The IMF and Moral Hazard
The late 1990s saw a strengthening of the International Monetary Fund's core mandate as a global financial parent on the lookout for perceived instabilities to correct in the name of economic development. Several alterations in the scope of its operations following the crises of the previous 20 years had given the Fund a far wider range of policy options, as well as far greater resources, with which to support faltering economies.
The crises of the late 1980s and '90s — the Mexican peso crisis, the Russian debt default, the Asian crisis, the Brazilian currency crisis, and the Argentine crisis, among others — all were used to strengthen the Fund's core operating mandate, which is to stabilize exchange rates in order to facilitate global trade. The IMF's failures to immediately stabilize previous crises were reckoned to have been due to a lack of procedural guidelines allowing it to speedily aid the ailing economies. Each time a shortcoming appeared following the IMF's rush to maintain global financial stability, it was assumed that the existing scope of operations was inadequate, not that there was something fundamentally wrong with the very existence of these operations.
In some ways, Iceland's financial crisis could be recorded in the history books as much like the crises in Mexico, Russia, Brazil, Argentina, or any number of Asian nations. However, it differs in two major ways. First, the extent of its boom and subsequent collapse is much greater than anything experienced in the aforementioned developing countries. More important, and more puzzling, is the fact that Iceland is the first developed country to suffer a financial calamity of this scope since the Great Depression.
In response to these prior financial collapses, the world's centralized banking and monetary authorities, headed primarily by the International Monetary Fund, collaborated to initiate a period of surveillance, aid, and guarantees for the world's financial markets the extent of which had never been seen before. The short-term result was a long period of expansion and calm. Capital markets remained eerily liquid, even in the wake of such traumatic events as the September 11 attacks. The foreign exchange markets entered a period of reduced volatility. Investor optimism not only increased accordingly; it turned into irrational exuberance (to borrow a well-known phrase). The result of this artificially induced calm was a general underpricing of uncertainty. It is now widely recognized that the overleveraged banking system was unsustainable.
When seeking an explanation for this reduced perception of risk and for the rapid growth in cross-border investments, it seems reasonable to start by looking at currency markets, since money is the link between all transactions. But foreign exchange rates have not entered a period of what we could consider unusual calm, nor has our ability to forecast these rates improved significantly.1 If anything, (with the exception of the expanding European Monetary Zone) the tendency has been for additional countries to switch to floating exchange-rate regimes. This has made an additional component of entrepreneurial foresight necessary to navigate the market. Not only must input costs and output prices be estimated, but if either side of the profit equation is reckoned in a currency different from one's own, the exchange-rate fluctuation during the intervening period must also be approximated.
If the average risk of cross-border investing has not been reduced, specific volatile episodes have been greatly mitigated. International organizations have been only too eager to step in to prevent sovereign bankruptcies — those cases where governments declare bankruptcy, typically by defaulting on their debts and inflating their currency to worthlessness. The IMF has progressed through a period of increasing interventions into small or developing economies, aimed at saving investors from undue volatility or losses.
Following the Asian crises of the late 1990s, the IMF embarked upon an unprecedented expansion of its operating powers. The Fund disbursed deals worth $17 billion for Thailand, $43 billion for Indonesia, and $57 billion for South Korea — deals with conditions stretching far beyond the IMF's operating mandate.2 Of course, the IMF was not only battling economic crises in exotic locales, but also a political crisis closer to home. The Fund, which was formed in 1944 as part of the Bretton Woods Standard, had suffered a loss of relevance due to recent changes in the international monetary system. The Fund originally had four goals: 1) promotion of exchange-rate stability, 2) cooperation of monetary policy, 3) expansion of international trade, and 4) to function as a lender of last resort. In the early days of Bretton Woods, with a complex array of fixed exchange rates, at least some of these goals could not be promoted by individual countries. Constrained by their respective exchange-rate regimes, many countries found their interventionist hands tied when crises developed.
A shift to a global system of flexible-rate monetary regimes altered the situation fundamentally. Central banks could unilaterally expand their monetary base to combat liquidity crises, irrespective of depreciations of exchange rates (which had been constrained under the previous Bretton Woods system). There was no need to explicitly coordinate cross-border monetary policies. Each country's central bank could pursue its own policy, for better or worse, and reap the benefits or shoulder the costs of its own decisions. International trade was hardly in need of further promotion. The vast majority of the world had witnessed the advantages that open borders had created during the postwar period, and physical barriers to trade were becoming a thing of the past. A panoply of acronymed trade agreements (both unilateral and bilateral) appeared that promoted free trade without the need for an international bureaucracy like the International Monetary Fund.
These changes led to a crisis of relevance for the IMF. Effectively, it was left with only one of its four original goals to pursue: maintaining the stability of exchange rates. Admittedly, with the new and ever-expanding complex of flexible rates, this could be viewed as being a broader goal than ever before. The prevalence of flexible rates also gave the Fund an excuse to begin intervening at the slightest whiff of trouble to ensure that exchange rates remained "stable," or "controlled," lest the now-secondary goal of promoting international trade be threatened.
