Lax Public Sector, Destabilizing Private Sector: Origins of Capital Market Crises
A principal message of this paper is that external financial crises are not caused by an alert private sector pouncing upon the public sector’s foolish actions such as running an unsustainable fiscal deficit or creating moral hazards. They are better described as private sectors (both domestic and foreign) acting to make high short-term profits when policy and history provide the preconditions and the public sector acquiesces. This conclusion emerges from a review of balance of payments crises in the Southern Cone around 1980, Mexico in 1994-95, East Asia in 1997-98, and Russia in 1998 in light of existing theories - speculative attack models and moral hazard - and a synthesis of ideas proposed by Salih Neftci and Roberto Frenkel. The standard theories do not explain history well. The Frenkel-Neftci framework supports a better description of crisis dynamics in terms of five elements:(1) the nominal exchange rate is fixed or close to being pre-determined; (2) there are few barriers to external capital inflows and outflows; (3) historical factors and the conjuncture act together to create wide financial "spreads" between returns to national assets and borrowing rates abroad - these in turn generate capital inflows which push the domestic financial system in the direction of being long on domestic assets and short on foreign holdings; (4) regulation of the system is lax and probably pro-cyclical; (5) stock-flow repercussions of these initially microeconomic changes through the balance of payments and the financial system’s flows of funds and balance sheets set off a dynamic macro process which is unstable. Policy alternatives are discussed in terms of these five conditions and the present global macroeconomic environment, in particular the destabilizing interventions of the International Monetary Fund in East Asia.
|Date of creation:||Jul 1998|
|Date of revision:||Oct 1998|
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