I. The Model

To discuss the different effects that a country insurance policy may have on policymakers’ incentives to undertake reforms, we consider the following stylized framework. At the beginning of the period, the policymaker inherits a fixed amount of debt and decides on the amount of reform effort he is willing to undertake. A reformist attitude (high effort) increases the probability of avoiding a crisis in the long run but at the same time reduces the policymaker’s ability to reap immediate political returns (which may include political patronage or fund diversion). After the effort decision is made, an exogenous state of nature (representing macroeconomic fundamentals) is revealed. In the absence of insurance, the probability of being unable to repay creditors at the end of the period (henceforth, a crisis) is a function of macroeconomic fundamentals and reform efforts previously chosen.⁴

We assume that, unlike the returns from short-run policies, returns from reforms take time to materialize and depend on the evolution of the macroeconomic environment.⁵ In addition, to capture the fact that the effective cost of a crisis influences reform incentives (alternatively, the moral hazard problem associated with insurance), we assume that a crisis event has specific real effects (which translate into a political cost to the government) above and beyond those related to macroeconomic fundamentals, and that the implementation of reforms reduces the likelihood of a crisis episode.

Three cases are considered: a benchmark under which no insurance is provided (denoted by NI), and two alternative insurance contracts that stipulate the conditions under which an insurer provides the funds needed to repay lenders in the event of insolvency: blanket insurance (BI) that insures the borrower against insolvency in all states, and contingent insurance (CI) that provides the funds only in bad states of nature.⁶ Note that an insurance contract could, in principle, be written as a function of a realized reform effort. In practice, however, the measurement and verifiability of reform is bound to be contestable, to an extent that may prevent the enforcement of the contract. To capture this limitation, we assume that reform efforts are not verifiable and thus cannot be used to condition the provision of insurance.

Depending on the case under consideration, the country may face three possible scenarios: solvency (which we henceforth denote as tranquil times); insolvency, in which default is avoided through the activation of the insurance policy (turbulent times); and insolvency followed by default (crisis). The distinction between the last two scenarios reflects the fact that, while insurance may save the country the additional costs of a crisis, it does not fully eliminate the real consequences of the adverse macroeconomic conditions that led to insolvency in the first place.

More formally, we assume that insolvency occurs with probability π_j=1 - s_je, where e denotes the government’s reform efforts, associated with a quadratic opportunity cost c(e) = e² that represents the foregone returns from alternative short-run policies. The stochastic variable s_j, j = B, G, denotes an observable exogenous state of nature, where the subscripts B and G refer to good and bad states, so that s_b < s_g < 1. In this simple setup, for a given level of effort, the probability of insolvency is higher in bad states; for a given state, insolvency is more likely when reform efforts have been low. For expositional simplicity, we further assume that Pr(sb) = Pr(s_G) = ½, and that s_b = γ - α; s_g = γ + α. These two assumptions imply that the ex ante probability of insolvency is given by π = 1 - γe. From now on, we refer to γ as the expected state of nature (alternatively, expected macroeconomic fundamentals) and to α as exogenous volatility, and we assume that γ ≥ α.

As noted before, we assume that reform efforts generate returns to the government. We let such returns be equal to µ in tranquil times, to β in turbulent times, and to λ in crisis periods. To rule out trivial cases in which country insurance is either always or never optimal, we work under the assumption that

In addition, we assume that the occurrence of a crisis entails an additional fixed cost to the government equal to C, such that

Assumptions (1) and (2) ensure that, in equilibrium, the ex-post probability of insolvency is nonnegative and less than one (that is, π_j ∈ [0, 1)). Finally, the assumption that, in the event of insolvency, reform payoffs are higher if the country is insured captures the effort-increasing incentive (the carrot) of the insurance policy. The rewards for reforms decline both with deteriorating fundamentals and with the unraveling of a debt crisis. Insurance cannot eliminate the former, but it helps avoid the latter.⁷ This effect is counterbalanced by the standard moral hazard effect introduced by the insurance policy which, in our framework, is associated with the elimination of the fixed cost of a crisis, C, in those states in which the insurance is activated.⁸ Figure 1 summarizes the dynamic structure of the model.

