By Itay Goldstein and Assaf Razin
June 2013

The last few years have been characterized by a great
turmoil in the world’s financial markets

These events exhibit ingredients from all types of financial
crises in recent history:
◦ Banking crises
◦ National currency and single currency area crises
◦ Credit frictions
◦ Market freezes
◦ Asset bubbles: booms and Busts
◦ Sovereign Debt Crises cum Eurocrisis
2
--Enable the efficient transmission of resources from
savers to the best investment opportunities.


--Provide risk sharing possibilities, so that investors
can take more risk and advance the economy. 


--Enable aggregation of information that provides
guidance for more efficient investment decisions.

--Monetary arrangements, such as the European 
Monetary Union (EMU) are created to facilitate free
trade and financial transactions among countries,
thereby improving real efficiency.
3

A financial crisis marks a severe disruption of
these normal functions of financial and
monetary systems, thereby hurting the
normal functioning of the real economy.
4

The models reviewed here describe situations in which financial systems are
fragile and prone to crises.

Main problems:
Agency problems
Those who are making the decisions might not fully reflect the interests
of those on whose behalf they were supposed to be acting.
◦ Coordination failures
e.g., Banks rely on the fact that only forecastable fraction of depositors
will have short term liquidity needs. But there is self fulfilling equilibrium
where all depositors demand early withdrawal.
◦ Strategic Complementarities
E.g., When more depositors withdraw their money the bank is more likely
to fail and so other depositors have a stronger incentive to withdraw.
5
◦ Principal-Agent moral hazard
e.g., The borrower has the ability to divert resources to himself at the
expense of the creditor. This creates a limit on credit. The limit can get
tightens when economic conditions worsen.
◦ Risk Shifting
e.g., An investor who borrow to buy assets benefits from the upside while
having limited exposure to the downside risk.
◦ Heterogeneous beliefs and leverage
e.g., where the optimists-pessimists composition in the investor
population shifts endogenously leverage bubbles are created and burst.
◦ Fragile institutional of monetary and exchange rate arrangements
◦ E.g. European Monetary System
6

Governments/central banks try to maintain certain financial
and monetary arrangements, most notably a fixed-exchange
rate regime, or more recently, a regional monetary union.
Their goal is to stabilize the economy or the region.

At times, these arrangements become unstable and collapse
leading to debt crises and banking crises

The strand of the literature analyzes currency crises
characterized by a speculative attack on a fixed exchange
rate regime. The newer strand emphasizes banking and fiscal
union as a backstop to single currency area crises.
7

A tri-lemma is a situation in which someone faces the choice
among three options, each of which comes with some
inevitable choices because not all the three can be
simultaneously accomplished.
8
First, make the country’s economy open to international capital
flows, because by doing so they let investors diversify their
portfolios overseas and achieve risk sharing. They also benefit from
the expertise brought to the country by foreign investors.

Second, use an independent monetary policy as a tool to help
stabilize inflation, output, and the financial sector in the economy.
This is achieved as the central bank can increase the money supply
and reduce interest rates when the economy is depressed, and
reduce money growth and raise interest rates when it is overheated.
Moreover, it can serve as a lender of last resort in case of financial
panic.
9

Third, maintain stability in the exchange rate. This
is because a volatile exchange rate, at times driven
by speculation, can be a source of broader financial
volatility, and makes it harder for households and
businesses to trade in the world economy and for
investors to plan for the future.
10

By attempting to maintain a fixed exchange rate and capital
mobility, the central bank loses its ability to control the
interest rate or equivalently the monetary base – its policy
instruments – as the interest rate becomes anchored to the
world interest rate by the interest rate parity and the
monetary base is automatically adjusted. This is the case of
individual members of the EMU.
11
In order to keep control over the interest rate
or equivalently the money supply, the central
bank has to let the exchange rate float freely,
as in the case of the US.

12

If the central bank wishes to maintain both exchange rate
stability and control over the monetary policy, the only way to
do it is by imposing domestic credit controls and
international capital controls, as in the case of China.
13

Currency crises occur when the country is trying to
maintain a fixed exchange rate regime with capital
mobility, but faces conflicting policy needs, such as
fiscal imbalances or fragile financial sector, that
need to be resolved by independent monetary
policy, and effectively shift the regime from the
first solution of the tri-lemma described above to
the second solution and the tri-lemma.
14

This branch of models, the so-called ‘first generation models
of currency attacks’ was motivated by a series of events
where fixed exchange rate regimes collapsed following
speculative attacks, for example, the early 1970s
breakdown of the Bretton Wood global system.

