Chari is professor, department of economics, University of Minnesota
and Kehoe is Ronald S. Lauder professor of economics, University
both are monetary advisers at the Federal Reserve Bank of Minneapolis.
The views expressed herein are not necessarily those of the
Federal Reserve System.
The authors would like to thank Andrew Atkeson, Harold Cole,
David Fettig, Narayana Kocherlakota, Lee Ohanian and Art Rolnick
for helpful comments.
The ideas in this paper were heavily influenced by those
in Feldstein (1998), Jackson (1986) and Sachs (1995).
The International Monetary Fund was established after World War
II to manage a system of fixed exchange rates. In the early 1970s
that system collapsed, and since then the IMF has been a bureaucracy
in search of a mission. In the 1990s the IMF has greatly increased
its lending, especially in Mexico in 1995 and in Asia in 1997-1998.
This evolution has led to an extensive debate on the appropriateness
of its activities and has raised the question: What should be the
mission of the IMF?
One view in this debate is that the IMF should be abolished. A
second view is that the IMF should serve as an international lender
of last resort by expanding its lending to debtor countries in financial
difficulty to prevent worldwide financial crises. A third view is
that the IMF should take on a new role; namely, it should serve
as a type of international bankruptcy court that handles international
Our view is that the IMF should cease its lending activities altogether.
We argue that there is no need for the IMF to act as a lender of
last resort because any threats to the integrity of the international
financial system as a whole can be effectively handled by the central
banks of the major powers. Moreover, current IMF lending policies
encourage improvident international lending.
We do not believe, however, that the IMF should be abolished.
We think, for example, that the IMF can serve an important role
as a type of international bankruptcy court that handles international
debt problems. We think the last two decades of international lending
make it clear that private markets and national governments have
not resolved these problems effectively.
Our framework for analyzing the debate consists of asking three
questions that are the right ones for evaluating the appropriateness
of the IMF's activities. But first the debate.
Both critics and defenders of the IMF argue that the recent activities
of the IMF resemble those of an international lender of last resort.
Krugman (1998) and Fischer (1999) argue that the recent actions
of the IMF are necessary for the smooth functioning of international
financial markets. Indeed, they accept the view that by bailing
out financially distressed countries the IMF has become a world
lender of last resort and applaud it for doing so. They argue that
everyone accepts the need for a domestic lender of last resort so
that, by analogy, everyone should also accept the need for a world
lender of last resort.
Friedman (1998), Schultz (1998) and Schwartz (1998) accept that
the IMF is trying to function as a lender of last resort and argue
that it should be abolished. The crux of their argument for abolition
is that IMF funds too often are used to bail out foreign lenders.
The prospect of these bailouts reduces the incentives of lenders
to probe into the conditions of individual countries. Individual
governments, in turn, have less of an incentive to pursue painful,
but responsible policies needed to convince lenders of their creditworthiness.
These critics argue that since IMF loans distort the operations
of international financial markets it is doing more harm than good.
Feldstein (1998) adopts an intermediate and somewhat more nuanced
position. He argues that international financial institutions are
needed to overcome the problems in the operation of private markets,
but severely criticizes the IMF and insists that its lending programs
should be tailored more finely to overcome problems in private markets.
Finally, Sachs (1995) is both a critic and a defender of the IMF.
He argues that the world needs a lender of last resort, like the
IMF, but that lately the IMF has been doing a poor job. In addition,
he argues that the world needs a new institutional framework that
functions as an international bankruptcy court.
To help resolve this debate, we provide a framework that is based
on the presumption that international agencies like the IMF should
solve only problems that countries or individuals, acting on their
own, cannot solve or solve poorly; such problems are known as international
collective action problems. As we explain below, the IMF was designed
to solve this type of problem. Collective action problems exist
if actions taken by individuals or governments result in greater
welfare when actions are coordinated rather than independently made.
Thus, to determine if a suggested role for the IMF is appropriate,
we must ask the right questions:
- Is there a clear collective action problem?
- Is the proposed solution narrowly tailored to solve the identified
collective action problem?
- Is the IMF the best institution to solve the identified collective
If the answer to any of these questions is no, then the suggested
role for the IMF is not appropriate.
A classic example of an international collective action problem
is in setting tariff policy. Each country acting on its own has
an incentive to set high tariffs in order to exploit its market
power, but if all countries collectively agreed to lower their tariffs,
all countries would be made better off. While it is easy to find
collective action problems it is often difficult to solve them.
The difficulty in solving the tariff problem, for example, is that
if all other countries lowered their tariffs there would be an incentive
for any one country to charge high tariffs. To solve this problem,
then, enforceable agreements need to be reached that provide individual
countries with the appropriate incentives to follow the coordinated
We use this framework to analyze the historical record of the
IMF and to argue that the IMF should cease its lending activities
and reconstitute itself as an international bankruptcy court.
An overview of our analysis
The IMF's designers saw the need for an institution to solve a collective
action problem in monetary policy similar to that in tariff policy.
This problem is that each country acting on its own has the incentive
to pursue self-interested monetary policies that help itself and
hurt other countries. Coordination in monetary policies could make
all countries better off. The particular method proposed to coordinate
monetary policy was through a fixed exchange rate system administered
by the IMF. By the early 1970s a consensus developed that while
there was a collective action problem in monetary policy, this particular
solution had smaller benefits than costs, and the system was disbanded.
