Moral Hazard Goes Global: The IMF, Mexico and Asia
By Allan H. Meltzer
While the international aid package extended to Mexico in 1995 was good news for Mexican banks and for those with investments in Mexico, it only made matters worse for ordinary Mexican citizens and for their country's economy. That pattern may well be repeated in Asia.
The 1997 collapse of Asian financial systems is the latest in a series of dramatic financial failures. Each of the troubled Asian countries--Thailand, Indonesia, Malaysia, the Philippines, and Korea--has its own story, and none of the stories is identical to another. But they share a common core: mistaken public policies encourage large-scale domestic and foreign borrowing; explicit or implicit guarantees make risks appear lower than they are; an unanticipated event suddenly changes reality and perceptions of risk; industrial, commercial, and financial failures grow; and the International Monetary Fund (IMF), assisted by the U.S. Treasury and others, lends money to prevent some of the failures.
The $150 billion loss from the failures of U.S. saving and loan institutions in the 1980s was a costly demonstration of what can happen when government policies undermine normal market incentives to be prudent in taking financial risks. The problem is known as moral hazard: when the government guarantees that some or all of an institution's losses will be shifted to taxpayers (through underpriced insurance, IMF bailout, or other safety-net guarantees), while gains will be kept by the institution's owners, the institution will be led to take excessive risks. An external economic shock--such as the unanticipated fall in inflation that lowered future values of land and property--precipitated the U.S. saving and loan collapse. A shock of this kind can quickly transform moral hazard from a balance-sheet abstraction to a real calamity for taxpayers and the economic system as a whole.
The same policy problem, with the same result, can be found in many countries. Earlier in this decade, Japan, Sweden, Finland, and a host of other countries faced financial failures. More recently, the troubled countries have been in Asia. Although some of these countries have recognized the moral hazard problem and have attempted to correct it in their domestic policies, the IMF, with help from the U.S. Treasury, appears to be moving in the opposite direction, increasing problems of moral hazard on an international scale. First in Mexico and now in Thailand and Indonesia, the IMF has lent money at low interest rates to shore up insolvent financial institutions and to protect foreign banks and investors by limiting their losses. The IMF has now asked for a 45 percent increase in the quotas of member countries so that it will have the resources to intervene "more effectively" in similar circumstances.
And there will be similar circumstances. International banks and financial institutions are now more certain that the IMF provides a safety net protecting them from some or most of their losses. The financial risks remain; indeed, they are increased by moral hazard. But some of the losses are shifted from the lenders to the IMF and, therefore, to the taxpayers in developed countries who supply the capital that the IMF mismanages.
The Case of Mexico
Mexico is an excellent case study of the effects of mistaken domestic policies and IMF and U.S. government "help." The ordinary Mexican citizen may read in the newspaper about the assistance that Mexico gets from its friends at the IMF and the U.S. Treasury, but his or her own experience is very different. The real income of Mexicans is today no higher than it was twenty-four years ago--a period of significant economic progress in much of the world--while their burden of debt has increased greatly.
Figure 1 shows Mexico's real external debt in U.S. dollars since 1973. With few exceptions, the debt has increased annually. The exceptions occur in 1984-1985, 1988-1989, and 1996--each period following, by one or two years, a presidential election, a financial crisis, and a policy change. Help from the IMF and foreign lenders during or after the crisis raises the real value of debt that Mexican taxpayers owe. The debt reaches a new peak within a few years of each crisis.
Whether debt is good or bad depends on the uses to which the borrowing is put. If borrowing finances increases in productive capital, income increases; the debt can be serviced or repaid from the increased wealth that it helps to generate. Alternatively, if borrowing is used to hold the exchange rate so that private lenders can flee, there are no productive assets to provide interest payments. And if the government borrows from the IMF or the U.S. Treasury to pay off investors and speculators directly, as Mexico did in 1995, the burden of unproductive borrowing falls on Mexican taxpayers.
