CURRENCY CRISES
1. The canonical model
2. More sophisticated models
3. Disputed issues: self-fulfilling crises, herd behavior, large agents,contagion
4. Case study 1: the ERM crises of 1992-3
5. Case study 2: the Latin crisis, 1994-5
6. Case study 3: the Asian crisis, 1997-?
7. Macroeconomic questions
8. Can crises be prevented?
On July 2 of this year, after months of asserting that it would do nosuch thing, the government of Thailand abandoned its efforts to maintaina fixed exchange rate for the baht. The currency quickly depreciated bymore than 20 percent; within a few days most neighboring countries hadbeen forced to emulate the Thai example.
What forced Thailand to devalue its currency was massive speculationagainst the baht, speculation that over a few months had consumed mostof what initially seemed an awesomely large warchest of foreign exchange.And why were speculators betting against Thailand? Because they expectedthe baht to be devalued, of course.
This sort of circular logic - in which investors flee a currency becausethey expect it to be devalued, and much (though usually not all) of thepressure on the currency comes precisely because of this investor lackof confidence - is the defining feature of a currency crisis. We need notseek a more formal or careful definition; almost always we know a currencycrisis when we see one. And we have been seeing a lot of them lately. The1990s have, in fact, offered the spectacle of three distinct regional wavesof currency crises: Europe in 1992-3, Latin America in 1994-5, and theAsian crises still unfolding at the time of writing.
Currency crises have been the subject of an extensive economic literature,both theoretical and empirical. Yet there remain some important unresolvedissues, and each new set of crises presents new puzzles. The purpose ofthis paper is to provide an overview both of what we know and of what wedo not know about currency crises, illustrated by reference to recent experience.
The paper begins by describing the "canonical" crisis model,a simple yet suggestive analysis that was developed 20 years ago but remainsthe starting point for most discussion. Despite that canonical model'svirtues, however, it has come in for justified criticism because of itsfailure to offer a realistic picture either of the objectives of centralbanks or of the constraints they face; thus the paper turns next to a descriptionof "second-generation" crisis models that try to remedy thesedefects.
As it turns out, second-generation models have suggested a reconsiderationof a basic question that the canonical model seemed to have answered: arecurrency crises always justified? That is, do currencies always get attackedbecause the markets perceive (rightly or wrongly) some underlying inconsistencyin the nation's policies, or can they happen arbitrarily to countries whosecurrencies would otherwise have remained sound? The paper describes severaldifferent scenarios for currency crises that are not driven by fundamentals,including self-fulfilling crises in which endogenous policy ends up justifyinginvestor pessimism, "herding" by investors, and the machinationsof large agents ("Soroi"). Closely related to the question ofarbitrary crises is "contagion", the phenomenon in which a currencycrisis in one country often seems to trigger crises in other countrieswhich which it seemingly has only weak economic links (e.g., Mexico andArgentina, or Thailand and the Philippines).
From there the paper moves to cases, considering in turn the three regionalcrisis waves of the 90s (so far).Comparison of these waves turns out toraise a further puzzle: while the onset of crisis was similar in each case,the consequences of the crises seem to have been very different in theEuropean as opposed to the Latin and Asian cases.
Finally, of course, we must ask the big question: is there any way tomake crises less frequent, and if so what?
1.The canonical crisis model
The canonical crisis model derives from work done in the mid-1970s byStephen Salant, at that time at the Federal Reserve's International FinanceSection. Salant's concern was not with currency crises, but with the pitfallsof schemes to stabilize commodity prices. Such price stabilization, viathe establishment of international agencies that would buy and sell commodities,was a major demand of proponents of the so-called New International EconomicOrder. Salant, however, argued on theoretical grounds that such schemeswould be subject to devastating speculative attacks.
His starting point was the proposition that speculators will hold anexhaustible resource if and only if they expect its price to rise rapidlyenough to offer them a rate of return equivalent (after adjusting for risk)to that on other assets. This proposition is the basis of the famous Hotellingmodel of exhaustible resource pricing: the price of such a resource shouldrise over time at the rate of interest, with the level of the price pathdetermined by the requirement that the resource just be exhausted by thetime the price has risen to the "choke point" at which thereis no more demand.
But what will happen, asked Salant, if an official price stabilizationboard announces its willingness to buy or sell the resource at some fixedprice? As long as the price is above the level that would prevail in theabsence of the board - that is, above the Hotelling path - speculatorswill sell off their holdings, reasoning that they can no longer expectto realize capital gains. Thus the board will initially find itself acquiringa large stockpile. Eventually, however, the price that would have prevailedwithout the stabilization scheme - the "shadow price" - willrise above the board's target. At that point speculators will regard thecommodity as a desirable asset, and will begin buying it up; if the boardcontinues to try to stabilize the price, it will quickly - instantaneously,in the model - find its stocks exhausted. Salant pointed out that a hugewave of speculative buying had in effect forced the closure of the openmarket in gold in 1969, and suggested that a similar fate would await NIEOprice-stabilization schemes.
This basic logic was described briefly in a classic 1978 paper by Salantand his colleague Dale Henderson (their main concern in that paper waswith the more recent behavior of the gold price, and in particular withthe effects of unpredictable sales of official gold stocks). Other researcherssoon realized, however, that similar logic could be applied to speculativeattacks not on commodity boards trying to stabilize commodity prices, buton central banks trying to stabilize exchange rates.
The canonical currency-crisis model, as laid out initially by Krugman(1979) and refined by Flood and Garber (1984), was designed to mimic thecommodity-board story. The upward trend in the "shadow" priceof foreign exchange - the price that would prevail after the speculativeattack - was supplied by assuming that the government of the target economywas engaged in steady, uncontrollable issue of money to finance a budgetdeficit. Despite this trend, the central bank was assumed to try to holdthe exchange rate fixed using a stock of foreign exchange reserves, whichit stood ready to buy or sell at the target rate.
