Since the end of the Bretton Woods system of fixed exchange rates in the 1970s, a dysfunctional relationship between lenders and borrowers in international finance has developed. The problem has become more acute in the 1990s as the severity and frequency of international financial crises have grown. Through official lending and mediation, usually led by the International Monetary Fund, authorities have reduced the possibility of sovereign default in an effort to avoid the spread of financial turmoil. That strategy has shielded investors and debtors from economic reality, has prompted calls for changes in the international financial architecture, and is leading to some reforms at the IMF.
IMF initiatives to provide preventive bailouts to countries before difficulties arise and to “bail in” the private sector are fraught with problems. Preventive lines of credit are likely to be misused and to increase moral hazard, while efforts to force losses on the private sector may precipitate the very crises they are intended to prevent. The historical experience suggests that direct two-party bargaining between creditors and debtors is a better way of handling financial crises than is reliance on official third-party interventions. Private investors in the 19th and 20th centuries regularly solved collective action problems and supplied so-called public goods that official agencies intend to provide. Default, or the real possibility of default, led to renegotiations of debt conditioned on reforms in the debtor country.
Official intervention, on the other hand, has not been characterized by fundamental reforms based on credible conditionality, as evidenced by the recent experiences of Russia, Brazil, and East Asia. During the Third World debt crisis of the 1980s, moreover, IMF lending created among all parties a sort of stalemate that postponed recovery for years. In a world characterized by direct two-party negotiations, market institutions in insurance, credit, and surveillance would do much more to stabilize the international financial system than can be hoped for from continued interventions.