CHAPTER 4

Financial Stability: The International Monetary Fund

The case for global financial markets is less clear-cut than that for international trade. There is a fundamental difference between financial markets and markets for physical goods and services. The latter deal with known quantities, the former with quantities that are not merely unknown but actually unknowable.

 

Markets do show a tendency toward equilibrium when they deal with known quantities, but financial markets are different. They discount the future, but the future they discount is contingent on how the financial markets discount it at present. Instead of a predictable outcome, the future is genuinely uncertain and is unlikely to correspond to expectations. The bias inherent in market expectations is one of the factors that shape the course of events. There is a two-way interaction between expectations and outcomes that I call “reflexivity.”

 

The idea that market prices are influenced by market sentiment is nothing new. But the idea that market prices can influence the so-called fundamentals is less well recognized. For instance, the boom in Internet and telecommunication stocks accelerated the pace at which innovations could be introduced and allowed startup companies to capture the market for the most advanced products. Inversely, the bust is bringing a slowdown in new product introductions and allows established companies such as the regional telephone operators to gobble up the newcomers. This changes the relationship between supply and demand for many products, with profoundly negative effects on earnings. The jury is out on the question of whether the acceleration of productivity that could be observed in the last few years is going to be reversed in the next few years.

 

I contend that reflexivity provides a better conceptual framework for understanding how financial markets function than the concept of equilibrium. Equilibrium implies a determinate outcome, but in financial markets the outcome is genuinely indeterminate. It is characteristic of reflexive situations that there is a divergence between expectations and outcomes, and participants cannot base their decisions on knowledge. Their judgments are biased, and the participants’ bias becomes a factor in determining the outcome. At times the bias is so insignificant that it can be ignored; we can then speak of equilibrium. At other times the gap between expectations and outcomes is wider; we must then speak of far-from-equilibrium situations. Reflexivity allows for vicious and virtuous circles that are initially self-reinforcing but eventually selfdefeating.

 

It should be emphasized that the implications of reflexivity are not generally recognized. On the contrary, economic theory, in its endeavor to produce determinate results, has gone to great lengths to leave it out of account. Financial economics is built on the assumption of efficient markets and rational expectations. I contend that the theory of rational expectations is self-contradictory: In conditions of radical uncertainty it is irrational to base one’s expectations on the assumption that prices are based on rational expectations. In practice, few people do so.

 

Admittedly, some advanced theoretical studies, notably the second generation of theories about financial crises, have taken reflexive phenomena into account and have recognized the possibility of what they call “multiple equilibria.” But the prevailing view continues to be based on a fundamentally flawed market fundamentalist interpretation of how financial markets operate. That view is now endangering the stability of global financial markets.

 

Instead of moving toward equilibrium, financial markets, left to their own devices, are liable to go to extremes and eventually break down. Therefore they cannot be left to their own devices; they must be supervised, and to some extent managed, by the monetary authorities. Whatever the theory, this fact has been recognized in practice. The history of financial markets has been punctuated by crises, and each crisis has led to an addition to the regulatory framework. That is how central banking and the regulation of financial markets have evolved over time. The monetary authorities in the advanced industrial countries are well developed, but the evolution of the international regulatory framework has not kept pace with the globalization of financial markets. This can be seen by looking at recent history. The last 20 years have been marked by financial crises: the great international debt crisis that started in Mexico in 1982 and spread to most heavily indebted countries; another Mexican crisis in 1994 that spread to Latin America through the so-called tequila effect; and the emerging market crisis of 1997 that started in Asia and spread around the world, triggering the Russian default and ending with the devaluation of the Brazilian real in January 1999.

 

It is a distinguishing feature of these crises that they afflicted the periphery of the international financial system. The countries at the center remained largely unaffected because when they were threatened the monetary authorities took the appropriate actions to prevent a collapse of the international financial system.⁶⁰ This has caused a tremendous disparity in the economic and financial performance of the center and periphery. While the periphery went from crisis to crisis, the center remained remarkably stable and prosperous.⁶¹ Being in charge of the system has given the center a significant advantage.

