The IMF and Indonesia: Two Equal Partners
By Ernst Juerg Weber

Two economic crises stand out during the twentieth century: the Great Depression in the 1930s and the current crisis in Asia. The Asian crisis challenges modern macroeconomic opinion of all shades: Keynesian, monetarist and new-classical. In the 1930s, Keynes concluded that rigid wages accounted for the Great Depression. Ever since, rigid wages have played a prominent role in business cycle research. But the Keynesian approach is irrelevant in Asia because the crisis occurred in countries with unregulated labour markets. Monetarists do not fare better in explaining the Asian crisis. Certainly, the sorry shape of Asian financial institutions is now a major impediment to economic recovery. But, unlike the Volcker recession in the United States in the 1980s or the Keating recession in Australia in the early 1990s, careless monetary policy did not cause the Asian crisis. Finally, the new-classical brand of macroeconomics, which has dominated economics during the past 15 years, fails in Asia. New-classical economists have developed ‘real’ business cycle models that attribute economic fluctuations to technological shocks. There is no obvious technological shock that might have hit Asia in 1997.

The high profile of the International Monetary Fund (IMF) during the Asian crisis has attracted criticism from several quarters: economists, politicians and journalists – all of whom hold their own views on how to deal with the crisis. This article comments on the role of the IMF in Indonesia. As long as macroeconomists cannot put forward a convincing explanation of the Asian crisis, any judgment of the IMF’s role stands on shaky grounds. Therefore, the next section starts with a macroeconomic analysis of the Indonesian crisis.

Macroeconomics

Until 1996 Indonesia showed no signs of economic fragility. Like its Asian neighbours, the country had enjoyed strong economic growth for decades. During the 1990s, output grew at an average annual rate of 7·2% (table 1), close to trend growth of 7% since the Suharto regime came to power in the 1960s. Prior to the crisis there was no overheating of the Indonesian economy that might explain the subsequent downfall. In 1995-96 the country experienced an economic boom that falls well within the range of a normal business cycle in a rapidly growing economy. Output growth averaged 8% – just 1% above trend – for two years. The current account deficit, which measured US$3 billion per year in the early 1990s, exceeded US$7 billion in 1995 and 1996. This did not really threaten Indonesia’s solvency because foreign debt was moderate and the debt position had been improving in the first half of the 1990s. The ratio of foreign debt to GDP dropped from a peak of 66·2% in 1992 to 56·9% in 1995, and the debt-export ratio also improved.

Applying both debt indicators, the World Bank in 1996 classified Indonesia as a ‘moderately indebted middle-income’ country along with the Philippines, Greece and others. This put Indonesia one level below Malaysia (less-indebted middle-income) and above Argentina (severely indebted middle-income). Thus, the macroeconomic record suggests that Indonesia should have experienced a moderate economic downturn that would have restored sustainable long-term growth – about 7% per year – in the late 1990s. Instead, the Indonesian economy nosedived, in a way that is unprecedented for both developing and developed countries in peacetime.

There were also no warning signs on the monetary side of the economy that a crisis was imminent. During the 1990s, consumer prices increased on average by 8·6% per year (table 1). This is 1% less than the average rate during the past 20 years. As is always the case, the source of long-term inflation was excessive money growth. The average annual increase in the money stock amounted to 14·3% in the 1990s. A broader monetary aggregate that includes both money and quasi-money rose even more rapidly at 21·9%. Until 1996 the Indonesian economy behaved like any other at a steady rate inflating economy, say Australia and New Zealand in the 1970s and 80s.

Table 1. Indonesian Economic Statistics (Annual)

Source: IMF, 1997.

There is nothing special about the behaviour of the macroeconomic variables in table 1 and their long-term relationship that would signal an inherent weakness of the Indonesian economy. The peak in money growth in 1993-94 accounted for the modest boom in 1995-96. Considering the mean values in the bottom row, money growth exceeded inflation because output growth induced an increase in real money demand. The third column shows the growth rate of real money demand, which is calculated as the difference between nominal money growth minus inflation. The Indonesian data confirm the general rule that the output elasticity of real money demand is close to one, and possibly somewhat less. Dividing the average increase in real money demand by the increase in output yields an elasticity of 0·78.

The most outstanding feature of the Indonesian crisis is that the collapse of the exchange rate and the blowout in inflation were not caused by excessive money creation. Table 2 provides quarterly figures for money growth, inflation and the growth rate of real money demand in 1996-97. As can be seen, money growth and inflation remained stable until the third quarter of 1997. Still, the Indonesian monetary authorities played with fire in the first half of the year. The money stock grew by 16% in the first quarter and by another 7·9% in the second.

