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Puzzling over the Anatomy of Crises: Liquidity and the Veil of Finance

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  • Guillermo Calvo

    (Columbia University and NBER (E-mail: gc2286@columbia.edu))

Abstract

The paper claims that conventional monetary theory obliterates the central role played by media of exchange in the workings and instability of capitalist economies; and that a significant part of the financial system depends on the resiliency of paper currency and liquid assets that have been built on top of it. The resilience of the resulting financial tree is questionable if regulators are not there to adequately trim its branches to keep it from toppling by its own weight or minor wind gusts. The issues raised in the paper are not entirely new but have been ignored in conventional theory. This is very strange because disregard for these key issues has lasted for more than half a century. Are we destined to keep on making the same mistake? The paper argues that a way to prevent that is to understand its roots, and traces them to the Keynes/Hicks tradition. In addition, the paper presents a narrative and some empirical evidence suggesting a key channel from Liquidity Crunch to Sudden Stop, which supports the view that liquidity/credit shocks have been a central factor in recent crises. In addition, the paper claims that liquidity considerations help to explain (a) why a credit boom may precede financial crisis, (b) why capital inflows grow in the run-up of balance-of-payments crises, and (c) why gross flows are pro-cyclical.

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Bibliographic Info

Paper provided by Institute for Monetary and Economic Studies, Bank of Japan in its series IMES Discussion Paper Series with number 13-E-09.

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Date of creation: Sep 2013
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Handle: RePEc:ime:imedps:13-e-09

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Keywords: Financial Crises; Bubbles; Sudden Stop;

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  1. Broner, Fernando A & Didier, Tatiana & Erce, Aitor & Schmukler, Sergio, 2011. "Gross Capital Flows: Dynamics and Crises," CEPR Discussion Papers, C.E.P.R. Discussion Papers 8591, C.E.P.R. Discussion Papers.
  2. Adam Copeland & Antoine Martin & Michael Walker, 2011. "Repo runs: evidence from the tri-party repo market," Staff Reports, Federal Reserve Bank of New York 506, Federal Reserve Bank of New York.
  3. Calvo, Guillermo & Coricelli, Fabrizio & Ottonello, Pablo, 2012. "The Labor Market Consequences of Financial Crises With or Without Inflation: Jobless and Wageless Recoveries," CEPR Discussion Papers, C.E.P.R. Discussion Papers 9218, C.E.P.R. Discussion Papers.
  4. Javier Bianchi, 2010. "Overborrowing and Systemic Externalities in the Business Cycle," 2010 Meeting Papers, Society for Economic Dynamics 96, Society for Economic Dynamics.
  5. Gary Gorton & Andrew Metrick, 2009. "Securitized Banking and the Run on Repo," Yale School of Management Working Papers, Yale School of Management amz2358, Yale School of Management, revised 01 Sep 2009.
  6. Manuel Agosin & Franklin Huaita, 2009. "Overreaction in capital flows to emerging markets: Booms and sudden stops," Working Papers, University of Chile, Department of Economics wp295, University of Chile, Department of Economics.
  7. Michael D. Bordo, 2006. "Sudden Stops, Financial Crises, and Original Sin in Emerging Countries: Déjà vu?," NBER Working Papers 12393, National Bureau of Economic Research, Inc.
  8. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
  9. Guillermo A. Calvo & Alejandro Izquierdo & Ernesto Talvi, 2006. "Phoenix Miracles in Emerging Markets: Recovering without Credit from Systemic Financial Crises," Research Department Publications, Inter-American Development Bank, Research Department 4474, Inter-American Development Bank, Research Department.
  10. Guillermo A. Calvo & Leonardo Leiderman & Carmen M. Reinhart, 1993. "Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors," IMF Staff Papers, Palgrave Macmillan, vol. 40(1), pages 108-151, March.
  11. Guillermo A. Calvo & Alejandro Izquierdo & Luis-Fernando Mejía, 2008. "Systemic Sudden Stops: The Relevance Of Balance-Sheet Effects And Financial Integration," NBER Working Papers 14026, National Bureau of Economic Research, Inc.
  12. Guillermo A. Calvo, 1998. "Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops," Journal of Applied Economics, Universidad del CEMA, vol. 0, pages 35-54, November.
  13. Guillermo A. Calvo & Alejandro Izquierdo & Rudy Loo-Kung, 2012. "Optimal Holdings of International Reserves: Self-Insurance against Sudden Stop," NBER Working Papers 18219, National Bureau of Economic Research, Inc.
  14. Guillermo A. Calvo, 2012. "The Price Theory of Money, Prospero's Liquidity Trap, and Sudden Stop: Back to Basics and Back," NBER Working Papers 18285, National Bureau of Economic Research, Inc.
  15. Guido Lorenzoni, 2007. "Inefficient Credit Booms," NBER Working Papers 13639, National Bureau of Economic Research, Inc.
  16. Dvorak, Tomas, 2003. "Gross capital flows and asymmetric information," Journal of International Money and Finance, Elsevier, Elsevier, vol. 22(6), pages 835-864, November.
  17. Dani Rodrik & Andres Velasco, 1999. "Short-Term Capital Flows," NBER Working Papers 7364, National Bureau of Economic Research, Inc.
  18. Carmen M. Reinhart & Vincent R. Reinhart, 2010. "After the Fall," NBER Working Papers 16334, National Bureau of Economic Research, Inc.
  19. Enrique G. Mendoza & Marco E. Terrones, 2008. "An anatomy of credit booms: evidence from macro aggregates and micro data," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 936, Board of Governors of the Federal Reserve System (U.S.).
  20. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(3), pages 401-19, June.
  21. Enrique G. Mendoza, 2010. "Sudden Stops, Financial Crises, and Leverage," American Economic Review, American Economic Association, American Economic Association, vol. 100(5), pages 1941-66, December.
  22. Guillermo A. Calvo, 2005. "Emerging Capital Markets in Turmoil: Bad Luck or Bad Policy?," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 0262033348, December.
  23. Claudio Borio, 2012. "The financial cycle and macroeconomics: What have we learnt?," BIS Working Papers 395, Bank for International Settlements.
  24. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, Princeton University Press, edition 1, volume 1, number 8973.
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