Desai said (eds ) global governance and financial crises (2004)

Global Governance andFinancial Crises Are global financial markets rational or are manias possible?. Global Governance and Financial Crises provides a new understanding of this important

Global Governance and

Financial Crises

Are global financial markets rational or are manias possible? Should crises beallowed to run their course and purge the system? Should a lender of last resortintervene to dampen their impact on the real economy? These questions and others are addressed in this impressive book

The editors of this book have pulled together a collection of essays that reviewthe spate of financial crises that have occurred in recent years starting withMexico in 1994 and moving on to more recent crises in Turkey and Argentina.With impressive contributors such as Douglas Gale, Gabriel Palma, MichelAglietta and Andrew Gamble, the book is a timely and authoritative study

Global Governance and Financial Crises provides a new understanding of this

important area with a combination of economic history, political economy as well

as the most recent developments in analytical economic theory Students,researchers and policy makers would do well to read it and learn some importantlessons for the future

Meghnad Desai is Director of the Centre for the Study of Global Governance and

Professor of Economics at the London School of Economics He is also author of

Marx’s Revenge (2002).

Yahia Said is a Research Officer at the Centre for the Study of Global

Governance at the London School of Economics He has also worked as a corporatefinance consultant

Routledge studies in the modern world economy

1 Interest Rates and Budget Deficits

A study of the advanced economies

Kanhaya L Gupta and Bakhtiar Moazzami

2 World Trade after the Uruguay Round

Prospects and policy options for the twenty-first century

Edited by Harald Sander and András Inotai

3 The Flow Analysis of Labour Markets

Edited by Ronald Schettkat

4 Inflation and Unemployment

Contributions to a new macroeconomic approach

Edited by Alvaro Cencini and Mauro Baranzini

5 Macroeconomic Dimensions of Public Finance

Essays in honour of Vito Tanzi

Edited by Mario I Blejer and Teresa M Ter-Minassian

6 Fiscal Policy and Economic Reforms

Essays in honour of Vito Tanzi

Edited by Mario I Blejer and Teresa M Ter-Minassian

7 Competition Policy in the Global Economy

Modalities for co-operation

Edited by Leonard Waverman, William S Comanor and Akira Goto

8 Working in the Macro Economy

A study of the US labor market

Martin F J Prachowny

9 How Does Privatization Work?

Edited by Anthony Bennett

10 The Economics and Politics of International Trade

Freedom and trade: Volume II

Edited by Gary Cook

11 The Legal and Moral Aspects of International Trade

Freedom and trade: Volume III

Edited by Asif Qureshi, Hillel Steiner and Geraint Parry

12 Capital Markets and Corporate Governance in

Japan, Germany and the United States

Organizational response to market inefficiencies

15 Trade, Theory and Econometrics

Essays in honour of John S Chipman

Edited by James C Moore, Raymond Reizman, James R Melvin

16 Who Benefits from Privatisation?

Edited by Moazzem Hossain and Justin Malbon

17 Towards a Fair Global Labour Market

Avoiding the New Slave Trade

Ozay Mehmet, Errol Mendes and Robert Sinding

18 Models of Futures Markets

Edited by Barry Goss

19 Venture Capital Investment

An agency analysis of UK practice

Gavin C Reid

20 Macroeconomic Forecasting

A sociological appraisal

Robert Evans

21 Multimedia and Regional Economic Restructuring

Edited by Hans-Joachim Braczyk, Gerhard Fuchs

and Hans-Georg Wolf

22 The New Industrial Geography

Regions, regulation and institutions

Edited by Trevor J Barnes and Meric S Gertler

23 The Employment Impact of Innovation

Evidence and policy

Edited by Marco Vivarelli and Mario Pianta

24 International Health Care Reform

A legal, economic and political analysis

Colleen Flood

25 Competition Policy Analysis

Edited by Einar Hope

26 Culture and Enterprise

The development, representation and morality of business

Don Lavoie and Emily Chamlee-Wright

27 Global Financial Crises and Reforms

Cases and caveats

B N Ghosh

28 Geography of Production and Economic Integration

Miroslav N Jovanovi ´c

29 Technology, Trade and Growth in OECD Countries

Does specialisation matter?

Valentina Meliciani

30 Post-Industrial Labour Markets

Profiles of North America and Scandinavia

Edited by Thomas P Boje and Bengt Furaker

31 Capital Flows without Crisis

Reconciling capital mobility and economic stability

Edited by Dipak Dasgupta, Marc Uzan and Dominic Wilson

32 International Trade and National Welfare

Edited by John Cantwell, Alfonso Gambardella

and Ove Granstrand

35 Before and Beyond EMU

Historical lessons and future prospects

Edited by Patrick Crowley

36 Fiscal Decentralization

Ehtisham Ahmad and Vito Tanzi

37 The Regionalization of Internationalized Innovation

Locations for advanced industrial development

and disparities in participation

Edited by Ulrich Hilpert

38 Gold and the Modern World Economy

Edited by MoonJoong Tcha

39 Global Economic Institutions

Willem Molle

40 Global Governance and Financial Crises

Edited by Meghnad Desai and Yahia Said

Global Governance and

Financial Crises

Edited by Meghnad Desai and Yahia Said

First published 2004

by Routledge

11 New Fetter Lane, London EC4P 4EE

Simultaneously published in the USA and Canada

by Routledge

29 West 35th Street, New York, NY 10001

Routledge is an imprint of the Taylor & Francis Group

© 2004 Meghnad Desai and Yahia Said for selection and editorial matter; individual contributors for their chapters

All rights reserved No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers.

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

Library of Congress Cataloging in Publication Data

Desai, Meghnad.

Global governance and financial crises / Meghnad Desai and Yahia Said.

p cm – (Routledge studies in the modern world economy ; 40) Includes bibliographical references and index.

1 Developing countries–Economic conditions 2 Financial crises– Developing countries 3 Monetary policy–Developing countries

4 International finance I Said, Yahia, 1965– II Title III Series HC59.7.D368 2003

ISBN 0–415–30529–2

This edition published in the Taylor & Francis e-Library, 2004.

ISBN 0-203-71321-4 Master e-book ISBN

ISBN 0-203-34284-4 (Adobe eReader Format)

(Print Edition)

4.1Reserve positions in the Fund and international reserves 51

4.3 Total liabilities of beneficiary countries in percentage of IMF

6.1East Asian 4: monthly interest rates, January 1997–May 2000 956.2 East Asian 4: monthly foreign exchange rates,

6.3 (a) Indonesia, Korea, Thailand and Malaysia: annual budget

balances, 1996–99; (b) Korea, Thailand and Malaysia:

6.A1(a) Thailand: quarterly merchandise trade balance and

reserves, 1997Q1–2000Q1; (b) Indonesia: quarterly

merchandise trade balance and reserves, 1997Q1–99Q4;

(c) Malaysia: quarterly merchandise trade balance and

reserves, 1997Q1–99Q4; (d) Korea: quarterly merchandise

6.A2 (a) Thailand: GDP growth, foreign exchange and interest

rate, 1997Q1–2000Q1; (b) Indonesia: GDP growth, foreign

exchange and interest rate, 1997Q1–2000Q1; (c) Malaysia:

GDP growth, foreign exchange and interest rate,

1997Q1–2000Q1; (d) Korea: GDP growth, foreign exchange

7.1Latin America and East Asia: aggregate net capital flows

before financial liberalisation, and between financial

7.3 Derivatives markets: notional values of outstanding

‘over-the-counter’ interest rate, currency and exchange-traded derivative

7.4 East Asia and Latin America: credit to private sector between the beginning of financial liberalisation and respective financial crises 1257.5 Latin America and East Asia: domestic real lending rates between the beginning of financial liberalisation and respective financial

7.6 Latin America and East Asia: imports of consumer goods between the beginning of financial liberalisation and respective financial

7.7 Latin America and East Asia: annual stock market indices

between the beginning of financial liberalisation and

7.8 Latin America, East Asia, USA and Europe: stock market indices 1307.9 Latin America and East Asia: real estate price indices between the beginning of financial liberalisation and respective financial crisis 1317.10 Mexico: investment in residential construction, infrastructure and

