Crisis
-
-
-
Foundations
o Keynes (1937), Minsky (1972, 1977, 1978), Krugman (1979), Obstfeld (1996), Krugman
(1998), Gourevitch (1986), Pettis (2001)
Many types of “financial crisis” – focusing here on several post-Cold War examples
Mexican crisis of 1994-1995
Bulgarian crisis of 1996/1997
o As “third-generation” model: Berlemann, et al. (2002)
Albanian crisis of 1997
o Bezemer (2001)
East Asian crisis of 1997-1999
o Pempel (1999), Haggard (2000), Noble and Ravenhill (2000), Wade (2000)
US crisis of 2007-2008
o Stiglitz (2001), Stiglitz (2010), Helleiner (2011)
o Financial crises as set off by innovation (securitization for US, but opaque): Kindleberger
(1978), Roubini and Mihm (2010), Strange (1998), Blyth (2003), Best (2005)
One manifestation of global crisis: Eurozone and the Greek debt crisis
o Featherstone (2011), Arghyrou and Tsoukalas (2011), Aggarwal (2012)
Other evidence for the importance of institutions [see development outline]
o Polanyi (1944), Gerschenkron (1962), Chaudhry (1997)
-
Foundations
o Keynes (1937)
 Financial markets are periodically unstable – money is a financing “veil”
between the real asset and the wealth owner, which explains why capitalist
economies are “so given to fluctuations”
 The monetized economy is inherently dynamic, since the key economic
transaction is the exchange of money today (current goods) for money
tomorrow (financial assets)
 If too much money is in savings, we are returning society less than it
gave to us, so cumulative fall in everyone’s income  depression
(vulnerability to savings and investment)
o Minsky (1972, 1977, 1978)
 “financial instability hypothesis” – fragile financial markets are prone to a nonsustainable boom, ending in financial distress or even a recession
 Ponzi schemes are located at the extreme end of a spectrum of financial
markets, classified according to their “fragility”
 Views about the future can undergo marked changes in short periods of
time, generating instability (financial commitments are made in the face
of intractable uncertainty – not able to calculate risks)
o “Hedge finance” – assets with cash flow revenues equal to or
larger than cash flow commitments in both the short and long
run
o “Speculative finance” – capital assets with short-term cash flow
revenues that fall short of short-term commitments; met by
rolling over or refinancing debts in the expectation that longrun revenues will be large enough to meet outstanding
commitments (example: banking)
o “Ponzi finance” – assets characterized by cash flow
commitments that are larger than cash flow revenues in both
the long and short run, and hence need perpetual rolling over,
which is naturally not sustainable
 During the boom, expectations grow optimistic to the point of euphoria, so
lenders accept assets that would previously have been considered low-yield;
depending on the dominance of Ponzi/speculative finance and on financial
policies, the unwinding of euphoria may occur with little trouble, and a new
boom may begin; but it may also involve financial instability, and become the
source of deep depression and stagnation
 Financial crisis thus occurs if units need or desire more cash than is available
from their usual sources and they resort to unusual ways of raising cash, such as
liquidating positions
o Krugman (1979)
 “First-generation crisis model” – speculative attack against a currency peg is the
deterministic outcome of an unsustainable fiscal expansion pursued by a
narrow-minded government and financed by excessive money creation
depleting foreign currency reserves; when reserves fall below a critical
threshold, rational agents, in anticipation of the peg’s future collapse, buy the
government’s remaining reserves forcing an immediate devaluation; this thus
restores the exchange rate to a value consistent with purchasing power parity

o
o
o
Often called a “fundamental crisis” since it is the existence of a large
fiscal deficit – a fundamental reason – that makes it impossible for the
central bank to further stabilize the exchange rate
Problem: represent government’s policy in a very simplistic way

Obstfeld (1996)
 “Second-generation currency crisis model” – honoring or abandoning an
exchange-rate peg commitment is the outcome of a loss minimization problem
solved by a fully rational government; to decide optimal course of action,
government balances the credibility cost incurred by defaulting on the peg
against the macro-economic cost arising from deviating from the equilibrium
exchange rate implied by the peg’s maintenance; below a critical over-valuation
threshold, abandoning the peg is costlier than maintaining it, so the government
finds it optimal to honor it; above this critical threshold, the opposite holds;
peg’s cost is endogenous to private sector’s expectations; so, defending the peg
is less costly under credible commitment; there are also self-fulfilling crises, in
the multiple-equilibria zone, where a shift in expectations from credible to noncredible commitment tilts the government’s optimal response from maintaining
to abandoning the peg (so peg collapsed because market expects it to)
 Devaluation here (unlike in first-generation) is a political decision, not
the unavoidable result of policy inconsistencies
 Crises can also occur when there is no bad development in the
fundamentals forcing a country to abandon the currency peg
Things to consider: contagion and herding
 Contagion – a crisis in one country may conceivably trigger a crisis elsewhere; a
currency crisis in one country makes a currency crisis in another country more
likely (can be due to actual linkages between countries and “spillover,” to an
international liquidity shortage of investors, to “irrational” reasons like
assuming a group of countries are similar in some way, or to “membership”
contagion, like being in EMU)
 Herding: market participants mimic the behavior of other participants, which
can lead to a currency crisis (Krugman’s “bandwagon effect”)
Krugman (1998)
 “third-generation crisis model” – introduces default risk; high international
liquidity and government guarantees to the liabilities of insufficiently regulated
financial intermediaries assumed; currency crisis is one aspect of wider financial
crisis caused by the distorting effects of guarantees on investment incentives;
under guarantees and lax supervision, intermediaries have both the incentive
and ability to borrow short-term funds at low interest rates from international
money markets, which are then used to finance highly speculative domestic
investment projects (low expected return, but small probability of very large
gains); investors bear no downside risk; investors demand a lot of stakes in
these projects, which drives up price and value, which increases confidence in
project’s success, which then leads to more short-term loans to intermediaries,
and so on; returns on projects gradually revealed, usually little, which then
