536 PA R T V I International Finance and Monetary Policy currency depreciation and still greater deterioration of balance sheets The resulting increase in moral hazard and adverse selection problems in financial markets, along the lines discussed in Chapter 8, would only make the financial crisis worse Central banks in emerging-market countries therefore have only a very limited ability to successfully engage in a lender-of-last-resort operation However, liquidity provided by an international lender of last resort does not have these undesirable consequences, and in helping to stabilize the value of the domestic currency it strengthens domestic balance sheets Moreover, an international lender of last resort may be able to prevent contagion, the situation in which a successful speculative attack on one emerging-market currency leads to attacks on other emerging-market currencies, spreading financial and economic disruption Since a lender of last resort for emerging-market countries is needed at times, and since it cannot be provided domestically, there is a strong rationale for an international institution to fill this role Indeed, since Mexico s financial crisis in 1994, the International Monetary Fund and other international agencies have stepped into the lender-of-last-resort role and provided emergency lending to countries threatened by financial instability However, support from an international lender of last resort brings risks of its own, especially the risk that the perception it is standing ready to bail out irresponsible financial institutions may lead to excessive risk taking of the sort that makes financial crises more likely In the Mexican and East Asian crises, governments in the crisis countries used IMF support to protect depositors and other creditors of banking institutions from losses This safety net creates a well-known moral hazard problem because the depositors and other creditors have less incentive to monitor these banking institutions and withdraw their deposits if the institutions are taking on too much risk The result is that these institutions are encouraged to take on excessive risks Indeed, critics of the IMF most prominently the U.S Congressional Commission headed by Professor Alan Meltzer of Carnegie-Mellon University contend that IMF lending in the Mexican crisis, which was used to bail out foreign lenders, set the stage for the East Asian crisis They argue that these lenders expected to be bailed out if things went wrong and thus provided funds that were used to fuel excessive risk taking.8 An international lender of last resort must find ways to limit this moral hazard problem, or it can actually make the situation worse The international lender of last resort can make it clear that it will extend liquidity only to governments that put the proper measures in place to prevent excessive risk taking In addition, it can reduce the incentives for risk taking by restricting the ability of governments to bail out stockholders and large uninsured creditors of domestic financial institutions Some critics of the IMF believe that the IMF has not put enough pressure on the governments to which it lends to contain the moral hazard problem One problem that arises for international organizations like the IMF engaged in lender-of-last-resort operations is that they know that if they don t come to the rescue, the emerging-market country will suffer extreme hardship and possible political instability Politicians in the crisis country may exploit these concerns and engage in a game of chicken with the international lender of last resort: they resist necessary reforms, hoping that the IMF will cave in Elements of this game were present in the Mexican crisis of 1995 and were also a particularly important feature of the negotiations between the IMF and Indonesia during the Asian crisis See International Financial Institution Advisory Commission, Report (IFIAC: Washington, D.C., 2000)