- Email: [email protected]
Optimal currency crises A comment
Carnegie-Rochester Conference Series on Public Policy 53 (2000) 231-238 North-Holland www.elsevier.nl/Iocate/econbase
O p t i m a l c u r r e n c y crises A comment Nancy P. Marion Dartmouth College
Allen and Gale model a banking crisis triggered by the discovery that returns on risky bank assets are particularly low. Their view that banking crises can be caused by weak fundamentals builds nicely on some earlier work by Gorton (1988). It is also consistent with empirical evidence on U.S. bank panics in the nineteenth and early twentieth centuries that shows bank crises associated with business-cycle downturns. In my view, having a fundamentals-driven banking crisis is a nice addition to the open-economy crisis literature. To date, the only open-economy bank-run models we have are ones where a run is the unanticipated outcome of a self-fulfilling loss of confidence, along the lines of Diamond-Dybvig (1983). These models were developed after the 1997 Asian financial crisis by Goldfajn and Valdes (1997), Chang and Velasco, (1998a, 1998b), and others. They provide many useful insights, but there is no reason to believe that all banking crises are caused by selffulfilling shifts in expectations. Ultimately, the debate about whether most crises are the unanticipated outcome of inconsistent policies and deteriorating fundamentals or the unanticipated outcome of self-fulfilling changes in market expectations must be resolved empirically. In the meantime, we need theoretical models of each kind of crisis. We also need models that examine banking and currency crises in a single framework, as this paper attempts to do. The intriguing title of Allen and Gale's paper is Optimal Currency Crises. Can a crisis ever be optimal? The authors call a crisis optimal if it can duplicate the first-best allocation chosen by a social planner. In the closed-economy version of their model, which has nothing to say about currency crises but does examine banking crises, a social planner can achieve the first-best allocation by making state-contingent contracts. The planner maximizes the ex ante expected utility of all consumers by appropriately choosing how much to invest in safe and risky assets. The planner 0167-2231/00/$ - see front matter © 2000 Elsevier Science B.V. All rights reserved. PII: SO167-2231 (01)00031-8
then gets to allocate consumption between those with early and late liquidity needs after seeing an indicator that is perfectly correlated with next period's return on the risky asset. When this asset return is particularly low, it is optimal for early and late consumers to consume equal amounts of the available output. When the asset return is high enough (so that more than half the output is produced in the final period), then those with early liquidity needs should consume the readily-available safe asset and those with late liquidity needs should consume the return on the risky investment available in the final period. In this way, the planner achieves optimal risk-sharing between early and late consumers. Moreover, the planner avoids costly early liquidation of the risky asset. In a closed economy without a social planner, where bank deposit contracts promise to pay a fixed amount of nominal domestic currency, a central bank can make these deposit contracts state-contingent in real terms by increasing the price level when the return on the risky asset is low. Higher prices force both early and late consumers to accept less real consumption. As a result, the central-bank policy achieves the first-best allocation of the social planner. It preserves optimal risk-sharing and avoids the costly early liquidation of the risky asset that is normally associated with a bank run. An open-economy version of the model is developed by adding an international bond market where the country can borrow and lend at a fixed rate. As before, an "optimal" crisis is one that achieves the first-best allocation of the social planner. Because the international market is risk neutral and bank depositors risk averse, a social planner will find it optimal to shift all risk from depositors to the international market. The planner achieves this outcome by using state-contingent income transfers to obtain full insurance. The income transfer is the difference between the country's net present value income and its realized income. If the country faces a low return on the risky asset, its realized income falls short of net present value income and the country receives an income transfer from abroad. If the asset return is high, the global market receives the transfer. Consequently, the planner can shift all risk from depositors to the international market and provide depositors with a constant amount of consumption independent of the return on the risky asset. In the absence of a social planner, can a currency crisis achieve the same outcome, shifting all risk from depositors to the international market? In other words, can there be an "optimal" currency crisis? It is highly unlikely. If the country's banks can borrow abroad in domestic currency, and if deposit contracts are specified in nominal domestic-currency terms, then a central bank policy that allows currency depreciation when asset returns are low may be able to shift all risk from depositors to the international market. But two conditions must hold. First, the country 232