forces bailouts (circular again, until at some point, the cost of bailout reaches
critical level)

o
Here, additional possible source of instability added to the story: the
banking sector (since currency and banking crises often occur together
in these models  “twin crises models”)
 Types of third generation models: moral hazard and random-withdrawal
o Note: there is a fourth-generation model, but not as wellspecified – appears to follow second-generation model rather
closely
Gourevitch (1986)
 Crises combine three properties: a major downturn in a regular
investment/business cycle, a major change in the geographical distribution of
production, and a significant growth of new products and new productive
processes
 Sequence of events: in prosperous years preceding the crisis, a policy approach
and support coalition developed; the crisis came and challenged both policy and
coalition; the crisis opened the system of relationships, making politics and
policy more fluid; resolution reached, closing the system for a while, but only
until the next crisis
 Critical realignments occur during crises
 Crisis of 1873-1896
 Free trade had spread, then in 1873 prices slumped  protectionism;
alliances formed in some cases (German example: coalition of iron and
rye in support of tariffs), but nearly everywhere, agriculture and labor
found it difficult to cooperate; international economy played
considerable role in shaping domestic politics
 Crisis of 1929-1949
 After economic depression spread, universal policy response was the
classical position that deflation produces the best result in the long run:
cut all costs to encourage sales and investment, which meant cutting
wages, taxes, and spending
 Deflation failed to produce desired results – agriculture and labor
everywhere turned desperate early, seeking state aid  coalitions
 Demand stimulus experimented with by Nazi Germany, Sweden, and US
o Policy preferences and coalitional proclivities of economic
actors strongly affected by situation in international economy;
growth in role of associations in mediating relations among
social forces (example: Nazi party was able to mobilize a wide
range of groups including numbers of people working for wages
through populism laden with racism and nationalism)
o State structure also played a role, but there are no
characteristics of associations or state structure that can stand
independently of societal factors in explaining policy outputs
 Crisis of 1971 to the present (1986?)
 All social categories face the same general problem in devising political
strategies – each has to balance the task of managing the economy as a
whole against the task of asserting the particularities of its own
situation – these changes in political relationships operate to constrain
governments and to limit policy experimentation (policy fluctuates
between neoclassical revival and market regulation/social welfare)
o
-
-
Pettis (2001)
 There are two types of crisis: solvency (actual lack of money) and liquidity (bank
run, though they have enough assets, but when investors demand quick
repayments they cannot sell fast enough)
 Plunging prices on assets can turn a liquidity crisis into a solvency crisis,
enhanced when currencies weaken and foreign debt therefore increase
in real terms
- Liberal perspective on the crisis: Nau (2007)
o Complex interdependence – financial crises marred the 1990s (Mexico  Russia 
Asian developing countries  Argentina)
 All crises had similar patterns – a local currency came under pressure, either
from sliding exports (Mexico) or burgeoning imports (Argentina); investors sold
out anticipating a depreciation of the currency; currency devalued, so then local
businesses and investors had to repay foreign debts with much larger amounts
of local currency
 IMF stepped in to supply liquidity and help stabilize the situation; imposed
austerity (tight monetary and fiscal policies) to free up domestic resources to
increase exports and restore foreign confidence in the currency
 Critics: this compounded the problem by driving local economies into
serious recession
 Crises sparked debate on whether capital controls should be reinstated,
especially on “hot money” (most volatile short-term capital flows)
o Bhagwati (1998): yes – underlying cause of the crisis was
speculative capital flows
o Hale (1998): no – domestic policy changes in order, not constraints
on international capital flows because underlying cause of the crisis
was either underdeveloped banking system in Asian countries that
encouraged excessive lending and borrowing by local and foreign
investors or policy to maintain exchange rate tied to the dollar or
export structure that produced products already in surplus on world
markets
[realist perspective: hegemonic stability theory (see institutions/trade outline)]
There are different types of – broadly-speaking – “financial crises”
The Great Depression (what Gourevitch (1986) labels from 1929-1949)
o Overview: US stock market collapsed on October 29, 1929 (“Black Tuesday”), but then
turned upward again in early 1930; US Federal Reserve failed to take action, which
contracted the money supply, and at the same time allowed some large public bank failures
which produced panic and widespread runs of the banks (no emergency lending); Britain
returned to the gold standard at pre-WWI parities; severe drought in 1930; interest rates
dropped, but consumers were hesitant to borrow (loss of confidence from stock market
crash – consumers thought they could stay clear of further losses by staying out of the
market); Smoot-Hawley Tariff Act of 1930 raised US tariffs on over 20,000 imported goods
to record levels; deflationary spiral began in 1931 as many countries tried to shore up their
economies through protectionist policies (other countries retaliated), which worsened the
collapse in global trade; decline in world economy reached bottom in 1933
Latin American crisis of 1982: debt
o
-
-
Overview: in 1960s/70s, countries like Argentina, Brazil, and Mexico borrowed huge sums of
money from international creditors for industrialization (especially infrastructure); public
loans were typically through the World Bank or private banks that had an influx of funds
from oil-rich countries (after 1973); when oil prices skyrocketed in 1970s/80s (world
economy in recession), interest rates increased, which meant debt payments also increased,
making it more difficult for borrowing countries to pay back their debts; deterioration of
exchange rate with US dollar meant Latin American governments owed huge amounts of
national currencies; contraction of world trade in 1981 made prices of primary goods fall;
August 1982 – Mexico’s Finance Minister declares they can’t pay back debt and requested
renegotiation of payment periods; after Mexico’s default, lending halted to Latin America,
so refinancing refused and crisis ensued (billions of dollars of short-term loans were due
immediately); IMF intervened to give new loans with very strict conditions; World Bank also
