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.