The international financial crises that have swept through the global economy over the past twenty years reflect a fundamental change in the system: financial integration has linked economies to an extent that is possibly matched only by the remarkable degree of integration achieved under the gold standard of the late 19th century. Of course, that earlier period of integration, or "globalization," foundered on the shoals of post-war adjustment burdens, dysfunctional international monetary arrangements, and the retreat from trade openness.
The last great age of globalization was lost in the 1930s, as Krugman has argued, because it lacked the governance arrangements needed to assist its adherents deal with the challenges of adjustment in a manner that would sustain a positive-sum global economy. And as countries "defected" from the system of open economies and liberal trade, they introduced beggar-thy-neighbour policies "destructive of national and international prosperity." The result was a decade-long period of global stagnation.
The IMF was founded on the wreckage of a global war in order to assist its members strike a judicious balance between financing and adjustment. In the post-war Bretton Woods era, it did so by providing short-term balance of payments support ("financing") and counseling "adjustment" through the compression of domestic absorption (the sum of private consumption, investment and government expenditure). In cases of "fundamental disequilibrium" in the balance of payments, large exchange rate changes were permitted.
In that halcyon age, the Fund had the resources needed to deal with the current account problems its members periodically encountered. Those balance of payments difficulties were typically modest--a few percentage points of GDP--reflecting the fact that they stemmed from differences in national saving and investment rates. Nevertheless, they posed difficult challenges to finance ministers, who had to take difficult measures to constrain domestic demand.
We are now in a post-Bretton Woods era. Over the past quarter century, the capital controls that had formerly limited private capital flows were eliminated as countries sought the benefits of financial integration (risk-diversification benefits and access to foreign savings to fund investment). The result of this, however, is that private capital now dwarfs official sector resources that the IMF and other International Financial Institutions can mobilize. This is because balance of payments problems now reflect shifts of asset stocks in the capital account, rather than differences in flows of saving and investment. The result is financial crises that can resemble bank runs, as investors make a panicked exit.
In this brave new world, the IMF is confronted with a much more difficult role in times of crisis. In effect, it tries to "catalyze" private sector lending by the judicious use of its limited funds. When the IMF succeeds, as, arguably, it did in the case of Brazil more than a decade ago, it averts a painful disruption of economic activity and the corresponding social dislocation that accompanies crises. If it fails, the Fund can inadvertently exacerbate the problem of national insolvency by adding to the debt burden — or bailing out private creditors--while delaying the adjustments needed to restore sustainable growth.
The problem is that the Fund is in an extremely difficult position. Debt restructuring is costly for sovereign borrowers. This is no mere coincidence — if it were not so, there may be too many defaults. The result, however, is that governments in severe financial circumstances seek to avoid calling in its creditors, hoping that some change of fortune (an improvement in the terms of trade, possibly, or some other windfall) will render a restructuring unnecessary. The official sector, meanwhile, respectful of the prerogatives of sovereign states, and itself reluctant to trigger economic disruption, may be prepared to accommodate the sovereign's wish for additional financing. As a result, there is a risk that, rather than underwrite genuine reforms, IMF lending finances the status quo.
What might be done to reduce the virulence and frequency of financial crisis?
Part of the answer may be to enhance the functioning of global capital markets ex ante by promoting the appropriate pricing of risk and the efficient allocation of capital. The starting point is to recognize that wherever there is lending there are potential agency problems — that is to say, there are countless possibilities for the interests of the lender and the borrower to diverge.
The case above of a sovereign borrower in difficulty is an example. The IMF lends in the expectation that the borrower will implement measures to contain the crisis and promote a return to sustainable growth. But, if those policies are politically difficult to implement, as they most often are, the sovereign may be tempted to delay needed reforms. The result is more debt, no reform, and a possibly bigger required adjustment that is more costly to the citizens of the country.
There are, of course, numerous other potential examples of agency problems. These can be sorted into two distinct types, which are referred to common agency and dual agency problems.
The first type refers to a situation in which many lenders provide loans to a single borrower. While each individual lender may appropriately factor the credit risk of the borrower into the pricing of the loan, she is unlikely to consider the impact of her incremental loan on the borrower's ability (or possibly willingness) to repay. The greater the indebtedness of the borrower, however, the greater the risk that an external terms of trade shock will render the borrower incapable of meeting all of his obligations; alternatively, the greater the debt level (and corresponding claims on domestic output), the greater the borrower's incentive to claim poverty and default.
Dual agency problems arise when the returns to lending depend on the actions of more than party. Consider the case of lending to a firm. The returns to lending depend on the idiosyncratic characteristics of the firm — the project being financing, the quality of the firm's management, expected demand for the firm's output, and so on. But the returns on that loan are also influenced by the macroeconomic environment in which the firm operates. These are not under the control of the firm, but of the government. In this respect, the return to the lender is subject to the actions of two separate parties — a problem of dual agency.
The question is: how might foreign lending affect behaviour of the agents? Consider the case of a foreign lender lending to a private sector entity. As more foreign money enters the capital structure of the firm, a larger and larger share of the firm's expected future profit stream is claimed by foreigners in the form of dividends and interest payments. This dilution in domestic claims on the firm could have perverse effects on the incentives of the government. There may, for example, be less of an incentive to maintain a stable macroeconomic environment. Similarly, the government may be tempted to expropriate the firm: having secured foreign investment, the threat of expropriation, which allows the government to appropriate the returns on the investment, rises.
The following post will consider the possible role of the International Financial Institutions in mitigating the common and dual agency problems. Stay tuned!