By Itay Goldstein and Assaf RazinJune 2013

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

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--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 .

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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.

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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.

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◦ 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

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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 1970s

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.

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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.

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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 StBF,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.

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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.

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.

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*

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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.

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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.

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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.

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Following the collapse of the ERM in the early 1990s, 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).

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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.

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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.

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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.

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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

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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.

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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.

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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 fixed-

exchange 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.

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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.

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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.

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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.

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

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In the late 1990s, 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).

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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.

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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 general-

equilibrium 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.

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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.

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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)).

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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.

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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.

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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 the 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.

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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.

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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.

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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.

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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 1990s and

the one in Latin America in the early 1980s. A vast empirical

literature provides evidence that trade links can account for

contagion to some extent.

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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.

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In the 1960s, 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 McKinnon, 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.”

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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.

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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 BoE, 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 .

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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

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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

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The fiscal union aspect comes in because of the need to have government budget as shock absorber based on Keynes’ savings paradox 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 .

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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 de-leveraging period .

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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

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 .

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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 .

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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 .

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.

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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 )

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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.

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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 .

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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.

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Source: IMF 

 

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