Paul Krugman, January 2010
As this is formally billed on this program as the Nobel lecture, I suppose that I’m expected to focus on the work for which I was honored with the prize. And yet … proud as I am of the work I and many others did on increasing-returns trade and economic geography, given what is happening in the world – and given what I’ve largely been working on these past dozen years – that work is not uppermost in my mind.
Fortunately, there’s an out. The Nobel committee did cite another line of work that goes back to the first good paper I ever wrote: “A model of balance of payments crises”, published in 1979 but originally written while I was in still in grad school. When I’m in an expansive mood, I like to say that I invented currency crises – not the thing itself, which goes back to the invention of paper money, but the modern academic literature. And business has been good ever since.
Now, most of what has gone wrong with the world these past two years has not taken the form of classic currency crises (though give it time – the Baltic nations, in particular, seem well positioned to follow in Argentina’s footsteps). But there are strong parallels between the kinds of crises we actually have been experiencing and what those of us in the currency crisis biz call “third-generation” crises. Both the similarities and the differences are, I think, illuminating.
So without further ado, let me launch into a discussion of currency crises, their relationship to financial crises in general, and what all of that tells us about current prospects.
A history of violence
The sudden implosion of world financial markets, trade, and industrial production in 2008 shocked many if not most economists. I think it’s fair to say, however, that international macroeconomists were less startled. That’s not to say that we predicted the crisis: speaking personally, I saw that we had a monstrous housing bubble and expected bad things as it deflated, but both the form and the scale of the collapse surprised me. What is true, however, is that international macroeconomists were aware, in a way those who focused mainly on domestic data were not, that the world economy has a history of violence. Drastic events – sudden speculative attacks that emerge out of a seemingly clear blue sky, abrupt economic implosions that slash real GDP by 5, 10, even 15 percent – are regular occurrences on the international scene.
Let me illustrate the point with the figure below, which shows peak-to-trough declines in real GDP during “third generation” currency crises (a term I’ll explain in a little while). This list is close to, but not identical to, the Reinhart and Rogoff (2009) list of banking crises: as R&R point out, crises often combine elements of several of their ideal types. What I’ve done in this case – in a poor man’s homage to Reinhart and Rogoff’s awesome data-collection effort – is scan the Total Economy Database for all cases of sharp GDP declines in high-and middle-income countries since 1950, then do some cursory historical research to ask whether they fit the profile of a third-generation crisis.
GDP declines in third-generation currency crises
0 Mexico 1994 Korea 1997 Chile 1981 Malaysia 1997 Finland 1990 Thailand 1997 Indonesia 1997 Argentina 2002 5 10 15 20
A few observations: First of all, we’re talking huge declines here – Depression-level, in some cases. You can see why international macroeconomists were more attuned to the possibility of disaster than domestic macroeconomists: if you were looking only at US data, your idea of a really bad slump would be 1981-1982, when real GDP fell only 2.3 percent.
Second, if you know a bit about the history, you get a very strong sense of just how wrong conventional wisdom can be. Reinhart and Rogoff emphasize the “this time is different” syndrome, the way people wave off clear parallels to earlier crises. I’d go a bit further and argue that there’s...
References: Aghion, Philippe, Philippe Bacchetta, and Abhijit Banerjee, 2000, “Currency Crises and Monetary Policy with Credit Constraints” (unpublished; Cambridge, Massachusetts: Harvard University). Chang, Roberto and Andres Velasco 1999, “Liquidity Crises in Emerging Markets: Theory and Policy,” NBER Working Paper No. 7272. Eichengreen, Barry, Rose, Andrew, Wyplosz, Charles and Dumas, Bernard, “Exchange Market Mayhem: The Antecedents and Aftermath of Speculative Attacks”, Economic Policy, October. Flood, Robert, and Peter Garber 1984, “Collapsing Exchange Rate Regimes: Some Linear Examples,” Journal of International Economics, Vol. 17, pp. 1–13. Krugman, Paul, 1979, “A Model of Balance of Payments Crises,” Journal of Money, Credit and Banking, Vol. 11, pp. 311-325. Krugman, Paul, 1999, “Balance Sheets, The Transfer Problem, and Financial Crises,” in Flood, Robert, Isard, Peter, Razin, Assaf, and Rose, Andrew, eds., International finance and financial crises: essays in honor of Robert P . Flood, Jr., Kluwer. Krugman, Paul 2002, “Crises: the next generation” in Assaf Razin, Elhanan Helpman, and Efraim Sadka, eds., Economic policy in the international economy: essays in honor of Assaf Razin, Cambridge. Obstfeld, Maurice; 1994, “The Logic of Currency Crises,” Cahiers Economiques et Monetaires, Bank of France, Vol. 43, pp. 189-213. Reinhart, Carmen and Rogoff, Kenneth 2009, This Time is Different: Eight Centuries of Financial Folly, Princeton. Salant, Stephen and Henderson, Dale 1978, “Market Anticipations of Government Policies and the Price of Gold”, Journal of Political Economy
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