Information about Asia and the Pacific Asia y el Pacífico
Asian Financial crises

Chapter 23 Comments on “What’s Wrong with the IMF” and “Containing the Risks”

International Monetary Fund
Published Date:
January 2001
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I review the arguments made by the two authors and emphasize the importance of ill-defined property rights as a central problem in precipitating crises. I also argue that the unfortunate handling of the failure of Long-Term Capital Management provides some lessons for crisis management in developing countries.

I found the papers by de Swaan and Meltzer to be quite interesting and provocative. In my comments I aim to accomplish three things. First, I identify the main points of agreement among the two papers. Next, I discuss the two main points of disagreement between the two authors. Finally, I make a couple of observations about the current crises and what we can conclude about their implications for future crises.


At first glance one might read the de Swaan paper as suggesting that there are five preconditions that are needed in order for a rescue operation to be mounted and for banking supervision to be able to do its job. On the other hand, it appears that Meltzer believes that the current system is badly broken and that even if these conditions hold that it is doubtful that the combination of an IMF and domestic regulators can prevent crises. Superficially, this might lead one to conclude that the two authors completely disagree about what needs to be done. In fact, I think there is strong agreement between both authors that the establishment of property rights and an elected and accountable government are of central importance.

The paramount importance of the rule of law, together with the development of a legitimate, honest government is most easily seen by reviewing the preconditions put forward by de Swaan. He starts out by arguing that it is essential that a country have good macro policy. Both he and Meltzer argue that fixed exchange rates constituted bad macro policy for many of the Asian countries now facing crises. But, why do countries choose fixed exchange rates in the first place? A key factor is that in most cases you can’t trust anyone to make monetary policy. So the decision to tie the hands of the monetary authority is really just an admission that you do not have a capable set of government officials that can be counted on to act responsibly.

De Swaan’s second precondition is good public infrastructure. The essence of public infrastructure is a functioning government and legal system.

His third and fourth preconditions are effective market discipline and procedures for efficient resolution of problems at banks. The presence of a well-functioning legal system together with a set of honest civil servants does not guarantee that these conditions will exist in a country. However, their absence makes it virtually impossible for markets to operate and for workouts to be done on an orderly basis. Thus, four of de Swaan’s five preconditions really can only occur when the legal system and the government are sound—I return to discussing his last precondition for effective banking supervision below.

These same factors are also important for understanding why both authors argue you can’t cram down programs on elected governments. Why would the international community want to force some sort of adjustment program on an unwilling government? The outsiders must believe that the government is either incompetent, not capable of telling good choices form bad, corrupt, having different goals than the public, or impotent, being too weak to do the right thing. All three of these diagnoses imply that the international community doubts the quality of the government or strength of the legal and political system.

Finally, there is the issue of “hot money.” Much of the discussion at the conference has focussed on the potentially destabilizing aspects of large short-term capital flows (i.e. hot money). I think of hot money as a direct consequence of bad infrastructure. As Rajan and Zingales (1998) observe, if the ability to enforce property rights is doubtful, and one wants to lend in such an environment, then it is natural to structure the lending so that you can get your money back quickly without having to go through the legal system. While making the lending callable on short notice offers imperfect protection for lenders it surely beats long-term contracting.

This perspective suggests that hot money is more of symptom than a cause of problems. Moreover, it follows that capital controls are unlikely help deal with the hot money problem. If the lending is being done on a short-term basis because the legal system is shaky, imposing rules that outlaw short-term lending without fixing the basic imbalance in the legal system seems pointless. So once again we are led back to the importance of the infrastructure, legal institutions, human capital and the like.

If one accepts that these factors are the key to setting up sustainable policy and avoiding crises it makes me wonder about the role of the IMF. I think even the most ardent defenders of the fund would concede that it was not designed to provide this kind of technical assistance. It does not have much a track record in trying to do this and does not recruit professionals that specialize in these issues. If we agree that these factors are essential for good policy even in large, relatively developed countries, then I believe we need to consider whether the IMF needs to be downsized and/or replaced by an organization with a different mandate and set of experts. I welcome an active debate on whether the return to investing so much money on macroeconomic stabilization efforts is as high as the return to investing in political and legal infrastructure.


There is one significant point of disagreement among the authors. It boils down to differences of opinion about how the IMF’s existence changes the type of market discipline and public safety net that we will observe. Essentially, de Swaan believes that market discipline and a public safety net can coexist with the IMF, and Meltzer believes that cannot.

I believe that the concerns raised by Meltzer about the incentives of bureaucrats and regulators are very important. Indeed, the recent lesson from the workout arranged by the Federal Reserve for Long-term Capital Management (LTCM) appears to provide decisive evidence about the problems created by regulators. Let me review the three most relevant facts about the LTCM rescue.