 

The fact that global financial markets have created a very uneven playing field does not fit the market fundamentalist doctrine, which holds that markets ensure the optimum allocation of resources. Indeed, under the influence of market fundamentalism the emerging market crisis of 1997–1999 was an exception to the general rule that every crisis is followed by a strengthening of regulations. There has been some tightening of financial market and banking regulations in individual countries, but the general tendency has been to give greater play to market forces and a lesser role to official intervention at the international level.

 

Nobody questions the severity of the 1997–1999 crisis and the damage it has done, but opinions differ about the causes of the crisis. The prevailing view is that the way the IMF was operating interfered with market discipline and encouraged an irrational boom in international lending and investing, which then led to a bust. There were other factors at play as well: Many of the afflicted countries had unsound banking systems and followed inappropriate macroeconomic policies. But a root cause was deemed to be the moral hazard created by past IMF interventions; it was claimed that they led lenders to believe that in an emergency the IMF could be counted on to bail them out by coming to the rescue of the countries that got into difficulties in meeting their obligations. Whether this was valid or not, it came to be believed that future crises could be avoided by eliminating the moral hazard.⁶²

I do not disagree with this argument completely. The intervention of the financial authorities did introduce a moral hazard, and the moral hazard did contribute to an untenable boom in emerging markets. Where I disagree is in the consequences of eliminating the moral hazard. Market fundamentalists claim that if you remove the moral hazard, market discipline will do the rest. I contend that financial markets are inherently unstable and the playing field is inherently uneven; curing the moral hazard will cause new dislocations, but in the opposite direction, creating a shortage of capital in the emerging markets. I believe that the IMF needs to play a larger rather than a lesser role and that special steps need to be taken to reduce the disparity between center and periphery.

 

The argument is not easy to present because the problems are quite complex and, in part, highly technical. I shall first give a brief historical overview of how we got where we are, then analyze the situation that has arisen in the aftermath of the 1997–1999 emerging market crisis, and finally put forward some proposals for reforming the international financial system.

A CAPSULE HISTORY OF THE IMF

When it was established at Bretton Woods in July 1944, the IMF was designed for a world characterized by fixed exchange rates and capital controls. Its mission was to make the growth of international trade possible by establishing rules for managing exchange rates and international payments and by providing temporary financing for adjustments in the balance of payments.

 

Capital controls were gradually lifted, and the fixed exchange rate system broke down in 1971. The first oil crisis of 1973 created profound imbalances in trade, and it was left to the commercial banks to finance them. There was a tremendous expansion in sovereign lending, which led to a crisis in 1982. Preserving the international banking system became a priority. The IMF was the lead agency in putting together rescue packages that allowed debtor countries to service their debt. The central banks exerted pressure on the commercial banks to “voluntarily” extend the maturities of their loans and to put up some “new” money so that the debtors could pay the interest due. On the whole, the IMF was successful in carrying out its mission: Major defaults were avoided. This was the origin of what came to be seen as a moral hazard: In case of crisis the lenders could look to the IMF for rescue.

 

Most of the burden of adjustment fell on the debtor countries. It is true that the lenders had to set up reserves for bad debts and eventually, after the crisis had passed and the banks could afford it, much of the debt was reorganized in the form of Brady bonds, which yielded less and had longer maturities than the debts for which they were exchanged.⁶³ The first Brady bonds were issued by Mexico in 1989. On balance, the damage to debtor countries was much greater than to the banks: South America lost a decade of growth.

 

Under the liberalizing, deregulating impetus of the Reagan administration in the United States and the Thatcher government in the United Kingdom, international financial markets continued to develop apace during the 1980s even while the international lending crisis continued to fester. A plethora of derivatives, synthetic products, and other new financial products were introduced, and the financial landscape changed out of all recognition. That is when globalization truly took shape.

 

In 1994, Mexico ran into trouble once again. It had borrowed increasing amounts to preserve an overvalued exchange rate, and the government overspent prior to the 1994 elections; when the currency peg broke, the burden of debt became unsustainable. Once again, the IMF came to the rescue with a large assist from the U.S. Treasury. The holders of tesobonos—Mexican treasury bills denominated in pesos but indexed to the U.S. dollar—were paid off in full and, according to market fundamentalists, the moral hazard became more pronounced.