Given this stylized representation of the situation, the logic of currencycrisis was the same as that of speculative attack on a commodity stock.Suppose speculators were to wait until the reserves were exhausted in thenatural course of events. At that point they would know that the priceof foreign exchange, fixed up to now, would begin rising; this would makeholding foreign exchange more attractive than holding domestic currency,leading to a jump in the exchange rate. But foresighted speculators, realizingthat such a jump was in prospect, would sell domestic currency just beforethe exhaustion of reserves - and in so doing advance the date of that exhaustion,leading speculators to sell even earlier, and so on ... The result wouldbe that when reserves fell to some critical level - perhaps a level thatmight seem large enough to finance years of payments deficits - there wouldbe an abrupt speculative attack that would quickly drive those reservesto zero and force an abandonment of the fixed exchange rate.
The canonical currency crisis model, then, explains such crises as theresult of a fundamental inconsistency between domestic policies - typicallythe persistence of money-financed budget deficits - and the attempt tomaintain a fixed exchange rate. This inconsistency can be temporarily paperedover if the central bank has sufficiently large reserves, but when thesereserves become inadequate speculators force the issue with a wave of selling.
This model has some important virtues. First of all, many currency crisesclearlydo reflect a basic inconsistency between domestic and exchangerate policy; the specific, highly simplified form of that discrepancy inthe canonical model may be viewed as a metaphor for the more complex butoften equally stark policy incoherence of many exchange regimes. Second,the model demonstrates clearly that the abrupt, billions-lost-in-days characterof runs on a currency need not reflect either investor irrationality orthe schemes of market manipulators. It can be simply the result of thelogic of the situation, in which holding a currency will become unattractiveonce its price is no longer stabilized, and the end of the price stabilizationis itself triggered by the speculative flight of capital.
These insights are important, especially as a corrective to the tendencyof observers unfamiliar with the logic of currency crises to view themas somehow outside the normal universe of economic events - whether asa revelation that markets have been taken over by chaos theory, that "virtualmoney" has now overpowered the real economy (Drucker 1997), or asprima facie evidence of malevolent market manipulation.
Despite the virtues of the canonical model, however, a number of economistshave argued that it is an inadequate representation of the forces at workin most real crises. These economists have developed what are sometimesknown as "second-generation" crisis models, to which we now turn.
2.More sophisticated models
Perhaps the best way to describe what is wrong with the canonical crisismodel is to say that it represents government policy (though not the marketresponse) in a very mechanical way. The government is assumed to blindlykeep on printing money to cover a budget deficit, regardless of the externalsituation; the central bank is assumed to doggedly sell foreign exchangeto peg the exchange rate until the last dollar of reserves is gone. Inreality the range of possible policies is much wider. Governments can anddo try to condition fiscal policies on the balance of payments. Meanwhile,central banks have a variety of tools other than exchange market interventionavailable to defend the exchange rate, including in particular the abilityto tighten domestic monetary policies. Obviously there are costs to suchpolicies; but it may be important to recognize that the defense of an exchangerate is a matter of tradeoffs rather than a simple matter of selling foreignexchange until the money is gone.
So-called second-generation models (perhaps best represented by Obstfeld(1994)), require three ingredients. First, there must be a reason why thegovernment would like to abandon its fixed exchange rate. Second, theremust be a reason why the government would like todefend the exchangerate - so that there is a tension between these motives. Finally, in orderto create the circular logic that drives a crisis, the cost of defendinga fixed rate must itself increase when people expect (or at least suspect)that the rate might be abandoned.
Why might a government have a motive to allow its currency to depreciate?The general slogan here is that "it takes two nominals to make a real".In order for a government to have a real incentive to change the exchangerate,something must be awkwardly fixed in domestic currency. Oneobvious possibility is a large debt burden denominated in domestic currency- a burden that a government might be tempted to inflate away, but cannotas long as it is committed to a fixed exchange rate. (For example, theattacks on the French franc during the 1920s were triggered mainly by suspicionsthat the government might try to inflate away its legacy of debt from WorldWar I). Another possibility is that the country suffers from unemploymentdue to downwardly rigid nominal wage rate, and would like to adopt a moreexpansionary monetary policy, but cannot as long as it is committed toa fixed exchange rate. (This was in essence the motivation both for Britain'sabandonment of the gold standard in 1931 and its departure from the exchangerate mechanism of the European Monetary System in 1992).
Given a motive to depreciate, why would a government choose insteadto defend a fixed rate? One answer might be that it believes that a fixedrate is important in facilitating international trade and investment. Anothermight be that it has a history of inflation, and regards a fixed rate asa guarantor of credibility. Finally, the exchange rate often takes on animportant role as a symbol of national pride and/or commitment to internationalcooperation (as in the European Monetary System).
Finally, why would public lack of confidence in the maintenance of afixed rate itself have the effect of making that rate more difficult todefend? Here there is a somewhat subtle distinction between two variantsof the story. Some modelers - notably Obstfeld (1994) - emphasize thata fixed rate will be costly to defend if people expectedin the pastthat it would be depreciatednow. For example, debt-holders mighthave demanded a high rate of interest in anticipation of a depreciation,therefore making the current debt burden so large that it is hard to managewithout a depreciation. Or unions, expecting depreciation, might have setwages at levels that leave the country's industry uncompetitive at thecurrent exchange rate.
The alternative (which to my mind seems much closer to what happensin real crises) is to suppose that a fixed rate is costly to defend ifpeoplenow expect that it will be depreciatedin the future.The usual channel involves short-term interest rates: to defend the currencyin the face of expectations of future depreciation requires high short-termrates; but such high rates may either worsen the cash flow of the government(or indebted enterprises) or depress output and employment.
