Economic Domino Theory

But the IMF Will Bail Us Out, Right?

The expectation of a bailout by the International Monetary Fund has led investors to become increasingly blasé about the levels of risk they are taking in investing in emerging markets. This phenomenon is known in economists' circles as "moral hazard" - it basically means that the link between risk and reward is being severed, which leads people to invest their money in less stable financial institutions, who in turn distribute it in bad risk loans (such as to Indonesia's crony capitalists). The argument states that if people fully understood the levels of risk they were taking with their investments, they would invest in safer vehicles with less likelihood of default but somewhat diminished returns. The real risk of moral hazard is that good risks - such as a domestic community redevelopment project - might be unable to get funding because the available funds are being invested in risky projects abroad.

So why does the IMF interfere? Why not simply allow these economies to collapse and let the foolish investors reap what they have sown? As with everything economic, the answer is not that simple.

If we simply allowed an economy to collapse, large investors would lose money, which would lead to layoffs back home, followed by decreased consumption and further losses in corporate profits and jobs. By stepping in with a temporary loan to keep an economy afloat, the IMF can stabilize the situation before it spirals out of control. The bailout of Mexico in 1995 is a good example - the $48 billion package managed to stabilize the economy, and Mexico has already begun making repayments on schedule.

Unfortunately, in the short run the IMF-mandated reforms often cause further economic upheaval, particularly for the poor. IMF policies prescribe stable exchange rates and higher interest rates to staunch capital outflows, but this can put the ailing economy into recession. Critics point out that the IMF is bailing out rich bankers at the expense of poor workers since recipients must dramatically cut budget deficits to qualify for bailout funds, and social programs are often the first to go. In Thailand, IMF strings have caused the government to cut spending by nearly 30 percent, ending many public works projects and social programs.

However, proponents argue that in the long run everyone will be better off because of the stabilized domestic economy and the opportunity to play a part in the global economy. Future investment is assured because IMF funds come with fiscal and monetary policies that adhere to international standards. That means that relatives of the country's president can no longer receive loans at lower rates than those for other investments of similar risk, and that more accounting information is becoming available regarding investments in developing and emerging markets. The availability of information is what economists call "transparency," and in the long run it assures future economic growth and stability because it encourages investment by reducing the risks of investing.