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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. Persson, Torsten & Tabellini, Guido, 1999. "Political Economics and Public Finance," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2235, C.E.P.R. Discussion Papers.
  2. Roberto Chang & Andres Velasco, 1999. "Liquidity crises in emerging markets: Theory and policy," Working Paper, Federal Reserve Bank of Atlanta 99-15, Federal Reserve Bank of Atlanta.
  3. Acemoglu, Daron & Johnson, Simon & Robinson, James A & Thaicharoen, Yunyong, 2002. "Institutional Causes, Macroeconomic Symptoms: Volatility, Crises and Growth," CEPR Discussion Papers, C.E.P.R. Discussion Papers 3575, C.E.P.R. Discussion Papers.
  4. John Ferejohn, 1986. "Incumbent performance and electoral control," Public Choice, Springer, Springer, vol. 50(1), pages 5-25, January.
  5. Persson, T. & Tabellini, G., 1997. "Political Economics and Macroeconomic Policy," Papers, Stockholm - International Economic Studies 630, Stockholm - International Economic Studies.
  6. Chang, Roberto & Majnoni, Giovanni, 2002. "Fundamentals, beliefs, and financial contagion," European Economic Review, Elsevier, Elsevier, vol. 46(4-5), pages 801-808, May.
  7. Jeffrey A. Frankel, 2005. "Contractionary Currency Crashes in Developing Countries," NBER Working Papers 11508, National Bureau of Economic Research, Inc.
  8. Eaton, Jonathan & Fernandez, Raquel, 1995. "Sovereign debt," Handbook of International Economics, Elsevier, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 3, pages 2031-2077 Elsevier.
  9. Garber, P.M. & Svensson, L.E.O., 1994. "The Operation and Collapse of Fixed Exchange Rate Regimes," Papers, Stockholm - International Economic Studies 588, Stockholm - International Economic Studies.
  10. Stephan Haggard, 2000. "Political Economy of the Asian Financial Crisis, The," Peterson Institute Press: All Books, Peterson Institute for International Economics, Peterson Institute for International Economics, number 107, July.
  11. Mariano Tommasi, 1995. "Why Does it Take a Nixon to go to China?," UCLA Economics Working Papers, UCLA Department of Economics 728, UCLA Department of Economics.
  12. Roberto Chang, 1999. "Understanding recent crises in emerging markets," Economic Review, Federal Reserve Bank of Atlanta, Federal Reserve Bank of Atlanta, issue Q2, pages 6-16.
  13. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 11(3), pages 311-25, August.
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Cited by:
  1. 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.
  2. Dejan Eric & Ivan Stosic, 2012. "Development of European Financial System: Challenges for the Balkan Countries Integration Process," Book Chapters, Institute of Economic Sciences.
  3. Herrera, Helios & Ordoñez, Guillermo & Trebesch, Christoph, 2014. "Political Booms, Financial Crises," Discussion Papers in Economics, University of Munich, Department of Economics 21265, University of Munich, Department of Economics.
  4. Guillermo Ordonez & Christoph Trebesch & Helios Herrera, 2013. "Political Booms, Financial Crises," 2013 Meeting Papers, Society for Economic Dynamics 224, Society for Economic Dynamics.
  5. 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.
  6. 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.
  7. Emanuel Kohlscheen, 2010. "Sovereign risk: constitutions rule," Oxford Economic Papers, Oxford University Press, vol. 62(1), pages 62-85, January.
  8. Van Rijckeghem, Caroline & Weder di Mauro, Beatrice, 2004. "The Politics Of Debt Crises," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4683, C.E.P.R. Discussion Papers.
  9. Betty C. Daniel, 2012. "Private Sector Risk and Financial Crises in Emerging Markets," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 122(561), pages 825-847, 06.
  10. 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., Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 47(136), pages 169-189.
  11. Roberto Chang, 2006. "Electoral Uncertainty and the Volatility of International Capital Flows," NBER Working Papers 12448, National Bureau of Economic Research, Inc.
  12. 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, IIIS iiisdp062, IIIS.
  13. Ionescu Cristian, 2012. "Financial Instability And Political Instability," Annals - Economy Series, Constantin Brancusi University, Faculty of Economics, vol. 4, pages 154-158, December.
  14. Victor Vaugirard, 2005. "Crony Capitalism and Sovereign Default," Open Economies Review, Springer, Springer, vol. 16(1), pages 77-99, January.
  15. 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.
  16. Hasman, Augusto & López, Ángel L. & SamartIín, Margarita, 2011. "Government, taxes and banking crises," Journal of Banking & Finance, Elsevier, Elsevier, vol. 35(10), pages 2761-2770, October.
  17. Carlo de Bassa Scheresberg, Francesco Passarelli, 2011. "Strategic Sovereign Defaults under International Sanctions," ISLA Working Papers, ISLA, Centre for research on Latin American Studies and Transition Economies, Universita' Bocconi, Milano, Italy 42, ISLA, Centre for research on Latin American Studies and Transition Economies, Universita' Bocconi, Milano, Italy.

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