In essence, the IMF has listened too closely to Wall Street in recent years, taken at face value the recommendations and commentary of investors in emerging markets. The key interest of these short-term investors is straightforward. If you are a US bank with investments in Brazil, the main thing that you want is for Brazil to maintain its currency exchange rate until the time that you have been repaid - after that, who cares! Thus, you pressure the IMF and the US Treasury to urge Brazil, or Russia, or any other unfortunate IMF-loan recipient, to defend its currency at all costs. This gives the foreign investor time to get his money out of the country unscathed by a change in currency values.

But let's look at the consequences. Brazil's currency was too strong for several years, thereby punishing the country's exporters and contributing to low economic growth. The financial markets came to understand this basic fact, and therefore began to expect a currency devaluation. As a result, to defend its currency (as it did until Wednesday), it was necessary for Brazil to maintain punishingly high interest rates at home, in order to encourage investors, both foreign and domestic, to take the risk of keeping their money in Brazil.

These crushingly high interest rates, of 50 per cent per year or more, threw the economy into recession. But for the foreign creditors, that didn't matter - or so they thought. They just wanted to be repaid without a devaluation. For example, if a defence of the currency succeeds for six months, that's just fine for international banks that have 90-day loans on their books.

Actually, the consequences went beyond the recession itself. To defend the value of the exchange rate, the Brazilian Central Bank had to sell dollars and buy local currency. Thus,the country's foreign exchange reserves began to fall sharply. This put Brazil at risk of a terrible financial panic, since a country without enough foreign reserves can easily be thrown into default on foreign obligations (as occured in Russia in August 1997).

The IMF stepped in when Brazil's reserve levels declined at an alarming rate last autumn. To the cheers of the financial establishment, the IMF told Brazil in December: 'Don't worry about your falling foreign exchange reserves, we'll give you another $41 billion of short-term loans for you to defend your currency'.

This was insidious. IMF loans are effectively used to repay the foreign investors, either through a fairly direct mechanism (as was the case in Korea in December 1997), or indirectly when the central bank sells the dollars in the foreign exchange market as part of its currency defence operations.

In the end, the Brazilian people took on $41 billion of new debt, part of which was used to repay foreign loans. Brazil's taxes will now have to be raised, or spending cut, to service the IMF's loans.

Of course, in the end, everybody has lost in the Brazilian fiasco. The Brazilian people's debts have risen as a result of the IMF 'bailout', the currency has crashed anyway, the Brazilian economy is unnecessarily in tatters, and many foreign investors have lost some of their investments, since only a portion of the investors were able to get out in time. The result: a disaster made with the complicity of the official institution charged with helping its member countries such as Brazil.

What are the remedies? First, after years of failure, the G7, for its own good, should lead the IMF's managing director, Michel Camdessus, to the door. Second, there needs to be a complete revamp of IMF operations. The institution should stop its failed prescriptions of crushingly high interest rates and large loans to countries to defend their overvalued currencies.

On the part of developing countries, two crucial steps are needed. First, countries should - in the vast majority of cases - adopt flexible exchange rate systems,rather than pegged exchange rate systems. Second, they should reject the sweet enticements of short-term loans from international banks and from the IMF. The combination of overvalued currencies, short-term debts, and IMF 'rescue packages' have proved to be an explosive brew.

• Jeffrey Sachs Prof Sachs is director of the Centre for International Development at Harvard University