis Institute for National Security and Foreign Policy

Reprinted with permission of Foxnews.com