Review of Theories of Financial Crises Currency Crises

Review of Theories of Financial Crises: Currency Crises By Itay Goldstein and Assaf Razin June 2013

Scope � The last few years have been characterized by a great turmoil in the world’s financial markets � These events exhibit ingredients from all types of financial crises in recent history: ◦ Banking crises ◦ National currency and single currency area crises ◦ Credit frictions ◦ Market freezes ◦ Asset bubbles: booms and Busts ◦ Sovereign Debt Crises cum Eurocrisis 2

Financial and Monetary institutions --Enable the efficient transmission of resources from savers to the best investment opportunities. � � --Provide risk sharing possibilities, so that investors can take more risk and advance the economy. � � � --Enable aggregation of information that provides guidance for more efficient investment decisions. � --Monetary arrangements, such as the European � Monetary Union (EMU) are created to facilitate free trade and financial transactions among countries, thereby improving real efficiency. 3

Financial Crisis �A financial crisis marks a severe disruption of these normal functions of financial and monetary systems, thereby hurting the normal functioning of the real economy. 4

Financial Fragility � The models reviewed here describe situations in which financial systems are fragile and prone to crises. � Main problems: Agency problems Those who are making the decisions might not fully reflect the interests of those on whose behalf they were supposed to be acting. ◦ Coordination failures e. g. , Banks rely on the fact that only forecastable fraction of depositors will have short term liquidity needs. But there is self fulfilling equilibrium where all depositors demand early withdrawal. ◦ Strategic Complementarities E. g. , When more depositors withdraw their money the bank is more likely to fail and so other depositors have a stronger incentive to withdraw. 5

◦ Principal-Agent moral hazard e. g. , The borrower has the ability to divert resources to himself at the expense of the creditor. This creates a limit on credit. The limit can get tightens when economic conditions worsen. ◦ Risk Shifting e. g. , An investor who borrow to buy assets benefits from the upside while having limited exposure to the downside risk. ◦ Heterogeneous beliefs and leverage e. g. , where the optimists-pessimists composition in the investor population shifts endogenously leverage bubbles are created and burst. ◦ Fragile institutional of monetary and exchange rate arrangements ◦ E. g. European Monetary System 6

Currency Crises � Governments/central banks try to maintain certain financial and monetary arrangements, most notably a fixed-exchange rate regime, or more recently, a regional monetary union. Their goal is to stabilize the economy or the region. � At times, these arrangements become unstable and collapse leading to debt crises and banking crises � The strand of the literature analyzes currency crises characterized by a speculative attack on a fixed exchange rate regime. The newer strand emphasizes banking and fiscal union as a backstop to single currency area crises. 7

The International-Finance Tri. Lemma � A tri-lemma is a situation in which someone faces the choice among three options, each of which comes with some inevitable choices because not all the three can be simultaneously accomplished. 8

Monetary Policy Options First, make the country’s economy open to international capital flows, because by doing so they let investors diversify their portfolios overseas and achieve risk sharing. They also benefit from the expertise brought to the country by foreign investors. � Second, use an independent monetary policy as a tool to help stabilize inflation, output, and the financial sector in the economy. This is achieved as the central bank can increase the money supply and reduce interest rates when the economy is depressed, and reduce money growth and raise interest rates when it is overheated. Moreover, it can serve as a lender of last resort in case of financial panic. 9

Options � Third, maintain stability in the exchange rate. This is because a volatile exchange rate, at times driven by speculation, can be a source of broader financial volatility, and makes it harder for households and businesses to trade in the world economy and for investors to plan for the future. 10

Fixed exchange rate and capital mobility � By attempting to maintain a fixed exchange rate and capital mobility, the central bank loses its ability to control the interest rate or equivalently the monetary base – its policy instruments – as the interest rate becomes anchored to the world interest rate by the interest rate parity and the monetary base is automatically adjusted. This is the case of individual members of the EMU. 11

