In the months that followed, O’Neill’s disdain for the IMF and its shortcomings during the Clinton years became the barbed edge of the Bush administration’s new rhetorical stance concerning financial crises. The media dubbed the administration’s approach “tough love” because it appeared aimed at putting a stop to big bailouts, based on the theory that countries and financial markets, like wayward children, sometimes need harsh discipline rather than rescue. For all of O’Neill’s bluster and lack of regard for the diplomatic harm his thunderbolts might inflict, the Treasury chief made some incisive points on the issue. The IMF had been “too often associated with failure,” he noted; and its loans—which ultimately came from “plumbers and carpenters” and other taxpayers—frequently helped investors and lenders avoid losses on their risky bets in far-off lands. “We could teach some very valuable lessons by letting so-called hot money take a bath,” he told a House committee in May 2001. He added, referring to investors who had earned high yields on their emerging-market plays: “The nasty part of what we have done in bailing out some of these countries is we have ... let people get away without paying the risk premium that was implied in the rate of return that they were able to get. And we need to figure out a way that when somebody, in effect, bets the farm on a 25 percent interest-rate environment, if the circumstances suggest they should lose it all, they should lose it all.”
The desire of the Bush administration to distance itself from the international policies of Bob Rubin and Larry Summers struck some observers as odd. After all, the world economy had escaped with only a mild slowdown in 1998-1999, and the U.S. economy had emerged virtually unscathed, despite Korea’s near-default in late 1997 and the seize-up in U.S. markets during autumn 1998. For this achievement, the small band of top officials who were then running the Treasury, the Fed, and the IMF could take Justifiable pride.
But the Bush team inherited something of a mess. The IMF’s credibility as a crisis fighter had taken a beating in every one of the countries whose crises have been recounted in this book, because its giant loan packages so often proved ineffective at restoring investor confidence. As a result, the impact of future IMF rescues would be diminished by the memories of 1997-1999. At the same time, the enormity of these packages had created expectations in the minds of the global public, and global markets, about what would be forthcoming in future cases. If any good-sized emerging market were to become financially strapped, a refusal to provide it with large-scale emergency loans would risk creating the impression that the High Command cared little about what might happen to the nation in question.
Thus, O’Neill and his colleagues were understandably concerned that they were confronting the worst of both worlds—as was Horst Köhler, the IMF’s new managing director, who made it clear when he took office in spring 2000 that he wanted to limit the amount of assistance the Fund could give to individual countries. It was bad enough that the large sums of money involved in international rescues often failed to achieve the desired aims of calming nerves, halting the withdrawal of capital, and helping countries regain their footing when crises erupted. To make matters worse, the fact that megabailouts had become such an accepted part of the global financial landscape engendered moral hazard, because some members of the Electronic Herd—figuring they stood a good chance of getting their money back regardless of what happened to the countries in question—would be tempted to invest and lend recklessly, setting the stage for future crises.
But despite the scorn heaped by O’Neill on previous IMF bailouts, and all the tough-love talk, the policies adopted by the High Command under Köhler and Team Bush have differed very little from the policies of Camdessus and Team Clinton. For the real-life crises that have arisen in the first few years of the twenty-first century, large bailouts have materialized pretty much as they did in the late 1990s.
Under the new regime, several countries including Turkey, Uruguay, and Brazil have received loans from the IMF—and in some cases, new loans on top of existing loans—that substantially exceeded the Fund’s normal limits considering the size of those countries’ quotas. Tiny Uruguay, for example, is normally entitled under IMF rules to borrow a cumulative total of $1.2 billion from the Fund at any one time. But because its problems were deemed to be “exceptional circumstances”—the crises in large neighboring countries have hammered confidence in the country’s financial system—Uruguay received IMF commitments totaling $2.8 billion in 2002. As for Turkey, its borrowing ceiling is supposed to be $3.8 billion, but in 2002 it owed the IMF about five times that much; the Bush White House signed off on a $10 billion “augmentation” to Turkey’s Fund program in spring 2001. Brazil, meanwhile, reaped the biggest pledge of direct IMF loans ever given to a single country—a $30 billion program, approved in summer 2002.
One tough-love display came in December 2001, when the IMF refused further loans to Argentina, forcing the Argentine government to default on its debts and drop the currency board arrangement that had pegged the peso to the dollar at a one-to-one ratio. But that came only after Argentina had received an $8 billion increase the previous August in its already sizable aid package. With that exception (which closely resembled the Clinton team’s decision to give Russia an additional loan and then cut the country off when the rescue failed to work), the IMF and its overseers in the Bush administration have bowed to arguments that every effort must be made to avoid meltdowns. Explaining the discrepancy between the administration’s rhetoric and actions, John Taylor, the undersecretary of the Treasury for international affairs, said in August 2002: “There’s always a matter of degree in how fast you move to change a system. It shouldn’t be done rapidly. It should be done as gradually as possible.”