came in to encourage open markets; finally, US/IMF pushed for debt relief
Mexican crisis of 1994-1995: profligate government spending and solvency
o Overview (note: often compared to East Asia to show differences): had been running capital
account deficits for a number of years and there were irresponsible policies, like lax banking
practices and corruption; unrest in Chiapas made investors nervous, so they began selling
“tesobonos” (peso-denominated bonds), which ultimately forced the devaluation of the
peso; this currency crisis did have regional effects (often called the “Tequila Effect”), causing
capital outflows throughout Latin America (and, in Argentina, a banking crisis); there was no
sound plan for dealing with the crisis, which prolonged it; rapid intervention in the form of a
$50 billion loan from the US and international organizations enabled a quick turnaround and
by 1996 the economy was growing again
Bulgarian crisis of 1996/1997: banking crisis  currency crisis (note: Romania also affected)
o Overview: Bulgaria had huge external debt following the collapse of communism and
depended significantly on external trade with the former Soviet Union; 1991 – price
liberalization began, but by the end of the year inflation was near 500%; 1992-1996 –
administrative control of prices increased; negative balances of state-owned enterprises and
banks (SOEs) led to high budget deficits, increasing internal debt, and monetization of these
losses by the Bulgarian National Bank (subsidized SOEs by giving direct loans or security
bonds); privatization delayed in Bulgaria – by 1996, only around 20% of land properties had
been restored to their owners and by 1997, only 20% of state assets were privatized;
Bulgaria had inherited non-performing loans from centrally-planned economy – some
became public debt and others were replaced with government securities, but these also
become non-performing (delayed reforms, poor management, lack of financial discipline);
legislation underdeveloped, so didn’t take action against insolvent banks (BNB couldn’t close
failed banks); by end of 1995, 66% of “unrecoverable” loans belonged to state-owned
banks; major problem was that different economic agents manipulated transition to derive
profits for themselves while at the same time, many macro-economic vulnerabilities 
political instability; there were temporary crises in 1994 and 1995, but the IMF came in to
stabilize; overall, though, Bulgaria lacked access to private creditors (no official agreement
with IMF); 1996 crisis – bank closures and “conservatorship”  massive withdrawals of
foreign currency deposits from banks  lev devaluation  withdrawals intensified 
hyper-inflation; solution: IMF money-based stabilization failed  currency board to fix
exchange rate (restricted BNB and pegged lev to German mark) + rapid banking sector
privatization by strategic foreign investors + prudential regulations (banking and monetary
policy) + banking supervision
o
-
Unlike Asian crisis, there was not a lot of capital outflow since the entire transition period
was characterized by low foreign capital inflows
o Berlemann, et al. (2002)
 “Twin crisis” – almost simultaneously occurring banking and currency crisis that can
be explained by the third-generation currency crisis model
 Substantial moral hazard behavior of the banking sector
 Currency crisis – exchange rate heavily devalues in a short period of time;
often as a result of a speculative attack
 Banking crisis – substantial number of banking institutions go bankrupt
and/or a substantial amount of bank deposits are lost by failing banks
 Banking system reform post-1989: sector-specific banks  commercial banks, twotier system; early 1991, there was BNB (which was granted independence), State
Saving Bank, and many commercial banks (with restricted – national – or full –
national and international – licenses) organized as joint-stock companies; these
banks then consolidated  sector dominated by state-owned banks, as commercial
banks were used by the government to provide subsidies (credits) to loss-making
SOEs; BSB as lender of first resort; many bad practices like bad loans and circular
loans (with commercial banks, Ministry of Finance, and BSB)
 This is an example of moral hazard model (third-generation) – before the crisis,
there was no formal law guaranteeing bank deposits, but the population expected
to be compensated in cases of losses anyway
Albanian crisis of 1997: pyramid schemes
o Bezemer (2001) [fits nicely with Chaudhry, Fish, Stiglitz in privatization/liberalization debate
in CPE, developing outline]
 “Albanian Paradox” – massive reforms starting in 1992, continued through 1996,
celebrated as an example of sound post-Socialist economic policy in line with the
“Washington Consensus”; macroeconomic indicators were good; then, economic
collapse and ensuing protests/looting/violence in early 1997 (often viewed as a
result of “Albanians’ mistaken notion of capitalism” – but note, these schemes
occurred all over post-socialist transition region)
 IMF reforms: liberalization of price controls and trade, tight fiscal and
monetary policies, and a floating exchange rate; privatization; depreciation
of the lek; creation of two-tiered banking system (Bank of Albania
committed to restrictive monetary and fiscal policies)
 Problem: absence of well-developed stock, real estate markets or access to
investment credit – this induced people and firms to revert to transactions
on informal markets; inflow came from (1) remittances (mainly from Greece
and Italy; 15-20% of annual GDP in 1992-96), (2) smuggling (fuel, cigarettes)
due to the international blockade on the Yugoslav warring states, (3) foreign
sources (EU aid)
o  informal markets  Ponzi schemes
o Informal financial sector did not have to report on their sources of
capital – not subject to strict banking law and licenses not required
 productive activities increasingly funded with Ponzi money
o Ponzi schemes are attractive because they offer savers high interest
rates; also, had some credibility, as associated with government
officials; last quarter of 1996: schemes had more than $250 million
in their accounts, but this represented only 40% of their liabilities

-
January 1997 – under IMF pressure, National Bank of Albania ruled that
“money firms” were limited in how much they could withdraw; funds set
dates to repay principal, but failed to do so; announcement of nonsustainable nature of schemes  masses of citizens besieged banks/firms to
get their money back
 Collapse effects: large parts of Albania controlled by irregular, armed bands,
economy shrank considerably, violence increased, and poverty rose
dramatically; brought down president/government and induced new reform
 The high incidence of Ponzi schemes and other financial-market aberrations in the
region was inadvertently fostered by the combination of restrictive monetary
