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Credit for All

October 9, 1998

Tags Financial MarketsCapital and Interest TheoryMoney and Banking

Confusion reigned this week as the IMF, the World Bank, the Fed, and the White House tried to cobble together some way of dealing with the global financial meltdown. Treasury secretary Robert Rubin was reduced to paraphrasing Rodney King: can't we all just get along?

Some convergence does seem to be in the offing, however, which is bad news for taxpayers and the future of the world economy. The Clinton administration, with the blessing of the other players, is endorsing a new lending/bailout fund administered by the IMF, for countries whose currencies are under "attack" by international money markets. This would allow "early intervention" to shore up the currencies before matters got out of hand.

But this suggests the Clinton administration does not understand the first thing about the worldwide crash much less the role that IMF lending has played in deepening and prolonging it. They believe they can create an international bailout fund while at the same time avoiding the "moral hazard" inherent in all financial welfare programs, since irresponsible conduct is encouraged by subsidizing it.

Starting with first principles, currencies do not come under "attack" from money markets without good reason. Traders examine the books, lending policies, debt structure, and money supply of a profligate government, and conclude that its currency is overvalued. They reduce their holdings of that currency relative to sounder ones, thereby driving down its exchange rate. Markets are merely doing what they do best: seeing through the fog to discover true value.

Of course the managers of the currency being sold are furious. They denounce speculators and pledge to defend the currency by dumping their hard-currency reserves and buying their own soft one. They attempt to reverse the judgement of the markets, which only sets off more alarms. Market forces then zero in on the government for its attempted defiance of economic law, and eventually win. Every time.

Yet governments do, in fact, have a choice when swatted by the markets. They can get their fiscal house in order, stop the currency printing presses, let unsound banks fail, and permit the much-needed economic contraction to take place on its own terms, so as to set a firm foundation for future growth. Sadly, few regimes are wise and honest enough to mend their ways. Instead, they start grasping for an easy way out.

In recent years, that's where the IMF, the World Bank, the Fed, and the White House have come in. If these institutions regard the exposed government as a pal, or if big banks have large holdings in the falling currency, they come to the rescue with infusions of hard currency. That not only puts off the much-needed correction; it signals other politicians and big investors that they too can avoid the consequences of bad choices.

The proponents of global welfare tell us that they can create a bailout fund and prevent it from generating moral hazards. How? Harvard's Martin Feldstein suggests the fund lend money at "above-market" interest rates. But this is absurd. If private markets were willing to lend money at lower rates and on the same terms as offered by the proposed fund, why set up a fund? By definition, rates will be subsidized.

Moreover, it is not only the terms of the guaranteed loan that generate the moral hazard; it is also the very existence of a fund. After Mexico was bailed out, Bill Clinton assured us it would not set a precedent. And yet, Thailand, Indonesia, Korea, Japan, and Russia have lined up at the trough. Had Clinton never started this process, the current meltdown might not be so messy.

Other schemes are similarly flawed. One proposal would force countries to put up large amounts of foreign currency reserves and even their industries as collateral. But here again, if collateral were enough to compensate for the risk, private lenders would be happy to extend the loans themselves.

Clinton calls Congress irresponsible for failing to send more tax money to the IMF during a crisis. In fact, we are not in a crisis but rather in a much-needed correction, and giving the IMF more cash to waste cannot prevent the inevitable. Governments can do enormous damage to markets in the short run, but they can never outwit them in the long run.

There's been some recent nostalgia, expressed even in Alan Greenspan's pronouncements, for the predictability, efficiency, honesty, and sturdiness of the old-world gold standard. But nostalgia doesn't pay the bills. Financial leaders should define the dollar in terms of gold and be done with it. If they can't do that, they should do absolutely nothing.

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