Financial Crises, Liquidity, and the International Monetary System / Edition 1

by Jean Tirole

Overview

Once upon a time, economists saw capital account liberalization—the free and unrestricted flow of capital in and out of countries—as unambiguously good. Good for debtor states, good for the world economy. No longer. Spectacular banking and currency crises in recent decades have shattered the consensus. In this remarkably clear and pithy volume, one of Europe's leading economists examines these crises, the reforms being undertaken to prevent them, and how global financial institutions might be restructured to this end.


Jean Tirole first analyzes the current views on the crises and on the reform of the international financial architecture. Reform proposals often treat the symptoms rather than the fundamentals, he argues, and sometimes fail to reconcile the objectives of setting effective financing conditions while ensuring that a country "owns" its reform program. A proper identification of market failures is essential to reformulating the mission of an institution such as the IMF, he emphasizes. Next he adapts the basic principles of corporate governance, liquidity provision, and risk management of corporations to the particulars of country borrowing. Building on a "dual- and common-agency perspective," he revisits commonly advocated policies and considers how multilateral organizations can help debtor countries reap enhanced benefits while liberalizing their capital accounts.


Based on the Paolo Baffi Lecture the author delivered at the Bank of Italy, this refreshingly accessible book is teeming with rich insights that researchers, policymakers, and students at all levels will find indispensable.

Product Details

ISBN-13:	9780691099859
Publisher:	Princeton University Press
Publication date:	07/21/2002
Edition description:	New Edition
Pages:	168
Product dimensions:	5.50(w) x 8.50(h) x (d)

About the Author

Jean Tirole, the winner of the 2014 Nobel Prize in Economics, is chairman of the Foundation Jean-Jacques Laffont at the Toulouse School of Economics, scientific director of Toulouse's Industrial Economics Institute, and annual visiting professor of economics at the Massachusetts Institute of Technology. His books include The Theory of Corporate Finance (Princeton), The Theory of Industrial Organization, Game Theory (with Drew Fudenberg), and A Theory of Incentives in Procurement and Regulation (with Jean-Jacques Laffont).

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Introduction

A wide consensus had emerged among economists. Capital account liberalization—allowing capital to flow freely in and out of countries without restrictions—was unambiguously good. Good for the debtor countries, good for the world economy. The twofold case for capital mobility is relatively straightforward: First, capital mobility creates superior insurance opportunities and promotes an efficient allocation of investment and consumption. Capital mobility allows households and firms to insure against country-specific shocks in worldwide markets; households can thereby smooth their consumption and firms better manage their risks. Business cycles are dampened, improved liquidity management boosts investment and promotes growth. Second, besides insurance, capital mobility also permits the transfer of savings from low- to high-return countries. This transfer raises worldwide growth and further gives a chance to the labor force of low-income countries to live better. In these two respects, the increase in the flow of private capital from industrial to developing countries from $174 billion in the 1980s to $1.3trillion during the 1990s¹ should be considered good news.

That consensus has been shattered lately. A number of capital account liberalizations have been followed by spectacular foreign exchange and banking crises.² The past twenty years have witnessed large scale crises such as those in Latin America (early 1980s), Scandinavia (early 1990s), Mexico (1994), Thailand, Indonesia, and South Korea (1997), Russia (1998), Brazil (1998-9) and Argentina (2001), as well as many smaller episodes. The crises have imposed substantial welfare losses on hundreds of millions of people in those countries.

Economists, as we will discuss later, still strongly favor some form of capital mobility but are currently widely divided about the interpretation of the crises and especially their implications for capital controls and the governance of the international financial system. Are such crises just an undesirable, but unavoidable byproduct of an otherwise desirable full capital account liberalization? Should the world evolve either to the corporate model where workouts are a regular non-crisis event or to the municipal bond model where defaults are rare? Would a better sequencing (e.g., liberalization of foreign direct and portfolio investments and the building of stronger institutions for the prudential supervision of financial intermediaries before the liberalization of short-term capital flows) have prevented these episodes? Should temporary or permanent restrictions on short-term capital flows be imposed? How does this all fit with the choice of an exchange rate regime? Were the crises handled properly? And, should our international financial institutions be reformed?