 

That was the background against which the emerging market crisis of 1997–1999 unfolded. The IMF was once again called upon to intervene in Thailand, Indonesia, and South Korea. But this time the programs did not work, and the contagion spread until it engulfed almost the entire periphery of the global financial system.

 

It can be argued that the IMF applied the wrong prescription in the Asian crisis. Its programs consisted of allowing currencies to float, raising interest rates to contain the currency decline, and reducing government expenditures to contain the budget deficit. In addition, a number of conditions were imposed, aimed mainly at the banking system but also addressing other structural defects such as the sectoral monopolies in Indonesia. The outcome was to aggravate the economic collapse. The prescription had been developed in dealing with excesses in the public sector, but in this case the excesses had occurred in the private sector.⁶⁴

It must be asked, however, whether the IMF had much of a choice. In my view, the appropriate course of action would have been to introduce a moratorium followed by debt reorganization. If the immediate pressure of debt repayments had been relieved, currency depreciation could have been contained without raising interest rates to punitive levels. The effect on the domestic economies would have been far less devastating. I have to admit, however, that a moratorium could have damaged the international financial system and spread the contagion. Since the primary mission of the IMF is to preserve the financial system, it could not take any chances. As it is, South Korea came close to a moratorium in December 1997, but the central banks intervened by leaning on the commercial banks to reschedule their loans on a “voluntary” basis. The arrangement was reminiscent of 1982, and it sent shudders through the financial markets. The contagion spread to Russia, and when Russia eventually defaulted in August 1998, the international financial system came close to a meltdown. It was avoided only by the timely intervention of the U.S. Federal Reserve.

 

Where the IMF did have a choice was in pressing emerging economies to open their capital markets. In retrospect it is clear that the international community under the leadership of the U.S. Treasury went too far in that direction. The IMF was even proposing to include the opening of capital markets among its core objectives at the time the Asian crisis erupted. Not much has been heard of that proposal since that time.

THE CURRENT SITUATION

The crisis of 1997–1999 revealed a fundamental flaw in the architecture of the international financial system. The countries at the center of the system are in a position to apply countercyclical policies. For instance, in the current downturn, the United States has aggressively reduced interest rates and cut taxes. But the conditions imposed by the IMF are pro-cyclical: They push countries into recessions by forcing them to raise interest rates and cut budgetary expenditures—exactly the opposite of what the United States is doing in similar circumstances.

 

In the past, countries with IMF programs were able to recover because financial markets had confidence in the IMF and were willing to follow its lead. For example, Korea was heavily indebted in 1980 and was caught up in the international lending crisis, but it managed to grow itself out of the problem beautifully. Since the 1997–1999 crisis, however, the emperor has no clothes: IMF programs fail to impress the markets. The afflicted countries seem to be caught in a downward cycle.

 

This problem is not new. It is a feature of the gold standard, and it was at the heart of the Great Depression of the 1930s. The founders of the Bretton Woods institutions, especially Keynes, intended that deficit and surplus countries should be treated symmetrically, both equally obligated to adjust to restore balance. In practice, the IMF’s leverage over surplus countries is almost nonexistent, and the burden of adjusting international payments imbalances has fallen almost exclusively on the borrowing countries.

 

Market fundamentalists see nothing wrong with this because they believe in market discipline. They are reluctant to accept that the system may be fundamentally flawed when it is working so well for those who are in charge. They attribute the crisis of 1997–1999 to structural faults in the affected countries. Insofar as they acknowledge any systemic defect, they attribute it to the moral hazard introduced by the IMF bailouts.

 

Undoubtedly there have been structural defects in individual countries, and it is also true that the IMF created a moral hazard, although the case is often overstated. But how will the system work without a moral hazard? The IMF rescue packages have served as a counterweight to the inherent disadvantages of the periphery and allowed the emerging economies to attract capital from abroad. The system does need to be changed, but it is not enough to eliminate the moral hazard. Something else must be put in its place to counterbalance the inherent disadvantages of the periphery and create a more even playing field. That is why I am arguing for credit guarantees and other credit enhancements, as I have been arguing from early on in the crisis.⁶⁵

 

