IMF partly to blame for the misery

IMF partly to blame for the misery

By Steven Susanto

JAKARTA (JP): It is not hard to get the impression that the
International Monetary Fund forced the government of Indonesia to
liquidate 16 banks in November 1997.

This sudden liquidation caused people to worry about the
safety of their money in the banking system and, accordingly,
introduced a monetary crisis through a rush for liquidity.

It is ironical that many people here are suffering because the
IMF team does not have a good understanding of the properties of
money.

Money has two unique properties: a zero elasticity of
production and a zero elasticity of substitution.

When a commodity possesses a positive elasticity of
production, any increase in the demand for this commodity will
induce entrepreneurs to produce more of it by hiring additional
workers.

Because production of money is legally prohibited except by
monetary authorities, money is not a producible commodity or its
elasticity of production is zero. In other words, an increase in
the demand for money due to liquidation does not provoke any
increase in the demand for workers to produce it.

A positive elasticity of substitution means a commodity can be
substituted for others if the price of this commodity rises. Some
of the demand for this commodity, whose price increases will be
diverted to some other commodity or commodities, is a substitute
for the first.

Since the elasticity of substitution between money and
producible commodities is zero, the increase in the demand for
money cannot be diverted by the rising cost of money (interest
rates) back to things which are readily produced by labor.

This is because the reduction in the public's demand for
commodities in favor of money will immediately reduce the sales
of all employers and cause layoffs. Therefore, the rush to money
induced by the liquidation policy not only caused workers to be
laid off, but also they cannot be reemployed to produce the extra
money that the public desires. Stagnation and unemployment set in
inescapably.

The basic reason for withdrawing money from the banking sector
is the precautionary motive. The motive represents a barometer of
the degree of distrust in the government concerning the probable
subsequent policy that might affect people's lifestyle and
welfare.

The liquidation policy terrified people, provoking a fear of
financial loss. People viewed the policy as a threat to their
wealth and welfare. Their confidence in the monetary policy was
shaken and their precautionary motive for holding more money was
activated.

Prospects became less certain and people were no longer sure
of the outcome of their actions and reactions. Past experience
was no longer the common basis for determining responses to
different and unusual courses of events. More money was needed to
respond to the changing prospects.

Consequently, people deferred decisions about the use of
claims on resources in order to preserve additional options for
potential future action.

The rush to money made the atmosphere even riskier which
further altered the spending patterns. This alteration is
reflected in the swift shift in liquidity preferences from
illiquid resources to liquid ones.

This shift results in a higher demand for money because money
is the most liquid and least risky of all assets available as
stores of value overtime. The banking sector began to feel the
squeeze as liquidity became tougher to retain.

People had a higher degree of concern over things they were
not quite prepared for financially and money provides the most
certain link between the present and the unknowable future.

They reduced their current purchases of goods and services and
stored more of their current income in the form of money since
money is a means of deferring decisions about the use of
resources.

Because more money is stored up, the commodities that were
being produced were left unconsumed and unsold. In the end, there
is an increasing deficiency of domestic demand for reproducible
commodities because the increased demand for money is only to
further avoid the commitment of claims on resources.

Savings rose as people postponed or reduced their current
purchases of goods and services. A decrease in consumption
expenditure out of income is equivalent to an increase in saving.
In a world where surprises and disappointments are inevitable,
savings are unavoidable, but savings must not increase
simultaneously and abruptly, for, otherwise, unemployment rises
inevitably.

The IMF fails to understand that saving, as a decision to
defer prevailing commitments of resources, is the cause of
unemployment, and thus it is dangerous to devise a contractionary
policy to raise the saving level across the board. Because the
substitution of money for other produced commodities has a zero
elasticity, the plethora of unemployed created by the reduced
spending cannot be reemployed.

The liquidation also aggravated the formidable problem in the
whole financial sector. In continuation of the swift shift from
illiquid to liquid assets, a further move was a salient shift
from other liquid assets to dollar currency as an alternative
store of value.

The conversion knocked down stock and bond prices. Market
sentiments worked to impair public confidence across the board
and make the stock and bond markets precarious and fragile.

Gloomy prospects and bleak expectations were rife after the
stock index was toppled by the wild currency turbulence that
brought the rupiah to a devastating record low. The rush to
currency created liquidity panic that exhausted virtually all
cash reserves of a large number of banks. It led to a general
decline in asset values and raised credit standards. At last, it
resulted in liquidity havoc and bankruptcy in a credit crunch as
has become evident.

The IMF is partly responsible for this dismal state of affairs
in Indonesia. Its advice on liquidating 16 banks resulted in a
new dreadful episode of the most hurtful sort for the country and
its people.

The IMF team should have never advised a policy that disrupts
the stability of the system. The existing patterns of production
and consumption should only change gradually to avoid chaos and
disorder in the economic system.

People need system stability to allow them to work
productively and enjoy life comfortably. It is the stability of
the system that permits enterprises to engage in production
process and provides a basis for a sticky price level of
producible commodities.

Unfortunately, the decision to surprise and terrify people has
been implemented although it has only given most Indonesians
greater misery.

The writer is a financial consultant of PT ISI & Rekan,
Jakarta.

Window: The IMF fails to understand that saving, as a decision to
defer prevailing commitments of resources, is the cause of
unemployment, and thus it is dangerous to devise a contractionary
policy to raise the saving level across the board.