1. INTERNATIONAL CRISES Professor Lawrence Summers October 20, 2015

2. Agenda International crises: theory International crisis response and the IMF

3. International borrowing and sudden stops (Under any exchange rate regime) A country’s foreign borrowing is equal to its current account deficit: S-I = X-M What happens if foreign investors stop lending? Country A Borrowers Net foreign lending (S-I) Lenders Consumers (importers) Producers (exporters) Current account deficit (X-M)

4. International borrowing and sudden stops (Under any exchange rate regime) A country’s foreign borrowing is equal to its current account deficit: S-I = X-M What happens if foreign investors stop lending? Country A Borrowers Net foreign lending (S-I) Lenders Consumers (importers) Producers (exporters) Current account deficit (X-M) Net foreign lending has fallen – so the current account deficit must fall. If foreign lending totally stops, the current account must go into surplus. Exports rise Imports fall Domestic savings/investment need to adjust: Savings rise; and/or Investment falls  Fall in aggregate demand

5. How are exchange rates determined? Under floating exchange rates, the exchange rate is allowed to fluctuate in response to changing economic conditions. Examples: US Dollar, Japanese Yen, GBP, Euro Under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price. Example: gold standard. Variants: Pegs: Set exchange rate to another currency, e.g. US dollar. Crawling Peg: Set exchange rate target, allow limited fluctuation. Currency/monetary union: All member countries have single currency. Example: the Eurozone

6. Currency crises Country A has a fixed exchange rate. What happens if foreign investors think that it will devalue its currency? Capital flight: Investors sell or short-sell currency Selling puts pressure on the currency to depreciate Central bank forced to raise interest rates and sell foreign reserves More difficult for central bank to continue to maintain exchange rate in future Investors believe A will devalue currency Justified by fundamentals, or A self-fulfilling crisis?

7. 3 types of crises tend to reinforce each other Currency crisis Banking crisis Sudden stop A sudden reduction in external capital can trigger crisis in the domestic financial system. Domestic bank problems can trigger a sudden stop of external capital. A currency devaluation – or interest rate rises to prevent it – can trigger banking crises A domestic banking crisis can precipitate an attack on the currency. A sudden reduction in external capital can increase downward pressure on the currency. Belief that a fixed exchange rate will break can reduce capital inflows.

8. Liquidity and solvency: also key distinction in country crises “To avert panic, central banks should lend early and freely (i.e. without limit), to solvent firms, against good collateral, and at ‘high rates.’” Walter Bagehot (Lombard Street, 1877. chapter 7) Do not lend in the face of insolvency! But: who is the lender of last resort in a country crisis?

9. Agenda International crises: theory International crisis response and the IMF

10. The IMF Among other roles, the IMF provides emergency lending Source: Reserve Bank of Australia, IMF LatAm crisis Asian crisis Global financial crisis

11. Review: the Prisoners’ Dilemma Prisoner B stays silent (cooperates) Prisoner B betrays (defects) Prisoner A stays silent (cooperates) 1,13,0 Prisoner A betrays (defects) 0,32,2 2 prisoners, accused of jointly committing a crime, are interrogated separately. Each prisoner can choose to cooperate with his partner by staying silent, or defect and betray his partner by confessing. The numbers in the boxes are the number of years each prisoner will have to serve in jail under each outcome Nash equilibrium Better than the Nash equilibrium

12. IMF Conditionality IMF and recipient countries are in a similar Prisoners’ Dilemma situation: As a result, IMF conditionality: countries required to pursue economic adjustment policies as condition of assistance. Helps reduce moral hazard: countries less likely to rely on IMF support if have to pursue painful structural adjustment. Country AdjustDon’t adjust IMF Support1,13,0 Don’t support0,32,2 Nash equilibrium is worse than if the country adjusts policies and IMF provides financial support.

13. Typical adjustment conditions “Stabilization” conditions reduce domestic consumption, which can lead to recession. “Adjustment” is intended to counteract this shock and accelerate growth. Devaluation of the local currency increases exports – export income helps to repay foreign debt The policy reform - “structural” adjustment - element aims to raise steady state output: Privatization Trade liberalization Banking sector reform De-regulation

14. But : the Samaritan’s Dilemma If you know that someone will bail you out when you’re in trouble – do you behave less prudently as a result? The Samaritan’s dilemma (Buchanan 1975): Caring about the recipient creates moral hazard. Imposing strict conditions is unlikely to be credible. Implication: “Countries know that, faced with underperformance and a weak economy, the IMF is unlikely to impose strict conditionality, because it is concerned with the borrowing country's welfare. Simply put, penalties established in advance have limited credibility because they are unlikely to be enforced.” IMF Finance and Development- 2002