policies, a lack of market regulation, large capital inflows, and weak governments
(typical of transition economies)
East Asian crisis of 1997-1999: liquidity + over-borrowing by private sector
o “Asian economic miracle” – countries experienced sustained high growth rates of 8-12
percent of GDP in the late 1980s and 1990s (high interest rates attracted foreign investors
looking for a high rate of return)
o Basics of the liquidity crisis: private companies and banks had borrowed short-term funds
denominated in foreign currencies from international investors for long-term projects; when
investors began to pull money out, debtors with long-term investments were not able to
repay; as investors sold Baht to buy dollars, the supply of Baht increased vis-à-vis the
demand, increasing pressures for devaluation; Thailand devalued the Baht, which made it
worth fewer dollars, making it even harder for debtors to repay their loans; because of this,
even more investors pulled out their money, with a contagion effect across many countries;
the contagion then led other countries to depreciate their currencies  cycle of competitive
devaluations; Thailand and Indonesia went to the IMF for a bailout, which said it needed
harsh structural reforms in the banking sector (but opaque), which hurt investor confidence
and thus the crisis continued with more investors pulling out their money
o Pempel (1999)
 The Asian crisis was different than the earlier IMF bailouts in Mexico and Argentina
– in Asia, there was over-borrowing by the private sector and an ensuing liquidity
crisis; the problem was not profligate government spending and a solvency crisis;
these countries had strong fiscal positions, low inflation, and high growth rates
 Four external causes:
 Changes in international and regional balance of power (US less tolerant of
Asian trade policies – with end of Cold War, began to see Asia as
competitor)
 Increasing interconnectedness of national economies (Asia’s economies
driven by complex web of production networks)
 Changes in the nature of corporate production processes (verticallyintegrated within single nations to international reflexive-manufacturing
systems)
 Increase in size and speed of cross-national capital flows (surge of supply in
US and Japan)
 There were different effects across countries: China, Taiwan, and the Philippines
were relatively unaffected (in the Philippines, cronyism allowed banks to borrow
from the government and then relend at higher interest rates); Indonesia and
o
o
Thailand, on the other hand, were the most vulnerable to hot capital for varying
reasons:
 Indonesia – Suharto’s policy preferences were uncertain and fluctuating, the
economy contracted by 15 percent, and Suharto was toppled
 Thailand – the parliamentary system was fragmented, which made rapid
response impossible, so the incumbent was thrown out, a new constitution
developed, and technocrats charged with implementing financial reforms to
avoid future cronyism
 The IMF responded inappropriately: provided credit rather than relying on private
banks and it forced Asian governments – not the private sector – to make changes;
this was most extreme in South Korea, where the US demanded structural changes
like allowing foreign ownership of corporations and the import of foreign cars,
which weren’t particularly related to liquidity problems
 ASEAN played little role – the nature of economic regional ties (based on
“coordination and consensus”) meant that a unified regional political response was
impossible
Haggard (2000)
 Three phases of the crisis:
 July 1997 – Thai Baht allowed to float and other SE Asian nations followed
 October 1997 – Taiwan floated currency; speculation then hit the Hong
Kong dollar, which was pegged; interest rates rose, stock market crashed,
and contagion began
 December 1997 – South Korea agreed to IMF reform program
 Can we actually group these countries? Some commonalities:
 Successful, outward-oriented growth strategies; high growth
 Not laissez-faire – used a variety of instruments like subsidies and selective
protection
 Political systems were authoritarian or semi-democratic, non-transparent,
and sometimes had corrupt business-government relations
 “Regimes of accumulation” – these political systems were geared to
generating high levels of investment
 “Crony capitalism” – institutions and relationships that were useful at one time
turned into vulnerabilities later
 Initially, the close business-government ties assured investors in highly
uncertain political environments and thus induced high levels of capital
accumulation
Noble and Ravenhill (2000)
 Internal causes – the “fatal combination”:
 Capital account liberalization
 Basically inflexible exchange rates
 Largely ineffective oversight of financial systems
 South Korea and Taiwan are similar on many factors, but what differentiates them is
divergent legacies of government-business relations and different approaches to the
allocation of capital – this led to different levels in the severity of the crisis
 South Korea – “big-push capitalism”; less flexible economic structure than
Taiwan, worse macro-economic conditions – this constrained policy options
available to governments

o
Taiwan – “bifurcated capitalism”; better macro-economic conditions, more
leading sectors (computers, electronics, textiles – whereas South Korea only
had electronics), stable political domination – this led to more policy options
Wade (2000)
 South Korea, Thailand, Malaysia, Indonesia, and the Philippines
 Crisis happened in the context of sustained success and did not result from the
things that are thought to be the normal causes of economic crisis in developing
countries – bad “fundamentals,” meaning fiscal deficits, trade deficits, and inflation
 Official-academic consensus: causes were still mostly “homegrown,” “failure of
Asian governance” theory
 Crisis trigger was the sharp reversal of private capital flows starting in mid1997
 Explanations: (1) “lack of transparency” in company and bank accounts,
which meant that institutional investors could not know the truth about the
position of their borrowers, (2) “weak prudential regulation” by the
monetary authorities, which allowed banks to lend to heavily indebted
companies, (3) “poor” exchange rate management, meaning commitment
to a fixed exchange rate, which seemed to rule out foreign exchange risk,
making foreign borrowing too cheap, (4) “moral hazard,” meaning investors
expected that the banks and firms they were lending to would be bailed out
by the Asian governments (“implicit guarantees”)
 These causes are consequences of East Asia’s “cronyistic” system of
economic governance, where banks rather than capital markets
intermediate finance; banks, big firms, and governments have close and
long-term relations; agreements made behind the scenes, unmonitored by
independent parties, unenforced by courts
o So, these governments needed to reform and establish “sound”
