International Economics Update October/November 2001 Copyright (C) 2001 The International Economics Network http://www.internationaleconomics.net Marginal Notes. First and Second Generation Financial Crises [1] Since the seminal work on balance of payments crises and speculative attacks by Krugman (1979), the literature on financial crises has evolved over time. The first generation models (see, for example, Krugman 1979 and Flood and Garber 1984) dealt with the unsustainability of a fixed currency peg due to the inconsistency between money creation in order to finance the budget deficit and the maintenance of the peg that required monetary policy to be amenable to the defense of the currency. Being aware of this, rational agents will engage in a speculative attack of the exchange rate, which triggers an adjustment of the exchange rate. Later models (Flood, Garber & Kramer 1996; Flood & Marion 1996) extend the analyses to include scenarios where monetary authorities are non-passive as well as cases where uncertainties exist. However, these models were premised on the existence of weaknesses in macroeconomic fundamentals, and a key element missing in the first generation models is the existence of contagion and contagion effects. The second generation models of financial crises focused on the existence of multiple equilibria as an explanation for currency and banking crises, best captured in the papers by Obstfeld (1986, 1994), introduced the notion that such crises could possibly be explained by a movement from one equilibrium towards another, which can be alluded to as a “bad” equilibrium, through nonlinearities in government behavior. These nonlinearities are often triggered by incompatibilities between the expectations of agents and government signals or incentives. Second generation models also spawned the possibility of herding behavior as a cause of currency and financial crises. In the aftermath of the Asian financial crisis, there arose a new strand in the theoretical literature that emphasized moral hazard as well as contagion (Chang & Velasco 1998; Corsetti, Pesenti & Roubini 1999) as the missing links that could possibly reconcile the two disparate trends between the first generation fundamentals-based and the second generation self-fulfilling, multiple equilibria-based models [2]. Endnotes 1. A useful summary of the currency crisis literature is provided by Flood & Marion (1998). 2. Note that these models implicitly assert that there is no pure contagion phenomenon, only a concerted failure attributable to symmetric structural weaknesses across (possibly) highly integrated economies, as transmitted through trade and/or financial channels. The differences in definition are discussed below. References Chang, R. & A. Velasco (1998), ‘Financial Crises in Emerging Markets’, NBER Working Paper no. 6606. Corsetti, G., M. Pericoli & M. Sbracia (2001), ‘Correlation Analysis of Financial Contagion: What One Should Know Before Running a Test’, Yale Economic Growth Center Working Paper no. 822. Flood, R. & P. Garber (1984), ‘Collapsing Exchange Rate Regimes: Some Linear Example’, Journal of International Economics 17: 1-13. Flood, R., P. Garber & C. Kramer (1996), ‘Collapsing Exchange Rate Regimes: Another Linear Example’, Journal of International Economics 41, no. 3/4: 223-34. Flood, R. & N. Marion (1996), ‘Speculative Attacks: Fundamentals and Self-Fulfilling Prophecies’, NBER Working Paper no. 5789. Flood, R. & N. Marion (1998), ‘Perspectives on the Recent Currency Crisis Literature’, NBER Working Paper no. 6380. Krugman, P. (1979), ‘A Model of Balance of Payments Crises’, Journal of Money, Credit and Banking 11: 311-25. Obstfeld, M. (1986), ‘Rational and Self-Fulfilling Balance of Payments Crises’, American Economic Review 76 (Mar): 72-81. Obstfeld, M. (1994), ‘The Logic of Currency Crises’, Cahiers Economiques et Monetaires 43, Bank of France: 189-213. Website Additions. No major new additions this month, unfortunately, although updates continue to be made on the research papers section. Interesting Readings. 1. Whither the Pound? The British are talking about the Euro again. Steve Pollard provides an insightful analysis ('Blair Goes for Broke', http://interactive.wsj.com/cgi-bin/wsjgate?source=jopinemaowsj&subURI=http%3A%2F%2Finteractive.wsj.com%2Farticles%2FSB1002139922513245360.htm&nonsubURI=http%3A%2F%2Finteractive.wsj.com%2Ftour), whilst the Financial Times has an inside view ('Tories refuse to be 'suckered' into euro obsession', http://tm0.com/sbct.cgi?s=185070289&i=399379&d=1857767). 2. Integration Deliberation: In a similar vein, the Financial Times reports that Romani Prodi, the president of the European Commission, has renewed a call to step up efforts aimed at speeding European integration ('Prodi urges acceleration of EU integration', http://tm0.com/sbct.cgi?s=185070289&i=403446&d=1889841). 3. Awakening the Dead: The U.S. shift towards deficit spending in an attempt to prop up its flagging economy is quintessentially Keynes, as Gerard Baker and Ed Crooks, writing in the Financial Times, observe ('Keynes revisited', http://news.ft.com/ft/gx.cgi/ftc?pagename=View&c=Article&cid=FT36HLEBGSC&live=true&tagid=ZZZU2IUKJ0C), together with others ('Friedman Boos, Stiglitz Cheers as Keynes Returns to Washington', http://quote.bloomberg.com/fgcgi.cgi?ptitle=Top%20Financial%20News&s1=blk&tp=ad_topright_topfin&T=markets_bfgcgi_content99.ht&s2=ad_right1_topfin&bt=ad_position1_topfin&middle=ad_frame2_topfin&s=AO85UyRbURnJpZWRt). However, stimulus from the monetary side of the economy has by no means been ignored ('Ineffective Rate Cuts', http://tm0.com/IHT/sbct.cgi?s=131847734&i=399289&d=1857353; 'The Dam Breaks', http://www.mises.org/fullstory.asp?control=795). The question is: why isn't anything working? And will it ever be enough? ('No More Economic Stimulus Needed', http://interactive.wsj.com/cgi-bin/wsjgate?source=jopinemaowsj&subURI=http%3A%2F%2Finteractive.wsj.com%2Farticles%2FSB1002671888556045120.htm&nonsubURI=http%3A%2F%2Finteractive.wsj.com%2Ftour). There is a consensus building up here that there looks to be a paradigm shift in the U.S. approach to free-market economics ('Role Reversal: U.S. Forsakes Market Gospel', http://www.iht.com/articles/36902.html). 4. Poor Losers: The most unfortunate losers in the aftermath of the Sep 11th attacks on the U.S. are ironically going to be the poor countries themselves ('Economic disaster for developing countries', http://tm0.com/sbct.cgi?s=185070289&i=403446&d=1889834), 'UN warns of impending economic crisis', http://www.atimes.com/global-econ/CJ13Dj01.html). This underscores my editorial for last month ('Terrorism and the Wealth of Nations', http://home4.pacific.net.sg/~jamus/comment20.html), and the dangers of a vicious cycle emerging. 5. Old McDonald's: International business, it would seem, has been reckoned as collateral damage in the wake of September 11th ('From Golden Arches to Lightning Rod', http://tm0.com/IHT/sbct.cgi?s=131847734&i=403140&d=1894478). Of course, there are those who view globalisation as a clear inevitability ('Countries Can't Go It Alone', http://www.imf.org/external/np/vc/2001/090101.htm). Endnotes. This update is sent by request to subscribers. 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