March 12, 1998

MEMORANDUM TO: OPINION LEADERS

FROM: GARY SCHMITT

SUBJECT: IMF, Congress and American Economic Leadership

I enclose a short paper written by Lawrence Lindsey, holder of the Arthur F. Burns chair at the American Enterprise Institute and former governor of the Federal Reserve. Lindsey argues that Congress should treat the Clinton Administration’s request for additional funds for the International Monetary Fund “as an opportunity to address a series of fundamental issues concerning global capital markets. By attaching appropriate conditions to the legislation, Congress can facilitate the IMF becoming a mechanism for promoting” reforms which encourage sound market practices in countries receiving IMF loans. Instead of loading up the IMF appropriation with a host of dubious labor and environmental conditions, Lindsey makes the case that the U.S. should use its position within the IMF to foster serious changes that are consonant with American economic principles and the realities of today’s global markets.

Getting Our Dollars’ Worth:
The IMF and Sound Capital Investment Practices for the 21st Century

Lawrence B. Lindsey

Congress has been asked to provide additional funds for the International Monetary Fund (IMF) to help support the IMF’s efforts to address the Asian economic crisis. The administration will argue that not increasing the U.S. contribution to the IMF simply poses too great a danger to the global financial system. And the likelihood is that a majority of Congressmen, if only out of a fear of the unknown, will ultimately go along. Nevertheless, the opposition has an important case to make: Congress should be reluctant to refund the IMF if the result is merely to allow the various participants in the recent Asian debacle, both creditors and debtors, to continue the practices that produced the crisis in the first place.

Congress should, instead, treat the administration’s request as an opportunity to address a series of more fundamental issues concerning global capital markets. By attaching appropriate conditions to the legislation, Congress can facilitate the IMF becoming a mechanism for promoting the reform of capital markets in the developing world and for putting into place a set of guidelines that will make future financial crises much more manageable.

In all probability, financial crises cannot be entirely prevented, either in the developing world, or, for that matter, anywhere else. Indeed, in the early 1990s, the U.S. encountered a fairly costly crisis involving many Savings and Loan (S&L) institutions which had become overextended with respect to real estate loans. However, the mechanisms were largely in place to disentangle the situation relatively quickly. While an immediate financial loss to the government could not be avoided, the economy as a whole suffered only to a relatively small degree, and was soon able to put the crisis behind it.

Any re-funding of the IMF must be accompanied with an attempt to set out a series of fundamental measures that would apply this experience to global financial crises generally. Some of the major elements of such a program are considered below. Although additional reforms might be advisable, the following comprise the core of a program for making the world safe for today's global financial flows, and vice versa.

• First, there must be a minimum standard for rules and regulations dealing with the bankruptcy of private firms. While each country will have its own detailed procedures, they must all recognize a method of granting insolvent firms some form of protection against creditors, transferring equity to creditors to extinguish unrealistic debt burdens, and, most importantly, allowing the firm's productive assets to get back to work as soon as possible.

• Similarly, bank insolvency or illiquidity must quickly trigger some form of regulatory intervention, both to guarantee the assets of protected classes of creditors (such as depositors) and to extinguish the claims of other creditors, either by partial payment of the amount owed or by transfer of equity. Much greater transparency is required so that the actual financial status of banks can be better known to investors and depositors, and to make it more difficult for government regulators to artificially prolong the life of ailing banks.

• Finally, some internationally-recognized mechanisms should be developed for dealing with the recurring problems of excessive and insupportable sovereign debt. General rules for creditor committees (including, for example, voting systems which, while requiring super-majorities to approve restructuring agreements, make it impossible for small creditors to unduly delay or derail them) should be established. While it may be true that sovereign debtors don't go bankrupt, the establishment of a general mechanism for dealing with restructuring sovereign debt will provide the necessary context in which creditors can estimate the degree of loss which they might sustain. This would make it easier to assess the degree of risk that should be attributed to sovereign debt when setting capital adequacy standards for banks.
Underlying all these proposals is the notion that, if global financial markets are to operate efficiently, there must be mechanism for preventing and rapidly dealing with the kinds of excessive debt burden which can paralyze banking systems and pour sand in the gears of commerce, as is currently the case in East Asia.

Greater transparency will make it clear sooner when debt has reached unsustainable levels; a greater readiness to force firms or banks into bankruptcy -- or sovereign debtors into restructuring -- will enable those debt levels to be extinguished by means of partial payments and transfers of equity; and the existence of these procedures and the experience gained as they are implemented will enable creditors to make more informed assessments of the risks they are running. Most importantly, these procedures will allow capital and productive assets to be quickly returned to a condition in which market forces can reallocate them to their best and highest uses.

• If this is to work on a global scale, then nations can no longer make distinctions between debt and equity investment by foreigners. In other words, if foreigners are allowed to lend money to a nation's businesses or banks, then they must be allowed to hold equity in them as well, generally on the same terms as domestic investors. Otherwise, the unwinding of excessive debt burdens will be too dependent on bail-outs by organizations such as the IMF, as is now the case. Of course, nations may wish to impose limited restrictions on this right: for example, the United States does not allow foreigners to hold equity in defense contractors or broadcasters on the same terms as citizens. In general, however, the nations that wish to enjoy the manifest advantages of global financial markets in the 21st century will have to recognize a similar globalization with respect to equity ownership of firms and banks.

The bottom line: The Clinton Administration has set a high priority on Congress appropriating an additional $18 billion to the IMF in the wake of the crisis in East Asia. As a result, Congress is in a position to insist that the administration and the IMF condition any new loans to a state (over and above its existing IMF quota) on that state first having adopted the sound capital investment standards outlined above. Although these suggested reforms are not meant to preclude other reforms Congress might want to link to the IMF appropriation, they are central to the U.S. using its position as the world's economic leader to promote market principles and practices that will serve both the world's interests and our own.

Lawrence B. Lindsey, a former governor of the Federal Reserve, holds the Arthur F. Burns Chair in Economics at the American Enterprise Institute.