The IMF Gets It Wrong Again Commentary

David Malpass / Wall Street Journal 17aug01

David Malpass is a senior managing director at Bear Stearns & Co. From 1984-1993, Mr. Malpass worked in government economic posts in the Reagan and Bush administrations.

Earlier this week, the International Monetary Fund published its annual review of the U.S. economy. Diving into U.S. politics, the Fund commented negatively on the size of the Bush tax cut, the safety of the dollar, and the feasibility of individual retirement accounts. It went on to compliment the Clinton tax hike of 1994 and gave it, more than entrepreneurialism or high levels of employment, credit for the fiscal surplus.

Luckily, the IMF is not known for its prescience or insight in evaluating economic programs. If anything, its model for economic development is most identified with the sad outcomes in Russia, Indonesia and, in the 1980s, Yugoslavia. The IMF's policy is to forego growth, and to instead prescribe austerity, high tax rates, and currency instability. The developing countries that adopt these policies continue to face decline and ruin.

Eager Beaver

The IMF's policies were harmful even in the 1990s -- a decade of good economic growth (except for IMF clients). But now, given signs of a global recession, they are all the more worrisome. This argues for an urgent and sweeping pro-growth change in the IMF's policy prescriptions. And if its report on the U.S. economy is anything to go by, a lot of work needs to be done before the IMF is a positive factor in global growth.

In measuring the impact of taxes, the IMF assumes that tax rates don't have much effect on the economic growth rate: The higher the tax rate, the more the revenue. Under this model, any tax increase -- no matter how onerous -- is assumed to improve fiscal accounts and to lower interest rates. How has this worked in practice? Guided by the IMF, Argentina has suffered through years of tax-rate increases and new taxes, yet tax receipts have fallen steadily, bringing Argentina to the brink of collapse.

In the U.S., the IMF determined that the Bush tax cut would cost the economy $2.5 trillion over 10 years. It made no allowance for the added growth that tax-rate reductions would bring. In fact, it suggested that the U.S. implement the tax cut in a "flexible" manner, meaning that the country should raise tax rates back toward their old levels. The IMF, rather than urging faster tax cuts -- as economic logic would argue -- was suggesting we roll back the cuts already made, even as the economy slumps.

In assessing the U.S. exchange rate, the IMF deployed its standard austerity model. It explained that trade deficits are dangerous and that they should be curtailed through cuts in consumption. In the IMF's model, exchange rates are expected to adjust to counteract the trade balance, implying a weaker dollar.

This advice couldn't have come at a worse time. A weak dollar would be sure to deepen the global recession: U.S. interest rates would rise to compensate for currency weakness. The IMF should have focused on the deflation pressures in the world economy rather than the trade deficit. It could have argued for substantially lower interest rates and a shift to a stable-dollar policy. A proper growth model connects exchange rates to monetary policy rather than trade policy.

Ever the eager beaver, the IMF even commented extensively on the Social Security debate. It noted that "if part of the surpluses in the Social Security trust fund were used to finance reforms such as the establishment of individual pension accounts, it would create a new gap in Social Security's finances that would need to be addressed. Also, the guidelines provided to the new [Social Security] commission seemed to suggest that significant reductions in benefits to future retirees may be required . . . " U.S. critics of retirement reform were thrilled.

In sum, the IMF used its 55-page report to recommend a tax increase (with the "flexibility" euphemism) and a weaker exchange rate (by linking exchange rates to trade deficits). The report helped to fuel massive turmoil in the currency markets, as the dollar fell against all its major counterparts. This, perversely, added to the IMF's importance in global financial affairs even as its antigrowth policies contribute to a global recession.

If this were the only time that the IMF had recommended high tax rates, weak currencies and lower living standards, it wouldn't be so bad. The U.S. is strong enough to withstand IMF advice. But the world's poorer countries don't have the option of ignoring IMF malpractice. The organization continues to occupy a position of massive power and influence: It provides jobs for the elite, holds sway over loans by the World Bank and its regional sister organizations, and even controls bilateral loan programs through the Paris Club process.

To earn the IMF's approval, countries systematically make themselves poorer. Turkey has seen its living standard halved over the past year as a result of an IMF tax increase and the resulting collapse in the exchange rate. Tens of billions of dollars of aid commitments still haven't improved Turkey's economic prospects; it now takes 1.46 million Turkish lira to buy a U.S. dollar.

Two detailed sets of IMF demands and conditions have failed miserably to stop Turkey's decline. The policies have instead weakened the government, while completely failing to address the key issue of currency stability and domestic interest rates. As a North Atlantic Treaty Organization ally and the linchpin of secular government in the Islamic world, Turkey's success is important to the U.S. and the world. It deserves a growth program based on sound money.

That will only happen if the IMF is made to change. To date, U.S. efforts to reform the IMF have focused on limiting its growth and insisting that it make conditions tougher on foreign countries. This won't work. As we've seen recently with the efforts to stop new IMF support for Argentina, the organization is too powerful and intertwined in the world financial system to downsize, at least while the world is in a recession.

Furthermore, the IMF and World Bank enjoy a unique loophole in the U.S. budget law, so that U.S. contributions don't show up in the fiscal balance or the national debt. This advantage alone makes it hard to think that the U.S. will curtail its use of the IMF in international affairs.

Successful Reform

In sum, successful IMF reform would have to go to the heart of the IMF's approach -- changing its focus from austerity programs to growth programs. The U.S. should work with the IMF to champion sound money, reasonable tax rates, and faster growth as part of a common interest in global prosperity. These goals are possible even in poorer countries.

No doubt the leaders in many a developing country were snickering at the thought of the IMF -- with its record of failure -- giving the U.S. economic advice. A greater cause for smiles, however, would be if the IMF would admit the backwardness of its approach, and start doing something that really will help the world's struggling economies.