International Economics Update
May 2002
Copyright (C) 2002 The International Economics Network
http://www.internationaleconomics.net

Marginal Notes.

A rational choice approach to the Asian financial crisis would begin with the assumption that the actors involved in the financial crisis are utility maximizing; they respond to incentives, being limited by (more often than not) monetary constraints. As aptly summarized by Levi (1988), the central hypothesis is that (p.2):

"...[R]ulers maximize the revenue accruing to the state subject to the constraints of their relative bargaining power, transactions costs, and discount rates. Relative bargaining power is defined by the degree of control over coercive, economic, and political resources. Transactions costs are the costs of negotiating an agreement on policy and the costs of implementing policy. The discount rate refers to the time horizon of a decision maker. The more an individual values the future relative to the present, the lower the discount rate." (p. 2)

In the present context, one possible interpretation of players are currency speculators, such as financier George Soros,[1] and central banks. These currency speculators, seeking to maximize profit, see an opportunity in betting against a particular Asian currency. They are constrained by their limited command of political and financial resources, although as a group they wield significant financial influence. Since speculators typically have a very short time horizon (a high discount rate), so long as sentiments between speculators are sufficiently aligned, when it captures enough momentum, the currency attack becomes a self-fulfilling, self-reinforcing cycle.

At the other end of the table, central banks seek to minimize losses faced by economies when currencies devalue. Their constraints are similarly monetary,[1] although they can draw on the political resources that exist within the country, such as the ability to completely limit capital flows (as Malaysia did). Since currency markets are relatively frictionless, we shall assume away transactions costs in the analysis that follows.

The interplay between the speculators and central bankers thus becomes one of a repeated game (with finite horizon), which is represented in normal form, with arbitrary payoffs, below.[3]

The Currency Crisis Game

		Speculators
		Buy			Sell
Central Bank	Buy	(-100, 0)	(-50, 200)
		Sell	(200, -50)	(-100, 0)

The unique Nash equilibrium in this game is (Buy, Sell). However, this is clearly not sustainable: at some point in the future, due to limited resources, the central banker will be forced to stop buying. Rational speculators, sensing this, will then seek to sell off their final holdings of the currency before the central bank goes broke; in this case, both have an incentive to sell and the Nash equilibrium shifts to (Sell, Sell) - the currency rapidly devalues and a currency crisis results.

Clearly, the above scenario hinges on the change in payoffs midway through the game - this possibility for multiple equilibria makes it difficult to pin down a satisfactory solution for when a crisis will erupt.

References

Levi, M. (1988). Of Rule and Revenue. Berkeley: University of California Press.

Endnotes

1. Who had been often derided by Malaysian prime minister Mahatir as the source of the entire episode, with the latter once going as far as to term Soros a "moron".

2. This point is more subtle. Although central banks can theoretically print money to finance their currency defense operations, they are limited by the fact that this would generate inflationary expectations in the economy.

3. The payoffs are largely self-explanatory. The only possible contention is the payoffs to the central bank in the case of (B, B) and (S, S); these arise because central bankers prefer a stable currency.

Website Additions.

No major new additions this month, unfortunately, although updates continue to be made on the news and research papers section.

Interesting Readings.

1. Downsize or Die: Corporate and institutional banks are merging in order to survive in the very highly competitive international banking scene. Following downsizing plans from other big-name banks, the Economist envisions ('Strategies for corporate and institutional banking', http://www.economist.com/displaystory.cfm?story_id=1067052) that there will only be a few major players globally. Joe Quinlan and Rebecca McCaughrin (MSDW) provide a more general analysis of global M&A trends ('Global: M&A Activity - Beyond the Headlines', http://www.morganstanley.com/GEFdata/digests/20020405-fri.html#anchor1).

2. The Return of Asia: Economists are predicting a recovery in East Asian economies to their pre-Asian financial crisis levels (after the promising V-shaped recovery petered out in 2000/01 with the asynchronous recession of the global economy) ('Southeast Asia awaits upturn', http://tm0.com/IHT/sbct.cgi?s=131847734&i=494359&m=1&d=2498753). A similar optimism pervades industrial economies ('Are Forecasts of Recovery Credible?', http://www.imf.org/external/np/vc/2002/031802.htm), although there are the decidedly skeptical ('Global: Unfinished Business', http://www.morganstanley.com/GEFdata/digests/20020401-mon.html#anchor0).

3. Overshooting Expectations: 25 years after the publication of Rudiger Dornbusch's seminal 'Expectations and Exchange Rate Dynamics', the milestone in exchange rate dynamics still remains a favorite of both theorists and policymakers. Ken Rogoff provides an interesting read in his Mundell-Fleming Lecture ('Dornbusch's Overshooting Model After Twenty-Five Years', http://www.imf.org/external/pubs/cat/longres.cfm?sk=15653.0).

4. Oil Toils: Supply-side energy shocks were largely responsibly for the global downturns in the early and late 1970s. Is such a possibility again in the offing? Not necessarily, although the consequences are certainly worth thinking about, especially in light of recent events in the Middle East, as Stephen Roach suggests ('Global: Oil Shock Sensitivity Analysis', http://www.morganstanley.com/GEFdata/digests/20020409-tue.html#anchor0). Paul Krugman provides another take ('The Third Oil Crisis?', http://www.nytimes.com/2002/04/09/opinion/09KRUG.html).

5. Bilateral Collateral: Dana Dillon and Sara Fitzgerald, writing from the auspices of the Heritage Foundation, argue on why a bilateral free trade agreement with Singapore makes sense ('Why the United States Should Complete the Bilateral Free Trade Agreement with Singapore', http://www.heritage.org/library/execmemo/em810.html).

Endnotes.

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