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Financial crises and political crises

  • Chang, Roberto

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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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
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505566

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  1. Persson, Torsten & Tabellini , Guido, 1997. "Political Economics and Macroeconomic Policy," Seminar Papers 630, Stockholm University, Institute for International Economic Studies.
  2. Roberto Chang & Andrés Velasco, 1999. "Liquidity Crises in Emerging Markets: Theory and Policy," Documentos de Trabajo 59, Centro de Economía Aplicada, Universidad de Chile.
  3. 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.
  4. 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.
  5. Jonathan Eaton & Raquel Fernandez, 1995. "Sovereign Debt," NBER Working Papers 5131, National Bureau of Economic Research, Inc.
  6. Cukierman, A. & Tommasi, M., 1997. "When Does It Take a Nixon to Go to China," Papers 30-97, Tel Aviv.
  7. Stephan Haggard, 2000. "Political Economy of the Asian Financial Crisis, The," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 107, March.
  8. 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.
  9. Frankel, Jeffrey, 2005. "Contractionary Currency Crashes In Developing Countries," Working Paper Series rwp05-017, Harvard University, John F. Kennedy School of Government.
  10. Chang, Roberto & Majnoni, Giovanni, 2002. "Fundamentals, beliefs, and financial contagion," European Economic Review, Elsevier, vol. 46(4-5), pages 801-808, May.
  11. Persson, Torsten & Tabellini, Guido, 1999. "Political Economics and Public Finance," CEPR Discussion Papers 2235, C.E.P.R. Discussion Papers.
  12. Roberto Chang, 1999. "Understanding recent crises in emerging markets," Economic Review, Federal Reserve Bank of Atlanta, issue Q2, pages 6-16.
  13. John Ferejohn, 1986. "Incumbent performance and electoral control," Public Choice, Springer, vol. 50(1), pages 5-25, January.
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