As lame as that rationalization might sound, the current rules of the global financial system offer no attractive alternatives to the options the Bush team has chosen. Today’s crisis fighters face a grim, essentially binary dilemma: They can hold their noses and approve large conventional IMF bailouts, with all the attendant disadvantages of moral hazard and high probability of failure; or they can throw countries to the wolves by consigning them to default. The appalling dangers of the latter choice were vividly illustrated in Argentina, where deadly riots at the end of 2001 toppled two presidents, and in ensuing months the economy sank so low that children died of malnutrition in a country known as one of the world’s great food producers.
Therein lies a fundamental challenge for the designers of what has become known as the “new international financial architecture.” Ever since the Mexican peso crisis, in finance ministries, think tanks, and universities around the world, and at the IMF too, some of the world’s foremost economic minds have been sifting and crafting proposals for changing the rules and practices of the global financial system, with the goal of minimizing the risks of future crises and improving the international community’s response when they do occur.
These efforts have borne some fruit, albeit slowly and in piecemeal fashion. The IMF is strongly encouraging countries to disclose key information about their financial situation and hard-currency reserves on a timely basis, to minimize the chances of unsettling markets with shocking revelations. More than fifty countries have met a special standard the Fund has established on data dissemination. Separately, to help countries strengthen their banking systems, the Fund Joined with the World Bank in a program that intensively surveys banks and regulatory systems in about two dozen countries a year and provides advice about how to reduce risks and vulnerabilities. Furthermore, Köhler created a new Capital Markets Department in the IMF as part of an initiative to spot early warning signs of crises. An additional innovation is the establishment of the IMF’s Contingent Credit Line (CCL), available to countries with certifiably sound policies, ensuring that they can obtain emergency loans quickly if a speculative attack should occur.
But nobody pretends that these steps amount to anything very sweeping. (In the first three and a half years of the CCL’s existence, not a single countr
y signed up for the insurance it supposedly provided.) The IMF has floated one radical proposal (more on that shortly), but in the meantime the system’s basic vulnerabilities remain, and the smart money is betting that the only changes likely to be implemented soon will be cosmetic—an interior decorating Job instead of new architecture, to cite a favorite metaphor of the skeptics. Now that O’Neill has been discharged, the responsibility for proving the skeptics wrong will weigh heavily on his successor, John Snow, and his administration colleagues as they exercise Washington’s traditional leadership role in the international community.
Among the bailouts that failed in the late 1990s, two shining exceptions stand out, and they provide a beacon to guide the architects of the new system. One is the second rescue of South Korea on Christmas Eve 1997, and the other is the second rescue of Brazil in March 1999. Those two—call them Korea II and Brazil II—worked brilliantly at bringing the countries in question back from the brink.
One explanation for these positive outcomes, favored by some of the folks from the Rubin-era Treasury Department and the IMF, is that it was mainly a function of the countries implementing the conditions pledged in their Fund programs. Korea, under its newly elected President Kim Dae Jung, showed a determination to reform the country’s economic system; and Brazil, under its new central banker Arminio Fraga, showed a determination to maintain a disciplined monetary policy. Accordingly, once the markets perceived a change in the countries’ policies, confidence rapidly returned—or so the theory goes—especially by comparison with what happened in Indonesia and Russia, where reforms were resisted. Thailand’s turnaround in early 1998 following the accession of a new, more reform-minded government is offered as further proof of this theory.
This argument should not be dismissed lightly; a crisis-stricken country that shows little sign of changing its economic policies, or of living up to its promises, isn’t going to instill confidence in investors or lenders, no matter how great the support it gets from the international community. The old cliché about how “you can’t help someone who isn’t willing to help himself” applies to countries as well as people.
Yet a fair reading of the evidence does not support the view that IMF programs have worked when they were faithfully implemented by the countries’ authorities but have failed when they weren’t. The rescues of Thailand and Indonesia began souring even before the authorities had the chance to demonstrate a lack of fidelity to Fund conditions. And the first rescues of Korea and Brazil went sour mainly for reasons unrelated to the authorities’ adherence to the terms of their programs. Likewise, the flop of the IMF’s Russian program, though no doubt due in part to the clear inability of the country’s reformers to deliver, was also attributable to problems associated with the Goldman, Sachs exchange offer.
So what made Korea II and Brazil II successful where the others failed? The most crucial common factor was surely the bailing-in of the countries’ private creditors. In both crises, the High Command finally intervened—more heavy-handedly in the Korean case, less so in the Brazilian episode—to confront the Electronic Herd and constrain its members from acting in a manner destructive of the countries’ well-being and that of the global financial system (not to mention the Herd’s collective self-interest). It is no coincidence that private-sector involvement was a major element in the rescues that ended triumphantly, whereas it was absent (or instituted too late or half-heartedly) in the rescues that fizzled. Bail-ins were thus beneficial from the standpoint of Justice, in the sense that taxpayer funds were kept from flowing into the pockets of the undeserving rich; and also from the standpoint of welfare, in the sense that financial stampedes were halted.
That lesson, among all that should be learned from the crises of the 1990s, ranks near the top in importance. Global capital markets have gotten so huge, so unruly, and so panic-prone that the High Command can be easily overwhelmed when crises arise, and this is especially true if the High Command’s response is confined to large loan packages and demands for economic reforms in the country involved.
