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Preventing the next crisis

NEW YORK: So will it be business as usual in 1999? The recent dramatic volatility in financial markets is but a distant memory. The miseries of Russians and Indonesians seem far away. But the global financial system still has fundamental flaws. Unless these problems are addressed and we learn the lessons of the past year, the system is liable to collapse.

Booms and busts are endemic in financial markets. Instead of moving like a pendulum, markets can move like a wrecking ball, knocking over one economy after another. The swings cannot be avoided altogether, but they need to be brought under control. International financial institutions, notably the International Monetary Fund and the World Bank, were designed for a world devoid of large-scale capital flows. In the recent crisis, the IMF proved part of the problem rather than the solution.

The primary mission of the IMF is to preserve the international financial system. Its task is to ensure that a debtor country will be able to meet its international obligations, if not right away, then within the foreseeable future. The conditions it imposes on the debtor country include punitively high interest rates, which serve the dual purpose of stabilizing exchange rates and creating a trade surplus by precipitating a recession. Both developments indirectly benefit lenders because they facilitate the repayment of debts.

This method of operation has given rise to what is now recognized as a moral hazard. In case of trouble, lenders can count on the IMF to bail them out; this has supposedly encouraged sloppy lending practices. Actually, the moral hazard is better described as an asymmetry in the treatment of lenders and borrowers.