Bankruptcy and Moral Hazard
When the adjustment does not occur smoothly, there is a crisis. Such crises occur, for instance, when a real estate bubble bursts, as it did in Thailand. Those who borrowed from abroad to finance their real estate ventures could not repay their loans. Bankruptcy became widespread. How the IMF handles bankruptcy represents still another arena where the Fund’s approach is plagued with intellectual inconsistencies.
In standard market economics, if a lender makes a bad loan, he bears the consequence. The borrower may well go into bankruptcy, and countries have laws on how such bankruptcies should be worked out. This is the way market economies are supposed to work. Instead, repeatedly, the IMF programs provide funds for governments to bail out Western creditors. The creditors, anticipating an IMF bailout, have weakened incentives to ensure that the borrowers will be able to repay. This is the infamous moral hazard problem well known in the insurance industry and, now, in economics. Insurance reduces your incentive to take care, to be prudent. A bailout in the event of a crisis is like “free” insurance. If you are a lender, you take less care in screening your applicants—when you know you will be bailed out if the loans go sour. Similarly prudent firms facing foreign exchange volatility can insure against it. But if the IMF intervenes to stabilize the exchange rate—arguing that otherwise there would be defaults—then borrowers are being encouraged to incur excess risk—and not worry about it. These moral hazard problems were particularly relevant in the lead-up to the ruble crisis in Russia in 1998. In that instance, even as the Wall Street creditors were making loans to Russia, they were letting it be known how large a bailout they thought was needed and, given Russia’s nuclear status, they believed Russia would get.
The IMF, focusing on the symptoms, tries to defend its interventions by saying that without them, the country will default, and as a result it will not be able to get credit in the future. A coherent approach would have recognized the fallacy in this argument. If capital markets work well—certainly, if they worked anywhere near as well as the IMF market fundamentalists seem to argue—then they are forward-looking; in assessing what interest rates to charge, they look at the risk going forward. A country that has discharged a heavy overhang of debt, even by defaulting, is in better shape to grow, and thus more able to repay any additional borrowing. That is part of the rationale for bankruptcy in the first place: the discharge or restructuring of debt allows firms—and countries—to move forward and grow. Eighteenth-century debtor prisons may have provided strong incentives for individuals not to go into bankruptcy, but they did not help debtors get reestablished. Not only were they inhumane, but they did not enhance overall economic efficiency.
History supports this theoretical analysis. In the most recent instance, Russia, which had a massive debt default in 1998 and was widely criticized for not even consulting creditors, was able to borrow from the market by 2001 and capital began to flow back to the country. Likewise, capital started flowing back to South Korea, even though the nation effectively forced a restructuring of its debt, giving foreign creditors a choice of rolling over loans or not being repaid.
Consider how the IMF, if it had developed a coherent model, might have approached one of the most difficult problems in East Asia: whether or not to raise interest rates in the midst of the crisis. Raising them, of course, would force thousands of firms into bankruptcy. The contention of the IMF was that failing to raise rates would lead to a collapse of the exchange rate, and the collapse of the exchange rate would lead to even more bankruptcy. Put aside, for the moment, the question of whether raising interest rates (with the resulting exacerbation of the recession) would lead to a stronger exchange rate (in real life it did not). Put aside, too, the empirical question of whether more firms would be hurt by raising interest rates or the fall in the exchange rate (at least in Thailand, the evidence strongly suggested that the damage from a further fall in the exchange rate would be smaller). The problem of economic disruption caused by exchange rate devaluations is caused by the firms that choose not to buy insurance against the collapse of the exchange rate. A coherent analysis of the problem would have begun by asking why the seeming market failure—why do firms not buy the insurance? And any analysis would have suggested that the IMF itself was a big part of the problem: IMF interventions to support the exchange rate, as noted above, make it less necessary for firms to buy insurance, exacerbating in the future the very problem the intervention was supposed to address.
From Bailout to Bail-In
As the IMF’s failures became increasingly evident, it sought new strategies, but the lack of coherency ensured that its quest for viable alternatives had little chance of success. The extensive criticism of its bailout strategy induced it to try what some have called a “bail-in” strategy. The IMF wanted the private sector institutions to be “in” on any bailouts. It began to insist that before it lent money to a country in a bailout, there had to be extensive “participation” by the private sector lenders; they would have to take a “haircut,” forgiving a substantial part of the debt that was owed. Not surprisingly, this new strategy was first tried not on major countries like Brazil and Russia, but on powerless countries like Ecuador and Romania, too weak to resist the IMF. The strategy quickly proved to be both problematic in conception and flawed in implementation, with highly negative consequences for the countries targeted for the experiment.
Romania was a particularly mystifying example. It was not threatening a default; it only wanted new money from the IMF to signal that it was creditworthy, which would help to lower the interest rates it paid. But new lenders will only lend if they get an interest rate commensurate with the risk they face. New lenders cannot be forced to take a “haircut.” If the IMF had based its policies on a coherent theory of well-functioning capital markets, it would have realized this.
