Elgar Encyclopedia of Financial Crises (Elgar Encyclopedias in Economics and Finance series) 1800377355, 9781800377356

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Elgar Encyclopedia of Financial Crises

ELGAR ENCYCLOPEDIAS IN ECONOMICS AND FINANCE Elgar Encyclopedias in Economics and Finance serve as the definitive reference works in the field. The Encyclopedias present a comprehensive guide to a wide variety of subject areas within economics and finance, and form an essential resource for academics, practitioners, and students alike. Each Encyclopedia is edited by one or more leading scholars, internationally recognized as preeminent names within the field. They each include an overarching collection of entries authored by key scholars within the field, which collectively aim to provide a concise and accessible coverage of the essential areas. Equally useful as reference tools or high-level introductions to specific topics, issues, methods, and debates, these Encyclopedias represent an invaluable contribution to the field. For a full list of Edward Elgar published titles, including the titles in this series, visit our website at www​.e​-elgar​.com​.

Elgar Encyclopedia of Financial Crises Edited by

Sara Hsu Clinical Associate Professor, University of Tennessee, Knoxville, USA

ELGAR ENCYCLOPEDIAS IN ECONOMICS AND FINANCE

Cheltenham, UK • Northampton, MA, USA

© Sara Hsu 2023

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library Library of Congress Control Number: 2023946801 This book is available electronically in the Economics subject collection http://dx.doi.org/10.4337/9781800377363

ISBN 978 1 80037 735 6 (cased) ISBN 978 1 80037 736 3 (eBook)

EEP BoX

Contents

List of contributorsx Prefacexii 1

2002 Uruguay banking crisis Simone Selva

1

2

2008 Financial Crisis in the US Sara Hsu and Brandon Dupont

7

3

4

5

A Classical-Keynesian approach to financial crises Carlo Panico A financial crisis as a form of VUCA (volatile, uncertain, complex, and ambiguous situation) Tiia Vissak A modern Greek tragedy: the crises of 2009–2015 Animesh Ghoshal

11

12 Bolivia—debt accumulation in the 1970s, hyperinflation in the 1980s Gabriel Xavier Martinez

54

21

14 Canada’s asset-backed commercial paper crisis Ian Roberge

62

7

Asian financial crisis Andrew Sheng

31

Austrian School monetary explanation for the business cycle Cameron M. Weber

51

58

26

9

11 Belgium’s crises in the pre-World War I era Gertjan Verdickt

13 Canada and the global financial crisis Ian Roberge

Argentina’s 1989 crisis Hernán Eduardo Neyra and Andrés Ernesto Ferrari Haines

Assessing reserve management during economic crises: lessons from Indonesia and Nigeria Phyllis Papadavid

48

17

6

8

10 Bank and corporate balance sheet vulnerabilities and currency crises Manuel Duarte Rocha and Roberto Accioly Perrelli

15 Central banks Nicolás Varela García 16 Changes in commodity prices as the factor triggering financial crises Marek Dabrowski 17 Chile: the 1973 economic crisis and the military coup Juan M. Padín

35

18 Chile’s 1981–83 crisis Gabriel Xavier Martinez

43

19 Colombia during the financial crisis of the 1980s Carlos Eduardo Hernández and Edwin López-Rivera

v

65

70

76 78

84

vi  Elgar encyclopedia of financial crises

20 Colombia during the financial crisis of the late 1990s Carlos Eduardo Hernández and Edwin López-Rivera

88

21 Colombia during the Great Depression92 Carlos Eduardo Hernández and Edwin López-Rivera 22 Crisis prevention and resolution Sara Hsu

95

23 Definition of banking crisis Ali Ari

98

24 Determinants of banking crises Ali Ari 25 Discovering business opportunities emerging from financial crises Tiia Vissak 26 Early warning systems (EWS) of currency crises Manuel Duarte Rocha and Roberto Accioly Perrelli 27 Ecuador’s 1999 triple financial crisis Gabriel Xavier Martinez

101

105

108

111

28 Egypt’s currency and financial crisis 118 Simon Neaime and Isabelle Gaysset 29 Factors determining public debt sustainability Marek Dabrowski

121

30 Financial crises and financial regulation: what relationship?127 Lyubov Klapkiv and Faruk Ülgen 31 Financial crises in Spain after Bretton Woods: 1977 and 2008 crises 136 Concha Betrán and María A. Pons

32 Financial crises in the Ottoman Empire Mehmet Akif Berber 33 Financial crises in Turkey Ali Ari

141 146

34 Financial crises, their forms, interrelations between them, and crises’ origins 151 Marek Dabrowski 35 Financial liberalization, the capital surge, and the 1994–1995 peso crisis Juan Carlos Moreno-Brid and Joaquín Sánchez Gómez 36 Financial stability in the insurance sector: the case of the American International Group, AIG Lyubov Klapkiv and Faruk Ülgen 37 Firms’ ways to deal with financial crises Tiia Vissak

155

157

162

38 Fiscal policy and financial instability165 John Lodewijks 39 Global capital flows and financial instability John Lodewijks

168

40 Global imbalances and global recession Ensar Yılmaz

171

41 Global pandemic and stock market volatility of Asia-Pacific countries Naji Mansour Nomran and Razali Haron

176

42 Great crises of the twentieth and twenty-first centuries: a Schumpeterian perspective on financial innovations 181 Faruk Ülgen and Lyubov Klapkiv

Contents  vii

43 Hyman Minsky (1919–1996) Brenda Spotton Visano 44 IMF and World Bank remedies for financial instability John Lodewijks 45 Income inequality before the Great Depression and Global Recession Ensar Yılmaz

189

191

194

58 Malaysian crisis 1985 Simone Selva

248

59 Marxian crisis theory Debamanyu Das

251

60 Monetary policy and financial stability in Africa during COVID-19 Phyllis Papadavid and Dirk Willem te Velde

253

46 India’s balance of payments crises 199 Animesh Ghoshal

61 Panic of 1857 William V. Rapp

256

47 Inequality created by active monetary policy Cameron M. Weber

204

62 Panic of 1907 William V. Rapp

260

48 Inflation Nicolás Varela García

209

63 Philippines banking crisis of 1981 264 Simone Selva

49 International banking regulation Martina Metzger

214

64 Portuguese banking crisis of 1876 267 Rita Martins de Sousa

219

65 Portuguese financial crisis of 1890/91 Rita Martins de Sousa

222

66 Recoveries from financial crises Peter H. Bent

50 Italy and the 1992 crisis of the European Monetary System Roberto Di Quirico 51 Italy and the Eurozone crisis Roberto Di Quirico

52 John Maynard Keynes (1883–1946)226 Brenda Spotton Visano 53 Joseph Alois Schumpeter (1883–1950)230 Brenda Spotton Visano 232 54 Lebanon’s perfect storm Simon Neaime and Isabelle Gaysset 55 Liability dollarization Gabriel Xavier Martinez

236

67 Southeast Asian crisis from a currency perspective Martina Metzger

270 275

280

68 Spain’s crises in the interwar period: the Great Depression284 Concha Betrán and María A. Pons 69 Spain’s crises in the second half of the nineteenth century (gold standard system) 289 Concha Betrán and María A. Pons

56 London and the exchange-rate crisis of 1931 Christopher Godden

240

70 Systemic risk and credit risk Victor A. Beker

57 London and the financial crisis of 1914 Christopher Godden

244

71 Thailand 1997: the spark that started the fire Gabriel Xavier Martinez

294

296

viii  Elgar encyclopedia of financial crises

72 The 1893 bank crisis Brandon Dupont

303

73 The 1931 banking crisis in Italy Roberto Di Quirico

307

74 The 1935 Italian currency crisis Roberto Di Quirico

311

75 The 1967 Indonesian banking crisis Agusman Agusman

314

76 The 1997–1998 Korean financial crisis Seung Jung Lee

317

77 The 1997–1998 financial crisis in Japan Hiromichi Iwaki

320

78 The 1997/1998 Indonesian banking crisis Agusman Agusman

326

79 The 1998 Russian debt crisis Peter C. Earle

82 The 2008–2009 international financial crisis: influenza or minor cold in Mexico? Juan Carlos Moreno-Brid and Joaquín Sánchez Gómez 83 The 2008/2009 financial crisis in Brazil Rafael F. Schiozer and Paulo R. S. Terra 84 The Argentinean financial and debt crisis of 2019 Juan Santarcángelo

86 The Brazilian banking crisis of 1994/95 Rafael F. Schiozer and Paulo R. S. Terra 87 The Brazilian currency crisis of 1999 Rafael F. Schiozer and Paulo R. S. Terra 88 The Covid-19 crisis in Mexico (2020 …) Juan Carlo Moreno-Brid and Joaquín Sánchez Gómez 89 The Credit-Anstalt crisis of 1931 Aurel Schubert