The problem of the government in the absence of insurance is given by

which gives the optimal level of effort⁹

As expected, the optimal level of effort is a positive function of the cost of a crisis ($\frac{\partial e_{NI}^{*}}{\partial C}>0$) and the expected quality of macroeconomic fundamentals ($\frac{\partial e_{NI}^{*}}{\partial \gamma }>0$).

Effort also increases with the reform payoff in tranquil times ($\frac{\partial e_{NI}^{*}}{\partial \mu }>0$). The reform payoff during a crisis, λ, has, however, an ambiguous effect on policymakers’ willingness to undertake reforms. A higher value of λ, by reducing the loss associated with defaults, raises the payoff of reforms. However, it also weakens the incentives to reduce the probability of insolvency. In the Appendix, we show that the first effect dominates the second when the cost of the crisis is low enough, a situation in which the disciplinary effect of a crisis is necessarily limited.

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Dynamic Structure of the Model

Citation: IMF Staff Papers 2005, 005; 10.5089/9781589064478.024.A006

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The introduction of a blanket insurance policy that guarantees creditors whenever the country becomes insolvent (a case denoted by the subscript BI) modifies the problem to

from which we have

Again, reform efforts increase with the quality of macroeconomic fundamentals ($\frac{\partial e_{BI}^{*}}{\partial \gamma }>0$) and with reform payoffs in tranquil ($\frac{\partial e_{BI}^{*}}{\partial \mu }>0$) and turbulent times ($\frac{\partial e_{BI}^{*}}{\partial \beta }>0$). As expected, under a blanket insurance policy, the disciplinary effect of the crisis is bound to play no role.

Finally, we study the effects of a contingent insurance policy (denoted by the subscript CI) under which insurance is provided exclusively in bad times (s = s_b). The government’s problem can now be rewritten as

from which we obtain

As in the first case, the optimal level of reform effort is a positive function of the cost of a crisis ($\frac{\P e_{\text{CI}}^{*}}{\P \text{C}}>0$), the expected state of nature ($\frac{\partial e_{\text{CI}}^{*}}{\partial \gamma }>0$), and the reform payoff in tranquil times ($\frac{\P e_{\text{CI}}^{*}}{\P \text{m}}>0$). The reform payoffs in turbulent (b) and in crisis times (l) have, however, an ambiguous effect on policymakers’ willingness to undertake reforms. As in the no-insurance case, the reform payoff during a crisis, l, has a positive effect on policymakers’ willingness to undertake reforms only when the political costs of the crisis are low enough. The same is true for the reform payoffs in turbulent times: only when the disciplinary effect of the crisis is limited does the insurance effect dominate the moral hazard effect under a contingent insurance policy.

We are now in a position to compare reform efforts under the three different cases outlined above and see under which conditions country insurance schemes foster or hinder reform efforts.

Result 1 (i) If crisis costs are very low ${}_{L}C<C_1"\frac{\left(b-1\right)\left(1-mg-ab\right)}{\left(g+a\right)\left(1-\left(m-b\right)g\right)1}$, the reform effort is highest under blanket insurance and lowest under the no-insurance regime ($\left(e_{BI}>e_{CI}>e_{NI}\right)$);

(ii) If crisis costs are low ${}_L{C}_1<C<C_2"\frac{\left(b-1\right)\left(1-mg\right)}{g\left(1-\left(m-b\right)g\right)1}$, the reform effort is highest under conditional insurance and lowest under no insurance (e_CI > e_BI > e_ni);

(iii) If crisis costs are high ${}_L{C}_2<C<C_3"\frac{\left(b-1\right)\left(1-ml+al\right)}{\left(g-a\right)\left(1-\left(m-b\right)g\right)1}$ the reform effort is highest under conditional insurance and lowest under blanket insurance (e_CI> e_NI> e_BI);

(iv) If crisis costs are very high (C > C₃), the reform effort is highest under no insurance and lowest under blanket insurance (e_NI > e_CI > e_bI).

