Why Asia should swallow the IMF's prescribed medicine

THE International Monetary Fund (IMF) has become everybody's favourite villain since financial cataclysm engulfed Asia. No matter that the markets seem, for now, to have stabilised. There is still no shortage of alternative financial therapists lining up to criticise the IMF for prescribing the wrong medicine.

They range from development charities concerned about the effect of tough fiscal and monetary policies on the poor to high-powered economists such as Jeffrey Sachs of Harvard University. He has argued that conventional austerity measures are out of place in responding to the financial crisis. Rather, he has claimed in some fierce attacks on the Fund, the right medicine to cure what he diagnoses as a self-fulfilling investor panic is increased liquidity in the banking system, not tighter monetary and fiscal policy.

Behind the volley of criticisms lies a common conventional wisdom. This says that even if austerity policies eventually do make things better, first of all they make things worse, and possibly catastrophically worse. The IMF is seen by its opponents as an old-fashioned leech doctor, sucking economies dry by imposing a recession which exacerbates poverty and political conflict. This, in turn, risks undermining any eventual economic stabilisation. Rather than a no-gain-without-pain cure, it is a pain-means-no-gain one.

Like most accepted truths, there is very little evidence for this view, however. Counter-intuitive as this may seem when Indonesia looks to be on the verge of appalling political violence, some episodes of IMF austerity in developing countries have been followed by economic expansion and many have not been particularly recessionary (because better policies have reduced long-term real interest rates). Besides, the pop wisdom makes no attempt to allow for the counter-factual possibility that the economy would have been in worse shape without the imposed monetary and fiscal policies.

What the debate boils down to is the question of who bears the responsibility for economic outcomes. Is it the insiders, the local politicians who have been setting policies for years? Or the outsiders, whether the fickle and instable "speculators" who triggered the crisis or the IMF trying to resolve it? A recent strand of academic research has been trying to answer that question.

One clue lies in an observation by Amartya Sen, the revered development economist, that famines never occur in democracies. This has been followed up by Dani Rodrik, a researcher at Harvard University's Kennedy School of Government, with two sets of findings*. One is that wages are higher in democracies. Controlling for obvious explanations for disparate wage levels, mainly differing levels of productivity, an improvement in democracy - measured by an index based on civil liberties and political rights - can raise wages by 20-40 per cent above the level pure economic indicators would predict. If Mexicans enjoyed the same political liberties as Americans, their wages would rise by 30 per cent, Professor Rodrik predicts.

The other result is that countries with less social conflict and stronger political institutions cope better with external shocks. The mid-1970s oil crisis slowed growth far more in those countries which suffered from high income inequality, ethnic tensions, corrupt bureaucracies and inadequate social insurance for the very poor. Differences in investment and government economic policies have very little extra power to explain differences in growth rates once the social and political factors have been included.

Another Harvard man has built an explicit defence of the IMF approach on these empirical foundations**. Alberto Alesina argues that the poor do not necessarily suffer because of the austerity measures, but rather because of the bias in government spending in many emerging countries towards spending on the vocal middle classes instead of the truly needy. For example, many governments - including those in Indonesia and Malaysia - heavily favour spending on higher rather than primary education, to the benefit of the well-off. Safeguarding traditional social spending would actually often just preserve patronage and interest group entitlement.

He notes, dryly: "The macroeconomic imbalances that eventually lead to IMF-supported adjustments are rarely the result of successful attempts at reducing poverty and inequality."

By contrast, the "alternative therapy" view does not pin the blame for crises - imbalances, in economist-speak - on internal policies. Its preferred culprit is footloose global capital, which the IMF is alleged to be bailing out by forcing Asian countries to alter their policies and repay their loans. If volatile capital flows caused the crisis, then by implication, the solution lies in controlling financial markets rather than improving government policies. There is certainly a bandwagon rolling in favour of this solution.

So which world view, the IMF approach or the anti-market alternative, is more plausible? Are government policies or market whims to blame for financial crises? The evidence in favour of the latter is that the Asian model of economic management worked well until last year, and the thing that has changed is not the policy or degree of political patronage, but the amount of foreign capital sloshing around. This lends support to calls for more transparency and better co-operation in the regulation of international investment and lending.

But this cannot possibly be the only explanation. The evidence for internal policy weaknesses is overwhelming. For instance, Indonesia is riven by ethnic tensions held in check only by force, while its business sector is dominated by relatives of the president. The surprise is surely that the economy worked so well for so long, not that it cracked under the strain of a big external shock. The right response on the part of the IMF, which is, after all, channelling billions of dollars into the country, is to insist on better policy and politics, not to try to make sure that the same kind of external shock cannot be repeated.

This is not to dismiss concerns about the outlook for the most vulnerable people, whether Indonesia's landless poor or South Korea's workers - simply to point out that their situation is more likely to be improved by internal reform than by ignoring the IMF prescription.

* 'Democracies Pay Higher Wages' and 'Where Did All the Growth Go?' by Dani Rodrik, Centre for Economic Policy Research Discussion Papers nos. 1776 and 1789, 0171-878 2900.

** Chapter by Alberto Alesina in 'Income Distribution and High Quality Growth' ed. Vito Tanzi and Ke-young Chu, MIT Press December 1997, pounds 46.50.