The fact is that the moral hazard has already been cured. In the 1997–1999 crisis, the IMF did not succeed in bailing out the banks in Indonesia and Russia, and investors suffered serious losses. Moreover, in the course of the crisis the IMF has shifted its posture by 180 degrees: Instead of bailing out, it now insists on “bailing in” the private sector. The shift occurred gradually: By the time the Russian crisis came to a climax in August 1998, moral hazard had become a politically sensitive issue and constrained the financial authorities in their efforts to avoid the default. Thereafter, the IMF insisted on private sector participation in the rescue package for Brazil. This delayed the process and aggravated the crisis because commercial banks reduced their exposure in anticipation of having to maintain their credit lines. Subsequently, the IMF tried to find a country where it could demonstrate its new policy of private sector burden sharing. It tried in Ukraine and Romania and finally succeeded in Ecuador. The principle is now established and is reflected in the market prices of emerging market debt instruments.

 

What used to be a theoretical argument appears to be turning into reality. Emerging market economies are suffering from capital outflows and higher borrowing costs. Chart 4.1 shows the financial flows to emerging markets. It can be seen that the flow of credit has dropped sharply since 1996. What is less clearly visible, because it is obscured by the innocuous term “resident lending,” is that capital flight has offset most of the inflow. Taking resident lending, portfolio investment, and private credit flows together, there has actually been a net outflow from emerging markets since 1997, going from positive $81.7 billion in 1996 to a negative $106 billion in 2000, offset by slightly larger inflows of foreign direct investment and by official financing. Chart 4.2 shows the J. P. Morgan emerging market bond index (EMBI) from 1991 to 2001. It can be seen that the risk premium has settled at levels significantly higher than those that prevailed prior to the crisis of 1997–1999. The only question is whether the change is temporary or permanent. Market fundamentalists regard it as transitory; I maintain that it is structural.

Chart 4.1: Emerging Market Economies’ External Financing (in Billions of Dollars)

Source: Institute of International Finance, Washington, D.C., September 20, 2001.

Chart 4.2: EMBI January 1991-December 2001 Global Sovereign Spread

It is true that markets have become more discriminating among individual countries, but the attitude of the financial markets toward periphery countries is predominantly negative. The risks of lending to or investing in periphery countries or holding their currencies have greatly increased and, since those risks are reflected in higher borrowing costs, the rewards have diminished. Consequently it has become much harder to generate economic growth in the periphery countries, and the lack of progress generates political risks. In another manifestation of the uneven playing field, even the best emerging market companies may have to pay large interest premiums to raise capital, damaging their ability to compete in the global market and making them easy takeover targets for industrial country-based firms.⁶⁶ This holds true for countries as far apart as South Africa, Bulgaria, and Brazil. The high cost or unavailability of capital is the new contagion. It manifests itself not only in the lack of foreign investment but also in the flight of domestic capital. After the crisis of 1997–1999, the world’s savings flowed to the United States in search of better investment opportunities; after the bursting of the technology bubble, the inflow continued, motivated by the search for a safe haven. Unlike the periphery, the United States has had no trouble financing its current account deficit, which in 2000 reached 4.4 percent of GDP.⁶⁷

 

What is missing now is a set of incentives to encourage the flow of capital to emerging markets. It is a common occurrence in history that correcting one defect creates another. After World War I, the French built the Maginot Line to put themselves in a better position for trench warfare, and in World War II they were overrun by tanks. Similarly, the shift in IMF policy from bailing out to bailing in was aimed at winning yesterday’s war: avoiding a credit crisis by preventing a recurrence of an unsound lending boom. It has succeeded in its objective but has also sown the seeds of the next crisis: an inadequate flow of capital to the emerging markets.

NO MIRACLE SOLUTIONS

It is easier to identify the problems than to cure them. I have explained earlier why financial markets are inherently unstable. There is no magic formula that can change this condition. The financial system offers some excellent examples of problems that have no solutions. It is important to understand them to devise some practical proposals that would minimize their adverse consequences.