Monetary Control and Capital Mobility In order to keep control over the interest rate or equivalently the money supply, the central bank has to let the exchange rate float freely, as in the case of the US. � 12

Exchange Rate Stability and Monetary Control � If the central bank wishes to maintain both exchange rate stability and control over the monetary policy, the only way to do it is by imposing domestic credit controls and international capital controls, as in the case of China. 13

Currency Crises and the Tri. Lemma � Currency crises occur when the country is trying to maintain a fixed exchange rate regime with capital mobility, but faces conflicting policy needs, such as fiscal imbalances or fragile financial sector, that need to be resolved by independent monetary policy, and effectively shift the regime from the first solution of the tri-lemma described above to the second solution and the tri-lemma. 14

First-Generation Models of Currency Crises � This branch of models, the so-called ‘first generation models of currency attacks’ was motivated by a series of events where fixed exchange rate regimes collapsed following speculative attacks, for example, the early 1970 s breakdown of the Bretton Wood global system. � The first paper here is the one by Krugman (1979). � He describes a government that tries to maintain a fixed exchange rate regime, but is subject to a constant loss of reserves, due to the need to monetize government budget deficits. 15

First-Generation Model of Currency Crises � These two features of the policy are inconsistent with each other, and lead to an eventual attack on the reserves of the central bank, that culminate in a collapse of the fixed exchange rate regime. � Flood and Garber (1984) extended and clarified the basic mechanism, suggested by Krugman (1979), generating the formulation that was widely used since then. 16

A First-Generation Model of Currency Crises � Recall that the asset-side of the central bank’s balance sheet at time t is composed of domestic assets BH, t � the domestic-currency value of foreign assets St. BF, t � where St denotes the exchange rate, i. e. , the value of foreign currency in terms of domestic currency. � The total assets have to equal the total liabilities of the central bank, which are, by definition, the monetary base, denoted as Mt. 17

Currency Crises . First-Generation Model of Currency Crises � Due to fiscal imbalances, the domestic assets grow in a fixed and exogenous rate: � Because of perfect capital mobility, the domestic interest rate is determined through the interest rate parity, as follows: � Where it denotes the domestic interest rate at time t and it* denotes the foreign interest rate at time t. 18

Currency Crises First-Generation Model of Currency Crises � The supply of money, i. e. , the monetary base, has to be equal to the demand for money, which is denoted as L(it), a decreasing function of the domestic interest rate. � The inconsistency between a fixed exchange rate regime: with capital mobility, and the fiscal imbalances, comes due to the fact that the domestic assets of the central bank keep growing, but the total assets cannot change since the monetary base is pinned down by the demand for money, L(it*), which is determined by the foreign interest rate it* 19

Currency Crises First-Generation Model of Currency Crises � Hence, the obligation of the central bank to keep financing the fiscal needs, puts downward pressure on the domestic interest rate, which, in turn, puts upward pressure on the exchange rate. � In order to prevent depreciation, the central bank has to intervene by reducing the inventory of foreign reserves. � Overall, decreases by the same amount as BH, t increases, so the monetary base remains the same. 20

Currency Crises First-Generation Model of Currency Crises � The problem is that this process cannot continue forever, since the reserves of foreign currency have a lower bound. � Eventually, the central bank will have to abandon the solution of the tri-lemma through a fixed exchange rate regime and perfect capital mobility to a solution through flexible exchange rate with flexible monetary policy (i. e. , flexible monetary base or equivalently domestic interest rate) and perfect capital mobility. 21

Currency Crises First-Generation Model of Currency Crises � The analytical question is what is the critical level of domestic assets BH, T , and the corresponding period of time T, at which the fixed-exchange rate regime collapses. � This happens when the (conditionally) expected shadow exchange rate – -defined as the flexible exchange rate under the assumption that the central bank’s foreign reserves reached their lower bound while the central bank keeps increasing the domestic assets to accommodate the fiscal needs – -is equal to the pegged exchange rate. 22

