Prepared Testimony of Dr. Steve H. Hanke
Professor of Applied Economics
The Johns Hopkins University
Baltimore, Maryland 21218
Mr. Chairman, thank you for this opportunity to express my views concerning the findings of the International Financial Institution Advisory Commission (IFIAC), as they relate to the International Monetary Fund (IMF). I had the opportunity to testify before the IFIAC on 3 January 2000. My written testimony ("Some Reflections on Monetary Institutions and Exchange - Rate Regimes") is contained in the IFIAC's compendium, Expert Papers, which was published in March 2000. My remarks today will elaborate on some of the themes contained in my IFICA testimony. I will also present vignettes based on some of my first-hand experiences in dealing with the IMF, particularly when I was involved in direct negotiations as a representative of Lithuania (1994) and Indonesia (1998).
The IFIAC's findings, in brief, are that the IMF has greatly expanded its scope and scale in an opportunistic manner, and in the process, has lost its way. As a consequence of misguided IMF policies, currency crises and banking panics have become more frequent and their magnitudes much greater. Unfortunately, all this has caused great hardship in many of the IMF's client countries. I agree with the IFIAC's diagnosis.
To remedy the problems at the IMF, and the ensuing national and international money and banking problems, the IFIAC has made a number of recommendations that would greatly reduce the scope and scale of the IMF. In short, the IFIAC's prescriptions require a reengineering of the IMF. Although I am in agreement with the thrust of these prescriptions, I am skeptical that the IMF can be reengineered and reined in. Indeed, I co-authored an article, "The IMF Hydra", Jobs and Capital, Vol. VI, No. 2, Spring 1997, in which I argued that all attempts to rein in the IMF had ended in failure, and that the IMF had turned these challenges into opportunities to expand its scope and scale.
One vignette will put my skepticism into perspective. With the election of Ronald Reagan in 1980, it looked as if the glory days of the IMF might come to an end. The Reagan administration favored restrictions on IMF lending. But the Mexican debt crisis changed all that. The hydra grew another head: IMF lending was necessary for "preventing debt crises and bank failures." Ronald Reagan himself proclaimed that he had personally lobbied 400 out of 435 congressmen to obtain approval for a U.S. quota increase for the IMF, and from 1980 to 1985 IMF lending increased by 27 percent in real terms. Of course, most of this lending was little more than a bailout of foreign banks that were overexposed in Latin America.
Unfortunately, the IFIAC, in making its recommendations, has failed to acknowledge the adage that if you strike at the King, be damn sure you kill him. That is why I believe that a more prudent prescription, one that follows logically from the IFIAC's diagnosis, would be to shut down the IMF, entirely and permanently.
To appreciate why my shut-down counsel is more prudent than the IFIAC's, consider that the core function of a reengineered IMF, as seen by the IFIAC, would be to focus on crisis management and to supply short-term liquidity assistance at a penalty rate to borrowers that put up good collateral.
Ironically, that echoes the Clinton administration and the IMF. The idea that the IMF should be an international lender of last resort was planted in 1995, when the Clinton administration cobbled together a multibillion dollar bailout for those who had invested in tesobonos, cetes and dollar-denominated loans to nonfinancial enterprises in Mexico. It wasn't until 3 January 1999, however, when the IMF's acting managing director Stanley Fischer addressed a gathering of the American Economic Association, that the idea got legs.
The classical lender of last resort idea was first proposed in the 19th century by Henry Thornton and Walter Bagehot. The classical theory was that banking panics could be averted if central banks stood ready to supply liquidity (high-powered money) at rates above those prevailing in the market to solvent, but illiquid, banks that put up good collateral.
In practice, central banks don't adhere to the classical prescription. Indeed, central banks in emerging market countries, where the IMF plies its wares, egregiously flout the classical lender of last resort rules. The Bank of Indonesia (BI), for example, is insolvent because it broke every classical rule in the book. In late 1997 and early 1998, the BI allowed commercial banks to overdraft the payments system to the tune of $37 billion. Insolvent banks automatically received high-powered liquidity from the BI at below market rates and without putting up any collateral. All this went unnoticed by the IMF technocrats who were in Jakarta. Among other things, I had to bring this to the attention of former President Suharto.