Currently, countries try to solve the collective action problem
in monetary policy with informal agreements like those between the
United States and Japan, and regional agreements like the European
Since the early 1970s the most coherent rationale for the IMF
is that it solves a collective action problem created when uncoordinated
lenders set off a worldwide financial crisis by fleeing from the
debts of many developing countries' governments or from the banking
systems in such countries. The IMF attempts to solve this collective
action problem by bailing out financially distressed countries with
loans that have various conditions attached. The justification for
these bailouts is the IMF is acting as a world lender of last resort,
a role analogous to the one a domestic central bank plays in stemming
domestic banking panics.
Does the world need a lender of last resort, and, if so, are the
IMF's actions appropriate for such a lender? The need for a world
lender of last resort is sometimes based on a flawed analogy between
individual banks and governments. Just as domestic banking systems
could suffer from bank runs, it is argued that governments could
suffer from liquidity crises in which they are unable to roll over
their short-term debt. In a domestic context the critical feature
that allows bank panics to happen in the first place is the mismatch
of the duration of assets and liabilities in the banking system
taken as a whole. Assets and liabilities of virtually all developed
countries' governments are not mismatched. Hence, a crisis affecting
a developing country is unlikely to spill over into the developed
nations, and this analogy does not justify a world lender of last
The flawed analogy notwithstanding, the world does need some mechanism
to deal with the possibility that worldwide financial crises, similar
to domestic banking panics, could occur. The questions here are
what is the appropriate way a world lender of last resort should
function and what is the extent to which existing central banks
can handle crises. We argue that a lender of last resort should
not bail out individual financially distressed institutions. In
the event of a financial crisis, such a lender should rather provide
liquidity to the market as a whole, say by open market operations
and by giving all banks more favorable terms at the discount window
of the central bank. In essence the lender will end up supplying
liquidity by replacing less liquid assets with more liquid assets.
The market can then allocate this new liquidity as it sees fit.
Under this policy, some financially distressed institutions will
fail, but the financial system as a whole will not collapse. Fortunately,
we already have mechanisms in place to deal with worldwide financial
crises. The major central banks of the world have the capacity and
the will to provide liquidity in a coordinated fashion. One example
of this capacity and will was in the fall of 1998 when, in the face
of a possible worldwide financial crisis, major central banks reduced
short-term interest rates in an apparently coordinated fashion.
In this sense, the IMF is redundant to prevent worldwide financial
Furthermore, these central banks typically provide liquidity to
the market as a whole rather than attempting to bail out specific
institutions. In sharp contrast, IMF loans are always made to specific
countries and governments in trouble. The IMF's policies generate
rampant moral hazard so that they may actually increase the likelihood
that countries get into financial difficulties. In this sense, the
IMF's activities are harmful.
While we think the central banks of the major powers can and do
deal with worldwide financial crises efficiently, we think there
is a need for an international bankruptcy court to resolve smaller
collective action problems between individual debtor countries and
their creditors. We have seen two types of such problems at the
country level in the last two decades. First, there can be coordination
problems among lenders that lead to creditor panics for otherwise
healthy economies. Cole and Kehoe (1996) argue that the situation
in Mexico in 1995 is a classic example of a creditor panic: Mexico
was unable to roll over its short-term debts even though most observers
agreed that Mexico was fundamentally sound. Second, for unhealthy
economies with large external debts, there can be a need for a coordinated
debt workout. For example, Bulow and Rogoff (1990) argue that coordination
problems among private sector banks blocked efficiency-enhancing
debt workouts in the Latin American debt crises of the late 1980s.
We argue that both kinds of coordination problems can be efficiently
handled by a new international mechanism that is somewhat analogous
to a bankruptcy court. This court would work as follows: When a
debtor government is unable to meet its debt obligations it would
seek the protection of the international bankruptcy court. The court
would then assemble the creditors to facilitate negotiations and
to provide expertise in evaluating conditions in the debtor country.
If the court and the creditors determined that the government was
financially sound, an agreement would be reached to solve the immediate
liquidity problem. If they determined that the government was financially
unsound, then the court and the creditors would propose a debt workout
plan to the government. If the government in question agreed with
the plan, then it would be carried out; if the government in question
refused to abide by the plan; then creditors would be free to pursue
their claims against the government through the standard channels.
This court would thus serve to ameliorate the major coordination
problems on the creditor side.
In addition, there are two other collective action problems that
the IMF could solve. Briefly, the IMF could provide a nominal anchor
by issuing a type of world money and making its supply independent
of any particular country's economic conditions. Countries could
peg their currency to this world money rather than to the currencies
of major powers. In so doing they could make their commitment to
responsible monetary policy transparent and not be subject to the
vagaries of policies in other countries. Such a nominal anchor is
a public good that private markets and individual governments have
difficulty providing. The IMF could also enforce the disclosure
of accurate information regarding countries' economic conditions
and policies. Such information helps international financial markets
function smoothly. Private markets and individual governments might
have problems ensuring that information is accurately disclosed.
