The Economics of Currency Crises

[Image: Judit Klein]
[Image: Judit Klein]

A fixed exchange rate system is where the exchange rate remains constant over time. It is extremely difficult for an exchange rate to remain constant over time and when it doesn’t it is often called a ‘currency crisis’. Indeed, a currency crisis is when speculators ‘attack’ the currency – normally to bring it down.

There are three main types of currency crises. The first is known as the ‘first generation’ (shock!) and was developed by P. Krugman and others over thirty years ago. This model suggests that currency crises are caused by large and unsustainable government budget deficits.

If the government is running a huge budget deficit then it is financing its expenditure by borrowing money, largely from abroad. This can be a huge problem if there is a ‘sudden stop’ of overseas lending (i.e. no-one wants to lend to the government). The government only has two realistic options to solve this funding problem or it would be forced to scrap the fixed exchange rate system and devalue (as this would help attract foreign capital again).

The first option is that the government could sell its foreign reserves and use it to buy up its own currency (this helps defend the peg) or it can engage in monetary financing (printing money to help support domestic investment which before came from overseas).

However, if the currency comes under attack then only the first option is left since printing money (option two) would only devalue the exchange further and make the problem bigger. Hence, why a lot of emerging market economies with fixed exchange rates back up their currencies with huge foreign currency reserves because that is the only way to prop the exchange rate back up again after a speculative attack.

The second generation was developed in the 1980s by M. Obstfeld, the current Chief Economist of the IMF. It suggests some gibberish about there being the existence of multiple equilibria in exchange rates – however, there is a key point about currency crises being self-fulfilling. Indeed, a lot of currency crises are what can be described as none other than ‘contagion’. If you look back at the 1997 Asian currency crises which started in Thailand then many nearby countries simply ‘caught the flu’ even though there was no real underlying problem in many of them.

The third generation is based on problems in the financial sector. Simplistically, problems in the financial sector can cause a recession or severe slowdown which means that the currency gets hit. It then becomes a problem because you want a lower interest rate to help the financial sector (via improving the economy, good economy = good banking system) but by doing this you are only devaluing the currency further…hence you have an option – defend the economy or fixed exchange rate.

The solutions to a currency crisis generally involve good governance, limited government borrowing and large foreign capital reserves. However, there is one different idea – the Tobin tax – a tax on currency transactions.If you tax currency transactions then people are less likely to speculate in currencies as the movements in currencies are usually very small i.e. the tax part would take up a significant proportion of the profitability.

In recent years the Tobin tax has been hijacked by a bunch of Marxists who want a ‘Robin Hood tax’ (the same thing) in order to hit the financial world with a massive stick by associating the idea with a Nobel Laureate. However, the original concept was a tax to help limit the amount of short-term speculation in the foreign exchange market.

To conclude would be to say that fixed exchange rate systems can be attacked by speculators. This can happen for a multitude of reasons including fears about the size of the government’s budget deficit, fears about financial stability but also due to self-fulfilling reasons. The solutions involved include a tobin tax and higher currency reserves. However, an alternative currency arrangement i.e. floating exchange rates is no better due to ‘overshooting’ – which I will explain in my next article.

Sam writes a regular personal blog on a range of issues, which can be found at smebthewizard.wordpress.com

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