330

80 The 2001 Argentina financial crisis 332 Hernán Eduardo Neyra and Andrés Ernesto Ferrari Haines 81 The 2007 financial crisis in the United Kingdom Seung Jung Lee

85 The banking crisis in Norway 1987–1993 Ola Honningdal Grytten

340

343

346

351

354

360

363

368

372

90 The debt crisis in Latin America in the 1980s Juan Santarcángelo

376

91 The developing country debt crisis of the 1980s Harald Sander

379

92 The Euro Crisis Harald Sander

383

93 The financial crisis in Japan in the 1920s Hiromichi Iwaki

389

94 The Finnish banking crisis of the 1930s Karlo Kauko

394

95 The Finnish banking crisis of the 1990s Karlo Kauko

397

96 The Great Depression in Norway Ola Honningdal Grytten 97 The Great Depression in the United States Charles Bartlett

402

406

Contents  ix

98 The Icelandic banking crisis of 2008 Karlo Kauko

413

99 The impacts of financial crises on firms’ exports Tiia Vissak

417

100 The Irish financial crisis of 2007–2010420 Aurel Schubert 101 The lost decade and the 1982 debt crisis in Mexico Juan Carlos Moreno-Brid and Joaquín Sánchez Gómez 102 The Norwegian monetary crisis in the mid-1920s Ola Honningdal Grytten

424

426

103 The “odious” route to a sovereign debt crisis in the Democratic Republic of Congo 431 Mohit Arora 104 The period of the 1930s in the Portuguese economy Rita Martins de Sousa

436

105 The post-war depression in Norway in the early 1920s Ola Honningdal Grytten

440

106 The special period in Cuba Peter C. Earle

444

107 The US savings and loan crisis James R. Barth, Yanfei Sun and Min Gu

446

108 Tobin Tax and capital controls John Lodewijks

452

109 Too big to fail Victor A. Beker

455

110 Tulip mania 1637 and other crises in the Netherlands Simone Selva

458

111 US financial crises and growing federal oversight of banking James R. Barth and Stephen Matteo Miller

463

Index473

Contributors

Agusman Agusman, Bank Indonesia, Indonesia.

Christopher Godden, University of Manchester, UK.

Ali Ari, Marmara University, Turkey.

Joaquín Sánchez Gómez, National Autonomous University of Mexico, Mexico.

Mohit Arora, University of Massachusetts Amherst, USA.

Ola Honningdal Grytten, Norwegian School of Economics, Norway.

James R. Barth, Auburn University and Milken Institute, USA.

Min Gu, Auburn University, USA.

Charles Bartlett, University of Miami, USA.

Andrés Ernesto Ferrari Haines, Federal University of Rio Grande do Norte, Brazil.

Victor A. Beker, University of Belgrano, Argentina.

Razali Haron, IIUM Institute of Islamic Banking and Finance, Malaysia.

Peter H. Bent, Trinity College, UK.

Carlos Eduardo Hernández, Universidad de los Andes School of Management, Colombia.

Mehmet Akif Berber, Marmara University, Turkey.

Sara Hsu, University of Tennessee, USA.

Concha Betrán, University of Valencia, Spain.

Hiromichi Iwaki, Daito Bunka University, Japan.

Marek Dabrowski, Center for Social and Economic Research in Warsaw, Poland.

Karlo Kauko, Bank of Finland, Finland.

Debamanyu Das, University of Massachusetts, USA.

Lyubov Klapkiv, Maria Curie-Skłodowska University, Poland.

Rita Martins de Sousa, Lisbon School of Economics and Management, Portugal.

Seung Jung Lee, Board of Governors of the Federal Reserve System, USA.

Roberto Di Quirico, Università di Cagliari, Italy.

John Lodewijks, S P Jain School of Global Management, Australia.

Brandon Dupont, Western Washington University, USA.

Edwin López-Rivera, University of Bogota Jorge Tadeo Lozano, Colombia.

Peter C. Earle, American Institute for Economic Research, USA.

Gabriel Xavier Martinez, Ave Maria University, USA.

Andrés Ernesto Ferrari Haines, Universidade Federal do Rio Grande do Sul, Brazil.

Martina Metzger, Berlin School of Economics and Law, Germany.

Nicolás Varela García, Universidad Carlos III de Madrid, Spain.

Stephen Matteo Miller, Mercatus Center, USA.

Isabelle Gaysset, American University of Beirut, Lebanon.

Juan Carlos Moreno-Brid, National Autonomous University of Mexico, Mexico.

Animesh Ghoshal, DePaul University, USA.

Simon Neaime, American University of Beirut, Lebanon. x

Contributors  xi

Hernán Eduardo Neyra, University of Buenos Aires, Argentina.

Rafael F. Schiozer, Fundação Getulio Vargas, Brazil.

Naji Mansour Nomran, Kingdom University Bahrain, Bahrain.

Aurel Schubert, Vienna University of Economics and Business, Austria.

Juan M. Padín, National University of Quilmes, Argentina.

Simone Selva, University of Naples L’Orientale, Italy.

Carlo Panico, University of Naples Federico II, Italy.

Andrew Sheng, Asia Global Institute at the University of Hong Kong, China.

Phyllis Papadavid, Asia House, UK.

Yanfei Sun, Toronto Metropolitan University, Canada.

Roberto Accioly Perrelli, International Monetary Fund, USA. María A. Pons, University of Valencia, Spain. William V. Rapp, New Jersey Institute of Technology, USA.

Paolo R. S. Terra, Fundação Getulio Vargas, Brazil. Faruk Ülgen, Université Grenoble Alpes, France. Dirk Willem te Velde, Asia House, UK.

Ian Roberge, York University, Canada.

Gertjan Verdickt, KU Leuven, Belgium.

Manuel Duarte Rocha, Faculdade de Economia, Universidade do Porto, Portugal.

Brenda Spotton Visano, York University, Canada.

Harald Sander, Maastricht School of Management, the Netherlands.

Tiia Vissak, University of Tartu, Estonia.

Juan Santarcángelo, National Scientific and Technical Research Council, Argentina.

Cameron M. Weber, St. John’s University, USA. Ensar Yılmaz, Yildiz Technical University, Turkey.

Preface

of financial crises in various regions and at various times throughout modern history. I wish to thank our contributors who have worked diligently on their entries. I was impressed with the dedication many of them have to bringing more understanding to a complex topic. Our contributors come from diverse backgrounds and locations, and many of them have dedicated their careers to understanding complex financial and economic systems and the policies that shape them. I also want to thank Daniel Mather and the production team at Edward Elgar, who have devoted their time to producing this volume. I appreciate their patience and commitment. We are proud to present our readers with over 100 entries written by experts in the field. I hope you will gain new insights and ideas from this work. Sara Hsu

Since the 2008 global crisis began in the United States, and particularly after the COVID-19 pandemic shook economies around the world, academics, practitioners, and other experts have become increasingly sensitized to the potential for financial and economic fragility to result in a systemic breakdown. This has caused some to revisit the causes and consequences of past financial crises in order to glean new lessons. This Encyclopedia was written for those who wish to learn from the past in preparation for economic turbulence ahead. We include entries on financial crises around the world, covering six continents, as well as entries on general terms and phenomena to better understand the financial crisis history and literature. The Encyclopedia is not exhaustive but does attempt to provide coverage of causes, events, and outcomes for a sample

xii

1. 2002 Uruguay banking crisis

of the economy on foreign lenders and foreign currency-denominated loans.

The origins and conditions that set the stage for the banking crisis

Introduction

During the 1990s, the Uruguayan economy performed relatively well; by the decade’s end, it was a middle-income country with a per-capita income of US$6000 (Seelig and Terrier 2009). In 1999 the Uruguayan economy suffered a significant economic recession that resulted in multiple implications for the country’s fiscal debt, the debt-to-GDP ratio, and the profitability and liquidity of the banking sector. A significant cause of the recession was the devaluation of the Brazilian Real in 1999, followed by a devaluation of the Argentinean Peso in 2001. This twin devaluation hit the competitive position of Uruguay’s exports and led to a currency appreciation. Likewise, it set conditions to terminate the exchange rate commitment of the Uruguayan currency that had helped stabilize the public debt during the 1990s. As a result of the 1999 prolonged recession, it was registered first as a major fiscal crisis: recession-triggered revenue reductions led the government deficit to surge from 38 percent of GDP in 1998 to 58 percent of GDP by 2001. Therefore, shortly before the beginning of the banking crisis, total public sector debt amounted to roughly US$107 billion. This worsened budget deficit increased the country’s dependence on foreign capital and investors: the deepening of the public deficit caused by the fiscal crisis forced Uruguay to issue foreign currency-denominated bonds and debt certificates to finance the Uruguayan debt. When the crisis erupted, 83 percent of public debt was denominated in foreign currencies (De La Plaza and Sirtaine 2005). This increased role of foreign capital took place against a high dollarization and foreign currency denomination of the national banking sector’s assets, liabilities, and public debt. The process of dollarization had been taking shape throughout the 1990s. It is noteworthy to make sense of the prominent role of foreign capital in the process of capitalization of the national banking sector to understand better the banking crisis that followed suit. By December 2001, both liabilities and assets of the Uruguayan banks were highly dollarized (De Brun and Licandro 2006).