Table 2. Indonesian Economic Statistics (Quarterly)

Quarter	Money Growth (1)	Inflation (2)	Difference (1)-(2)
1996 I	4.6	3.8	0.8
1996 II	5.1	1.2	3.9
1996 III	3.6	0.6	3.0
1996 IV	-3.8	1.1	-4.9
1997 I	16.0	2.3	13.8
1997 II	7.9	0.9	7.0
1997 III	-7.4	1.6	-9.1

Source: IMF, 1998.

Initially, the public willingly absorbed most of the additional liquidity; real money holdings rose by 20·8% during the first half of 1997. However, there was no real reason for the public to hold all this extra money as output grew at an annual rate of at most 8%. The attempt by the public to readjust money holdings resulted in an outright run on the Indonesian currency in the third quarter of 1997. Bank Indonesia responded by destroying liquidity in order to maintain the exchange rate and keep inflation at bay. The money stock fell by 7·4% in the third quarter and the money market interest rate hit 62·3% in August, to no avail. The government was no more successful in containing the financial panic than it was in fighting the wildfires in Borneo. The exchange rate of the rupiah fell precipitously and inflation jumped to an annualised rate of 21·9% in October-November.

The broader monetary aggregate confirms that money creation did not account for the financial crisis. The sum of money and quasi-money rose at an annualised rate of 21·6% during the first three quarters of 1997, close to the average rate of 21·9% since 1990.

The Indonesian crisis is remarkable because Bank Indonesia faced a cataclysmic collapse of real money demand that is without precedent in peacetime, in Indonesia and elsewhere. During the panic, the public dumped rupiah-denominated assets – money included – for foreign currencies and possibly gold. As a consequence, the rupiah depreciated and inflation blew out. Macroeconomic factors cannot explain the Indonesian crisis. The Indonesian monetary system was hit by an abrupt loss of confidence notwithstanding the strong macroeconomic record.

The source of the Indonesian crisis is political. The run on the rupiah manifested a deep malaise in Indonesian society that came to a head in 1997. General Suharto imposed an authoritarian rule on Indonesia for more than three decades, during which corruption became rampant in Indonesian society (see Schwarz (1994) on Indonesia’s political evolution). There was no free press and political dissidents ran the risk of long jail sentences. Marketing boards and monopolies that were controlled by leading families and their cronies tightly regulated many aspects of the economy. In studies on corruption, which were regularly published in the financial press, Indonesia invariably figured among the most corrupt countries in the world.¹

The ‘new institutional economics’ (see Coase (1998)) stresses the importance of political and social institutions for economic performance. Lingle (1998) emphasises the link between political freedom and sustainable economic growth. Barro (1997) quantified the relationship between economic growth and political institutions. The rule of law is conducive to economic growth, while corruption impedes it. Too little (and too much) democracy stifles economic growth. On the other hand, economic growth induces demand for democratic rights – the Lipset hypothesis. These findings suggest that the Indonesian political system had become an impediment to continuous economic growth by the 1990s. The Suharto regime’s refusal to yield to the call for more democracy by the growing middle class had led to an impasse that eventually resulted in the downfall of the regime. The political instability accounted for the loss of confidence in Indonesian financial markets and the run on the rupiah.

Did Financial Markets Overreact?

Politicians are quick to complain when financial markets send signals that are not to their liking. The diatribes of Dr. Mahathir, Prime Minister of Malaysia, against free capital markets are legendary. Impervious to the repressive nature of the Suharto regime, Paul Keating attributed the severity of the crisis to popular misconceptions about Indonesia’s political system.

Why did this crisis happen? The main reason is that the future of Indonesia’s economy became caught up in judgments about its political system. ... most importantly, Indonesia was disproportionately punished because a grossly inaccurate view had taken hold that it was a rogue state, to be talked about in the same breath as Mobutu’s Zaire or Marcos’s Philippines. Partly as a result of East Timor and a domestic dispute over political fundraising in the United States, Indonesia had become a symbol and a caricature rather than a real, complex and deeply important country (Keating 1998).