Origins of the IMF
The IMF was originally designed to promote cooperation among countries
in the conduct of monetary policy. Before World War I all the major
powers were on the gold standard. The commitment to peg to gold
both fixed countries' exchange rates and sharply limited any country's
ability to pursue an autonomous monetary policy. During the interwar
period countries went on and off the gold standard and exchange
rates fluctuated wildly. Figure 1 shows the absolute change in the
nominal exchange rates between the currencies of six major economic
powers and the U.S. dollar. The figure shows that before 1913 the
exchange rates changed hardly at all, while between 1919 and 1938
they fluctuated enormously.
The designers of the IMF saw the extraordinary volatility in exchange
rates as deriving substantially from the attempts of each country
to use its policies for domestic gain. They saw the system as one
with a collective action problem in which all nations lost as each
nation privately pursued its own gain. Specifically, they believed
that during recessions each country has an incentive to devalue
its currency to aid exporters and thereby raise domestic employment
and income. This devaluation reduces imports and thus reduces employment
and income abroad.
In July 1944, over 300 representatives of 44 allied nations met
for three weeks at Bretton Woods, N.H. The participants in the meeting
wanted to create an institution that would remedy the collective
action problem. The Bretton Woods meeting led to the Articles of
Agreement that established the IMF. (See Purposes of the IMF, General obligations of members, Governance and operating procedures).
These articles make clear that the designers wanted to promote cooperation
in the conduct of monetary policy. In particular, the articles set
up a system in which exchange rates could be altered only by mutual
consent through the approval of the IMF. The idea was that each
country would gain more by the commitment of other countries not
to devalue than it would lose by giving up its freedom to do so.
The evolving role of the IMF
The role of the IMF has greatly evolved over its tenure.
The Bretton Woods years
From 1946-1958 most countries in the world had capital controls
that restricted the holdings of foreign assets by their domestic
residents and the IMF played a minimal role. Over this period, the
system evolved into one where the United States pegged the dollar
to gold and other countries pegged to the dollar. In the 1960s the
system ran into more and more problems. Germany revalued in 1961
and again in 1969; the United Kingdom suffered a major currency
crisis and was forced to devalue in 1967; France suffered a currency
crisis in 1969 and devalued.
Fixed exchange rates constrained monetary policy severely. The
persistent devaluations and revaluations during this period revealed
that most countries wanted to use monetary policy to meet domestic
objectives and were unwilling to accept the constraints imposed
by the fixed exchange rate system. Thus, when there was a conflict
between domestic objectives and keeping the exchange rate fixed,
most countries preferred to change the exchange rate.
The United States faced this conflict as well and showed unwillingness
to sacrifice domestic objectives for fixed exchange rates. Over
the 1960s the United States chose to increase its money supply growth
rates substantially to achieve some domestic objectives. The consequent
increase in inflation meant that the United States could not maintain
the price of the dollar fixed relative to gold without a subsequent
deflation. Unwilling to follow deflationary policies, the United
States let the system collapse. After 1973 countries were at liberty
to let their exchange rates fluctuate without IMF consent.
The Bretton Woods system collapsed and was not revived because
of a growing consensus that a system of fixed exchange rates for
the world as a whole was not the appropriate solution to the collective
action problem in monetary policy. This system placed such severe
limits on discretionary monetary policy that the benefits from this
type of coordination were smaller than the costs. A variety of other
formal and informal mechanisms are now pursued to solve this collective
After Bretton Woods: Searching for a mission
With the collapse of the IMF's original mission, the history since
1973, on the face of it, seems to reveal a bureaucracy at the IMF
in search of a new mission. The IMF appears to see a variety of
collective action problems that it must remedy. Its remedies have
been criticized vigorously.
During the late 1970s Latin American countries greatly increased
their indebtedness to the rest of the world, particularly to banks
in the developed countries. In the 1980s a deterioration of their
economic circumstances made it clear that they would not be able
to repay these debts. Collectively, creditors could gain by restructuring
their debts in a coordinated fashion, thereby preventing default,
but each creditor had an incentive to let the burden of restructuring
to fall on other creditors. Hence there was the potential for the
IMF to play a useful role in solving this collective action problem
by coordinating the restructuring of government debts owed to the
A number of economists, including Bulow and Rogoff (1990), argue
that instead of helping matters the IMF intervention actually worsened
them. They argue that the banks hardened their positions on the
hope that by doing so the IMF would end up giving more subsidized
loans to the indebted countries that could then be used to increase
the amount that the banks received. Hence, the net effect of the
IMF's interventions was to prolong the bargaining process during
which the unresolved claims of the banks discouraged other investors
from investing. In this sense, the IMF's actions may well have harmed
its intended beneficiaries.
More recently, the IMF has taken on a somewhat more ambitious role.
Figure 2 shows outstanding loans from the IMF to its member countries
and shows a very sizable increase in the level of IMF loan activity.
In 1994, the Mexican government had difficulty rolling over its
short-term debt, raising the possibility that the government would
default. The collective action problem here was that if only lenders
could jointly agree to roll over the debt there would be no prospect
of default and all the lenders would have profited. The fear that
other lenders would not lend raised the prospect of default and
made each individual lender reluctant to lend. We refer to this
type of collective action problem at the country level as a creditor
Operationally, the IMF and the U.S. government attempted to solve this
collective action problem by providing substantial funding. The IMF
provided about $18 billion in loans, roughly 5 percent of Mexican GDP,
out of a total loan package of $55 billion, about 16 percent of Mexican
GDP. The conditions attached to the loans primarily required the Mexican
government to follow responsible monetary and fiscal policies. Friedman,
Schwartz, Schultz and others argue that this funding package was at
better rates than the market would provide and hence was a bailout.
