Baffled by Brazil

The International Monetary Fund's $30bn rescue package for Brazil and a $1.5bn US bridge loan to Uruguay signal the utter collapse of the ill-conceived US policy towards emerging markets announced barely a year ago.

According to that policy, no large bailouts would be granted and no bilateral assistance would be given. Understandably, emerging markets are now seriously confused by the gap between rhetoric and fact - a confusion that undermines the international community's ability to deal with financial crises. It is time the US Treasury and the IMF closed this gap: they need to put their mouths where their money is.

Last year Paul O'Neill, US Treasury secretary, in a vain attempt to differentiate himself from his more successful predecessors, proposed a new approach to financial crises based on five principles: no large bailouts; no bilateral assistance; insistence on "ownership" of programmes by the recipient countries involved; greater emphasis on "prior actions" - the implementation of policy changes before money is granted; and greater use of private-sector involvement, or "burden-sharing".

Common sense has demanded that each of these principles be abandoned. But the logic of this failure needs to be articulated.

The principles were based on the conviction that moral hazard was the central distortion in international finance. According to this view, the international financial community's willingness to help countries in trouble promoted the type of irresponsible lending that was the ultimate cause of crises. The commitment to provide no new bailouts, coupled with a greater tolerance for sovereign defaults, would force markets to assess risk better.

The policy did lessen the volume of capital flows to emerging markets but, alas, has not reduced the incidence of crises. Instead, we have since seen the worst crisis ever and there may be more to come.

As Guillermo Ortiz, governor of the Bank of Mexico, pointed out in his recent Per Jacobsen lecture, study after study has empirically refuted the importance of moral hazard. The US's obsession with this issue has left it with no understanding of other, more important problems in international finance.

If moral hazard were the problem, it would be hard to see why the world needs an IMF at all. But to admit that would leave Mr O'Neill and Horst Köhler, IMF managing director, without a vision for the organisation or a justification for their actions.

Mr O'Neill's comments on Argentina last summer and on Brazil a couple of weeks ago were meant to scare the markets out of a moral-hazard complacency. In both cases, the adverse market reaction led to a kiss-and-make-up trip and the promise of more money to patch things up.

The old IMF argued that crises were caused not by reckless lending, but by asymmetric and imperfect information about a country's financial strength. In some cases, markets could wrongly attack a solvent country, thus precipitating an unnecessary liquidity crisis. In other cases, markets would attack a country that needed to change its policies but that was unable to convince markets of its willingness to do so. In yet other cases, markets would react to countries that are, in effect, bankrupt.

To address these problems, the IMF used to send a mission to the country, to assess the situation and the government's willingness to deal with it. If an adjustment were needed, it would negotiate a plan to make the country stable. It would then announce its support for the programme and back up its word by putting its own money into the crisis.

To make the markets calm down it would disburse enough money up-front to give time for confidence to be re-established. To make the government's reform commitment credible, it would make additional disbursements conditional on adherence to the plan.

Threatening the markets with default or burden-sharing, it was understood, would only make matters worse: it would cause a stampede. Restricting the volume of lending would only limit the effectiveness of the commitment of the international community to see the crisis resolved.

In the case of Uruguay and Brazil, the lack of clarity and purpose has caused a potentially crippling delay in reacting to the unfolding drama, limiting the effectiveness of the eventual support. In neither case were policy changes needed or required. In the case of Brazil, there is less money than meets the eye, and probably insufficient to undo the damage caused by delay and neglect.

The US Treasury and the IMF need to articulate a philosophy that makes sense of their actions, lest these be interpreted as the result of a weak and ineffectual leadership that buckles under political pressures. At the moment, the IMF puts up the money but lacks the means to explain what it is trying to achieve. The world needs both.