Currency crisis

A currency crisis, which is also called a balance-of-payments crisis, is a sudden devaluation of a currency which often ends in a speculative attack in the foreign exchange market. A currency crisis may result from chronic balance-of-payments deficits or from market speculation about the ability of a government to back its currency. Currency crises usually affect fixed exchange rate regimes, rather than floating regimes.

A currency crisis is a type of financial crisis, and is often associated with a real economic crisis. Currency crises can be especially destructive to small open economies or bigger, but not sufficiently stable ones. Governments often take on the role of fending off such attacks by satisfying the excess demand for a given currency using the country's own currency reserves or its foreign reserves (usually in the United States dollar, Euro or Pound sterling). Currency crises have large, measurable costs on an economy, but the ability to predict the timing and magnitude of crises is limited by theoretical understanding of the complex interactions between macroeconomic fundamentals, investor expectations, and government policy.

Recessions attributed to currency crises include the 1994 economic crisis in Mexico, 1997 Asian Financial Crisis, 1998 Russian financial crisis, and the Argentine economic crisis (1999-2002).

Theories

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

First generation

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

Second generation

The 'second generation' of models of currency crises starts with the paper of Obstfeld (1986). In these models, doubts about whether the government is willing to maintain its exchange rate peg lead to multiple equilibria, suggesting that self-fulfilling prophecies may be possible, in which the reason investors attack the currency is that they expect other investors to attack the currency.

Third generation

'Third generation' models of currency crises have explored how problems in the banking and financial system interact with currency crises, and how crises can have real effects on the rest of the economy.

McKinnon & Pill (1996), Krugman (1998), Corsetti, Pesenti, & Roubini (1998) suggested that "over borrowing" by banks to fund moral hazard lending was a form of hidden government debts (to the extent that governments would bail out failing banks).

Radelet & Sachs (1998) suggested that self-fulfilling panics that hit the financial intermediaries, force liquidation of long run assets, which then "confirms" the panics.

Chang and Velasco (2000) argue that a currency crisis may cause a banking crisis if local banks have debts denominated in foreign currency,

Burnside, Eichenbaum, and Rebelo (2001 and 2004) argue that a government guarantee of the banking system may give banks an incentive to take on foreign debt, making both the currency and the banking system vulnerable to attack.

Krugman(1999) suggested another two factors, in an attempt to explain the Asian financial crisis: (1) firms' balance sheets affect their ability to spend, and (2) capital flows affect the real exchange rate. (He proposed his model as "yet another candidate for third generation crisis modeling" (p32)). However, in his model, banking system plays no role. His model led to the policy prescription: impose a curfew on capital flight which was implemented by Malaysia during the Asian financial crisis.

See also

• Alter-globalization
• ATTAC (Association for the Taxation of Financial Transactions for the Aid of Citizens)
• Central banks - which issue currency
• Currencies
• Currency transaction tax
• Economic collapse
• Exorbitant privilege
• Financial markets
• Financial transaction tax
• Fluctuation in exchange rates
• Foreign exchange controls
• Foreign exchange market
• Global Justice Movement
• Jubilee 2000
• Liquidity crisis
• Money Market
• Paul Bernd Spahn
• Spahn tax
• Speculation
• Speculative attack
• Sudden stop (economics)
• Speculation in foreign exchange markets
• Tobin tax

Related economic crises

• 1994 economic crisis in Mexico
• 1997 Asian Financial Crisis
• 1998 Russian financial crisis
• Argentine economic crisis (1999–2002)
• Financial crisis of 2007–2010

External links

• Mindmapping for Economic Crises