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by William Easterly

  Part of the IMF’s role is to enforce “financial discipline,” i.e., get countries to pay their bills and repay their creditors. Credit enforcers are always unpopular, but they do play a valuable role. If borrowers could default on their loans without fear of consequences, lenders would not make loans. Loans can finance productive investment that borrowers can’t finance on their own. Loans can tide countries over bad times; countries can repay loans during good times. In the private market, collection agencies’ combination of threats and negotiation facilitates borrowers’ access to the benefits of future loans. The IMF client maintains its access to future Western loans by following IMF dictates, meanwhile getting an IMF loan to ease the pain (or more accurately, to postpone the pain to when it can repay the loan). Critics unfairly vilify the IMF because of the stereotype of the evil creditor squeezing the last drop of blood from the debtor. The international system including the IMF helped make a large market in lending to poor countries possible. The IMF is preferable to the earlier Western method for collecting debts—sending in gunboats to seize the poor country’s customs revenues, or even invading the country to take over the government.

  As for IMF conditions on its loans, you could understand them as a way to ensure that the loan is repaid. If your ne’er-do-well cousin asks for a loan, you may decide to give it only on condition that he change his behavior in a way that makes it likely that he will pay back the loan—that he stop drinking, that he get a job, etc.

  The IMF has had some notable successes. It helped South Korea and Thailand with financial squeezes in the 1980s, after which they had rapid growth. The IMF bailout of Mexico in 1994–1995, although much criticized at the time, worked well. The Mexican government repaid the loans in advance, and economic growth resumed. Most recently, the IMF handled the 1997–1998 East Asian financial crisis with some success, especially, again, in South Korea.

  The IMF recruits talented Ph.D.’s in economics, who observe strong norms of professional analysis. It has an outstanding research department, as well as other specialized departments that provide valuable technical advice to poor countries on their fiscal and financial systems. The IMF has been a good source of economic advice to countries on the wisdom of government solvency and the folly of excessive government debt and deficits. (One backward country is currently not heeding this advice, the one whose capital is the same city in which the IMF is located.)

  But the IMF’s more ambitious attempts to reform poor economies have had more mixed success. Even the core function of enforcing financial discipline is flawed by an intrusive Planner’s mentality that sets arbitrary numerical targets for key indicators of government behavior. Like all Planners, the IMF fits the complex reality of economic systems into a Procrustean bed of numerical targets that have little to do with that complexity. The conditions on its loans often roil internal politics in a way that is much too intrusive. And in the end, it is not even clear that the conditions contribute to repayment of the loans.

  The IMF does not force country governments to enter its agreements; they do so willingly. If IMF agreements are sometimes counterproductive, why do governments enter into such agreements? Usually it is because the government is myopic—a financial crisis makes it desperate for a loan right away, no matter what the long-term consequences. The IMF is often the only way to get such a loan.

  So Many Pesos, So Few Dollars

  The standard IMF loan is a “standby arrangement.” The IMF loan is conditional upon the government’s getting its finances in order so it can pay the loan back quickly.

  The IMF’s approach is simple. A poor country runs out of money when its central bank runs out of dollars. The central bank needs an adequate supply of dollars for two reasons. First, so that residents of the poor country who want to buy foreign goods can change their domestic money (let’s call it pesos) into dollars. Second, so those poor-country residents, firms, or governments who owe money to foreigners can change their pesos into dollars with which to make debt repayments to their foreign creditors.

  What makes the central bank run out of dollars? The central bank not only holds the nation’s official supply of dollars (foreign exchange reserves), it also makes loans to the government and supplies the domestic currency for the nation’s economy. In accounting lingo, the central bank has two assets, foreign exchange reserves and credit to the government, and one liability, domestic currency.

  In many poor nations, the government’s main source of finance for any excess of spending over tax revenues is credit from the central bank (the other main source is foreign borrowing; more on that later). The central bank extends credit to the government and prints up a corresponding amount of currency to hand over to the government as the proceeds of the loan. The government spends the currency, and the pesos pass into the hands of people throughout the economy.

  But are people willing to hold the currency? The printing of more currency drives down the value of currency if people spend it on the existing amount of goods—too much currency chasing too few goods. People don’t hold pesos whose value is falling—this is like a savings account with a negative interest rate.

  So they take the pesos back to the central bank to exchange them for dollars. Since they are unwilling to hold more pesos, they exchange pesos for dollars until the amount of pesos they hold is the same as it was before. At the end, the central bank holds more credit to the government and fewer dollar reserves, with the same amount of pesos outstanding. The effect of printing more currency that people don’t want is to run down the central bank’s dollar holdings.

