Dealing with Bank System Failure: Indonesia, 1997–2002

The crisis recovery program in Indonesia has failed badly in relation to the two key objectives of development economics policy-making: efficiency and equity. The economy went into a very severe recession within a few months of the IMF appearing on the scene, and five years later output was still only at approximately the pre-crisis level. The collapse of the banking system and the associated bailout of depositors by the government has had the effect of imposing a loss on the general public, and the poor in particular, of the order of 40% of GDP. This paper describes the collapse of the banking system and the policies the government has followed in response to it, under advice from the IMF. It then goes on to propose an alternative scheme that might have been followed—and that could be followed in future banking crises—the twin objectives of which are to maintain the integrity of the payments system while avoiding inequitable wealth transfers that result from government bailouts of banks and their depositors. JEL classification codes: E42, E58, E65, G21, G28