institutions and policies, meaning consistent with the Washington
Consensus
o Assumes that the “golden rule” of the new international financial
system should be transparency, because that allows capital markets
to be stable and deliver big net benefits to developing countries
open to them
 Problems with the “failure of Asian governance” theory: no evidence of systemic
misreporting of macro-variables relevant to crisis; investors were ignorant not
mainly because information was falsified or unavailable, but because they weren’t
paying attention to what was available; little evidence distinguishes the quality of
banks in the Asian crisis economies from those in non-crisis emerging markets
 Alternative: “failure of international financial markets”
 In the late 1980s and 1990s, several East Asian governments lifted most
restrictions on capital mobility  foreign capital flooded in during 1990s,
mostly in bank loans and portfolio investments with short-term maturities,
much of it in assets prone to bubbles  increased reserve assets 
fragilities
o East Asia’s continued high growth rates during the 1990s concealed
a change in the source – by mid-1990s, an appreciable part of the
total was bubble growth rather than real growth (company profits
-
and debt repayment came to depend increasingly on rising asset
prices)
 Conjunctural shocks – East Asian exports suddenly faltered in 1996, world
growth slowed, Japan and China slowed, China and Mexico devalued, dollar
appreciated
 Asian crisis was a crisis of overinvestment
o Similar to Mexican crisis of 1994-1995 in some ways: domestic
credit boom generated by unsterilized foreign capital inflows, which
were attracted by proximity to the United States and by anticipated
economic success
 But, difference: credit boom in Mexico gave a surge of
imported consumer goods, reflecting high consumption
propensities, while the Asian credit boom vented itself
more in excess investment, reflecting high savings
propensities
 Excess consumption  easier recovery because it
entails less debt and excess capacity to be worked
out of
 Recovery: squeezed domestic economy to reduce imports and shift more
resources into export production; this solved external crisis sometime in
1998 (exchange rates stabilized), but worsened internal credit contraction
crisis, which continued into 1999
 So, need regulation!
US/global financial crisis of 2007-2008 (“The Great Recession”)
o Stiglitz (2001, foreward to Polanyi (1944))
 Polanyi stresses the interrelatedness of the doctrines of free labor markets, free
trade, and the self-regulating monetary mechanism of the gold standard
 Today, we have flexible exchange rates, but excessive changes in these prices, and
investor expectations more broadly, can wreak havoc on an economy
 Self-regulating economy does not always work as well as its proponents would like
us to believe
 Not even the US Treasury or the IMF believe that governments should not intervene
in the exchange rate
 The IMF is a public organization that regularly intervenes in exchange rate
markets, providing funds to bail out foreign creditors while pushing for
usurious interest rates that bankrupt domestic firms
 The recent push for financial and capital market liberalization in developing
countries had disastrous consequences, as evidenced by recent global financial
crisis; liberalization could impose enormous risks on a country, and those risks
borne disproportionately by the poor
 Free international trade allows a country to take advantage of its comparative
advantage, increasing incomes on average, though it may cost some individuals
their jobs, but in developing countries – with high levels of unemployment – the job
destruction that results from trade liberalization may be more evident than the job
creation, and this is especially the case in IMF “reform” packages that combine
trade liberalization with high interest rates, making job and enterprise creation
virtually impossible

o
Polanyi’s defect in self-regulating economy: relationship between economy and
society – in each case, not only did economic policies contribute to a breakdown in
long-standing social relations, but the breakdown of social relations itself had
adverse economic effects since investors were wary of putting their money into
countries where social tensions seemed high and many others took their money out
 Latin America – extended periods of unemployment, persistent high levels
of inequality, pervasive poverty has had disastrous effect on social cohesion
 Russia – put into place the notion of the self-regulating market economy
before the government had a chance to put into place the necessary legal
and institutional infrastructure  economy shrank by almost half,
privatization led a few oligarchs to become billionaires, but government
didn’t have money to pay pensions; manner and speed of reforms eroded
social relations, destroyed social capital, and led to the creation and
perhaps dominance of the mafia
 East Asia – IMF, US Treasury (neoliberal doctrines) resisted default; loans
were, for the most part, private sector loans to private borrowers; typically,
if borrowers cannot pay  bankruptcy; IMF said no, that bankruptcy would
be a violation of sanctity of contracts; instead, provided funds to
governments to bail out foreign creditors, who had failed to engage in due
diligence in lending
o East Asian crisis was the most dramatic illustration of the failure of
the self-regulating market: it was the liberalization of the short-term
capital flows, the billions of dollars sloshing around the world
looking for the highest return, subject to the quick and irrational
changes in sentiment, that lay at the root of the crisis
Stiglitz (2010)
 The financial sector is supposed to allocate capital and manage risk, both with low
transaction costs – before the crisis, it did none of this
 Problem was that the banks and others in the financial sector were not stopped
from behaving badly by the regulators – this allowed the financial sector to prey on
the poorest Americans
 Two main reasons for failure: (1) agents were too caught up with short-term returns
and (2) externalities existed (where a market exchange imposes costs and benefits
on some who aren’t party to the exchange)
 This led to inefficiency
 Little or no effective quality control
 Idea of “too-big-to-fail” led to excessive risk-taking
 “Too-big-to-fail” means that if a bank is under the threat of going bankrupt,
the shareholders and bondholders lose everything, and enough money is
put into the bank to keep it going and to prevent losses to the depositors
 Bankers acted too greedily – they knew they could take risks because the
federal reserve and treasury would bail them out; they also acted lazily –
the math was just wrong (using lognormal distribution, but these “low
probability” events were actually happening more frequently than they
“should” – the model was wrong – needed fat-tailed distribution!)