 

The first insoluble problem is the currency regime. Whatever regime prevails is bound to be defective, and the passage of time will reveal the flaw. Fixed exchange rates are too rigid; floating exchange rates are prone to develop self-reinforcing trends that eventually carry them into far-from-equilibrium territory. The major currencies clearly show such patterns. Trends often persist for several years before they are reversed, causing wide and disruptive fluctuations. ⁶⁸

 

Currency pegs, that is, tying the value of a currency to the dollar, the euro, or a basket of currencies, are also unsustainable. The breakdown of currency pegs in Southeast Asia was the immediate cause of the crisis in 1997. After the crisis, a theory was put forward that the solution is to be found at either of the two extremes or “corners”: either a currency board or a free float. Currency boards are more formal and more rigid than currency pegs. Under a currency board the monetary authority is by law prohibited from issuing national currency unless an equivalent amount of hard currency has been deposited with it.

 

Events have already proven the corner solution theory false. The currency board arrangement placed Argentina in an untenable position, and floating exchange rates have led to the seemingly endless appreciation of the dollar. The only lasting solution would be a single currency, but the world is not ready for it. Even the EU has difficulties managing its single currency, the euro.

 

The second insoluble problem is the absence of a global central bank. The IMF cannot act as lender of last resort because it does not exercise control over domestic banking systems. Acting in that capacity would mean signing a blank check. The absence of a lender of last resort forces the periphery countries to follow pro-cyclical, anti-Keynesian monetary policies.

 

De facto, it is the Federal Reserve System and the U.S. Treasury that are in charge of the world’s macroeconomic policy, although the other G7 countries also have a voice.⁶⁹

Being in charge gives the United States a tremendous advantage, although this fact is not usually acknowledged. The U.S. authorities pay considerable attention to conditions abroad, but their primary responsibility is for conditions at home, and in the ultimate analysis that is what guides their actions. When financial markets at the center are threatened they intervene vigorously, but they are able to suffer the pain of periphery countries without flinching.

 

The benefits that come from being in charge of the system can be demonstrated by contrasting the role of Germany in 1992 with that role today. In 1992, the Bundesbank was in charge of the monetary policy of the European Exchange Rate Mechanism (ERM). The reunification of Germany with a currency exchange rate of essentially 1:1 set up inflationary pressures in Germany while the rest of Europe was suffering from high unemployment and recession. The Bundesbank was duty bound by its constitution to raise interest rates, whereas the rest of Europe needed lower rates. The resulting tensions led to the breakdown of the ERM.

Today Germany has only one voice in the European Central Bank (ECB). It received no economic stimulus from the introduction of the euro, whereas the periphery countries of the Eurozone—Spain, Italy, and Ireland—benefited from a decline in their domestic interest rates close to the level that prevails at the center, namely Germany. As a consequence, these countries are doing better while the German economy is the weakest within the Eurozone. ECB policy is based on economic conditions in the Eurozone as a whole, and Germany is fast becoming the sick man of Europe. This example goes to show that being in charge of the system confers a definite advantage quite irrespective of being wealthy or not. But of course, being wealthy and powerful tends to put you in charge.

SOME PRACTICAL PROPOSALS

It would be unrealistic to advocate a wholesale change in the prevailing structure of the international financial system. The relative power of individual countries may shift over time, but the United States is not going to abdicate its position, nor will other countries be able to rebel against it. Periphery countries may find it painful to belong to the system, but opting out may be even more painful.

 

It is not unrealistic, however, to advocate some improvements in the prevailing arrangements. Open society is an imperfect society that holds itself open to improvement. The present financial architecture certainly qualifies as imperfect, and it would benefit all members, including the United States, to improve it. Some countries like Argentina and Turkey have been hovering on the brink of disaster, and other periphery countries are suffering from high risk premiums and lack of investment flows. Conditions in the rest of the world have become a matter of grave concern for the financial authorities at the center.

 

I have already proposed an important improvement in chapter 2: the use of SDRs for providing international assistance. This could serve to reduce the disparity between center and periphery; it could also serve as a countercyclical policy tool that could turn out to be particularly valuable if the world economy slipped into deflation. Here I want to probe deeper and examine what other improvements could be made to the international financial system.

 

We can identify two major deficiencies or, more exactly, asymmetries in the way the IMF has been operating until recently. One is a disparity between crisis prevention and crisis intervention; the other is a disparity in the treatment of lenders and borrowers.