7.11 South Korea: sectoral surpluses of the corporate, household, public

7.12 Mexico: composition of net private capital inflows 1347.13 Korea: composition of net private capital inflows 1347.14 Latin America and East Asia: ratio of short-term debt to total

debt between the beginning of financial liberalisation and

7.15 Latin America and East Asia: ratio of foreign exchange reserves

to short-term debt between the beginning of financial

7.16 Latin America and East Asia: ratio of foreign exchange reserves

to M2 between the beginning of financial liberalisation and

7.17 Chile: composition of net private capital inflows 1417.18 Chile: net equity securities and other investment 1427.19 Chile: real effective exchange rate and foreign exchange reserves 1427.20 Chile versus Brazil and Thailand: short-term foreign debt 144

7.23 Chile: credit to the private sector and real interest rates 146

7.25 Malaysia: composition of net private capital inflows 1487.26 Malaysia: net ‘other’, portfolio investment and ‘errors’ 149

6.2 East Asian four: lending by BIS reporting banks by sector 876.3 Exposure of BIS reporting banks to non-BIS borrowers 886.4 Maturity distribution of lending by BIS reporting banks to

6.6 East Asian four: exchange rates and depreciation against

6.A3(a) Thailand: loans and advances by commercial banks 1186.A3(b) Indonesia: loans and advances by commercial banks 1186.A3(c) Malaysia: loans and advances by commercial banks 119

Michel Aglietta is a senior member of l’Institut Universitaire de France Former

administrator of INSEE, he is Professor of Economics at the University ofParis X-Nanterre and scientific adviser to the Centre d’Etudes Prospectives etd’Informations Internationales (CEPII) He also serves on the economic groupwhich advises the French Prime Minister His recent publications include

Macro-économie financière, premier tome, Finance, croissance et cycles, deuxième tome, Crises financières et régulation monétaire, Repères La Découverte (2001).

Franklin Allen is the Nippon Life Professor of Finance and Economics at the

Wharton School of the University of Pennsylvania and an Adjunct Professor ofFinance at New York University He is currently Co-Director of the WhartonFinancial Institutions Center He was formerly Vice Dean and Director ofWharton Doctoral Programs and Executive Editor of the Review of FinancialStudies, one of the leading academic finance journals He is a past President ofthe American Finance Association, the Western Finance Association and theSociety of Financial Studies He received his doctorate from Oxford University

Dr Allen’s main areas of interest are corporate finance, asset pricing, financialinnovation and comparative financial systems

Meghnad Desai is Professor of Economics, Director of the Centre for the Study

of Global Governance and Chairman of the Asia Research Centre at the LondonSchool of Economics He was created Lord Desai of St Clement Danes in 1991

His recent publications include: Money, Macroeconomics and Keynes, Essays

in honour of Victoria Chick, Volume 1, edited with Arestis, P and Dow, S (Routledge, 2002) and Marx’s Revenge; The Resurgence of Capitalism and the Death of Statist Socialism (Verso; London, New York, 2002).

Douglas Gale received his PhD in Economics from the University of Cambridge

and was elected to a Junior Research Fellowship at Churchill College,Cambridge He has taught at the London School of Economics and the

xii Contributors

University of Pennsylvania and is currently Professor of Economics at New

York University He has served as the co-editor of Econometrica and Economic Theory, an associate editor of the Journal of Economic Theory, the Journal of Mathematical Economics, and Research in Economics, and an advisory editor of Macroeconomic Dynamics He became a Fellow of the

Econometric Society in 1987 and is currently a Senior Fellow of the FinancialInstitutions Center at the Wharton School of the University of Pennsylvania

He is the author of several books and a large number of articles on economictheory and financial economics

Andrew Gamble teaches Political Economy and Political Thought at the

Department of Politics at Sheffield University He joined the Department in

1973 and was appointed to a Chair in 1986 He is a former Chairman of theDepartment, Dean of the Faculty of Social Sciences He read economics atCambridge for his first degree, then transferred to Durham to take an MAcourse in politics before returning to Cambridge to undertake research for hisPhD in social and political sciences He is Director of the Political Economy

Research Centre (PERC) and joint editor of New Political Economy and Political Quarterly He won the Isaac Deutscher Memorial Prize (1972) and Mitchell Prize (1977) His recent publications include: The Political Economy of the Company (2000) (co-edited with John Parkinson and Gavin

Kelly) and ‘Regionalism, World Order and the New Medievalism’, in M Telo

(ed.), From Capitalism to Capitalism (RIIA 2000).

Jomo Kwame Sundaram is a Professor in the Faculty of Economics and

Administration, University of Malaya His teaching experience includesHarvard, 1974–75 (teaching fellow); Yale College, 1977 (visiting instructor);National University of Malaysia (UKM), 1977–82 (lecturer; associate professorfrom 1981); University of Malaya, 1982–present (associate professor; professor1986–89, 1992–present); Wolfson College, Cambridge, 1987–88 (visiting fellow); and Cornell University, fall 1993 (visiting professor) His most recent

publications include Malaysian Eclipse: Economic Crisis and Recovery (Zed

Books, London, 2001)

Gabriel Palma is a University Senior Lecturer in Economics at the University of

Cambridge He specialises on the economic development of Latin Americaand East Asia and their integration within the World Economy In particular,the study of these economies from the point of view of their economic history,macroeconomics, international trade and international finance Recent

publications include: Capital Controversy, Post Keynesian Economics and the History of Economic Thought (Routledge 1996) and Financial Liberalisation and the East Asian Crisis (Palgrave 2001).

Yahia Said is a Research Officer at the Centre for the Study of Global

Governance at the LSE His experience combines academic research with private sector work and activism Prior to joining the LSE he worked as a corporate finance consultant with Ernst & Young in Russia He also worked as

a project coordinator with the Helsinki Citizens’ Assembly in Prague YahiaSaid specialises in issues of economic transition and security in post-totalitariansocieties His publications include with Meghnad Desai ‘Money and the globalcivil society: the new anti-capitalist movement’, in Anheier, Glasius and

Kaldor (eds), Global Civil Society 2001 (OUP 2001), and with Yash Ghai and Mark Lattimer, Building Democracy in Iraq (Minority Rights Group 2003).

1 Introduction

Meghnad Desai and Yahia Said

The new century is barely three years old and many of the certainties of the lastcentury are being re-examined During the last decade of the last century, therewas an overwhelming confidence about the economy A ‘New Paradigm’ washailed; the business cycle had been abolished we were told It seemed that theknowledge economy did not obey the old laws of economics There would be nolonger boom and bust as a new generation of central bankers and prudent FinanceMinisters had fashioned the perfect combination of monetary and fiscal policiesfor us

There was a warning in 1997 with the Asian crisis and the triple bypass forLong-Term Capital Management The 1997 crisis was the first crisis of the newphase of globalisation But while it sloshed about in Russia and Brazil, it failed

to reach the shores of the New York or London financial markets Smugnessreturned until in early 2001, the Dow Jones and Footsie began their journey southwards We were soon hearing of a double-dip recession, retrenchment in thefinancial services sector and large budget deficits in the USA, Germany, Francewith no upturn in sight for Japan after ten years of stagnation

The business cycle is back with us; indeed, it never went away While a financialmeltdown is a rare occurrence in developed country markets, the frequency ofsuch events in periphery is worrisome In the last ten years, we have had crises inMexico, Indonesia, Thailand, Malaysia, South Korea, Brazil, Argentina andTurkey There is financial fragility in India and China The uneasy marriage ofmoral hazard of lenders lending to sovereign governments in the knowledge of acertain bailout and the inability of sovereign borrowers to follow time-consistentstrategies in shaping their debt profile is becoming a major problem The questionsare many but the answers are few

This volume attempts to address some of the questions raised by the string offinancial crises over the past ten years As Desai puts it – are global financial markets rational or are manias possible? Should crises which follow manias beallowed to run their course and purge the system or should a lender of last resortintervene to dampen their impact on the real economy? Who can play this role atthe global level?

In Chapter 2, Desai explores the term ‘crisis’ and finds parallels between themedical and financial use of the words Crises in both areas indicate (a) a turning

point (b) a sudden and (c) precipitous drop in most indicators It also may havebenevolent characteristics by purging the system of previous excess and markingthe end of the ailment.

