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PA R T V I

International Finance and Monetary Policy
currency depreciation and still greater deterioration of balance sheets. The resulting increase in moral hazard and adverse selection problems in financial markets,
along the lines discussed in Chapter 8, would only make the financial crisis worse.
Central banks in emerging-market countries therefore have only a very limited
ability to successfully engage in a lender-of-last-resort operation. However,
liquidity provided by an international lender of last resort does not have these
undesirable consequences, and in helping to stabilize the value of the domestic
currency it strengthens domestic balance sheets. Moreover, an international lender
of last resort may be able to prevent contagion, the situation in which a successful speculative attack on one emerging-market currency leads to attacks on other
emerging-market currencies, spreading financial and economic disruption. Since a
lender of last resort for emerging-market countries is needed at times, and since it
cannot be provided domestically, there is a strong rationale for an international
institution to fill this role. Indeed, since Mexico s financial crisis in 1994, the
International Monetary Fund and other international agencies have stepped into
the lender-of-last-resort role and provided emergency lending to countries threatened by financial instability.
However, support from an international lender of last resort brings risks of its
own, especially the risk that the perception it is standing ready to bail out irresponsible financial institutions may lead to excessive risk taking of the sort that makes
financial crises more likely. In the Mexican and East Asian crises, governments in
the crisis countries used IMF support to protect depositors and other creditors of
banking institutions from losses. This safety net creates a well-known moral hazard problem because the depositors and other creditors have less incentive to
monitor these banking institutions and withdraw their deposits if the institutions
are taking on too much risk. The result is that these institutions are encouraged to
take on excessive risks. Indeed, critics of the IMF most prominently the U.S.
Congressional Commission headed by Professor Alan Meltzer of Carnegie-Mellon
University contend that IMF lending in the Mexican crisis, which was used to bail
out foreign lenders, set the stage for the East Asian crisis. They argue that these
lenders expected to be bailed out if things went wrong and thus provided funds

that were used to fuel excessive risk taking.8
An international lender of last resort must find ways to limit this moral hazard
problem, or it can actually make the situation worse. The international lender of
last resort can make it clear that it will extend liquidity only to governments that
put the proper measures in place to prevent excessive risk taking. In addition, it
can reduce the incentives for risk taking by restricting the ability of governments
to bail out stockholders and large uninsured creditors of domestic financial institutions. Some critics of the IMF believe that the IMF has not put enough pressure
on the governments to which it lends to contain the moral hazard problem.
One problem that arises for international organizations like the IMF engaged
in lender-of-last-resort operations is that they know that if they don t come to the
rescue, the emerging-market country will suffer extreme hardship and possible
political instability. Politicians in the crisis country may exploit these concerns and
engage in a game of chicken with the international lender of last resort: they resist
necessary reforms, hoping that the IMF will cave in. Elements of this game were
present in the Mexican crisis of 1995 and were also a particularly important feature of the negotiations between the IMF and Indonesia during the Asian crisis.

8

See International Financial Institution Advisory Commission, Report (IFIAC: Washington, D.C., 2000).