 

The general principles that structural reforms in the IMF ought to follow are clear. There ought to be a better balance between crisis prevention and intervention and a better balance between offering incentives to countries that follow sound policies and penalizing those that do not. The two objectives are connected: It is only by offering incentives that the IMF can exert stronger influence on the economic policies of individual countries prior to a country turning to the IMF in a crisis.

 

These general principles have received widespread recognition, but they have not been properly implemented because market fundamentalism has stood in the way. Instead of devising an appropriate set of sticks and carrots, the monetary authorities have relied on market discipline to a greater extent than appropriate. Their approach could be justified if financial markets in fact tended toward equilibrium, but now that multiple equilibria have become an accepted part of economic theory, that belief is no longer tenable. Market discipline provides the stick but the carrots are missing—although not totally.

 

The IMF has made some progress in the area of prevention by introducing Contingency Credit Lines (CCLs). The CCL rewards countries following sound policies by giving them access to IMF credit lines before rather than after a crisis has erupted. Unfortunately, the desire for crisis prevention clashed with the emphasis on market discipline, and the latter won out: The original terms were too restrictive and expensive to attract any takers. The conditions were recently modified to make the facility more attractive. Nevertheless, there are still no takers.

 

The IMF and its major shareholders ought to actively promote the use of CCLs. The Fund has plenty of liquidity; it should be put to more active use. If necessary, the IMF should be provided with additional capital.

 

In addition to the CCL, other steps could be taken to strengthen the incentives for good policies and to reduce the imbalance between center and periphery. Several alternatives may be considered:

(i) The IMF could rate countries. The highest grade would make a country automatically eligible for CCLs at little or no cost, and bondholders would be given an assurance that in case of an IMF program their claims would be fully respected. This would provide a powerful enhancement of the country’s credit. By contrast, for countries in the lowest grade, the IMF would make it clear in advance that it would not be willing to enter into a program without private sector burden sharing. Caveat emptor: Buyer beware. There could be one or more intermediate grades where the IMF may insist on various degrees of burden sharing.

(ii) The Basel Accord, which sets internationally agreed capital standards for commercial banks, could translate the IMF ratings into variations in capital requirements for commercial bank loans.

(iii) The Federal Reserve, the ECB, the Bank of England (BOE), and the Bank of Japan (BOJ) could accept at their discount windows designated treasury bill issues of selected countries. This privilege could be reserved for specific countries or particularly perilous situations. For instance, after Argentina defaulted, the privilege could have been extended to other Latin American countries that followed sound policies. This would prevent contagion from spreading to countries such as Brazil, Chile, or even Mexico.

(iv) To push the outside of the envelope even further—perhaps too far—the same central banks could also accept at their discount windows longer term bonds of selected countries, imposing discounts that may vary from time to time. This would shrink risk premiums and help periphery countries to lengthen the maturity of their debt. Even more important, it would enable them to pursue countercyclical policies—provided the central banks set the discounts at suitable levels.

(v) Alternatively, the Federal Reserve, the ECB, the BOE, and the BOJ could agree to conduct open market operations using the safest tranches of government paper issued by periphery countries with the highest Fund rating.

These arrangements would help alleviate both asymmetries at the same time. The IMF would be in a better position to prevent crises from developing because it would be one of the requirements for a high rating that there should be a ceiling on a country’s short-term obligations. The country concerned would be obliged to collect and publish adequate data on foreign borrowings. This would allow the IMF to monitor the debt profile of individual countries more intensely, and it could downgrade them if macroeconomic conditions deteriorate.⁷⁰ At the same time, there would be a better balance in the treatment of lenders and borrowers. Countries that follow sound policies would enjoy credit enhancements, while lenders to poorly rated countries would be exposed to greater risks.

 

It is noteworthy that only one of these proposals, namely varying the capital requirements of commercial banks, was seriously considered, and even that discussion has taken a somewhat different direction. The Basel Committee on Banking Supervision has accepted the idea of rating countries, but would let sophisticated financial institutions rely to a large extent on their own internal risk evaluations to determine the amount of capital to be allocated to their sovereign loans. Less sophisticated financial institutions could rely on commercial credit rating agencies instead.⁷¹

 

The proposal to have the IMF rate its members has encountered strenuous opposition. Some argue that the IMF would not dare to downgrade a country because doing so might precipitate the crisis it was supposed to prevent. But the IMF has an institutional interest in preserving the system, and precipitating a crisis sooner rather than later would reduce its severity. Alternatively, it is argued that the IMF would be prevented from downgrading a country by political pressures. But the IMF would be on solid ground in resisting such pressures because if it made a misjudgment, it would be obligated to put its own resources at risk.