Desai briefly reviews the state of academic inquiry into the subject He findsthat while various researchers can provide useful insights into individual aspects

of crises there is no coherent and empirically supported theory that brings allthese aspects together He likens the state of research in this area to the joke aboutthe elephant being described by several blind men who are holding on to differentparts of his body and trying to extrapolate an understanding of the whole, eachfrom his own limited perspective

Marx who had in mind ten-year long Juglar type cycles viewed crises asendogenous, natural and an endemic phenomena of capitalism He therefore concluded that nothing could be done to prevent them or manage their impact.Hayek believed that cycles should not occur in a healthy capitalist economy Theyare likely to occur, however, as a result of overindulgence, such as excessive creditexpansion In this case, crises have the benevolent property of purging the system.They should be left to run their course, which may take a long time Governmentintervention is only liable to exacerbate matters Schumpeter analysing longKondratieff type cycles believed that they are the only way to technical innova-tion Crises are part of the process and indicated realignment to the steady state.Keynes’s analysis of short-term Kitchin type cycles has a similar perspective tothat of Hayek although he disagrees with him about their causes, which he attrib-utes to the market’s propensity to turn into a casino on occasion Keynes believedthat crises are predictable, pathological and warrant drastic remedies Minsky in afollow-up to Keynes’s ISLM framework viewed cycles as Walrasian, non-endoge-nous events triggered by external shocks and caused by the market’s propensity to overshoot

Desai proceeds to review the history of financial crises over the past 170 years

He agrees with Kindelberger on the pattern of manias, panics and crashes, whichseem to feed into each other to produce them He also points out to the effective-ness at various junctions of lender-of-last-resort intervention whether in the form

of the Bank of England during the gold standard years in the nineteenth century

or the Federal Reserve in the most recent crises He attributes the severity of theGreat Depression and the failure to address it over a long period to the absence of

a lender of last resort at that moment in history – the Bank of England was nolonger in the position to play that role and the Federal Reserve was not yet ready

In this context, he also blames the lack of awareness of the global nature of theGreat Depression and the failure to coordinate actions between the US andEuropean financial authorities

During the Bretton Woods years, according to Desai, crises became mild recessions due to the Keynesian system of effective financial separation and fixed exchange rates Indeed, the 1970s stagflation and the failure to mitigate it is

a consequence of the system’s collapse in 1970

In the new era of globalisation, according to Desai, it is the US Federal Reservewhich assumed the mantle of the lender of last resort and not the IMF He views

the IMF as a lender of first resort charged with maintaining the exchange ratepegs with US support, conducting structural adjustment programmes and coordi-nating rescue packages The problem with IMF intervention in crises is that ituses economic models that do not allow for cycles or crises As such it viewscycles as disequilibria, which can be remedied by drastic cuts.

Desai concludes that crises are likely to recur with varying reach, timing andmagnitude They are endogenous to capitalism and spread with it With global-isation, crises have become intertwined Desai believes that lender of last resort

‘tweaking’ should be sufficient to mitigate most crises This role is not played by

an international institution but rather by the central bank of the hegemonic power

at the time

In Chapter 3, Alan and Gale provide a quantitative analysis of the recent spate

of financial crises They find confirmation for Kindelberger’s identification ofcredit expansion as a determining factor behind asset price bubbles They pointout that historically asset price bubbles followed reforms, which led to creditexpansion such as financial liberalisation, fiscal expansion and relaxation ofreserve requirements They cite Japan in the 1980s as an example of this phenomenon

The mechanism through which financial deregulation feeds into asset pricebubbles according to Alan and Gale is by exacerbating the agency problem.Speculative investors with improved access to credit shift the risk to financialintermediaries This encourages them to bid prices even higher Uncertainty overmonetary policy further exacerbates this dynamic On the down side, banks liquidate assets to meet demands, which further accelerates the negative bubble.Alan and Gale conclude that financial authorities can mitigate asset price collapse

by expanding liquidity

In Chapter 4, Aglietta provides an analysis of the IMF and proposals for itsreform He views crises as endogenous to financial markets and attributes them

to a vicious cycle of credit expansion and asset price appreciation

Aglietta attributes the Fund’s failure to adequately react to the recent spate offinancial crises to the disjuncture between the changing environment, withinwhich it operates and its structural and doctrinal rigidities He argues that not onlytechnical but also political measures are needed if IMF reforms are to succeed.Aglietta argues that the IMF emerged in a world dominated by governmentintervention and international cooperation As market dominance spread, theFund reacted by accumulating and layering new functions, which are sometimesmutually exclusive Thus, the Fund is simultaneously acting as an assuror ofmutual assistance, an issuer of world currency (albeit discontinued), a financialintermediary and a crises manager In particular, Aglietta sees a conflict of interest

in the Fund acting both as a financial intermediary through its structural adjustmentfacilities and as a crises manager

Aglietta recommends that the Fund should (a) focus on prudential issues both

in terms of prevention and crises management This should entail streamlining itsportfolio of financial products and working closely with the private sector toshare risks and strengthen international supervision The IMF should work

through national central banks or directly as a crises manager/lender of last resort.Aglietta is not proposing the IMF as a replacement to the Bank of InternationalSettlements but as a more democratic complement to it since the latter is moredominated by the USA and the G7.

In Chapter 5, Gamble who believes that crises are a result of thirty years ofderegulation, describes three models of globalisation and analyses their implicationsfor financial crises theory and practice

At one extreme are the hyper-globalists who proclaim the end of the nationstate They could be Marxists arguing that the state’s loss of discretion over markets is what causes crises or Neoliberals who argue that crises are caused bythe remnants of state regulation Both believe that markets are all powerful andreforms are either useless or unnecessary

The sceptics, on the other hand, believe that states still have leverage over markets and that deregulation was voluntary rather than imposed by globalisation.They see state action – either unilateral (i.e capital controls) or coordinatedthrough international organisations – as the key to preventing crises and managingtheir consequences

The transformationists believe that the state is still an important player but thatglobalisation has changed the constraints under which governments and theeconomies operate They see crises as a result of a mismatch between an emergingglobal economy and national politics Transformationists believe in the imperative

to address crises because of their high cost Some see the answer in global governance solutions, which are more than international arrangements Others,whom Gamble calls hegemonists, see a role for the USA and its financial authorities

in addressing crises

Globalisation can also, according to Gamble, be viewed as a change in themodel of capitalism from a nationalist model marked by a compromise betweennational capital and national labour to a transnational one where no compromise

is necessary Thus, both hyper-globalists and sceptics believe that a convergence

is taking place on the Anglo-Saxon model of capitalism which leaves no space forreform while transformationalists see a possibility of maintaining local andregional institutional diversity in combination with global governance, be it democratic or hegemonic

In Chapters 6 and 7, Jomo and Palma explore the crises in East Asia and Latin America, respectively

Jomo, analysing the causes of the Asian crises, identifies a coalition of foreigncapital and domestic constituencies including business leaders and politicians asthe main culprits This coalition, according to Jomo, pushed through a financialliberalisation process which was fitful and uneven due to conflicting interests ofthe various parties

Jomo points out that the East Asian countries, regardless of the differencesbetween them, used short-term foreign financial flows to finance the service side

of their current account deficit As a consequence these flows did not end up feeding economic growth but rather an asset price bubble The ensuing collapseaccording to Jomo was not the result of fiscal profligacy but of the reversal of

those short-term flows The main causes of the crises were investor sentiment,herding behaviour and contagion The IMF remedies of conditionality and corporate governance reform were therefore misdirected, they only exacerbatedthe problem What these countries needed was a Keynesian stimulus package.Jomo proceeds to propose a set of recommendations for international financereforms He suggests that the international financial community should notmerely tolerate the imposition of selective and temporary financial controls butexplicitly endorse them In the case of crises, Jomo suggests that countries shouldhave access to quick and unconditional liquidity In general, sovereign debtorsshould be offered fairer terms for debt workout including a standstill Jomobelieves that developed countries should coordinate actions to ensure currencystability He recommends the development of a prudential controls system whichrecognises diversity Finally, Jomo believes that countries should have discretionover the exchange regime they choose.