This book was prompted by a questioning of my own understanding of its subject. Several times over recent years I have been swayed by a well-expounded and coherent proposal only to discover, with striking naivety, that I later found an equally eloquent, but inconsistent, argument just as persuasive. While this probably reflected lazy thinking on my part, I also came to wonder how it is that economists whom I respect very highly could agree broadly on the facts and yet disagree strongly on their implications.

I also realized that I was missing a ''broad picture''. An epitome for this lack of perspective relates to international institutions. I have never had a clear view of what, leaving aside the fight against poverty, the International Monetary Fund (IMF) and other international financial institutions (IFIs) were trying to achieve: avoid financial crises, resolve them in an orderly manner, economize on taxpayers' money, protect foreign investors, respect national sovereignty, limit output volatility, prevent contagion, facilitate a country's access to funds, promote long-term growth, force structural reforms—not to mention the IMF's traditional current account, international reserves and inflation objectives.³

This book is to some extent an attempt to go back to first principles and to identify a specific form of market failure, that will guide our thinking about crisis prevention and institutional design. Needless to say, I will be focusing on a particular take on the international financial system, which need not exclude other and complementary approaches. I believe, though, that the specific angle taken here may prove useful in clarifying the issues.

The book is organized as follows. Chapter 1 is a concise overview of recent crises and institutional moves for the reader with limited familiarity with the topic. Chapter 2 summarizes and offers a critique of economists' views on the subject. Chapter 3 provides a roadmap for our main argument. Basically, I suggest that international financing is similar to standard corporate financing except in two crucial respects, which I name the ''dual-agency problem'' and the ''common-agency problem''. Chapter 4 therefore provides the reader with a concise review of those key insights of corporate finance that are relevant for international finance. Chapter 5 describes the market failure. Chapter 6 draws its implications for crisis prevention and management. Chapter 7 investigates the lessons of the analysis for the design of international financial institutions.Finally, Chapter 8 summarizes and discusses routes for future research.

Table of Contents

	Acknowledgments	vii
	Introduction	ix
1.	Emerging Markets Crises and Policy Responses	1
	The pre-crisis period	1
	The crisis	7
	IMF reforms, regulatory changes, and private sector innovations	18
2.	The Economists' Views	23
	Consensus view	23
	Conflicting advice and the topsy-turvy principle	29
	"Unrealistic" encroachments of sovereignty	36
	Theories	36
3.	Outline of the Argument and Main Message	47
	The problem of a standard borrower	48
	Why is external borrowing different?	48
	Institutional and policy responses to market failure	50
4.	Liquidity and Risk-Management in a Closed Economy	53
	Corporate financing: key organizing principles	53
	Domestic liquidity provision	70
5.	Identification of Market Failure: Are Debtor Countries Ordinary Borrowers?	77
	The analogy and a few potential differences	77
	A dual-agency perspective	81
	The government's incentives	86
	Discussion	88
	A common-agency perspective	92
6.	Implications of the Dual- and Common-Agency Perspectives	97
Implication 1	The representation hypothesis	97
Implication 2	Policy analysis	102
	Cross-country comparisons	108
	Is there a need for an international lender of last resort?	110
7.	Institutional Implications: What Role for the IMF?	113
	From market failure to mission design	114
	Governance	116
8.	Conclusion	129
	References	131
	Index	145

What People are Saying About This

Ken Rogoff

In this remarkably ambitious and insightful book, Jean Tirole tackles the core issues in the economics of international lending with his usual superb clarity of thought. This book is essential reading to anyone interested in understanding the economics behind the recent drive to improve the international financial architecture.
— Ken Rogoff, Chief Economist and Director of Research, International Monetary Fund

Kenen

Most proposals for reforming the international financial system derive from ad hoc explanations for recent crises. Jean Tirole goes back to first principles. He asks how relations between lenders and borrowers differ in the international context from those in the domestic context. You may not agree with all of his conclusions but will have to rethink your own views after you have read it.
— Peter B. Kenen, Princeton University

Olivier Jeanne

This book presents one of the first comprehensive attempts to bring rigorous theoretical foundations into the debate on the international financial architecture. The analysis is simple, elegant, and yields insights that are often unconventional and always thought-provoking. This is an indispensable reference for all economists interested in the current debates on the international financial architecture.
— Olivier Jeanne, International Monetary Fund

