The Economics Book

292 SPECULATION AND CURRENCY DEVALUATION

such as the crisis in Mexico in

1982. However, in 1992–93, a
      currency crisis erupted in the
      European Monetary System (EMS),
      which appeared to contradict this
      model. Under this system’s
      Exchange Rate Mechanism (ERM),
      European countries effectively
      fixed, or pegged, their currencies
      to the German Deutsche Mark
      (DM). Several currencies came
      under pressure from speculators,
      notably the financier George Soros.
      It would be difficult to argue that
      countries such as the UK were
      running policies inconsistent with
      the targeted exchange rate. The
      UK had a very small budget deficit
      and had previously been running at
      a surplus, yet in 1992, the country
      was forced to withdraw from
      the ERM, to the great political
      embarrassment of Chancellor of
      the Exchequer (finance minister)
      Norman Lamont. A new model was
      needed to explain these events.

Self-fulfilling crises
In the first generation models, the
government’s policy is “fixed:”
the authorities mechanically use up
their foreign reserves to defend the
currency. A second generation of

models allowed the government to

have a choice. It may be committed

to a fixed exchange rate, but this

“rule” has an escape clause. If

unemployment becomes very high,

the government may abandon its

commitment to the fixed exchange

rate because the social costs of

defending the currency (for

instance through high interest

rates) are too great. We can see

these hard choices in the plight

of Greece in 2012. However,

without a speculative attack these

extra social costs would not arise.

These models imply that more than

one outcome is possible,

what economists call “multiple

equilibriums.” A speculative attack

might occur if enough people

believe that other people are going

to attack the currency. They

will then attack it, and a crisis will

unfold. But if people don’t hold

these beliefs, the crisis may not

happen. In these models crises are

“self-fulfilling.” At an extreme they

suggest that a crisis could happen

irrespective of the economic

fundamentals of a country. These

new models, based on the work of

economists such as the American

Maurice Obstfeld, seemed more

realistic than the earlier ones since

they allowed for governments’ use

of instruments, such as interest

rates, to defend the currency,

raising interest rates to prevent

devaluation. They also seemed to

dovetail with the experience of the

ERM crisis, where government

policies were constrained by high

levels of unemployment.

Financial fragility

The East Asian crisis of 1997 (see

opposite) seemed not to fit the first

two types of model. Unemployment

was not a concern, yet East Asian

When one country's currency is pegged

to another, pressures from outside or inside the

country can force the link to be broken. At

that point the currency's value may collapse.

The only absolutely sure-

fire way not to have

one’s currency speculated

against... is not to have an

independent currency.

Paul Krugman

The value

of the

currency

to which

currency

“X” is fixed

remains

the same.

Currency “X” is

forced to devalue.

Internal and external

economic factors put

downward pressure on

the currency’s value.