Bail Out or Work Out? Theoretical Considerations

Abstract

This paper assesses various crisis resolution proposals using a theoretical model of liquidity and solvency crisis. The model suggests that payments standstills and last-resort lending are an equally efficient means of dealing with liquidity crises, while coordinated lending through creditor committees is second-best. Debt write-downs are preferred to subsidised IMF financing when dealing with solvency crises, because of the negative moral hazard implications of the latter tool. Finally, the model suggests that international bankruptcy court proposals may be superior to existing contractual approaches in securing such write-downs. On many measures, the incidence of international financial crises increased in the last part of the twentieth century (Bordo et al., 2001). But it is not just the incidence of financial crises that has altered in recent years. So too has their nature. The recent crises in Mexico, across South-East Asia, Russia, Brazil, Turkey and Argentina were clearly rooted in the capital, rather than current, account of the balance of payments. We appear to have entered an era of capital account crises (IMF, 2002). Theoretical models of financial crisis have developed in lockstep with crisis experience. A 'third generation' of models of financial crisis has emerged (Chang and Velasco, 1998; Krugman, 1999). These models combine imperfections in fundamentals (as suggested by so-called 'first-generation' models) and fragility in expectations (as suggested by 'second-generation' models) to explain crises. Under the third generation approach, capital account crises can originate in either fundamentals or expectations. We have 'solvency' as well as 'liquidity' capital account crises.