News Release

August 20, 2003

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International Financial Crises: What Role for Government?

Argentina's stunning default on its sovereign debt in December 2001 and the Brazilian crisis in 2002 are only the latest examples of how bad government policies undermine confidence and destroy wealth. The International Monetary Fund's refusal to bail out Argentina was an implicit admission that a new approach is needed to deal with sovereign debt crises.

Although the IMF has poured billions of dollars into emerging market countries since the 1994-95 Mexican peso crisis, the credibility problem remains -- namely, how to create an institutional framework in which governments "do no harm," so that markets can increase economic growth and stability. That issue and the question of whether IMF intervention can improve on potential market solutions to sovereign debt crises are the focus of the Spring/Summer 2003 Cato Journal (vol. 23, no. 1).

The distinguished contributors to this issue of the CJ

• Examine the lessons to be learned from the Argentine and Brazilian financial crises.
• Contrast alternative approaches to resolving sovereign debt crises -- namely, the IMF's statutory approach or "sovereign debt restructuring mechanism" (SDRM) and the contractual or market-based approach.
• Consider the best way to increase financial resilience and economic growth in emerging markets.

In his article, "Promoting Financial Resilience," William McDonough, former president of the New York Federal Reserve Bank and current chairman of the Public Company Accounting Oversight Board, argues against "grand solutions" to international financial crises and in favor of solutions that are "market-based and adaptive." He recommends working with market participants to improve the debt restructuring process.

Jack Boorman, special advisor to the managing director of the IMF, is not opposed to the contractual approach but thinks the SDRM would be a superior approach to resolving sovereign debt crises. Like Jeffrey Sachs, director of The Earth Institute at Columbia University, Boorman favors a sovereign bankruptcy law. Anna J. Schwartz, an economist at the National Bureau of Economic Research, finds no demand by either borrows or lenders for an SDRM. In her view, "IMF intervention is a solution to a problem that does not exist."

One of the main lessons from the Argentine crisis is that without political reform, economic reform is always tentative. Fiscal deficits (fueled by overspending), the lack of trade liberalization, and an imperfect currency board combined to end the "Argentine miracle." (Steve Hanke, an economist at the Johns Hopkins University, points to the discretion exercised by the central bank and argues for dollarization.) The root cause of economic instability, however, was the failure to limit government and institute a rule of law. As Allan Meltzer, past chairman of the International Financial Institution Advisory Commission writes, "Without political reform, there is little prospect that new promises will be kept" -- an assertion that former Argentinean finance minister Ricardo López Murphy agrees with.

John B. Taylor, Under Secretary of the Treasury for International Affairs, one of the first to support expanding the use of collective action clauses (CACs) to facilitate sovereign debt workouts, thinks all policy alternatives should be evaluated in terms of how well they encourage emerging market countries to develop sound policies, reduce crises, attract private investment, and improve credit ratings. If official assistance is given, says Taylor, it should be limited to developing countries that are pursuing market friendly policies; "there should be no lending into unsustainable debt situations."

The lack of support for the SDRM among private investors, many emerging market countries, and the Bush administration suggests that we could see increased use of CACs in the near future. However, if the IMF decides to bail out Argentina, which owes the Fund $12.5 billion over the next three years ($3 billion of which is due on September 9), all bets are off for real reform.