Can the Moral Hazard Caused by IMF Bailouts be Reduced? Geneva Reports on the World Economy Special Report 1

The need to limit IMF financial rescues is a theme of the literature on how to make the world a safer financial place. IMF bailouts create moral hazard, their critics allege. They weaken market discipline and heighten crisis risk. Those who propose to simply prohibit IMF rescues assume that it is politically feasible for the Fund to stand aside when a crisis erupts. The reality is that the costs of inaction (a severe economic contraction, an extended interruption to capital-market access, and a lengthy and difficult restructuring) are too painful for the official community to bear. In this first 'Special Report' in the ICMB/CEPR series of Geneva Reports on the World Economy, Professor Eichengreen argues that institutional reforms that address these dilemmas are needed if the international policy community is to succeed in containing moral hazard. Two new approaches to containing and resolving financial crises are IMF-sanctioned payments standstills and the addition of renegotiation-friendly collective action clauses to loan contracts. Standstills are ideal for liquidity crises and collective action clauses for crises caused by problems with fundamentals and requiring debt restructuring. Which measure is more attractive depends, therefore, on which type of crisis is more frequent. While neither proposal is without its problems, some initiative along these lines is essential if the international financial architecture is to be reformed to limit reliance on IMF bailouts and to ameliorate the moral hazard problem.