  This was the insight of early IMF official Jacques Polak, the father of IMF financial programming. The central bank’s holdings of dollars runs low because the central bank prints too many pesos, which people then want to exchange at the central bank for its dollars.8

  There will often be a panic element to buying dollars from the central bank in this situation. People’s willingness to hold pesos is the key variable. When the public begins to suspect that the central bank is printing too much money for its existing holdings of dollars, it will rush to buy up its dollars before the supply runs out. Too few dollars for the outstanding stock of pesos is kind of like the Titanic with too few lifeboats. People will rush for the lifeboats (i.e., rush to buy dollars), and the stock of dollar reserves at the central bank will fall. People wanting to buy dollars for imports or to service foreign debts will then be out of luck. The country then calls on the IMF.

  Excessive money printing also affects another important goal of IMF programs—controlling inflation. Too much money chasing too few goods will drive up the prices of those goods, causing inflation. Again, the key is how much money people are willing to hold relative to buying goods. If their desire to keep money in their wallet increases, that money won’t be out on the town chasing goods.

  The last insight of IMF financial programming is that excessive government deficits cause excessive printing of money. The government finances its deficit by borrowing from the central bank, which finances the loan by printing money. So the standard IMF prescription to build up reserves again is to force a contraction of central bank credit to the government, which requires a reduction in the government’s budget deficit.

  This all sounds very technical and neutral, but the IMF then gets involved in how the government is spending the money (i.e., which items to cut). It often forces the government to do unpopular things, such as cut subsidies for bread or cooking oil. People in the country receiving the IMF loan often blame the IMF when the government does those things, and they take to the streets to protest IMF-enforced austerity. One big trouble sign in IMF stabilization plans is their disturbance of domestic politics.

  IMF Riots

  Quito is a favorite destination of IMF staff, who gave Ecuador sixteen standby loans over 1960–2000. In the year 2000, the latest IMF loan’s austerity measures induced reductions in teacher salaries and increases in fuel and electricity prices.

  On January 22, 20
00, three thousand protesters from Ecuador’s indigenous groups occupied Congress, while more than ten thousand demonstrated outside. The government of democratically elected president Jamil Mahaud confronted them with more than thirty-five thousand soldiers and police. The leaders of the armed forces saw the handwriting on the wall, however, and deposed Mahaud on January 23, 2000, in favor of his vice-president, Gustavo Noboa. Noboa insisted he would continue with the IMF reforms.

  In May 2000, teachers in Ecuador went on strike for five weeks to protest salary reductions. The government dispersed a demonstration of teachers in the capital with tear gas and riot police. On June 15, 2000, protest groups organized a general strike, which included teachers (again), government employees, doctors, oil workers, and unions. There was another tear gas confrontation between riot police and protesters in Quito. The army sent a unit under Colonel Lucio Gutiérrez to break up the protests. Colonel Gutiérrez instead sided with the indigenous protesters and attempted an unsuccessful coup. The army put down the coup and fired Gutiérrez.

  Noboa temporarily managed to survive the protests, and the country wound up complying with the IMF conditions. The protesters got revenge at the next election, in November 2002, when the voters elected as president former coup leader and populist hero Lucio Gutiérrez.

  By February 2004, the indigenous groups began protesting against Lucio Gutiérrez for once again cozying up to the IMF. On April 20, 2005, Gutiérrez, like his many predecessors, fled the presidential palace for good.9

  Ecuador was not alone in protesting against the IMF. In the first nine months of 2000 alone, there were demonstrations against IMF programs in Argentina, Bolivia, Brazil, Colombia, Costa Rica, Honduras, Kenya, Malawi, Nigeria, and Zambia.10 We cannot always conclude that the protesters are representative of the majority, but at the very least, it is a sign of the impact of the IMF on domestic politics.

  We still haven’t exhausted the roll call of IMF involvement in domestic politics. There is an association between IMF involvement and the most extreme political event: total state collapse. Of course, prior to disappearing into the parallel universe of social collapse these governments were already very sick at the time they were getting IMF loans. It is unclear how much blame the IMF bears for subsequent collapse in these unfortunate countries, but financial indiscipline was the least of their problems. Liberia spent 77 percent of the period 1963–1985 in an IMF program, before finally collapsing into anarchy after 1985. Somalia spent 78 percent of the decade 1980–1989 in an IMF program, after which the warlords tore the country apart.

  Table 4 shows that of all eight cases worldwide of state failure or collapse, seven of them had a high share of time under IMF programs in the ten years preceding their collapse. Statistically, spending a lot of time under an IMF program is associated with a higher risk of state collapse.

  The IMF should have been more careful imposing its comprehensive reforms on such fragile political systems. At best, the IMF doing a program in these countries was like recommending heart-healthy calisthenics every morning for patients with broken limbs. The IMF feels its mandate requires it to help any and all countries in financial difficulty. However, the Planners’ mentality in which the IMF applies the same type of program to all countries is ill matched to such ill societies. In retrospect, it would have been better if the IMF were not involved at all in these cases.