In the real world, the lender of last resort causes more banking panics than it stops. In the past two decades, 150 major financial breakdowns have affected 130 countries in which central banks have actively used their lender of last resort facilities. These breakdowns have imposed enormous bank bailout costs on taxpayers. Indeed, in some cases, these costs have exceeded 50% of GDP. By endless repetition and obeisance, the lender of last resort idea has congealed into a crust of economic dogma.
Where does all this leave the IMF as a potential international lender of last resort? Since the IMF cannot create high-powered money, it would act as a pseudo-lender of last resort, one that had to rely on its own resources, its ability to borrow or its capacity to create more Special Drawing Rights. This liquidity would be funneled through the IMF's Supplementary Reserve Facility and be made available at penalty rates to borrowers that put up good collateral.
International capital markets are ready, willing and able to provide liquidity on these terms. Indeed, in December 1996, Argentina adopted a formal "liquidity policy." Its linchpin is a contingent repurchase facility in which the Argentine central bank has the option to sell certain domestic assets valued at about $7 billion in exchange for greenbacks to a group of international banks subject to a repurchase clause. The cost of this liquidity protection is modest. The option premium is 32 basis points and the cost of funds implicit in the repo agreement is roughly LIBOR plus 205 basis points. Mexico has also tapped international capital markets for liquidity protection by establishing a $2.1 billion credit line with international banks.
Who needs the IMF as an international lender of last resort? At best, it would be a half-baked, redundant affair.
During the last century, there has been an explosion of central banks and new national monies. In 1900, there were only 18 central banks in the world. By 1940, that number had risen to 40. After World War II and with the growth of newly independent countries, the number of central banks grew rapidly, more than tripling to 136 in 1980. Today, there are 173 central banks.
The IMF played a leading role in this dramatic growth of central banking. And why not? It resulted in jobs for the boys. In any rational universe, the advocacy of central banking, particularly in emerging countries with a weak rule of law, makes about as much sense as giving an impoverished arsonist gasoline and then complaining about the resulting fires. Indeed, central banks in these counties have given rise to currency crises and banking panics, promoted corruption, impoverished citizens, and yes, given the IMF its raison d'être.
If the IMF is to be put out of business, I believe that central banking in emerging countries must be, in effect, put out of business, and commercial banks in those countries must be put on a sound footing.
Much like a three-legged stool, the cure rests firmly on three closely-linked reforms. The first would make base money sound by installing currency boards with liabilities (high-powered money) that are fully backed by a foreign reserve currency or by simply replacing national money with sound foreign money or monies. (This last option is something currently being championed by Senator Connie Mack - see: S.1879 - and has recently been adopted in Kosovo, Montenegro, East Timor and Ecuador.) The second would make bank money sound by requiring 100% liquid reserves against checkable bank deposits. And the third would separate the money and credit circuits and require lending (credit) to be extended by merchant banks whose liabilities are not monetary.
This reform package might appear radical, but it is not. Indeed, it is nothing more than the application of the currency principle which was fully developed in the nineteenth century, particularly in Great Britain. That principle, when initially developed, would have required money to be fully covered by and convertible into specie. It was first enshrined in Peel's Act of 1844. Tragically, this Act ended in failure because, unlike bank notes, it failed to require bank demand deposits to be covered by specie reserves.
Base money is the purview of monetary authorities, either central banks or currency boards. Central banks have broad latitude to create base money. Currency boards (and their close cousin, "dollarized" systems) do not have this flexibility. They are governed by the currency principle. An orthodox currency board system requires that domestic notes and coins, as well as deposit liabilities, be fully covered (usually at 100% to 115%) by foreign reserves denominated in a foreign anchor currency, and that the domestic currency must trade, without restrictions, at an absolutely fixed exchange rate with the anchor currency. An orthodox currency board cannot create credit. Therefore, it cannot extend credit to the fiscal authorities or act as a lender of last resort to the banking system. Currency boards run on automatic pilot, with changes in the monetary base determined solely by changes in the demand for domestic base money - the balance of payments.