Suppose we take these three generic elements together: a reason to depreciate,another reason not to depreciate, and some reason why expectations of adepreciation themselves alter the balance between the costs and benefitsof maintaining a fixed parity. As pointed out in Krugman (1996), it ispossible to combine these elements to produce a general story about currencycrises that is quite similar to that in the canonical model. Suppose thata country's fundamental tradeoff between the costs of maintaining the currentparity and the costs of abandoning it is predictably deteriorating, sothat at some future date the country would be likely to devalue even inthe absence of a speculative attack. Then speculators would surely tryto get out of the currency ahead of that devaluation - but in so doingthey would worsen the government's tradeoff, leading to an earlier devaluation.Smart investors, realizing this, would try to get out still earlier ...the end result will therefore be a crisis that ends the fixed exchangerate regime well before the fundamentals would appear to make devaluationnecessary.
We can actually be more specific: given an inevitable eventual abandonmentof a currency peg, and perfectly informed investors, a speculative attackon a currency will occurat the earliest date at which such an attackcould succeed. The reason is essentially arbitrage: an attack at anylater date would offer speculators a sure profit; this profit will be competedaway by attempts to anticipate the crisis.
It is important to notice one point about this scenario. In the casejust described - as in the canonical model - the crisis is ultimately provokedby the inconsistency of government policies, which make the long-run survivalof the fixed rate impossible. In that sense the crisis is driven by economicfundamentals. Yet that is not the way it might seem when the crisis actuallystrikes: the government of the target country would feel that it was fullyprepared to maintain the exchange rate for a long time, and would in facthave done so, yet was forced to abandon it by a speculative attack thatmade defending the rate simply too expensive.
I think that it is fair to say that the standard reaction both of mosteconomists and of international officials to currency crises is, at leastinformally, based on something like the scenario just described. That is,they recognize that the speculative attack, driven by expectations of devaluation,was itself the main proximate reason for devaluation; yet they regard thewhole process as ultimately caused by the policies of the attacked country,and in particular by a conflict between domestic objectives and the currencypeg which made an eventual collapse of that peg inevitable. In effect,the financial markets simply bring home the news, albeit sooner than thecountry might have wanted to hear it.
A significant number of economists studying this issue do, however,believe that the complaints of countries that they are being unfairly orarbitrarily attacked have at least some potential merit. So let me turnto the possible ways that - especially in the context of "second-generation"models - such complaints might in fact be justified.
3.Disputed issues: self-fulfilling crises etc.
I have just argued that although the detailed workings of a "second-generation"currency crisis model may be very different from those of the originalmodels, their general result can be much the same: a currency crisis isessentially the result of policies inconsistent with the long-run maintenanceof a fixed exchange rate. Financial markets simply force the issue, andindeed must do so as long as investors are forward-looking.
However, it is possible to conceive of a number of circumstances underwhich the financial markets are not as blameless as all that. The listbelow may not include all the relevant scenarios, but seems to cover thecases most often mentioned.
Self-fulfilling crises
Suppose that, contrary to our earlier assumption, an eventual end toa currency peg is not completely preordained. There may be no worseningtrend in the fundamentals; or there may be an adverse trend, but at leastsome realistic possibility that policies may change in a way that reversesthat trend. Nonetheless, it may be the case that the government will abandonthe peg if faced with a sufficiently severe speculative attack.
The result in such cases will be the possibility of self-fulfillingexchange rate crises. An individual investor will not pull his money outof the country if he believes that the currency regime is in no imminentdanger; but he will do so if a currency collapse seems likely. A crisis,however, will materialize precisely if many individual investors do pulltheir money out. The result is that either optimism or pessimism will beself-confirming; and in the case of self-confirming pessimism, a countrywill be justified in claiming that it suffered an unnecessary crisis.
How seriously should we take this analysis? One obvious caveat understoodby the economists studying this issue, but perhaps too easily forgottenby political figures, is that this analysis does not imply either thatany currency can be subject to speculative attack or that all speculativeattacks are unjustified by fundamentals. Even in models with self-fulfillingfeatures, it is only when fundamentals - such as foreign exchange reserves,the government fiscal position, the political commitment of the governmentto the exchange regime - are sufficiently weak that the country is potentiallyvulnerable to speculative attack. A country whose government is expectedto defend its currency firmly and effectively will probably not need todo so, while a country whose government is very likely to abandon its pegeventually in any case will almost surely find its timetable acceleratedby speculative pressure. Or to put it a bit differently: one can thinkof a range of fundamentals in which a crisis cannot happen, and a rangeof fundamentals in which it must happen; at most, self-fulfilling crisismodels say that there is an intermediate range in which a crisis can happen,but need not. It is an empirical question (though not an easy one) howwide this range is.
It is also important to remember that a country whose fundamentals arepersistently and predictably deteriorating will necessarily have a crisisat some point. Since the logic of predictable crises is that they happenwell before the fundamentals have reached the point at which the exchangerate would have collapsed in the absence of speculative attack - indeed,as argued above, they happen as soon as an attack can "succeed"- it will always seem at the time that the crisis has been provoked bya speculative attack not justified by current fundamentals.
