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Published by EH.NET (September 2003)

Barry Eichengreen, Financial Crises and What to Do about Them. New York: Oxford University Press, 2002. ix + 194 pp. $60 (cloth), ISBN: 0-19-925743-4; $19.95 (paperback), ISBN:0-19-925744-2.

Reviewed for EH NET by Anna J. Schwartz, National Bureau of Economic Research.

Barry Eichengreen (Department of Economics, University of California – Berkeley) has combined the Felix Neuburgh Lecture that he gave in Gotenberg, Sweden, and the Louise and Goran Ehrnrooth Lectures in Helsinki, Finland, and published them as a book. The subject of both lectures was reform of the international financial architecture.

In the introductory chapter of six that the book comprises, Eichengreen notes that the prevailing international monetary and financial system is not discredited even though it may be widely criticized, but there is no consensus on specific reforms that are needed even among those who advocate change. He aims to evaluate what must be done, what has been done, and what remains to be done. He regards crises as unavoidable concomitants of international financial markets, especially so in developing countries, where cultural differences impede transmission of information between borrowers and lenders and contracts that anticipate contingencies are difficult to write and enforce.

Crises have clustered at twenty-year intervals over the past two centuries, and have been more frequent in the current period of globalization than in its pre-World War I predecessor. Eichengreen attributes the greater incidence of currency crises in our era than in the late nineteenth century — both periods of high capital mobility — to the incompatibility of the goal of exchange rate stability with democratic domestic policy goals. Crises in middle-income developing countries, he emphasizes, should not, however, deflect attention from crises in the large number of low-income developing countries.

Eichengreen describes the steps that have been taken to reduce the frequency and severity of crises in chapter 2 on crisis prevention. Prevention can take many forms, depending on the causes of crises. Unsustainable monetary and fiscal policies can be countered by improved macroeconomic policies. Faulty exchange rate arrangements — exemplified by the attempt to maintain a hard peg when a country does not credibly subordinate domestic policies to that goal, or it adopts a monetary policy operating strategy that relies on the exchange rate for its anchor — can be corrected. Weak financial systems can be strengthened by sound public debt management, improved market discipline and prudential supervision. Limits to the financial safety net can be set so that financial institutions do not rely on guarantees that encourage excessive risk taking.

Eichengreen cites as evidence of progress on prevention less co-movement of other countries’ spreads with those of Argentina in winter 2001-2. He interprets this change as an indication of less contagion that reflects improvements in transparency, enabling investors to differentiate responsible from irresponsible emerging market countries. Other evidence of progress on prevention includes better bank regulation that reduced fire sales of emerging market debt by highly leveraged institutions; better monetary, fiscal, and debt-management policies in some emerging markets; and the move to greater exchange rate flexibility.

To achieve stronger financial and political systems, Eichengreen stresses that much remains to be done. Crisis-prevention efforts in middle-income countries, moreover, may slow economic development in low-income economies. For example, changes in the Basel Capital Accord to limit risky lending by international banks may deny external funding for infrastructure to those countries.

Crisis management, the subject of chapter 3, deals with the need to change the response of multilaterals and creditor countries to crises. The pattern of bailouts since 1995 has distorted the operation of financial markets by creating moral hazard. Investor losses are minimized and government borrowers cling to unsustainable policies. The IMF’s loans are repaid and the people in crisis countries foot the bill. Eichengreen notes that for this reason the developing world exhibits animosity to the IMF. However, progress on developing alternatives to bailouts has been elusive. When new crises in Turkey and Argentina could not be headed off, official finance was once more the only way the international community was able to deal with them.

To resolve a crisis when multilateral assistance has been denied, the country that is unable to keep current on its debts must “concert’ its creditors — in IMF parlance — to agree to restructuring terms in order to avoid default. In the case of Argentina in August 2001 the international policy community feared that default would lead creditors to attach foreign assets not only of the government but also of Argentine corporations, and that contagion would destabilize the international financial system. This was the situation until the end of 2001, when throwing more money at the problem in Argentina became an embarrassment. Argentina was then cut off from assistance. Turkey was not.

The official attitude to the concerted approach regards it as messy and uncertain. The catalytic approach offers IMF lending to a crisis country to “catalyze” — IMF parlance again — capital inflows, removing investor incentive to exit.

Eichengreen suggests three options as alternatives to IMF lending: (a) The status quo. Eichengreen rejects the argument that the market knows how to go about restructuring and that litigation by rogue creditors is not a serious problem. (b) Limiting size of IMF rescue packages. Eichengreen argues that agreeing on lending limits does not preclude a political decision to disregard them because politicians will not gamble on a threat to financial stability. (c) IMF-sanctioned or other versions of stays and standstills. Eichengreen submits that this option does not expand available strategies: Countries already can suspend payments and impose capital and exchange controls to prevent deposit or capital flight. The IMF already can provide working capital by lending into arrears. The option does not protect debtors from litigation.

A proposal to solve standstill problems would include a standstill provision in every loan agreement with an option by the issuer to roll over principal and defer interest one time only for, say, 90 days, with a penalty for exercising the option. Eichengreen believes this option is inadequate when crises result from fundamental problems. He favors collective action and collective representation clauses to provide a framework for restructuring negotiations.

In chapter 4 he reviews the roots of the crises in Argentina and Turkey and draws ten lessons from their experience. Among the implications of these crises he notes the need for better alternatives to large-scale multilateral finance. Proposals for an international bankruptcy court, an international financial regulator, and an international lender of last resort, according to him, may solve the crisis problem in theory, but he questions their economic and political workability.

Chapter 5, on the way forward, devotes attention to the IMF-sponsored bankruptcy law for sovereign debtors that Anne Krueger proposed in 2001 and 2002. Eichengreen cites its virtues and the sticky issues it raises. Readers should be aware that in the spring of 2003 the IMF decided not to proceed with the implementation of the proposal.

Eichengreen’s views on what to do about crises are centrist. Hr is not a critic in the style of Joseph Stiglitz who finds IMF policy advice harmful to emerging market countries in crisis. He does not challenge multilateral espousal of borrowing by these countries as the road to development in the style of Jeremy Bulow who believes that they are too immature financially to use loans productively. He does not reject a bankruptcy law, motivated by borrower protection sentiments, as does Andrei Schleifer, who emphasizes that domestic bankruptcy laws were enacted for the protection of creditors.

References:

Bulow, J. 2002. “First World Governments and Third World Debt.” Brookings Papers on Economic Activity 1: 229-55.

Schleifer, A. 2003. “Will the Government Debt Market Survive?” NBER Working Paper 9493.

Stiglitz, J. 2002. Globalization and Its Discontents. New York: Norton.

Anna J. Schwartz is a Research Associate of the National Bureau of Economic Research. She is the author of “Do Sovereign Debtors Need a Bankruptcy Law?” published in the Cato Journal 23(1) Spring/Summer 2003 issue, pp.87-100.