Currency Crises: A Challenge to Economic Theory and Economic Policy

From the viewpoint of policy makers, the understanding of the causes and the course of financial crises remains inadequate. The theoretical analysis of currency crises has been hampered by the lack of empirical regularities in those of the past. Nonetheless, attempts are made repeatedly to provide a canonical explanation of international financial crises and to propose economic policies to prevent such crises. This article surveys the recent theoretical, empirical and economic policy literature on financial crises (with emphasis on the Asian crisis). Much of the recent theoretical literature, in particular that dealing with the Asian crisis, refers to the complex relationship between the constitutive imperfections of financial markets resulting from asymmetric information and the worldwide liberalization of the financial and capital markets. It is an outstanding feature of financial markets that they are strongly dominated by expectations. The actual market outcome may correspond to expectations even if these expectations were unjustified ex ante or absurd. Thus, expectations determine whether market outcomes tend toward a "good" or "bad" equilibrium. In principle, changes in international investors" expectations for the worse – whether justified or not – may trigger crises (self-fulfilling crises) and move a country from a "good" (high growth) to a "bad" (low growth) equilibrium. According to the views of leading theoreticians and practitioners, this mechanism was the preeminent element of the Asian crisis. It is a surprising insight that "self-fulfilling crises" may indeed be the result of rational behavior, given the constitutive imperfections of financial and capital markets. In a world of liberalized financial markets, such crises cannot in principle be averted and are very difficult to forecast. A reversal of the liberalization of financial markets or the re-introduction of capital controls would be the wrong response, however. A superior option in economic policy is the establishment of "support" systems to increase the efficiency and stability of international financial markets. Core elements of such systems would be institutions of financial surveillance and monitoring, which among other tasks could fulfill the important function of a "lender of last resort" at the international level, and provide an internationally accepted set of rules for standstill agreements, debt relief for and financial default of countries.