THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 567

CHAPTER 20 The International Financial System 535 for this view by suggesting that capital inflows can lead to a lending boom and excessive risk taking on the part of banks, which then helps trigger a financial crisis However, controls on capital inflows have the undesirable feature that they may block from entering a country funds that would be used for productive investment opportunities Although such controls may limit the fuel supplied to lending booms through capital flows, over time they produce substantial distortions and misallocation of resources as households and businesses try to get around them Indeed, just as with controls on capital outflows, controls on capital inflows can lead to corruption There are serious doubts whether capital controls can be effective in today s environment, in which trade is open and where there are many financial instruments that make it easier to get around these controls On the other hand, there is a strong case for improving bank regulation and supervision so that capital inflows are less likely to produce a lending boom and encourage excessive risk taking by banking institutions For example, restricting banks in how fast their borrowing can grow might substantially limit capital inflows Supervisory controls that focus on the sources of financial fragility, rather than the symptoms, can enhance the efficiency of the financial system rather than hamper it THE RO LE OF T HE I M F The International Monetary Fund was originally set up under the Bretton Woods system to help countries deal with balance-of-payments problems and stay with the fixed exchange rates by lending to deficit countries When the Bretton Woods system of fixed exchange rates collapsed in 1971, the IMF took on new roles The IMF continues to function as a data collector and provides technical assistance to its member countries Although the IMF no longer attempts to encourage fixed exchange rates, its role as an international lender has become more important recently This role first came to the fore in the 1980s during the third-world debt crisis, in which the IMF assisted developing countries in repaying their loans The financial crises in Mexico in 1994 1995 and in East Asia in 1997 1998 led to huge loans by the IMF to these and other affected countries to help them recover from their financial crises and to prevent the spread of these crises to other countries This role, in which the IMF acts like an international lender of last resort to cope with financial instability, is indeed highly controversial Should the IMF Be an International Lender of Last Resort? As we saw in Chapter 17, when a financial crisis occurs in industrialized countries and the financial system threatens to seize up, domestic central banks can address matters with a lender-of-last-resort operation to limit the degree of instability in the banking system In emerging markets, however, where the credibility of the central bank as an inflation fighter may be in doubt and debt contracts are typically shortterm and in foreign currencies, a lender-of-last-resort operation becomes a doubleedged sword as likely to exacerbate the financial crisis as to alleviate it For example, when the U.S Federal Reserve engaged in a lender-of-last-resort operation during the 1987 stock market crash and after the 2001 terrorist destruction of the World Trade Center, there was almost no sentiment in the markets that there would be substantially higher inflation However, for a central bank with less inflation-fighting credibility than the Fed, central bank lending to the financial system in the wake of a financial crisis even under the lender-of-last-resort rhetoric may well arouse fears of inflation spiralling out of control, causing an even greater