Second-Generation Model of Currency Crises � Following the collapse of the ERM in the early 1990 s, which was characterized by the tradeoff between the declining activity level and abandoning the exchange rate management system, the so-called first-generation model of currency attacks did not seem suitable any more to explain the ongoing crisis phenomena. � This led to the development of the so-called ‘second generation model of currency attacks, ’ pioneered by Obstfeld (1994, 1996). 23

Currency Crises Second-Generation Model of Currency Crises � A basic idea here is that the government’s policy is not just on ‘automatic pilot’ like in Krugman (1979) above, but rather that the government is setting the policy endogenously, trying to maximize a well-specified objective function, without being able to fully commit to a given policy. � In this group of models, there are usually self-fulfilling multiple equilibria, where the expectation of a collapse of the fixed exchange rate regime leads the government to abandon the regime. � This is related to the Diamond and Dybvig (1983) model of bank runs, creating a link between these two strands of the literature. 24

Currency Crises Second-Generation Model of Currency Crises � Obstfeld (1996) discusses various mechanisms that can create the multiplicity of equilibria in a currency-crisis model. Let us describe one of them, which is inspired by Barro and Gordon (1983). � Suppose that the government minimizes a loss function of the following type: � Here, y is the level of output, y* is the target level of output, and ε is the rate of depreciation, which in the model is equal to the inflation rate. 25

Currency Crises Second-Generation Model of Currency Crises � Hence, the interpretation is that the government is in a regime of zero depreciation (a fixed exchange rate regime). Deviating from this regime has two costs. � The first one is captured by the index function in the third term above, which says that there is a fixed cost in case the government depreciates the currency. � The second one is captured by the second term above, saying that there are costs to the economy in case of inflation. 26

Currency Crises Second-Generation Model of Currency Crises � But, there is also a benefit: the government wishes to reduce deviations from the target level of output, and increasing the depreciation rate above the expected level serves to boost output, via the Philips Curve. � This can be seen in the following expression, specifying how output is determined: � Here, is the natural output, u is a random shock, and is the expected level of depreciation/inflation that is set endogenously in the model by wage setters based on rational expectations 27

Currency Crises Second-Generation Model of Currency Crises � The idea is that an unexpected inflationary shock boosts output by reducing real wages and increasing production. � Importantly, the government cannot commit to a fixed exchange rate. Otherwise, it would achieve minimum loss by committing to ε=0. � However, due to lack of commitment, a sizable shock u will lead the government to depreciate and achieve the increase in output bearing the loss of credibility. 28

Currency Crises Second-Generation Model of Currency Crises � Going back to the tri-lemma discussed above, a fixed exchange rate regime prevents the government from using monetary policy to boost output, and a large enough shock will cause the government to deviate from the fixed exchange rate regime. � It can be shown that the above model generates multiplicity of equilibria. If wage setters coordinate on a high level of expected depreciation/inflation, then the government will validate this expectation with its policy by depreciating more often. 29

Currency Crises Second-Generation Model of Currency Crises � If they coordinate on a low level of expected depreciation, then the government will have a weaker incentive to deviate from the fixed exchange rate regime. � Hence, a depreciation becomes a self-fulfilling expectation. � Similarly, one can describe mechanisms where speculators may force the government to abandon an existing fixedexchange rate regime by attacking its foreign currency reserves and making the maintenance of the regime too costly. If many speculators attack, the government will lose many reserves, and will be more likely to abandon the regime. 30

Currency Crises Second-Generation Model of Currency Crises � A self-fulfilling speculative attack is profitable only if many speculators join it. � Consequently, there is one equilibrium with a speculative attack and a collapse of the regime, and there is another equilibrium, where these things do not happen. � Similarly, speculators can attack government bonds demanding higher rates due to expected sovereign-debt default, creating an incentive for the central bank to abandon a currency regime and reduce the value of the debt. 31

Currency Crises Second-Generation Model of Currency Crises � As argued by Paul De Grauwe (2011), the problem can become more severe for countries that participate in a currency union since their governments do not have the independent monetary tools to reduce the cost of the debt. � Morris and Shin (1998) applied global games methods to tackle the problem of multiplicity of equilibrium in the second-generation models of speculative attacks. 32

