The empirics of currency and banking crises.

• Author: Eichengreen, Barry
• Position: A non-theoretical study of financial crises

Currency and banking crises are potholes on the road to financial liberalization. It is relatively rare for them to cause a vehicle to break an axle - to bring the process of growth and liberalization to an utter and extended halt - but the flats they cause can result in significant losses of time and output and set back the process of policy reform. The output costs of both currency and banking crises can be a year or more of economic growth and the resolution costs of banking crises have often been the equivalent of two or more years of GNP growth. As capital becomes increasingly mobile, the severity and prevalence of these problems has grown, as amply demonstrated by recent experience in Asia, Latin America, and Europe.

There is no shortage of theoretical models of the causes and consequences of banking and financial crises.(1) But in comparison, systematic empirical work has been scarce. For the last several years, therefore, together and with a number of collaborators, we have attempted to reorient work on this subject in empirical directions.

In this article, we review this empirical research on currency and banking crises and provide a critical review of related literature. In addition, we offer some suggestions - and cautions - for future research.

Currency Crises

Contrary to the assumption of convenience made in some other recent writings, currency crises cannot be identified with changes in the exchange rate regime. Not all decisions to devalue or float the exchange rate are preceded by speculative attacks.(2) More importantly, a central bank may successfully defend its currency against attack by using its international reserves to intervene in the foreign exchange market. Alternatively, it may discourage speculation against the currency by raising interest rates or forcing the government to adopt other austerity policies.

An innovation of our work therefore has been to construct empirical measures of speculative attacks. We measure speculative pressure as a weighted average of changes in exchange rates, interest rates, and reserves, where all variables are measured relative to those of a center country.(3) Intuitively, speculative pressure can lead to a loss of reserves, be rebuffed by a rise in domestic interest rates, or be conceded by a depreciation or devaluation of the exchange rate.(4) Speculative attacks or currency crises (we use the terms interchangeably) are then defined as periods when this speculative pressure index reaches extreme values.

With this distinction in mind, we have analyzed of the experience of more than 20 OECD countries, using data that stretch back to the late 1950s.(5) We find that devaluations - as distinct from currency crises - generally have occurred after periods of overly expansionary monetary and fiscal policies. These expansionary policies lead to price and wage inflation, deteriorating international competitiveness, and weak external accounts. They occur when unemployment is high. as if governments are attempting to stimulate an economy in which unemployment has political and economic costs. But that stimulus leads to a loss of reserves, which jeopardizes exchange rate stability. There are some signs that governments react by adjusting policy in more restrictive directions in an effort to stem the loss of reserves. In episodes that culminate in devaluation, however, these adjustments prove inadequate. Reserves continue to decline, eventually forcing the government to devalue the exchange rate. When devaluation finally occurs, it is accompanied by some monetary and fiscal retrenchment to reassure investors and render the new level of the exchange rate sustainable. As inflationary pressures fall, there is a sustained boost to competitiveness that helps to restore balance to the external accounts. This comes at the expense of sustained unemployment and falling employment and output growth.

It is more difficult to generalize about currency crises. Put another way, devaluations are more predictable than speculative attacks.(6) Although there are signs that crises, like devaluations, are preceded by loose monetary policies and inflation, there is less sign of governments attempting to rein in their expansionary policies as the threat to the exchange rate develops. The foreign exchange market intervention that occurs is sterilized (its potential effects on the domestic money supply are neutralized, and its effectiveness is therefore reduced). There are fewer signs of monetary and fiscal retrenchment in the wake of the event. The exchange rate changes that take place in response tend to be disorderly. They do not lead to the establishment of parities that are clearly sustainable. Indeed, the exchange rate is frequently floated rather than merely being devalued.

Thus, the failure of governments to adapt policy in a manner consistent with their exchange rate targets is at the heart of many currency crises. This points to the need for studying political incentives and constraints on economic policy formulation. One approach is to build on the theory of optimum currency areas and ask whether economic characteristics of countries that make exchange rate stability advantageous are associated with extensive and concerted foreign exchange market intervention.(7) Another approach is to assess political considerations directly. We have tested whether speculative attacks are more likely to occur before or after elections and whether left- or right-wing...