But there was a more serious problem, which goes to the IMF’s core mission. The Fund was created to deal with the liquidity crises caused by the credit market’s occasional irrationality, its refusal to lend to countries that were in fact creditworthy. Now the IMF was handing power over its lending policies to the same individuals and institutions that precipitated crises. Only if they were willing to lend could it be willing to lend. These lenders quickly saw the profound implications of the change, even if the IMF did not. If creditors refuse to lend the client country money, or to go along with a settlement, the borrowing country will not be able to get funds—not just from the IMF but from the World Bank and other institutions which made their lending contingent on IMF approval. The creditors suddenly had enormous leverage. A twenty-eight-year-old man in the Bucharest branch of an international private bank, by making a loan of a few million dollars, had the power to decide whether or not the IMF, the World Bank, and the EU would provide Romania with more than a billion dollars of money. In effect, the Fund had delegated its responsibility for assessing whether to lend to the country to this twenty-eight-year-old. Not surprisingly, the twenty-eight-year-old, and other thirty- and thirty-five-year-old bankers in the branches of the other international banks in Bucharest, quickly grasped their newly granted bargaining powers. Each time the Fund lowered the amount of money it demanded that the private banks put up, the private banks lowered the amount that they were willing to offer. At one point, Romania appeared to be only $36 million of private sector loans short to receive the billion-dollar aid package. The private banks assembling the money required by the IMF demanded not only top dollar (high interest rates) but, at least in one case, some discreet relaxation of Romania’s regulatory rules. This “regulatory forbearance” would allow the creditor to do things he might otherwise not be able to do—to lend more, or to make riskier, higher interest rate loans—increasing his profits, but increasing the riskiness of the banking system, and undermining the very reason for regulation. Less competent or more corrupt governments might have been tempted, but Romania did not accept the offer, partly because it was not really that desperate for money
in the first place.
The issue can be seen another way. The IMF’s decision to make a loan is supposed to be based on how a country is addressing its fundamental macroeconomic problems. Under the “participatory” strategy, a country could have a perfectly satisfactory set of macropolicies, but if it could not raise the amount that the IMF said it had to raise from the private banks, it might not be able to receive funds from any of the sources. The IMF is supposed to have the expertise on these questions, not the twenty-eight-year-old bank officer in Bucharest.
Eventually, at least in the case of Romania, the failings of the strategy became evident even to the IMF, and it proceeded to provide funds to the country even though the private sector had not provided the amounts the IMF had “insisted” upon.
The Best Defense Is an Offense: Expanding the Role of the IMF as “Lender of Last Resort”
In the light of increasing perceptions of the Fund’s failures and growing demands that its scope be cut back, in 1999 the IMF’s first deputy manager, Stanley Fischer, proposed that the Fund expand its role to make it a lender of last resort. Given that the IMF had failed to use the powers it had well, the proposal to increase its power was quite bold. It was based on an appealing analogy: Inside countries, central banks act as a lender of last resort, lending money to banks which are “solvent but not liquid,” that is, which have a positive net worth, but which cannot obtain funds from elsewhere. The IMF would perform the same role for countries. Had the IMF had a coherent view of the capital market, it would have quickly seen the flaw in the idea.1 Under the perfect market theory, if a business is solvent, it should be able to borrow money from the market; any firm that is solvent is liquid. Just as IMF economists, who normally seem to have such faith in markets, believe that they can judge better than the market what the exchange rate should be, so too do they seem to think that they can judge better than the market whether the borrowing country is creditworthy.
I don’t believe capital markets work perfectly. Ironically, while I think they work far less well than IMF economists typically suggest, I think that they are somewhat more “rational” than the IMF seems to believe when it intervenes. There are advantages to IMF lending; often the Fund lends when the capital markets simply refuse to do so. But at the same time, I recognize that the country pays dearly for the “cheap” money it gets from the IMF. If a national economy goes sour and default looms, the IMF is the preferred creditor. It gets paid back first—even if others, such as foreign creditors, do not. These get what’s left over. They might get nothing. So a rational private sector financial institution is going to insist on a risk premium—a higher interest rate to cover the higher likelihood of not getting paid back. If more of a country’s money goes to the IMF, there is less to go to private sector foreign lenders, and these lenders will insist on a commensurately higher interest rate. A coherent theory of the capital market would have made the IMF more aware of this—and made it more reluctant to lend the billions and billions it has provided in bailout packages. A more coherent theory of markets would have had the IMF, in times of crisis, looking harder for alternatives, like those we discussed in chapter 8.
THE IMF’S NEW AGENDA?
The fact that a lack of coherence has led to a multitude of problems is perhaps not surprising. The question is, why the lack of coherence? Why does it persist, on issue after issue, even after the problems are pointed out? Part of the explanation is that the problems that the IMF has to confront are difficult; the world is complex; the Fund’s economists are practical men striving to make hard decisions quickly, rather than academics calmly striving for intellectual coherence and consistency. But I think that there is a more fundamental reason: The IMF is pursuing not just the objectives set out in its original mandate, of enhancing global stability and ensuring that there are funds for countries facing a threat of recession to pursue expansionary policies. It is also pursuing the interests of the financial community. This means the IMF has objectives that often conflict.