The first paper here is the one by Krugman (1979).

He describes a government that tries to maintain a fixed
exchange rate regime, but is subject to a constant loss of
reserves, due to the need to monetize government budget
deficits.
15

These two features of the policy are inconsistent
with each other, and lead to an eventual attack on
the reserves of the central bank, that culminate in a
collapse of the fixed exchange rate regime.

Flood and Garber (1984) extended and clarified the
basic mechanism, suggested by Krugman (1979),
generating the formulation that was widely used
since then.
16

Recall that the asset-side of the central bank’s balance sheet
at time t is composed of domestic assets BH,t

the domestic-currency value of foreign assets StBF,t

where St denotes the exchange rate, i.e., the value of foreign
currency in terms of domestic currency.

The total assets have to equal the total liabilities of the
central bank, which are, by definition, the monetary base,
denoted as Mt.
17
.

Due to fiscal imbalances, the domestic assets grow in a fixed
and exogenous rate:

Because of perfect capital mobility, the domestic interest rate
is determined through the interest rate parity, as follows:

Where it denotes the domestic interest rate at time t and it*
denotes the foreign interest rate at time t.
18

The supply of money, i.e., the monetary base, has to be equal to the
demand for money, which is denoted as L(it), a decreasing function
of the domestic interest rate.

The inconsistency between a fixed exchange rate regime:
with capital mobility, and the fiscal imbalances, comes due to the
fact that the domestic assets of the central bank keep growing, but
the total assets cannot change since the monetary base is pinned
down by the demand for money, L(it*), which is determined by the
foreign interest rate it*
19

Hence, the obligation of the central bank to keep financing
the fiscal needs, puts downward pressure on the domestic
interest rate, which, in turn, puts upward pressure on the
exchange rate.

In order to prevent depreciation, the central bank has to
intervene by reducing the inventory of foreign reserves.

Overall,
decreases by the same amount as BH,t increases,
so the monetary base remains the same.
20

The problem is that this process cannot continue forever,
since the reserves of foreign currency have a lower bound.

Eventually, the central bank will have to abandon the solution
of the tri-lemma through a fixed exchange rate regime and
perfect capital mobility to a solution through flexible
exchange rate with flexible monetary policy (i.e., flexible
monetary base or equivalently domestic interest rate) and
perfect capital mobility.
21

The analytical question is what is the critical level of domestic
assets BH,T , and the corresponding period of time T, at which
the fixed-exchange rate regime collapses.

This happens when the (conditionally) expected shadow
exchange rate – -defined as the flexible exchange rate under
the assumption that the central bank’s foreign reserves
reached their lower bound while the central bank keeps
increasing the domestic assets to accommodate the fiscal
needs – -is equal to the pegged exchange rate.
22

Following the collapse of the ERM in the early 1990s, which
was characterized by the tradeoff between the declining
activity level and abandoning the exchange rate management
system, the so-called first-generation model of currency
attacks did not seem suitable any more to explain the
ongoing crisis phenomena.

This led to the development of the so-called ‘second
generation model of currency attacks,’ pioneered by Obstfeld
(1994, 1996).
23

A basic idea here is that the government’s policy is not just on
‘automatic pilot’ like in Krugman (1979) above, but rather that the
government is setting the policy endogenously, trying to maximize a
well-specified objective function, without being able to fully commit
to a given policy.

In this group of models, there are usually self-fulfilling multiple
equilibria, where the expectation of a collapse of the fixed exchange
rate regime leads the government to abandon the regime.

This is related to the Diamond and Dybvig (1983) model of bank
runs, creating a link between these two strands of the literature.
24

Obstfeld (1996) discusses various mechanisms that can
create the multiplicity of equilibria in a currency-crisis model.
Let us describe one of them, which is inspired by Barro and
Gordon (1983).

Suppose that the government minimizes a loss function of
the following type:

Here, y is the level of output, y* is the target level of output,
and ε is the rate of depreciation, which in the model is equal
to the inflation rate.
25

Hence, the interpretation is that the government is in a
regime of zero depreciation (a fixed exchange rate regime).
Deviating from this regime has two costs.

The first one is captured by the index function in the third
term above, which says that there is a fixed cost in case the
government depreciates the currency.