must be able to issue domestic-currency debt oil the international market. This privilege is generally reserved for mature markets, like the Scandinavian countries in the early 1990s, who might face banking and currency crises. Second, banks must borrow from the international market an infinite amount in domestic currency and then invest the borrowed funds in safe foreigncurrency-denominated bonds. Only in the limit can risk be shifted from depositors as a whole. Although the open-economy case just described closely parallels its closedeconomy counterpart in terms of using the price level (exchange rate) to achieve optimal risk-sharing, it relies on the ability of the country in question to issue debt denominated in its own currency on the international market. The problem, as the authors acknowledge, is that most countries with banking and currency crisis--the emerging markets--cannot issue domesticcurrency-denominated debt internationally. 1 There are several reasons for this restriction. Foreign creditors may worry that an emerging market will be tempted to use inflation to reduce its foreign liabilities if they are denominated in domestic currency. Additionally, foreign creditors may worry about currency risk since, if the emerging market allows its currency to depreciate, foreign creditors will receive less in terms of their own currency. Foreign lenders often cannot hedge against this currency risk because liquid derivative markets for emerging-market currencies are lacking. So what about the case of emerging markets who must borrow on the international market in foreign currency? Can they have an "optimal" currency crisis? Allen and Gale look at two examples. First they consider a dollarized economy, where banks borrow from abroad in foreign currency and accept deposits denominated in foreign currency. But the dollarized economy cannot have a currency crisis because there is no fixed exchange rate to attack. Domestic currency does not circulate. Next they consider an economy with a central bank and domestic currency, where bank deposits are specified in nominal, domestic-currency terms but banks must borrow in foreign currency. In that case, which corresponds to the situation of practically all emerging markets, a central-bank policy of currency depreciation when asset returns are low cannot shift risk from depositors to the international market. By reducing the real value of domestic deposits, the depreciation may improve risk-sharing between early and late consumers, but it cannot prevent costly liquidation of the risky asset or shift risk to the international market. Thus for a fundamentals-driven banking crisis in emerging markets, a corresponding currency crisis is not optimal. The analysis hinges on comparing various open-economy cases with the open-economy benchmark case of the social planner. Unfortunately, the 1See Hausmann, Panizza, and Stein (1999) for an elaboration on the inability of emerging markets to borrow internationally in their own currencies. 233
benchmark case may not be a particularly relevant one. Recall that in the benchmark case, the social planner can write state-contingent contracts with the international capital market. Relying on international income transfers tied to asset returns, the planner is able to obtain full insurance from the international market and eliminate all risk for depositors. The problem is that the benchmark case may not be viable for well-known reasons having to do with country risk. For example, consider default risk. 2 We can endogenize default risk by adding another constraint to the benchmark case in Section 4.1. Suppose:
I(r) <_a[rh(x)/p] + ~[py]
(1)
This constraint says that the domestic economy will avoid default if its income transfer to the international market, I, is less than the default penalty. The penalty is the share of asset returns that the international market can extract in case of default. If the international market has little bargaining power, the fractions a and fl are small and this constraint is violated. As a result, the social planner will be unable to use the international market to provide complete insurance. Other problems with the benchmark case come to mind, such as the inability of the international market to monitor effort put into the risky investment, or the inability to verify income earned on the investment, or the inability to verify outcomes without incurring a monitoring cost. These considerations make the planner's problem more complex but suggest that the international market cannot provide complete insurance, even for the social planner. An important implication is that the comparison of a modified benchmark case with a case where the central bank responds to a banking crisis with currency depreciation is not likely to yield a clear welfare ranking. Despite their inability to show that a currency crisis is optimal for an emerging market with banking problems, Allen and Gale reinforce an important point--namely, it is not optimal to eliminate crises completely. They show that a currency crisis can achieve optimal risk-sharing in certain circumstances. The notion that it may not be optimal to eliminate crises completely is also a theme of the escape-clause literature as applied to currency crises. 3 We know that it is difficult to construct rules, such as a fixed exchange-rate rule, that are contingent on all possible states of nature. However, if the state is bad enough, it is generally optimal for the monetary authority to invoke the escape clause, abandoning the fixed exchange rate in favor of currency depreciation. In the Allen and Gale paper, a currency crisis is a byproduct of a banking crisis. This linkage is important. As Kaminsky and Reinhart (1999) have 2See Aizenman (1989) for an analysis that incorporates default risk. 3For example, see Flood and Isard (1989) and Obstfeld (1997). 234