In view of the strong macroeconomic record, many economists concurred that Asian financial markets were overreacting. They were seduced by a new strand of financial research that stresses positive and negative asset price bubbles (Flood and Garber (1994)). However, the research on asset price bubbles is irrelevant for the Asian crisis. Bubbles are extremely difficult to detect, requiring the use of sophisticated econometric techniques. In particular, there exists no technique to identify a bubble in the making, although the financial rewards would be enormous. There is no reason to believe that large and long lasting bubbles distort asset prices. The evidence on bubbles has remained mostly anecdotal, for example the tulipmania in Holland during the seventeenth century. Indeed, the preoccupation with bubbles in modern macroeconomics obscures a proper appreciation of the role that financial markets play in the economy.

Financial markets correctly signalled that something was amiss in Indonesia. The country had reached a point beyond which it could not progress without fundamental changes to the economic and political system. The Suharto regime should have heeded this message because financial markets provided a free forum for public opinion. By depreciating the rupiah by as much as three quarters, the public unequivocally conveyed to the government that without fundamental structural changes Indonesia would not rise above the level of a poor country manufacturing labour intensive goods. Like many autocratic regimes before, the Suharto regime disregarded the impartial advice of financial markets at its own peril.

The culmination of the political crisis in May 1998 confirmed that financial markets had been right all along. The idea that financial markets impart a candid appraisal of economic and political conditions predates the modern research on the efficient market hypothesis by at least a century. Across history, autocratic regimes have shared a disdain of financial markets as the last bastion of free public opinion. The economist Max Wirth, who lived in central Europe in the second half of the nineteenth century, commented on the autocratic regimes of Napoleon Bonaparte and his nephew:

Louis Napoleon would have had to have been a less ardent admirer and imitator of his uncle, than he proved himself to be in the constitution of 1851-1852, had he not paid great attention to the stock exchange like the first Napoleon. For the stock exchange had become an important public power already under Napoleon Bonaparte, remaining the only free organ of public opinion in a time when public opinion was suppressed by force of arms and when the newspapers were edited by the prefects. Napoleon Bonaparte however erred by not taking the stock exchange as the barometer showing the weather but by taking it as the body making the weather. When the stock exchange indicated bad weather, he became annoyed, complaining about the ingratitude of the capitalists, whom he had supposedly saved from the dangers of revolution.  ... Instead of inquiring into the causes of the irritation of the stock exchange and removing these causes, he rather deprived himself of a sensible advisor, as far as this was possible. (Wirth 1858/90, pp. 268-69. Reprinted on the back cover of the Journal of Political Economy 95/3, 1987, by G. Stigler. Suggested and translated by E.J. Weber.)

The Feldstein-Fischer Controversy

In January 1998 the IMF committed US$40 billion to Indonesia on condition that the economy would be restructured in a way that would restore its financial strength. The IMF program concerned monetary policy, fiscal policy, banking reform, and other structural reforms. This sweeping reform program proved impractical and negotiations continued without success during the first half of 1998.

Two main criticisms are commonly raised against the IMF’s programs for Asian countries. The IMF is said to usurp the role of policy maker in developing countries, and the provision of funds to indebted countries is viewed as an unjustified bailout of international financial institutions. A recent controversy between Martin Feldstein, Professor of Economics at Harvard University and President of the National Bureau of Economic Research, and Stanley Fischer, First Deputy Managing Director of the International Monetary Fund, illustrates these points.

Feldstein (1998) describes the IMF as an international organisation in need of a mission. He argues that the collapse of the postwar fixed exchange rate regime in 1971 has undermined the IMF’s raison d’être because the IMF was established as a guardian of fixed exchange rates. Feldstein charges that the IMF is now seeking a new purpose by making a foray into development economics, imposing its subjective policy agenda on sovereign countries.

The fundamental issue is the appropriate role for an international agency and its technical staff in dealing with sovereign countries that come to it for assistance. It is important to remember that the IMF cannot initiate programs but develops a program for a member country only when that country seeks help. The country is the IMF’s client or patient, but not its ward. The legitimate political institutions of the country should determine the nation’s economic structure and the nature of its institutions (Feldstein 1998).

Feldstein considers traditional austerity measures as sufficient to end the crisis in Indonesia. In particular, he denies the need for a comprehensive restructuring of the Indonesian economy to restore access to international capital markets.

In Indonesia, for example, in exchange for a $40 billion package (more than 25 percent of Indonesia’s GDP), the IMF insisted on a long list of reforms, specifying in minute detail such things as the price of gasoline and the manner of selling plywood. The government has also been told to end the country’s widespread corruption and curtail the special business privileges used to enrich President Suharto’s family and the political allies that maintain his regime. Although such changes may be desirable in many ways, past experience suggests that they are not needed to maintain a flow of foreign funds (Feldstein 1998).

