Currency crisis

A currency crisis is a form of financial crisis marked by the abrupt devaluation of a nation's currency ending a period of fixed or pegged exchange rates. A sudden shift in international asset portfolios, with its rapid reversal of capital flows, is the proximate cause of a severe collapse in the external value of a nation's monetary unit. And most would agree that all such events are characterized by "investors fleeing a currency en masse out of fear that it might be devalued, in turn fueling the very devaluation they anticipated" (Krugman, 2007, p. 1). While investor action driven by a fear of a crisis drives the actual crisis, the dramatic change in the external value of a nation's currency defining the actual crisis implicates a nation's macroeconomic accounts, particularly its fiscal deficit, sovereign debt, and balance of payments.

Theories about currency crises differ fundamentally in their assignment of an underlying cause to either macroeconomic imbalances or speculation itself, which in turn are based on fundamentally different views of the economic environment. In the neoclassical economics literature, three "generations" of exchange rate models have been offered as theories of currency crises (Kaminsky, 2008). In the first-generation models (coinciding with the Latin American crises of the 1960s), real or fundamental imbalances in the current account, sourced in monetized fiscal deficits, drive a loss in international reserves. In the second-generation models (roughly associated with the European Monetary System's crisis of the early 1990s), governments face competing objectives that force a tension between defending a pegged exchange rate and devaluing the currency. In the third-generation models, emerging after the currency crises in the late 1990s, focus shifts away from traditional macroeconomic policy choices towards the roles played by information asymmetries and financial regulation in the observed "twin" (currency and banking) crises in Asia, Brazil and Russia, for example. In all generations of neoclassical models, macroeconomic imbalances ground investor fears of instability.

Contrariwise, post-Keynesian theories privilege the destabilizing effects of Keynesian-like speculation (see Davidson, 1997). Grounded in a view of the world that sees future market valuations as uncertain and unknowable, Keynes (1936, pp. 158-9) introduced the now-familiar distinction between speculation - as "the activity of forecasting the psychology of the market" - and enterprise or the "activity of forecasting prospective yield of assets over their whole life". When a market psychology emerges independently of real economic developments, investors turn their energies to forecasting the average opinion of other investors - or anticipating what average opinion expects the average opinion to be, to recall Keynes's famous description of the judging behaviour in his beauty contest analogy. In the post-Keynesian schools of thought, speculation may have real economic consequences, and will when, as Keynes stated, "enterprise becomes the bubble on a whirlpool of speculation" (ibid., p. 142). Such outcomes are never more of a risk than in highly liquid asset markets such as foreign currency markets (see Spotton Visano, 2006). In these classes of models, speculation creates macroeconomic imbalances and currency crises.

Forms of prevention variously prescribed (see Dimand and Dore, 2000) are dependent on the assumed theoretical cause. Proponents of a neoclassical explana- tion advocate in favour of greater "free" market discipline and a diminished role for government in the provision of goods and services to constrain macroeconomic imbal- ances. Keynes advocated a system of strict capital controls, thus disciplining investor speculation and preserving national monetary autonomy. For disciplining investor speculation, James Tobin (1978) emphasized price, rather than quantity, incentives in his proposed tax on foreign currency transactions. As a means of raising the cost of speculative transactions, levying a "Tobin tax" would "throw some sand in the wheels of our excessively efficient international money markets" (Tobin, 1978, p. 154). Paul Davidson (1997) dismisses the potential effectiveness of the Tobin tax - arguing the likely possibility that expected gains from speculation could easily outstrip the cost of a speculative tax - and advocates in favour of a supranational settlement system designed to stabilize both global effective demand and international capital flows. Of course, a single currency would eliminate entirely the possibility of exchange rate fluctuations, but then national monetary autonomy would be sacrificed, as Walter Bagehot (1868) noted nearly a century and a half ago.

See also:

Asymmetric information; Bagehot, Walter; Capital controls; Capital flight; Convertibility law; Cross-border retail banking; Financial crisis; International settlement institution; Sudden stops; Tobin tax; Twin crises.