From the end of 2001 through 2002, Uruguay suffered from a financial crisis that, unlike any suggestions from mainstream analysis, was not limited to the banking sector: it was a time of fiscal crisis, public debt crisis, and banking crisis. Like Menem’s Argentina (Bandeira 2002), during the 1990s Uruguay had embarked upon a full-scale liberalization of its economy through liberalization of the capital and current account on the balance of payments and other measures aimed at opening the national trade and financial system to foreign investments. However, unlike Argentina and other Latin American countries, Uruguay’s banking system was based on local private-owned banks, foreign banks, and large public banks. According to some studies, this distinctive structure of the Uruguayan banking system explains why the crisis was less intense and severe than elsewhere across Latin America or less intense than the banking crisis that affected the country in 1982 (Marshall 2010). On the other hand, when the banking crisis erupted, banking regulation and the regulatory structure of the national financial system were feeble. From the end of the crisis onwards, it substantially improved. One more distinctive feature of the Uruguayan financial crisis was the country’s dependence on foreign capital on assets and liabilities: this applied to the capitalization of the national banking sector and the public debt. The first section outlines the macroeconomic conditions at the origins of the banking crisis before 2002; the second section outlines the outbreak and development of the crisis since late 2001. The third section offers a description of policies implemented to face up to the crisis of the banking sector in the framework of combined fiscal, debt, and growth crises that shook the Uruguayan economy throughout 2002. Finally, this chapter stresses how the financial crisis that stemmed from the banking system affected Uruguay on multiple levels: revenues, sovereign debt, domestic growth, and fiscal sustainability, as well as the capitalization and increased dependence 1

2  Elgar encyclopedia of financial crises

On the liability side, liquid foreign currency deposits amounted to 90 percent of total deposits, of which 47 percent were deposits by non-residents. In contrast, total dollar deposits were worth up to US$15.4 billion (De La Plaza and Sirtaine 2005). On the asset side, about 75 percent of total loans were denominated in foreign currencies (Seelig and Terrier 2009). By the time the crisis began, the two largest public banks (Banco de la República Oriental del Uruguay (BROU) and Banco Hipotecario del Uruguay (BHU)) lay in critical financial condition because their ratio of non-performing loans to total loans was on average 39.1 percent, compared to 5.6 percent for the private banks. This weakness of the banking sector against the backdrop of combined recession, declining fiscal posture, and skyrocketing debt-to-GDP ratio with a growing share of total debt financed through issuing debt certificates abroad and in foreign currencies made the country and its banking sector extremely vulnerable to external shocks. The financial crisis that plagued the Uruguayan economy and its banking sector in 2002 came about as a classical financial contagion triggered by an external shock originating from the economic turmoil that rocked Argentina at the start of the new century (Reinhart and Rogoff 2009).

The outbreak and development of the 2002 financial crisis

Traditionally, the economic relationship between the Argentinean and Uruguayan economies had been solid. Throughout the postwar decades, Brazil and Argentina were the main trading partners of Uruguay. Argentina, even more than Brazil, was tied to the destiny of the Uruguayan economy. As was the case with the early 1980s crisis, any time Argentina abandoned its price stabilization plan, the GDP of Uruguay contracted substantially. In contrast, any time Buenos Aires GDP declined, Uruguay’s GDP grew modestly. Likewise, over the postwar decades, the banking sectors of the two countries became interdependent. In particular, Argentinean savers and investment companies placed large amounts of funds with Uruguayan private and publicly owned banks. Because of the ubiquitous and uncertain trajectory of Simone Selva

the Argentinean economy, the Uruguayan banks had become safe financial outlets for Argentinean savers. By the end of 2001, 45 percent of Uruguay’s total deposits came from Argentinean investors (Marshall 2010). At the time, the two national public banks were owned by Argentinean financial groups. In contrast, the largest Uruguayan banks were primarily exposed to either Buenos Aires’ public debt or the largest Argentinean banking groups. In December 2001, the Argentinean authorities approved capital controls and deposit freezes on Argentine nationals. This decision, coupled with the termination of Buenos Aires’ currency pegging to the US dollar, prompted many Argentinean investors to withdraw funds from Uruguay, thus plummeting its financial sectors into a liquidity crisis. The two largest private banks of Uruguay, Banco de Galicia Uruguay and Banco Comercial, were hit the most by capital outflows. Banco de Galicia Uruguay, then the second largest Uruguayan bank by assets, was a subsidiary of Banco de Galicia, the largest Argentinean group. As its banking activities revolved by and large around taking deposits from Argentinean banks and companies and lending to the same type of clients, the freeze of deposits and the enforcement of capital controls hit Banco de Galicia Uruguay, which suddenly suffered from a liquidity crisis. This led the Central Bank of Uruguay to suspend its activities in February 2002. As much as Banco Galicia, Banco Comercial, the largest private bank of Uruguay, was overexposed to Argentine’s borrowers: it held a large amount of the Argentinian government’s public debt. It was a significant creditor to Grupo Banco General de Negocio, a leading financial holding in Argentina. In 2002, this two-fold overcommitment to Argentina was the leading cause of the liquidity crisis that shook Banco Comercial that year. The crisis of the largest private banks of Uruguay took place against the framework of a currency and liquidity crisis that, throughout the spring and summer of 2002, steadily worsened. By March, 12 percent of total bank deposits had been withdrawn, mostly by non-residents. This downward sloping trend continued even after the implementation of measures by the government and the International Monetary Fund (IMF) to forestall the liquidity crisis and its spinning

2002 Uruguay banking crisis  3

effects on the Uruguayan economy at large. By May 2002, 18 percent more deposits had been withdrawn; this time, non-resident withdrawals were paired with money cashed by residents from public banks. The run on deposits continued throughout the beginning of the summer and reached its crisis point in July when the run on dollar deposits was coupled with a rush to cash local currency deposits. The combined rush to cash by foreign investors and local residents led to a total outflow of 38 percent of total deposits in the country. By mid-summer, most private banks had become insolvent; on the other hand, the public banks, though liquidity support provided by the IMF amounted to US$1,1221 million as of August 2002, suffered from significant liquidity imbalances and extremely precarious balance sheets (IMF 2003). This downward trend meant the country’s international reserves plummeted, as did its capability to service the public debt. In July, Uruguay’s foreign currency reserves, which by December 2001 amounted to US$3.1 billion, reached the lowest level ever of US$650 (Banco Central del Uruguay 2003). Therefore, the banking crisis that erupted in 2002 had striking side effects on the Uruguayan currency, foreign exchange reserves, and the country’s capability to service the public debt. Rather than merely affecting the liquidity position of Uruguayan private banks, massive capital outflows reduced the country’s foreign exchange reserves. Assuming the country’s international reserves as of December 2001 as a benchmark, by the second half of 2002 they had declined by 80 percent. This decline in international reserves jeopardized the exchange rate commitment and, thus, the likelihood of servicing the public debt. This trajectory of the financial crisis led the Uruguayan authorities in July 2002 to halt the exchange rate commitment and to approve a 27 percent currency devaluation that led exports to temporarily bounce back by the end of 2002 (Oddone and Marandino 2019). However, the devaluation had a downside in terms of debt sustainability; insofar as the foreign financing of the national public debt was highly dollar-denominated, the termination of the Uruguayan exchange rate commitment and its devaluation set the national debt

on an unsustainable track (Rial and Vicente 2003). The unfinished deposit withdrawals featured in the first half of 2002 led to a credit crunch that triggered systematic curtailing of credit by private banks to the non-banking sector. During that year, banking credit to the non-financial sector contracted by 37 percent (Banco Central del Uruguay 2003). Suppose one considers that during that same year, the country suffered a GDP contraction of 10.7 percent. In that case, it is noticeable how the financial crisis had remarkable consequences not only for international reserves and public debt but also for the GDP and the debt-to-GDP ratio.