 Systemic risk – there are regulations because of externalities (there are
consequences for others from domestic failures); when each bank is judging risk, it
o
is only looking at consequences to itself, not at the systemic consequences that
might arise from its bad behavior (note: even small banks – if they have correlated
behavior – can give rise to systemic risk)
 What is needed? Regulation and government intervention (countries like India,
Brazil, and China weathered the storm better because they had good regulation)
Helleiner (2011)
 Stages of the crisis:
 Began in US with burst of housing bubble and growth of mortgage defaults
 hedge funds collapsed  attempted to calm the markets with large
doses of liquidity  March 2008, US investment bank Bear Sterns had to be
rescued by US authorities  September 2008, Fannie Mae and Freddie
Mac, government-sponsored mortgage lending agencies, went under a form
of public “conservatorship” because of the enormous losses they were
experiencing, Lehman Brothers forced into bankruptcy, American
International Group (AIG – world’s largest insurance company) was rescued
and nationalized by US government [shows similarities to Bulgaria]
 US and European banks pulled back their international loans, triggering
severe financial problems and debt crises in countries that had been
borrowing heavily from abroad; international trade credits dried up;
financial contagion felt particularly strongly in countries whose financial
systems were already vulnerable due to home-grown housing bubbles,
financial excesses, and/or large current account deficits
 Impact spread globally through various spillovers operating through the
“real economy,” such as collapsing exports, commodity prices, and
remittance payments
 Explanations for the crisis: innovation + excessive risk taking
 Market failures generated excessive risk taking and a financial bubble during
the years leading up to the crisis
 Kindleberger (1978): financial manias are usually set off by a change in
expectations or “displacement,” often caused by some kind of innovation,
which then generates overtrading and the emergence of a bubble driven by
a kind of excessive optimism and herd behavior; when bubble eventually
bursts, panic ensues
 Roubini and Mihm (2010): innovation in this crisis is new kinds of
securitization in financial sector itself
o Mortgage-backed securities, MBSs, structured in complex ways,
bundled together, sold/traded worldwide  divided and
repackaged together again into collateralized debt obligations,
CDOs
o New derivatives: credit default swap (CDS) – allowed for speculation
on the likelihood of default on specific bonds
o So basically, there was rapid growth in the trading of credit risk,
which market players believed were boosting the stability and
resilience of the financial system by dispersing risk and deepening
markets for risk
o

Note, however, that the crisis was not indiscriminate in its effects;
only countries whose financial systems suffered from similar frailties
fell victim to it (example: Canada was fine – tougher regulations)
 Differentiated experiences show that national financial
systems remain regulated in distinct ways, despite
globalization.
o Problems of securitization: investors frequently lacked full
understanding of complex securities they purchased or the quality
of the loans underlying the asset-backed securities in which they
invested; relied on credit-rating agencies; increased the number of
financial actors who fell outside of traditional prudential regulations
covering commercial banks; the large-scale buying and selling of
complex securities and derivatives had increasingly taken place
among a very small number of financial institutions (it had
concentrated, not dispersed, risk); approximately half of the MBSs
and CDOs created by Wall Street were sold to foreigners, especially
European banks and hedge funds, but there was no transparency
 Explanations for the crisis: “international financial standards regime”
o Regulators worked intensively to build and strengthen
internationally coordinated prudential standards following the
Mexican and East Asian financial crises; Basel I/II (1996/2004),
Financial Stability Forum (1999)
o Problems: common international capital standards were developed
for banks, but those standards did not apply to the institutions that
were becoming more important because of securitization trends,
like investment banks, insurance companies, and hedge funds;
trend toward “market-friendly” approaches to regulation that
trusted private actors to self-regulate
 Strange (1998), Blyth (2003), Best (2005)
o Global markets increasingly out of the control of regulators and
supervisors; warned against delegation of regulatory functions to
private actors in international standards and the opacity of, and
leverage within, derivative markets
o Complexity of derivatives made risk monitoring particularly difficult;
growth in complex derivatives would mean that future crises would
be amplified through the system in unpredictable ways
o Derivatives create links across markets; opaqueness makes it
difficult for market actors to accurately determine any institution’s
risk at any given time
Another explanation: macroeconomic environment of cheap credit during half
decade before 2007 also led to excessive risk-taking
 International capital flows – capital inflows drove down the cost of credit in
the US; there was too much foreign investment in the US (much of it coming
from foreign governments like China, Japan, oil-exporting countries, and
some developing economies, particularly in Asia)
o This led to foreign reserve accumulation (of dollars)
o Foreigners were too supportive/enthusiastic about US assets – they
didn’t pull out their money (unlike in most emerging-market
-
countries over the previous two decades, the bursting of domestic
financial bubbles was not accompanied by capital flight)
 This is a product of what Strange (1998) calls America’s
“structural power” in global finance
 Structural power – while US may be declining in
material power, structural power is the ability of a
hegemon to continue to set the rules and
procedures of economic relations
More specifically, Eurozone and the Greek debt crisis. What makes it so different? The EU memberstates in the Eurozone can’t devalue their currencies. Here, particularly, Greece cannot devalue the
Euro – the option is to leave the Eurozone and revert to the drachma.