Proof: See Appendix.

To understand these results, it is best to start by comparing the no-insurance and blanket-insurance cases. First, notice that the main force at work is the interplay between the motivating carrot of insurance, captured by the difference between the reform payoff in turbulent and crisis times, and the dissuasive stick of crisis costs, which the insurance policy necessarily attenuates. It is not surprising, then, that if the stick is large enough, reform efforts will be lower under an unconditional insurance policy. Conversely, a small stick would imply a minor moral hazard problem as a result of blanket insurance, tilting the carrot-stick balance in favor of the former.

The moral hazard aspect detracts from the benefits of blanket insurance when the cost of the crisis increases. This effect can be attenuated by making the insurance contingent to the realization of a bad shock. The reason this might be incentive compatible is well known in principal-agent models.¹⁰ Indeed, state-contingent insurance increases the value of effort in those states in which a failure is most likely to be the consequence of external circumstances (a bad shock) and preserves the stick in those states in which a failure is most likely to be associated with insufficient reform. In terms of the previous trade-off, this contingent policy entails both a smaller carrot (since it is now available only in the event of a bad shock) and a weaker stick (effective only if the country becomes insolvent under good macroeconomic conditions). However, the first effect is proportionally smaller than the second one, improving upon blanket insurance as moral hazard becomes important (C > C₁), and leading to more reform than under the no-insurance case as long as moral hazard does not become an overwhelming concern (C < C₃).

A clearer understanding of the conditioning mechanism can be obtained with the help of a limiting example in which a bad shock causes insolvency with certainty (α = γ, so that s_b = 0). Substituting these values in the first-order conditions of the maximization problem, it follows immediately that the difference in the marginal benefit of a reform effort between the contingent-insurance and the no-insurance scenarios $\left(\frac{\partial U_{CI}}{\partial e}-\frac{\partial U_{NI}}{\partial e}\right)$ is given simply by $\frac{\left(\beta -\lambda \right)}{2}$. In this case, the only effect of the introduction of insurance is a higher return on reforms contingent on a bad shock. The moral hazard component, on the other hand, disappears because, in this extreme situation, reform has no effect on the probability of insolvency under adverse macroeconomic conditions.

The above example suggests that the effectiveness of country insurance contracts in fostering reforms depends not only on the reform payoffs under different scenarios, but also on the expected state of nature and its volatility. More precisely, if the case for country insurance is built on its ability to foster reform efforts, we have

Result 2: The higher the probability of a crisis for a given level of reform (the lower y), the stronger the case for insurance.

Proof: See Appendix.

These results suggest that crisis-prone volatile economies would be natural candidates for country insurance. Indeed, in the presence of good and stable macro-economic conditions, the moral hazard component of insurance is likely to undermine the already high expected reform payoffs. By contrast, when these payoffs are downgraded by a highly unpredictable macroeconomic context, country insurance strengthens reform incentives, while moral hazard plays a lesser role. It is then not surprising that large exogenous volatility reinforces the case for conditional insurance. Under such a policy, the insurance is in place only when moral hazard effects are necessarily subdued, preserving the disciplining effect of crisis costs when moral hazard is more likely to be a concern.

II. Insurance and Reforms

The simplified model presented above highlights the main trade-offs underlying much of the discussion on international safety nets and, in particular, their effect on government moral hazard. In this section, we tailor the analysis to better illuminate its policy implications. More precisely, we first look at how the insurance-incentive nexus depends on the nature of the reform under scrutiny. Then, we address the critical issue of the insurance contract’s implementation costs.