They argue that this bailout raised the beliefs of lenders that similar
bailouts would occur in other developing countries when a crisis arose.
Hence, the bailout in Mexico reduced the incentives of lenders to probe
into the conditions of other countries before making new loans. In addition,
and perhaps to a lesser extent, the prospect of similar bailouts gave
these governments less of an incentive to pursue painful, but responsible
policies needed to convince lenders of their creditworthiness. Hence,
they argue the bailout policies of the IMF, paradoxically, tend to destabilize
international financial markets. In our view there is considerable merit
to these arguments.
The IMF is also extensively involved in providing assistance to
the countries of Eastern Europe and the former Soviet Union. The
loans to these countries are intended to make their transition to
capitalist economies smoother. The conditions attached to these
loans go well beyond traditional monetary and fiscal policy prescriptions,
specifying a comprehensive agenda for structural reforms which includes
details of privatizing large parts of their economy, facilitating
land registration, increasing public awareness of property rights
and agreements that the government will not renationalize or increase
its equity position in enterprises and commercial banks. (See Camdessus
1996.) The nature of the collective action problem associated with
reforming domestic institutions and legal arrangements is not clear
In many of the countries the IMF deals with there is also the problem
of misuse of funds. Recently, Treasury Secretary Rubin testified
that much of the $4.8 billion in loans to Russia in the summer of
1998 may have simply helped wealthy Russian oligarchs move billions
of dollars out of the country, instead of being used to help further
the reforms that Russia agreed to. (See New York Times,
March 19, 1999.) Critics of the IMF like Friedman, Schwartz, Schultz
and others use examples like this to argue that besides leading
to moral hazard many of the loans are simply wasted.
In July 1997, a financial crisis struck a number of countries in
Asia. There were sharp reversals in capital flows as lenders refused
to roll over short-term loans. Banks in these countries had borrowed
heavily using short-term debt and had difficulties meeting their
payments to foreign creditors. The IMF helped organize substantial
loans to these countries.
For example, in Indonesia the IMF lent approximately $10 billion,
roughly 5 percent of Indonesian GDP out of a total loan package
of $33 billion, about 16 percent of Indonesian GDP. In Korea, the
IMF lent approximately $20 billion, roughly 4 percent of Korean
GDP out of a total loan package of $57 billion, about 12 percent
of Korean GDP. The conditions attached to these loans went well
beyond the traditional strictures governing fiscal and monetary
policy. In Korea, for example, the conditions included raising the
ceiling on foreign ownership of a firm's equity from 7 percent to
50 percent, a variety of measures to open the economy to imports,
changes in accounting standards for corporations and a variety of
detailed reforms of labor markets that made layoffs easier. Again,
the collective action problem associated with reforming domestic
institutions escapes us.
Analyzing the roles of the IMF
The IMF's analysis of its role
The IMF's leadership has sought to develop an intellectual rationale
for its actions. The IMF leadership apparently sees three types of
problems that it should solve. First, its goal is to ensure that defaults
by developing country governments do not have contagious effects on
other countries and lead to worldwide financial crises (see Fischer
1999). Second, the IMF's goal is to prevent financial panics in developing
countries even when they do not threaten to destabilize international
financial markets. Such panics can reduce the volume of trade and
thereby reduce employment and income in the rest of the world. Third,
the IMF sees its goal as one of encouraging and enforcing general
policy reform, even if it is not directly connected to countries'
financial systems (see Masson and Mussa 1997).
We think that the contagious effects of developing country defaults
are partly based on a flawed analogy. We do think worldwide financial
crises can be triggered in various ways, including problems in developing
countries, but they are best handled by the central banks of the
major powers. We think that financial panics affecting developing
country governments are also the result of a collective action problem,
but they are best handled by an international bankruptcy court.
Finally, we question whether poor policy, in general, is the result
of an obvious collective action problem. While it is well understood
that for some policies, like tariffs on international trade, there
is collective action problem, for a variety of other policies, like
facilitating land registration in Russia or reforming labor markets
in Korea, there is no obvious collective action problem for the
world as a whole to solve.
An inappropriate role: Lender of last resort
The argument for an international lender of last resort begins with
the observation that most economists agree on the need for a domestic
lender of last resort; therefore, it follows that we need an international
lender of last resort. For some, like Krugman (1998), the argument
ends with this observation, while others, such as Fischer (1999),
conduct a deeper analysis of the strengths and weakness of the analogy.
While economists agree that it is desirable to establish institutions
that prevent countrywide financial panics, there is less agreement
on how such lenders of last resort should operate. One view, espoused
by Fischer (1999), is that in the event of a crisis the lender of
last resort should provide favorable terms to those banks that are
financially distressed. We term this the bailout prescription. A second view, espoused by Bordo (1993), is that in the event of
a crisis this lender of last resort should not focus on financially
distressed institutions but instead should provide liquidity to
the market as a whole, say by open market operations or by giving
all banks more favorable terms at the discount window of the central
bank. In essence the central bank will end up supplying liquidity
by replacing less liquid assets with more liquid assets. The market
can then allocate this new liquidity as it sees fit. We term this
the liquidity provider prescription.
