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Financial Crises and Political Crises

  • Roberto Chang

    ()

    (Rutgers University)

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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Paper provided by Rutgers University, Department of Economics in its series Departmental Working Papers with number 200229.

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Date of creation: 17 Dec 2002
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Handle: RePEc:rut:rutres:200229
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  1. Daron Acemoglu & Simon Johnson & James Robinson & Yunyong Thaicharoen, 2002. "Institutional Causes, Macroeconomic Symptoms: Volatility, Crises and Growth," NBER Working Papers 9124, National Bureau of Economic Research, Inc.
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  8. Roberto Chang & Andres Velasco, 1999. "Liquidity crises in emerging markets: Theory and policy," Working Paper 99-15, Federal Reserve Bank of Atlanta.
  9. Garber, P.M. & Svensson, L.E.O., 1994. "The Operation and Collapse of Fixed Exchange Rate Regimes," Papers 588, Stockholm - International Economic Studies.
  10. Frankel, Jeffrey, 2005. "Contractionary Currency Crashes In Developing Countries," Working Paper Series rwp05-017, Harvard University, John F. Kennedy School of Government.
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  13. Stephan Haggard, 2000. "Political Economy of the Asian Financial Crisis, The," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 107.
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