Two prescriptions naturally follow from this diagnosis. First, actions should be taken to cull the short-termers among the Electronic Herd, to reduce the sheer volume of their inflows and outflows in developing countries and thereby reduce the likelihood and intensity of crises. The most sensible measure in this regard is for developing countries to tax foreign capital that flows in for relatively brief periods, as Chile has done during times when such capital is abundant. Second, when the short-termers are bolting, the High Command should be bolder in corralling them. That means aggressively formulating bail-in schemes that induce investors and lenders to stop panicky withdrawals of money, and require them to bear a fair share of the burden for ending crises.
The first of these proposals is relatively straightforward, but the second is far easier said than done, because global capital markets are not only much larger than they used to be; they’re also more complex. The Korea II and Brazil II rescues were possible because both countries (Korea in particular) had such a large proportion of their foreign debt in the form of bank loans, and the High Command was able to round up the bankers and pressure them to keep their money in those countries. But in recent years, many emerging-market countries have obtained substantial amounts of capital from overseas in the form of bonds or other securities, whose owners—as noted in the case of Russian GKOs—number in the thousands and are not amenable to being ordered around. Indeed, their securities are often subject to U.S. laws that give them the right to file lawsuits and block changes in repayment terms.
The bad news is, there’s no simple way to corral the Electronic Herd in these instances. This is the thorniest, most contentious issue in the debate over the new architecture. According to one line of argument, it is best not even to try resolving it systematically, because that approach involves risks to the smooth functioning of global finance. The fear is that if the High Command becomes too assertive in restricting outflows of capital or forcing members of the Herd to accept slower or lower paybacks, the Herd will shrink from supplying funds to emerging markets, and it will flee countries at the first sign of trouble.
In his book The Lexus and the Olive Tree, Tom Friedman presents the case against allowing the High Command to use a stronger hand in taming the Herd’s excesses. The Herd not only provides capital that helps countries to grow, Friedman argues; it also disciplines them into adopting good policies because governments have learned that sticking with their old ways—cronyism and poorly supervised banking systems, for example—may subject them to the Herd’s brutal treatment. Although the Herd often “overreacts and overshoots” by first swamping countries with capital and then abandoning them in a flash, it always returns in the end to countries with sound fundamentals, Friedman contends, so “globalization did us all a favor” by melting down the economies of Asia, Russia, and Brazil, “because it laid bare a lot of rotten practices and institutions.” He also argues against putting a little “sand in the gears” to slow the global movement of hot money: “I don’t think it is ever very wise to put sand in the gears of a machine when you barely know where the gears are. If you put sand in the gears of such a fast, lubricated, stainless-steel machine, it might not slow down. It could come to a screeching, metal-bending halt.”
One doesn’t have to be anticapitalism, or antiglobalization, to find this sort of faith in markets to be inordinate. The “longhorns” within the Herd—the Nikes, the Hewlett-Packards, and other multinationals that build factories abroad—may indeed confer the blessings of resources and technology, but the fact remains that when the “shorthorns,” or financial investors and lenders, become too ebullient about a country, the excessive amounts of capital they inject may lull the political leadership into ignoring festering problems rather than addressing them. A government basking in the glow of market optimism over its nation’s prospects is unlikely to bother fixing underlying weaknesses in the economy. This was clearly a major part of what went wrong in Thai
land and Russia in particular.
As for what happens when the shorthorns’ sentiment suddenly turns negative, the human cost of the recent slew of crises is reason enough to question whether the result “did us all a favor.” Even if the Thais, Koreans, and others ultimately gained by having their countries’ rotten practices and institutions exposed, the phenomenon of contagion offers yet another compelling reason for doubting the wisdom of leaving global capital markets unfettered. Consider the fact that, thanks to the Herd’s whims, Hong Kong suffered a sharp recession in 1999 as a result of the global financial crisis. Hong Kong wasn’t a bastion of rottenness; its financial system enjoyed a reputation as one of the cleanest and best-run on earth, but its authorities were obliged to keep interest rates painfully high because currency speculators were betting that the Hong Kong dollar would follow the Thai baht, the Indonesian rupiah, and other neighboring countries’ currencies down the drain. Or consider the fact that the United States came so close to falling prey to the contagion of 1998. Doesn’t that suggest that, at the very least, we should be searching hard for some appropriate places in the gears of the global financial system to sprinkle some sand?
Some ideas for fixing the international financial architecture involve much more than sand-sprinkling. The most noteworthy of these include the following:
1. Abolish the IMF. This may sound like the mantra of antiglobalization protesters, but it is also a prescription put forward by a number of prominent conservatives, including former Secretary of State and Treasury George Shultz. For anyone who yearns to see the Electronic Herd get its Just deserts, the idea of a no-IMF world has its charms. Without an IMF, if a country runs out of hard currency, its foreign creditors would be forced to accept whatever they could get in negotiations or lawsuits. If the foreign creditors weren’t satisfied, they could refuse to extend additional hard currency. In theory, everyone would take extra care to avoid a crisis, knowing how disastrous the consequences would be. Government officials would run more prudent economic policies, and the Herd would be more vigilant about where its money goes.
The Chastening Page 41