We argue that bailouts lead to rampant moral hazard problems and
that a lender of last resort which acts solely as a liquidity provider
can contain financial panics effectively and efficiently. We begin
by reviewing the case for a domestic lender of last resort and then
see what parts of that case apply in the international setting.
We will argue that while there is a need for an international lender
of last resort, that role is already adequately filled by the central
banks of the major powers.
The case for a domestic lender of last resort
Bank liabilities are largely deposits that pay fixed rates and can
be redeemed upon demand. Thus deposits can be thought of as bonds
of instantaneous maturity that are automatically rolled over by
depositors until they are withdrawn. Bank assets are typically relatively
longer-term claims on firms and households. There are a variety
of reasons for this way of structuring assets and liabilities, but
this structure almost automatically creates the possibility of systemwide
In such panics most depositors attempt to redeem their deposits
because they fear that banks will become insolvent. To meet depositors'
demands the banking system as a whole attempts to sell its assets
and call in its loans. Asset prices fall, economic activity declines
and the banking system is unable to meet its depositors' demands.
When asset prices fall, many hitherto solvent banks can become insolvent.
This panic is self-fulfilling. If depositors did not attempt to
redeem their deposits, asset prices would not fall, banks would
not become insolvent and each depositor could be assured that his
deposits would be reasonably safe. This dependence of the asset
side of banks' balance sheets on the behavior of those who hold
their liabilities creates the possibility of an uncertain outcome,
or what is known as a multiple equilibrium problem. If depositors
fear that other depositors will redeem their deposits, they should
rationally attempt to redeem their deposits first, while if they
are confident that other depositors will not, then they should not
The decline in economic activity associated with a systemwide banking
panic imposes significant social costs. Obviously, these costs could
be avoided if only depositors could all somehow agree jointly not
to withdraw their deposits. Almost from the beginnings of banking
systems, bankers have understood the extent to which they collectively
depend upon the confidence of the public and have attempted a variety
of institutional arrangements to solve this problem. The most widely
used is the prescription that a central bank should provide all
the liquidity that is needed to stem the crisis. This assurance
by the central bank enables the banking system to meet the claims
of its depositors without selling assets or calling in loans. Individual
depositors, therefore, can be confident that their deposits are
relatively safe even if other depositors run on banks. This confidence
eliminates the panic equilibrium.
The central bank can carry out its prescription in two distinct
ways. Each way recognizes that to meet their depositors' needs banks
may have to sell assets both to the central bank and to the public.
In the bailout view, the central bank directly lends to troubled
banks at subsidized rates. In the liquidity provider view the central
bank purchases a sufficient amount of securities in the marketplace
to ensure that the banking system as a whole has access to the liquidity
it needs to fulfill its obligations to depositors. At first the
central bank buys securities like treasury bills and commercial
paper. If that is insufficient it lends to the banking system as
a whole against less liquid assets like mortgages. The net effect
of the central bank's liquidity injection is to ensure that the
panic does not reduce the overall level of asset prices in the economy
too much. Troubled banks can then sell their assets, not to the
central bank, but to the marketplace to obtain the liquidity they
need to pay off their depositors.
In our view the bailout prescription leads to severe moral hazard
problems similar to those created by deposit insurance. The prospect
of receiving funds from the lender of last resort, even if the bank
is insolvent, reduces the extent to which interest rates on deposits
vary with the riskiness of the bank's portfolio. Thus, the lender
of last resort implicitly subsidizes the risk taking by banks. This
subsidy leads banks to take on excessive risk and paradoxically
can make financial panics more frequent and more severe when they
occur. One way the lender of last resort could avoid moral hazard
problems is to lend only to illiquid but solvent banks. In practice,
it is often difficult to distinguish insolvent from illiquid banks
and to evaluate the quality of the collateral, so that moral hazard
problems cannot be avoided. The moral hazard problems here are essentially
identical to those created by deposit insurance. (See Boyd
and Rolnick 1988 and the references therein.)
The liquidity provider prescription does not suffer from moral
hazard problems because the lender of last resort is not implicitly
subsidizing individual banks. Under this prescription illiquid but
solvent banks borrow directly from the market, at unsubsidized rates,
to pay off their depositors. An important aspect of this prescription
is that the lender of last resort should lend directly to troubled
banks only on readily marketable securities. If the lender of last
resort attempts to substitute its judgment for that of the market
about the value of other securities it runs the risk of implicitly
subsidizing risk taking. We should emphasize that under this prescription
it is quite likely that some banks will fail when financial panics
occur. The reason is that financial panics typically occur when
economic conditions are poor and in such situations some banks are
likely to be insolvent. This kind of failure of individual insolvent
banks, like the failure of other firms in the economy, is part of
a well-functioning economic system.
