ECON3315 International Economic Issues

ECON3315International Economic Issues Instructor: Patrick M. Crowley Issue 19: Financial Crises

Overview • Types of financial crisis • Debt crises: what is the issue? • What happens in a financial crisis? • Approaches • Historical perspective • Reputation effects

Types of financial crisis • Debt crises • Speculative bubbles and crashes • International financial crises Each has a different effect, and can have limited “country-wide” impact (e.g. Finnish banking crisis of 1992) or can be international in nature (e.g. South East Asian crisis)

Debt crisis: what is the issue? • The issue is that countries sometimes spend beyond their means and end up not being able to pay their debts. • These are known as “sovereign debts” and as a country cannot go bankrupt (all debts from any government are automatically inherited by the next government), should there be some way to deal with this on an international level? • Why? Because if a crisis is allowed to happen, it can often lead to contagion and regional instability and might even cause a regional collapse in economic confidence. • Access to international capital markets allows countries to borrow. International capital markets assess a country’s ability to pay back on macroeconomic performance, so this is key here.

What happens in a debt crisis? • Bonds are the sovereign debt of a country • When countries no longer have the funds to pay interest on their bonds, a “default” occurs • Usually the lenders get together and go to the country to negotiate a “debt restructuring” which sometimes lowers interest rates so a payment can be made, sometimes agrees upon a future debt repayment schedule. These lenders are usually known as “clubs”. • Usually an economic crisis occurs at the same time so the IMF is heavily involved, and so economic reforms are expected • Once the IMF is happy and releases funds, usually private funds begin to flow back to the country and lending resumes

Approaches ameliorating debt crises Several different approaches have been made to solving this problem in the literature: • Introduce a “Chaper 11” bankruptcy type process for countries (Anne Krueger) • Allow the IMF to operate as an international “lender of last resort” (Barry Eichengreen) • Capital controls and flexible exchange rates (Jeffrey Sachs)

Debt crises: an historical perspective – the usual suspects? Many countries are “serial defaulters” – that is, they have defaulted many times • Brazil has defaulted on it’s debt 7 times over the past 175 years • Venezuela has defaulted on it’s debt 9 times over the past 175 years • Some countries have only ever defaulted once, and many developing countries have never defaulted on their debts. • But looking further back in time things were very different…

Not necessarily the “usual suspects”!

Reputation effects Interestingly, if you think that Brazil and Argentina and Columbia have extremely high debts to begin with, you’d be wrong… • In 2001 when Argentina defaulted, its debt/GDP level was only 52%, less than the level the US debt/GDP level is forecast to be for 2009 • Currently Japan has extremely high debt/GDP levels, and yet there is no talk of default…why? • Seems to be reputation effect at work, and this is why serial offenders common…you either default a lot, or not at all. • Clearly costs of defaulting for the first time are significant, and once default occurs, likely that international capital markets will not lend to you as freely again

Reputation effects Surprising result here, as no linear relationship between debt to GDP at all….

So what is going on here? Seems to be 3 groups at play…and reputation clearly matters….

Speculative bubbles • Dutch tulip bulb bubble in the 1700s was first known speculative bubble • Idea is that if people know that other people expect prices to go up, then prices will rise in a self-reinforcing way, until the bubble bursts and you get a “crash” • Experimental economics shows that these bubbles occur even with small numbers of traders – seems to be behavioral • Sometimes also known as “herd behaviour” or “bandwagon effects” • Examples are Great crash (USA), Late 2000s internet stockmarket bubble (USA), oil prices in summer of 2008, and UK and some US housing markets in recent years

Financial crises • Presentation

ECON3315 International Economic Issues