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Financial crises and political crises

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  • Chang, Roberto

Abstract

Why are some financial crises associated with political crises and some are not? Does political instability cause financial fragility or the other way around? What are the implications of political distortions for policy in countries experiencing financial turmoil? This paper studies these and other questions in a formal model of debt, default, and financial crisis. A key assumption is that the default decision is made by a government that has superior information than the public about the social costs of default. Citizens, however, can dismiss the government, and overrule its default decision, at the cost of a political crisis. If there is a divergence between the objectives of the government and its people, political crisis may emerge in equilibrium. For this to be the case, the foreign debt must be large enough, and international reserves low. When this political equilibrium is seen as a part of a larger investment problem, I show that there are equilibria in which crises are "only financial," and equilibria in which default and political crises occur. In some cases, both kinds of equilibria coexist and, in this sense, a loss of confidence by foreign lenders can exacerbate the likelihood of a political crisis. If so, international intervention in financial markets may ensure financial and political stability at little cost. Policy analysis is delicate, however, and may require linking financial policies to political outcomes.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 54 (2007)
Issue (Month): 8 (November)
Pages: 2409-2420

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Handle: RePEc:eee:moneco:v:54:y:2007:i:8:p:2409-2420

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Web page: http://www.elsevier.com/locate/inca/505566

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  1. Torsten Persson & Guido Tabellini, 1997. "Political Economics and Macroeconomic Policy," NBER Working Papers 6329, National Bureau of Economic Research, Inc.
  2. Mariano Tommasi, 1995. "Why Does it Take a Nixon to go to China?," UCLA Economics Working Papers 728, UCLA Department of Economics.
  3. Jonathan Eaton & Raquel Fernandez, 1995. "Sovereign Debt," Boston University - Institute for Economic Development 59, Boston University, Institute for Economic Development.
  4. Torsten Persson & Guido Tabellini, 1999. "Political Economics and Public Finance," NBER Working Papers 7097, National Bureau of Economic Research, Inc.
  5. Roberto Chang & Andres Velasco, 1999. "Liquidity crises in emerging markets: Theory and policy," Working Paper 99-15, Federal Reserve Bank of Atlanta.
  6. Acemoglu, Daron & Johnson, Simon & Robinson, James & Thaicharoen, Yunyong, 2003. "Institutional causes, macroeconomic symptoms: volatility, crises and growth," Journal of Monetary Economics, Elsevier, vol. 50(1), pages 49-123, January.
  7. Chang, Roberto & Majnoni, Giovanni, 2002. "Fundamentals, beliefs, and financial contagion," European Economic Review, Elsevier, vol. 46(4-5), pages 801-808, May.
  8. Jeffrey A. Frankel, 2005. "Contractionary Currency Crashes in Developing Countries," NBER Working Papers 11508, National Bureau of Economic Research, Inc.
  9. John Ferejohn, 1986. "Incumbent performance and electoral control," Public Choice, Springer, vol. 50(1), pages 5-25, January.
  10. Garber, Peter M. & Svensson, Lars E.O., 1995. "The operation and collapse of fixed exchange rate regimes," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 36, pages 1865-1911 Elsevier.
  11. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-25, August.
  12. Roberto Chang, 1999. "Understanding recent crises in emerging markets," Economic Review, Federal Reserve Bank of Atlanta, issue Q2, pages 6-16.
  13. Stephan Haggard, 2000. "Political Economy of the Asian Financial Crisis, The," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 107.
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Cited by:
  1. Moser, Christoph, 2007. "The Impact of Political Risk on Sovereign Bond Spreads - Evidence from Latin America," Proceedings of the German Development Economics Conference, Göttingen 2007 24, Verein für Socialpolitik, Research Committee Development Economics.
  2. Emanuel Kohlscheen, 2006. "Sovereign Risk: Constitutions Rule," 2006 Meeting Papers 25, Society for Economic Dynamics.
  3. Victor Vaugirard, 2005. "Crony Capitalism and Sovereign Default," Open Economies Review, Springer, vol. 16(1), pages 77-99, January.
  4. Betty Daniel, 2008. "Private Sector Risk and Financial Crises in Emerging Markets," Discussion Papers 08-10, University at Albany, SUNY, Department of Economics.
  5. Roberto Pasten & James P. Cover, 2010. "The Political Economy of Unsustainable Fiscal Deficits," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 47(136), pages 169-189.
  6. Ionescu Cristian, 2012. "Financial Instability And Political Instability," Annals - Economy Series, Constantin Brancusi University, Faculty of Economics, vol. 4, pages 154-158, December.
  7. Martínez, Juan & Santiso, Javier, 2003. "Financial Markets and Politics: The Confidence Game in Latin American Emerging Economies," MPRA Paper 12909, University Library of Munich, Germany.
  8. Roberto Chang, 2006. "Electoral Uncertainty and the Volatility of International Capital Flows," NBER Working Papers 12448, National Bureau of Economic Research, Inc.
  9. Galina Hale, 2005. "Courage to Capital? A Model of the Effects of Rating Agencies on Sovereign Debt Roll–over," The Institute for International Integration Studies Discussion Paper Series iiisdp062, IIIS.
  10. Carlo de Bassa Scheresberg, Francesco Passarelli, 2011. "Strategic Sovereign Defaults under International Sanctions," ISLA Working Papers 42, ISLA, Centre for research on Latin American Studies and Transition Economies, Universita' Bocconi, Milano, Italy.
  11. Dejan Eric & Aleksandar Zdravkovic & Drasko Nikolic, 2009. "Influence of World Crisis on Western Balkans Countries – Undertaken Measures and Expected Effects," Book Chapters, Institute of Economic Sciences.
  12. Hasman, Augusto & López, Ángel L. & SamartIín, Margarita, 2011. "Government, taxes and banking crises," Journal of Banking & Finance, Elsevier, vol. 35(10), pages 2761-2770, October.
  13. Andrade, Sandro C. & Kohlscheen, Emanuel, 2010. "Pessimistic Foreign Investors and Turmoil in Emerging Markets : The Case of Brazil in 2002," The Warwick Economics Research Paper Series (TWERPS) 926, University of Warwick, Department of Economics.
  14. Dejan Eric & Ivan Stosic, 2012. "Development of European Financial System: Challenges for the Balkan Countries Integration Process," Book Chapters, Institute of Economic Sciences.
  15. Van Rijckeghem, Caroline & Weder di Mauro, Beatrice, 2004. "The Politics Of Debt Crises," CEPR Discussion Papers 4683, C.E.P.R. Discussion Papers.

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