Read the following passages carefully and answer the questions  given at the end of each passage:

Every loan has a lender and a borrower; both voluntarily engage in the transaction. If the loan goes bad, there is at least a prima facie case that the lender is as guilty as the borrower. In fact, since lenders are supposed to be sophisticated in risk analysis and in making judgments about a reasonable debt burden, they should perhaps bear even more culpability.

Does it make a difference if we say there is over-lending rather than over-borrowing? The difference in where we see the problem affects where we seek the solution. Is the problem more on the side of the lenders, that they are not exercising due diligence in judging who is creditworthy? Or on the borrowers, being profligate and irresponsible? If we consider the problem to be over borrowing, then we naturally think of making it more difficult for borrowers to discharge their debts, on the contrary, if the problem is over lending, we focus on strengthening incentives for lenders to exercise due diligence.

The political economy of over-borrowing is easy to understand. The current borrowing government benefits and later governments have to deal with the consequences. But why have sophisticated, profit maximizing lenders so often over-lent? Lenders encourage indebtedness because it is profitable. Developing country governments are sometimes even pressured to over-borrow. There may be kickbacks in loans, or even to be influenced by Western businessmen and financiers. They wine and dine those responsible for borrowing as they sell their loan packages, and tell them why this is good time to borrow, why their particular package is attractive, why this is the right time to restructure debt? Countries that are not sure that borrowing is worth the risk are told how important it is to establish a credit rating: borrow even if you really don’t need the money.

Excessive borrowing increases the chance of a crisis, and the cost of a crisis are borne not just by lenders but by all of society. In recent years, IMF programs may have resulted in significant further distortions in lenders’ incentives. When crisis occurred, the IMF lent money in what was called a ‘bail-out’- but the money was not really a bail-out for the country; it was a bail out for western banks. In both East Asia and Latin America, bail-outs provided money to repay foreign creditors, thus absolving creditors from having to bear the costs of their mistaken lending. In some instances, governments even assumed private liabilities, effectively socializing private risk. The creditors were left off the hook, but the IMF’s money wasn’t gift, just another loan- and the developing country was left to pay the bill. In effect, the poor country’s taxpayers paid for rich country’s lending mistakes.

The bail-outs give rise to the famous ‘moral hazard’ problem. Moral hazard arises when a party does not bear all the risks associated with his action and as a result does not do everything he can to avoid risk. The term originates in the insurance literature; it was deemed immoral for an individual to take less care in preventing a fire simply because he had insurance coverage. It is of course, simply a matter of incentives: those with insurance may not set their houses on fire deliberately, but their incentive to avoid a fire is still weakened. With loans, the risk is default, with all of its consequences; lenders can reduce that risk simply by lending less. If they perceive a high likelihood of a bail-out, they lend more than they otherwise would.

Lending markets are also characterized by, in the famous words of former chairman of the U.S. Federal Reserve Alan Greenspan, ‘irrational exuberance’, as well as irrational pessimism. Lenders rush into a market in a mood of optimism, and rush out when the mood changes. Markets move in fads and fashions, and it is hard to resist joining the latest fad. If only one firm were affected by a mood of irrational optimism, it would have to bear the cost of its mistake; but when large numbers share the mood, in a fad, there are macroeconomic consequences, potentially affecting everyone in the country.