It is certainly true that domestic lenders of last resort have
not always carried out their role by strictly adhering to our liquidity
provider prescription. We would argue, however, that in the United
States and elsewhere concerns about moral hazard are shifting policy
away from bailouts and toward liquidity provision. For example,
between 1985 and 1990 over 99.7 percent of uninsured depositors
at failed banks were fully protected by the U.S. government. Concern
that the virtual 100 percent guarantee to uninsured depositors was
leading to moral hazard led Congress to pass the Federal Deposit
Insurance Corp. Improvement Act in 1991. This act erected a number
of hurdles that must be passed before any uninsured depositors can
be protected. These hurdles include approval by two-thirds of the
governors of the Federal Reserve System, two-thirds of the directors
of the Federal Deposit Insurance Corp. and approval of the Secretary
of the Treasury. Although these new hurdles are an important step
in mitigating moral hazard, Feldman
and Rolnick (1997) argue that these hurdles are not yet high
enough, and they give specific proposals on how they should be raised.
In this sense the winds seems to be shifting away from bailouts
domestically. We argue that it should shift in the international
arena as well.
It is sometimes argued (see Fischer 1999) that the bailout prescription
follows directly from the policies advocated in the classic analyses
of a lender of last resort by Bagehot (1873) and Thornton (1802).
We argue that this interpretation is mistaken. These writers thought
the lender of last resort had the obligation to guarantee the liquidity
of the whole economy, but not to particular institutions in the
economy. They prescribed last-resort lending to the market as a
whole during systemwide panics and not for emergency situations
affecting isolated banks. For example, Bagehot (1873) in urging
the central bank to lend liberally to the marketplace as a whole
“The holders of the cash reserve must be ready not only to
keep it for their own liabilities, but to advance it most freely
for the liabilities of others. They must lend to merchants, to minor
bankers, to 'this man and that man', whenever the security is good.”
(p. 25, 1962 edition)
Thornton (1802) clearly had moral hazard in mind when he wrote:
“It is by no means intended to imply, that it would become
the Bank of England to relieve every distress which the rashness
of country banks may bring upon them: the bank, by doing this, might
encourage their improvidence.” 1
To summarize, the case for a domestic lender of last resort stems
from the extreme mismatch between maturities and risk characteristics
of assets and liabilities common to banking systems. There are compelling
reasons for the lender of last resort to lend freely in the general
marketplace rather than to individual banks.
The case against the IMF as an international lender of last
In the international arena, there is no necessary mismatch between
maturities of assets and liabilities of governments. If assets and
liabilities are roughly matched, then international financial panics,
if they occur at all, are unlikely to bear any resemblance to domestic
banking panics. In this sense, when assets and liabilities are roughly
matched there is no case for an international lender of last resort.
Less-developed countries' governments, especially those in troubled
economic times, rely heavily on short-term debt. Since the assets
of governments are mostly claims to future tax revenues, such governments
face a mismatch between assets and liabilities. In such a situation
panics are possible. If the government issues only short-term debt
it is forced to rely on the willingness of creditors to roll over
the debt as it comes due. If the size of the debt is large relative
to the resources of individual creditors, there is a potential coordination
problem which arises when each creditor correctly believes that
other creditors will be unwilling to roll over their portion of
the debt. If few of the lenders are unwilling to role over their
debt, then the government is faced with a liquidity crisis and is
often forced into default. The prospect of default makes it rational
for each creditor to refrain from rolling over the debt and justifies
each creditor's beliefs about other creditors. The basic problem
here arises from the presumed inability of creditors to coordinate
their behavior. This coordination problem can lead to a flight from
the country's debt, which we refer to as creditor panics.
As we describe below, creditor panics can justify an international
body to define and enforce rules that help solve the coordination
problem. (In “Can creditor panics be avoided by other means”?
we investigate whether private markets can solve this coordination
problem.) These panics, however, do not provide a justification
for lending at subsidized rates to troubled countries. First, such
panics can occur only if the government chooses to rely heavily
on short-term financing. Most developed countries stagger their
debt maturities so that at any given time only a small fraction
of the overall debt has to be rolled over. Therefore, developed
countries are relatively immune from creditor panics. Second, even
if financial panics contagiously spread from one nation to another
through some mechanism other than creditor panics, central banks
have the ability and the willingness to expand world liquidity to
prevent severe damage to the world economy.
The liquidity provider role of a lender of last resort can be played,
for the world as a whole, through joint intervention by the central
banks of the major powers. Recall that these interventions do not
require that funds be directed to a particular country. All that
is needed is that liquid funds be readily available in the marketplace
so that the market can direct them to the best possible use. Indeed,
we think there is considerable merit in the argument that interest
rate reductions taken in the summer and the fall of 1998 by the
Federal Reserve System and most European central banks was a coordinated
response by major economic powers to stem concerns about potential
international financial panics. IMF lending is therefore unnecessary
to stem worldwide financial crises. Furthermore, since it is directed
at individual borrowers, it is harmful because of the moral hazard
problems such lending creates. The IMF perhaps has a role to play
in advising central banks about the state of international financial
markets, but the central banks of the major powers can be, have
been and should be the international lenders of last resort.
Some appropriate roles for the IMF
Since, as we have argued, the IMF is not necessary to solve the
collective action problem associated with the lender of last resort,
and that such an institution can even exacerbate the problem, where
does that leave the IMF? Based on our framework, we identify three
collective action problems and propose the following roles for the
IMF: to serve as an international bankruptcy court, to provide a
nominal anchor through issuance of a type of world currency and
to enforce disclosure of accurate information regarding countries'
economic conditions and policies.
