Currency crisis

The currency crises and sovereign debt crises that have occurred with increasing frequency since the Latin American debt crisis of the 1980s have inspired a huge amount of research. There have been several 'generations' of models of currency crises.^[7]

The 'first generation' of models of currency crises began with Paul Krugman's adaptation of Stephen Salant and Dale Henderson's model of speculative attacks in the gold market.^[8] In his article,^[9] Krugman argues that a sudden speculative attack on a fixed exchange rate, even though it appears to be an irrational change in expectations, can result from rational behavior by investors. This happens if investors foresee that a government is running an excessive deficit, causing it to run short of liquid assets or "harder" foreign currency which it can sell to support its currency at the fixed rate. Investors are willing to continue holding the currency as long as they expect the exchange rate to remain fixed, but they flee the currency en masse when they anticipate that the peg is about to end.

The 'second generation' of models of currency crises starts with the paper of Obstfeld (1986).^[10] In these models, doubts about whether the government is willing to maintain its exchange rate peg lead to multiple equilibria, suggesting that self-fulfilling prophecies may be possible. Specifically, investors expect a contingent commitment by the government and if things get bad enough, the peg is not maintained. For example, in the 1992 ERM crisis, the UK was experiencing an economic downturn just as Germany was booming due to the reunification. As a result, the German Bundesbank increased interest rates to slow the expansion. To maintain the peg to Germany, it would have been necessary for the Bank of England to slow the UK economy further by increasing its interest rates as well. As the UK was already in a downturn, increasing interest rates would have increased unemployment further and investors anticipated that the UK politicians were not willing to maintain the peg. As a result, investors attacked the currency and the UK left the peg.

'Third generation' models of currency crises have explored how problems in the banking and financial system interact with currency crises, and how crises can have real effects on the rest of the economy.^[11] McKinnon & Pill (1996), Krugman (1998), Corsetti, Pesenti, & Roubini (1998) suggested that "over borrowing" by banks to fund moral hazard lending was a form of hidden government debts (to the extent that governments would bail out failing banks).^{[citation needed]} Radelet & Sachs (1998) suggested that self-fulfilling panics that hit the financial intermediaries, force liquidation of long run assets, which then "confirms" the panics.^{[citation needed]}

Chang and Velasco (2000) argue that a currency crisis may cause a banking crisis if local banks have debts denominated in foreign currency,^[12] Burnside, Eichenbaum, and Rebelo (2001 and 2004) argue that a government guarantee of the banking system may give banks an incentive to take on foreign debt, making both the currency and the banking system vulnerable to attack.^[13][14]

Krugman (1999)^[15] suggested another two factors, in an attempt to explain the Asian financial crisis: (1) firms' balance sheets affect their ability to spend, and (2) capital flows affect the real exchange rate. (He proposed his model as "yet another candidate for third generation crisis modeling" (p32)). However, the banking system plays no role in his model.

 

 

According to some economists the Eurozone crisis was in fact a balance-of-payments crisis or at least can be thought of as at least as much as a fiscal crisis.^[17] According to this view, a capital flow bonanza of private funds took place during the boom years preceding this crisis into countries of Southern Europe or of the periphery of the Eurozone, including Spain, Ireland and Greece; this massive flow financed huge excesses of spending over income, i.e. bubbles, in the private sector, the public sector, or both. Then following the global financial crisis of 2007–08, came a sudden stop to these capital inflows that in some cases even led to a total reversal, i.e. a capital flight.^[18]

Others, like some of the followers of the Modern Monetary Theory (MMT) school, have argued that a region with its own currency cannot have a balance-of-payments crisis because there exists a mechanism, the TARGET2 system, that ensures that Eurozone member countries can always fund their current account deficits.^[19][20] These authors do not claim that the current account imbalances in the Eurozone are irrelevant but simply that a currency union cannot have a balance of payments crisis proper.^[21] Some authors tackling the crisis from an MMT perspective have claimed that those authors who are denoting the crisis as a 'balance of payments crisis' are changing the meaning of the term.^[20][22]