Let me add a conjecture here, which has not to my knowledge been addressedin the theoretical literature to date. A situation in which a crisis couldhappen but need not presents speculators with a "one-way option":they will reap a capital gain (or, if you measure it in foreign currency,avoid a capital loss) by selling domestic currency if the exchange regimecollapses, but will not suffer an equivalent loss if it does not. What,then, prevents them from fleeing the currency at even a hint of trouble?My conjecture is that microeconomic frictions - transaction costs, thedifficulty of arranging credit lines, and so on - play an important role.Ordinarily we think of these frictions as being of trivial importance formacroeconomic issues, on the grounds that they are only a small fractionof a percentage point of the value transacted. However, currency crisesunfold over very short periods, in which even small transaction costs canoffset very large annualized rates of return. It may be small frictionsthat prevent a subjectively low-probability crisis from ballooning intoa full-fledged speculative attack. If this is true, then the improvingtechnical efficiency of markets may actually be a contributory factor tothe frequency of currency crises in the 1990s.
If self-fulfilling crises are a real possibility, what sets them off?The answer is that anything could in principle be the trigger. That is,we are now in the familiar terrain of "sunspot" dynamics, inwhich any arbitrary piece of information becomes relevant if market participantsbelieve it is relevant.
Herding
Both the canonical currency crisis model and the "second-generation"models presume that foreign exchange markets are efficient - that is, thatthey make the best use of the available information. There is, however,very little evidence that such markets are in fact efficient - on the contrary,the foreign exchange market (like financial markets in general) exhibitsstrong "anomalies" that can be reconciled with efficiency, ifat all, only with layers of otherwise unpersuasive assumptions that irresistiblysuggest the epicycles of pre-Copernican astronomy.
What difference might inefficient markets make to the study of currencycrises? The most obvious difference is the possibility of "herding".In general, herding can be exemplified by the result found by Shiller's(1989) remarkable survey of investors during the 1987 stock market crash:the only reason consistently given by those selling stocks for their actionswas the fact that prices were going down. In the context of a currencycrisis, of course, such behavior could mean that a wave of selling, whateverits initial cause, could be magnified through sheer imitation and turn,quite literally, into a stampede out of the currency.
Aside from the (very real) biases and limitations of human cognition,why might herding occur? Theorists have proposed two answers consistentwith individual rationality. One involves bandwagon effects driven by theawareness that investors have private information. Suppose that investor1 has special information about the Thai real estate market, investor 2has special information about the financial condition of the banks, investor3 has information about the internal discussions of the government. Ifinvestor 1 gets some negative information, he may sell, since that is allhe has to go on; if investor 2 learns that 1 has sold, he may sell alsoeven if his own private information is neutral or even slightly positive.And investor 3 may then end up selling even if his own information is favorable,because the fact that both 1 and 2 have sold leads him to conclude thatboth may well have received bad news, even though in fact they have not.Kehoe and Chari (1996) have argued that such bandwagon effects in marketswith private information create a sort of "hot money" that atleast sometimes causes foreign exchange markets to overreact to news aboutnational economic prospects.
Another explanation focusses on the fact that much of the money thathas been invested in crisis-prone countries is managed by agents ratherthan directly by principals. Imagine a pension-fund manager investing inemerging-market funds. She surely has far more to lose from staying ina currently unpopular market and turning out to be wrong than she doesto gain from sticking with the market and turning out to be right. To theextent that money managers are compensated based on comparison with othermoney managers, then, they may have strong incentives to act alike evenif they have information suggesting that the market's judgement is in factwrong. (As an aside, herding by individual investors may well result froma similar kind of internal principal-agent problem; as Schelling (198?)has argued, many aspects of individual behavior make sense only if viewedas the result of a sort of internal struggle between agents with longer-termand shorter-term perspectives. Put it this way: I will probablyfeelworse if I lose money in a Thai devaluation when others do not than I willif I lose the same amount of money in a general rout).
A final point: anyone who has followed the currency crises of the 1990smust at least have speculated on what we might call reverse herding: ingeneral, as described at greater length below, the markets seem to havebeen oddly complacent until shortly before the crises, even though therewere ample reasons to think that there was at least some risk of such crises.Principal-agent-type stories might be one explanation of this passivity:money managers (or internal, subjective money management "modules")were less concerned about crisis than they should have been, because theywere acting the same way as everyone else.
Contagion
The currency crises of the 1990s have consisted of three regional "waves":the ERM crises in Europe from 1992-3, the Latin American crises of 1994-5,and the Asian crises currently in progress. But why should there be suchregional waves - as Ronald Reagan said after visiting Latin America, theyare all different countries, so why should they experience a common crisis?This is the issue of "contagion".
One simple explanation of contagion involves real linkages between thecountries: a currency crisis in country A worsens the fundamentals of countryB. For example, the southeast Asian countries currently under speculativeattack are, to at least some extent, selling similar products in worldexport markets; thus a Thai devaluation tends to depress Malaysian exports,and could push Malaysia past the critical point that triggers a crisis.In the European crises of 1992-3, there was an element of competitive devaluation:depreciation of the pound adversely affected the trade and employment ofFrance, or at least was perceived to do so, and thus increased the pressureson the French government to abandon its own commitment to a fixed exchangerate.
However, even in the European and Asian cases the trade links appearfairly weak; and in the Latin American crisis of 1995 they were virtuallynil. Mexico is neither an important market nor an important competitorfor Argentina; why, then, should one peso crisis have triggered another?
At this point two interesting "rational" explanations forcrisis contagion between seemingly unlinked economies have been advanced(Drazen 1997). One is that countries are perceived as a group with somecommon, but imperfectly observed characteristics. To caricature this position,Latin American countries share a common culture and therefore, perhaps,a "Latin temperament"; but the implications of that temperamentfor economic policy may be unclear. Once investors have seen one countrywith that cultural background abandon its peg under pressure, they mayrevise downward their estimate of the willingness of other such countriesto defend their parities. (A personal observation: in 1982 Latin countriessuffered a crisis which, although it mainly involved dollar-denominateddebt rather than domestic currency, was similar in form and psychologyto currency crises. This crisis quickly spread from Mexico through thewhole area. The Philippines, however, were at first unaffected, even thoughboth the policies and the debt burden were quite as bad as those of Mexico,Argentina, and Brazil; it was not until almost a year after the originalonset that investors seem to have decided that this former Spanish colonywas in fact a Latin rather than an Asian country, and attacked).