o Overview (of recent events):
 2001 – Greece joins Eurozone (drachma  Euro)
 Troika = EC, IMF, ECB
 2009 – S&P cuts Greece from A  A-, Papandreou/PASOK win, Finance Minister
Papakonstantinou reports new deficit statistics, new budget, S&P downgrades again
 2010 – plan to bring within EU deficit limit (3%) by 2012, EU Commissioner: “Greece
will not default. In the euro area, default does not exist,” austerity package,
emergency loans from EU decided upon (30 billion euros over a year, IMF adds 15
billion), revised statistics, Moody’s cuts Greece’s rating, Papandreou asks for the 45
billion euro bailout, S&P gives Greece junk status, agrees to 110 billion euro rescue
package-Greece agrees to 30 billion in austerity cuts over next three years, protests,
750 billion euro rescue mechanism set up (European Financial Stability Facility),
Greece receives first of bailout, Moody’s downgrades to junk, budget plan to cut
deficit to 7% of GDP by 2011
 2011 – Fitch cuts Greece to junk, EU agrees to cut rates on emergency loans,
Papandreou announces 78 billion euros of austerity measures with 50 billion from
state asset sales, more downgrades, EU finance ministers discuss idea of extending
Greece’s debt-repayment schedule (May), Greece passes another six billion Euros in
austerity measures, S&P cuts Greece to worst rating for any country it reviews in the
world, Papandreou announces Cabinet reshuffle and confidence vote, he survives,
approve 78 billion in austerity despite protests, EU passes second bailout, bankers
agree to take losses of 21 percent on net present value of Greek bond holdings,
draft budget for 2012 agreed with targeted deficit of 8.5% (missed 2011 target),
more austerity including wage and pension cuts and laying-off 30,000 state workers,
EU decides to force private investors to take a 50% haircut and will extend new aid
package of 130 billion euros, Papandreou calls referendum, stocks/bonds plunge, EU
cuts off aid payments, Papandreou backs down and calls for government of national
unity led by Papademos
 2012 – biggest sovereign debt restructuring in history, S&P downgrade to “selective
default,” but then 95.7% investor participation in restructuring puts them back up;
elections – Samaras doesn’t form coalition, Tsipras doesn’t form coalition; new
elections – Samaras forms coalition (ND, PASOK, Dem Left) and calls for
renegotiations of austerity measures
o Featherstone (2011)
 Internal weaknesses: poor intra-governmental coordination, efficiency, and
resources, prime minister has almost presidential powers, but lacks centralization of
resources and cabinet is very limited; bureaucracy – low-skill, low-tech, legalistic








operating norms, and strong union power; weak control of public expenditure;
problems of raising tax revenue; vulnerable to corruption and political culture is
marked by clientelism, rent-seeking, and corruption (ranked worse by CPI than any
of its south European counterparts); “disjointed corporatism” – domestic market of
anti-competitive regulation, barriers to entry, relatively cheap labor, and stable
product demand – constituency for liberal market reforms has been shallow; large
informal economy; state health service and education are paralleled by the highest
levels of private expenditure on health and education in the EU; lack
competitiveness; high public debt  low reform capacity
October 20, 2009 – George Papakonstantinou announced a tripling of the level of
government debt for 2009, from 3.6% of GDP (Karamanlis’ reported number) to
13.6% by 2010 (note: new finance minister – this was just two weeks or so after the
election)
December 8, 2009 – all three major credit rating agencies further downgraded
Greece’s status
April 27, 2010 – Standard and Poor gave Greek bonds “junk status”
 These ratings agencies exerted power over sovereign states – constituting
“governance without government,” raising issues of accountability
Key problem for euro area: any monetary union must rely on state-level
administrations for the supply of data that will affect its policy management (made
National Statistical Service independent in July 2010)
Eurosystem ill-equipped to deal with a crisis like that of 2010, lacking the capacity
for speedy reaction, policy discretion, and centralized action
 Merkel: German public condemned Greece, German Constitutional Court in
its adjudication of the Maastricht Treaty emphasized that transfer of
sovereignty was justified as long as the new euro currency was couched in a
regime of monetary stability (rescuing Greece challenged such principles);
Merkel protected national interests; Maastricht – no “bail-out” of states
with excessive deficits; at the same time, denied powers of intervention to
the EMU institutions (no way to expel a bad state/no way to deal with moral
hazard issues)
May 2, 2010 – 110 billion Euro loan with strict conditions (and part from IMF)  by
trying to stay out of a rescue, the EU governments had been dragged more deeply
into it
 German government was obliged – like its partners – to accept the stark
choice of bailing out Greece or bailing out its own banking system; at the
same time, recourse to the IMF created doubts about the governance of the
Eurosystem
Government cutbacks – public sector posts, salaries, and pensions cut; liberalize
“closed-shop professions”
EMU reform – May 9, 2010 – established European Financial Stability Fund as a
rescue mechanism; idea that the Commission would monitor the position of
member governments by reference to the concept of “prudent fiscal policy-making”
along with macro-economic indicator monitoring; desired to impose fines against
democratically elected governments that weren’t following rules (much criticism of
this); other idea was to create a “European Debt Agency” where profligate states