As safeguard against inappropriate interference into the domestic affairs of developing countries, Feldstein proposes three questions that the IMF should ask when deciding whether to insist on a particular measure.

Is this reform really needed to restore the country’s access to international capital markets? Is this a technical matter that does not interfere unnecessarily with the proper jurisdiction of a sovereign government? If the policies to be changed are also practiced in the major industrial economies of Europe, would the IMF think it appropriate to force similar changes in those countries if they were subject to a fund program? (Feldstein 1998).

Feldstein answers no to all three questions: the reforms are not needed to restore access to international capital markets; they interfere with Indonesia’s sovereignty; and the IMF is biased, pushing for structural reforms in developing countries without promoting similar measures in Europe.

Fischer (1998) vigorously defends the IMF’s program against these charges. He maintains that the most important question is missing from Feldstein’s list, namely:

Does this program address the underlying causes of the crisis? There is neither point nor excuse for the international community to provide financial assistance to a country unless that country takes measures to prevent future such crises. That is the fundamental reason for the inclusion of structural measures in Fund-supported programs (Fischer 1998).

Fischer takes it for granted that the IMF should provide large scale financial assistance to Indonesia. Feldstein disputes this on the grounds that the proposed financial rescue package would give rise to the problem of moral hazard in international lending. The risk of losses is crucial for the proper working of credit markets; it forces lenders to exercise due vigilance. The provision of IMF funds rewards careless lending and excessive risk taking. International financial institutions will lower lending standards if they can count on the IMF to assume bad debts.

The provision of IMF funds may also give the incumbent regime the financial means to delay necessary reforms, a type of political moral hazard. Feldstein criticises the IMF for taking the lead in providing credit to Indonesia, noting that the IMF’s role was more modest during the Latin American crisis. He argues that international financial institutions should reschedule debts under the auspices of the IMF.

Evaluation

The IMF programs for Asian countries consist of two parts, the provision of IMF funds and an agenda of structural reforms. Fischer advocates a big financial rescue package and deep structural reforms. In the case of Indonesia, structural reforms are crucial because, as observed in the first two sections, the country is suffering a severe social and political crisis that undermines monetary stability. But the maximalist approach interferes with sovereign governance, and it generates moral hazard, both in international lending and politically. Therefore, Feldstein envisages a program that includes only minimal IMF funding and few reforms. This minimises political interference and moral hazard, and would be suitable for the more democratic Asian countries and those where the rule of law remains strong, for example South Korea and Hong Kong. But a minimal reform program is inadequate in Indonesia.

Politicians and the media favour a third type of program, one that combines lavish IMF lending with only token structural reforms. This approach effectively combines the shortcomings of the programs of Fischer and Feldstein. The program would bail out international financial institutions, giving rise to moral hazard, without addressing the social crisis in Indonesia. This leaves a fourth and final program, one that combines minimal IMF lending with extensive structural reforms. The advantage of this approach is that it avoids moral hazard, while it deals with the political crisis that accounts for the loss of confidence in Indonesian financial markets. The remainder of this section considers this type of program.

The most valuable asset of a central bank is the goodwill that it earns by holding the purchasing power of its currency stable. The growing interdependence of international financial markets has enhanced competition between central banks. The rapid advance in information technology forces central banks to keep inflation under control because people can easily switch to stable foreign currencies. A central bank that is perceived as being soft on inflation finds it difficult to keep money in circulation in an open monetary system.

This is particularly important during a political crisis that threatens the central bank’s ability to control the printing press. As in Indonesia, a crisis of confidence may erupt during which the demand for domestic money collapses. The exchange rate crashes and the currency inflates into oblivion unless the central bank redeems currency with foreign assets. This is a modern day version of an old idea – the so-called law of reflux – that was well known to nineteenth century economists, who were accustomed to monetary systems in which a number of private and state-run banks issued currency competitively under the umbrella of the international gold standard.

The standard way of restoring confidence in a currency is to raise interest rates, though this is a double-edged measure. High interest rates compensate the holders of debt instruments for country risk. But rising interest rates also force borrowers into bankruptcy and choke off investment. During the third quarter of 1997, Bank Indonesia instigated a liquidity crunch, reducing the nominal money stock by 7·4% (table 2). In August-September, short-term interest rate averaged 57·5%, while the annualised inflation rate was only 13·1%. This implied an exorbitant real interest rate of 44·4% that exacerbated the crisis. The policy induced liquidity crunch shows that Bank Indonesia had sufficient assets to manage the money stock even without emergency funding by the IMF. Still, it is not worthwhile to maintain the figment of a national currency if interest rates have to be raised to levels that destroy the livelihood of those who cannot easily transact in foreign currencies, namely the poor.

