The International Monetary Fund's astonishingly aggressive response to Indonesia's "radical" currency-board plan - now apparently suspended - reflects the defensive behaviour of an institution under attack. Once cornered, this bunch can show their fangs.The IMF was conceived in the Bretton Woods era, a point in history when it was believed that management of economies could be fine-tuned by rational economic planners. But faith in economic planning has long since bitten the dust. The Reagan and Thatcherite revolutions proved that price signals sent by the market are a far better way of determining the allocation of scarce resources than are the arbitrary decisions of elitist bureaucrats. As a consequence, pseudo-scientific mechanistic approaches, such as the econometric models once so beloved by macro "forecasters", have been rightly discredited. Today there is much greater appreciation of the fact even if the models were right, they depended on data inputs that are suspect at best - garbage in meansgarbage out. Consequently, the people who predicted Asia's deflationary debt crisis (and such people do exist) were not the ones busy analyzing data from previous business cycles, but those with enough common sense to take alarm at the unprecedented growth in credit, much of it borrowed on a short-term basis.
Although the questioning of old mechanisms represents progress, there is one area where faith in the discretionary management favored by the IMF remains absolute, even among cynical market traders. That is the credibility accorded to central bankers as the unanointed wise men of the financial world. Given central bankers' track record, this continued faith in them is baffling.
Modern central banking is by its nature an extremely discretionary exercise, especially the key power to act as lender of last resort, courtesy of the long suffering tax-payer. Central bankers have won many plaudits in recent years for the defeat of inflation. But in fact their role in inflation's demise has been hugelyexaggerated.
The historical reality is that great inflations, as experienced during the Cold War era, always breed great deflations when credit-driven investment booms result in huge over-capacity. That's what is happening now, with the additional significant fact that the cycle has been artificially extended by central bankers' determination to keep bailing everyone out. Hence, liquidation tends to be postponed, which is why watching deflation in Japan during the past seven years has been an experience not unlike watching paint dry.
Central bankers should therefore be seen as mere surfers bobbing along on the waves of history. They are "important" today mainly because the financial markets still assume they are important, just as financial markets used to think money supply statistics were important but no longer do so. The impact of central bankers is only at the margin, however. Consider the Federal Reserve's much-vaunted manipulation of short-term interest rates. Is this really what has causedinflationary pressures to collapse in the U.S.? Only minimally. Far more influential has been the role of the bond market, where investors have demanded a high real return because of enduring memories of the losses they suffered during the 1970s. Sustained high long-term real interest rates will naturally cause inflationary pressures to decline. Inflation is only likely to reappear when bond investors stop worrying about it and no longer demand high real returns.
Another dodgy article of faith is the assertion that central bankers can combat deflation by the simple mechanistic means of printing money. This notion has been hammered into generations of economics students. The Great Depression of the 1930s could have been avoided, goes the almost universally received wisdom, if only the U.S. Federal Reserve of the time had printed money. From this mistaken assumption flows the prevailing orthodoxy that open-market operations - the central banking practice of buying government securities from the banking systemwith printed money-will cure all evils. This mechanistic monetarism shows remarkable faith in the ability of the printing press to counter long term cyclical forces. It is as historically naive as the now discredited Keynesian dogma that you can deficit spend your way out of a deflation, a point Japan now appears to appreciate after countless failed fiscal packages during the 1990s. What has all this go to do with Indonesia and its currency board? A great deal. The IMF is a product of modern central banking tradition. Indeed, in one sense, it is a central banker to the central banks - the ultimate lender of last resort. Therefore, the IMF is also the ultimate creator of moral hazard. Its discomfort with currency boards is all to understandable given that under a pure currency-board arrangement there is no place for a central bank.
The growing popularity of currency boards for reform-minded countries thus represents a direct challenge to the institutional dominance of the IMF. Indeed it threatens toundermine the organization's entire raison d'etre and make it utterly irrelevant. The trouble for the IMF bureaucrats is that this is not the only trend going against them. The growing acceptance of currency boards reflects the emerging acknowledgement of a fait accompli-namely the dominant trend toward the dollarization of developing countries. The adoption of a currency board means above all the acceptance of dollarization (though indirect) of an economy and the surrender of independent monetary policy. In this sense the emerging markets are moving back towards the late 19th Century era of a gold standard; though today it is a dollar, not a bullion, standard.
It is a trend entirely to be welcomed.s Governments have two choices when it comes to economic policy. Either float a currency and control the supply of money, or fix the currency against an anchor like the dollar and let the balance of payments determine liquidity flows. Half-way houses - such as crawling pegs-which seek to manage both the moneysupply and the exchange rate usually end up in disaster.
In a perfect universe, floating exchange rates may make perfect theoretical sense. But in the emerging market context they are vulnerable (as Indonesia's example shows) to the control politicians wield over central banks, and this means the temptations of the printing press. That is another reason why currency boards should be embraced in the emerging-market context; and particularly in Asia, where gross misallocation of credit has been a major contributor to the present crisis.
Reports out of Jakarta this weekend indicate that the IMF and its handmaidens may have succeeded in destroying the prospects of a currency board. If so, that is to be regretted. Indonesia at present stands on a knife edge. Successful implementation of a currency board could dramatically transform for the better the prospects not only of this densely populated country but also those of the entire Asian region. By contrast, failure will have catastrophic consequences.
TheIMF response to this initiative should have been far more constructive than it has been. It is therefore difficult to avoid two ominous conclusions: That the institution put saving its own role ahead of concern for economic success in Asia and/or that the IMF's leadership bashed the currency-board idea out of pique over the fact that it was not consulted first. After all, to be hated can be flattering, but to be ignored is positively insulting.
By arrangement with The Wall Street Journal
Copyright © 1998 Indian Express Newspapers (Bombay) Ltd.
