The Economics Book

290

In “first generation”

crisis models, when

one currency is fixed to

another, its “real” value,

or shadow rate, may fall

below the value at which

it is fixed. In this case

this is the point at

which the shadow

exchange rate rises

above 2 pesos/$1.

When this happens, the

currency is vulnerable

to attack as speculators

buy the country’s

foreign currency

reserves in anticipation

of a devaluation.

IN CONTEXT

FOCUS

Global economy

KEY THINKER

Paul Krugman (1953– )

BEFORE

1944 Greece experiences

the largest currency crash

in history.

1978 US economic historian

Charles Kindleberger stresses

the role of irrational behavior

in crises.

AFTER

2009 US economists Carmen

Reinhart and Kenneth Rogoff

publish This Time is Different:

Eight Centuries of Financial

Folly, in which they draw

similarities between crises

over the centuries.

2010–12 Divergent national

priorities, serious policy

errors, and huge speculative

pressures threaten the

breakup of the euro.

SPECULATION AND CURRENCY DEVALUATION

when money was based on

precious metals, a currency usually

lost its value through currency

debasement, which occurred when

a ruler reduced the precious metal

content of the coinage. After money

began to be printed on paper by

central banks, high inflation would

cause a country’s currency to

collapse. This happened in

Germany in 1923, where at one

point prices were doubling every

two days. However, a country does

not need hyperinflation to have a

currency crisis. For example during

the Great Depression of 1929–33,

prices of commodities such as

minerals and food collapsed, and

the currencies of Latin American

countries, which were reliant on

this export trade, fell with them.

Inconsistent policies

Writing in 1979, US economist

Paul Krugman showed that for a

currency crisis to happen, all that is

needed is for a government to carry

out policies that are inconsistent

with the exchange rate.

Krugman’s argument is the

foundation for a first generation of

currency crisis models. These

models start by assuming that

there is a fixed exchange rate

between the home currency and an

external currency, and that the

home government is running a

budget deficit (it is spending more

than it is collecting in tax), which

it is financing by printing money.

By increasing the supply of the

currency, this policy creates an

inconsistency with the value of the

currency set by the fixed exchange

rate. Other things being equal, the

policy will cause the “real” value

of the home currency to fall.

Next, the models assume

that the central bank sells its own

reserves of foreign currency in order

to support the currency. However,

A

currency crisis is a large

and sudden collapse in

the value of one nation’s

currency relative to other currencies.

For about 30 years after World

War II the world’s main currencies

were governed by the Bretton

Woods system (pp.186–87),

which was based on fixed, but

adjustable, exchange rates.

When this system ended in

1971, currency crises became more

common. In general a currency

crisis is triggered by people selling

a country’s currency in large

amounts. This behavior seems

to stem from the interaction of

people’s expectations and certain

underlying economic weaknesses

(known as “fundamentals”)—in

other words people’s reactions to

perceived problems. Economists

have tried to model this interaction

mathematically, but every time they

think they have found a model that

fits the data, a new type of crisis

seems to emerge.

Currency crises in context

Like hurricanes, financial crises

happen surprisingly often but are

hard to predict. Centuries ago,

EXCHANGE RATE (PESOS PER $)

Shadow rate

starts at 1.5

pesos/$1 but

rises over time

Fixed rate

Fixed rate is

2 pesos/$1

TIME

Currency is

attacked when

the shadow rate

rises above the

fixed rate

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