The first currency board was established in 1849, and beginning about 1913, that system spread rapidly throughout most parts of the world. In the 1950s and 1960s, many currency boards were abandoned and replaced by central banks. This was a remarkable development. The performance of currency boards had been excellent. All had maintained full convertibility into their anchor currencies. Furthermore, countries with boards had achieved price stability, respectable economic growth and balanced government budgets.
The demise of currency boards resulted from a confluence of three factors. A chorus of influential economists was singing the praises of central banking's flexibility and fine-tuning capacities. In addition to changing intellectual fashions, newly independent states were trying to shake off their ties with former imperial powers. And the International Monetary Fund, anxious to obtain new clients and jobs for the boys, lent its weight and money to the establishment of new central banks. In the end, the Bank of England provided the only institutional voice which favored currency boards. That was obviously not enough. Politics, not the economic record, prevailed.
The picture began to change in 1983. After the currency crises of May-September 1983, when the Hong Kong dollar lost 40% of its value against the US dollar, Hong Kong reestablished its currency board system. This was followed in the 1990s, when Argentina (1991), Estonia (1992), Lithuania (1994), Bulgaria (1997) and Bosnia (1997) established currency board-like systems.
These developments trouble some analysts who fret about the inflexibility of currency boards and dollarized systems. The Economist summarized these sentiments in an article, "The Great Escape," which appeared in the 3 May 1997 issue. That article asserted: that currency boards cannot cope with external shocks; that they are vulnerable to surges in inflation triggered by capital inflows; and that with limited lender of last resort capacities, they cannot deal effectively with financial emergencies.
The evidence does not support these oft-repeated assertions about the alleged drawbacks of currency boards and dollarized systems. Post-1950 data from emerging countries show that countries with these systems have had average growth of rates that were 1.5 times higher than those with central banks, and that the variability of those growth rates (measured by their standard deviations) was virtually identical. As for inflation, currency boards and dollarized systems were also superior to central banks, with average inflation rates being 4.9 times higher and 4.2 times more variable in central banking than in currency board and dollarized countries. Fiscal deficits as a percent of GDP were 1.7 times higher in central banking countries. Financial emergencies have also been much less frequent and less severe in countries with currency boards or dollarized systems than in those with central banks.
A monetary constitution reform that makes base money sound, but leaves bank money unsound, is incomplete. Clearing banks are not required to hold 100% liquid reserves against checkable deposits. In consequence of this fractional reserve system, banks can create liabilities (bank money). To eliminate this element of discretion in the money circuit, the currency principle should be extended to all clearing banks that accept deposits, something that Peel's Act of 1844 failed to do. Fractional-reserve banking should be replaced by 100%-reserve banking. By requiring bank deposits to be covered by 100% liquid reserves, the money circuit would be closed and bank money would be as sound as base money.
Under 100%-reserve banking, depositors would no longer have to live in fear of being unable to withdraw their deposits because banks would have the liquid reserves to cover withdrawals. Banking panics, system-wide banking crises and tax-payer bailouts would truly be a thing of the past.
Another important advantage of 100%-reserve banking is the fact that banks would need very little equity capital to cover the small risks associated with the matching of their assets and deposits. This makes 100%-reserve system particularly well suited for emerging economies, where banks are notoriously undercapitalized.
If the currency principle is applied to both base and bank money, money will be sound. But how would credit be supplied? Merchant (or investment) banks would assume that function. They could generate credit (not money) by issuing shares and/or subordinated debt instruments.