III. Extensions

In this section, we extend our analysis to address two additional channels recently discussed in the literature whose interaction with country insurance schemes might significantly affect reform incentives. First, we sketch a dynamic version of our model to illustrate the way in which country insurance may influence the behavior of forward-looking policymakers. Second, we allow for the possibility of self-fulfilling crises, to show how, in such circumstances, the positive effects of country insurance are magnified.

IV. Conclusion

This paper presented a simple analytical framework to address the incentive effects associated with country insurance, and it identified an important channel through which insurance can foster reforms. By reducing the probability that deteriorating fundamentals evolve into full-blown crises, country insurance schemes may enhance the expected political payoffs of reforms, increasing reform incentives.

We argued that this channel would tend to be particularly effective in crisis-prone volatile economies, and for enhancing reforms that pay off relatively more handsomely in good times. By contrast, buffering reforms that tend to offset the impact of adverse shocks may be discouraged by insurance-type international safety nets. It follows that the effects of the latter on government moral hazard depend crucially on the nature of the specific policies under consideration, as well as on countries’ political and institutional features.

Having shown that, under certain conditions, an incentive-compatible country insurance scheme is feasible, it remains to discuss how this scheme fares in terms of other alternatives. In particular, while we assumed that crisis costs were exogenously given, it follows from the previous analysis that an alternative way to guarantee that reforms are undertaken consists in raising such costs. Indeed, this argument underscores the basic approach to the debt-crisis problem adopted by those who tend to see moral hazard as an overriding concern.²⁰

One has to bear in mind, however, that the relevant crisis costs are those imposed on the decision makers (in our case, the governments) who are often only partially correlated with the economic situation. For instance, a populist government may gain substantial political rents (in time of economic distress), blaming external factors (past governments, the international environment, evil lenders, and even the IFIs) for the dismal effect of the crisis, thereby reducing its political costs.²¹

At any rate, even abstracting from a possible Samaritan’s dilemma, it might not always be feasible for the international community to increase the pain of a defaulting government to any desired level.

Moreover, substantive crisis costs, while leading to deeper reform, would mean a loss for the government (and for the economy as a whole) should the crisis nonetheless occur. It follows that, for any level of reform effort attainable through the provision of country insurance, the stick of higher crisis costs is welfare-dominated by the carrot of insurance. This, of course, does not deny the positive effect a stick may have on the willingness to reform and the related probability of a crisis. Indeed, it follows from our analysis that there are cases in which effort levels associated with sufficiently large crisis costs cannot be reached through country insurance. However, because these costs are mostly wasted resources, larger sticks, if feasible, would lead to more disciplined, but poorer, countries.²²

Ultimately, the way in which this carrot and stick trade-off plays out in the real world depends, as is always the case, on a number of case-specific factors. Furthermore, while the empirical assessment of the moral hazard effect has proved to be elusive, the still-untested insurance effect is likely to be as difficult to elucidate. However, a few recent experiences might provide preliminary insights into how international financial safety nets might help create positive incentive effects.

Among the latest financial crises, perhaps the two episodes that most closely illustrate the incentive effects of rescue packages are Mexico (1994) and Brazil (2002). In the first case, the country was offered a prompt bailout package that helped prevent default. In the second, a generous safety net was provided in a timely way to help the country get through the turbulence of an election year. The aftermath of these episodes is illuminating. The Mexican bailout, heavily criticized at the time for its moral hazard consequences, led instead to a rapid sequence of reforms.²³ In addition, the government has experienced primary fiscal surpluses every year since then, which helped to almost halve the debt-to-GDP ratio,²⁴ while substituting local-currency domestic debt for foreign-currency external obligations (a recognized source of external vulnerability)—policies that certainly contributed to the country’s achievement of an investment-grade rating. In Brazil, IMF assistance was followed by fiscal tightening and a partial de-dollarization of government liabilities to enhance debt sustainability as well as advances on the social security and tax reform fronts, implemented by the same policymakers who had triggered market jitters in the run-up to the election. Overall, rather than the surge of opportunistic populism that the moral hazard view envisaged, the two countries exhibited sensible policies in line with the insurance effect examined in this paper.

