What's Wrong with the IMF? What Would Be Better?

• Author: MELTZER, ALLAN H.

The International Monetary Fund (IMF) and the World Bank, created in 1944, reflected the experience of the 1920s and 1930s. The Fund's tasks were to adjust current-account imbalances and manage the exchange-rate system. The Bank's main tasks were to lend for the reconstruction of Europe and to eliminate the alleged bias against lending to developing countries.

Whatever conditions might have been in the 1940s, the international financial system has found other means of solving the problems that the Fund and the Bank were supposed to solve. Changes in exchange rates are now one common means of adjusting current-account imbalances. Leading countries, including the United States, Japan, Britain, and the European Union, allow their currencies to float. Western Europe now has a common currency and a single central bank in place of fixed but adjustable exchange rates.

Many of the problems or international financial crises of recent years arose because there is too much lending, especially short-term lending, to developing countries, not too little. Recent history gives strong support to the proposition that if a country adopts market-oriented policies of privatization and deregulation, opens its trade to competition in foreign markets and by foreigners in domestic markets, and carefully controls its budget, foreign lenders and investors are willing to finance its development.

Yet the international financial system is crisis-prone. Latin America in the 1980s, Mexico in the mid-1990s, and Asia and Russia most recently present well-known examples of deep, pervasive financial crises that have been costly to the public in the countries with financial problems, to their trading partners, and, often, to much the rest of the world. The past fifteen years have seen ninety serious banking crises, most of them followed by deep recessions. More than twenty of these crises produced direct losses to a developing country exceeding 10 percent of its GDP. In half of these cases, including several Asian countries now, losses exceed 25 percent of GDP (Caprio and Klingabiel 1996, 1997; Calomiris 1998). These losses, relative to GDP, are far larger than the cost of the U.S. savings-and-loan problem to U.S. taxpayers.

The frequency and severity of recent international financial problems, and their occurrence in a period of growth, economic progress, and low inflation should raise a number of questions. Why is there so much financial fragility? Are current international institutions appropriate for current conditions? Have international financial arrangements and institutions adapted appropriately to changes in the world economy? Is it time to agree on new arrangements? What international financial arrangements would serve the world well in coming decades?

I do not pretend to have complete answers to all of these questions, but I believe that economists and policy makers must ask and try to answer them. In this article I attempt to contribute to that discussion. After pointing out some of the failures of current arrangements and the incapacity of those arrangements to resolve current problems, I propose some changes. I concentrate on the IMF, although there is now substantial convergence in the activities of the Bank and the Fund. I omit discussion of policy errors, for example, in Asia in 1997. All policy makers err at times. The important issue is not errors of judgment but structural flaws that exacerbate financial fragility.

Origins and Rationale of the Fund and the Bank

Planning for postwar international monetary cooperation began before the United States entered World War II. The lend-lease agreement, under which Britain and other nations obtained military supplies and equipment on "credit," provided that the United States could waive postwar repayment if the British agreed to eliminate trade "discrimination." The term was not further defined, but the objective it expressed included elimination of the prewar system of imperial preference that bound its empire to Britain and favored British exports to its colonies.

As negotiations of postwar arrangements proceeded, trade issues faded into the background, and financial issues moved to center stage. By September 1941, John Maynard Keynes had developed a proposal for an international currency union as part of the British contribution to discussion of postwar arrangements. With minor adjustments, Keynes's proposal became the British government's proposal in April 1943, when formal bilateral discussions began (Meltzer 1988, 236-37).

Keynes visited the United States in the fall of 1941 and may have discussed his plan informally. In December, a week after the United States entered World War II, Treasury Secretary Henry Morgenthau asked Harry Dexter White to "prepare a memorandum on the establishment of an inter-Allied stabilization fund" as the basis for postwar international monetary arrangement (Blum 1967, 3: 228-29). Morgenthau's diary suggests that he had a vague idea about expanding the 1936 Tripartite Pact to avoid competitive devaluations.

Keynes ([1923] 1971) had analyzed the basic problem. Each country acting alone can achieve either stable prices or a fixed exchange rate, but not both. To achieve both requires international cooperation or agreement. The classical gold standard was one such agreement. Keynes, among others, had recognized earlier that the gold standard required deficit countries to bear the cost of adjustment, required procyclical monetary policies, and was inflexible and costly for a country with downward wage rigidity. Like White and many others, he considered the inflexibility of the gold standard, the distribution of gold, and the monetary policies of the surplus countries, mainly France and the United States, to have been leading causes of the Great Depression. The aim was to avoid a return to the classical gold standard while retaining enough of its features to solve the coordination problem and while making the arrangement acceptable to prospective surplus and deficit countries.

Both Keynes's and White's plans and the 1944 Bretton Woods agreement imposed costs on surplus countries that would neither expand their imports nor lend to deficit countries. The justification was elimination of an externality. By forcing adjustment on surplus countries, this approach would spare deficit countries the costs of higher interest rates and contraction. This policy would also benefit surplus countries and others, because their exports and incomes would be maintained. If the surplus countries could be made to lend to the deficit countries, fluctuations in economic activity would be damped. Both surplus and deficit countries would gain. Of course, this policy could work only if the imbalance was temporary. Persistent imbalances would require a change in exchange rates, with the consent of the IMF.

Both Keynes and White limited their proposals for the IMF to the financing of current-account deficits. To the extent that the plans discussed financing of capital flows, it was the proposed Bank for Reconstruction and Development (later the World Bank) that would be responsible. White explained privately why the United States favored an international bank. "Many of the loans will be risky and there will be some losses. This is one of the reasons why we insisted that the Bank be an international bank rather than to take the risks ourselves. We felt that the benefits would be worldwide and that other countries should be at risk" (H. D. White to the Board of Governors and Reserve Bank Presidents, Board Minutes, March 2, 1945, 17).

There were two principal arguments for the proposed bank. One was risk sharing, a rationale that continues to be advanced. This is a distributive, not an efficiency argument. The second was the anticipated benefit to the world economy. This claim reflected the belief that economic development was hindered by risk-averse lenders, who restricted the supply of capital and charged premium rates. The supply of capital to developing countries was believed to be suboptimal. The proposed bank would remove the capital-market restriction. Although this second argument was not developed more carefully, it was widely accepted. The experience of the 1930s, when there were sizable defaults by developing countries, was taken as evidence that lenders would be restrictive in the future.

The international system did not evolve as planned. Experience proved that many of the beliefs and conjectures on which the plan had been based were wrong. The United States did not return to its interwar policies. Instead of running large, persistent surpluses and maintaining high tariffs, it ran small surpluses or deficits on current account and worked to reduce tariffs globally. Loans and transfers added to the dollar claims held by foreigners. By 1951, the U.S. gold stock had started a fall...