Alternatively, one may argue that the political commitment to a fixedexchange rate is itself subject to herding effects. This is perhaps clearestin the European crises: once Britain and Italy have left the exchange ratemechanism, it is less politically costly for Sweden to abandon its pegto the Deutsche mark than it would have been had Sweden devalued on itsown.
One may also argue, of course, that contagion reflects irrational behavioron the part of investors, either because individuals are really irrationalor because money managers face asymmetric incentives. South Korea has fewstrong trade links with the troubled economies of Southeast Asia; yet afund manager who did not reduce exposure in South Korea, then was caughtin a devaluation of the won, might well be blamed for lack of due diligence- after all, Asian currencies have been risky in recent months, haven'tthey?
As in the case of herding in general, there seems to be positive aswell as negative contagion. During the wave of optimism that followed Mexicanand Argentine reforms in the early 1990s, countries that had done littleactual reform, such as Brazil, were also lifted by the rising tide; andthe apparent myopia of markets about Asian risks seems to have been fedby a general sense of optimism about Asian economies in general.
Market manipulation
Scenarios in which crises are generated either by self-fulfilling rationalexpectations or by irrational herding behavior imply at least the possibilityof profitable market manipulation by large speculators. (Krugman 1996 proposesthat such hypothetical agents be referred to as "Soroi"). Supposethat a country is vulnerable to a run on its currency: either investorsbelieve that it will abandon its currency peg if challenged by a speculativeattack, or they simply emulate each other and can therefore be stampeded.Then a large investor could engineer profits for himself by first quietlytaking a short position in that country's currency, then deliberately triggeringa crisis - which he could do through some combination of public statementsand ostentatious selling.
The classic example of this strategy is, of course, George Soros' attackon the British pound in 1992. As argued in the case study below, it islikely that the pound would have dropped out of the exchange rate mechanismin any case; but Soros's actions may have triggered an earlier exit thanwould have happened otherwise.
In addition to being the classic example of how a market manipulatorcan generate a crisis, however, Soros's attack on the pound may be theonly example in recent years. At any rate, it is hard to come up with anyother clear-cut examples. This has not, of course, prevented politiciansfrom blaming market manipulation in general and Soros in particular forcurrency crises, even when there is no evidence that they have played arole.
Why are such engineered speculative attacks rare? One answer is thatthe scope for self-fulfilling crises is actually rather limited: most currenciestend to get attacked soon after it becomes apparent that they are vulnerableto such an attack. As argued earlier, this will happen if a continuingdeterioration in the fundamentals is predictable: knowing that an eventualcollapse of the exchange regime is inevitable, investors will try to anticipatethe collapse, thereby bringing it forward in time, and thus will tend toattack as soon as such an attack can succeed. In Krugman 1996 I also arguethat the existence of Soroi itself tends to advance the date of speculativeattack: since everyone knows that a currency that is vulnerable to a self-fulfillingattack presents a profit opportunity for large players, investors willsell the currency in anticipation that one or another of these playerswill in fact undermine the exchange regime - and in so doing investorswill force the collapse of the regime even without the aid of a Soros.
Of course, if currencies spontaneously collapse as soon as a potentialprofit for Soroi appears, this will eliminate the opportunity for Soroito make profits; but if nobody is playing that game, investors will nolonger expect collapsible currency regimes to be collapsed ... This paradoxis essentially the same as that which arises in the context of strugglesfor corporate control: a takeover attempt will not be profitable if thepotential gains are already in the stock price, but there will be no gainsif there is no takeover attempt. From a modelling point of view this seemsto suggest the absence of any equilibrium, unless one introduces sufficient"noise" into the story. In practical terms we may simply notethat for whatever reason, the success of Soros at making money by provokingthe pound's devaluation seems thus far to have been a one-time event.
4.Case study 1: the ERM crises of 1992-3
In the fall of 1992 massive capital flows led to the exit of Britain,Italy, and Spain from the exchange rate mechanism of the European MonetarySystem. (Strictly speaking, they remained within the system itself). Inthe summer of 1993 a second wave of attacks led to a decision to widenthe exchange rate bands of that system, essentially to allow the Frenchfranc to depreciate without any formal exit. In subsequent years eventshave unfolded in somewhat ironic ways: France, having been given leewayfor a somewhat weaker franc, chose not to use it, returning to the originalnarrow band against the mark; while the boom in the UK economy that followedthe exit from the ERM has now pushed the pound above the rate at whichit originally exited. Still, the ERM crises remain one of the classic episodesof speculative attack, and is the most thoroughly studied such episode.
Part of what makes the ERM crises so classic is that they so clearlydemonstrate the importance of second-, as opposed to first-, generationmodels. The European countries attacked in 1992 and 1993 did not fit thecanonical crisis model at all. In all cases, governments retained fullaccess to capital markets, both domestic and foreign. This meant, firstof all, that they had no need to monetize their budget deficits; and indeedthey did not have exceptionally rapid growth of domestic credit (Eichengreen,Rose, and Wyplosz 1995). It also meant that they were not suffering fromany ironclad limitation on foreign exchange reserves: they remained ableto borrow on foreign markets, and indeed clearly retained the ability tostabilize their currencies had they so chosen simply by raising domesticinterest rates sufficiently. Finally, all of the target economies had lowand stable inflation both before and after the crisis.