documented, banking fragility often leads to currency crises, especially in the deregulated environment of the 1990s. While the good news is that the Allen and Gale model links banking and currency crises together, the bad news is that the two crises my be too closely linked. We know that countries may suffer banking crises without succumbing to currency crises. As such, it would be useful to explore cases where the monetary authority has reasons for maintaining the fixed exchange rate even in the face of banking problems. A few additional points are worth noting. First, the paper suggests that when serious banking problems occur, a large exchange -rate adjustment may be desirable because it allows better risk-sharing in some circumstances. But surely there can be substantial costs to large currency depreciations. A large depreciation may turn good assets into bad as domestic banks and firms see the domestic-currency value of their foreign-currency debt balloon. We need to pay attention to the costs as well as the benefits of large currency depreciations. Second, in this paper it does not matter whether the country borrows short-term or long-term. All uncertainty is resolved by the start of the middle period. Therefore any short-term debt acquired initially can be rolled over. Whether the country chooses to borrow short-term or long-term depends only on the yield curve. Empirical evidence suggests that the growth in the ratio of short-term foreign-currency-denominateddebt to international reserves is an important predictor of financial crises. 4 If foreign debt is short-term and foreign creditors panic because uncertainty grows rather than diminishes as a crisis unfolds, the country may not be able to roll over its debts or obtain new loans just at the time it needs liquidity.5 The maturity structure of foreign-currency-denominateddebt will then matter. Third, in the model there are many banks, all of whom behave competitively and maximize the ex a n t e expected utility of their depositors. These assumptions about bank behavior are certainly an appropriate starting point for any analysis. It is worth noting, however, that some different views about bank behavior have been put forward in connection with the Asian crisis. For example, Dooley (1998) has developed a crisis model where bank (or firm) behavior is distorted because of explicit or implicit government guarantees. Banks appropriate a fraction of each deposit, knowing that this fraction will be covered by a future bailout. An interesting extension would be to consider other types of bank behavior in addition to the competitive version modeled here. Finally, since the theme of this year's Carnegie-Rochester Conference is the role of the IMF in financial crises, it is useful to ask what we learn about the IMF's role from this paper. Allen and Gale say their paper provides a 4See Furman and Stiglitz (1998) and Chang and Velasco (1998b). 5See Aizenman and Marion (1999).
235
framework for understanding why people disagree on whether the IMF has a role to play. They suggest that the IMF has little role to play when advanced industrial economies experience financial crises, since these countries can issue debt denominated in their own currency and adjust the exchange rate to achieve optimal risk-sharing. The IMF may have a role when emerging markets face financial crises, since these economies must borrow abroad in foreign currency and cannot use the exchange rate to promote risk-sharing. IMF financing could help prevent the costly liquidation associated with these crises and improve the allocation of resources. In truth, most of the disagreement about the IMF's role is in relation to the financial crises of emerging markets. The debate reflects the inherent tension between the (ex ante) moral hazard problem created by expected IMF bailouts and the (ex post) efficiency gains obtained by a lender-of-lastresort. Even in the absence of IMF financing, there are different views about an IMF role in coordinating the actions of private banks. Since Allen and Gale do not model the role of the IMF explicitly, one suggestion would be for them to do so. Such a modeling effort should pay attention to the notion that potential IMF interventions can affect the ex ante behavior of private agents. Additionally, it would be helpful to compare any recommended role for the IMF with Bagehot's (1873) advice for a lenderof-last-resort. If we take the models in the paper literally, allowing the IMF to act as lender-of-last-resort is questionable because the banks are not just illiquid, they are insolvent. How then is the IMF to follow Bagehot's principle of lending against good collateral?
