Asian Financial crises

Chapter 33 Moral Hazard

International Monetary Fund
Published Date:
January 2001
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Moral hazard is a great sounding topic. Whenever I think of it, a picture of Monica Lewinsky and Linda Tripp comes to mind. However, moral hazard has really very little to do with morality and is not, indeed, a topic that is more appropriate for Geraldo than for a Chicago Fed Conference. Moral hazard is actually a technical economic concept, and there are literally hundreds of examples in the economic literature of the concept of moral hazard applied both to private business arrangements, and to public sector intervention.

It is important to understand that if our objective was to eliminate virtually every instance in which moral hazard was at all an issue, we would certainly have to abolish the IMF, abolish the World Bank, abolish the Federal Reserve, and abolish the U.S. government. Indeed, we would have to abolish most of our gross domestic product, if we wanted to be certain to get it all. So I think we want to restrict our attention, given that understanding, to circumstances in which moral hazard is really a significant problem that does need to be seriously addressed.

Now there are several things that I want to comment on in this regard.

First, the potential moral hazard directly generated by international support packages, sponsored by the IMF is certainly far less than the moral hazard problems that are typically associated with interventions by national governments. The IMF gives loans that it firmly expects to be repaid. It does not make gifts.

I found it ironic that, at the same time congressmen were complaining about the moral hazard potentially associated with the approval of the IMF quota increase, they were busily passing yet another bill to spend $4 billion bailing out farmers in the United States and continuing our policy of supporting that sector of the economy. Such support may be justified for a variety of reasons, but there is no doubt that it generates moral hazard. Meanwhile, the German government is generously spending $1 trillion in this decade to smooth transition of 18-million citizens of the eastern Länder into the greater Germany. There is surely moral hazard being generated in all that spending.

In contrast, as Charles pointed out, the subsidy on IMF lending is quite modest. But the suggestion is made, nevertheless, that the IMF facilitates moral hazard because the IMF support for Korea made it possible and legitimized the bailout of foreign banks that had lent money to Korean banks. Now, suppose that the Korean government had an additional $50 billion worth of reserves last December, it could then have done the bailout on its own without coming to the international community or the fund. Thus, while the Korean government created a moral hazard problem when it guaranteed the flows through Korean banks, the availability of liquidity support when the government faced liquidity problems, was not the fundamental source of that moral hazard problem.

Now you could say that it would be useful if the IMF and others were more forceful in seeking to have a system in which national governments were less generous and predictable in supporting weak banks and their creditors. I think that is right. But it is not just the IMF that could be doing that; also the BIS, the OECD, and the whole range of the economics profession should be doing it. I do not think that denying liquidity support, and forcing an even larger economic disaster on Korea than is already befalling it can plausibly be recommended as a rational way of dealing with this issue.

Second, lessening the true economic damage associated with economic crises, and thereby lessening the perceived hazard of damage associated with such crises, does not necessarily imply the creation of moral hazard. The objective is not to make a crisis as large and costly as possible so that we can discourage all risk taking. We do not want to have central bankers that will create big recessions because that will make people be more cautious in their investments. To the extent that international support packages do reduce the true economic damage associated with economic crises, that is a good thing. And to the extent that people therefore perceive less risk that is also a good thing. It only becomes a moral hazard problem to the extent that we are inducing people to undertake economically inappropriate risk, not to the extent that we are diminishing true risk.

Third, and this was a point raised by John Lipsky, when we look at the problems besetting the international financial system today, the crisis of world liquidity, and when we look before that at the narrowing of spreads and the escalation of asset prices that occurred over the course of the 1990s, before this crisis started, these trends are not plausibly a problem of moral hazard generated either by the fund or by anybody else. The subsequent reversal of these trends is also not a problem of moral hazard.

Fourth, some amount of moral hazard is almost inevitably a consequence of international support packages. But the issue is a balancing one. As President Abraham Lincoln put it, “There are few things wholly evil or wholly good.” Almost everything, especially government policy, is an inseparable combination of the two, so that our best judgment as to the preponderance between them is continually demanded.” That subject of balance has never been addressed by many of the critics of the fund and the international support packages. Rather, they simply argue: moral hazard is bad; support packages contain moral hazards; therefore, the support packages are bad. But there is real hazard out there and real damage and one seeks legitimately to balance the containment of this damage against the concern that some moral hazard may be generated. In particular, while some moral hazard may have followed from the example set in the Mexican crisis, this must be weighed against the very real damage that was avoided with the aid of international support.

Further, it is important to distinguish among cases. If we look at Russia, I think there is no doubt that there was a perception in the private financial market that Russia was “too nuclear to fail,” and that financial support would be provided to Russia on terms and conditions that were not justified by the economic situation and economic policies of Russia but rather for other reasons. That generated a problem of moral hazard by facilitating flows of capital that would not otherwise have gone to Russia. But in the case of Korea, I agree with John and Charles, moral hazard generated by expectations of fund support is simply not a plausible explanation of capital flows to Korea before the crisis. Money flowed to Korea because investors thought Korea was a strong economy or they thought that, if the Korean banks had problems, the Korean government would cover the damage. It did not flow there because there was any significant perception that Korea was likely to come to the IMF and get an inappropriate financial support package.

Next, I would like to address the suggestions on how to deal with the problems of moral hazard. One suggestion, in the context of moral hazard problems associated with the fund itself has been to raise interest rates on fund loans. I have always thought that was a good idea; the fund charges somewhat too little. That problem, however, is being addressed by the higher charges the fund now makes on some of its large support packages. The more serious problem is how we are going to address moral hazard that is created by the actions of national governments. Here, there have been a number of useful suggestions. John has one. Charles has one. This is an important issue and the international community as a whole, including the fund but including others as well, needs to work much harder and more effectively on this issue.

However, I disagree with the suggestions that, “If a country comes to the fund in order to get an international support package because it is experiencing economic difficulties, then as a condition of providing that package, its creditors should be required to take a haircut.” In other words, the policy would say that coming to the fund means a country must default on its debt obligations. The nature of a debt contract says that the creditor is entitled to receive his interest and principal regardless of what happens. He is not an equity holder. Now, as a practical matter, it is not that simple. The creditor receives interest and principal payments provided things do not go too badly. But if we have a particularly adverse outcome, then the creditor may not get fully paid. He has then to find some way to negotiate with the debtor to find a solution to the problem. But debt contracts are not written in such a way that accepts that creditors regularly expect to take a haircut. We call the circumstances in which the creditor takes a haircut a default. And defaults, particularly by sovereign governments, should be very rare events. However, they will not be events that never occur. That is important to containing the problem of moral hazard.

I want to emphasize that this is necessarily done in a dichotomous way. It should not be the case that every country that has an external problem and comes to the fund will have to default. That would be senseless. On the other hand, there will be some cases in which even sovereign defaults will occur. That has been and remains a policy of the international community. In Mexico in the 1980s, the banks had to delay and write down their claims. They were not bailed out. In Mexico in the 1990s, the perception was it was a liquidity problem and the creditors of the Mexican sovereign got out whole. In Russia, they took substantial losses. In other words, we cannot, should not, and do not have a system in which in every case creditors are expected to take losses or a system where creditors never take losses. Either would be senseless.

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