IMF Bailouts and Global Financial Flows

Key Points The IMF has been transformed into an instrument for prying open third world markets to foreign capital and for collecting foreign debts. This transformation violates the IMF charter in spirit and substance, and has increased the costs to countries requesting IMF financial aid. The IMF’s operational crisis stems from growing debtor resistance to its policy demands, soaring fiscal costs, and accumulating evidence of IMF policy failure. The International Monetary Fund (IMF) is the central agency for enforcing the Bretton Woods Articles of Agreement, whose terms serve as its charter. The objective of the agreement, which was reached by the major capitalist powers toward the end of World War II, was to establish a postwar economic order in which international trade and investment as well as stable, convertible exchange rates would not conflict with high employment, progressive taxation, and other components of welfare capitalism. Controlling international capital flows was judged essential for this entire set of goals to be mutually attainable. Hence, Article VI requires the IMF to deny emergency credits if used “to meet a large or sustained outflow of capital,” authorizes members “to exercise such controls as are necessary to regulate international capital movements,” and mandates the IMF to ask for such controls. In practice, the IMF has neither requested such controls nor suspended credits when they were used to finance capital flight. During the first three post-war decades, however, its importance as an emergency lender was subordinated to cold war-motivated official grants and credits in the 1950s and 1960s, and (as “foreign aid fatigue” set in) to commercial bank lending to assorted third world countries in the 1970s. Since then, the U.S. has found the IMF increasingly useful for handling third world debt crises and for opening third world commodity and asset markets to foreign capital. From minor lender of last resort, the IMF has become the enforcer of foreign debt service and a promoter of integrating developing countries into the G-7 financial markets. In pursuing these functions, the IMF has made capital controls a major target of attack, moving from neglect to active violation of Article VI. This pursuit has augmented the policy changes that the IMF routinely demands of countries seeking its credits. Prior to the 1980s the IMF’s primary intent was to relieve foreign exchange crises at moderate socioeconomic cost to the supplicant economies. As such, the fund insisted on combinations of monetary-fiscal tightening and devaluation but left capital controls largely untouched. After 1980, however, the goal became to resolve these crises by attracting private capital. Thus, measures that cut deeply into the structures of the supplicant economies and increased their adjustment costs were added to the IMF’s policy demands. Supplicant countries are now forced to ease capital controls and rely instead on higher interest rates to halt capital outflows and attract inflows. Often these moves have generated massive bankruptcies, a systemic banking crisis, and a credit crunch that has depressed domestic output and employment. To attract equity investment, supplicants are expected to privatize state assets, reduce social expenditures, and repeal laws protecting employment or privileging domestic over foreign firms. One component of the operational crisis enveloping the IMF is an increasing resistance to the augmented hardships the fund imposes and to IMF meddling in politically sensitive areas. Debt relief has also hardened. When official loans constituted most of third world debt, the IMF could ease debt servicing by persuading official creditors to stretch out repayments. But leaning similarly on private lenders deters new lending, undermining the goal of advancing global financial integration. Protecting debt service has thus become de rigeur for the IMF, and to pacify panicky creditors the fund has even required supplicant governments to sign retroactive rewrites of private debt contracts. During its 1995 crisis, for example, Mexico was forced to transform tesebonos (government notes payable in pesos at a price indexed to the peso/dollar exchange rate) into U.S. dollar payments. In compensation for its hard-line policy on debt servicing, the IMF has been expanding its emergency credits. But as currency-cum-banking crises have become more frequent, a second component of the IMF’s operational crisis has emerged legislative resistance in creditor countries to the rising fiscal burden of replenishing IMF coffers and providing supplemental loans. The Mexican bailout, for example, dwarfed previous bailouts, and the Asian bailouts are