The Fund is back in town

The tough remedies of the IMF won it few friends and, in recent years, countries have found more obl

A year ago I attended an informal briefing in Washington by a senior British policymaker who lamented the passing of the International Monetary Fund as an institution of any worth. Globalisation meant that bankrupt nations no longer needed IMF medicine to cure their ills. Rather, they could obtain all the finance they required from the global banking system without strings attached.

Instead of a nasty IMF able to topple governments - as almost happened in Britain during the sterling crisis of 1976 - the world needed a different kind of international authority: one that was slimmer, cheaper to run, fleeter of foot and able to provide advice on the great global issues of the day, such as the mismatch of exchange rates between the US dollar and the Chinese yuan.

The IMF could no longer rely on the interest rate charges it received on loans to support its operations, as the last of a previous generation of big borrowers, Argentina and Brazil, paid back their debts by the start of 2006, two years ahead of schedule. To stay afloat, the IMF would have to sell off some of its huge gold reserves, paid in by western governments as the Second World War drew to a close. That same year, the governor of the Bank of England, Mervyn King, warned that the Fund was in danger of "slipping into obscurity".

How rapidly things changed. By the spring of 2008 the IMF, under the leadership of the then recently appointed managing director, Dominique Strauss-Kahn, a socialist and former French finance minister, was among the first global organisations to predict doom for the world's banking system. When it suggested the eventual losses from the US sub-prime debacle could reach $1trn, this was airily dismissed by bankers and policymakers as scaremongering. It is now clear that the eventual cost could be at least twice that.

Now, a crisis that began in the more recherché areas of the banking system is spreading far and wide. Countries from Iceland to Pakistan are knocking on the doors of the IMF's fortress-like headquarters in Washington, a few hundred yards from the White House, asking for advice and money. The Fund is back in business.

It is unfortunate, therefore, that just as the IMF is starting to be revitalised by the task of saving global capitalism from itself, it has been bedevilled by allegations concerning the priapic behaviour of its leader. Strauss-Kahn now finds himself under investigation by one of the world's largest law firms (on behalf of the IMF's board) over allegations of an improper relationship with a former member of staff, Piroska Nagy, an economist who worked in the Fund's Africa department. Nagy, a Hungarian national, has since moved on to work for the European Bank for Reconstruction and Development but, according to the Wall Street Journal, may have received "an excessive pay-off" when she left.

The incident will rekindle memories of the departure of Paul Wolfowitz from the World Bank in June 2007, after similar allegations of an affair with a member of staff. In both cases, the complex politics of the Bretton Woods institutions played a part. Wolfowitz was under fire for his neoconservative views and for using the Bank to support regimes he favoured. Strauss-Kahn is being targeted for his advocacy of tight market regulation and his support of Keynesian policies to refloat the global economy.

Irrespective of what the investigators turn up at the IMF (in the Wolfowitz case, a huge dossier of documents eventually emerged), it would be calamitous if Strauss-Kahn were forced to step aside at present.

The IMF's previous boss, Rodrigo Rato, resigned for mysterious "personal reasons" in October 2007, midway through his term of office. This exposed a huge rift over the traditional, undemocratic way in which the leaders of the IMF and World Bank are chosen. His torically, the Europeans - when they eventually agree among themselves - have chosen the managing director of the IMF, while the Americans have chosen the president of the World Bank.

This convention has so far blocked Asian, Russian and Latin American access to these hugely influential jobs.

The last thing the world needs now, with the banking and financial system on the edge of a precipice and the capital markets all but closed down, is a long-drawn-out fight over financial leadership. As we saw in the US Congress, when the Treasury's $700bn bailout of American banking was first rejected, politics plays badly on Wall Street and financial markets around the world. A fight for the soul of the IMF, in the middle of a crisis, could be dangerous.

The flow of capital from the west to emerging market economies is under severe pressure because of the banking catastrophe. Last year, emerging markets received inflows of $900bn from western financial institutions. This year, the figure will be only $56bn, thus starving countries across the world of the money they need to service their debts, to invest and to buy goods on global markets.

Moreover, nations holding large foreign exchange reserves, such as China and the oil-rich Gulf states, are pulling in their horns because of market uncertainty. It is when the flow of capital dries up that the global “lender of last resort”, the IMF, comes into play.

In the 1980s, the IMF was at the forefront of economic reform in Latin America. The arrival of IMF teams with proposals to end food subsidies would often result in rioting on the streets. In the 1990s, the Fund turned its attention to the former Soviet Union and its satellites, unleashing a period of klepto-capitalism.

This time around, Iceland, which has caused so much grief for British local authorities and consumers, is at the front of the queue and will collect $3.5bn in loans. Iceland is a classic case of a country in need. The banks have been nationalised. The currency, the krona, has fallen 18 per cent since March, and interest rates have been raised to 15 per cent with little noticeable effect.

But what is true of Iceland is typical of many nations around the world that have been able to live beyond their means because of the explosion in free capital flows. No one has worried about running a balance-of-payments deficit, because the assumption has always been that there will be a bank or foreign investment fund willing to meet the difference.

The year 2008 is starting to feel like 1996-97, when the Asian economies were under siege and suffered a precipitous drop in living standards.

Eastern European economies led by Hungary and Ukraine are struggling to remain solvent. South Korea, having had a run on its currency, has made a desperate call to Washington. Tur key, a perennial IMF client, is back in trouble. And Pakistan, up to its neck in debt and political unrest, also needs a bailout.

It could all become much worse, and developing nations are likely to be the victims hardest hit. One of the features of a slump is falling prices for primary goods and commodities. Just since July, commodity prices have fallen 37 per cent, cutting off a huge source of income for growers and people working in the mining industry. With western banks in disarray, there is little possibility that private capital flows will fill the vacuum. The only choice countries will have is to borrow from the IMF, whose money does not come cheap. And its loan fees come with austerity packages attached.

Strauss-Kahn may plead the Keynesian case to save the world from depression, but the IMF economists have been trained on a diet of balanced budgets, an end to subsidy, and privatisation. The result can be politically disruptive and socially divisive. The Fund is back and there is no reason to believe that it will be any more accommodating than in the past. That is not its way.

Alex Brummer is City editor of the Daily Mail