From the Publisher

"In this remarkably ambitious and insightful book, Jean Tirole tackles the core issues in the economics of international lending with his usual superb clarity of thought. This book is essential reading to anyone interested in understanding the economics behind the recent drive to improve the international financial architecture."—Ken Rogoff, Chief Economist and Director of Research, International Monetary Fund

"Jean Tirole is living proof of the value of good economic thinking. He shines new light on, and dissipates heat from, every issue he touches. In this book he offers us an amazing combination of detailed facts and rigorous theory about international financial crises. His perspective of dual and common agencies enriches our understanding of the roles and shortcomings of international economic institutions, and points the way to reform. All the supposed experts who engage in controversies on these matters should learn from this book."—Avinash Dixit, Princeton University

"This book presents one of the first comprehensive attempts to bring rigorous theoretical foundations into the debate on the international financial architecture. The analysis is simple, elegant, and yields insights that are often unconventional and always thought-provoking. This is an indispensable reference for all economists interested in the current debates on the international financial architecture."—Olivier Jeanne, International Monetary Fund

"Most proposals for reforming the international financial system derive from ad hoc explanations for recent crises. Jean Tirole goes back to first principles. He asks how relations between lenders and borrowers differ in the international context from those in the domestic context. You may not agree with all of his conclusions but will have to rethink your own views after you have read it."—Peter B. Kenen, Princeton University

"Jean Tirole uses the tools of corporate finance to analyse some key aspects of international finance. As we expect from him, we get deep and fruitful insights into issues such as borrower and lender behavior, the appropriate role of the IMF, and private sector involvement in orderly workouts. This is essential reading for all those concerned with the 'international financial architecture.'"—Richard Portes, London Business School

Richard Portes

Jean Tirole uses the tools of corporate finance to analyse some key aspects of international finance. As we expect from him, we get deep and fruitful insights into issues such as borrower and lender behavior, the appropriate role of the IMF, and private sector involvement in orderly workouts. This is essential reading for all those concerned with the 'international financial architecture.'
— Richard Portes, London Business School

Avinash Dixit

Jean Tirole is living proof of the value of good economic thinking. He shines new light on, and dissipates heat from, every issue he touches. In this book he offers us an amazing combination of detailed facts and rigorous theory about international financial crises. His perspective of dual and common agencies enriches our understanding of the roles and shortcomings of international economic institutions, and points the way to reform. All the supposed experts who engage in controversies on these matters should learn from this book.
— Avinash Dixit, Princeton University

Recipe

"In this remarkably ambitious and insightful book, Jean Tirole tackles the core issues in the economics of international lending with his usual superb clarity of thought. This book is essential reading to anyone interested in understanding the economics behind the recent drive to improve the international financial architecture."—Ken Rogoff, Chief Economist and Director of Research, International Monetary Fund

"Jean Tirole is living proof of the value of good economic thinking. He shines new light on, and dissipates heat from, every issue he touches. In this book he offers us an amazing combination of detailed facts and rigorous theory about international financial crises. His perspective of dual and common agencies enriches our understanding of the roles and shortcomings of international economic institutions, and points the way to reform. All the supposed experts who engage in controversies on these matters should learn from this book."—Avinash Dixit, Princeton University

"This book presents one of the first comprehensive attempts to bring rigorous theoretical foundations into the debate on the international financial architecture. The analysis is simple, elegant, and yields insights that are often unconventional and always thought-provoking. This is an indispensable reference for all economists interested in the current debates on the international financial architecture."—Olivier Jeanne, International Monetary Fund

"Most proposals for reforming the international financial system derive from ad hoc explanations for recent crises. Jean Tirole goes back to first principles. He asks how relations between lenders and borrowers differ in theinternational context from those in the domestic context. You may not agree with all of his conclusions but will have to rethink your own views after you have read it."—Peter B. Kenen, Princeton University

"Jean Tirole uses the tools of corporate finance to analyse some key aspects of international finance. As we expect from him, we get deep and fruitful insights into issues such as borrower and lender behavior, the appropriate role of the IMF, and private sector involvement in orderly workouts. This is essential reading for all those concerned with the 'international financial architecture.'"—Richard Portes, London Business School

Editorial Reviews

Jean Tirole, Winner of the 2014 Nobel Prize in Economics

From the Publisher

"An insightful contribution to the expanding economics research that reexamines the role of the International Monetary Fund in emerging markets and financial crises."

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