A senior official for the International Monetary Fund (IMF) recently asked "Why are we in this mess?" referring to the financial crises in many foreign economies. He could probably be enlightened by any novice student of economics on the topic of "moral hazard," the technical term used in banking and insurance that describes what happens when bad business decisions are rewarded. The IMF has perfected the practice of moral hazard.
Contrary to conventional wisdom, the present crisis in Asia and other emerging markets is not the result of market failure but government failure. Protected from foreign competition, financial institutions in Asia lacked market discipline and made bad loans and investments. Instead of closing down or merging these insolvent institutions, they have been kept open like a bleeding wound.
The IMF played a pivotal role in this crisis, primarily through two channels. First, by "bailing out" struggling countries, the expected losses of investing in an emerging market are reduced. Whats wrong with that, you ask? Anything that distorts the financial and economic risk of an investment leads to a misallocation of capital. For example, what do you think would happen to the asset mix between cash and stocks if the federal government suddenly guaranteed against any capital losses on stocks?
What the IMF does to wreck foreign economies is important to the people of Michigan not just because as federal taxpayers we help pay the tab for IMF subsidies. Michigans economy depends increasingly on trade with the rest of the world: We export 13 percent of our gross state product, more than the national average of 10 percent. Michigan export businesses and workers get hurt when IMF policies cripple the ability of foreigners to buy our goods.
The IMF helped jump-start the current crisis in 1994 with a $50 billion bailout for Mexico. Naturally, the money wasnt for the Mexicans but for U.S. banks to protect their loans in Mexico. The average Mexican is now far worse off after the devaluation wrecked the purchasing power of the peso.
Buoyed by the bailout in Mexico, investors sank more money in the emerging markets, despite deteriorating fundamentals. And why not? They could always rely upon the IMFs generosity if the sky started falling. Thailand, South Korea and Indonesia were next in line at the IMF kitty, receiving a whopping $120 billion. Need we remind anyone how much worse these nations economies performed after the "bailout?"
Then came the Russians, who begged for and got $22.6 billion from the worlds taxpayers (which is where the IMF gets its money). The logic here seemed strained. If President Reagan spent $3 trillion on defense to beat the Soviets, why not spend another $20 billion to bail them out? Despite the aid package, Russia defaulted on its external debt and then announced plans to manufacture huge additional quantities of paper money.
We shouldnt criticize the IMF before looking in the mirror first. As the most highly regulated and well-capitalized country in the world, the United States set the standard for moral hazard a decade ago with the savings and loan debacle. This "too-big-to-fail" doctrine was reinforced when the Federal Reserve recently organized the bailout of the private hedge fund, Long-Term Capital Management.
The second channel where IMF destroys wealth is through the austerity measures it imposes upon "reforming" nations. Austerity measures typically take the form of tight money (i.e., high interest rates), caps on federal spending, and higher taxes. Unfortunately, higher taxes are counterproductive in a recession and temporary spending cuts are no substitute for effective free-market reforms.
To prevent the spread of economic depression, many believe our citizens have no choice but to continue funding struggling nations through the IMF. They are wrong. Like an abuser of drugs or alcohol, a nation sometimes must hit rock bottom before it starts making real reform but the IMF only prolongs and deepens the problem.
America could teach the world a valuable lesson if it pulled the plug on the IMF.