Indeed, calls for increasing regulation over monetary affairs were becoming the norm. The IMF was changing from a reactive agency, designed to aid countries only after they required help and had exhausted all other options, to a proactive agency intruding in others' affairs before a need was even apparent.3 Following the Latin American and, especially, the Southeast Asian crises of the 1990s, the calls for regulation intensified.
"Governments must now preside over a process of strengthening the institutional and policy bases of their economies to make them hardy enough to withstand and the benefit from globalization.… The IMF can and should play a role in advancing every part of this process," declared David Lipton.4 While discussing the financial role of the IMF, "the important point", according to Jack Boorman,5 was that
liberalization and privatization do not imply a lesser role for government.… If the crisis has taught us anything, it should be a reminder of the key importance of the institutional infrastructure needed to manage a successful market capitalist economy — legal systems, bankruptcy procedures, standards, transparency — many of the things now captured under the heading of architecture.
The IMF's Deputy Managing Director, Anne Krueger, reiterated these sentiments to the Icelandic public at a speech given on June 24, 2004 at the Central Bank of Iceland:
Crises have always been part of the Fund's work. The challenge for the IMF is to do as much as possible to prevent them, but, once crises occur, to resolve them as smoothly as possible.6
As the current crisis worsened a large number of government deficits, the Fund has called on the world's developing countries to make more resources available for it to combat the crisis. At a recent summit, the G20 agreed to triple the IMF's lending capability to $750 billion.7 It pledged to expand the IMF's own "currency" unit, the special drawing right, by $250 billion.8
As rapid and substantial support is given to countries at risk of liquidity or solvency problems, foreign investors' confidence remains elevated and their fear of default is removed (or at least reduced). Investors are enticed to take on higher degrees of debt in these countries. The elevated level of investment in these countries results in increased instability.
A second danger also arises from enhancing the stability of a country's finances. As international investment and confidence in a country's long-term perspective are increased, the volatility of foreign exchanges rates is commensurately reduced.9 Consequently, the enhanced financial stability gives domestic investors the advantage of denominating debts in foreign currencies, which often offer lower interest rates. This enables them to secure substantial savings as compared to using comparable financing denominated in the domestic currency. This shift from domestic to foreign sources of funding entails a cost that may or may not be embedded in the cost of borrowing; namely, the currency-exchange risk inherent in any debt undertaking where the currency of the income source or asset is different from that of the liability.
Recently, the International Monetary Fund has stepped in to provide rules for insolvency reorganizations. In response to a number of major global financial crises throughout the 1990s, the IMF increased its role as an intermediary in these international affairs. There were increased calls for the IMF to function as an international lender of last resort in order to stave off these insolvency crises and allow for more orderly exits to normalcy.10 With the existence of an overseeing agency, international capital markets could function with renewed confidence that future financial crises would not jeopardize debt repayments.
What is overlooked in this push for an international lender of last resort is that the more countries the IMF bails out, the greater will be the moral-hazard problem in other countries. In normal markets, lenders make loans to borrowers, and borrowers may enter bankruptcy. The debts are settled via a bankruptcy procedure in the court system; "this is how market economies are supposed to work."11 Risky countries, and, more importantly, their creditors, view the guarantee of bailouts as an insurance policy. Investors are less cautious about investing in developing economies as the IMF has implicitly guaranteed to cover their losses in the event of a financial calamity.
The work to establish an international lender of last resort may be unnecessary in most instances. After all, a sovereign nation has the built-in advantage that its central bank can inflate the money supply and retire debt obligations denominated in its own currency.12 This salient feature — a central bank acting as a lender of last resort — should eliminate the possibility that the banking system will become insolvent, provided debts are denominated in the domestic currency.
However, artificially induced stability in emerging countries has enabled entrepreneurs to diversify funding away from the domestic currency (which still suffers from an embedded and elevated risk premium) and into more stable foreign currencies.13 These foreign funding sources offer the advantage of a lower risk premium, which reduces the carrying cost of debt. Stable exchange rates induced by the IMF lead to an underpricing of risk, in the form of decreased foreign-exchange-rate volatility. As a result, there are strong forces enticing both governments and entrepreneurs to take on liabilities in foreign currencies.
This underpricing of risk led Icelandic banks to take on liabilities denominated in foreign currency. It also caused an increase in international speculation in Iceland as foreigners were lulled into thinking the króna was less risky than its fundamentals would have suggested.
- 1. Richard A. Meese and Kenneth Rogoff, "Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?" Journal of International Economics 14 (1983): pp. 3–24, and Richard A. Meese, "Currency Fluctuations in the Post-Bretton Woods Era," Journal of Economic Perspectives 4, no. 1 (1990): pp. 117–134, provide evidence that the predictive value that economic models have for monthly or quarterly exchange rates is essentially zero.