What, then, provided the motivation for devaluation that we have seenis a crucial ingredient for second-generation models? The answer was clearlyunemployment due to inadequate demand, and the resulting pressure on monetaryauthorities to engage in expansionary policies - policies that could notbe pursued as long as the countries remained committed to a fixed exchangerate - was the essential fuel for the crises. Essentially we can thinkof European governments as facing a tradeoff between the political costsof unemployment over and above its "structural" or "natural"level, on one side, and the political costs of dropping out of the ERMon the other.
Behind the unemployment problem, in turn, was an unusual situation triggeredby the interaction between the fall of the Berlin Wall and the role ofthe Deutsche mark as the de facto key currency of the European MonetarySystem. The heavy expenditures by Germany on its newly reunited easternLander amounted to an expansionary fiscal policy for Western Germany; theBundesbank, like the Federal Reserve faced with the deficit spending ofthe 1980s, responded with a tight monetary policy. However, other Europeancountries pegging to the mark found themselves obliged to match the tightmonetary policy without the fiscal expansion; thus they were pushed intorecession.
All the ingredients for crisis, then, were in place. However, four specialaspects of the ERM crises should be noted.
First was the role of a large actor - George Soros - in triggering thecrisis. Soros had divined early in the game the possibility of a sterlingdevaluation, and set about discreetly establishing a short position inthe form of a number of short-term credit lines, totalling approximately$15 billion. He was thus in a position to profit from a collapse of theexchange regime, and did in fact attempt by his own sales to precipitatethat collapse. It remains unclear, however, how important a role his actionsactually played; it is arguable that the fundamental reasons for the crisiswould have set it off even without any action on Soros's part. A guessmight be that he advanced the date of the crisis by only a few weeks ormonths.
Second, the crisis demonstrated the near-irrelevance of foreign exchangereserves in a world of high capital mobility. The central banks of bothBritain and Italy had substantial reserves, and were also entitled underERM rules to credit lines from Germany. Thus they were able to engage indirect foreign exchange intervention on a very large scale - Britain appearsto have bought some $50 billion worth of sterling over the course of afew days. However, this intervention was sterilized - that is, it was offsetby open market operations so as to avoid reducing the size of the monetarybase. And it was clearly ineffectual. It became clear that sterling couldbe defended only by a domestic monetary contraction, and after only two(?) days of higher interest rates the Bank of England abandoned the fixedparity.
Third, retrospectives on the ERM crises turn up a surprising fact: thecrises seem to have been virtually unanticipated by the financial markets.Rose and Svensson (1994) show that interest differentials against the targetcurrencies did not begin to widen until August 1992 - a month before thebreakup.
Finally, a remarkable fact about the ERM crises is that the countrieswhich "failed", and were driven off their pegs, did better byalmost any measure in the following period than those that succeeded indefending their currencies. The UK, in particular, experienced a rapiddrop in its unemployment rate without any corresponding rise in inflation.
5.Case study 2: the Latin crises, 1994-5
The Latin crisis of 1994-5 was similar to the ERM crises in some respects,quite different in others. Above all, its consequences were much more severefor the affected economies.
Claims that several Latin currencies, in particular the Mexican andArgentine peso, were common among economists as early as the beginningof 1993 (see, for example, Dornbusch 1993). These claims were based onone or more of three observations: purchasing power parity calculations,which suggested that costs and prices had gotten out of line with thoseof trading partners; large current account deficits; and slow growth (inthe case of Mexico) or high unemployment (in the case of Argentina), suggestingthat there would be room for monetary expansion if only the exchange ratewere not a constraint.
In Latin America, however, as in Europe, these warnings appear to havebeen more or less ignored by financial markets. Government officials wereadamant that devaluation was not under consideration, and the markets believedthem. Through the whole of 1993 interest premia on the pesos remained low,and the current account deficits were easily financed.
Mexico experienced a deteriorating situation over the course of 1994.Political uncertainty emerged following two unexpected events: the peasantrebellion in Chiapas, and the assassination of the ruling party's Presidentialcandidate. The government also appeared to relax monetary and fiscal disciplinein the runup to the presidential election. Foreign capital inflows beganto dry up, and there was a rapid decline in foreign exchange reserves.A critical point was reached when the government found itself unable toroll over thetesobonos, dollar-denominated short-term debt.
Faced with this external pressure, Mexico decided shortly after theelection to devalue the peso. However, the devaluation was botched in severalrespects. First, the size of the devaluation, at 15 percent, was widelyregarded as inadequate; thus the government had sacrificed the credibilityof its commitment to a fixed rate without satisfying markets that the devaluationwas behind it. Second, by consulting business leaders about the plan, thegovernment in effect gave Mexican insiders the opportunity to make profitsat the expense of uninformed foreign investors, helping to discredit thepolicy. Finally, Mexican officials managed to convey a sense of both arroganceand incompetence to foreign investors in the days immediately followingthe devaluation.
Perhaps for these reasons, the initial small devaluation was followedby a near-complete loss of confidence in Mexican policies and prospects.The peso quickly fell to half its pre-crisis value; the resulting spikein import prices caused inflation, which had previously fallen to low single-digitlevels, to soar. In order to stabilize the peso and the inflation rate,the government was obliged to raise domestic interest rates to very highlevels, peaking at above 80 percent. The high rates in turn led to a sharpcontraction in domestic demand, and real GDP fell by 7 percent in the yearfollowing the crisis.
Fears that the crisis would undermine Mexico's political stability ledthe United States to engineer a massive international loan to the Mexicangovernment, hoping to buy a breathing space while confidence was restored.This effort was successful: during 1996 economic growth resumed, and Mexicoregained normal access to international capital markets, repaying the emergencyloan ahead of schedule.