nearly triple the Mexican totals. A third component of the IMF’s operational crisis is a growing awareness that the fund lacks workable remedies. Typically, third world debt crises catch the IMF unaware. It then reacts with assessments that demand drastic measures only of the stricken countries, not of the lenders or of the international financial markets governing their behavior. The remedies notwithstanding, new crises erupt, followed by revised one-sided assessments and corrective measures, and then more crises Problems with Current U.S. Policy Key Problems The current policy line is based on flawed theorizing about the behavior of decontrolled financial markets. Globalized financial markets thwart G-7 efforts to contain exchange rate volatility and the rising incidence of financial crises. Debt leveraging and mounting G-7 bond rates have triggered a prolonged rise in global wealth concentration reminiscent of the 1920s. The IMF’s operational crisis reflects a major flaw in its basic policy line. But since the U.S. sets the essential policy line of the Bretton Woods institutions and cuts them little slack, the IMF’s crisis is a U.S. policy crisis. The IMF’s current policy line stands the original Bretton Woods position on its head, contending that free international capital mobility advances (rather than undermines) the basic Bretton Woods goals. The claim is that by globally integrating financial markets, capital flows reduce the cost of capital and bring about both an international converging of real interest rates and a more accurate pricing of capital assets. This should raise the global rate of investment and improve its efficient allocation. By rewarding “sound” policies with capital inflows and punishing “unsound” ones with capital outflows, the globalized financial markets should also improve domestic policymaking. All this should raise productivity and global output;most dramatically in the capital-short, technology-dependent third world, where the return on investment should be highest. Thus, the increased socioeconomic costs to debtor nations of IMF stipulations merely prescribe short-term pain for greater long-term gain. But this claim is an assertion with negligible support from economic theory and is refuted by the actual trends since the 1970s. Removing capital controls has opened the gates to an accelerating volume of financial flows. This has been paralleled, however, by slackened growth of investment, savings, output, trade volume, and productivity in both the third world and the OECD countries, with the main exceptionsthe East Asian “ miracle” economies now joining the pack. The explosive growth of cross-currency financial flows has also been paralleled by increasing volatility of both nominal and real exchange rates and by sharply rising real interest rates. This identifies one of the causal links between increased capital mobility and its attendant growth slowdown. Higher volatility raises the risks of investing long-term, while higher real interest rates boost the cost of capital. Each deters long-term investment. Thus, private investment has been tilted toward projects with short-term payoffs, which contribute less to productivity growth than did the long-term investments dominating the less-volatile Bretton Woods decades. An extreme example is the upsurge since the 1980s of investments in mergers, acquisitions, and exchange and interest rate speculation, none of which adds to productive capacity. The surging financial flows have been predominately short-term. Over 80% of global foreign exchange (Forex) turnover;which exceeded $300 trillion in 1995 compared to only $4.6 trillion in 1977;involves round trips of a week or less. About 5% of Forex turnover is used to finance trade in commodities and nonfinancial services, compared to around 30% in the 1970s. Most of the rest reflects purely financial transactions: to exploit discrepancies between intercountry interest rate differences and corresponding exchange rate differences, to capitalize on movements of bonds and equities in different markets, and to speculate on exchange rate variations. The short-term focus of these flows makes them highly skittish. Hence, as their volume has increased, so have the frequency and disastrous effects of these sudden capital inflows and outflows. Since 1980, one-fourth of the IMF member countries have suffered major currency-cum-banking crises, usually with adverse economic repercussions on other members. The architects of the Bretton Woods Agreement had contended that the dynamics of unregulated international financial markets tend inexorably to the dominance of short-term speculation and increasing financial instability. They therefore built into the agreement controls