236
References
Aizenman, J., (1989). Country Risk, Incomplete Information and Taxes on International Borrowing. Economic Journal, 99: 147-161. Aizenman, J. and Marion, N., (1999). Uncertainty and the Disappearance of International Credit. R. Glick, R. Moreno, and M. Spiegel (eds.), Financial Crises in Emerging Markets, Cambridge: Cambridge University Press, 167190. Bagehot, W., (1873). Lombard Street: A Description of the Money Market, London: Kegan, Paul & Co. Chang, R. and Velasco, A., (1998a). Financial Crises in Emerging Markets: A Canonical Model, NBER Working Paper No. 6606. Chang, R. and Velasco, A., (1998b). The Asian Liquidity Crisis, NBER Working Paper No. 6796. Diamond, D., and Dybvig, P., (1983). Bank Runs, Liquidity and Deposit Insurance. Journal of Political Economy, 91: 401-419. Dooley, M.P., (1998). A Model of Crises in Emerging Markets, International Finance Discussion Paper No. 630, Board of Governors of the Federal Reserve System, Washington, D.C. (Earlier version in NBER Working Paper No. 6300, 1997). Flood, R. and Isard, P., (1989). Monetary Policy Strategies. International Monetary Fund Staff Papers, 36: 612-632. Furman, J. and Stiglitz, J., (1998). Economic Crises: Evidence and Insights from East Asia. Brookings Papers on Economic Activity, 2: 1-136. Goldfajn, I. and Valdes, R., (1997). Capital Flows and the Twin Crises: The Role of Liquidity. International Monetary Fund Working Paper WP/97/87. (Revised September, 1998). Gorton, G., (1988). Banking Panics and Business Cycles. Oxford Economic Papers, 40: 751-81. Hausmann, R., Panizza, U., and Stein, E., (1999). Why Do Countries Float 237
the Way They Float? Working Paper, Research Department, Inter~American Development Bank, Washington, D.C., November. Kaminsky, G. and Reinhart, C., (1999). The Twin Crises: The Causes of Banking and Balance-of-Payments Problems. American Economic Review, 89: 473-500. Obstfeld, M., (1997). Destabilizing Effects of Exchange Rate Escape Clauses. Journal of International Economics, 43: Nos. 1/2, 61-78.
238
O p t i m a l c u r r e n c y crises A comment Nancy P. Marion Dartmouth College
Allen and Gale model a banking crisis triggered by the discovery that returns on risky bank assets are particularly low. Their view that banking crises can be caused by weak fundamentals builds nicely on some earlier work by Gorton (1988). It is also consistent with empirical evidence on U.S. bank panics in the nineteenth and early twentieth centuries that shows bank crises associated with business-cycle downturns. In my view, having a fundamentals-driven banking crisis is a nice addition to the open-economy crisis literature. To date, the only open-economy bank-run models we have are ones where a run is the unanticipated outcome of a self-fulfilling loss of confidence, along the lines of Diamond-Dybvig (1983). These models were developed after the 1997 Asian financial crisis by Goldfajn and Valdes (1997), Chang and Velasco, (1998a, 1998b), and others. They provide many useful insights, but there is no reason to believe that all banking crises are caused by selffulfilling shifts in expectations. Ultimately, the debate about whether most crises are the unanticipated outcome of inconsistent policies and deteriorating fundamentals or the unanticipated outcome of self-fulfilling changes in market expectations must be resolved empirically. In the meantime, we need theoretical models of each kind of crisis. We also need models that examine banking and currency crises in a single framework, as this paper attempts to do. The intriguing title of Allen and Gale's paper is Optimal Currency Crises. Can a crisis ever be optimal? The authors call a crisis optimal if it can duplicate the first-best allocation chosen by a social planner. In the closed-economy version of their model, which has nothing to say about currency crises but does examine banking crises, a social planner can achieve the first-best allocation by making state-contingent contracts. The planner maximizes the ex ante expected utility of all consumers by appropriately choosing how much to invest in safe and risky assets. The planner 0167-2231/00/$ - see front matter © 2000 Elsevier Science B.V. All rights reserved. PII: SO167-2231 (01)00031-8
then gets to allocate consumption between those with early and late liquidity needs after seeing an indicator that is perfectly correlated with next period's return on the risky asset. When this asset return is particularly low, it is optimal for early and late consumers to consume equal amounts of the available output. When the asset return is high enough (so that more than half the output is produced in the final period), then those with early liquidity needs should consume the readily-available safe asset and those with late liquidity needs should consume the return on the risky investment available in the final period. In this way, the planner achieves optimal risk-sharing between early and late consumers. Moreover, the planner avoids costly early liquidation of the risky asset. In a closed economy without a social planner, where bank deposit contracts promise to pay a fixed amount of nominal domestic currency, a central bank can make these deposit contracts state-contingent in real terms by increasing the price level when the return on the risky asset is low. Higher prices force both early and late consumers to accept