  Sierra Leone had a horrific civil war after its state collapse in 1990, following years of heavy IMF involvement. Deranged rebels cut off thousands of civilians’ hands to spread random terror. During a pause in the civil war, the IMF entered again to grant loans to Sierra Leone, which spent 83 percent of the period 1994–1998 under an IMF program. Civil war broke out again in 1998, not to be ended until the intervention of UN peacekeeping forces, including British troops, in 2001. The IMF quickly reentered, granting a new loan. Isn’t there any society with an illness so advanced that the IMF will decline to prescribe its irrelevant medicine?

  Here are some highlights of the IMF program begun in 2001:

  “The quantitative performance criterion for end-September 2001 relating to net domestic bank credit to the government was slightly exceeded, reflecting the difficulties we faced in limiting recourse to domestic financing in the context of substantial technical delays in the disbursement of budgetary assistance…. The structural benchmark relating to the passage of the bill to grant autonomy to the Central Statistical Office by end-September 2001 was, however, missed due to the heavy legislative schedule.”

  “Progress has also been made in implementing structural reforms and capacity building, although there were significant delays in implementing some key structural reform measures. In the area of economic management, work has continued in developing the medium-term expenditure framework (MTEF).”

  The Economist Intelligence Unit summed up the Sierra Leone situation as of 2004:

  “The rank-and-file [former rebels], particularly in rural areas, remain largely unemployed…the government still cannot project fully its authority in the diamond mining areas in the east of the country.”

  A couple million people internally or externally displaced out of 5 million are coming back to their old homes; meanwhile, traumatized amputees are getting less in benefits than the soldiers who committed the atrocities.

  “Indigenous institutions remain weak and, despite the outward appearance of peace and stability following the ending of the war, peace is being maintained by a large, albeit diminishing, contingent of UN peacekeeping troops. With most of the UN peacekeeping force due to be withdrawn by mid-2005 [recently postponed until end of 2005], it is not clear if the president will be able to hold the country together.”

  IMF management, please phone home for a reality check. There may be some places that you can help, but Sierra Leone is not one of them.

  Untidy Numbers

  Although we can certainly blame the IMF for messing with fragile countries when it shouldn’t, not all criticisms of the IMF are fair. People often blame the Fund for scarce government resources. Governments in poor countries have scarce resources because they are poor, not because of the IMF. Governments cannot live beyond their means on central bank credit, depleting a limited stock of international reserves.

  What combination of government spending, budget deficit, and central bank credit makes the books balance? The answer is more imprecise than the IMF acknowledges. The IMF financial programming model is the monetary Planners’ equivalent of the Big Push model of the aid Planners. If the numbers are so unreliable, then it is not clear that the IMF conditions are actually increasing the likelihood of its loans being repaid.

  Like doctors, the IMF officials cultivate the art of issuing confident pronouncements on the diagnosis and the cure of financial ills. They patiently explain that it’s just arithmetic, little more than two plus two. Central bank credit to the government must be no more than the demand to hold currency minus the level of necessary dollar reserves (valued in domestic currency at the current exchange rate). For the banking system as a whole, the expansion of credit (including credit to the government) must not exceed the public’s demand to hold currency and bank deposits minus the banking system’s foreign exchange reserves. If credit is too high, the system will lose foreign exchange reserves as people turn in unwanted money at the central bank for dollars.

  There are two problems here: (1) inadequate knowledge of what is really happening on the ground, and (2) complexities that are not captured by the financial programming model.

  Planners everywhere like to manage by the numbers. The planning arithmetic is not as straightforward as it appears. Accurate information on all of the items in the central bank balance sheet are as hard to come by in many poor countries as an honest customs collector.

  I can remember visiting the central bank of The Gambia in one of my first trips for the World Bank. The figures for currency outstanding, central bank credit, and international reserves were in a ledger book, which I saw with my own eye
s. The figures were in pencil. The figures showed signs of having been erased and recalculated several times. The sum at the bottom was not equal to the sum of the entries in the column. My faith in central bank accounting suffered.

  The IMF’s standard training manual on financial programming gives the example of Turkey’s central bank accounts. A mysterious item pops up, called “other items, net,” which balances central bank assets (foreign exchange reserves plus domestic credit to the government) with central bank liabilities (currency and deposits by banks). Nobody knows what an “other items, net” is or where it will wake up tomorrow morning. The change in “other items, net” was one fourth of the change in domestic credit from one year to the next in the Turkey example from the IMF training manual.11 This figure is about average for all of the data on central bank accounts in all countries over the last four decades.

  The IMF’s own numbers are not internally consistent. The IMF reports data in two ways: in its statistical publication, International Financial Statistics (IFS), and in the country reports that IMF staff prepare when they are designing a program for a country. The two sets of numbers measure the same concepts, such as the key variable net international reserves (local currency equivalent). Yet the numbers are often at odds.

  I randomly assembled a sample of the most recent country reports that reflected active IMF programs, as shown on the IMF Web site in February 2004, and compared their data with that available in IFS at the same time. Table 5 shows very distinct estimates in some countries for net international reserves in the monetary survey.