This approach allows for expanding credit flows, while separating money from credit. By doing so, safety and soundness would be injected into the credit circuit. Indeed, shareholders would provide an important source of market discipline to the merchant banks because the owners of these banks risk losing their investments in case of merchant bank failures. The other element in the merchant banks' capital structure would, at least initially, be provided by subordinated debt. This debt also provides an attractive source of market discipline because, as distinct from depositors, the holders of capital notes cannot withdraw their funds on demand, when bad news surfaces. The holders of subordinated debt, therefore, have an incentive to prefer safe, conservatively managed merchant banks. Indeed, investors will only purchase riskier capital notes at significantly higher interest rates, and these higher rates (the cost of capital) will impose a strong market discipline on risky merchant banks.
The Achilles' heel of the emerging economies is the flexibility of their money and banking systems, something that has been actively promoted by the IMF. Fortunately, a time-tested cure is at hand. The currency principle should be extended to base money via currency boards and dollarized systems and to bank money via 100%-reserve banking. Money and credit circuits should be separated, with credit being the sole domain of merchant and investment banks capitalized via equity and subordinated debt. Incidentally, it goes without saying that foreign banks should be allowed free entry and be allowed to operate under the same rules as domestic banks. This is something that the IFIAC correctly stressed. This set of reforms, which is consistent with the IFIAC's recommendations, would give the money and banking systems in the emerging economies the soundness required to establish a secure tap-root into the vast pool of global savings and to do so without any IMF interference.
In closing, allow me to mention a few important vignettes. In order to maintain their position as the final arbitrators over whether a country can adopt currency boards or dollarized systems, the powers that reside in Washington - including the IMF and to a certain degree even the IFIAC - hold to the notion that certain preconditions must be satisfied. The Washington dogma, as stated by the Council of Economic Advisers is: "a currency board is unlikely to be successful without the solid fundamentals of adequate reserves, fiscal discipline and a strong and well-managed financial system, in addition to the rule of law" (The Annual Report of the Council of Economic Advisers. Washington: USGPO 1999, p.289).
This statement is literally fantastic. Indeed, as I have said before, "what nonsense." As a former Senior Economist at the CEA, I am shocked that such an absurd and unsupportable statement could have passed muster at the CEA, an institution that traditionally has had very high "fact-checking" standards. The CEA's statement on preconditions demonstrates how far off base professional economists can get when they fail to carefully study the history, workings and results of alternative institutional arrangements.
At best, few of the so-called preconditions have been met by any countries that have introduced currency boards or dollarized in the 1990s. Indeed, I would go so far as to state that none of the preconditions have been met in the countries that have most recently adopted currency boards or a foreign currency -- Bulgaria, Bosnia, Kosovo, East Timor, Montenegro, and Ecuador. All were basket cases. Bulgaria's currency board has been a roaring success, and the one in Bosnia, which was mandated by the Dayton Accords, represents perhaps the only achievement of the that international treaty. The story is much the same for all other currency boards that have been introduced in the 1990s.
In the historical context, it is important to mention that the so-called preconditions argument has never held water. Indeed, since the first currency board was installed in 1849, no currency board has ever failed to produce a stable, fully convertible currency. And that includes cases in which none of the so-called preconditions were met, a notable example being the North Russian currency board that was designed by none other than John Maynard Keynes in 1918 (S.H. Hanke and K. Schuler, "Keynes's Russian Currency Board," in: S.H. Hanke and A.A. Walters. Capital Markets and Development, San Francisco: ICS Press, 1991). It also includes cases in which all the preconditions were met, notably the with reintroduction of Hong Kong's currency board in 1983.
This precondition dogma and others promoted by the IMF are disseminated in the IMF's publications. Dissenting opinions are rarely even acknowledged in the footnotes of these texts. There is only one way, the IMF way. In cases where things go wrong, as they usually do, the IMF repeats its common refrain: "if they would have implemented our program, everything would have turned out as we predicted." In this regard, the IMF has much in common with General Phull, a pedantic Prussian general who would have won all of his lost battles, if the troops would have only followed his tactics and strategy. General Phull was rightly made an object of ridicule in Tolstoy's novel, War and Peace. To complement the IFIAC's report, perhaps a modern-day Tolstoy needs to take a crack at the IMF.
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