An appropriate role: To establish an international bankruptcy court
Even if the central banks of the major powers adequately fill the
role of lender of last resort, there still can be smaller collective
action problems at the country level that create the need for institutions
that can solve the coordination problems of debtors. First, as we
argue below, there can be coordination problems among lenders that
lead to creditor panics for otherwise healthy economies. Second,
for unhealthy economies with large external debts there can be a
need for a coordinated debt workout. This is a case where an analogy
to a domestic institution is helpful rather than misleading. Coordination
problems of this kind occur in lending to firms as well as countries.
Countries solve this coordination problem through bankruptcy procedures,
which are difficult to set up internationally, but are just as necessary.
(This view is held by Eaton (1990), Feldstein (1998) and especially
To see how coordination problems can arise at the level of lending
to an individual firm consider the following. Suppose the legal
system pays off debtors of firms in order of when they lay claims.
Consider a firm with an existing stock of debt payments currently
due that is larger than the value of its current stock of physical
assets. Suppose first that the firm, if allowed to continue in operation,
can pay off its debt claims with future revenues. The creditors
of such a firm can face a coordination problem analogous to that
faced by debtors to a government. If each creditor believes that
none of the other creditors will lay claims, then he has no incentive
to do so and the firm will be able to pay off all of its debts.
But, if each debtor believes that other creditors will lay claims
to the firm and dismember it, then that debtor should attempt to
lay a claim as well. This coordination problem can create creditor
panics at the level of individual firms.
Suppose next that the firm cannot pay off its debt claims with
future revenues, even if it is allowed to continue. Coordination
problems among creditors can lead to prolonged periods of disagreement
during which the value of the assets that will eventually be divided
up shrink greatly.
Such problems typically do not arise at the level of the individual
firm because sensibly organized societies adopt bankruptcy procedures
rather than paying off creditors in the order in which they happen
to show up. Three provisions of bankruptcy procedures in the United
States seem directly oriented toward resolving coordination problems.
The first provision is the Automatic Stay Provision which
prevents "any act to collect, assess, or recover a claim against
the debtor that arose before the commencement" of the bankruptcy
proceeding that remains in force until the bankruptcy is resolved.
The second provision requires that plans for reorganizing the financial
structure of the firm treat creditors within each class equitably
within and across classes of creditors. The third, the Debtor
in Possession Provision, allows firms to obtain working capital
and continue in operation under court supervision by assigning priority
to the new loans above the loans obtained before the bankruptcy
The first two provisions ensure that in the event of bankruptcy
no debtor gains by attempting to lay claims and seizing assets ahead
of other creditors. The third provision allows a bankrupt firm with
relatively good prospects to continue in operation and thereby enhance
overall payments to the creditors. The three provisions together
effectively eliminate creditor panics. This analysis of bankruptcy
law draws heavily on Jackson (1986).
In the international arena, legal agreements cannot be enforced
without the cooperation of the governments of the involved countries.
Debt contracts between lenders and governments are particularly
prone to difficulties in enforcement. The absence of international
bankruptcy procedures creates the possibility of creditor panics.
This is one area where international agreements seem particularly
necessary and can be highly beneficial.
We have argued that there is a need for an institution that can
oversee and administer debt contracts between governments and foreign
lenders. That is, the world needs an international bankruptcy court.
Such an institution could be empowered to administer provisions
similar to the three described above. The automatic stay and the
equitable treatment provisions have the effect of lengthening the
maturity structure of the government debt and, thereby, reducing
the liquidity squeeze. The debtor in possession provision allows
the government to continue collecting revenues from its citizens
as well as providing necessary services to them until the financial
reorganization is finalized. Notice that suspension of convertibility
practiced by the U.S. banking system in the 19th century is a type
of automatic stay provision. In the same way that suspension of
convertibility helped to stem bank panics, our suggested procedures
can help to stem creditor panics.
An international bankruptcy court can also deal with situations
where the borrowing country is simply unable to meet its debt commitments.
In such a situation the court could oversee orderly debt workouts
and arrange for an equitable reduction in payments owed to foreigners.
One concern about the functioning of an international bankruptcy
court is that such a court obviously cannot have the powers to dismiss
governments or to seize collateral located in the borrowing country.
In this respect, such a court seems much weaker than a domestic
bankruptcy court that can replace incumbent management or liquidate
assets. This concern has some validity, but an international court
does have effective powers of enforcement. The principal such power
is to stop protecting governments from the demands of their creditors.
Effectively, such a move would allow each creditor to pursue his
or her claims without hindrance. In this process, ordinary trade,
of course, would be disrupted and substantial costs would be imposed
upon the borrowing countries. Indeed, the country may be forced
A subtle concern is that a well-functioning court, by making it
easy to renegotiate contracts, might distort the kinds of contracts
the parties sign in the first place. 2 It is uncertain how important this consideration is relative to
the possibility of creditor panics. Fortunately, we can let the
market make this judgment by requiring that all new debt contracts
specify whether they will be adjudicated by the international bankruptcy
court in the event of disputes. Presumably the parties will agree
to the arrangement that delivers the highest ex-ante benefits.