Currency Crises Second-Generation Model of Currency Crises � Using the global-game methodology, pioneered by Carlsson and van Damme (1993), they are able to derive a unique equilibrium, where the fundamentals of the economy uniquely determine whether a crisis occurs or not. This enabled them to ask questions as to the effect of policy tools on the probability of a currency attack. 33

Third generation Currency Crises models While the 1 st and 2 nd generation currency � crisis literature focused on the government alone, the ‘Third-generation’ models connect currency crises to models of banking crises and credit frictions. 34

Twin Crises � In the late 1990 s, a wave of crises hit the emerging economies in Asia, including Thailand, South Korea, Indonesia, Philippines, and Malaysia. A clear feature of these crises was the combination of the collapse of fixed exchange rate regimes, capital flows, financial institutions, and credit This led to extensive research on the interplay between currency and banking crises, sometimes referred to as the twin crises, and balance sheet effects of depreciations For a broad description of the events around the crisis, see Radelet and Sachs (1998). The importance of capital flows was anticipated by Calvo (1995). 35

Currency mismatch between their assets and liabilities � One of the first models to capture this joint problem was presented in Krugman (1999). � In his model, firms suffer from a currency mismatch between their assets and liabilities: their assets are denominated in domestic goods and their liabilities are denominated in foreign goods. � Then, a real exchange rate depreciation increases the value of liabilities relative to assets, leading to deterioration in firms’ balance sheets. 36

Add Credit Frictions � Because of credit frictions as in Holmstrom and Tirole (1997), described in the next section, this deterioration in firms’ balance sheets implies that they can borrow less and invest less. � The novelty in Krugman’s paper is that the decrease in investment validates the real depreciation in the generalequilibrium setup. � This is because the decreased investment by foreigners in the domestic market implies that there will be a decrease in demand for local goods relative to foreign goods, leading to real depreciation. 37

Multiple Equilibrium � Hence, the system has a multiple equilibrium with high economic activity, appreciated exchange rate, and strong balance sheets in one equilibrium, and low economic activity, depreciated exchange rate, and weak balance sheets in the other equilibrium. � Other models that extended and continued this line of research include: Aghion, Bacchetta, and Banerjee (2001), Caballero and Krishnamurthy (2001), and Schneider and Tornell (2004). The latter fully endogeneize the currency mismatch between firms’ assets and liabilities. 38

Third-Generation Model of Currency Crises � The global-game methodology, relying on heterogeneous information across speculators, also brought to the forefront the issue of information in currency-attack episodes, leading to analysis of the effect that transparency, signaling, and learning can have on such episodes (e. g. , Angeletos, Hellwig, and Pavan (2006)). 39

Bank Runs and Currency Crises � Chang and Velasco (2001) and Goldstein (2004) model the vicious circle between bank runs and speculative attacks on the currency. � On the one hand, the expected collapse of the currency worsens banks’ prospects, as they have foreign liabilities and domestic assets, and thus generates bank runs, as described in the previous section. Bank runs are more likely in a currency union without a single-currency-wide bank union, or the ability of the central bank to act as a lender of last resort for sovereign debt. 40

Circular relationship between currency crises and banking crises On the other hand, the collapse of the banks leads to capital � outflows that deplete the reserves of the government, encouraging speculative attacks against the currency. � Accounting for the circular relationship between currency crises and banking crises complicates policy analysis. For example, a lender-of-last-resort policy or other expansionary policies during a banking crisis might backfire as it depletes the reserves available to the government, making a currency crisis more likely, which in turn might further hurt the banking sector that is exposed to a currency mismatch. 41

Contagion of Currency Crises � The forceful transmission of crises across countries generated a large literature of international financial contagion. � Kaminsky, Reinhart, and Vegh (2003) provide a nice review of theories behind such contagion. They define contagion as an immediate reaction in one country to a crisis in another country. � There are several theories that link such contagion to fundamental explanations. 42