Gabriel Palma, analysing financial crises in Latin America and Asia, posits thatthey were a result of lenders and borrowers accumulating excessive amounts ofrisk He then asks the question whether this was due to exogenous market inter-ference which distorted their otherwise rational behaviour or whether they did sobecause specific market failures within the financial market led them to be unable

to assess and price their risk properly

The surge in capital flows, according to Palma, rendered any policy aimed attheir absorption inefficient These flows were caused by excess liquidity in inter-national markets and domestic policy aimed at attracting them Emergingeconomies acted as a market of last resort – excess liquidity combined with slowgrowth in developed markets fed into excessive expectations and created artificialincentives

After analysing the various routes which led countries into crises, Palma evaluates their exit strategies focusing on capital controls Price-based capitalcontrols employed by Chile had little effect on the volume of capital flows but hadsome effect on their composition They also had some positive effect on themacro-economic environment Quantitative controls such as those employed byMalaysia had, on the other hand, a stronger and more lasting effect on the volume

of capital flows

Palma concludes that economic dogma is preventing proper reaction to crises.Capital controls are of some help but not sufficient Instead he suggests thatdiverse strategies should be targeted at expanding domestic lending for consumption and investment, sterilisating inbound financial flows and changingtheir composition

2 Financial crises and global

in the summer of 1998 That was the first crisis of the recent phase of globalisation

It led in its turn to demands for ‘new financial architecture’ and much activity bythe IMF/World Bank and G7 leaders in the summer of 1998 was directed towardscoping with the global crisis.2As it happened (and this is my reading of the events

of October 1998), a small number of interest rate cuts by the Federal Reserve(Fed) calmed the markets and resolved the crisis While some new institutionssuch as the Forum on Financial Stability were introduced, the global financialsystem has escaped any drastic structural adjustment or reform

In the new century, stock markets in G7 countries again witnessed a prolongeddecline with widespread failures in the dot.com sector Events of September 11,

2001 had less impact than the news of accounting malpractice at Enron andWorld.com While during the 1990s there was talk of a new paradigm and abolition

of the business cycle (as indeed happens in every long boom), by 2002 there was

a widespread fear of a double-dip recession in the USA or even a depression Thebusiness cycle was back with us, alive and well

The questions raised during the Asian crisis in those fifteen months betweenJune 1997 and October 1998 and indeed since then in the most recent recessionshow that the issue of crises and cycles will not go away After the euphoria of thefirst phase of explosive growth in financial markets during the 1990s, questionsare being raised about the tendency of markets towards excess volatility and persistent bubbles, which take too long to burst.3Thus, the political economy offinancial markets, of their tendency towards crises and cycles, still requires some

Financial crises and global governance 7coherent consideration Starkly put the main questions are:

1Is the global financial system an autonomously equilibrating, regulatory system requiring no policy intervention: either because the finan-

self-reversing endogenously without the need of any exogenous shock/intervention; or

occa-sional coordinated policy intervention to prevent escalation of local difficulties into a global meltdown; or

and/or inequitable outcomes so that it is neither desirable nor efficient toleave it unregulated or even partially/occasionally tweaked but needs supra-national or global government?

These questions are germane to the interpretation of the recent crises and theunderstanding of the next few as well But the same set of questions has been put

much better, perhaps in an earlier context by Kindleberger in his classic Manias, Panics and Crashes (MPC hereafter) (Kindleberger 1989) His argument can be

summarised as follows:

Are markets so rational that manias – irrational by definition – cannot occur?

If, on the other hand, such manias do occur, should they be allowed to run theircourse without government or other authoritative interference – at the risk offinancial crisis and panic that may spread through propagation by one means oranother to other financial markets at home and possibly abroad? Or is there asalutary role to be played by a ‘lender of last resort,’ who comes to the rescue andprovides the public good of stability that the private market is unable to producefor itself ?5And, if the services of a lender of last resort are provided nationally,

by governments or by such official institutions as a central bank, what agency oragencies can furnish stability to the international system, for which no governmentexists? (Kindleberger 1989, p 4)

Thus, not only do financial crises recur, the ways of studying them also do so

In this chapter, I want to briefly and quickly survey the history of financial crises

as well as the small amount of theoretical literature that is available (see Allen andGale Chapter 3 in this volume for other references) Then I want to pose the issuesabout the policy choices These choices very much hinge on the theories we haveabout the nature and causes of financial crises

Defining crises and explaining cycles

Before getting into the history of financial crises, it is worthwhile to define them

To begin with, we need to define the much abused word ‘crisis’ The term originates

in medicine and relates to a turning point in the state of a fevered body The physician notices a crisis when there is an abrupt, that is, sudden and unanticipated,fall in temperature (see Box 2.1)

In applying this idea to financial crises, we note the three elements in the definition above (a) It is a turning point (b) It is abrupt – sudden, unanticipated, discontinuous with what has gone before (c) It is represented by a large abruptchange in some indicator of the state of the system The definition given byRaymond Goldsmith in response to a paper by Minsky is succinct and very good.

He speaks of a sharp, brief and ultracyclical deterioration in a number of financialvariables – interest rates, asset prices, insolvencies (see Box 2.1) Thus, theabruptness and the turning point characteristic are noted in the economic as in themedical definition What is missing, however, in economics, is the benevolentinterpretation of a crisis as a means of resolution of the underlying problem,which is there in medicine

This is so because economists are not unanimous about the nature of the ‘fever’

to which the crisis is a resolution nor about the cycle during which a crisis occurs.Crises are not cycles but just the momentary turning points of a cycle.Economists differ not only as to the explanations for the cyclical phenomenon butalso even whether it really exists or could exist in a well functioning, efficientmarket economy Classical economists debated whether a ‘glut’ – an excess supply

of all commodities at once could happen Malthus thought it was possible butRicardo, James Mill and J B Say put forward irrefutable arguments that a glutcould not happen Supply created its own demand by logic and in fact, while somemarkets could be in oversupply, all markets could not be This idea implicitly of

(The Oxford Medical Companion, Walton, et al (1994).)

A financial crisis

(a) Sharp, brief, ultracyclical deterioration of all or most of a group offinancial indicators – short-term interest rates, asset (stock, real estate,land) prices, commercial insolvencies and failures of financial institutions.(Raymond Goldsmith (1982) as quoted in Kindleberger (1989).)

The pattern of cycle and crisis

Quiescence, improvement, confidence, prosperity, excitement, overtrading,convulsion, pressure, stagnation, ending again in quiescence (LordOvertone, nineteenth century British banker/economist, as quoted byBagehot (Kindleberger 1989, p 108).)

a general equilibrium was refined with a marginalist rather than a Labour theory

of value by Walras In such an equilibrium world, cycles are hard to fit But sincethere were periodic ups and downs in observed economic activity empirically, ifnot in theory, cycles seemed to be happening out there in the real world The question was, were cycles an accident or were they a systematic outcome of economic activity not accounted for in equilibrium theory

Studies of cycles have gone in and out of fashion as the fashion for equilibriumtheories has waxed and waned Cycles were much discussed in the periodbetween the mid-nineteenth century and the early half of the twentieth century butafter the Keynesian Revolution and especially after the Second World War cycles,

in fact, became mild and hence uninteresting to theorists But even in the hundredyears while cycles were discussed albeit not by leading theorists, one could discern a variety of approaches to the problem of cycles There were real theoriesand theories which traced the cycles to monetary factors There were great efforts

at measuring business cycles and economists got used to speaking of short –Kitchin – cycles around three years in length, ten-year – Juglar – cycles and thelonger fifty years – Kondratieff – cycles (For an early survey of cycle theoriesHaberler (1936), for cycles of different lengths and historical data Schumpeter(1940); the classic writings on cycles are covered in Gordon and Klein (1966).Cycles disappear from the literature in the 1960s.)

In a Walrasian model, cycles cannot happen as the efficient markets are perpetually in equilibrium Generating a fully endogenous theory of businesscycles in a Walrasian context was a programme that Hayek took up in the early1930s but abandoned later (Hayek 1933, 1939) More recently, the theory of RealBusiness Cycles has argued that cycles are caused by random shocks to technologyand tastes in a Walrasian system which in absence of these shocks would be cyclefree (Barro 1993) In such a theory, crises would be also random occurrenceswithout any special property – headaches rather than fevers The theory has also,

by and large, ignored financial markets and has not been extended to globalcycles More recently, there has been a theoretical research effort to generateendogenous cycles in a Walrasian model of overlapping generations It is not as yetempirically tractable (Benhabib 1992) In what follows, I want to explore otherarguments for cycles and the way in which they can be tackled