less real consumption. As a result, the central-bank policy achieves the first-best allocation of the social planner. It preserves optimal risk-sharing and avoids the costly early liquidation of the risky asset that is normally associated with a bank run. An open-economy version of the model is developed by adding an international bond market where the country can borrow and lend at a fixed rate. As before, an "optimal" crisis is one that achieves the first-best allocation of the social planner. Because the international market is risk neutral and bank depositors risk averse, a social planner will find it optimal to shift all risk from depositors to the international market. The planner achieves this outcome by using state-contingent income transfers to obtain full insurance. The income transfer is the difference between the country's net present value income and its realized income. If the country faces a low return on the risky asset, its realized income falls short of net present value income and the country receives an income transfer from abroad. If the asset return is high, the global market receives the transfer. Consequently, the planner can shift all risk from depositors to the international market and provide depositors with a constant amount of consumption independent of the return on the risky asset. In the absence of a social planner, can a currency crisis achieve the same outcome, shifting all risk from depositors to the international market? In other words, can there be an "optimal" currency crisis? It is highly unlikely. If the country's banks can borrow abroad in domestic currency, and if deposit contracts are specified in nominal domestic-currency terms, then a central bank policy that allows currency depreciation when asset returns are low may be able to shift all risk from depositors to the international market. But two conditions must hold. First, the country 232
must be able to issue domestic-currency debt oil the international market. This privilege is generally reserved for mature markets, like the Scandinavian countries in the early 1990s, who might face banking and currency crises. Second, banks must borrow from the international market an infinite amount in domestic currency and then invest the borrowed funds in safe foreigncurrency-denominated bonds. Only in the limit can risk be shifted from depositors as a whole. Although the open-economy case just described closely parallels its closedeconomy counterpart in terms of using the price level (exchange rate) to achieve optimal risk-sharing, it relies on the ability of the country in question to issue debt denominated in its own currency on the international market. The problem, as the authors acknowledge, is that most countries with banking and currency crisis--the emerging markets--cannot issue domesticcurrency-denominated debt internationally. 1 There are several reasons for this restriction. Foreign creditors may worry that an emerging market will be tempted to use inflation to reduce its foreign liabilities if they are denominated in domestic currency. Additionally, foreign creditors may worry about currency risk since, if the emerging market allows its currency to depreciate, foreign creditors will receive less in terms of their own currency. Foreign lenders often cannot hedge against this currency risk because liquid derivative markets for emerging-market currencies are lacking. So what about the case of emerging markets who must borrow on the international market in foreign currency? Can they have an "optimal" currency crisis? Allen and Gale look at two examples. First they consider a dollarized economy, where banks borrow from abroad in foreign currency and accept deposits denominated in foreign currency. But the dollarized economy cannot have a currency crisis because there is no fixed exchange rate to attack. Domestic currency does not circulate. Next they consider an economy with a central bank and domestic currency, where bank deposits are specified in nominal, domestic-currency terms but banks must borrow in foreign currency. In that case, which corresponds to the situation of practically all emerging markets, a central-bank policy of currency depreciation when asset returns are low cannot shift risk from depositors to the international market. By reducing the real value of domestic deposits, the depreciation may improve risk-sharing between early and late consumers, but it cannot prevent costly liquidation of the risky asset or shift risk to the international market. Thus for a fundamentals-driven banking crisis in emerging markets, a corresponding currency crisis is not optimal. The analysis hinges on comparing various open-economy cases with the open-economy benchmark case of the social planner. Unfortunately, the 1See Hausmann, Panizza, and Stein (1999) for an elaboration on the inability of emerging markets to borrow internationally in their own currencies. 233
benchmark case may not be a particularly relevant one. Recall that in the benchmark case, the social planner can write state-contingent contracts with the international capital market. Relying on international income transfers tied to asset returns, the planner is able to obtain full insurance from the international market and eliminate all risk for depositors. The problem is that the benchmark case may not be viable for well-known reasons having to do with country risk. For example, consider default risk. 2 We can endogenize default risk by adding another constraint to the benchmark case in Section 4.1. Suppose:
I(r) <_a[rh(x)/p] + ~[py]
(1)
This constraint says that the domestic economy will avoid default if its income transfer to the international market, I, is less than the default penalty. The penalty is the share of asset returns that the international market can extract in case of default. If the international market has little bargaining power, the fractions a and fl are small and this constraint is violated. As a result, the social planner will be unable to use the international market to provide complete insurance. Other problems with the benchmark case come to mind, such as the inability of the international market to monitor effort put into the risky investment, or the inability to verify income earned on the investment, or the inability to verify outcomes without incurring a monitoring cost. These considerations make the planner's problem more complex but suggest that the international market cannot provide complete insurance, even for the social planner. An important implication is that the comparison of a modified benchmark case with a case where the central bank responds to a banking crisis with currency depreciation is not likely to yield a clear welfare ranking. Despite their inability to show that a currency crisis is optimal for an emerging market with banking problems, Allen and Gale reinforce an important point--namely, it is not optimal to eliminate crises completely. They show that a currency crisis can achieve optimal risk-sharing in certain circumstances. The notion that it may not be optimal to eliminate crises completely is also a theme of the escape-clause literature as applied to currency crises. 3 We know that it is difficult to construct rules, such as a fixed exchange-rate rule, that are contingent on all possible states of nature. However, if the state is bad enough, it is generally optimal for the monetary authority to invoke the escape clause, abandoning the fixed exchange rate in favor of currency depreciation. In the Allen and Gale paper, a currency crisis is a byproduct of a banking crisis. This linkage is important. As Kaminsky and Reinhart (1999) have 2See Aizenman (1989) for an analysis that incorporates default risk. 3For example, see Flood and Isard (1989) and Obstfeld (1997). 234
documented, banking fragility often leads to currency crises, especially in the deregulated environment of the 1990s. While the good news is that the Allen and Gale model links banking and currency crises together, the bad news is that the two crises my be too closely linked. We know that countries may suffer banking crises without succumbing to currency crises. As such, it would be useful to explore cases where the monetary authority has reasons for maintaining the fixed exchange rate even in the face of banking problems. A few additional points are worth noting. First, the paper suggests that when serious banking problems occur, a large exchange -rate adjustment may be desirable because it allows better risk-sharing in some circumstances. But surely there can be substantial costs to large currency depreciations. A large depreciation may turn good assets into bad as domestic banks and firms see the domestic-currency value of their foreign-currency debt balloon. We need to pay attention to the costs as well as the benefits of large currency depreciations. Second, in this paper it does not matter whether the country borrows short-term or long-term. All uncertainty is resolved by the start of the middle period. Therefore any short-term debt acquired initially can be rolled over. Whether the country chooses to borrow short-term or long-term depends only on the yield curve. Empirical evidence suggests that the growth in the ratio of short-term foreign-currency-denominateddebt to international reserves is an important predictor of financial crises. 4 If foreign debt is short-term and foreign creditors panic because uncertainty grows rather than diminishes as a crisis unfolds, the country may not be able to roll over its debts or obtain new loans just at the time it needs liquidity.5 The maturity structure of foreign-currency-denominateddebt will then matter. Third, in the model there are many banks, all of whom behave competitively and maximize the ex a n t e expected utility of their depositors. These assumptions about bank behavior are certainly an appropriate starting point for any analysis. It is worth noting, however, that some different views about bank behavior have been put forward in connection with the Asian crisis. For example, Dooley (1998) has developed a crisis model where bank (or firm) behavior is distorted because of explicit or implicit government guarantees. Banks appropriate a fraction of each deposit, knowing that this fraction will be covered by a future bailout. An interesting extension would be to consider other types of bank behavior in addition to the competitive version modeled here. Finally, since the theme of this year's Carnegie-Rochester Conference is the role of the IMF in financial crises, it is useful to ask what we learn about the IMF's role from this paper. Allen and Gale say their paper provides a 4See Furman and Stiglitz (1998) and Chang and Velasco (1998b). 5See Aizenman and Marion (1999).