Contagion of Currency Crises � The clearest one would be that there is common information about the different countries, and so the collapse in one country leads investors to withdraw out of other countries. For a broader review, see the collection of articles in Claessens and Forbes (2001). � Calvo and Mendoza (2000) present a model where contagion is a result of learning from the events in one country about the fundamentals in another country. 43

Contagion of Currency Crises � They argue that such learning is likely to occur when there is vast diversification of portfolios, since then the cost of gathering information about each country in the portfolio becomes prohibitively large, encouraging investors to herd. � Another explanation is based on trade links (see e. g. , Gerlach and Smets (1995)). � If two countries compete in export markets, the devaluation of one’s currency hurts the competitiveness of the other, leading it to devalue the currency as well. A third explanation is the presence of financial links between the countries. 44

Currency Crises: Contagion � In Kodres and Pritsker (2002), investors optimize their portfolio allocation. � A decrease in the share of their portfolio held in one country due to a crisis, leads them to rebalance by reducing their holding in another country, and hence causes co-movement in prices. � In Allen and Gale (2000), different regions insure each other against excessive liquidity shocks, but this implies that a shock in one region is transmitted to the other region via the insurance linkage. 45

Currency Crises Contagion of Currency Crises � Empirical evidence has followed the above theories of contagion. � The common information explanation has vast support in the data. � Several of the clearest examples of contagion involve countries that appear very similar. Examples include the contagion that spread across East Asia in the late 1990 s and the one in Latin America in the early 1980 s. A vast empirical literature provides evidence that trade links can account for contagion to some extent. 46

Currency Crises Contagion of Currency Crises � These include Eichengreen, Rose, and Wyplosz (1996) and Glick and Rose (1999). � Others have shown that financial linkages are also empirically important in explaining contagion. For example, Kaminsky, Lyons, and Schmukler (2004) have shown that US-based mutual funds contribute to contagion by selling shares in one country when prices of shares decrease in another country. � Caramazza, Ricci, and Salgado (2004), Kaminsky and Reinhart (2000) and Van Rijckeghem and Weder (2003) show similar results for common commercial banks. 47

Single Currency Area: Theory In the 1960 s, a new concept emerged in international macroeconomics: optimum currency area theory. � � The question it sought to answer: when should countries adopt a common � currency? � Recall that by adopting a common currency, countries would give up much of their policy independence; the question was how costly that would be, and how large are the benefits. � � One variant, pushed by Ronald Mc. Kinnon, stressed the amount of trade; the more two countries trade, the bigger the advantages of not having to change currencies, and arguably, also, the less adjustment is needed to correct trade imbalances. Another (actually the first paper on the subject), by Robert Mundell, stressed labor mobility: you don’t need as much policy independence if unemployed workers can move to where the jobs are. A third, stressed by my late colleague Peter Kenen, stressed fiscal integration: if countries or regions share common budgets for major programs, there will be a lot of automatic compensation for “asymmetric shocks”. � � 48

Public debt denominated in own, or in foreign, currency � Paul De Grauwe notes that the benefits of retaining a currency on one’s own manifest in the post-crisis interest rates paid on long-term public debt: The ratio of net public debt to gross domestic � product of the UK and Spain are essentially identical. (IMF forecasts that in 2017, the ratio is 93 per cent for the UK and 95 per cent for Spain. ) Yet the yield on UK 10 -year bonds is firmly under 2 � per cent – among the lowest in UK history, and not much above Germany’s; but the yield on Spanish 10 year bonds, meanwhile, is about 5 per cent. 49

Lender of last resort � The ability and desire of the Bank of England to prevent outright default is more credible than that of the ECB: an independent, supranational central bank. The Bo. E, as lender of last resort, also � promises market liquidity. If the market for public debt is subject to self-fulfilling prophecies of good or bad outcomes, this should guarantee more stability at favorable rates. 50

