take place. They encompass standards and regulations applicable to financial systems, both national and international, as well as monetary and currency arrangements in emerging markets. Official Financial Support The main idea behind initiatives concerning official financial support relates to its function of lending of last resort at the international level. The basic argument for international versions of a lender of last resort is the same argument used in a domestic context: by promising in advance to provide financial support in case of unexpected need in which fundamentals are right or will be right, (liquidity) crises are prevented. In fact, financial panic rationalized by the damage in fundamentals that a massive financial withdrawal (a “run”) would generate cannot exist when there is a commitment of ample support that would avoid such damage. (Alternatively, in the case of insolvency, a lender of last resort could also intervene to facilitate the debt workout of reorganized entities at minimum cost.) However, current official initiatives attempt to scale back the level of official intervention relative to the volumes involved in rescue packages in recent years. Not only are volumes expected to be much lower, but also, in the new doctrine, the conditions under which such support would be forthcoming will be more discretional and less transparent, making use of the so-called “case-by-case approach” and “constructive ambiguity.” Furthermore, the extent of official support would be linked to the comparable treatment of private creditors, further limiting the scope of official support. The reason given for this official retrenchment is that large, unconditional, and unilateral support finances the bailout of private creditors, which promotes substantial moral hazard leading to overborrowing and crisis. As we will see, whether this is a good reason for retrenchment depends on the prevalence of liquidity or solvency crises. In the case of liquidity crises, lending of last resort prevents crises at no cost, and is therefore beneficial all around. Successful lending of last resort reduces private default risk, but this is not a source of moral hazard.
This is a legitimate reduction in risk obtained from
removing an inefficient risk factor, i.e., the panic equilibrium. This does not open a gap between social and private risks. In fact, lower expected risks will give rise to more capital flows that will be applied efficiently.
Liquidity crises call for large, unconditional, and unilateral official
financial support.
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