Question

In: Economics

Since most individual countries recognise the need for a National ‘Lender of Last Resort’, why has...

Since most individual countries recognise the need for a National ‘Lender of Last Resort’, why has it proved so difficult to agree on an International ‘Lender of Last Resort’? How has the absence of an international lender been dealt with and with what success?

Solutions

Expert Solution

The case for a domestic lender of last resort is broadly accepted. The question arises of whether the international financial system needs a lender of last resort. The issue is whether there is a useful role for an institution that takes responsibility for dealing with potential and actual crises, either as a crisis lender, or as a crisis manager, or both. This differs from the question that is sometimes asked as to whether leading central banks should accept some responsibility for the performance of the global economy, along with their national economy.

International agency acts as lender of last resort for countries facing an external financing crisis. In such a crisis, a country - both public and private sectors within the country - faces a typically massive demand for foreign exchange. The domestic central bank cannot produce this currency. Thus, the fact that the country may have its own central bank capable of creating the domestic currency is typically irrelevant to the solution of an external financing problem.

There is a potential need for such assistance to a country both because international capital flows are not only extremely volatile but also contagious, exhibiting the classic signs of financial panics, and because an international lender of last resort can help mitigate the effects of this instability and perhaps the instability itself. At the macroeconomic level, a country faced with a sudden demand for foreign exchange can permit its exchange rate to adjust and/or can restrict domestic demand to generate a current account surplus. At the microeconomic level, foreign creditors can attempt to collect on obligations and financial institutions and corporations can be put into bankruptcy. However, all such measures are likely in a panic to result in a considerable overshooting of the needed adjustment, and there is accordingly a case for the public sector both to provide emergency foreign exchange loans and to assist the domestic authorities in attempting to manage the crisis.


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