Eichengreen and Portes (p. xvi, 1995) take the view that a proposal
like ours is “a nonstarter, given the very great legal obstacles
to implementation.” They suggest a variety of more modest proposals,
which seem to come down to encouraging countries and lenders to
take actions that already seem to be in the interests of the parties
concerned. While we take no stand on the political feasibility of
our proposal, recent events have made obvious the economic benefits
of fundamental institutional change.
If the IMF carries out these responsibilities well we would expect
to see few, if any, creditor panics at the level of a country, just
as the domestic bankruptcy court tends to eliminate them at the
level of a firm. Moreover, for countries that are simply unable
to meet their debt commitments we would expect to see efficient
An appropriate role: To provide a stable nominal anchor
There is another collective action problem that the IMF could solve.
The IMF could provide a public good by providing an easy-to-verify
nominal anchor that any country that wishes can peg to for as little
or as long as the country sees fit. Private markets and individual
governments would clearly have difficulty in providing such an anchor.
A key monetary policy problem faced by most monetary authorities
is to convince their people that they are committed to pursue responsible
monetary policies. One transparent way of conveying their commitment
is to peg their exchange rates to a foreign currency. It is relatively
easy to verify whether a monetary authority is adhering to its commitment.
Alternative devices, such as money supply or inflation targets,
are subject to manipulation and extraneous forces and thus often
serve as poor communication devices of commitment to responsible
In practice many countries now peg to either a single foreign currency
or to a basket of foreign currencies. A major problem with either
of these is that changes in the foreign countries' economic conditions
and policies typically force domestic policy adjustments. These
adjustments are often undesirable, but are the price paid to purchase
commitment. A clear example of this problem occurred in the early
1970s when the Bretton Woods system broke down. U.S. monetary policy
led to high inflation in the United States, which was then transmitted
to the rest of the world through the fixed exchange rate system.
The rest of the world decided the costs of importing this high inflation
were less than the benefits from the peg and, since the United States
was unwilling to pursue deflationary policies, the system broke
If the IMF provided a currency whose supply expanded at a steady
rate, independent of economic conditions, individual countries could
peg to the IMF's currency, and thus they could purchase commitment
without being subject to the whims of other countries' policies.
In one sense, such a system would function somewhat like the gold
standard did, without being subject to the problem of fluctuations
in the price of gold relative to other commodities occasioned by
vagaries in the world supply of gold.
This nominal anchor is subject to a natural market test. It would
have no value if both no country chose to peg its currency to it
and no private individuals or institutions chose to use it in transactions.
The need for a stable nominal anchor is self-evident because so
many countries choose to peg to foreign countries.
An appropriate role: To certify policy and enforce accurate disclosure
The IMF appears to act as a certifier of good policy for financially
distressed borrowing countries. One question is whether there is
a collective action problem here, so that a publicly supported entity
is needed to certify the financial conditions of individual countries.
In answering this question it is helpful to draw analogies to domestic
financial markets. In such markets there are a variety of rating
agencies, securities analysts and the like whose job it is to certify
the financial conditions of firms. None of these is publicly funded.
In this sense, it is not obvious there is a collective action problem
in certifying good policy. Hence it is unlikely that the IMF is
necessary as a certifier of countries in global financial markets.
In domestic financial markets it is generally agreed that there
is a need for government agencies, like the Securities and Exchange
Commission, to enforce accurate disclosure of information. There
is every reason to believe that the market and individual governments
will not adequately provide these services when it comes to international
borrowing as well. Hence, there may well be a collective action
problem here that the IMF could solve by providing these services.
An important and useful service the IMF currently provides is to
collect and disseminate data. Given the public good nature of this
activity it seems clear that some international organization is
needed to ensure that this service is provided adequately.
To determine the appropriate role for the IMF, we must ask the right
- Is there a clear collective action problem?
- Is the proposed solution narrowly tailored to solve the identified
collective action problem?
- Is the IMF the best institution to solve the identified collective
If the answer to any of these questions is no, then the suggested
role for the IMF is not appropriate.
We have asked these questions and determined the following. Worldwide
financial crises are the result of a collective action problem,
but the IMF should not try to prevent them since the central banks
of the major powers can better handle this problem. Country-level
financial panics are the result of a collective action problem,
but the IMF should not bail out countries in order to prevent them
since an international bankruptcy court can better solve this problem.
The role of this international bankruptcy court, then, is an appropriate
one for the IMF. Additionally, there are collective action problems
in providing a stable nominal anchor and enforcing the accurate
disclosure of information, both of which the IMF can best solve.
International Monetary Fund website www.imf.org
1 In stemming the panic, Thornton
argues that, in a panic a lender of last resort should greatly increase
the amount of liquidity in the system to stop the problem from spreading
broadly through the system rather than focus on simply, bailing
out the individual banks.
“If any one bank fails, a general run on neighboring ones
is apt to take place, which if not checked at the beginning by a
pouring into the circulation a large quantity of gold, leads to
very extensive mischief.” (p. 180, 1962 edition)
2 Indeed, in optimal contract theory
with private information, a standard result is that ex-ante efficient
contracts are not ex-post efficient and increasing the extent to which
contracts are ex-post efficient can reduce their ax-ante efficiency. (See
Chari 1983 for example.)