Proof of Result 1

By a simple comparison of (4), (6), and (8), it is straightforward to verify that

The fact that C₃ > C₂ > C₁ > 0 completes the proof.

Proof of Result 2

Using Result 1,

• (i) It follows from $\frac{\partial {\text{C}}_3}{{\partial }_{\gamma }}=-\frac{\left(\beta -\lambda \right)\left(1+\alpha \lambda -\mu \gamma \right)\left(1-\alpha \beta +2\beta \gamma -\mu \gamma \right)}{{\left(\alpha -\gamma \right)}^2{\left(1+\beta \gamma -\mu \gamma \right)}^2}>0;$

• (ii) It follows from $\frac{\partial {\text{C}}_1}{{\partial }_{\alpha }}=-\frac{\beta -\lambda }{{\left(\alpha +\gamma \right)}^2}<0,\text{and}\frac{\partial C_3}{\partial \alpha }=-\frac{\left(\beta -\lambda \right)\left(1+\gamma \lambda -\mu \gamma \right)}{{\left(\alpha -\gamma \right)}^2\left(1+\beta \gamma -\mu \gamma \right)}>0.$

Proof of Result 3

To prove the proposition, it suffices to show that $\frac{\partial {\text{C}}_3}{{\partial }_{\epsilon }}>0.$ Substituting λ = β - (1 - k)ε and μ = β + kε into C₃, define

from which

Note that $\frac{\partial {\text{X}}_3}{{\partial }_{\epsilon }}>0$ if, and only if, $\epsilon \in \left[\frac{\alpha +k\left(\text{γ}-\text{a}\right)-\Psi }{\text{γk}\left(\text{α}+k\left(\text{γ}-\text{a}\right)\right)};\frac{\alpha +k\left(\text{γ}-\text{a}\right)+\Psi }{\text{γk}\left(\text{α}+k\left(\text{γ}-\text{α}\right)\right)}\right],$ with $\Psi \equiv \sqrt{\alpha {\left(1-\text{k}+\text{γk}\right)}^2\left({\text{βγ}}^2\text{k}+\text{α}\left(1-\text{k}\left(1+\text{βγ}\right)\right)\right)}.$ From $\underset{\epsilon \to 0}{\lim }\frac{\partial {\text{X}}_3}{\partial \epsilon }>0,$ it follows that $\frac{\alpha +k\left(\gamma -\alpha \right)-\Psi }{\gamma k\left(\alpha +k\left(\gamma -\alpha \right)\right)}<0,$ which, in turn, implies that $\frac{\alpha +k\left(\gamma -\alpha \right)+\Psi }{\gamma k\left(\alpha +k\left(\gamma -\alpha \right)\right)}>\frac{2\left(\alpha +k\left(\gamma -\alpha \right)\right)}{\gamma k\left(\alpha +k\left(\gamma -\alpha \right)\right)}=\frac{2}{\text{γk}}>1.$ Finally, (1) implies that ε < 1, which in turns implies that $\frac{\partial {\text{C}}_3}{{\partial }_{\text{ε}}}=\frac{1}{\left(\text{γ}-\text{α}\right)}\frac{\partial X_{\text{3}}}{\partial \text{ε}}>0.$

Proof of Result 4

It is enough to show that U_bi (e_bi) > U_NI (e_NI) for e_bi > e_NI, and U_Ci (e) > U_NI (e) for e_CI > e_NI . This follows from the fact that U_bi (e_NI) < U_NI (e_NI) and ${\frac{\partial U_{B{I}^{\left(e\right)}}}{\partial e}|}_{e<e_{BI}}>0$ imply that U_bi (e_bi) < U_NI (e_NI) for e_bi > e_NI. U_CI (e_CI) < U_NI (e_NI) for e_CI > e_NI follows from a similar argument.