Financial Crisis: How and Why It Happens

Financial Crises: How and Why and Lessons

Recent Major Financial Crises

1980’s: Debt crisis for developing countries (Latin America and Africa)

1992: European Exchange Rate Mechanism (especially UK and Sweden)

1994-95: Mexico (Tequila crisis) and Argentina

1997-98: Asian financial crisis (Thailand, Indonesia, Korea, Philippines, Malaysia)

1998: Russia

1999: Brazil

2000-02: Turkey

2001-02: Argentina (again)

Nature of Financial Crises

Exchange rate crises

Sudden, drastic depreciation of the country’s currency

Banking crises

Depositors lose confidence (disintermediation)

Banks can’t perform lending function

Effects

Severe recession, due to:

Collapse of bank loans

Reduction in consumer demand

Higher interest rates

Inflation, due to:

Higher import costs

Causes of Financial Crises:

1. Macroeconomic Imbalances

Where: Russia 1999, Brazil 1999, Turkey 2000, Argentina 2001

Characteristics of imbalances:

Causes of Macroeconomic Imbalances

High government spending (G) due to:

Public subsidies for businesses

Infrastructure spending

Lack of fiscal discipline

Insufficient tax revenues (T) due to:

Poorly developed tax systems

Lack of tax enforcement

Money supply (M) growth too high due to:

Lack of independence of central bank

Political pressure on central bank to accommodate fiscal deficits

Pressure on Exchange Rates

CA deficit and inflation cause pressure in forex markets on currency to depreciate.

Government does not want that due to:

Higher import costs

Loss of prestige

Government tries to keep currency from depreciating too fast:

By raising interest rates domestically

By using foreign reserves to buy its currency back

But this creates problems:

Higher interest rates slow the domestic economy

Loss of foreign reserves

Loss of Confidence

Foreigners stop lending

Speculators think the currency will depreciate further

Domestic owners of financial capital move that capital out of the country (capital flight)

Causes of Financial Crises:

2. Capital Flow Volatility

Where: Mexico 1994, Asia 1997-98

Characteristics