The tension is all the greater because this conflict can’t be brought out into the open: if the new role of the IMF were publicly acknowledged, support for that institution might weaken, and those who have succeeded in changing the mandate almost surely knew this. Thus the new mandate had to be clothed in ways that seemed at least superficially consistent with the old. Simplistic free market ideology provided the curtain behind which the real business of the “new” mandate could be transacted. The change in mandate and objectives, while it may have been quiet, was hardly subtle: from serving global economic interests to serving the interests of global finance.
I should be clear: the IMF never officially changed its mandate, nor did it ever formally set out to put the interests of the financial community over the stability of the global economy or the welfare of poor countries. We cannot talk meaningfully about the motivations and intentions of any institution, only of those who constitute and govern it. Even then, we often cannot ascertain true motivations—there may be a gap between what they say are their intentions and their true motivations. As social scientists, we can, however, attempt to describe the behavior of an institution in terms of what it appears to be doing. Looking at the IMF as if it were pursuing the interests of the financial community provides a way of making sense of what might otherwise seem to be contradictory and intellectually incoherent behaviors.
Moreover, the IMF’s behavior should come as no surprise: it approached the problems from the perspectives and ideology of the financial community, and these naturally were closely (though not perfectly) aligned with its interests. As we have noted before, many of its key personnel came from the financial community, and many of its key personnel, having served these interests well, left to well-paying jobs in the financial community. In modern democracies, there are concerns about such revolving doors, where those in government service move quickly from and to private sector jobs in firms that may benefit from government services or contracts, or that are affected by government regulations, for the obvious reason. Citizens worry, will government officials be tempted to treat potential future employers especially well, in the hopes that by doing so their future prospects will be enhanced, even if there is no explicit quid pro quo? Economists—and ordinary citizens—believe that incentives matter. If so, how could they not affect behavior, if ever so subtly, in these situations? Sensitive to these concerns, most democracies have imposed constraints on these revolving doors, even though in doing so, some talented individuals might be discouraged from public service. The IMF is so far removed from democratic accountability that these concerns did not seem to weigh at all; moving from the IMF to a bank that had benefited from an IMF bail-out was par for the course.
But one does not need to look for venality. The IMF (or at least many of its senior officials and staff members) believed that capital market liberalization would lead to faster growth for the developing countries, believed it so strongly that it gave little credence to any evidence that suggested otherwise. The IMF never wanted to harm the poor and believed that the policies it advocated would eventually benefit them; it believed in trickle-down economics and, again, did not want to look too closely at evidence that might suggest otherwise. It believed that the discipline of the capital markets would help poor countries grow, and therefore it believed that keeping in good stead with the capital markets was of first-order importance.
LOOKING AT THE IMF policies this way, its emphasis on getting foreign creditors repaid rather than helping domestic businesses remain open becomes more understandable. The IMF may not have become the bill collector of the G-7, but it clearly worked hard (though not always successfully) to make sure that the G-7 lenders got repaid. There was an alternative to its massive interventions, as we saw in chapter 8, an alternative that would have been better for the developing nations, and in the longer run, better for global stability. The IMF could have facilitated the workout process; it could have tried to engineer a standstill (the temporary interruption of paym
ents) that would have given the countries—and their firms—time to recoup, to restart their stalled economies. It could have tried to create an accelerated bankruptcy process.2 But bankruptcy and standstills were not (at the time) welcome options, for they meant that the creditors would not be repaid. Many of the loans were uncollateralized, so in the event of bankruptcy, little might be recovered.
The IMF worried that a default, by breaking the sanctity of contracts, would undermine capitalism. In this, they were wrong in several respects. Bankruptcy is an unwritten part of every credit contract; the law provides for what will happen if the debtor cannot pay the creditor. Because bankruptcy is an implicit part of the credit contract, bankruptcy does not violate the “sanctity” of the credit contract. But there is another, equally important, unwritten contract, that between citizens and their society and government, what is sometimes called “the social contract.” This contract requires the provision of basic social and economic protections, including reasonable opportunities for employment. While misguidingly working to preserve what it saw as the sanctity of the credit contract, the IMF was willing to tear apart the even more important social contract. In the end, it was the IMF policies which undermined the market as well as the long-run stability of the economy and society.
IT IS UNDERSTANDABLE then why the IMF and the strategies it foists on countries around the world are greeted with such hostility. The billions of dollars which it provides are used to maintain exchange rates at unsustainable levels for a short period, during which the foreigners and the rich are able to get their money out of the country at more favorable terms (through the open capital markets that the IMF has pushed on the countries). For each ruble, for each rupiah, for each cruzeiro, those in the country get more dollars as long as the exchange rates are sustained. The billions too are often used to pay back foreign creditors, even when the debt was private. What had been private liabilities were in effect in many instances nationalized.
Globalization and Its Discontents Revisited Page 40