It is often said that one of the reasons for the rise of Hitler in the 1930’s was that the Western countries wanted to use him as a shield between themselves and Communist Russia.
After the Second World War, the economies of most of the European countries were shattered. Taking advantage of this situation, the Soviet Union of Russia started influencing them. To prevent this spread of communism, the US came up with the Marshall Plan. In accordance with this plan, the US started doling out funds to the weak European countries to help them out of their precarious economic condition and away from the grasp of Russia. Behind this apparent altruism lay the objective of obstructing the growing power and strength of Russia. During the four years that the plan was in operation, the US spent more than $15 billion helping countries like Greece, Turkey and others.
Now, in the 21st century, the greatest threat a country faces is the threat of terrorism. It has almost become imperative for every country to allocate a fraction of funds from its budget to counter this menace. While countries like the US, England and even India can afford to spend large amounts to combat terrorism, smaller countries like Pakistan, Bangladesh and others just cannot do so. It is in these economically weak countries that the threat of terrorism is even higher.
Since 9/11, American policymakers have significantly increased military and nonmilitary assistance to Pakistan in an attempt to address their strategic concerns as well as to support Pakistani democracy. U.S. annual bilateral aid in total went from $5.3 million in 2000 to $798 million in 2002 to more than $4.4 billion in 2010. More than two-thirds (68 percent) of the $20.73 billion in total appropriated assistance over the past eight fiscal years has gone to security-related aid.
The above cited examples clearly point at the fact that there exists a symbiotic relationship between a superior economy (in this case US) and the inferior economies. While the inferior economies need considerable aid for reviving themselves from a possible breakdown, the superior economy comes to their rescue, but for its own strategic motives.
The natural questions that come to our mind at this instant are-1) How much aid will the supreme country provide? 2) Will the inferior economy be able to improve its situation? If not, then what happens to that economy? To answer these questions from an economic perspective a simple model is constructed to capture the behavior of both economies.
It is assumed that the economic conditions in the superior country are more or less stable, instability in the inferior country has a considerable impact on the superior country and that the funds are efficiently used by the inferior economy for the assigned purpose. Consider the following diagram:-
Let X be the superior country and Y be the inferior country. On the vertical axis we plot the vulnerability of Y. Vulnerability implies the instability or disturbance caused by a crisis situation in the inferior economy. It is measured by the loss in GDP of that country due to such disturbance. On the horizontal axis we plot the demand of funds by Y and the supply of funds by X. Up to point A, Y can handle any disturbance on its own after which it will have to rely on external aid. The demand for funds is positively dependent on the level of vulnerability in Y. Moreover, as vulnerability rises, the demand for external aid rises at an increasing rate. The inverse demand function plotted is thus concave.
X, being a powerful country, would not be affected much by an initial increase in vulnerability in Y. But after a critical level B, it will be induced to tackle the problem and hence the supply of funds is dependent on the level of vulnerability in Y. Also, as vulnerability rises supply initially rises at an increasing rate (X will try to urgently fix the crisis), after a point it starts rising at a decreasing rate, till it becomes vertical or inelastic at Q (the exogenous upper limit to the aid given by X). Again, by plotting the inverse supply function; the supply curve will first be concave, then convex and finally vertical.
Equilibrium, in this model, would imply a match between the demand and supply of funds such that vulnerability remains stable. That is, the situation does not worsen even if it does not improve. We have two equilibrium points-E and F. Note that E is a stable equilibrium because any divergence from E will lead to a movement towards E. For instance, at any vulnerability level slightly greater than E, the external assistance to mitigate the instability is greater than what is demanded by Y. Hence, with time, Y will recover and its vulnerability would come down. On the other hand, by the same logic, F is an unstable equilibrium. E is also a ‘good’ equilibrium because with a relatively low aid (q*), X has succeeded in stabilizing vulnerability at a lower level (V*).
