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Financial Crises and Political Crises

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  • Roberto Chang

Abstract

This paper is an analysis of the simultaneous determination of financial default and political crises and its consequences. It focuses on a small open economy that faces a debt default decision. Crucially, this decision is made by a government that has superior information than the public about the social costs of default. Citizens 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, a 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, there are equilibria in which crises are "only financial," and equilibria in which both default and political crises occur. In some cases, these two 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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11779.

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Date of creation: Nov 2005
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Publication status: published as Chang, Roberto. “Financial Crises and Political Crises.” Journal of Monetary Economics 54 (2007): 2409-2420.
Handle: RePEc:nbr:nberwo:11779

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  1. Frankel, Jeffrey, 2005. "Contractionary Currency Crashes In Developing Countries," Working Paper Series rwp05-017, Harvard University, John F. Kennedy School of Government.
  2. John Ferejohn, 1986. "Incumbent performance and electoral control," Public Choice, Springer, vol. 50(1), pages 5-25, January.
  3. 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.
  4. 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.
  5. Roberto Chang & Andres Velasco, 1999. "Liquidity crises in emerging markets: Theory and policy," Working Paper 99-15, Federal Reserve Bank of Atlanta.
  6. Jonathan Eaton & Raquel Fernandez, 1995. "Sovereign Debt," Boston University - Institute for Economic Development 59, Boston University, Institute for Economic Development.
  7. Torsten Persson & Guido Tabellini, . "Political Economics and Public Finance," Working Papers 149, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  8. Persson, Torsten & Tabellini, Guido, 1997. "Political Economics and Macroeconomic Policy," CEPR Discussion Papers 1759, C.E.P.R. Discussion Papers.
  9. Cukierman, A. & Tommasi, M., 1997. "When Does It Take a Nixon to Go to China," Papers 30-97, Tel Aviv.
  10. Roberto Chang, 1999. "Understanding recent crises in emerging markets," Economic Review, Federal Reserve Bank of Atlanta, issue Q2, pages 6-16.
  11. 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.
  12. Stephan Haggard, 2000. "Political Economy of the Asian Financial Crisis, The," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 107.
  13. Chang, Roberto & Majnoni, Giovanni, 2002. "Fundamentals, beliefs, and financial contagion," European Economic Review, Elsevier, vol. 46(4-5), pages 801-808, May.
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Cited by:
  1. Kohlscheen, Emanuel, 2005. "Sovereign Risk : Constitutions Rule," The Warwick Economics Research Paper Series (TWERPS) 731, University of Warwick, Department of Economics.
  2. Roberto Chang, 2006. "Electoral Uncertainty and the Volatility of International Capital Flows," NBER Working Papers 12448, National Bureau of Economic Research, Inc.
  3. Betty Daniel, 2008. "Private Sector Risk and Financial Crises in Emerging Markets," Discussion Papers 08-10, University at Albany, SUNY, Department of Economics.
  4. 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.
  5. 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.
  6. 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.
  7. Ionescu Cristian, 2012. "Financial Instability And Political Instability," Annals - Economy Series, Constantin Brancusi University, Faculty of Economics, vol. 4, pages 154-158, December.
  8. Victor Vaugirard, 2005. "Crony Capitalism and Sovereign Default," Open Economies Review, Springer, vol. 16(1), pages 77-99, January.
  9. 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.
  10. 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.
  11. 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.
  12. 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.
  13. Van Rijckeghem, Caroline & Weder di Mauro, Beatrice, 2004. "The Politics Of Debt Crises," CEPR Discussion Papers 4683, C.E.P.R. Discussion Papers.
  14. 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.
  15. Dejan Eric & Ivan Stosic, 2012. "Development of European Financial System: Challenges for the Balkan Countries Integration Process," Book Chapters, Institute of Economic Sciences.

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