Cycles could be regarded as ‘natural’ endogenous responses of a capitalist system based on private property and profitability Then their occurrence, recur-rence and turning points are neither good nor bad things They are endogenousand systematic elements of the disequilibrium dynamics of capitalism Or youcould think of a ‘healthy’ economy as a cycle-free system and cycles are then due to overindulgence of one kind or another – malinvestment, excessive lending

by banks, too much inflationary finance by public authorities Then a crisis is like

a purge – unpleasant but necessary Marx took the first view and Hayek takes thesecond view in his work during the 1930s (Marx 1867; Hayek 1933, 1939; Goodwin1967; Desai 1973) A third view attributable to Schumpeter would be that cycles(albeit long cycles of about fifty years) are not only good but the only way inno-vations can work through a capitalist economy (Schumpeter 1940) Crises signal

a slowing down of the economy as it gets back to a new stationary state

Modern theories rely on Keynes’s General Theory (Keynes 1936) Keynes didnot have a theory of cycles but he did have a view on the nature of the financialsystem This was that while most of the time the financial (equity and bond) mar-kets were necessary for maintaining investment at a high level, occasionally theygot overheated and became like casinos This is when there is an excessive boomwhich then crashes (Keynes 1936) This is the idea that normally healthy systemscan have a pathological deviation – a fever which is temporary but whose recur-rence is also predictable (There are similarities here between Keynes’s andHayek’s views but their causal structures are different.) Keynes’s views have beenexpanded in a full-scale theory of financial fragility by Minsky (Minsky (1982)which also contains other references to his work) Minsky correctly recognisesthat a financial crisis is a crucial moment in the financial-instability process but

it is only a moment Yet, it has proved difficult to formulate Minsky’s insightsanalytically (Taylor and O’Connell 1985; Skott 1995 contain other references).Finally, one ought to mention the second but much more popular variant ofKeynes’s model the ISLM version This model has been extended to generatecycles as a result of the dynamics in investment-lags in particular Here again, Ishould add that the textbook Keynesian ISLM model fails to generate undampedcycles in the absence of random shocks Thus, the textbook Keynesian model issimilar to the Walrasian model in its inability to generate endogenous cycles(Adelman and Adelman 1959)

These views can be summarised succinctly as:

system – Hayek

Schumpeter

Walras/Keynesian ISLM model

Of course, I am making a sharper distinction than is there in the literature.Schumpeter’s view (c) relates more to the long-Kondratieff-cycles, while Marxthought of them as ten-year (Juglar) cycles Hayek is not clear as to the length ofthe cycle he has in mind but his recovery periods are long or should be so This

is because he believes that any hasty attempt to stage a recovery may worsen thesituation by stopping the natural process of restoring an equilibrium (Desai and Redfern 1995; Desai 1996) The Walrasian Real Business cycle and theKeynesian ISLM models generate short – Kitchin – cycles which reproduce thepost-1945 US experience reasonably accurately though there are still disputesabout the sustainability of these cycles With Minsky, it is difficult to say whether

he does not think (unlike Keynes in General Theory) that the US economy in the1960s and 1970s was perpetually in a crisis In his discussion of Minsky’s model,Raymond Goldsmith criticised him for having too loose a definition of crises

After giving his own definition, which I mentioned earlier, he says of Minsky’sassertions:

This (i.e his own) definition would exclude several of Professor Minsky’s so-called financial crises, particularly the minor financial difficulties experi-enced in the United States in the 1960’s and 1970’s, on which he puts so muchemphasis, erroneously I feel, as they were at most potential or near crises

(Goldsmith in Kindleberger and Lafargue 1982, p 42)Using the medical analogy, Minsky, and by implication Kindleberger who adoptshis definition for his comprehensive dating of the crises in MPC, seem to includeevery minor headache and queasy tummy as crises when we should be looking at

a much more serious feverish condition Historically, crises have been markedevents punctuating cycles in a dramatic fashion

Crises: a brief historical account

A financial crisis seems to cover two phenomena, which though related are separate One is a panic and the other is a crash A panic is a rush on the banks,

a moment when everyone is trying to turn their financial assets into money It is

a sudden change in bank liabilities A crash is a drop in the price of equities,mainly, but may also be in the other asset prices There is thus a rough quantity/price distinction to be made here

Of course, panics and crashes are interrelated A panic may be triggered by

a crash or premonitions of an impending crash In a panic, everyone wants to convert assets into money but asset prices are falling and money is hard to get In

1825, the first crisis of modern capitalism, when seventy-three banks failed,brought Britain ‘within twenty four hours of barter’ (Kindleberger 1989, p 128).But panics and crashes can be prevented from mutually feeding one another bysuitable central bank intervention There are several instances of it

There were regular ten-year cycles in Great Britain in the century between

1815 and 1914 In the first half, the cycles were punctuated by panic Thus, thecrises of 1816, 1825, 1836, 1847, 1857 occurred in what seemed like regular ten-year intervals The 1866 crisis coincided with the run on the City bankersOverend, Gurney and Company This was the first crisis that the Bank of England(reformed in 1844) intervened in decisively Indeed, its intervention was thebeginning of modern central banking by some accounts And it seems to have succeeded In the fifty years after 1866, there was only one crisis in Britain andthis was the Baring crisis, which had more to do with Baring Brothers’ Argentineinvestments (shades of Nick Leeson a century later which scuppered the bank)than anything in London

Indeed, the Baring crisis of 1890 was very much a global crisis like the Asiancrisis of 1997 It started with German investors withdrawing capital fromArgentina This led to the failure of an offering by Buenos Aires Drainage andWaterworks Company of £3.5 million in November 1888 This forced Baring

Brothers to lend to Argentina on acceptance credits The Argentine government could not service the debt as a result of falling raw material prices in

1890 The Bank of England was forced to warn Baring Brothers to restrict theircredit to Argentina Then a crisis happened in New York in November 1890 andthere was a full-scale run on Baring Brothers The Bank of England then wentabout organising a guarantee by roping in other commercial banks, much as theIMF organises rescues of countries nowadays Thus, in the first global crisis at theend of the nineteenth century the central bank of the hegemonic economic poweracted to resolve the crisis just as in 1998 it was again the central bank of anotherhegemonic economic power which managed the rescue The parallel is strikingbetween the actions of the Bank of England in 1890 and the Fed in 1998 But thepoint remains that while cycles continued to occur in the British economy atroughly 8–10-year frequencies, panics and crashes became infrequent, thanks tocentral bank action Gorton and Kahn (1993) has, on the other hand, shown thatbetween 1865 and 1914 in the USA, in the absence of central banks, there werecrises in 7 out of 11 cycles

In the interwar period, there was a break in the pattern of cycles The half-centurypreceding 1914 had witnessed a globalised world with free movement of capitaland labour and Gold Standard which meant that except for Great Britain, no othercountry had monetary sovereignty Over the period, the cycles in 1864–1914became more interlinked across the developed countries of the globe and therewas a rough regularity about their frequency In the 1919–39 period the worlddeglobalised The free movement of labour came to a stop and the movements ofcapital became difficult across national barriers Great Britain lost its hegemony

of the world economy and the USA was not yet ready to take it up The cyclesbecame irregular and uncorrelated There was an upswing and inflation in theimmediate postwar period but by 1922/23 the deflationary phase began in majorEuropean economies The USA had a long boom without any severe inflationarypressures until 1929

The interwar period is marked, of course, by the Great Crash of 1929 and theGreat Depression of the 1930s This was a rare confluence of the short and thelong cycles in USA and Europe But even then, there have been attempts at seekingseparate national explanation for the Great Depression It has been argued in thecase of the USA by Milton Friedman that this was a case of central bank failure

on the part of the Fed British explanations rely on overvaluation of the Poundafter the 1925 return to the Gold Standard and the resulting shock to exports.German explanations hinge on the aftermath of the hyperinflation of 1923–24,reparations payments and the sudden reversal of US bank credits after the GreatCrash.6

But the crisis and the following downward cycle was an international and not

a national phenomenon And this internationalisation of the crash/panic wasmuch more damaging in this crisis than in any previous crisis Stock marketscrashed in Wall Street and this led to a credit squeeze American loans to Europewere recalled and banks failed in Europe leading to further price collapses andbank failures in the USA But if in the pre-1914 crises there was the Bank of

England to bail out the world, now there was no such hegemon The Fed was notready yet to take a global view and in its limited experience as a central banknothing of that order has happened before The Great Depression was thus themost severe episode in the history of modern capitalism but it was also uniquedue to the absence of a lender of last resort on a global basis Neither the 1987crash nor the 1997/98 Asian/Russian crisis was that severe because of the effectiveness of the Fed.