would have to pay a higher interest rate than others
 Problem: these things require a political union that just doesn’t exist
o
o
 The Greek crisis exposed the weakness of the EMU governance structure
Arghyrou and Tsoukalas (2011)
 Krugman’s (1979) “first-generation crisis model” likely doesn’t work – unlike the
collapse of a conventional peg, debt default is a much rarer and less likely event,
particularly for a Eurozone member with additional access to IMF emergency cash
 the escalation of the crisis in November 2009 unlikely to have been caused by
market fears of imminent Greek debt default
 Obstfeld’s (1996) “second-generation crisis model” can be interpreted in this case:
commitment to an exchange rate peg is commitment to future EMU participation
 Late 2008/early 2009, Greek fundamentals correctly judged by markets to
have deteriorated to the point to be inconsistent with long-run euro
participation; markets sold substantial but not critical volume of Greek
bonds  government should have taken corrective action because
commitment to EMU not questioned, but didn’t  after election, had a
little room to signal, but government sent mixed signals  budget
submitted to Commission in mid-November 2010 showed unwillingness to
address fundamentals  questioned commitment of Greece to Euro 
non-credible commitment side, not credible  steep increase in Greek
bond spreads  full-blown crisis of confidence in Greek monetary regime
 Krugman’s (1998) “third-generation crisis model” – Greece joined EMU in 2001; by
becoming a member of the single currency, funds flow in; markets perceived that
the rest of EMU countries had vested interest in Greek reforms; Greek accession
was perceived to convey implicit bailout guarantee with Germany in role of the
guarantor; as a result, markets stopped pricing Greek bonds on the basis of
expected fundamentals and started pricing them exclusively on the basis of
achievement of full real convergence to German fundamentals; in February/March
2010, Germany’s policy position made it clear that it wasn’t prepared to help Greece
unconditionally  withdrawal of fiscal guarantee  price of Greek bonds
plummeted
 Germany’s choice not to bail out Greece (“constructive ambiguity”)
introduced a previously non-existent default risk, causing the decline in
Greek bond prices to accelerate in March-April 2010
Aggarwal (2012, HBR blog)
 “History rhymes in the Greek debt crisis”
 Downside of global interdependence: the fact that Greece with a population of a
mere 11 million and a GDP of $300 billion (only 2% of the Eurozone economies) can
create systemic risk for the world
 As in previous crisis, the debate over debt rescheduling revolves around two key
concepts:
 Moral hazard – if you shield an actor from the consequences of
irresponsible decisions, you only encourage more bad behavior by that
actor and others and ultimately make things worse
 Systemic risk – “too big to fail” argument; even though you might find
bailing out profligate debtors distasteful, not doing so might bring the
system down
 1982 – following years of borrowing, Latin American countries as well as others in
Asia and elsewhere found themselves massively in debt; Reagan wanted to raise
interest rates to kill off US inflation

-
Other
o
o
o
Mexico was in particularly bad shape and, by August 1982, neared complete
default  signaled systemic risk
 Bank retrenchment and “redlining” – treating the whole region as being the
same – resulted in over 25 countries falling into arrears by 1983
 What followed for Mexico was a preview of the current Greek “debt game” –
Mexico was asked to develop an economic adjustment program in exchange for a
“jumbo loan” put together by the banks, the US government, and the IMF; central
banks pitched in with a $1.85 billion credit to be released in three tranches with
disbursement hinging on the results between Mexico and the IMF over austerity
measures
 Over next couple of years, main effort was to roll over loans and ensure Mexico
continued to fully service its debt
 Baker Plan (1985) – more of the same rollover failed to alter the basic course of
debt negotiations
 Only in the face of concerns about Mexico’s political stability did the US
position begin to change
 1988 – political instability in Mexico following elections; Brazilian debt moratorium
of 1987  US proposed debt reduction and/or debt service reduction be combined
with increased lending and continuation of growth-oriented economic adjustment;
IMF also changed tune saying that countries willing to enact domestic reforms
“need to be able, from the outset, to count on a more adequate alleviation of the
present drag of debt-service payments on their adjustment efforts”
 Secretary of the Treasury Brady forced the issue as banks resisted – gave Mexico’s
creditors three options: (1) reduce principal of the debt by 35 percent, (2) interestrate reduction to a fixed rate of 6.25 percent, (3) extension of new loans in
proportion to outstanding exposure
 41 percent of the debt covered by banks chose (1), 49 percent chose (2),
and the rest chose (3)  Mexico, and others in Latin America, began to
recover
 Differences between Greece and Mexico: without an independent monetary policy
or its own currency, Greece cannot follow looser monetary policy or devalue its
currency; debt has already been reduced by 53% (considerably more rapid than
Latin America, where the process took over seven years)
 Lessons: previous episodes of debt rescheduling show us that dragging things on
can exacerbate problems to the point where inaction or excessive deliberation
creates systemic risk
evidence of the importance of institutions and politics [see CPE, developing outline]
Polanyi (1944)
Gerschenkron (1962)
Chaudhry (1997)