The second one is captured by the second term above, saying
that there are costs to the economy in case of inflation.
26

But, there is also a benefit: the government wishes to reduce
deviations from the target level of output, and increasing the
depreciation rate above the expected level serves to boost output,
via the Philips Curve.

This can be seen in the following expression, specifying how output
is determined:

Here,
is the natural output, u is a random shock, and
is the
expected level of depreciation/inflation that is set endogenously in
the model by wage setters based on rational expectations
27

The idea is that an unexpected inflationary shock boosts
output by reducing real wages and increasing production.

Importantly, the government cannot commit to a fixed
exchange rate. Otherwise, it would achieve minimum loss by
committing to ε=0.

However, due to lack of commitment, a sizable shock u will
lead the government to depreciate and achieve the increase in
output bearing the loss of credibility.
28

Going back to the tri-lemma discussed above, a fixed
exchange rate regime prevents the government from using
monetary policy to boost output, and a large enough shock
will cause the government to deviate from the fixed exchange
rate regime.

It can be shown that the above model generates multiplicity
of equilibria. If wage setters coordinate on a high level of
expected depreciation/inflation, then the government will
validate this expectation with its policy by depreciating more
often.
29

If they coordinate on a low level of expected depreciation,
then the government will have a weaker incentive to deviate
from the fixed exchange rate regime.

Hence, a depreciation becomes a self-fulfilling expectation.

Similarly, one can describe mechanisms where speculators
may force the government to abandon an existing fixed-
exchange rate regime by attacking its foreign currency
reserves and making the maintenance of the regime too
costly. If many speculators attack, the government will lose
many reserves, and will be more likely to abandon the
regime.
30

A self-fulfilling speculative attack is profitable only if many
speculators join it.

Consequently, there is one equilibrium with a speculative
attack and a collapse of the regime, and there is another
equilibrium, where these things do not happen.

Similarly, speculators can attack government bonds
demanding higher rates due to expected sovereign-debt
default, creating an incentive for the central bank to abandon
a currency regime and reduce the value of the debt.
31

As argued by Paul De Grauwe (2011), the problem can
become more severe for countries that participate in a
currency union since their governments do not have the
independent monetary tools to reduce the cost of the debt.

Morris and Shin (1998) applied global games methods to
tackle the problem of multiplicity of equilibrium in the
second-generation models of speculative attacks.
32

Using the global-game methodology, pioneered by Carlsson
and van Damme (1993), they are able to derive a unique
equilibrium, where the fundamentals of the economy uniquely
determine whether a crisis occurs or not. This enabled them
to ask questions as to the effect of policy tools on the
probability of a currency attack.
33
While the 1st and 2nd generation currency 
crisis literature focused on the government
alone, the ‘Third-generation’ models connect
currency crises to models of banking crises
and credit frictions.
34

In the late 1990s, a wave of crises hit the emerging
economies in Asia, including Thailand, South Korea,
Indonesia, Philippines, and Malaysia. A clear feature of these
crises was the combination of the collapse of fixed exchange
rate regimes, capital flows, financial institutions, and credit
This led to extensive research on the interplay between
currency and banking crises, sometimes referred to as the
twin crises, and balance sheet effects of depreciations For a
broad description of the events around the crisis, see Radelet
and Sachs (1998). The importance of capital flows was
anticipated by Calvo (1995).
35

One of the first models to capture this joint problem was
presented in Krugman (1999).

In his model, firms suffer from a currency mismatch between
their assets and liabilities: their assets are denominated in
domestic goods and their liabilities are denominated in
foreign goods.

Then, a real exchange rate depreciation increases the value of
liabilities relative to assets, leading to deterioration in firms’
balance sheets.
36

Because of credit frictions as in Holmstrom and Tirole (1997),
described in the next section, this deterioration in firms’
balance sheets implies that they can borrow less and invest
less.

The novelty in Krugman’s paper is that the decrease in
investment validates the real depreciation in the general-
equilibrium setup.

This is because the decreased investment by foreigners in
the domestic market implies that there will be a decrease in
demand for local goods relative to foreign goods, leading to
real depreciation.
37

Hence, the system has a multiple equilibrium with high
economic activity, appreciated exchange rate, and strong
balance sheets in one equilibrium, and low economic activity,
depreciated exchange rate, and weak balance sheets in the
other equilibrium.