In the post-1945 period, the separation of national economies was deepenedthough the hegemony of the USA was established Capital markets were heavilyregulated, exchange rates were fixed in the Bretton Woods framework and convertibility of currencies was restored even among developed countries only by

1960 But thanks to Keynesian macro policies, cycles in each country were quitemild Depressions were replaced by recessions and sustained growth became thenorm rather than cyclical swings It was only after convertibility had beenrestored that the US excess spending during the later years of the 1960s spread

US inflation to other countries.7

As the economies began to be painfully reintegrated, the Bretton Woods systemfailed Exchange rates became variable The quadrupling of oil prices in 1973 andagain a sharp rise in 1979 revived the business cycle The stagflation of the 1970sturned into a more severe and widespread crisis after the second oil price rise of

1979 There were severe recessions in USA in 1980 and 1990 with ripple effects

in the United Kingdom The recycling of the petrodollars which were lent at lownominal and negative real interest rates during the 1970s to Third World countrieshad to be repaid at the much higher nominal and real interest rates after 1979when the developed countries adopted monetarist policies This led to the debtcrisis, which started with Mexico but soon visited many other countries But thesedebt crises were separately dealt with by the IMF’s structural adjustment policies.They did not constitute a global cycle The full international business cycle re-emerged only in the 1990s This is due to the liberalisation and growth offinancial markets This revealed a gap in the governance of global financial markets

Global financial governance

The Bretton Woods system had created IMF as a possible global central bank Ofcourse, in reality IMF was much less than that and a shadow of Keynes’s proposedsolution The IMF did not act as a central bank but only as a lender of the firstresort for countries facing balance of payments difficulties It tried to police thefixed exchange rates system but could only do it so far as all the other members

of the Fund except the USA were concerned The USA was the hegemon and itwas around the dollar that the dollar exchange system of fixed exchange ratesoperated The USA pursued policies during the 1960s, which a responsible keycurrency power should not have, but no one, and certainly not the IMF, could prevent it from doing whatever it chose to do The result was that the USA did notmanage its affairs very effectively and the system of fixed exchange rates had to

be abandoned in August 1971 After the abandonment of the fixed exchange ratesystem, the IMF turned its attention to the developing countries and their struc-tural adjustment problems and even in this it was rarely a success During the1990s, the IMF began to organise credit facilities to avert systemic failures inindividual national banking systems It played a role in organising rescue loansfor countries caught in the systemic crises but at the same time came in for a lot

of criticism in the way it managed the policy advice to the countries concerned.For what was a crisis of private bank lending with international liabilities, theIMF was still applying closed economy macro models and orthodox monetaristremedies In all its structural adjustment programmes, the IMF has relied on aChicago version of the macro model in which cycles do not occur If an economy

is in trouble this is seen to be a situation out of equilibrium and in a simple parative static fashion the answer is to impose fiscal and monetary cutbacks This

com-is supposed to get the economy back to equilibrium But in light of the survey oftheories and experience discussed earlier, this is hardly a correct recipe for avoiding

or dealing with financial and real crises If good global financial governance is to

be built we need to learn from history

The lessons seem to be as follows:

England in 1825 As capitalism spread, each country has witnessed the cyclicalphenomenon But cycles have changed in length and amplitude as well astheir range – national, regional and global In the period before the FirstWorld War, cycles became interlinked across the developed countries andnearly global while after the Second World War they were largely nationaland only weakly articulated across countries They seem now once again to

be global Cycles change their nature but do not disappear They seem to beendogenous and sustained as part of capitalism As capitalism has spreadacross the globe or indeed has been reintroduced in some countries cycleshave spread With drastic changes in financial flows and communicationstechnologies, these cycles have got intertwined

amount of tweaking restores the system to its self-regulating nature Tochange metaphors from fever to clocks, the pendulum swings but occasion-ally the clock needs oiling or rewinding This was the second of the threealternatives put forth earlier

institu-tional restructuring by the political authorities But this was done separately

in each national economy and this slowed down recovery There was no effectivecentral bank and the world suffered much greater output and employmentlosses than was necessary It took another ten years before the US or the UKeconomy recovered and then the war changed the context But the 1929/1931failure suggests that it is the third alternative which is the relevant one

two decades after 1945 These were the years of the Keynesian Golden Age

and cycles were damped and short Each country dealt with its own cyclicalproblem separately.

which interlinked the developed economies into a crisis of stagflation Thiswas more like a Hayek cycle of malinvestment (Desai 1996) There wereattempts at, or at least appeals for, coordinated policy response but eventuallyeach economy did its own thing The only exception to that statement would

be the Plaza Accord of 1985, which caused the devaluation of the dollar Notethat the IMF was not involved in the 1970s or the 1980s with the inter-national macro-economic stabilisation problems The G5 as they were thendid it themselves

for example but also the interlinked Asian crisis of 1997–98 The IMF played

a role in organising large loans for systemic bail out But the economic stabilisation problem was dealt with by the Fed It played the rolethat the Bank of England had played in the earlier nineteenth century phase ofglobalisation No new structure for financial governance, no new architecturemuch talked about in the summer of 1998 was created This gives credence

macro-to the second alternative above – a self-correcting system with an occasionalbreak down This is not however to say that the next crisis will be similar

Thus, historical experience lends credence to each of the alternatives we put forwardearlier This is hardly a consolation for someone looking for a clear answer.Theories of business cycle are however to blame Despite decades of theorising

we cannot say with any confidence that we have a theory that generates sustained(non-damped), endogenous (or if not endogenous with reliably regular exogenousshocks), transnational or global cycles linking financial and real variables, whichhas a credible empirical record Like in the story of the blind men and the elephant, each proponent of a solution can point to one aspect and generalise fromthat What we need is some theory that can encompass the varied experience oflocal damped or undamped cycles or global cycles, cycles of various lengths andamplitudes with financial and real variables properly articulated with systematicinfluences overlaid with stochastic shocks

But in the meantime, any architecture of global economic governance has totake a bet on which of the many stories is correct During the 1997/98 crisis, twoviews competed for attention One view was that of pervasive failure and need forglobal governance as put forward, for example, by Taylor and Eatwell They proposed a World Financial Authority The other view was that some local tinkering

of interest rates and some marginal improvements to IMF will suffice since thefinancial system was well functioning in the main The tweaking of interest rates bythe Fed and the resolution of the crisis or at least non-occurrence of a massive crash

on Wall Street meant that the milder lesson of the second alternative was adopted.The G7 decision in November 1998 was to postpone any drastic restructuring of theinternational financial system In February 1999, the Financial Stability Forumwas established by the G7 to attain ‘a better understanding of the sources of

systemic risk … ensure that international rules and standards of best practice aredeveloped … ensure consistent international rules … and a continuous flow ofinformation amongst authorities having responsibility for financial stability’(Eatwell and Taylor, p 26, quoting Hans Tietmayer) Thus, a talking shop Wasthis the correct move? Will the next crisis be as easy to tweak by the Fed or theIMF or will it require drastic New Deal style restructuring at the global level? Or

to take up the remaining alternative (the first), should we remove the IMF fromits role and let the system seek its own self-regulatory equilibrium as was argued

by the Meltzer Report to the US Congress?

Conclusion

My argument is that our present state of knowledge of financial crises and cyclesdoes not allow us to make an objective or reliable judgement on this issue Ourmodels are too specialised or too simple (though very rigorous) The need is toinvest resources into building models based on the best available theory, calibratethem and then test which of the alternative provides a plausible explanation It

is not an easy task It will require combining finance theory, econometrics andpolitical economy But it needs to be done

Notes

1For the affairs at LTCM see Lowenstein, R (2000) ‘When genius failed’, The Rise and

Fall of Long Term Capital Management, Random House, New York The Mexican peso

crisis, which happened in December 1994, was regional and did not grow into a global crisis as the Asian one did I am excluding it therefore There were other national crises

in Russia, Turkey, Argentina and Brazil.

2 For the 1998 debate on financial architecture see Eatwell and Taylor (1998) They propose a World Financial Authority as a regulator rather than a lender of last resort.

3 For excess volatility see Soros, George (2000) and for overvaluation and persistent bubble

Shiller, R (2001) Irrational Exuberance, Princeton University Press, Princeton, NJ.

4 Fama, E (1970) Efficient capital markets: a review of theory and empirical work,

Journal of Finance, 25: 383–417 There are many subsequent developments of the

notion of efficient financial markets see Shiller op cit for bibliography.

5 More recently the demand for global financial stability as a global public good has been

raised see Kaul et al (1999).

6 For the USA, Friedman, M and Schwartz, A (1963) A Monetary History of the United

States, Princeton University Press, Princeton, NJ For a dissenting view Temin (1994).

For an overall view across individual countries see Kindleberger, C.P.

7 But by late 1960s the long boom had lasted a long time and economists were talking

about the end of business cycles See Bronfenbrenner (1969) Is the Business Cycle

Obsolete?

References

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Model’, Econometrica, XXVII, October.

