ECON3315 International Economic Issues

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ECON3315International Economic Issues

• Instructor Patrick M. Crowley

Issue 19 Financial Crises
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Overview

• Types of financial crisis
• Debt crises what is the issue?
• What happens in a financial crisis?
• Approaches
• Historical perspective
• Reputation effects

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Types of financial crisis

• Debt crises
• Speculative bubbles and crashes
• International financial crises
• Each has a different effect, and can have limited
  country-wide impact (e.g. Finnish banking
  crisis of 1992) or can be international in nature
  (e.g. South East Asian crisis)

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Debt crisis what is the issue?

• The issue is that countries sometimes spend
  beyond their means and end up not being able to
  pay their debts.
• These are known as sovereign debts and as a
  country cannot go bankrupt (all debts from any
  government are automatically inherited by the
  next government), should there be some way to
  deal with this on an international level?
• Why? Because if a crisis is allowed to happen,
  it can often lead to contagion and regional
  instability and might even cause a regional
  collapse in economic confidence.
• Access to international capital markets allows
  countries to borrow. International capital
  markets assess a countrys ability to pay back on
  macroeconomic performance, so this is key here.

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What happens in a debt crisis?

• Bonds are the sovereign debt of a country
• When countries no longer have the funds to pay
  interest on their bonds, a default occurs
• Usually the lenders get together and go to the
  country to negotiate a debt restructuring which
  sometimes lowers interest rates so a payment can
  be made, sometimes agrees upon a future debt
  repayment schedule. These lenders are usually
  known as clubs.
• Usually an economic crisis occurs at the same
  time so the IMF is heavily involved, and so
  economic reforms are expected
• Once the IMF is happy and releases funds, usually
  private funds begin to flow back to the country
  and lending resumes

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Approaches ameliorating debt crises

• Several different approaches have been made to
  solving this problem in the literature
• Introduce a Chaper 11 bankruptcy type process
  for countries (Anne Krueger)
• Allow the IMF to operate as an international
  lender of last resort (Barry Eichengreen)
• Capital controls and flexible exchange rates
  (Jeffrey Sachs)

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Debt crises an historical perspective the
usual suspects?

• Many countries are serial defaulters that is,
  they have defaulted many times
• Brazil has defaulted on its debt 7 times over
  the past 175 years
• Venezuela has defaulted on its debt 9 times over
  the past 175 years
• Some countries have only ever defaulted once, and
  many developing countries have never defaulted on
  their debts.
• But looking further back in time things were very
  different

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Not necessarily the usual suspects!
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Reputation effects

• Interestingly, if you think that Brazil and
  Argentina and Columbia have extremely high debts
  to begin with, youd be wrong
• In 2001 when Argentina defaulted, its debt/GDP
  level was only 52, less than the level the US
  debt/GDP level is forecast to be for 2009
• Currently Japan has extremely high debt/GDP
  levels, and yet there is no talk of defaultwhy?
• Seems to be reputation effect at work, and this
  is why serial offenders commonyou either default
  a lot, or not at all.
• Clearly costs of defaulting for the first time
  are significant, and once default occurs, likely
  that international capital markets will not lend
  to you as freely again

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Reputation effects
Surprising result here, as no linear relationship
between debt to GDP at all.
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So what is going on here?
Seems to be 3 groups at playand reputation
clearly matters.
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Speculative bubbles

• Dutch tulip bulb bubble in the 1700s was first
  known speculative bubble
• Idea is that if people know that other people
  expect prices to go up, then prices will rise in
  a self-reinforcing way, until the bubble bursts
  and you get a crash
• Experimental economics shows that these bubbles
  occur even with small numbers of traders seems
  to be behavioral
• Sometimes also known as herd behaviour or
  bandwagon effects
• Examples are Great crash (USA), Late 2000s
  internet stockmarket bubble (USA), oil prices in
  summer of 2008, and UK and some US housing
  markets in recent years

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Financial crises

• Presentation