Argentina had initially hoped that its very different currency regime- a currency board system, with the peso rigidly linked to the dollar ata one-for-one parity, and with every peso in the monetary base backed bya dollar of reserves, would protect it from any spillover from the Mexicancrisis. In effect, Argentina had ensured that it was not vulnerable tothe kind of crisis envisaged by the canonical crisis model. Argentina mightalso have expected that the absence of any strong trade linkage with Mexicowould prevent any contagion. However, speculators attacked the currencynonetheless, presumably suspecting that Argentina might abandon the currencyboard in order to reduce the unemployment rate. (We might call this therevenge of the second-generation model).
Under the currency board system, the capital outflows led to a rapiddecline in the monetary base. This, in turn, created a crisis in the bankingsystem, which contributed to a downturn milder than Mexico's but stillextremely severe. International official loans, albeit on a smaller scalethan Mexico's, were needed to prop up the banking system.
In contrast to Mexico, Argentina chose to hang tough on its exchangerate regime, betting that the financial markets would eventually realizethat its commitment was absolute and that the pressure would ease. Andin 1996 Argentina also resumed economic growth.
The Latin crises thus share some common features with the European experiencebut also show some strong differences. The most striking commonality wasthe apparent failure of financial markets to anticipate the crises, oreven give any weight to the possibility of a crisis, until very late inthe game - in spite of widely circulated warnings by economists that suchcrises might be brewing. The most striking difference was in the aftermathof crisis. Suppose that one thinks of Britain and France as representingone matched pair - a country that gave in to the pressure, and one thatdid not - while Mexico and Argentina are another. In the first case thedevaluing country actually did very well post-devaluation (leading to somefacetious suggestions that a statue of George Soros be erected in TrafalgarSquare); the non-devaluing country did less well, but did not suffer anydramatic catastrophe. In the second case both countries suffered almostincredibly severe recessions, but the devaluing country was worse hit,at least initially.
6.Case study 3: Asian crises
The Asian situation is still in flux at the time of writing, informationis still incomplete, and no careful economic studies are yet available.So this can only be a brief and provisional summary.
During 1995 a number of economists had begun to wonder whether the countriesof Southeast Asia might be vulnerable to a Latin-type crisis. The mainobjective indicator was the emergence of very large current account deficits.Closer examination also revealed that several of the countries had developedworrying financial weaknesses: heavy investment in highly speculative realestate ventures, financed by borrowing either from poorly informed foreignsources or by credit from underregulated domestic financial institutions.It is now known that during 1996 officials from the IMF and World Bankactually began warning the governments of Thailand, Malaysia, and othercountries of the risks posed by their financial situation, and urged correctivepolicies. However, these warnings were brusquely rejected by those governments.
As in the case of the other regional currency crises, financial marketsshowed little sign of concern until very late in the game. The extraordinarygrowth record of the region seems to have convinced many that the usualcautions did not apply. (One pension fund manager described to me a briefingon Indonesian prospects by someone from Moody's. Some members of the audiencehad expressed worry about the reliability of the data and the financialreports they had seen. His response was that you should think of it asbeing like a Javanese shadow puppet show - you couldn't actually see thepuppets, but you could see their shadows, and that told the story).
The slide toward crisis began with an export slowdown in the region,partly due to the appreciation of the dollar (to which the target currencieswere pegged) against the yen, partly to specific developments in key industries,partly to growing competition from China. With export growth flagging,the overbuilding of real estate - especially in Thailand - became all tooapparent. In turn, dropping real estate prices pulled down stock pricesand placed the solvency of financial institutions in question.
Up to this point, the developments were mainly a domestic financialcrisis, similar in general outline to the bursting of Japan's "bubbleeconomy" in the early 1990s. During the first half of 1997, however,speculators finally began to wonder whether the financial distress of SoutheastAsian countries, especially Thailand, might provoke them to devalue inthe hope of reflating the economy. The growing suspicion that such a movemight be in prospect, despite government insistence that it was not, ledto widening interest premia; these in turn increased the pressure, bothby adding deflationary impetus and by creating cash flow problems for financiallystressed businesses.
On July 2 Thailand gave in to the pressures and floated the baht; asin the other crises, this led to speculation against other regional currencies,and was followed shortly by somewhat smaller devaluations in Malaysia,Indonesia, and the Philippines. The wave of devaluations, and the troubledfinancial picture revealed by the crisis, shook investor confidence; inan effort to regain that confidence, all of the countries involved haveimposed new fiscal austerity. Thailand received an emergency loan fromthe IMF; part of the conditionality was a cleanup of its financial system.
At this point the real consequences of the crisis are still to be revealed.There seems to be general agreement that Thailand, like Mexico, will sufferan initial blow to its growth. Typical estimates are that it will go fromthe 9 percent average rates of recent years to roughly zero growth overthe next year. The impact on neighboring economies is a subject of considerabledispute, with the IMF predicting only a small impact while many privateeconomists predict much more severe slowdowns.
At this point it remains unclear how far the contagion will spread.South Korea is the most interesting case: it has severe internal financialproblems and a massive current account deficit, but has few real linkagesto the Southeast Asian economies. At the time of writing there does notseem to have been any pressure on China, even though the giant nation isreported to have massive quantities of bad internal debt.
An interesting counterpoint to the Latin experience is provided by HongKong, which like Argentina has a currency board and is pegged to the U.S.dollar (and intends to remain that way, even though it is politically nowpart of China). After a brief probing, financial markets seem to have decidedthat the HK dollar is not at risk, and what is now the Special AdministrativeRegion thus seems to have insulated itself from the crisis.