Allen, F and Gale, D (2003) ‘Asset price bubbles and monetary policy’, in Meghnad Desai

and Yahia Said (eds), Global Governance and Financial Crises, Routledge, London.

Baranzini, M and Cencini, A (1996) Inflation and Unemployment, Routledge, London Barro, R (1989) Modern Business Cycle Theory, Basil Blackwell, Oxford.

Benhabib, J (ed.) (1992) Cycles and Chaos in Economic Equilibrium, Princeton University

Press, Princeton, NJ.

Bronfenbrenner, M (1969) Is the Business Cycle Obsolete?/based on a Conference of the

Social Science Research Council Committee on Economic Stability, Wiley-Interscience,

New York.

Desai, M (1973) ‘Growth cycles and inflation in a model of the class struggle’ Journal of

Economic Theory, 6: 527–545.

Desai, M (1996) ‘Hayek, Marx and the demise of official Keynesianism’, in M Baranzini

and A Cencini (eds) Inflation and Unemployment, Routledge, London.

Desai, M and Redfern, P (1994) ‘Trade cycle as a frustrated traverse: an analytical

reconstruction of Hayek’s model’, in M Colonna and O Hamouda (eds), Money and

Business Cycles: The Economics of F A Hayek vol 1, Edward Elgar, Aldershot, Hants.

Eatwell, J and Taylor, L (2000) Global Finance at Risk, Polity Press, Cambridge Epstein, G A and Gintis, H M (eds) (1995) Macroeconomic Policy after the

Conservative Era, Cambridge University Press, Cambridge.

Fama, E (1970) ‘Efficient capital markets: a review of theory and empirical work’ Journal

of Finance, 25: 383–417.

Friedman, M and Schwartz, A (1963) A Monetary History of the United States

1867–1960, Princeton University Press, Princeton, NJ.

Goldsmith, R W (1982) National Balance Sheet of the United States, 1953–1980,

University of Chicago Press, Chicago.

Goodwin, R M (1967) ‘A growth cycle’, in C Feinstein (ed.) Socialism, Capitalism and

Economic Growth: Essays in Honour of Maurice Dobb, Cambridge University Press,

Haberler, G (1936) Prosperity and Depression, League of Nations.

Hayek, F A (1933) Prices and Production, Routledge, London.

Hayek, F A (1939) Profits, Interest and Investment, Routledge, London.

Kaul, I Grunberg, I and Stern, M (eds) (1999) Global Public Goods, Oxford University

Press, New York.

Keynes, J M (1936) The General Theory of Employment, Interest and Money, Macmillan,

London.

Kindleberger, C P (1989) Manias, Panics and Crashes: A History of Financial Crises, 2nd

edition, Macmillan, London.

Kindleberger, C P and Laffargue, J.-P (eds) (1982), Financial Crises: Theory, History and

Policy, Cambridge University Press, Cambridge.

Lowenstein, R (2000) When Genius Failed: The Rise and Fall of Long-Term Capital

Management, Random House, New York.

Marx, K (1867/1884) Capital Vol 1 (various editions).

Minsky, H P (1982) ‘The financial-instability hypothesis: capitalist processes and

the behaviour of the economy’, in C P Kindleberger and L.-P Laffargne (eds), Financial

Crises: Theory, History and Policy, Cambridge University Press, Cambridge, pp 13–39.

Schumpeter, J A (1982 reprinted) Business Cycles: A Theoretical, Historical, and

Statistical Analysis of the Capitalist Process, Porcupine Press, Philadelphia.

Shiller, R J (2000) Irrational Exuberance, Princeton University Press, Princeton, NJ.

Skott, Peter (1995) ‘Financial innovation, deregulation and Minsky cycles’, in G A Epstein and H M Gintis (eds) pp 255–273.

Soros, G (1998) Towards an Open Society: The Crisis of Global Capitalism, Public

Affairs, New York.

Taylor, L and O’Connell, S (1985) ‘A Minsky Crisis’, Quarterly Journal of Economics,

Volume C, Issue 3 (Supplement), 871–887.

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Cambridge, MA.

Walton, J., Barondess, J and Lock, S (1994) The Oxford Medical Companion, Oxford

University Press, Oxford.

3 Asset price bubbles and monetary

In many recent cases where asset prices have risen and then collapsed ically, an expansion in credit following financial liberalization appears to havebeen an important factor Perhaps the best-known example of this type of phenomenon is the dramatic rise in real estate and stock prices that occurred inJapan in the late 1980s and their subsequent collapse in 1990 Financial liberal-ization throughout the 1980s and the desire to support the US dollar in the latterpart of the decade led to an expansion in credit During most of the 1980s asset pricesrose steadily, eventually reaching very high levels For example, the Nikkei 225index was around 10,000 in 1985 On December 19, 1989 it reached a peak of38,916 A new Governor of the Bank of Japan, less concerned with supporting the

dramat-US dollar and more concerned with fighting inflation, tightened monetary policyand this led to a sharp increase in interest rates in early 1990 (see Frankel 1993;Tschoegl 1993) The bubble burst The Nikkei 225 fell sharply during the firstpart of the year and by October 1, 1990 it had sunk to 20,222 Real estate pricesfollowed a similar pattern The next few years were marked by defaults andretrenchment in the financial system The real economy was adversely affected bythe aftermath of the bubble and growth rates during the 1990s have mostly beenslightly positive or negative, in contrast to most of the postwar period when theywere much higher

Similar events occurred in Norway, Finland and Sweden in the 1980s (seeHeiskanen 1993; Drees and Pazarbasioglu 1995) In Norway, the ratio of bankloans to nominal GDP went from 40 percent in 1984 to 68 percent in 1988 Assetprices soared while investment and consumption also increased significantly Thecollapse in oil prices helped burst the bubble and caused the most severe bankingcrisis and recession since the war In Finland, an expansionary budget in 1987resulted in massive credit expansion The ratio of bank loans to nominal GDP

20 Franklin Allen and Douglas Gale

increased from 55 percent in 1984 to 90 percent in 1990 Housing prices rose

by a total of 68 percent in 1987 and 1988 In 1989, the central bank increasedinterest rates and imposed reserve requirements to moderate credit expansion In

1990 and 1991, the economic situation was exacerbated by a fall in trade with theSoviet Union Asset prices collapsed, banks had to be supported by the govern-ment and GDP shrank by 7 percent In Sweden, a steady credit expansion throughthe late 1980s led to a property boom In the fall of 1990, credit was tightened andinterest rates rose In 1991, a number of banks had severe difficulties because oflending based on inflated asset values The government had to intervene and

a severe recession followed

Mexico provides a dramatic illustration of an emerging economy affected bythis type of problem In the early 1990s, the banks were privatized and a financialliberalization occurred Perhaps most significantly, reserve requirements wereeliminated Mishkin (1997) documents how bank credit to private nonfinancialenterprises went from a level of around 10 percent of GDP in the late 1980s to

40 percent of GDP in 1994 The stock market rose significantly during the early1990s In 1994, the Colosio assassination and the uprising in Chiapas triggeredthe collapse of the bubble The prices of stocks and other assets fell and bankingand foreign exchange crises occurred These were followed by a severe recession.These examples suggest a relationship between the occurrence of significant

rises in asset prices or positive bubbles and monetary and credit policy They also

illustrate that the collapse in the bubble can lead to severe problems because thefall in asset prices leads to strains on the banking sector Banks holding real estateand stocks with falling prices (or with loans to the owners of these assets) oftencome under severe pressure from withdrawals because their liabilities are fixed.This forces them to call in loans and liquidate their assets, which in turn appears

to exacerbate the problem of falling asset prices In other words, there may be

negative asset price bubbles as well as positive ones These negative bubbles

where asset prices fall too far can be very damaging to the banking system Thiscan make the problems in the real economy more severe than they need havebeen In addition to the role of monetary and credit policy in causing positiveprice bubbles there is also the question of whether monetary policy has a role toplay in preventing asset prices from falling too far In the Scandinavian andMexican examples, asset prices quickly rebounded and the spillovers to the realeconomy were relatively short-lived In Japan, asset prices did not rebound andthe real economy has been much less robust

