How Useful Are Clever Solutions?

• Author: Raghuram Rajan
• Position: Economic Counsellor and Director of the IMF's Research Department
• Pages: 56-57

Why fashionable proposals often don't work, as in the case of a new approach to dollarized debt and "original sin"

Page 56

Knotty problems abound in economics. For example, how can the poor obtain access to credit, or how can international economic policies help to cut short the duration of kleptocratic, despotic regimes? And clever solutions keep bubbling up. Give the poor formal title to their land because that will give them collateral against which to borrow. Declare the debt issued by terrible regimes "odious" and unenforceable so that investors will be unwilling to finance such regimes. The solutions seem ingenious, low-cost responses to the problems. Yet they are rarely implemented.

Often, this is not because there is a conspiracy to ignore the solutions, but because both the underlying causes of the problem and the ramifications of the proposed solution are broader than have been allowed for. Not only is it possible that the clever proposal will not solve the problem, but it may also have the unintended consequence of detracting from the less attractive, painful reform that is ultimately needed to solve it. This is not necessarily to say that one shouldn't propose clever ideas or try to implement them, but one should be aware that to have a high probability of working, solutions have to be robust-that is, allow for the possibility that the underlying problem is not the obvious one. Many clever solutions are not robust. Consider the following example.

Dollarization and original sin

The dollarization of liabilities has become widespread in recent years. More and more countries, banks, and firms in emerging markets issue debt denominated in a foreign currency (typically the dollar), even though they don't have large dollar revenues. When a country's currency depreciates, the resulting currency mismatch between revenues and obligations can have serious consequences- sovereign defaults, banking system melt-downs, and widespread corporate bankruptcy.

Given these risks, why do countries persist in borrowing in foreign currencies? One explanation-referred to as the "original sin" hypothesis-is that not only do countries not have any choice now but also they won't have a choice in the future. For some unspecified reason, perhaps to do with long-forgotten original sins, investors have feared a given country, refusing to accept paper denominated in its...