The most peculiar aspect of the Asian crisis has been the reaction ofsome of the region's leaders. Malaysia's Prime Minister, Mahathir bin Mohamed,has taken the lead, blaming the crisis on the conspiratorial activitiesof George Soros (whom he has described as a "moron"), promptedby U.S. government officials. Unless new evidence surfaces, this claimis even odder than it sounds: as far as market participants are aware,Soros was not even a player in this crisis, and indeed seems to have guessedwrong, buying Malaysian ringgit. Mahathir temporarily imposed limits onstock trading intended to stop the alleged conspiracy, and has made publiccalls for an end to currency trading that have made financial markets understandablynervous that he might try to impose capital controls.
7.Macroeconomic questions
Although the currency crises of the 90s have inspired a good deal ofresearch, one area remains neglected. What are the macroeconomic impactsof crisis, and why in particular have they differed so much between episodes?
The quick review of the main episodes in the decade to date indicatespretty clearly that crises in the 90s are best described by "second-generation"models - that is, the motives for devaluation lie in the perceived needfor more expansionary monetary policies rather than in budget deficitsand inflation. One might therefore suppose that when a country gives into temptation it would receive a reward - that whatever the cost in politicalcapital or long-term inflation credibility, there would at least be a payoffin terms of short-run economic expansion. And this was exactly what happenedin the European crises; indeed, those countries that abandoned their principlesseem to have gone completely unpunished.
In the Latin crisis, however, and at least as far as we can tell inthe Asian crises, the decision to devalue seems to have led to seriousadverse short-run consequences on all fronts. Instead of permitting reflation,the devaluations seem to have led to even more severe contraction. Why?And why has the experience been so different?
Systematic attempts to answer these questions are still lacking (althoughpapers prepared for the NBER's conference on currency crises, taking placethis February, may supply some answers). A quick conjecture is that thekey difference was how well informed markets were about the policy environmentin the respective sets of countries. A British devaluation, while it mayhave shattered the credibility of the current Chancellor of the Exchequer,did not shake confidence in British institutions in general; markets stillhad full confidence that the government of the UK would continue to allowfree markets to function, that it would honor its debts, that the Bankof England would continue to worry about inflation, and so on. Thus oncethe pound had depreciated substantially, markets were prepared to believethat investment in Britain was actually a good bet.
In Mexico, by contrast, the devaluation made markets question the wholepremise that the country was now run by reliable, reformist technocrats.As the crisis deepened, so did concerns that a backlash against the reformerswould lead to a return to dirigiste policies - and these concerns, by promotingfurther capital flight, deepened the crisis. One might summarize Mexico'ssituation in 1995 as one in which the country had to offer very high interestrates to offset the nervousness of investors about the country'spoliticalfuture - and in which that nervousness was largely the result of concernabout the political damage inflicted by high interest rates. The rescuepackage organized by the U.S. may be seen as an attempt to break this viciouscircle.
The Asian crisis, like that in Latin America, seems to have shaken basicconfidence in the countries much more than the crisis in Europe. Investorsare now emphasizing weaknesses in the political and institutional environment- lax bank regulation, widespread corruption, grandiose policies - thatwere obvious even to casual observers before this year, but which werebrushed off as minor blemishes on the Asian miracle until that miraclehit a speed bump.
At this point, however, this is merely loose speculation. More carefulanalyses are badly needed.
8.Can currency crises be prevented?
A world in which major currency crises occur at an average rate of oneevery 19 months is not a very comfortable one for economic policymakers.What, if anything, can be done to prevent them, or at least to keep themfrom happening so often?
One possibility would be to return to the world of the early 1960s,an era in which extensive capital controls prevented the massive flowsof hot money that now drive crises. Something like this seems to be whatMahathir is proposing, but nothing along these lines seems likely in thenear future.
Another possibility would simply be for countries to follow sound andconsistent policies, so that they are not attacked by speculators. Thereis a lot to be said for this; many crises do seem to be the result of obviousinconsistencies between the domestic policies of a country and its exchangeregime. However, the main point of second-generation models may be statedthis way: the real cause of currency crises is not so much what you areactually doing, as what the financial markets suspect you mightwantto do. Britain's monetary policy as a member of the ERM was impeccablycorrect; but Soros and others correctly suspected that when push came toshove the government would choose employment over the exchange rate. Inorder to have prevented such an attack, the British government would havehad to change not its policies, but its preferences.
This point also explains why institutional arrangements like currencyboards do not offer secure protection against speculative attack. A currencyfully backed by reserves means that one cannot be mechanically forced todevalue; but it does nothing to prevent you from choosing to devalue, evenif you have insisted that you will not and have up until now pursued policiesconsistent with a fixed rate.
Incidentally, these considerations have considerable bearing on Europeanprospects. It now appears very likely that a core group of European countrieswill formally enter European Monetary Union at the beginning of 1999, andthey may well lock the parities as early as May 1998. However, actual euronotes will not replace national currencies for several years. As a growingnumber of commentators have noticed, this means that it will still be technicallyquite possible for a country to drop out of EMU during this interim period- which means that currency crises are quite possibleafter EMUsupposedly has gone into effect.
How can a country ensure that it will not give in to speculative attack?It can attempt to raise the stakes, by placing the prestige of the governmenton the line; it can sign solemn treaties; and so on. The only absolutelysure-fire way not to have one's currency speculated against, however, isnot to have an independent currency. True monetary union is one answerto the problem of currency crisis.
The other answer is simply not to offer speculators an easy target,by refusing to defend any particular exchange rate in the first place.Once a country has a floating exchange rate, any speculative concerns aboutits future policies will already be reflected in the exchange rate. Thusanyone betting against the currency will face a real risk, rather thanthe one-way option in speculating against a fixed rate.
Reasoning along these lines has convinced a number of economists workingon currency crises that the ultimate lesson of the crisis-ridden 90s isthat countries should avoid halfway houses. They should either float theircurrencies, or join currency unions. It remains to be seen whether thisstark recommendation will survive closer scrutiny.
REFERENCES
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