Krugman 1984
Oday Forster
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.
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 crisesclearly do 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.
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