Despite the apparent empirical importance of the relationship between monetarypolicy and asset price bubbles there is no widely agreed theory of what underliesthese relationships The aim of this chapter is to summarize some of the recentwork we have done to try understand asset price bubbles, financial crises and therole of the central bank The next section looks at the relationship between creditexpansion and positive bubbles Allen and Gale (2000) provide a theory of thisbased on the existence of an agency problem Many investors in real estate andstock markets obtain their investment funds from external sources If the ultimateproviders of funds are unable to observe the characteristics of the investment,

there is a classic risk shifting problem Risk shifting increases the return to investment

in the assets and causes investors to bid up the asset price above its fundamentalvalue A crucial determinant of asset prices is the amount of credit that is provided for speculative investment Financial liberalization, by expanding thevolume of credit for speculative investments and creating uncertainty about thefuture path of credit expansion, can interact with the agency problem and lead to

a bubble in asset prices

When the bubble bursts either because returns are low or because the centralbank tightens credit, banks are put under severe strain Many of their liabilitiesare fixed while their assets fall in value Depositors and other claimants maydecide to withdraw their funds in anticipation of problems to come This willforce banks to liquidate some of their assets and this may result in a further fall

in asset prices because of a lack of liquidity in the market The section “Bankingcrises and negative bubbles” considers how such negative bubbles arise Ratherthan focussing on the relationship between the bank and borrowers who makeinvestment decisions as in the section “Agency problems and positive bubbles,”the focus is on depositors and their decisions The analysis is based on that inAllen and Gale (1998) It is shown that if banks’ long-term risky assets are completely illiquid then runs can help achieve a good allocation of risk However,

if a market for these assets is introduced but there is limited liquidity then assetprices are determined by “cash-in-the-market pricing” and can fall below theirfair value This leads to an inefficient allocation of resources The central bankcan eliminate this inefficiency by an appropriate injection of liquidity into themarket

Finally, the last section contains concluding remarks

Agency problems and positive bubbles

How can the positive bubbles and ensuing crashes in Japan, Scandinavia andMexico mentioned earlier be understood? The typical sequence of events in suchcrises is as follows

There is initially a financial liberalization of some sort and this leads to

a significant expansion in credit Bank lending increases by a significant amount.Some of this lending finances new investment but much of it is used to buy assets

in fixed supply such as real estate and stocks Since the supply of these assets

is fixed the prices rise above their “fundamentals.” Practical problems in short selling such assets prevent the prices from being bid down as standard theory suggests The process continues until there is some real event that means returns onthe assets will be low in the future Another possibility is that the central bank

is forced to restrict credit because of fears of “overheating” and inflation The result

of one or both of these events is that the prices of real estate and stocks collapse

A banking crisis results because assets valued at “bubble” prices were used as collateral There may be a foreign exchange crisis as investors pull out their fundsand the central bank chooses between trying to ease the banking crisis or protect theexchange rate The crises spill over to the real economy and there is a recession

In the popular press and academic papers, these bubbles and crises are oftenrelated to the particular features of the country involved However, the fact that asimilar sequence of events can occur in such widely differing countries as Japan,Norway, Finland, Sweden and Mexico suggest such bubbles and crashes are

a general phenomenon

How can this phenomenon be understood? The crucial issues we will focus on are:

(i) What initiates a bubble?

(ii) What is the role of the banking system?

(iii) What causes a bubble to burst?

The risk shifting problem

A simple example is developed to illustrate the model in Allen and Gale (2000).1

They develop a theory based on rational behavior to try and provide some insightinto these issues Standard models of asset pricing assume that people investwith their own money We identify the price of an asset in this benchmark case

as the “fundamental.” A bubble is said to occur when the price of an asset risesabove this benchmark.2 If the people making investment decisions borrowmoney then because of default they are only interested in the upper part of thedistribution of returns of the risky asset As a result there is a risk shifting prob-lem and the price of the risky asset is bid up above the benchmark so there is abubble

In the example, the people who make investment decisions do so with borrowed money If they default there is limited liability Lenders cannot observethe riskiness of the projects invested in so there is an agency problem For the case

of real estate this representation of the agency problem is directly applicable Forthe case of stocks there are margin limits that prevent people from directly borrowing and investing in the asset However, a more appropriate interpretation

in this case is that it is institutional investors making the investment decisions.This group constitutes a large part of the market in many countries The agencyproblem that occurs is similar to that with a debt contract First, the people thatsupply the funds have little control over how they are invested Second, the rewardstructure is similar to what happens with a debt contract If the assets that the fundmanagers invest in do well, the managers attract more funds in the future andreceive higher payments as a result If the assets do badly there is a limit to thepenalty that is imposed on the managers The worst that can happen is that theyare fired This is analogous to limited liability (see Allen and Gorton 1993)

Initially there are two dates t1, 2 There are two assets in the example Thefirst is a safe asset in variable supply For each 1 unit invested in this asset at date 1the output is 1.5 at date 2 The second is a risky asset in fixed supply that can

be thought of as real estate or stocks There is 1 unit of this risky asset For each

unit purchased at price P at date 1 the output is 1 with prob 0.75 and 6 with prob.

0.25 at date 2 so the expected payoff is 2.25 The details of the two assets aregiven in Table 3.1

The fundamental

Suppose each investor has wealth B initially and invests her own wealth directly.

Since everybody is risk neutral the marginal returns on the two assets must beequated

The first issue is can P1.5 be the equilibrium price?

Consider what happens if an investor borrows 1 and invests in the safe asset.Marginal return safe asset1.51.33

Table 3.1 Details of the two assets

Asset Supply Investment at date 1 Payoff at date 2

The risky asset is clearly preferred when P1.5 since 0.670.17 This is therisk shifting problem The expected payoff on the two investments in 1 unit of thesafe asset and 1/1.5 units is the same at 1.5 The risky asset is more attractive tothe borrower though With the safe asset the borrower obtains 0.17 and the lenderobtains 1.33 With the risky asset the borrower obtains 0.67 while the lenderobtains 0.251.330.751(1/1.5)1.50.670.83 The risk of defaultallows 0.5 in expected value to be shifted from the lender to the borrower This isthe risk shifting problem If the lender could prevent the borrower from investing

in the risky asset he would do so but he cannot since this is unobservable.What is the equilibrium price of the risky asset given this agency problem?

In an equilibrium where the safe asset is used, the price of the risky asset, P,

will be bid up since it is in fixed supply, until the expected profit of borrowers isthe same for both the risky and the safe asset:

There is a bubble with the price of the risky asset above the benchmark of 1.5.The idea that there is a risk shifting problem when the lender is unable toobserve how the borrower invests the funds is not new (see, for example, Jensenand Meckling 1976; Stiglitz and Weiss 1981) However, it has not been widelyapplied in the asset pricing literature Instead of the standard result in corporatefinance textbooks that debt-financed firms being willing to accept negative netpresent value investments, the manifestation of the agency problem here is thatthe debt-financed investors are willing to invest in and bid up assets priced abovetheir fundamental

The amount of risk that is shifted depends on how risky the asset is The greaterthe risk the greater the potential to shift risk and hence the higher the price will

be To illustrate this consider the previous example but suppose the return on therisky assets is a mean-preserving spread of the original returns (Table 3.2)

Table 3.2 A mean-preserving spread of risky asset returns

Asset Supply Investment at date 1 Payoff at date 2

9 with prob 0.25

0 with prob 0.75

ER  2.25

Now the price of the risky asset is given by

In the equilibria considered above the investors are indifferent between investing

in the safe and risky asset Suppose for the sake of illustration that whenindifferent half choose to invest in the risky asset and half choose to invest in thesafe asset

Bank’s Payoff0.5[0.251.330.751]0.5[1.33]

1.21

If the banking sector is competitive this payoff will be paid out to depositors Inthis case it is the depositors that bear the cost of the agency problem In order for

this allocation to be feasible markets must be segmented The depositors and the

banks must not have access to the assets that the investors who borrow invest in.Clearly if they did they would be better off to just invest in the safe asset ratherthan put their money in the bank or lend to the investors

Credit and interest rate determination

The quantity of credit and the interest rate have so far been taken as exogenous.These factors are included in the example next to illustrate the relationshipbetween the amount of credit and the level of interest rates We start with the sim-

plest case where the central bank determines the aggregate amount of credit B

available to banks It does this by setting reserve requirements and determiningthe amount of assets available for use as reserves For ease of exposition we do

not fully model this process and simply assume the central bank sets B The

bank-ing sector is competitive The number of banks is normalized at 1 and the ber of investors is also normalized to 1 Each investor will therefore be able to

num-borrow B from each bank.

The return on the safe asset is determined by the marginal product of capital in

the economy This in turn depends on the amount of the consumption good x that

is invested at date 1 in the economy’s productive technology to produce f (x) units

0.25冢 1

1.591.33冣0.7501.51.33