Thursday, September 18, 2008

How Currency Crises Unfold (1)

It will be more and more difficult for speculators to mount another offensive. It's not going to be easy if you have concerted effort on the part of governments in the regions. Amunay Viravan Thai Finance Minister, May, 1997

Sept. 18, 2008 (Bloomberg) -- The Federal Reserve almost quadrupled the amount of dollars central banks can auction around the world to $247 billion in a coordinated bid to ease the worst crisis facing financial markets since the aftermath of the 1929 Wall Street crash.

The Fed increased the amount of dollars that the European Central Bank, the Bank of Japan and other counterparts can offer from $67 billion ``to address the continued elevated pressures in U.S. dollar short-term funding markets.'' The Bank of England, the Bank of Canada and the Swiss National Bank also participated. Several of them lent funds in their own currencies as well with the Fed adding a record $105 billion in temporary reserves

Denial, it is said, is the first stage of grief, and, apparently, along with intervention, the first policy option of governments facing currency crises. The guiding idea behind the policy is simply that, but for the action of evil speculators, no crisis would exist. In other words, the underlying fundamentals are strong.

Enter Andrew Cuomo NY Attorney General: My office will investigate and prosecute short-sellers who spread bad information and false rumors and who conspire to bring down a company's stock price or who engage in other manipulative and fraudulent conduct.

The denial phase lasts until continued losses in both currency and asset markets lead the wealthy (who tend to support the status quo) in the country to support reform minded politicians. This phase can last a few months.

During this phase the bone of contention is the fundamentals of the economy. Is it really the speculators or are we doing something wrong?

And what do you mean by a currency crisis anyway?

A currency crisis occurs when a country's currency falls swiftly and significantly enough to distress the real sector of the economy.

In the cases researched by economists over the past 50 years (i.e. during the Bretton Woods Regime) a currency crisis is usually signalled by a significant decline of the currency in question vs. the US$. The Italian and British crises of 1992 are usually considered vs. the DM.

Given that the US$ remains the anchor currency, and that, so far at least, competitive devaluations are not a policy option, I'm watching the US$'s exchange rate with Gold.

Getting back to the issue of "is it real or not?," Paul Krugman has written extensively about that question:

Suppose that a country's fundamental tradeoff between the costs of maintaining the current parity and the costs of abandoning it is predictably deteriorating, so that at some future date the country would be likely to devalue even in the absence of a speculative attack. Then speculators would surely try to get out of the currency ahead of that devaluation - but in so doing they would worsen the government's tradeoff, leading to an earlier devaluation.

We can actually be more specific: given an inevitable eventual abandonment of a currency peg, and perfectly informed investors, a speculative attack on a currency will occur at the earliest date at which such an attack could succeed. The reason is essentially arbitrage: an attack at any later date would offer speculators a sure profit; this profit will be competed away by attempts to anticipate the crisis.

It is important to notice one point about this scenario. In the case just described - as in the canonical model - the crisis is ultimately provoked by the inconsistency of government policies, which make the long-run survival of the fixed rate impossible. In that sense the crisis is driven by economic fundamentals. Yet that is not the way it might seem when the crisis actually strikes: the government of the target country would feel that it was fully prepared to maintain the exchange rate for a long time, and would in fact have done so, yet was forced to abandon it by a speculative attack that made defending the rate simply too expensive.

What if it really is just speculation:

Suppose that, contrary to our earlier assumption, an eventual end to a currency peg is not completely preordained. There may be no worsening trend in the fundamentals; or there may be an adverse trend, but at least some realistic possibility that policies may change in a way that reverses that trend. Nonetheless, it may be the case that the government will abandon the peg if faced with a sufficiently severe speculative attack.

The result in such cases will be the possibility of self-fulfilling exchange rate crises. An individual investor will not pull his money out of the country if he believes that the currency regime is in no imminent danger; but he will do so if a currency collapse seems likely. A crisis, however, will materialize precisely if many individual investors do pull their money out. The result is that either optimism or pessimism will be self-confirming; and in the case of self-confirming pessimism, a country will be justified in claiming that it suffered an unnecessary crisis.

How seriously should we take this analysis? One obvious caveat understood by the economists studying this issue, but perhaps too easily forgotten by political figures, is that this analysis does not imply either that any currency can be subject to speculative attack or that all speculative attacks are unjustified by fundamentals. Even in models with self-fulfilling features, it is only when fundamentals - such as foreign exchange reserves, the government fiscal position, the political commitment of the government to the exchange regime - are sufficiently weak that the country is potentially vulnerable to speculative can think of a range of fundamentals in which a crisis cannot happen, and a range of fundamentals in which it must happen; at most, self-fulfilling crisis models say that there is an intermediate range in which a crisis can happen, but need not. It is an empirical question (though not an easy one) how wide this range is.

It is also important to remember that a country whose fundamentals are persistently and predictably deteriorating will necessarily have a crisis at some point.

That's enough wonky stuff for today.

Tomorrow: The Big Differences between the US crisis and those of nations who don't issue the world's reserve currency.