on international capital movements as well as a lender-of-last-resort facility. By contrast, the present policy line views hot money surges as the financial markets mode of purging countries of & ;unsound economic policies and practices. In the midst of the current Asian crisis, Washington and the IMF are still pressing for the replacement of Article VI with the prescription that the IMF require its members to commit to the complete elimination of capital controls. The increasing frequency and severity of the crises, however, and the chronic failure of the IMF to identify unsoun policies before these crises hit or to devise sets of &l sound policies that ensure against new crises are eroding the current Washington-IMF policy line of credibility even in conservative circles. Reflecting on the current Asian collapse, Alan Greenspan observed that ;excessive leverage and short-term bank lending may turn out to be the Achilles heel of an international financial system that is subject to wide variations in financial confidence. Further evidence of fragility is the rising share of GDP generated by finance, insurance, and real estate (FIRE) activities that facilitate asset trading and the transfer of risk. Until the mid-1970s the rising FIRE/GDP ratio in each G-7 country was accompanied by a faster output growth of goods and nonfinancial services. Since then, however, the relationship between rising FIRE/GDP ratios and economic growth has turned negative, implying that the liberalized international financial system has been crowding out the production of goods and nonfinancial services. Even more troubling is the rise of the real interest rate on G-7 high-grade bonds to twice the real GDP growth rate of G-7 countries. Reinforced by increased debt leveraging, the holders of financial assets largely members of the wealthiest 10% of G-7 households have (since 1980) garnered a rising share of national income. Over the past 115 years, only the two interwar decades exhibited such a high real interest/GDP ratio, partly because real GDP collapsed in the deflationary 1930s. Toward a New Foreign Policy Key Recommendations Washington and the IMF should cease trying to abolish all controls on international capital movements, and should instead start enforcing Article VI of the IMF s charter. To discourage speculative financial flows, the IMF should require creditors to bear more of the cost of resolving currency crises along with their debtors. The G-7 should tax foreign exchange transactions at a uniform rate (e.g., the Tobin Tax) in order to stabilize exchange rates and to weaken the power that financial markets wield in dictating domestic policies. The Clinton administration s request that Congress replenish IMF coffers with another $18 billion is evoking criticis most vehemently from free market conservatives that IMF interventions have catalyzed financial instability. The IMF bailouts, they charge, have primarily aided international bankers and speculators, who are thereby encouraged to engage in still riskier forays. The 1995 Mexican bailout sowed the seeds of the current Asian crises. Without IMF interventions, these critics say, financial markets self-adjust more smoothly, while still effectively disciplining national policies. Rather than granting the IMF more funds, Congress should vote to abolish it. There is merit to their criticism of the bailouts, though not to their solution. Forcing speculators (and the institutions that bankroll them) to absorb more of thelosses when crises hit would lower the speculative fever. But replacing the IMF with a free-marketer s pipe dream a fully self-adjusting global financial market is a sure recipe for recreating 1930s-style chaos. The IMF needs substantial reforming, not elimination. Congressional liberals, on the other hand, condition their support for the $18 billion measure on the inclusion of language requiring the IMF to protect labor rights and environmental integrity in the borrower nations. Such a sop is no more likely to advance such worthy goals than have similar provisions in the NAFTA treaty. Instead, IMF critics should parlay their current opportunity, created by the Asian and IMF crises, into an effective effort to curb the power of the international financial system to disrupt trade and production and (by quick capital flight) to torpedo full employment and social welfare programs with their more delayed payoff periods. For over a decade, the G-7 has been trying unsuccessfully to curb exchange-rate volatility and misalignments by setting upper and lower bounds to exchange-rate movements, and by buying and selling foreign exchange to keep the rates within those bounds. These efforts have failed because the globalized financial