Government, monetary, and international responses to the crisis

The policy responses enacted to cope with the financial crisis revolved around a set of measures that, far from reflecting the multi-level nature of the crisis, specifically focused on the banking sector and its liquidity crisis. Therefore, the approval of measures to minimize the effects of capital outflows on the capitalization of public and private banks was combined with policy responses aimed at strengthening banking supervision and regulation to protect the country from future financial contagion and external shocks. Since the beginning of and during its first phase, the crisis appeared to be a matter of liquidity shortage affecting a limited section of the banking system. Therefore, liquidity assistance to either the largest private banks of Uruguay or the foreign-owned banking institutions, as well as the public banks, represented an unfinished line of economic intervention by the Central Bank of Uruguay, the government, and the IMF, the three leading institutions that came to the rescue of the Uruguayan economy throughout the evolution of the crisis in 2002 and then in 2003. In the beginning, in the spring of 2002, the Central Bank provided liquidity assistance to a limited number of banks that suffered the freezing of assets and capital controls approved and implemented in Argentina. During this first phase of financial rescue operations, liquidity assistance from the Central Bank and a government-owned investment company, Corporación Nacional para el Desarollo, was limited to several Simone Selva

4  Elgar encyclopedia of financial crises

banks insofar as the banking crisis did not look like a systemic set of events. By the start of summer 2002, the crisis began affecting core banks, such as the three largest private banks, and non-core banks; that is, the branches of foreign banks based in Uruguay. In light of this development of the banking crisis, the Uruguayan authorities provided liquidity injections to all the core banks. In contrast, the non-core banks were left to raise funds from other sources. Amidst a further deepening of the banking liquidity crisis in early summer, in July 2002 a new financial facility was established, the Fondo para la Fortificacion del Sistema Bancario, which amounted to US$2.5 billion. This facility marked the intervention of the IMF, which provided much liquidity in support of the Uruguayan government and its financial system. Notwithstanding the scale of this fund in July, both foreign exchange reserves and the liquidity of private banks got worse. On July 30, this Fondo’s financial operations were suspended and a bank holiday began. Shortly after the removal of the bank holiday on August 5, 2002, a run on deposits began again. Amidst the unfinished crisis, the government approved a law that, by combining an effort by the state finance with financial assistance provided by three leading international economic institutions—the IMF, the International Bank for Reconstruction and Development (IBRD), and the Inter-American Development Bank (IADB)—focused on both protecting dollar-denominated deposits in the country and initiating a suspension of the operations of the three largest private banks that paved the way for their restructuring or liquidation. In fact, on the one side, the Ley de Fortalecimiento del Sistema Financiero established the Fondo de Estabilización del Sistema Bancario worth up to US$ 1.4 billion. This fund, co-funded by the IMF (US$788 million), the IADB (US$388 million), and the IBRD (US$200 million), aimed at backing dollar-denominated sight and time deposits at public and private banks. The Ley also extended the maturity of US dollar time deposits held at the largest public banks as BHU and BROU, for a total of up to US$ 2.2 billion (Banco Central del Uruguay 2004). On the other hand, the law made provision for having the BROU absorb all the foreign currency deposits and time deposits held at BHU Simone Selva

and for suspending the operations of Banco Comercial, Banco de Montevideo-Caja Obrera, and Banco de Crédito. In addition, it set conditions for their restructuring or liquidation in the future. By the beginning of fall 2002, this set of measures led to a decline in total withdrawals and a resurgence of deposits by residents, which by 2005 had returned to their July 2002 level. During the fall of 2002 and 2003, the second set of crisis management measures was undertaken to restructure public banks’ debt and strengthen the structure of banking regulation and supervision in Uruguay, which was historically not well structured. Along these policy guidelines, the first measure was an IMF-backed restructuring of the most crisis-hit public banks; a selected number of loans by BROU, which throughout 2002 had lost roughly 66 percent of total deposits, were absorbed by a newly created state entity, while the bank’s lending operations were redirected to peso-denominated operations. A credit risk-management mechanism was established to reduce non-performing loans. The BHU, whose dollar-denominated deposits accounted for 77 percent of total deposits while 94 percent of total loans were peso-denominated, was severely rocked by the peso’s devaluation. The bank was radically restructured by the Ley del Fortalecimiento del Banco Hipotecario del Uruguay (December 2002), limiting its banking operation to housing saving plans and issuing of a limited number of mortgages, but prevented the BHU from taking deposits. Concerning the private banks, the three largest institutions were liquidated. The Banco Comercial and Banco Montevideo-Caja Obrera were placed under liquidation, and a new financial institution, Nuevo Banco Comercial, was established. The purpose of this new institution was to issue Certificates of Deposits to finance the acquisition of the assets of the two banks under liquidation. Concerning the Banco de Crédito, the third largest private bank, the government recapitalized it several times and then, in February 2003, placed it under liquidation. The other private banks, mainly owned by foreign banking institutions, had to rely on their own funding source to recapitalize. This action on the financial side of the banking crisis was paired with legislative initiatives to strengthen the supervisory and

2002 Uruguay banking crisis  5

regulatory system charged with presiding over the national banking system. A law passed in December 2002 set conditions for expanding the supervisory role of the Central Bank of Uruguay. It imposed new requirements on banking activities that included higher reserve requirements for deposits by non-resident investors, several rules to reduce foreign exchange risks and improve lending-decision making by national banks, and compulsory disclosure by banks of relevant financial information about their borrowers’ credit solvency. The same law also established the Fondo de Garantía de Deposito Bancario. On the other hand, the recovery programs encompassed a plan to reschedule a total of US$5.4 billion foreign currency-denominated sovereign debt.

Conclusion

By the end of 2002, the liquidity crisis that hit the banking system had triggered a contraction of total bank deposits by residents by about 46 percent and a reduction of total deposits by foreign investors of 65 percent. As a result of the crisis, the country’s GDP declined by 11 percent, whereas total public sector debt grew by 26 percent. In the framework of this expansion of public sector debt, it is worth pointing out that by the year’s end, official creditors accounted for 45 percent of total public debt, an increase of roughly 20 percent compared to their 25 percent share of the country’s sovereign debt as of the end of December 2001. Following the impressive peso devaluation and the GDP contraction in the summer of 2002, the debt-to-GDP ratio surged by the beginning of 2003 by 100 percent. Many in the international financial community envisaged the possibility of a sovereign default in the wake of what happened in Argentina. The financial measures adopted to restructure and liquidate the banking system, coupled with several regulatory and supervisory initiatives aimed at preventing the country from future crises triggered by external shocks, placed the country on track to full recovery and prevented Uruguay from suffering terrible consequences in terms of inflation and deficit (Oddone and Marandino 2019). By 2003 GDP had risen by over 12 percent, inflation had declined to 10 percent, the financial system’s deposits had regained US$800 million, and the primary surplus had

soared to 4.1 percent (De Brun and Licandro 2006). Certainly, a crisis stemming from a financial contagion caused by an external shock reduced domestic credit, contracted GDP, and destabilized revenues and the fiscal posture of the country (Rial and Vicente 2003; Licandro Ferrando and Vicente 2007). It also led to a decline in foreign currency reserves that, with the devaluation of the peso, devalued the peso-denominated assets of the banking system and increased the impact of dollar-denominated debt that the nation owed to external lenders. This jeopardized banks’ liquidity, sovereign debt, and domestic growth. This crisis trajectory, which led to a radical restructuring of the national banking system, sheds light on the multi-level nature of the financial crisis that hit Uruguay in 2002. Simone Selva

References

Banco Central del Uruguay (2003). Evolución Reciente y Situación Actual del Sistema Bancario. Montevideo: Banco Central del Uruguay. Banco Central del Uruguay (2004). Reporte de Estabilidade Financiera. Montevideo: Banco Central del Uruguay. Bandeira, Luiz Alberto Moniz (2002). “As políticas neoliberais e a crise na América do Sul”. Revista Brasileira de Política Internacional, Vol. 45, No. 2: pp. 135–146. De Brun, Julio and Gerardo Licandro (2006). “To hell and back: Crisis management in a dollarized economy”. In Adrían Armas, Alain Ize, and Eduardo Levy Yeyati (eds), Financial Dollarization: The Policy Agenda. London: Springer, pp. 147–176. De La Plaza, Luis and Sophie Sirtaine (December 2005). “An analysis of the 2002 Uruguayan banking crisis”. World Bank Policy Research Working Paper No. 3780, available at SSRN: https://​ssrn​.com/​abstract​=​872776. IMF (2003). Third Review under the Stand-By Arrangement and Request for Modification and Waiver of Applicability of Performance Criteria. Washington, DC: IMF. Licandro, Ferrando, Gerardo Marcelo, and Leonardo Vicente (2007). “The lack of fiscal consolidation in an inflationary economy: Uruguay 1970–2006”, pp. 415–457. Available at www​.bancaditalia​.it/​pubblicazioni/​altri​ -atti​-convegni/​2007​-fiscal​-policy/​Licandro​ _Vicente​.pdf​?language​_id​=​1. Marshall, Wesley C. (2010). “Banco del Sur and the need for downstream linkages: The role of

Simone Selva

6  Elgar encyclopedia of financial crises national publicly owned banks”. International Journal of Political Economy, Vol. 39, No. 3: pp. 81–99. Oddone, Gabriel and Joaquín Marandino (2019). The Monetary and Fiscal History of Uruguay. Chicago, IL: Becker Friedman institute Macro Finance Research Program. Reinhart, Carmen and Kenneth Rogoff (2009). This Time Is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press.