 

Another objection is that a dividing line between countries that do and do not get a high rating would create too much of a discontinuity. But the monetary authorities would have many means at their disposal to mitigate the discontinuity. They could vary the amounts of treasury bills they are willing to discount, or they could vary the discount rate on the paper. The Basel Accord could impose different capital requirements on bank loans in accordance with IMF rankings.

 

But the main opposition has come from market fundamentalists who are preoccupied with the issue of moral hazard. Wouldn’t a system of IMF guarantees encourage unsound lending? The answer is no. If unsound lending caused a crisis, then the IMF would have to accept the consequences and provide assistance. The IMF would be taking a real risk, not creating a moral hazard. This is another instance where the concept of moral hazard is overused.

 

The most potent objection is that the IMF lacks the methodology for distinguishing between sound and unsound economic policies. I accept the validity of this objection, especially in light of recent developments. After a flawed performance in the 1997–1999 crisis and now under attack from all sides, the IMF seems to have lost its way. I am not in a position to design the methodology the IMF ought to use in rating individual countries, but I have no doubt that the IMF itself would be able to do so if it were given the responsibility for it. After all, national central banks also lacked the appropriate methodology when they were first entrusted with preventing financial crises and keeping their economies on an even keel, but they developed it and became very successful at their job; the same would most likely happen with the IMF. Indeed, the IMF has already taken an important step toward more objective and vigorous assessments by introducing codes and standards for key components of policy performance and financial soundness, working closely with institutions like the Bank for International Settlements and the Basel Committee on Banking Supervision.

 

Before the steps advocated here could be introduced, some important legal issues would have to be resolved. At present, there are no bankruptcy procedures for sovereign debt; as a result, the IMF has no legal powers to impose any burden sharing on the private sector. A debt reorganization scheme mandated by the IMF would probably not be approved by the courts, at least U.S. courts, which govern a large part of international debt issues, unless it was also approved by the bondholders. But the mechanism for gaining approval is missing. Only around one-quarter of international bonds issued by emerging market borrowers contain collective action clauses limiting the ability of dissident bondholders to block a reorganization. Such clauses are not allowed under U.S. law.

 

Introducing bankruptcy court–type protection from creditors would probably require amending the IMF Articles of Agreement to clarify its standing to effect a standstill.⁷² The investment community has opposed such an amendment up to now. However, bondholders and investment banks would have little cause for complaint if the new standstill rules were accompanied by the credit enhancements outlined above.

 

The IMF, with support and encouragement from the U.S. Treasury, is now giving serious consideration to the creation of an international bankruptcy mechanism.⁷³ But there has been no consideration of the credit enhancements proposed in this book. That is a pity because the two measures would be easier to implement in conjunction with each other than a bankruptcy procedure without sweeteners.

 

The issue is pressing. Argentina has defaulted. The handwriting has been on the wall for a long time, and financial markets could clearly read the message, especially as it was in their own handwriting. The only question was whether it was going to be an orderly debt reorganization or a disorderly one. The answer depended largely but not entirely on whether the IMF could provide assistance to an orderly reduction of the debt burden against the objections of dissident bondholders. There were of course other conditions that Argentina would have had to meet to qualify for international assistance, but it was the absence of clarity on this issue that stood in the way of a meaningful dialogue.

