On Aug. 14, the day Indonesia floated the rupiah, Stanley Fischer, deputy director of the International Monetary Fund, announced that “the management of the IMF welcomes the timely decision of the Indonesian authorities. The floating of the rupiah, in combination with Indonesia’s strong fundamentals, supported by prudent fiscal and monetary policies, will allow its economy to continue its impressive economic performance of the last several years.”

What has happened since is the opposite of Mr. Fischer’s optimistic scenario. The floating rupiah went into free-fall, throwing Indonesia’s economy into a recession. And yet, the IMF is now using its considerable political and financial muscle to prevent Jakarta from establishing a currency board, which would clean up the mess by fixing the rupiah to the U.S. dollar.

Misguided Opposition

This pressure is coming from the very highest level. Michel Camdessus, the IMF’s managing director, sent the Indonesian government a strongly worded letter last week threatening to cut off aid if Indonesia establishes a currency board. President Clinton, whose administration seems to have blind trust in the IMF, last Friday made a personal telephone call to President Suharto supporting the IMF’s position.

Such opposition to a currency board is misguided. A currency board is the only system under consideration that would achieve what both Indonesia and the IMF want—a sound currency to support a return to high economic growth.

After Indonesia floated the rupiah against the U.S. dollar in August, with the IMF’s blessing, the rupiah began a depreciation that reached 85% before the rally of the past three weeks. The IMF then made matters even worse. Its first attempt to help banks created panic because the IMF proposed giving deposit insurance only to government-owned banks. Depositors started withdrawing money from some privately owned banks, threatening to bankrupt them, until insurance was extended to all banks. And in January the IMF had to revise its aid package, announced Oct. 31, to reflect that in just two months the currency and the economy had gotten much worse.

To be fair to the IMF, almost all other observers also misforecast Indonesia. But the institution should learn from the past. Its approach in Indonesia has simply not ended the currency crisis or the steep decline of the economy.

The IMF’s approach had not worked because it has not addressed the currency crisis. The IMF’s current program with Indonesia (summarized on the IMF’s Web site) has seven parts: keeping inflation below 20% while avoiding a recession; holding the government budget deficit to 1% of gross domestic product; moving shadowy off-budget government spending into the budget; canceling some wasteful government spending projects; giving the central bank “full autonomy” in monetary policy, in particular allowing it to charge high interest rates; restructuring banks and companies; and ending trade restrictions that benefit privileged business interests at the expense of the public.

Notice that not one of these items would attempt to stabilize the exchange rate. Indonesia could fulfill every part of the IMF program, yet still have a rapidly depreciating rupiah. Not all of the bad news about the Indonesian economy is known yet, but the currency crisis does not seem to be the fault of the usual suspect, excessive deficit spending by the government. Rather, the crisis results from uncertainty about Southeast Asia generally and the Indonesian government specifically, and about how much further the government and the central bank will let the rupiah depreciate.

Central banking in Indonesia, as elsewhere, lacks built-in restraints. Bank Indonesia is free to print as much money as it wishes. Providing a stable currency through Bank Indonesia is therefore a tricky business. During the nearly 50 years that Bank Indonesia has existed, the rupiah has fallen to less than a millionth of its original value against of the U.S. dollar. People have little reason to hold rupiah, even at interest rates of 40% or 50% a year, rather than trustworthy U.S. dollars.

A currency crisis of this magnitude threatens to make the IMF program irrelevant, because the waves of the crisis are sinking the Indonesian economy. The prices of imports have risen, inflation is following and businesses that owe dollar-denominated debt cannot replay it. A chain of bankruptcies has begun. Bankrupt business cannot replay their bank loans, so the banking system faces collapse. The government will be tempted to socialized these losses by using new money printed by Bank Indonesia to compensate the losers. The likely result is yet higher inflation and a deeper recession than Indonesia is already entering.

The way to end the currency crisis is to address it forthrightly, and that is by stabilizing the exchange rate. A currency board will do just that. A stable exchange rate at the level that has been discussed—5,000 to 5,500 rupiah per dollar—will enable many Indonesian companies that now cannot repay their foreign debt to begin doing so. It will limit fresh inflation, though some inflation has already occurred that must work its way through the system.

Because an orthodox currency board holds only foreign reserves, it cannot finance government budget deficits directly or, as Bank Indonesia can, even indirectly. That creates pressure to restrain off-budget spending and wasteful spending projects. A currency board, unlike a typical central bank, has true “full autonomy” from political pressures on monetary policy because it is completely rule-bound and has no discretion to use its resources for political ends.

IMF Has It Backward

The IMF has claimed that Indonesia does not yet meet some of the conditions necessary to establish a currency board, in particular a sound banking system. The IMF has it backward. The whole banking system, rather than just a few banks, is in trouble because the currency crisis has created problems throughout the economy. Stabilizing the exchange rate is essential to fixing the banking system. It is possible to restructure the banking system without a central bank. Argentina did so during its 1995 banking crisis.

The bank-restructuring fund that Indonesia recently established could work like the similar Argentine fund. The IMF supported Argentina then, and the results were good. It should support Indonesia now.