Simone Selva

Rial, Isabel and Leonardo Vicente (2003). “Sostenibilidad y vulnerabilidad de la deuda publica uruguaya: 1988–2015”. Revista de Economia (Central Bank of Uruguay), Vol. 10, No. 2: pp. 143–207. Seelig, Steven and Gilbert Terrier (2009). “Uruguay 2002–3: Recovery from economic contagion”. In E. Brau et al. (eds), Successes of the International Monetary Fund. London: Palgrave, pp. 125–147.

2. 2008 Financial Crisis in the US

brokers, banks that securitized the loans, and the large financial institutions that had purchased subprime-based assets. Regulators had been unaware of banks’ securitization of subprime mortgages since they were moved off balance sheet and sold to external investors (Crotty 2009). Banks had been deregulated under the Gramm-Leach-Bliley Act of 1999, which allowed them to participate in investment banking activities in addition to traditional banking practices. By moving assets off balance sheet, banks were participating in the largely unregulated “shadow banking” sector. The failure of the regulatory system to keep pace with innovations in financial services contributed to the buildup to the crisis. As subprime borrowers became increasingly unable to repay their loans, mortgage originators found themselves unable to sell their loans, and major financial institutions faced serious losses. Bear Stearns and other institutions in the UK and Europe announced losses in 2007. By the end of 2007, the US Federal Reserve coordinated action by five leading central banks worldwide to offer banks billions of dollars in loans. The mortgage lending boom that ultimately led to the 2008 crisis had been building for years. Recent work by Greenwood et al. (2022), drawing on the classic work of Minsky and Kindleger, supports the notion that credit expansion matters for financial instability. They find that “the combination of rapid credit and asset price growth over the prior three years, whether in the nonfinancial business or the household sector, is associated with a 40% probability of entering a financial crisis within the next three years” (p. 863). The subprime mortgages themselves were problematic for the lower-income households who were borrowing in these markets. Still, the securitization process magnified these issues and subjected the entire financial system to the risks that had been building for years in the housing market. New products, such as collateral debt obligations, collateralized loan obligations, and structured investment vehicles, were based on securitized subprime mortgages and sold to many institutional investors. Mian and Sufi (2009) found that the push of mortgage credit into subprime neighborhoods and the decoupling of this credit from income growth in the early 2000s was closely related to the growth

Origins of the crisis

The roots of the 2008 crisis are found in the subprime mortgage market and the securitization of those mortgages. Subprime mortgages were mortgages for those with low income, poor credit, and few assets. In the leadup to the Great Recession, subprime mortgages were given on an increasingly wide scale, usually with an adjustable-rate mortgage with a low introductory rate that jumped after a given period. Mian and Sufi (2009) showed that not only were subprime mortgages expanded into subprime zip codes between 2002 and 2005 but that this was also occurring while relative (and sometimes absolute) income growth was declining in those same neighborhoods. For many people, housing during this period became an asset on which one could make money rather than just a place to live. Angelo Mozilo, the CEO of Countrywide Mortgage, which failed during the crisis, explained that Housing prices were rising so rapidly—at a rate that I’d never seen in my 55 years in the business—that people, regular people, average people got caught up in the mania of buying a house, and flipping it, making money. It was happening. They buy a house, make $50,000 … and talk at a cocktail party about it … Housing suddenly went from being part of the American dream to house my family to settle down—it became a commodity. That was a change in the culture … It was sudden, unexpected. (FCIC Report 2011, pp. 5–6)

These practices were sustainable as long as home prices rose, as they had since the early 1990s, although at a significantly faster pace starting in the early 2000s. But housing prices peaked in the summer of 2006, falling by some 20 percent on average by mid-2009.1 When home prices started to decline, many homeowners could not refinance their homes, and families could not meet their debt obligations. At the end of 2005, household debt was about 87 percent of GDP; just two years later, by the end of 2007, household debt levels had surged to over 100 percent of GDP.2 The failure of these subprime loans then caused a chain reaction, causing losses for mortgage 7

8  Elgar encyclopedia of financial crises

of subprime mortgage securitization in this period.

The crisis

The crisis had thus been building for years but manifested rather quickly once the economy slowed and housing markets weakened. This slowdown exposed major Wall Street firms to unprecedented pressures. By March 2008, Bear Stearns was teetering on the brink of bankruptcy, which was only avoided when J.P. Morgan Chase acquired it, with assistance from the Federal Reserve, for only $2 per share, a 93 percent discount from its closing share price. The rapidly unfolding crisis next hit two government-sponsored enterprises, Fannie Mae and Freddie Mac. Fannie and Freddie became increasingly important in mortgage markets throughout 2007, purchasing three-quarters of all new mortgages, double what they had done just a year earlier (FCIC 2011, p. 312). By the end of the year, their losses had reached $2 billion. Lehman Brothers was significantly larger than Bear Stearns and struggled by the summer of 2008. Lehman’s massive leverage, exposure to real estate, and heavy reliance on short-term funding sources, including $7.8 billion in commercial paper at the end of March 2008, combined to topple the firm 158 years after its founding (FCIC 2011, p. 326). Unable to find a buyer, Lehman Brothers declared bankruptcy on September 15, 2008. With nearly $700 billion in assets, Lehman’s bankruptcy was the largest in American history, and it sparked a widespread stock market selloff; the Dow Jones industrial average fell by more than 500 points on the day of the Lehman bankruptcy, wiping out some $700 billion in value (FCIC 2011, p. 339). As the crisis deepened in the late summer and fall of 2018, one of the most important Wall Street firms, American International Group (AIG), was under increasing pressure. AIG, which had insured or purchased mortgage-backed securities, faced major losses due to the systemic meltdown. In total, the AIG conglomerate held $1 trillion in assets but had lost access to traditional sources of short-term funding while facing soaring demands for collateral from its credit default swap counterparties (FCIC 2011, p. 344). On September 16, the Federal Reserve and the Sara Hsu and Brandon Dupont

US Treasury authorized a loan of up to $85 billion to AIG in return for a 79.9 percent equity stake and the replacement of AIG management.3

The policy response

The Troubled Asset Relief Program (TARP) was introduced in October 2008 initially to purchase bad debts from failing institutions but was modified later to inject liquidity directly into failing institutions in return for government ownership of preferred stock. The government purchased preferred stock in Bank of America/Merrill Lynch, Bank of New York Mellon, Citigroup, Goldman Sachs, J.P. Morgan, Morgan Stanley, State Street, and Wells Fargo. TARP was widely criticized for failing to address the risks that caused the crisis. Liquidity was injected as a band-aid to a flagging financial system, but the real problem was that the quantity of bad assets among banks was unknown. Non-performing mortgages remained on the books of financial institutions as performing assets, obscuring balance sheet deterioration. TARP was also criticized for allowing large bonuses to executives who were viewed as responsible for creating the crisis. Furthermore, TARP was denounced for not improving liquidity in the economy, as banks did not lend these additional funds. The failure of the TARP plan weakened confidence in the US government to handle the crisis. The Federal Reserve created a temporary Term Auction Facility that enabled banks to borrow anonymously. The Federal Reserve also purchased mortgage-backed securities to lower residential mortgage rates and improve housing demand. These actions helped to increase public confidence that policymakers could mitigate the worst effects of crisis. The Federal Deposit Insurance Corporation (FDIC) also played an essential role in the efforts to save the economy. In particular, the FDIC’s Temporary Liquidity Guarantee Program (TLGP) guaranteed newly issued debt by banks, thrifts, financial holding companies, and bank affiliates. It also fully guaranteed some non-interest-bearing deposit accounts. While there have been only limited scholarly studies of the TLGP’s effectiveness, Ambrose et al. (2013) found that it promoted liquidity and confidence in the fixed-income markets.