 

To say that the Argentine default turned out to be disorderly may be an understatement. The full implications of what has happened have not yet sunk in. Argentina’s former economy minister, Domingo Cavallo, sacrificed practically everything on the altar of maintaining the currency board and meeting international obligations. The integrity of the domestic pension and banking systems was impaired and there was no refuge for domestic savings. When the break came it was a violent one as people rioted and the government fell. There was no fallback position and the financial system completely seized up. The consequences are disastrous for Argentina and there will also be some adverse repercussions for the international financial system—although these are not yet recognized by the financial markets. The first reaction of the markets was one of relief at the almost complete absence of contagion. The default was so predictable that it had been fully discounted. However, its longer-term consequences are yet to be felt. Foreign direct investments—banks, utilities, and oil companies—have been badly hurt. The extensive violation of contracts will endanger foreign direct investment, which had hitherto been considered the most stable and dependable element in capital flows to emerging markets. The contagion will be slow because direct investments move much more slowly than other financial assets, but it is likely to spread. Spanish banks and utilities that are hurt in Argentina are likely to retrench in other emerging markets, especially if the stock market penalizes them for their overseas exposure; and other direct investors, particularly in the financial sector, are bound to be influenced by their fate. How far the general retrenchment may go will depend to a large extent on the policy response.

 

Turmoil in Argentina is likely to bring matters to a head. The flaw in current arrangements, namely the increasing shortage of capital and the consequent rise in risk premiums for periphery countries will become more acute. The issue of how a sovereign default can be handled in an orderly manner will have to be resolved. The likely outcome is some kind of international bankruptcy procedure. This will impair the discipline that sustains international lending because, in contrast to corporate borrowers, sovereign states do not provide any tangible security; the only security the lender has is the pain that the borrower will suffer if it defaults. That is why the private sector has been so strenuously opposed to any measure that would reduce the pain, whether it is collective action clauses in sovereign bonds or the IMF “lending into arrears.” Collective action clauses allow a majority of bondholders to overrule the objections of a few dissidents in agreeing to a debt reorganization. Lending into arrears is a principle introduced since the emerging market crisis that allows the IMF to lend to countries that are in arrears to their bondholders. Both these initiatives are part of the new approach to moral hazard, insisting on bailing-in the private sector instead of bailing it out. Argentina will have cured the moral hazard for good, but it will have also demonstrated the devastation that can be wrought by a disorderly default.

 

Whether an international bankruptcy procedure is introduced or not, the lack of capital availability in emerging markets will become impossible to ignore, and the credit enhancements I have proposed will have to be considered. Thus the Argentine crisis may well turn out to be the catalyst that will bring the new financial architecture that I am advocating here into existence. It will differ from the present state of affairs by offering more carrots to periphery countries pursuing sound policies.

 

As mentioned previously, deciding what constitutes sound policy presents the toughest challenge. The Argentine crisis provides an excellent example. On the whole, Argentina followed macroeconomic policies that were in accordance with IMF orthodoxy. Its troubles stemmed from a currency board system that was approved by the IMF at the time of its creation but subsequently led to a currency misalignment. It made sense to insist on a currency realignment, but the Argentine government and much of its public opinion were firmly wedded to the currency board arrangement: They were determined not to return to a floating exchange rate that pushed Argentina into decades of currency depreciation. Moreover, monetary stability was the only achievement they had to show for years of painful recession. This placed the IMF and the U.S. Treasury in a predicament: whether to endorse a policy that they considered unsound or to allow Argentina to go into default. At first, they opted for the first alternative, but eventually they switched to the second. The sequence had the quality of a Greek tragedy.

 

This goes to show that there are no perfect solutions to the problems of the international financial system. Whatever solutions we devise, new problems are bound to arise. I am afraid that the proposals I have put forward here will also prove to be inadequate when they are implemented. Indeed, they seem to be puny when compared with the magnitude of the problems that they are supposed to resolve.

 

I do not see any point in proposing more radical solutions when the authorities are not ready to consider even the moderate ones outlined here. First they must realize that financial markets do not tend toward equilibrium; financial markets need a visible hand to guide them and keep them from going off the rails. Today the visible hand is that of the United States, supported by the Washington consensus. This has created a very uneven playing field. To ask for an even playing field is utopian; there has never been one. But it is not too much to ask to make the playing field less uneven; that would serve the interests of all parties.

 

Once this line of argument becomes the official line of the G7 governments, the meager reforms I have proposed here could go a long way in making the international financial system more stable and more equitable. For instance, as suggested, accepting the paper of sound periphery countries at the discount windows of the major central banks could significantly reduce their cost of borrowing. That will not be the end of the road. We shall have to continue to improve our institutional arrangements indefinitely because perfection is beyond our reach.