Financial crises

Question 1

What is the point of global financial systems?

Answer 1

• solve asymmetric information and moral hazard, so you can get money from more than just people you trust or can credibly threaten
• smooths inter temporal consumption
• improves growth by funding productive activities

Question 2

Explain the basic process of an old-style financial crisis

Answer 2

Overspending, overvaluation > resource revenues start running out > constraint demand > devaluation > social costs, wages fall > expansionary monetary policy > inflation > repeat

Question 3

Explain the basic process of a new-style financial crisis

Answer 3

Loss of currency confidence interacting with a balance sheet weakness

Balance sheet weaknesses

• non-performing loans
• maturity mismatches
• currency mismatches

Question 4

What were SAPs?

Answer 4

What were they:
Policies to be adopted, often as conditionality's, aiming to correct systemic misallocation
--- trade liberalization
--- financial liberalization
--- tax reform
--- privatization

Question 5

What evidence is there to suggest that SAPs didn’t work?

Answer 5

Sequencing: finance adjusts much quicker, so financial liberalization led to capital flight, which worsened the structure of the economy

Meeting targets but not adjusting structure

• met debt reduction targets, but as Easterly shows, it’s actually net worth that countries select as their long-run path
• so debt reduction was counteracted by measures maintaining net worth
• – cut public investment (35% average)
• – cut operations and maintenance (just deferring cost, could have saved $45 billion -WB)
• – privatization (profit from sale of SOEs consumed)

Question 6

What evidence is there to suggest that SAPs did work?

Answer 6

Estavoerdal and Taylor
- long-run growth effects of Uruguay round liberalization is good

Bau and Matray
- corrected misallocation in India, improved manufacturing by 6.5%

Easterly
- have at least gotten rid of the worst policies

Question 7

Explain the consequences of domestic inflation crises

Answer 7

Inflation tax

• ad hoc transfers from private > government
• transfer from lenders > borrowers
• sounds good for the poor, because most privileged can adjust via wage indexing, sophisticated financial instruments (eg. Brazil had many financiers become multimillionaires during the 90s)

Response

• capital flight
• currency substitution

Consequences of the response
capital controls > black markets > lower monetary base > seignorage > inflation > and repeat…

Question 8

Explain the sources of inflation crises

Answer 8

• too much money creation in response to BOP crises
• oil shocks
• natural disasters
• persistence due to backward prices indexing

Question 9

Give an example of a new-style crisis

Answer 9

Burnside, Eichenbaum, Rebelo: South Korea (1997-98)

Existing balance sheet weaknesses

• non-performing loans: politically connected chaebols manipulated to get cheap credit
• maturity mismatch: government allowed only short-term borrowing in the 1990s
• currency mismatch

Interaction : government had implicit, unbudgeted guarantees to financial sector

• so, market adjusted to expect more government liabilities, given non-performing loans
• difficult to lower expenditure or raise taxes during a banking crisis, so market expected seignorage to finance liabilities
• expected seignorage> expected inflation > decreased demand for Won (50%) > reduction in official reserves > currency mismatch > inability to pay back debt > Won depreciates by 50%, GDP cost of 25%

Question 10

Seven options in the face of a new-style crisis

Answer 10

1. Do nothing > collapse
2. Increase interest rates
   - increase return on domestic currency > reduce capital flight > keep exchange rate stable
   - makes cost of capital too high
3. Keep interest rates low
   - capital flight > exchange rate jump > unmanageable foreign debts
4. Declare bankruptcy
   - manage foreign debt
   - penalty to access international capital markets
5. IMF loan
   - reduce capital flight
   - aim to keep interest rate low without exchange rate jump
6. Capital/credit controls
   - inflow controls > reduce bank reliance on foreign debt
   - outflow controls > may reduce capital flight
7. Improve macroeconomic management
   - less growth
   - no crises

Question 11

Explain the process and consequence of sudden stops

Answer 11

Current account deficit > real exchange rate changes + high dollarization > insecurity about paying foreign debts> increased likelihood of sudden stop

Consequences

• reallocation to traceable goods
• lower TFP
• trade surplus
• depreciation of real exchange rate

Question 12

Where are some external (push) determinants of financial crises?

Answer 12

Credit booms

• most developing crises associated with credit booms
• more credit booms when preceded by large capital inflows and TFP gains (opposite for developed countries)
• 75% occur with fixed exchange rate regimes
• geographically clustered

Global financial cycles
- not much evidence that these play a big role

Forbes
- the dichotomy is wrong, outcomes determined by an interaction of country-specific and global determinants

Question 13

Is financial integration good for growth?

Answer 13

Composition matters

FDI
- only boosts growth in high human capital, open economies with strong financial sectors

Equity (best)

• lowers cost of capital
• new finance source
• boosts investment

Debt

• volatile, especially with poor institutional supervision
• banks speculate on forex > exchange rate risk

No clear evidence that financial globalization > financial crises

Question 14

What are challenges to measuring the impact of financial integration on growth?

Answer 14

Degree of enforcement
- De jure, de facto. De facto tends to find more positive results

Highly endogenous relationship