2008 Financial Crisis in the US  9

Despite the policy responses, the crisis had seeped into the real economy. As demand declined, the American automobile manufacturing industry suffered from a lack of sales. The industry was forced to request government assistance. In addition, General Motors and Chrysler filed for bankruptcy. In February 2009, US President Barack Obama was inaugurated and immediately implemented a large fiscal stimulus package. The stimulus provided $282 billion in tax cuts and $505 billion on new energy, science and technology projects, infrastructure, education, and health care (Teslik 2009). Quantitative easing was also initiated under the Large Scale Asset Purchase program to allow the Federal Reserve to purchase long-term assets, injecting more liquidity into the economy. This fiscal and monetary stimulus effectively reduces the worst impacts of the Great Recession, preventing this crisis from becoming as devastating as the Great Depression (Almunia et al. 2010). The worst direct effects of the crisis were over in the US by the end of 2009. Still, unemployment remained high, and Americans were unhappy about the preference shown by the government in bailing out banks rather than homeowners or workers. The Occupy Wall Street movement began as a protest against inequality. Rising unemployment and a decline in household wealth between 2007 and 2009 exacerbated dissatisfaction (Deaton 2012). The 2008 financial crisis fundamentally changed financial regulation. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was passed to improve financial stability in the future. The Act created a Consumer Financial Protection Bureau and a Financial Stability Oversight Council (FSOC). The FSOC was tasked with making recommendations to the Federal Reserve for stricter rules on capital and liquidity, increased regulation of non-bank financial institutions, and the breakup of large companies as a last resort. The FSOC also designated certain shadow banking institutions as systemically important and placed them under greater supervision (Lowrey 2012). The Office of Financial Research was also created to help support the FSOC in assessing risks and providing policymakers with options to deal with emerging crises. The Consumer Financial Protection Bureau was

also established to help consumers navigate financial choices and monitor financial markets for new consumer risks.

Conclusion

The 2008 financial crisis was enormously destructive, wiping out a massive amount of wealth. According to the FCIC (2011, p. 391): Households suffered the impact of the financial crisis not only in the job market but also in their net worth and their access to credit. Of the $17 trillion lost from 2007 to the first quarter of 2009 in household net wealth … about $5.6 trillion was due to declining house prices, with much of the remainder due to the declining value of financial assets.

The recession lasted 18 months, and unemployment hit nearly 10 percent, its highest level since 1982. Even as the economy slowly recovered and emerged from recession, the effects of the 2008 crisis persisted for at least a few years. Hall (2014), for example, showed that output in 2013 was 13 percent below its trend path from 1990 to 2007 and that the depletion of plant and equipment was the most significant contributor to that gap. But we also know that there are long-term “scarring” effects of high unemployment and reduced incomes. These longer-term effects can show up in reduced educational achievement, some of which can be passed down across generations. And while it was not the only factor in the populist political backlash in both the United States and Europe, it seems clear that the financial crisis played a role. Sara Hsu and Brandon Dupont

Notes 1.

2.

3.

S&P Dow Jones Indices LLC, S&P/Case-Shiller U.S. National Home Price Index, Federal Reserve Bank of St. Louis: https://​fred​.stlouisfed​.org/​series/​ CSUSHPINSA. International Monetary Fund, Household Debt to GDP for United States, Federal Reserve Bank of St. Louis: https://​fred​.stlouisfed​.org/​series/​ HDTGPDUSQ163N. www​.newyorkfed​.org/​aboutthefed/​aig​#slide1.

References

Almunia, Miguel, Agustín Bénétrix, Barry Eichengreen, Kevin H. O’Rourke, and Gisela Rua. 2010. “From Great Depression to Great

Sara Hsu and Brandon Dupont

10  Elgar encyclopedia of financial crises Credit Crisis: similarities, differences and Greenwood, Robin, Samuel G. Hanson, Andrei lessons.” Economic Policy 25(62): 219–265. Shleifer, and Jakob Ahm Sørensen. 2022. Ambrose, Brent W., Yiying Cheng, Tao-Hsien, “Predictable financial crises.” The Journal of and Dolly King. 2013. “The financial crisis and Finance 77(2): 863–921. Temporary Liquidity Guarantee Program: their Hall, Robert. 2014. “Quantifying the lasting harm impact on fixed-income markets.” Journal of to the U.S. economy from the financial crisis,” Fixed Income 23(2): 5–26. NBER chapters, in NBER Macroeconomics Crotty, James. 2009. “Structural causes of the Annual 29: 71–128. global financial crisis: a critical assessment of Lowrey, Annie. 2012. “Regulators move closer the ‘new financial architecture’.” Cambridge to oversight of nonbanks.” New York Times, Journal of Economics 33: 563–580. April 3. Deaton, Angus. 2012. “The financial crisis and the Mian, Atif and Amir Sufi. 2009. “The consewell-being of Americans.” Oxford Economic quences of mortgage credit expansion: eviPapers 64(1): 1–26. dence from the U.S. mortgage default crisis.” FCIC. 2011. “The financial crisis inquiry report: The Quarterly Journal of Economics 124(4): Final report of the National Commission on the 1449–1496. causes of the financial and economic crisis in Teslik, Lee Hudson. 2009. “The U.S. Economic the United States.” Washington, DC: Financial Stimulus Plan.” Council on Foreign Relations, fraser​ Feb 18, https://www.cfr.org/backgrounder/ Crisis Inquiry Commission, https://​ .stlouisfed​.org/​title/​5034. us-economic-stimulus-plan.

Sara Hsu and Brandon Dupont

3. A ClassicalKeynesian approach to financial crises

debt, and exchange crisis episodes. Most of them occurred in low- and middle-income countries. In 2007, however, the crisis set off in high-income nations, causing more damage and proving that these events can start everywhere. The increased frequency of crises has induced literature to investigate their origins. It has identified two main causes: (1) macroeconomic imbalances attributed to errors or abuses of the authorities and (2) institutional failures. The literature presented three generations of models. The first focused on external imbalances (Salant and Henderson, 1978; Krugman, 1979). The second stressed the role of speculative movements enhanced by problems of the institutional organization of policy (Obstfeld, 1994; Kaminsky and Reinhart, 1999; Goldfajn and Valdés, 1997; Flood and Marion, 1999; Chang and Velasco, 1999; Sarno and Taylor, 2003; Buiter, 2007). The third concentrated on the role of the news in influencing the perceptions of traders of the degree of liquidity of assets (Kaminsky and Schmukler, 2002; Kaminsky et al., 2003; Kaminsky et al., 2009).

Introduction

The Classical-Keynesian interpretation of crises comes from the writings of Keynes and Sraffa. They worked together on the monetary issues that were dominant in literature after World War I, such as the evolution of financial markets, the concept of liquidity, financial speculation, and the incorporation of money into the theoretical foundations of economic discipline. Keynes was the principal figure in this collaboration. Their work moved from analyzing the degree of liquidity of assets to criticizing how money was integrated into the theoretical foundations of the discipline. The degree of liquidity of assets depends on the investors’ perception of the stability of their future prices. This psychological element can be subject to wide variations that generate “irrational exuberance” and speculative bubbles (Stiglitz, 2003, p. 79). For Keynes and Sraffa, however, the powers that legislation confers on authorities over market stabilization play a crucial role in shaping psychological perceptions. If legislation fortifies the authorities’ ability to stabilize asset prices, the degree of liquidity improves and the solvency of the financial sector is promoted. On the contrary, failures in the institutional organization can destabilize the degree of liquidity and cause insolvency and crises. For the Classical-Keynesian approach, the role of the organization of financial markets is dominant concerning that of psychological perceptions. The study of crises should focus on the formation of legislation and policy, considering that their evolution depends on the pressures of economic and social groups over income distribution.

Historical antecedents

If we exclude the Bretton Woods era, financial crises have always characterized the history of economies. The formation in the UK of the first credit system in the early nineteenth century favored the country’s growth in the Victorian era. Still, it was accompanied by a series of systemic crises. The concern they caused led to the formation of what can be considered the first nucleus of monetary theory in the history of economic thought. Fetter (1965) named it British Monetary Orthodoxy. Its analytical structure focused on the cash flow problems of firms, considering them the primary source of demand for bank loans. Speculation on financial assets existed but played a limited role in the nineteenth century, and its analysis was little elaborated in those years. Marx was a careful reader of the British Monetary Orthodoxy. His views on money were often presented by moving from its analytical structure, which was still present, including the assumption that financial speculation played a minor role in the functioning of the credit system, in the writings of Marshall and the Cambridge School (Pigou, 1917; Keynes, 1923).