Other models that extended and continued this line of
research include: Aghion, Bacchetta, and Banerjee (2001),
Caballero and Krishnamurthy (2001), and Schneider and
Tornell (2004). The latter fully endogeneize the currency
mismatch between firms’ assets and liabilities.
38

The global-game methodology, relying on heterogeneous
information across speculators, also brought to the forefront
the issue of information in currency-attack episodes, leading
to analysis of the effect that transparency, signaling, and
learning can have on such episodes (e.g., Angeletos, Hellwig,
and Pavan (2006)).
39

Chang and Velasco (2001) and Goldstein (2004) model the
vicious circle between bank runs and speculative attacks on
the currency.

On the one hand, the expected collapse of the currency
worsens banks’ prospects, as they have foreign liabilities and
domestic assets, and thus generates bank runs, as described
in the previous section. Bank runs are more likely in a
currency union without a single-currency-wide bank union,
or the ability of the central bank to act as a lender of last
resort for sovereign debt.
40

On the other hand, the collapse of the banks leads to capital
outflows that deplete the reserves of the government,
encouraging speculative attacks against the currency.

Accounting for the circular relationship between currency
crises and banking crises complicates policy analysis. For
example, a lender-of-last-resort policy or other expansionary
policies during a banking crisis might backfire as it depletes
the reserves available to the government, making a currency
crisis more likely, which in turn might further hurt the
banking sector that is exposed to a currency mismatch.
41

The forceful transmission of crises across countries
generated a large literature of international financial
contagion.

Kaminsky, Reinhart, and Vegh (2003) provide a nice review of
the theories behind such contagion. They define contagion as
an immediate reaction in one country to a crisis in another
country.

There are several theories that link such contagion to
fundamental explanations.
42

The clearest one would be that there is common information
about the different countries, and so the collapse in one
country leads investors to withdraw out of other countries.
For a broader review, see the collection of articles in
Claessens and Forbes (2001).

Calvo and Mendoza (2000) present a model where contagion
is a result of learning from the events in one country about
the fundamentals in another country.
43

They argue that such learning is likely to occur when there is
vast diversification of portfolios, since then the cost of
gathering information about each country in the portfolio
becomes prohibitively large, encouraging investors to herd.

Another explanation is based on trade links (see e.g., Gerlach
and Smets (1995)).

If two countries compete in export markets, the devaluation
of one’s currency hurts the competitiveness of the other,
leading it to devalue the currency as well. A third explanation
is the presence of financial links between the countries.
44

In Kodres and Pritsker (2002), investors optimize their
portfolio allocation.

A decrease in the share of their portfolio held in one country
due to a crisis, leads them to rebalance by reducing their
holding in another country, and hence causes co-movement
in prices.

In Allen and Gale (2000), different regions insure each other
against excessive liquidity shocks, but this implies that a
shock in one region is transmitted to the other region via the
insurance linkage.
45

Empirical evidence has followed the above theories of
contagion.

The common information explanation has vast support in the
data.

Several of the clearest examples of contagion involve
countries that appear very similar. Examples include the
contagion that spread across East Asia in the late 1990s and
the one in Latin America in the early 1980s. A vast empirical
literature provides evidence that trade links can account for
contagion to some extent.
46

These include Eichengreen, Rose, and Wyplosz (1996) and
Glick and Rose (1999).

Others have shown that financial linkages are also empirically
important in explaining contagion. For example, Kaminsky,
Lyons, and Schmukler (2004) have shown that US-based
mutual funds contribute to contagion by selling shares in one
country when prices of shares decrease in another country.

Caramazza, Ricci, and Salgado (2004), Kaminsky and Reinhart
(2000) and Van Rijckeghem and Weder (2003) show similar
results for common commercial banks.
47
In the 1960s, a new concept emerged in international macroeconomics:
optimum currency area theory. 

The question it sought to answer: when should countries adopt a common 
currency? 
Recall that by adopting a common currency, countries would give up much of
their policy independence; the question was how costly that would be, and how
large are the benefits.


One variant, pushed by Ronald McKinnon, stressed the amount of trade; the more
two countries trade, the bigger the advantages of not having to change currencies,
and arguably, also, the less adjustment is needed to correct trade imbalances.
Another (actually the first paper on the subject), by Robert Mundell, stressed labor
mobility: you don’t need as much policy independence if unemployed workers can
move to where the jobs are. A third, stressed by my late colleague Peter Kenen,
stressed fiscal integration: if countries or regions share common budgets for
major programs, there will be a lot of automatic compensation for
“asymmetric shocks”.