markets can overwhelm the official Forex reserves that central banks stockpile in order to contain market movements. Global official reserves in 1977 totaled nearly 17 days of global Forex turnover. Yet despite a quadrupling of global official reserves in the interim, they totaled less than one day of Forex global turnover by 1995. Limiting exchange-rate variance requires curtailing Forex turnover, which requires curbing the short-term speculative flows that largely account for its rapid expansion. Stabilizing exchange rates would advance a full-employment objective, and curbing hot money flows would undermine the power that financial markets wield to impede egalitarian reforms. Nobel Laureate James Tobis proposal to impose a small, globally uniform tax on all Forex transactions offers a relatively efficient, market friendly way of advancing both objectives. The tax would reduce Forex turnover by squeezing the net profits from large-volume, rapid-turnover activities (such as exploiting interest rate differences across currencies and speculating in exchange rates) while leaving returns from long-term capital infusion (such as foreign trade and direct investment) relatively untouched. Exploratory estimates suggest that a global 0.25% tax could cut Forex turnover by up to 50% while generating annual tax revenues of $200 to $300 billion. Both developments would substantially strengthen the power of the G-7 to confine exchange rate movements. Such a tax would also reduce the power that financial markets wield (by threatening capital flight) to coerce domestic policies. For example, a 0.25% tax rate would allow country A interest rate on 30-day notes to diverge from s by an additional 6% before triggering arbitrage flows. This leeway, plus the tax revenues generated, would augment the economic feasibility of socioeconomic reforms, which yield mainly long-term payoffs. To date, the G-7 has avoided the Tobin proposal and discouraged public debate over its merits. The U.S. suppressed an attempt in 1996 by the UN Development Program to circulate a volume of expert papers on the Tobin Tax, pursuing, instead, its campaign to abolish Article VI of the Bretton Woods Agreement. Policymakers and concerned citizen groups should insist on the following conditions for supporting any new IMF funding: (1) Article VI should be preserved and enforced, (2) future IMF bailouts should equally penalize both lenders and borrowers, and (3) the Tobin Tax should be placed on the G-7 agenda. Sources for more information Organizations Bretton Woods Project Hamlyn House Macdonald Road London N19 5PG UK Tel: +44 2075617546 Email: Web: Center of Concern Rethinking Bretton Woods Project 3700 13th St. NE Washington, DC 20017 Voice: (202) 635-2757Fax: (202) 832-9494 Email: Website: Contact: Jo Marie Griesgraber Friends of the Earth 1025 Vermont Ave NW Washington, DC 20005 Voice: (202) 783-7400 Fax: (202) 783-0444 Email: Website: Contact: Michelle Chang 50 Years is Enough : U.S. Network for Global Economic Justice 1025 Vermont Ave NW, Suite 300 Voice: (202) 879-3187 Fax: (202) 879-3186 Email: Contact: Lisa McGowan Halifax Initiative (for information on Tobin Tax) One Nicolas Street, Suite 412 Ottawa, K1N7B7 Canada Voice: (613) 241-4611 Fax: (613) 241-2292 Email: Website: New School for Social Research Center for Economic Policy Analysis 80 Fifth Avenue, 5th Floor New York, New York 10011-8002 Phone: (212) 229-5901 Fax: (212) 229-5903 Email Website: Public Citizen Global Trade Watch 215 Pennsylvania Avenue SE Washington, DC 20003 Voice: (202) 546-4996 Fax: (202) 547-7392 Email: Website: Contact: Mike Dolan Publications David Felix, Financial Globalization vs. Free Trade: The Case for the Tobin Tax, UNCTAD Review 1996 (New York, NY: United Nations, 1996). On Drawing General Policy Lessons from Recent Latin American Currency Crises, Journal of Post Keynesian Economics , Vol. 20, No.2, Winter 1997-98. Le Projet de Taxe Tobin, Bete Noire, Le Monde Diplomatique . February 1997. Mahbub ul Haq, Inge Kaul, and Isabelle Grunberg, eds., The Tobin Tax: Coping with Financial Volatility (New York, NY: Oxford University Press, 1996). UNCTAD, Trade and Development Report, 1997: Globalization, Distribution and Growth (New York, NY: United Nations, 1997). Alex C. Michalos, Good Taxes: The Case for Taxing Foreign Currency Exchange and Other Financial Transactions (Dundurn Press, 1997). to receive weekly commentary and expert analysis via our Progressive Response ezine. This page was last modified on Tuesday, April 1, 2003 4:57 PM Contact the IRC’s webmaster with inquiries regarding the functionality of this website. Copyright 2001 IRC. All rights reserved.

Written by David Felix, Professor Emeritus, Washington
University in St. Louis