Increased frequency of crises in recent decades

The number and intensity of crises have increased during the last decades. Throughout the Bretton Woods era, bank insolvencies “had disappeared from the radar” (White, 2009, p. 39). From 1970 to 2017, Laeven and Valencia (2018) identified 461 banking, 11

12  Elgar encyclopedia of financial crises

The massive amount of public debt issued during World War I changed this situation. After the war, financial speculation grew in size, and the free movement of capital between Europe and the USA increased market volatility and caused the British economy to stagnate. These problems aroused new reflections, in which the concept of liquidity and financial speculation assumed a central position. Keynes benefited from an intense collaboration with Sraffa and was a leading figure in these debates. The first credit system that developed in the UK at the start of the nineteenth century was “specialized.” It sought to reduce the likelihood of a crisis by requiring consistency between the maturities of banks’ assets and liabilities and by attributing to the Bank of England the role of lender of last resort. When in 1873 the Bank of England took on this role formally and without delay, bank runs and systemic crises disappeared in the UK. A different credit system developed in Germany after its unification in 1871. It was the first “mixed” system in the history of economies. The maturity structure of assets and liabilities of mixed banks was unbalanced, with liabilities having short-term and assets having long-term maturity. The mixed system was chosen to favor the industrialization of Germany. It was riskier than the specialized and needed the bank of issue, the Reichsbank, to add to the role of lender of last resort that of lender of first resort, which systematically provides banks with abundant means of payment. With the support of the Reichsbank and the effective control by the authorities over bank managers, the mixed system was successful until World War I. Its achievements attracted the attention of politicians and economists and induced Italy to introduce it in the 1890s.

Keynes’ and Sraffa’s work on monetary issues

Keynes and Sraffa had similar views on various issues debated after World War I. Eventually, they subscribed to a historical-conventional interest rate theory that highlights the role of institutional organization and monetary policy. When they first met in August 1921, Keynes was so impressed by his young colleague’s knowledge of financial events that Carlo Panico

he asked him to write an article about the banking crisis shaking Italy for the weekly supplement of the Manchester Guardian Commercial. The text Sraffa wrote was too long for the Manchester Guardian but suitable for the Economic Journal, where it was published (Sraffa, 1922a). At the same time, a shorter article appeared in the Manchester Guardian on December 7 (Sraffa, 1922b). Sraffa argued that the leading cause of the Italian crisis was the failure of financial regulation to prevent the formation of large groups of companies capable of controlling sections of the economy, the media, and the political world and achieving monetary legislation and policies favorable to their interests: The general tendency seems to be towards the … formation of large “groups” of companies of the most varied kinds concentrated around one or more banks, mutually related by the exchange of shares and by the appointments of Directors common to them. Within these “groups” the various interests are all equally subject to the interests of a few individuals who control the whole group. … Very little is known … about these groups. … What the public knows and feels … is the enormous financial and political power which they have and the frequent use they make of it to influence both the foreign and home policy of the government in favour of their own interests. Each group keeps several press organs which support its policy, and some of the accusations made against certain Ministries of being actuated by the interests not of a class, but of private concerns, and of favoring one financial group against another, have no doubt a basis of truth. (Sraffa, 1922a, p. 196)

Weak regulatory controls allowed these groups, which Sraffa considered a danger to democracy, to distort credit flows toward questionable ends. Sraffa’s analysis clarified that (1) distributional conflicts influence monetary legislation; (2) failures in regulation favor the formation of large conglomerates; and (3) large conglomerates pursue their interests by increasing systemic risk. The article’s publication in the Manchester Guardian Commercial caused Sraffa a series of problems with the Italian fascist regime. He accepted Keynes’ invitation to protect himself by moving to Cambridge, but the British authorities did not permit him to enter the country in Dover. The literature has shown that these events did not prevent the

A Classical-Keynesian approach to financial crises  13

two from working together. From 1923 to 1927, when he moved to Cambridge, Sraffa kept discussing the evolution of financial markets and the concept of liquidity with Keynes. Among other things, he provided the author of A Tract with data on the forward exchange rates of the lira, data that ‘Keynes used in his presentation of the theory of forward interest rates’ (De Cecco, 2005, p. 354). Sraffa’s writings of that period also focused on forming legislation and monetary policy. Upon his arrival at Cambridge University in 1927, Keynes asked him to give a course on “Continental Banking” to elucidate the working of the German mixed system. A manuscript describing the content of those lectures can be found in the Sraffa Papers (S.P., D2/5). There, Sraffa argued – as he had done in the essay on the Italian crisis – that mixed banks are not riskier than specialized ones, provided that the central bank systematically supplies them with abundant means of payment and that regulation prevents the formation of large conglomerates that lead to dangerous investments. In the lectures, Sraffa developed these points by focusing on the notion of liquidity. He argued that the degree of liquidity of financial and real assets depends on the psychological perception that investors have of the stability of their prices. He identified several elements that affect this perception, showing a profound knowledge of the subject and stressing that the degree of liquidity depends more on the difficulty of selling the assets at the current price than on their maturity. For this reason, he stated that a large market and the availability of a large buyer, such as a central bank, to buy securities at a specific price improves the liquidity of assets. The powers that legislation confers on the authorities in stabilizing markets and refinancing credit institutions are the elements that most influence the liquidity of assets and the banking system’s solvency. The reference to the powers of the authorities clarifies that in Sraffa’s analysis, the role of the institutional organization of financial markets, which can be studied by observing their past evolution, is dominant with respect to that of psychological perceptions. This perspective is consistent with his commitment to applying an “objectivist” approach to economic

theory (Kurz and Salvadori, 2005; Panico, 2021). In the lectures, Sraffa recalled that German legislation endowed the Reichsbank with the power to establish closer cooperative relations with credit institutions than those existing in the UK. This form of institutional organization allowed mixed banks to fund German industrial development without having solvency problems. For Sraffa, the Reichsbank functioned as a leading entity in a planned economy, where banks finance production in strategic sectors and the central bank systematically provides ample funds rather than making them available in emergencies, as was the case in the UK. De Cecco (2005, pp. 355 and 358) states that until World War I, the Reichsbank acted as lender of first resort, adding this role to that of lender of last resort run by the Bank of England. As for theoretical research, the literature has shown that at Cambridge, Sraffa played a relevant role in the debates on A Treatise on Money. He was a prominent member of Cambridge Circus, as cherished by the expression ‘To the Circus Master—May Term 1931’ written by Joan Robinson on the cover of the abstract of her ‘A parable in saving and investment’ that she presented to Sraffa. His participation in those debates led the Italian economist to publish his first theoretical work on the relationship between money and distribution, a critical review of Hayek’s Prices and Production (Sraffa, 1932a, b). The profound knowledge of the concept of liquidity allowed Sraffa to clarify Hayek’s peculiar definition of the natural interest rate and to inspire, as Keynes (1936, p. 223) acknowledged, the analysis of “own interest rates” of chapter 17 of the General Theory. Sraffa’s involvement in preparing the General Theory and the discussions following its publication are well documented. He witnessed the changes that led to the proposal in the General Theory of a monetary theory of production, which moves from believing that financial events have permanent effects on production and income distribution. In the applied works written in previous years, Sraffa had implicitly adopted this view. Yet, he had not examined its theoretical implications nor foreseen the possibility of attributing to money an alternative role in the theory of distribution. Carlo Panico

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Keynes was aware that his monetary theory of production referred to the integration of money into the theoretical foundations of the discipline and represented a “scientific revolution” that had to induce the profession to interpret economic events in a new way. A central point of this revolution was the presentation of a monetary theory of interest, in which Keynes (1936, pp. 201–203) argued that (1) the determination of the interest rate is an institutional and conventional phenomenon rather than a psychological one; (2) individual perceptions of the future value of assets ultimately depend on the common view on the safe level of the interest rate; and (3) the organization of markets and monetary policy are the main determinants of this safe level. Like Sraffa, Keynes (1936, pp. 201–204) admitted that the presence in the market of a large buyer, as a central bank can be, tends to stabilize the price of assets and the “durable” or “average” interest rate, around which market rates fluctuate. It may be more accurate, perhaps, to say that the rate of interest is a highly conventional, rather than a highly psychological, phenomenon. For its actual value is largely governed by the prevailing view as to what its value is expected to be. Any level of interest which is accepted with sufficient conviction as likely to be durable, will be durable; subject, of course, in a changing society, to fluctuations for all kinds of reasons round the expected norm. (Keynes, 1936, p. 203; Keynes’ italics)

Unlike the Treatise, the General Theory asserted that monetary policy, rather than relying on an abstract and not directly observable natural rate, depends on the authorities’ assessment of what is most convenient for the country under the prevailing historical circumstances. The authorities consider various elements, some of which are related to financial causes, to make interest rate policies. Among them is the level of systemic risk that the existing institutional organization of financial markets tends to generate and the relationships between the national and international financial systems, the likelihood of capital outflows, and alarming changes in the exchange rate. The authorities’ decisions on the interest rates affect the rate of profits and the other distributive variables. Carlo Panico

Keynes and Sraffa shared a common vision of what was necessary to “revolutionize” the foundations of economic discipline. They knew that it was crucial to prove that neoclassical analyses contained logical errors and propose an alternative theory of production and distribution. These themes were at the heart of Sraffa’s subsequent work.