235
framework for understanding why people disagree on whether the IMF has a role to play. They suggest that the IMF has little role to play when advanced industrial economies experience financial crises, since these countries can issue debt denominated in their own currency and adjust the exchange rate to achieve optimal risk-sharing. The IMF may have a role when emerging markets face financial crises, since these economies must borrow abroad in foreign currency and cannot use the exchange rate to promote risk-sharing. IMF financing could help prevent the costly liquidation associated with these crises and improve the allocation of resources. In truth, most of the disagreement about the IMF's role is in relation to the financial crises of emerging markets. The debate reflects the inherent tension between the (ex ante) moral hazard problem created by expected IMF bailouts and the (ex post) efficiency gains obtained by a lender-of-lastresort. Even in the absence of IMF financing, there are different views about an IMF role in coordinating the actions of private banks. Since Allen and Gale do not model the role of the IMF explicitly, one suggestion would be for them to do so. Such a modeling effort should pay attention to the notion that potential IMF interventions can affect the ex ante behavior of private agents. Additionally, it would be helpful to compare any recommended role for the IMF with Bagehot's (1873) advice for a lenderof-last-resort. If we take the models in the paper literally, allowing the IMF to act as lender-of-last-resort is questionable because the banks are not just illiquid, they are insolvent. How then is the IMF to follow Bagehot's principle of lending against good collateral?
236
References
Aizenman, J., (1989). Country Risk, Incomplete Information and Taxes on International Borrowing. Economic Journal, 99: 147-161. Aizenman, J. and Marion, N., (1999). Uncertainty and the Disappearance of International Credit. R. Glick, R. Moreno, and M. Spiegel (eds.), Financial Crises in Emerging Markets, Cambridge: Cambridge University Press, 167190. Bagehot, W., (1873). Lombard Street: A Description of the Money Market, London: Kegan, Paul & Co. Chang, R. and Velasco, A., (1998a). Financial Crises in Emerging Markets: A Canonical Model, NBER Working Paper No. 6606. Chang, R. and Velasco, A., (1998b). The Asian Liquidity Crisis, NBER Working Paper No. 6796. Diamond, D., and Dybvig, P., (1983). Bank Runs, Liquidity and Deposit Insurance. Journal of Political Economy, 91: 401-419. Dooley, M.P., (1998). A Model of Crises in Emerging Markets, International Finance Discussion Paper No. 630, Board of Governors of the Federal Reserve System, Washington, D.C. (Earlier version in NBER Working Paper No. 6300, 1997). Flood, R. and Isard, P., (1989). Monetary Policy Strategies. International Monetary Fund Staff Papers, 36: 612-632. Furman, J. and Stiglitz, J., (1998). Economic Crises: Evidence and Insights from East Asia. Brookings Papers on Economic Activity, 2: 1-136. Goldfajn, I. and Valdes, R., (1997). Capital Flows and the Twin Crises: The Role of Liquidity. International Monetary Fund Working Paper WP/97/87. (Revised September, 1998). Gorton, G., (1988). Banking Panics and Business Cycles. Oxford Economic Papers, 40: 751-81. Hausmann, R., Panizza, U., and Stein, E., (1999). Why Do Countries Float 237
the Way They Float? Working Paper, Research Department, Inter~American Development Bank, Washington, D.C., November. Kaminsky, G. and Reinhart, C., (1999). The Twin Crises: The Causes of Banking and Balance-of-Payments Problems. American Economic Review, 89: 473-500. Obstfeld, M., (1997). Destabilizing Effects of Exchange Rate Escape Clauses. Journal of International Economics, 43: Nos. 1/2, 61-78.
238