CAMBRIDGE: The IMF’s record remains perfect -- five big rescues since mid-1997, five big failures. Brazil was the latest to go off the rails. Last week its currency collapsed and stock market plummeted. This wreck is likely to damage not only Brazil but much of Latin America.

All this was avoidable. The three engineers guiding Brazilian policy - its government, the IMF, and U.S. officials - were negligent. Until the IMF in particular is called to task for its failures everyone risks waking up to financial shocks that undermine living standards in developing countries and threaten global stability.

Bluntly, the IMF has been too solicitous of Wall Street. If you are, say, a U.S. bank with Brazilian investments, you want Brazil to maintain its exchange rate until you get repaid (after that, who cares!). So, you pressure the IMF and the U.S. Treasury to urge Brazil, or Russia, or any other hapless IMF-loan recipient to defend its currency. This gives you time to whisk your money out unscathed before any change in currency values.

Fortunately, those disastrous policies are being abandoned - too late and at too high a cost. Indeed, Brazil’s stock market soared on news that the country’s currency - the Real - was allowed to float and the nightmare of a monetary straitjacket lifted.

Brazil’s currency, however, had been over-valued for years, whacking Brazil’s exporters and contributing to low economic growth. Why? In 1994, Brazil suffered hyperinflation, with prices rising 2000% per year. The then finance minister (now President) Fernando Henrique Cardoso, imposed a new currency with a stable value to the U.S. dollar, roughly 1 Real per 1 dollar. Inflation dropped, but it took some time for it to cease altogether. Brazil began to recover, but the relative costs of productions were still going up for some time.

By late 1995, inflation was gone, but exporters were squeezed. Local costs doubled while the prices received for exports remained unchanged, since each $1 of exports translated into approximately 1 Real of local earnings.

Financial markets understood the impact of this and expected a devaluation. For Brazil to defend its currency, it was necessary to maintain punishingly high interest rates at home in order to encourage investors, foreign and domestic, to risk keeping their money in Brazil. For foreign creditors, such crushing rates didn’t matter (or so they thought). If a defense of the currency succeeds for six months, that’s all the time international banks with 90-day loans on their books need to make their get-away.

Brazil’s government, the IMF, and the U.S. didn’t need to go this route. They were urged to allow the Real to weaken slightly and gradually, according to market forces, in order to restore export profitability. By 1996, Cardoso was President, but he had fallen in love with the stable – though unrealistic - exchange rate. When Asia’s crisis hit in 1997, the IMF and the U.S. short-sightedly believed that exchange rate stability would help the world, and Brazil. They encouraged President Cardoso to defend the overvalued Real through stringent policies.

Defend he did. Interest rates were jacked up to 50% a year to encourage skittish investors to hold Brazilian assets. Investors aren’t blind. They knew the currency was overvalued. But at a 50% annual return, they gambled, and even expected (rightly) that the IMF would give Brazil big bucks to back up its currency if necessary.

During 1998, Brazil’s economy began a tragic, predictable descent into recession. High interest rates sent the budget deficit soaring, because Brazil’s government held large short-term debts, and the financing costs on them were sky-high. The deficit ballooned from 4% of national income in 1997 to 7% in 1998. Brazilian investors and U.S. banks began to take money out, forcing the Central Bank to sell scarce dollars in order to keep the hallowed stability of the currency.

Throughout 1998 it would have been preferable to lower interest rates and let the Real move to a realistic level. When Russia defaulted in August 1998, and investors began to bolt emerging markets, the U.S. and IMF decided to loan Brazil the proverbial rope to hang itself.

To the cheers of the financial establishment, the IMF told Brazil last December, "Don’t worry about your falling foreign exchange reserves, we’ll give you another $41billion of short-term loans to defend your currency." This was insidious. IMF loans are effectively used to repay foreign investors, either through a fairly direct mechanism (say, Korea in December 1997), or indirectly when the Central Bank sells dollars in the foreign exchange market as part of its currency defense. Brazilian taxpayers will now be hit hard, and social and other spending cut, to service the IMF’s $41billion in loans.

Now, Brazil has abandoned its currency defense, but only after sending the economy toward depression and building up huge debts following a year of astronomical interest rates. By floating the currency Brazil got some breathing room to cut interest rates and head off depression. Nonetheless, many investors may run in panic from Brazil and the rest of Latin America. There’s nothing like a high-profile failure of a Washington-backed policy to stoke a general retreat from the region, leading to cascading bank failures, economic contraction, and widespread hardship.

The IMF-U.S. strategy of telling countries to defend their exchange rates through high interest rates backed by IMF bailout loans should end and the IMF’s Managing Director, M. Michel Camdessus, shown the door. Brazil has seen the light - the hard way. Other developing countries should adopt flexible exchange rates and moderate interest rates, and avoid IMF rescue loans like a poisoned chalice.

Throughout Latin America, it will be necessary for major international banks and national governments to negotiate a responsible path forward, one in which governments behave sensibly and realistically, while large banks recognize their collective interest in avoiding panicked withdrawals. If bankers panic and yank their loans, they will bring enormous damage to themselves as well as to Latin American economies.