Banks and Governments Central Banks were given double task: � �Lender of last resort for banks: � backstop to counter panic and run on banks. �Lender of last resort to governments: � to counter run on government bond markets � � 51

Banks and Governments Banks and governments face similar problem: � unbalanced maturity structure of assets and liabilities �Making both banks and governments vulnerable for movements of distrust, which will lead to liquidity crisis, and can degenerate into solvency crisis. � � When banks collapse sovereign is in trouble � When government collapses banks are in trouble � 52

A Need for Fiscal Union The fiscal union aspect comes in because of the need to have government budget as shock absorber based on Keynes’ savings paradox: �When after crash private sector has to de-leverage. It does two things �It tries to save more. � �It sells assets. � �Private sector can only save more if government � sector borrows more (i. e. higher budget deficit) �But, if government also tries to save more, attempts to save more by private sector are self-defeating. The economy is pulled into deflationary spiral. � � � 53

Eurozone: Stabilizers are organized at national levels These stabilizing features relatively well organized at the � level of countries (US, UK, France, Germany), but, not at international level nor at the level of a monetary union like the Eurozone �These EMU design failures were only recognized after the � financial crisis, also because Optimum Currency Area Theory was pre-occupied with exogenous shocks, but not with an endogenous dynamics �And even then in many countries, especially in Northern � Europe the point is still not recognized because of dramatic diagnostic failure, focusing on government profligacy; giving rise to austerity policy during the deleveraging period. 54

Features that magnify private‐ and public‐sector financial fragility within the euro zone Financial integration undermines the ability of individual member governments credibly to backstop their national banking systems through purely fiscal means. Within the euro zone the key functions of bank regulations, depositor insurance, bank resolutions and fiscal policy remained national. � � � In the absence of national discretion over � last‐resort lending, money creation, and the exchange rate. � 55

A Fiscal Tri-lemma Obstfeld proposes a fiscal trilemma for the � euro zone: One cannot simultaneously maintain all three: (1) Cross‐border financial integration (2) Financial stability � (3) National fiscal independence. � � 56

Financial integration and financial stability with external fiscal support If countries are financially integrated, � they simply cannot credibly backstop their � financial systems without the certainty of external fiscal support, either directly (from partner country treasuries) or indirectly (through monetary financing from the union‐wide central bank); thus sacrificing national fiscal independence. 57

Alternatively, a country reliant mainly on its own fiscal resources will likely sacrifice financial integration as well as stability, because markets will then assess financial risks along national lines. 58

Financial repression to minimize financial fragility Voluntary withdrawal from the single financial market might allow a country with limited fiscal space to control and insulate its � financial sector enough to minimize fragility. � 59

Fragility of government bond market in a monetary union Governments of member states cannot guarantee to bond holders that cash would always be there to pay them out at maturity; in contrast with stand-alone countries that give this implicit guarantee, because they can and will force central bank to provide liquidity (There is no limit to money creating capacity) � 60

Self-fulfilling Sovereign Debt crises This lack of implicit guarantee to government debt can trigger liquidity crises. � � Because, (1) distrust by market leads to bond sales, and interest rate increases. (2) Liquidity is withdrawn from national markets, moving to safe havens. Government, unable to rollover debt, is forced to introduce immediate and intense austerity, producing deep recession and Government Debt to GDP ratio increases. � � � 61

In 2012 ECB has acted On September 6, 2012 ECB announced it will � buy unlimited amounts of government bonds. �Program is called “Outright Monetary � Transactions” (OMT) �Large parts of the euro area were in a bad � equilibrium in which self-fulfilling expectations were feeding on themselves. 62

Outright Monetary Transactions European Central Bank’s promises to � intervene via a program called outright monetary transactions (OMT). But, OMT is still less credible than lending of last resort by national central bank because in the context of supranational EMU institution there is no similar institution which provides a Eurozone fiscal backing. 63

Concluding Remarks

Far From a Fiscal Union: Austerity in the periphery to offset by stimulus in the core? � Source: IMF � � 65

Thank you