The Economics of Currency Crises: Part Two

Image: Ken Teegardin
Image: Ken Teegardin

In part one, I described some of the main theory behind currency crises. This second part will be a few examples of currency crises and a few words about the ongoing ‘global currency war’ which is linked to it.

An example of the first type of currency crisis (i.e. caused by large government budget deficits) is Mexico 1994 which arose due to large government spending by the previous administration in order to try and win the next election in December 1994. They were also fears over political stability (the incumbent party’s candidate was assassinated in March 1994) and fears over short-term debt financing (so called ‘tesobonos’) which paid out in US Dollars (so when the Mexican Peso fell…government borrowing costs went up). Needless to say it didn’t end well and the speculators won when the Mexican Peso was sharply devalued within a month after the election.

An example of the second type of currency crisis (self-fulfilling / multiple equilibria) is Asia 1997. This started in Thailand when the currency was attacked by speculators who knew that the government / central bank had little reserves to back it up. This then leapfrogged onto Indonesia and other nearby countries – a concept known as ‘contagion’.

The third generation (problems with the financial sector) is also heavily linked to Asia 1997 as many banks borrow and invest in US Dollars. However, this is the wrong order but if you look at individual countries, such as South Korea, then some of the companies were too closely linked to government. In other words, sometimes the government and these companies hide things around…

Indeed, what underpins most currency crises is politics and this is where most of the examples are. For example, the UK in 1992 (ERM) was political to its core as Major, Clarke, Howe and Heseltine and others at the time thought that it was a good idea to align itself with Germany / Europe. Another example is Russia’s currency crisis of 2014 which was due to sanctions and capital flight arising from its annexation of the Crimea. The list continues indefinitely especially if you believe some of the Socialists in South America…

However, a floating exchange rate is no better. Floating exchange rates are prone to speculative movements and panic. In economics, the theory is Dornbusch Overshooting which suggests that financial markets move faster than prices meaning that disequilibrium (if such a thing can exist) occurs. This ultimately means that any unexpected shock can lead to haywire in the financial markets before the economy can adjust. It is complete madness that the Mexican Peso in 2016 can bounce with 2-3% swings every day simply because of fears about a twit called ‘Donald Trump’ but believe me it does happen.

Onto the second part then we have the idea of a ‘global currency war’. A currency war isn’t a currency crisis but it worth writing about because the idea is important. A currency war is when countries competitively devalue their exchange rates against each other. This is to try and boost exports (by making them relatively cheaper) and hinder imports (by making them relatively more expensive) – a ‘strategy’ known as an ‘import substitution strategy’ (imaginative name I know).

The problem with this ‘strategy’ is that every other country thinks at the same way…hence a ‘currency war’. This idea can get worse when each other country continues to devalue by reducing its domestic interest rate because there is no other way of devaluing your currency. This then creates lots of cheap credit…which feeds into asset bubbles and zombie / mal-investments.

This is really bad but the really problematic thing is when interest rates go negative because this then hits banks profitability and when banks go under…you can get a third generation currency crisis.

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