Starting from V*, if there is a shock in Y (a sudden crisis), then vulnerability abruptly rises to a level, say V’. Since at this higher level, the supply of funds exceeds the demand, therefore, over time Y will be bailed out of its crisis solely by X’s aid. But, if it so happens that a massive crisis hits Y then vulnerability will suddenly shoot up to a very high level, say V”. At this level, Y is demanding more funds to deal with the crisis than the maximum that X can provide, i.e. Q. Due to the paucity of funds, the situation aggravates further as vulnerability keeps on increasing. Thus, unless X increases the exogenously determined maximum aid, Q, the future of Y is at stake.
It is at this critical juncture that the role of international bodies like UN, IMF and World Bank has to be appreciated. These organizations can come “to the rescue” of Y by providing a grant equal to the differential, CD, between the demand and supply of funds at V”. As a consequence, the combined supply curve of external aid (that provided by X plus that provided by IMF) shifts rightwards by CD (new supply curve is S’) and vulnerability will be stabilized at V”. Thus, an imminent danger of the collapse of Y will be mitigated.
Moreover, if these organizations grant an aid, which is slightly greater than CD, say CG, then the combined supply curve of external aid shifts further towards the right (say S”). With the new supply curve (S”) and the existing demand curve (DD), at V” the supply of external aid now exceeds the demand resulting in a fall in vulnerability over time. Thus, in the long run, Y’s situation will significantly improve.
How long should the IMF continue providing aid to Y? Once vulnerability falls below V”’ (the level corresponding to the earlier unstable equilibrium, F), the IMF can start phasing out its aid. This is because once the level of vulnerability is pushed below the unstable equilibrium level, it will automatically come down to the good equilibrium. In this manner, these international organizations play a crucial role in “bailing-out” inferior economies from their crises. The above model, with certain modifications with regard to the definition of vulnerability, can also be applied to the problem of “credit crunch” in commercial banks. Banks make profits by lending at a higher rate of interest than that paid to depositors. Thus, it is beneficial for the banks to “borrow short-term” at a low rate of interest and “lend long-term” at a higher rate of interest. However, banks have to be able to meet their customers’ demands for cash. Here, we invoke the concept of liquidity ratio which is the proportion of a bank’s assets held in liquid form (cash, balances at the central bank, short-term loans and government bonds with a year to maturity). Banks therefore have a difficult choice to make between the desire for profitability (which necessitates a low liquidity ratio) and the need to be prudent to avoid a financial panic (which demands a high liquidity ratio). Unless a balance is attained, the banks are ought to be deemed “shaky”.
Northern Rock was the UK’s fifth largest mortgage lender. It became very susceptible to the “credit crunch” as it had grown by raising increasing amounts of finance from the short-term money market and lending for long-term mortgages. During the American subprime mortgage crisis, banks became very reluctant to lend to other banks because borrowers were more likely to default on their loans. In September 2007, Northern Rock obtained emergency financial support from the Bank of England. Thus, it became the first bank in over 150 years to suffer a bank run and was ultimately nationalised in February 2008. Hence, the role of the central bank of a country as the “lender of the last resort” is akin to the role played by IMF in the context of the earlier model.
The US deferred nearly $800 million in counter terrorism funding to Pakistan in July 2011. This followed the US raid on Osama bin Laden’s hideout in Abbottabad. However, this is not an isolated incident, arrest of a CIA contractor in Lahore and assassination of a Pakistani journalist (allegedly involving the ISI) further fuelled tension in an already sour relationship. The United States allege that Pakistan is unable or rather unwilling to take decisive actions against militant groups attacking its troops in and around Afghanistan. Thus, withholding aid was the only logical step available to them.
The over simplifying assumption of the efficient utilization of funds by the crises ridden economy was the driving force of the above model. Unfortunately, its validity seems to be highly questionable in reality. As they say, ‘Beggars can’t be choosers’. Hence, it is in the interest of the inferior country to ensure that there are hardly any lapses and certainly, no mismanagement of funds.
Contributors:
Oindrilla Chakraborty
Siddhartha Tandon
Punit Parekh
Macro IN A NUTSHELL 