The notion of credibility has become central in monetary economics since the seminal research by Kydland and Prescott (1977) and Barro and Gordon (1983). This research suggests an important role for the IMF in restoring Bank Indonesia’s credibility. Indonesia should develop a reform package that addresses the social and political ills of the country. After decades of corruption, financial markets will inevitably view this program with scepticism. Indonesia is in need of an independent auditor – the IMF – that enhances the credibility of the reform process.

Similar auditing arrangements are common in the private sector. Private businesses often accept outside control over core aspects of their operations by voluntarily joining trade associations that establish certain minimum standards. The purpose of these schemes is to ascertain the credentials of a business. In the same way, Indonesia must establish the credentials of its reform program. Investors require reliable information about Indonesia’s economic and social reforms. It is not sufficient if the government publishes a reform program because the program may be abandoned at a later date. The government should precommit itself in a way that leaves no doubt about its resolve. This can be achieved by concluding a contract with the IMF that specifies a reform path. Breaking the contract would impose a political cost on the Indonesian government. In addition, the provision of penalties in case of noncompliance enhances credibility. These penalties may take the form of downgradings of Indonesia’s IMF membership.

This course of action does not include the provision of IMF funds to Indonesia. The IMF should not try to sweeten the deal by providing funds; the reforms should be adopted only if they can stand in their own right. Indonesia should be treated as a sovereign nation that reforms its economic and political system in the interest of its people. Today, IMF programs are unpopular because the conditional provision of IMF funds makes it look as if the IMF is imposing reforms by stealth, exploiting economically weak countries that are in no position to reject IMF funds.

Modern monetary economics provides the clue to the resolution of the Indonesian crisis. Any rescue package that does not centre on the restoration of Bank Indonesia’s credibility is doomed to failure. Indonesia does not need financial help to stabilise the rupiah. Bank Indonesia was capable of creating a liquidity crunch and high interest rates without IMF borrowing. What Indonesia really needs is a credible plan of economic and political reform.

Once the public is convinced that the government is irrevocably committed to reforms, money demand will stabilise and the financial crisis will abate. By acting as an outside auditor of the reform process, the IMF can help Bank Indonesia to regain credibility after a period of political instability. An agreement with the IMF is in the interest of Indonesia. It will enable Indonesia to overcome the current crisis with lower interest rates and at a smaller loss of output than would be necessary if it acted alone.
 
References

Barro, R.J. 1997, Determinants of Economic Growth, MIT Press.

Barro, R.J. and D.B. Gordon 1983, ‘A Positive Theory of Monetary Policy in a Natural Rate Model,’ Journal of Political Economy 91 (4): 589-610.

Coase, R. 1998, ‘The New Institutional Economics,’ American Economic Review, Papers and Proceedings.

Feldstein, M. 1998, ‘Refocusing the IMF,’ Foreign Affairs 77(2): 20-33.

Fischer, S. 1998, ‘The IMF and the Asian Crisis,’ Forum Funds Lecture, University of California at Los Angeles, March.

Flood, R. and P. Garber 1994, Speculative Bubbles, Speculative Attacks, and Policy Switching, MIT Press.

International Monetary Fund 1997, International Financial Statistics Yearbook, Washington.

International Monetary Fund 1998, International Financial Statistics, January, Washington.

Keating, P. 1998, ‘IMF is Wrong on Soeharto,’ The Australian Financial Review, 26 March.

Kydland, F.E. and E.C. Prescott 1977, ‘Rules Rather Than Discretion: The Inconsistency of Optimal Plans,’ Journal of Political Economy 85(3): 473-491.

Lingle, C. 1998, ‘The Asian Meltdown,’ Policy 14(1): 17-24.

Schwarz, A. 1994, A Nation in Waiting: Indonesia in the 1990s, Westview Press.

Wirth, M. 1858/90, Geschichte der Handelskrisen, Reprinted, Burt Franklin, 1968.

World Bank 1997, Global Development Finance, Washington.

Endotes
1) Sources on corruption include: World Competitiveness Yearbook, International Institute for Management Development, Lausanne; and International Corruption Perception Index, Transparency International and Gottingen University.

About the author:
Ernst Juerg Weber is a Senior Lecturer in Economics at the University of Western Australia.

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