- 2. Devesh Kapur, "The IMF: A Cure or a Curse?" Foreign Policy 111 (Summer, 1998): pp. 114–129.
- 3. Effectively, the Fund had become a "lender of first resort" (Daniel Cohen and Richard Portes, "Toward a Lender of First Resort," International Monetary Fund working paper WP/06/66, 2009).
- 4. David Lipton, "Refocusing the Role of the International Monetary Fund," in Reforming the International Monetary System, eds. Peter B. Kenen and Alexander K. Swoboda, pp. 345–365 (Washington, D.C.: International Monetary Fund, 2000), p. 346.
- 5. Jack Boorman, "On the Financial Role of the IMF," in Reforming the International Monetary System, eds. Peter B. Kenen and Alexander K. Swoboda, pp. 366–369 (Washington, D.C.: International Monetary Fund, 2000), p. 366.
- 6. Anne Krueger, "The IMF at Sixty: What Role for the Future?" Lecture at the Central Bank of Iceland, Reykjavik (June 24, 2004).
- 7. It is no longer clear whether the IMF will get what was originally promised to it. Only about half of this amount has been firmly pledged by governments to date.
- 8. Some have suggested that an international institution, such as the International Monetary Fund (IMF), should function as an international lender of last resort (Stanley Fischer, "On the Need for an International Lender of Last Resort," Journal of Economic Perspectives 13 : pp. 85–104; Nouriel Roubini and Brad Setser, Bailouts or Bail-Ins? Responding to Financial Crises in Emerging Economies [Washington, D.C.: Institute for International Economics, 2004]; Maurice Obstfeld, "Lenders of Last Resort in a Globalized World," Keynote address, International Conference of the Institute for Monetary and Economic Studies, Tokyo, Bank of Japan [May 27–28, 2009]). Forrest Capie, "Can There Be an International Lender-of-Last-Resort?" International Finance 1, no. 2 (1998): pp. 311–325, and Jeffrey A. Frankel, "International Lender of Last Resort," Presented at the Federal Reserve Bank of Boston Conference "Rethinking the International Monetary System," (June 7–9, 1999), point out that the IMF can't function as a lender of last resort in the traditional sense, as it lacks the ability to print money. The fund, however, closely approximates this role given its large reserves relative to the size of the economies it aims at aiding. Michele Fratianni and John Pattison, "The Bank for International Settlements: An Assessment of Its Role in International Monetary and Financial Policy Coordination," Open Economies Review 12, no. 2 (2001): pp. 197–222, argue that the Bank of International Settlements should undertake the international role of a lender of last resort, while Varadarajan V. Chari and Patrick Kehoe, "Asking the Right Questions About the IMF," Federal Reserve Bank of Minneapolis, Annual Report (1999): pp. 3–26, claim that a consortium of the Fed, ECB and Bank of Japan would be large enough to combat international liquidity crises. Alternatively, Barry Eichengreen and Christof Rühl, "the Bail-In Problem: Systematic Goals, Ad Hoc Means," Economic Systems 25, no. 1 (2001): pp. 3–32, consider the role of collective-action provisions in loan agreements in helping determine when restructuring is desirable. Barry Eichengreen, Toward a New International Financial Architecture: A Practical Post-Asia Agenda (Washington, D.C.: Institute for International Economics, 1999) surveys the relevant proposals.
- 9. This risk reduction as it will affect the marginal lenders. Interest rates may stay at what appears to be a high level that fully compensates for the perceived risk, while at the same time enticing marginal lenders to shoulder more risk than they would like to at the going interest rate. Ludwig von Mises, " 'Elastic Expectations' and the Austrian Theory of the Trade Cycle," Economica, n.s., 10, no. 39 (1943): pp. 251–52) pointed out that artificially depressed interest rates need not be low by any objective standard to have detrimental effects. Relative reductions compared to the real (i.e., not artificially manipulated) rate are sufficient to induce entrepreneurial error.
- 10. Robert Gilpin, The Challenge of Global Capitalism: The World Economy in the Twenty-First Century (Princeton, N.J.: Princeton University Press, 2000), p. 335.
- 11. Joseph E. Stiglitz, Globalization and Its Discontents (New York: W. W. Norton and Company, 2003), p. 201.
- 12. There are dollarized nations such as Monaco, Kosovo or Liechtenstein that have adopted foreign currencies, such as Euros or Swiss Francs. They lack the ability to inflate their debt obligations away (indeed, in some cases, there is actually no need for it: The Principality of Liechtenstein does not have any government debt). These are, however, in the minority compared to the number of sovereign nations with central banks and independent monetary policies.
- 13. The International Monetary Fund ("Review of Recent Crisis Programs," [September 14, 2009], p. 45) has recently made note of this, stating that while exchange-rate stability is vital for the growth of developing economies, this goal must be framed against the potential future needs for adjustment.