THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 567

CHAPTER 20

The International Financial System

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for this view by suggesting that capital inflows can lead to a lending boom and
excessive risk taking on the part of banks, which then helps trigger a financial crisis.
However, controls on capital inflows have the undesirable feature that they
may block from entering a country funds that would be used for productive investment opportunities. Although such controls may limit the fuel supplied to lending
booms through capital flows, over time they produce substantial distortions and
misallocation of resources as households and businesses try to get around them.
Indeed, just as with controls on capital outflows, controls on capital inflows can
lead to corruption. There are serious doubts whether capital controls can be effective in today s environment, in which trade is open and where there are many
financial instruments that make it easier to get around these controls.
On the other hand, there is a strong case for improving bank regulation and
supervision so that capital inflows are less likely to produce a lending boom and
encourage excessive risk taking by banking institutions. For example, restricting
banks in how fast their borrowing can grow might substantially limit capital
inflows. Supervisory controls that focus on the sources of financial fragility, rather
than the symptoms, can enhance the efficiency of the financial system rather than
hamper it.

THE RO LE OF T HE I M F
The International Monetary Fund was originally set up under the Bretton Woods
system to help countries deal with balance-of-payments problems and stay with
the fixed exchange rates by lending to deficit countries. When the Bretton Woods
system of fixed exchange rates collapsed in 1971, the IMF took on new roles.
The IMF continues to function as a data collector and provides technical assistance to its member countries. Although the IMF no longer attempts to encourage
fixed exchange rates, its role as an international lender has become more important recently. This role first came to the fore in the 1980s during the third-world
debt crisis, in which the IMF assisted developing countries in repaying their loans.

The financial crises in Mexico in 1994 1995 and in East Asia in 1997 1998 led to
huge loans by the IMF to these and other affected countries to help them recover
from their financial crises and to prevent the spread of these crises to other countries. This role, in which the IMF acts like an international lender of last resort to
cope with financial instability, is indeed highly controversial.

Should the
IMF Be an
International
Lender of Last
Resort?

As we saw in Chapter 17, when a financial crisis occurs in industrialized countries
and the financial system threatens to seize up, domestic central banks can address
matters with a lender-of-last-resort operation to limit the degree of instability in the
banking system. In emerging markets, however, where the credibility of the central
bank as an inflation fighter may be in doubt and debt contracts are typically shortterm and in foreign currencies, a lender-of-last-resort operation becomes a doubleedged sword as likely to exacerbate the financial crisis as to alleviate it. For
example, when the U.S. Federal Reserve engaged in a lender-of-last-resort operation during the 1987 stock market crash and after the 2001 terrorist destruction of
the World Trade Center, there was almost no sentiment in the markets that there
would be substantially higher inflation. However, for a central bank with less inflation-fighting credibility than the Fed, central bank lending to the financial system
in the wake of a financial crisis even under the lender-of-last-resort rhetoric
may well arouse fears of inflation spiralling out of control, causing an even greater