First, many observers, including me, believe that an outright failure of LTCM could have been very disruptive to capital markets throughout the world. Accordingly, I applaud the Federal Reserve Bank of New York’s decision to convene a meeting to bring together many the major parties in the case. Setting up the meeting was a wise decision.

The second key piece of information was that a private group led by Warren Buffett offered to take over LTCM and assume its liabilities. No one disputes that Buffet made a credible offer to acquire the firm and that if his group had succeeded that disruptions to the public markets would have been prevented. It appears that the Buffett bid may effectively wiped out the partners at LTCM. Even if this is true it should be of no concern to the Federal Reserve.

Finally, and most significantly, the Fed continued to encourage an alternative workout arrangement (that ultimately took place) after the Buffett bid was turned down by the LTCM management. The arrangement that was eventually consummated did protect the markets. In a technical sense the deal was also purely private since no federal money was put up. I believe that everyone also agrees that the presence of the Fed-orchestrated rescue coalition at least partially helped the LTCM management avoid having to accept the Buffett offer.

The Fed decision to not completely pull out of the scene once the Buffett offer surfaced is lamentable in several respects. First, even if the eventual non-Buffett deal included no promises or official money from the Fed, it certainly appears that arms were twisted. Appearances in these situations matter, because the next crisis will depend partly on what type of risks people believe they might be insured against. Even if the Fed did nothing improper, there have been many rumors to the contrary which feed the perception that a large, politically well-connected firm was given a break.1 This can only serve to encourage other firms, perhaps some time from now when the exact facts of the LTCM case are long-forgotten, to believe that a bailout will be available.

More significantly, the fact that Mr. Buffett’s group was thwarted at least partially because of the coordinating efforts of the Fed will act as deterrent for the private sector to help out in future crises. The incentive to put together a bid is completely undermined if there is a reasonable possibility that the government (or official international organizations) will offer the distressed firm a better alternative. If one worries at all about moral hazard, there should a strong presumption that if a private group is willing to provide a backstop that they should be permitted to do so—regardless of whether the private deal is ruthless in the way it treats the distressed firm.

The disturbing thing about the LTCM case is that it occurred in the United States where presumably all of the conditions identified by de Swaan are in place. It is amazing that a private sector offer was even an option. If the U.S. authorities are unwilling to risk letting the market handle one of these situations it seems very unlikely that any other major country will either. Moreover, it seems hypocritical to have U.S. officials criticizing “crony-capitalism” in other countries in light the failure to let the private agents deal with the LTCM crisies. In short, there was a perfect opportunity to see how a private workout could proceed and it was squandered.

In light of this evidence I do not see why should expect the IMF to be able to avoid the same temptation that seems to have overcome the Fed in the LTCM case. In this sense, I agree with the basic Meltzer argument that marginal changes to the current system are unlikely to be very successful.


It seems unlikely that we will ever be able to definitely sort out the role of moral hazard in the current crises in Asia and Russia. IMF officials are no doubt correct in saying that governments do not consciously pursue reckless policies because they know the IMF will bail them out. The costs to the countries of accepting the conditions of the official rescue packages are clearly large and politicians are often not pleased with the terms of the package. However, whether or not the lenders to many of these countries extend credit on the belief that a bailout may be possible is much more difficult to prove. If there is moral hazard problem it is clearly on the lender side.

Under this assumption it is hard to say how to answer the final question posed by Meltzer: “What should we do about Russia?” This is a much more political question than an economic one. Certainly we want the lenders who put up money to experience some losses. Looking back at how Russia has been handled, I believe we would have been better off if the IMF had never been called upon to lend to Russia. The case for lending was always somewhat political—we cannot let the second major nuclear superpower implode. This concern is the only reason that Russia still commands so much attention.

If explicit foreign aid had been offered instead of IMF money I believe we would have avoided setting some bad precedents. The way the money was sent to Russia can only serve to confuse other countries about what role the IMF and economics plays in the allocation of financial support. It is only counterproductive to let Russia continually default on the promises made to the IMF. If for the short-run at least we are destined to have an organization like the IMF making emergency loans to countries, let us avoid relying on tortured explanations that use on bad economics to justify certain lending programs.

If for political reasons we decide Russia too important to fail then we should admit this. If we make such an admission we will then have to live with the bad incentives that such policy might create. But, at least we will avoid sending the IMF in to work on political problems. This conclusion brings me back to the central point of agreement between de Swaan and Meltzer, that looking ahead devoting more resources to building political and legal infrastructure is highly desirable.

Acknowledgment: The views expressed herein are entirely my own and not necessarily endorsed by the Federal Reserve Bank of Chicago or the Federal Reserve System.


Importantly if the Fed governors believed that the nationalization of LTCM was needed to protect the financial system they have the authority proceed. Of course, in this case the partners at LTCM would be wiped out and the full details of what the Fed saw as the risks would be made public.


    RajanRaghuram and LuigiZingales. 1998Which Capitalism? Lessons from the East Asian Crisis,Journal of Applied Corporate Finance.

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