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The Curse of Currency Autarky

Author: Benn Steil, Senior Fellow and Director of International Economics
April 22, 2004
Wall Street Journal

The challenge facing the IMF's International Monetary and Financial Committee as it assembles for its spring meeting in Washington this weekend is to find a politic way of saying what its members already know: The emperors who adorn the vast bulk of the world's monies have no clothes. Only by eliminating the deadly germ of monetary sovereignty will currency crises become yesterday's disease, and will globalization live up to its economic and political promise.

The past decade has been marked by a series of major financial crises in so-called emerging economies. From Latin America to Russia to Asia and back to Latin America again, all of these have, to varying degrees, strained America's political relations with the affected countries and transparently politicized the work of the IMF. More important, in spite of the fact that all of these crises were ultimately brought on by currency mismatches in national balance sheets, we have come not a jot closer either to integrating these currencies into the global capital market or to figuring out how to prevent financial catastrophes when their governments try.

The IMF was created after World War II specifically to support a dollar-centered world, not a world of over a hundred autarkic currencies. The simple idea was that the Fund could assist countries in maintaining a fixed rate to the dollar with limited, short-term financing to ease temporary balance of payments problems. Over the past two decades, this world has changed beyond recognition, and has placed demands on the Fund it cannot possibly meet. The Bretton Woods system of fixed exchange rates enabled countries to control their interest rates while keeping their currency rate locked to the dollar (and gold) only because capital flows were restricted. Yet as governments and private institutions in developing countries began seeking international capital in the 1980s, many of their central banks and treasuries sought simultaneously to maintain low domestic interest rates and a stable dollar exchange rate, with disastrous results for their economies.

This put the Fund in an impossible position, from which it has been struggling unsuccessfully to adapt or to extricate itself ever since. In affirming the benefits of international capital, the Fund did no more than ratify the common sense that its growing clientele had already signed on to unilaterally: that access to a larger pool of capital lowered its cost. Problems emerged, however, when these governments also adopted dollar pegs to keep their exchange rates stable and simultaneously to anchor low inflation expectations domestically. Despite muted concerns that Fund staff expressed periodically over the dangers of overvaluation, it was impossible politically to challenge these policies openly, as to do so risked undermining their apparent success by scaring off the eager foreign investors.

By the time investors, domestic as well as foreign, did eventually smell whiffs of default risk in the exchange rate, it was too late for the Fund to do anything other than try to contain the flames. As a bank, the only way it could do so was through a combination of loans to forestall default on existing debts and policy conditionality to ensure that the governments would emerge capable of repaying the new debt to the Fund.

While the Fund has admitted mistakes in extending traditional conditionality, based on transparent requirements for client fiscal probity, into peripheral and highly sensitive areas such as corporate governance and "cronyism," it remains an ineluctable principle of banking that the bank must control its clients' behavior sufficiently to ensure that loans can be repaid and recycled into future loans. Even a bank without a profit-making mission must do so successfully in order to perpetuate itself. That the Fund has come popularly to be seen, and indeed seeks to be seen, as an institution with a humanitarian mission, however, assured that it would subsequently become popularly reviled in appearing to impose suffering on the poor in their moments of crisis. This was the case even where it should have been clear that the governments in crisis would have had to impose far harsher economic measures to avert default were IMF loans unavailable to give them breathing space for longer-term reforms to take hold.

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Yet the Fund has been subjected to another indictment, equally inevitable, from the right of the political spectrum. In lending massive sums of money to indebted governments, the Fund is wide open to the charge that it is "bailing out" irresponsible private lenders with public funds, and thereby encouraging even more such irresponsible borrowing and lending in the future. This is known as the problem of "moral hazard," which refers to the phenomenon whereby people who are insured against the consequences of risky activity will engage in more of it.

In the relative calm of the aftermath of debt crises in Argentina and Brazil , the Fund has been concentrating its energies on limiting future demand for its politically charged lending facilities by trying to transform itself into a sort of international bankruptcy court. This initiative, known as the Sovereign Debt Reduction Mechanism (SDRM), seeks not to prevent governments from defaulting, but to limit the economic damage of default by giving creditors more incentive to reach a speedy compromise on debt restructuring and injecting a mechanism to impose one where such compromise is not forthcoming. The attraction to the Fund itself is obvious, as success in such an initiative would keep its lending practices out of the cross hairs of the "anti-globalization" left and the "anti-moral-hazard" right when the next crisis hits. Unfortunately for the Fund, the proposal has been subjected to powerful criticism from both private lenders and sovereign borrowers, the former believing it will lead to more defaults and worse terms for creditors, and the latter that it will lead to higher borrowing costs.

Whether this scheme or some similar one is eventually implemented, more or less widely, the Fund's existential crisis will not end. The attractions of international capital will only increase as the financial services industry continues to expand, increase efficiency, and reduce global capital costs. Developed country supply of investable dollars and developing country demand for them will inevitably increase, to the clear net benefit of both.

Nevertheless, financial crises will continue to emerge so long as governments continue to inject autarkic national currencies into internationally integrated national economies. In such an environment, there is every prospect that demands on IMF lending facilities will not only overstrain its lending capacity, but fatally undermine its political legitimacy on both the left and right. Salvation lies in the Salvadoran solution, dollarization; the continued march of euro-ization; and perhaps the spread of a single Asian currency built on the back of political reconciliation between Japan and China. The only question is whether the IMF can muster the political courage to pronounce the last century's experiment in developing country central banks the failure it has so clearly been.


Mr. Steil is the Andre Meyer Senior Fellow in international economics at the Council on Foreign Relations.

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