48

Paul De Grauwe notes that the benefits of retaining a
currency on one’s own manifest in the post-crisis
interest rates paid on long-term public debt:
The ratio of net public debt to gross domestic 
product of the UK and Spain are essentially identical.
(IMF forecasts that in 2017, the ratio is 93 per cent
for the UK and 95 per cent for Spain.)
Yet the yield on UK 10-year bonds is firmly under 2 
per cent – among the lowest in UK history, and not
much above Germany’s; but the yield on Spanish 10year bonds, meanwhile, is about 5 per cent.
49

The ability and desire of the Bank of England
to prevent outright default is more credible
than that of the ECB: an independent,
supranational central bank.
The BoE, as lender of last resort, also 
promises market liquidity. If the market for
public debt is subject to self-fulfilling
prophecies of good or bad outcomes, this
should guarantee more stability at favorable
rates.
50
Central Banks were given double task: 
Lender of last resort for banks: 
backstop to counter panic and run on banks.
Lender of last resort to governments: 
to counter run on government bond markets


51
Banks and governments face similar problem: 
unbalanced maturity structure of assets and
liabilities
Making both banks and governments vulnerable
for movements of distrust, which will lead to
liquidity crisis, and can degenerate into solvency
crisis.


When banks collapse sovereign is in trouble 
When government collapses banks are in trouble

52
The fiscal union aspect comes in because of the need 
to have government budget as shock absorber based
on Keynes’ savings paradox paradox:
When after crash private sector has to de-leverage. 
It does two things
It tries to save more. 
It sells assets. 
Private sector can only save more if government 
sector borrows more (i.e. higher budget deficit)
But, if government also tries to save more, attempts 
to save more by private sector are self-defeating. The
economy is pulled into deflationary spiral.
53
These stabilizing features relatively well organized at the 
level of countries (US, UK, France, Germany), but, not at
international level nor at the level of a monetary union like
the Eurozone
These EMU design failures were only recognized after the
financial crisis, also because Optimum Currency Area
Theory was pre-occupied with exogenous shocks, but not
with an endogenous dynamics
And even then in many countries, especially in Northern 
Europe the point is still not recognized because of
dramatic diagnostic failure, focusing on government
profligacy; giving rise to austerity policy during the deleveraging period.

54
Financial integration undermines the ability of
individual member governments credibly to
backstop their
national banking systems through purely fiscal
means.
Within the euro zone the key functions of bank
regulations, depositor insurance, bank
resolutions and fiscal policy remained national.



In the absence of national discretion over 
last‐resort lending, money creation, and the
exchange rate. 
55
Obstfeld proposes a fiscal trilemma for the 
euro zone:
One cannot simultaneously maintain all three:
(1) Cross‐border financial integration
(2) Financial stability 
(3) National fiscal independence. 

56
If countries are financially integrated, 
they simply cannot credibly backstop their 
financial systems without the certainty of
external fiscal support, either directly (from
partner country treasuries) or indirectly
(through monetary financing from the
union‐wide central bank); thus sacrificing
national fiscal independence .
57
Alternatively, a country reliant
mainly on its own fiscal resources
will likely sacrifice financial
integration as well as stability,
because markets will then assess
financial risks along national lines.
58
Voluntary withdrawal from the single financial
market might allow a country with limited
fiscal space to control and insulate its 
financial sector enough to minimize fragility.

59
Governments of member states cannot
guarantee to bond holders that cash would
always be there to pay them out at maturity;
in contrast with stand-alone countries that
give this implicit guarantee, because they can
and will force central bank to provide
liquidity
(There is no limit to money creating capacity)

60
This lack of implicit guarantee to government debt can
trigger liquidity crises.


Because,
(1) distrust by market leads to bond sales, and interest rate
increases.
(2) Liquidity is withdrawn from national markets, moving 
to safe havens.
Government, unable to rollover debt, is forced to introduce
immediate and intense austerity, producing deep
recession and Government Debt to GDP ratio increases.


61
On September 6, 2012 ECB announced it will
buy unlimited amounts of government
bonds.
Program is called “Outright Monetary 
Transactions” (OMT)
Large parts of the euro area were in a bad 
equilibrium in which self-fulfilling
expectations were feeding on themselves.

62
European Central Bank’s promises to 
intervene via a program called outright
monetary transactions (OMT). But, OMT is still
less credible than lending of last resort by
national central bank because in the context
of supranational EMU institution there is no
similar institution which provides a Eurozone
fiscal backing.
63

Source: IMF




65