Listener: 22 October, 2005.

Keywords: Macroeconomics & Money;

Monetary activity is dominated by capital flows. Its interaction with the trade of goods and services may seem marginal, but a financial crisis in the monetary system threatens the payments system, and could lead to a depression. This is especially true internationally because of the foreign exchange requirements of trade.

A worldwide crash may have been just avoided in the past decade when a series of financial disasters could have collapsed the world payments system. The threats were possible major financial defaults by Mexico (in 1994-5), Thailand, Indonesia and South Korea (1997), Russia and Long Term Capital Management – LTCM (1998), Brazil (1999), Turkey (2000) and Argentina (2000-1).

The Chastening provides a thrilling and chilling account, in the words of the subtitle, “Inside the Crisis That Rocked the Global Financial System and Humbled the IMF”. Its author, Paul Blustein, an economics journalist for the Washington Post, has written an exceptionally revealing work, based on careful interviews with the main players and the documents.

At the heart of each bailout, LTCM excepted, was the International Monetary Fund. Although the world’s lender of last resort may be the bête noir of many people, Blustein’s sober account is more complex, more nuanced, and all the more revealing. When a country’s financial system was in difficulties (running out of foreign exchange), representatives of the IMF would turn up, do their best, act professionally, and generally behave honourably.

However, often they got it wrong – sometimes badly – especially from requiring too tight a fiscal stance. So the rescue package often had unintended outcomes. (The IMF thinks so, too. It has the commendable practice of reviewing its performance after each package. Would that our government agencies were as brave.)

It was not always the officials’ fault. Sometimes the troubled country would hide crucial information. Sometimes the IMF’s reserves were overwhelmed by the quantities of foreign exchange required for the bailout, and it had to go to other holders of foreign exchange with their own agendas – the US Treasury in particular. (Even New Zealand was asked to contribute, an indication that our dollar has some international standing.)

More important, the IMF staff were not always expert on the countries involved. Often they seemed to demand economic reforms so that the country conformed to the models that the officials understood. The packages then failed because the economies did not conform.

Although generally the IMF was more honourable than their critics allow, the Indonesia intervention is somewhat murkier. Blustein tells the story of Paul Volcker, the chairman of the American Federal Reserve Bank prior to Alan Greenspan, flying to Indonesia at the government’s invitation. It was a long flight. “I’m half asleep and I get to page 46 or something [of the IMF proposals] and there I see [the provision for dismantling the monopoly on cloves].” You may ask, as did Volcker, “What on earth has a spice monopoly to do with restoring financial stability?” It was not just that the IMF was trying to make the economy conform to their competitive models. The monopolist was a son of Indonesian President Suharto.

Blustein reports that there was even consideration given to using IMF et al leverage to topple Suharto. I have no truck with this unpleasant kleptocratic dictator who promoted graft, corruption and cronyism. But it is not the function of supranational authorities to decide who should be running a country. Fortunately, wiser heads within the IMF prevailed. The Indonesian crisis was the only case of such a contemplation of regime change that Blustein found.

Even though the IMF made numerous mistakes, marvellously their actions prevented the collapse of the global financial system. They may have lost battles, but they won the war, preventing a global monetary crisis. But it was damned close.

Why the war? Blustein largely takes it as the result of wrong policies in the crisis countries. However, the Reagan years, with their substantial US fiscal deficit, flooded the world with American dollars, facilitating poor quality financial practices in some countries. When the elder George Bush and Bill Clinton turned off the flood, the inept practices became exposed.

Blustein says that the IMF is humbler. Let’s hope it has learnt from its past mistakes. There will be more bailouts.