From 1973 to 1996, total Mexican debt increased fourteen times faster than the per capita income of Mexican citizens. As shown in figure 2, Mexican real income has fluctuated widely over this period, but it is not higher now than it was in 1974. In the thirty-five years shown in figure 2, real per capita GDP in dollars has grown about 2 percent a year--but all of the growth occurred from 1961 to 1974. Since 1974, real GDP has had periods of rapid growth, followed by equally sharp declines.
Not all of the blame for this performance goes to the IMF and the U.S. Treasury. Mexico's domestic policy actions are the root of the problem. Since the early 1970s, Mexico has followed highly variable policies. Banks have been nationalized and denationalized. Real public-sector spending has surged and declined.
Highly variable policies induce large swings in economic activity and, later, in inflation. As production and spending rise, business and consumers increase their borrowing. Once inflation starts to increase, investors borrow to buy land and property as a hedge against inflation. The buildup of debt, a characteristic part of most financial crises, gets underway.
Figure 3 compares the cycle of inflation and disinflation with the growth of money--the monetary base (reserve money growth). The monetary base is the amount of money directly produced by the Bank of Mexico. The chart shows three distinct periods.
From 1950 to 1970, inflation remained relatively low and was much less variable than in later years. Mexico was on a fixed exchange rate under the Bretton Woods agreement. Mexican policies underwent significant changes for the worse following the end of the fixed exchange rate system and the oil shocks of 1973. Monetary actions became erratic. Highly inflationary policies were followed by heavy borrowing, then by crises and disinflation. These policies contributed to the debt crisis of 1982, then worsened the effects of the crisis by again inflating and disinflating.
After 1988, policy actions moderated but remained highly variable. Instead of varying between 20 and 80 percent, inflation rates varied between 10 and 30 percent from 1988 to 1996.
How did this happen? Figure 3 suggests that there is not much mystery. Every surge in inflation since 1970 is preceded or accompanied by a surge in the monetary base, every period of disinflation by deceleration of the monetary base.
The Bank of Mexico does not, of course, set out intentionally to wreck the Mexican economy by producing the pattern we see in figure 3. It does not try to control, and probably does not watch, the monetary base. It controls, or overcontrols, an interest rate. It is too slow to raise the interest rate during periods when the economy expands or the Treasury has deficits to finance. To keep the interest rate from rising, the bank expands the monetary base. This starts the inflation process. After inflation gets out of hand, the bank raises interest rates, bankrupts many borrowers, and sends the economy into protracted recession to reduce inflation.
Some will see in Mexico's experience evidence in favor of a fixed exchange rate or a currency board. I believe that is the wrong lesson. No policy of either fixed or fluctuating rates can avoid crises if the underlying government policy is as variable as Mexico's policy has been since the early 1970s. And either fixed or fluctuating rates would work well if the underlying fiscal, regulatory, and property rights policies of the Mexican government were stabilizing instead of destabilizing.
International Helping Hands
The U.S. Treasury and the Federal Reserve have been "helping" Mexico since the 1930s. The IMF has been at it since the 1970s. Successive Mexican governments have learned that if they face a crisis, one or both of these friends will lend them money to make the immediate crisis appear less onerous. Investors have learned that they get bailed out, so they continue to invest. I believe that goes far toward explaining why Mexican policy has been erratic and undisciplined at times. The Bank of Mexico and the government take excessive risk and incur large losses for Mexican taxpayers.
The foreigners do not deserve all of the blame, of course, but they contribute. The results have been disastrous for the Mexican economy and its people. Without the IMF and the U.S. Treasury, Mexico would learn to run better policies. There would be less moral hazard, and better results for Mexicans.
The IMF and the U.S. Treasury have now extended these policies to Asian countries, perhaps postponing a major crisis. But moral hazard is more entrenched. Too much of the world has become "too big and too indebted to fail"; the costs will fall on those who are not big--average citizens in the developed nations that fund the IMF and average citizens in the "rescued" nations.
Allan H. Meltzer is the Allan H. Meltzer University Professor of Political Economy at Carnegie Mellon University and visiting scholar at the American Enterprise Institute. An earlier version of this essay was presented at a conference at the Cato Institute; another was published in the Financial Times.
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