The Classical-Keynesian approach to financial crises: a summing up

The Classical-Keynesian approach embraces a monetary theory that considers that legislation and monetary policy play a key role in determining the levels of production and distribution. It accepts that legislation on financial regulation shapes the organization of markets, which, in turn, defines how the central bank can conduct monetary policy. The approach notes that the degree of liquidity of assets improves if legislation fortifies the authorities’ ability to stabilize their prices. It also points out that in a mixed system, central banks must add to the role of lender of last resort that of lender of first resort. The approach considers legislation and policies as part of the distributive conflicts among economic and social groups. In a mixed system, failures in financial regulation favor the formation of large groups of companies, influencing the exertion of power and posing a danger to democracy. These groups can obtain legislation and policies that promote their interests while reinforcing social conflicts and increasing income inequality, systemic risk, and the likelihood of a crisis. The existence of legislation capable of preventing the formation of large financial conglomerates is thus necessary to avoid adverse effects on income distribution and the functioning of democracy and reduce the likelihood of crises.

The Classical-Keynesian approach and the crises of 1929–1933 and 2007–2009

Some literature argues that the changes in the institutional organization of financial markets, which occurred at the beginning of the twentieth century and after the breakdown of the Bretton Woods agreements, are the leading cause of the crises of 1929–1933 and 2007–2009 (Stiglitz, 2003; Wilmarth, 2020). As the Classical-Keynesian approach

A Classical-Keynesian approach to financial crises  15

suggests, in both cases the pressures of the financial industry succeeded in modifying regulation and transforming the US system from specialized to universal. This comprises firms that, like mixed banks, raise short-term funds and make long-term investments. Universal banks operate in a broader range of activities than mixed banks. Wilmarth (2020, pp. 14–21) defines them as financial conglomerates involved in a wide range of businesses, including traditional banking, capital markets activity, and insurance. Like the legislation introduced in the 1930s, that of the nineteenth century characterized the US system. The first attempts to develop universal banks were found in the late nineteenth century, when commercial banks began trading in corporate securities, taking advantage of the absence of an explicit prohibition in legislation and the tacit permission of regulators. Yet, some court decisions obliged the Comptroller of the Currency to change policy in 1902. This event induced commercial banks to organize affiliated companies operating in the capital markets. The organization of affiliated companies met with opposition from some public officials. The conflict led the House of Representatives to establish the Pujo subcommittee in 1912, which recommended in February 1913 that the financial system remain specialized. It proposed prohibiting investment banks from accepting deposits and commercial banks from trading securities (except government bonds), organizing affiliated companies, and owning shares of other financial firms. Yet, Congress did not adopt these recommendations. The clash between the banking industry and some public officials continued during the Democratic administration of Woodrow Wilson (1913–1921) and the Republican ones of Harding and Coolidge (1921–1929). The Comptrollers of the Currency appointed by Republican administrations removed several restrictions imposed on financial firms in previous years. At the same time, legislation passed by Congress incorporated many requests from the banking industry. As White (2009) points out, after the breakdown of the Bretton Woods agreements, the transformation of the US specialized system into a universal one required a period of transition (1971–1990). During this period, more than legislation, administrative meas-

ures gradually made the specialized system lose its supremacy. Legislation formalized the change in regulation and the adoption of the universal system during the 1990s. As it occurred after the breakdown of the Bretton Woods agreements, the attempts of the banking industry to change the financial system at the start of the twentieth century caused a deterioration of regulation that produced financial markets dominated by large conglomerates of universal banks. These companies enjoyed hegemonic powers over the culture and the political world. The concentration process impaired the governance of financial regulation, made it difficult for the authorities to control systemic risk, and facilitated the distortion of credit flows toward questionable ends (Levine, 2010). Reduced spending on bank examinations also contributed to the deterioration of regulation. The Office of the Comptroller of the Currency reduced this spending by 40 percent between 1923 and 1926. During the Reagan administration, the decline in spending changed supervision in quantity and quality (White, 2009, p. 36). Surprise inspections, which are the most effective, lost relevance. In the periods preceding both crises, the expansion of the US financial sector, which mainly occurred in real estate loans, consumer credit, and securities trading, was supported by financial innovation in the form of securitization and the formation of firms accepting deposits and trading in securities. The sector massively sold its services worldwide (Wilmarth, 2020, p. 202). The enlargement of its revenues caused a shift in income distribution in its favor. Consequently, inequality widened, distributive conflicts intensified, and economic growth progressed. Historians refer to the “roaring twenties.” Similarly, Stiglitz (2003) refers to the “roaring nineties.” In both periods, the credit boom was based on incentives for executives, officials, and employees of financial companies. These incentives promoted deceptive practices that induced inexperienced clients to invest in hazardous activities. They deteriorated credit quality and caused stock market bubbles, amplified by the reductions in interest rates implemented by monetary policy in the 1920s. A generalized and persistent decrease in interest rates has occurred in the US since the 1990s, with the Federal Reserve trying to counter the rise of systemic risk by playing Carlo Panico

16  Elgar encyclopedia of financial crises

the role of lender of first resort (see Capraro et al., 2021). This situation raised default rates and favored the emergence of “irrational exuberance” that led to the crises of 1929–1933 and 2007–2009. Carlo Panico

References

Buiter W., 2007, Lessons from the 2007 financial crisis, CEPR Discussion Papers, no. DP 6596. Capraro S., Panico C., Torres-González L.D., 2021, U.S. monetary policy and the decline in the interest rates (1990–2007), PERI Working Paper, N. 555, UMass Amherst, Amherst, MA. Chang R., Velasco A., 1999, Liquidity crises in emerging markets: theory and policy, NBER Macroeconomics Annual, 14, 11–78. De Cecco M., 2005, Sraffa’s lectures on Continental banking: A preliminary appraisal, Review of Political Economy, Special Issue: Piero Sraffa 1898–1983, 17 (3), 174–188. Fetter F.W., 1965, Development of the British Monetary Orthodoxy, Cambridge, MA: Harvard University Press. Flood R., Marion N., 1999, Perspective on the recent currency crisis literature, International Journal of Finance and Economics, 4 (1), 1–26. Goldfajn I., Valdés R.O., 1997, Capital flows and the twin crises: The role of liquidity, IMF Working Paper, 97/87. Kaminsky G., Mati A., Choueiri N., 2009, Thirty years of currency crises in Argentina: External shocks or domestic fragility?, National Bureau of Economic Research (NBER) Working Paper, no. 15478. Kaminsky G., Reinhart C.M., 1999, The twin crises: the causes of banking and balance-of-payments problems, American Economic Review, 89 (3), 473–500. Kaminsky G., Reinhart C.M., Végh C.A., 2003, The unholy trinity of financial contagion, Journal of Economic Perspectives, 17 (4), 51–74. Kaminsky G., Schmukler S.L., 2002, Emerging market instability: do sovereign ratings affect country risk and stock returns?, The World Bank Economic Review, 16 (2), 171–195. Keynes J.M., 1923, A Tract on Monetary Reform, in Moggridge D.E., ed., The Collected Writings of J.M. Keynes, Vol. IV, London: Macmillan (1971). Keynes J.M., 1936, The General Theory of Employment, Interest and Money, in Moggridge D.E., ed., The Collected Writings of J.M. Keynes, Vol. VII, London: Macmillan (1971).

Carlo Panico

Krugman P., 1979, A model of balance of payment crisis, Journal of Money, Credit and Banking, 11 (3), 311–325. Kurz H.D., Salvadori N., 2005, Representing the production and circulation of commodities: on Sraffa’s objectivism, Review of Political Economy, 17 (3), 414–441. Laeven L., Valencia F., 2018, Systemic banking crises revisited, IMF Working Papers, no. W.P./18/206. Levine R., 2010, The governance of financial regulation: reform lessons from the recent crisis, Bank of International Settlements, Working Papers, no. 329. Obstfeld M., 1994, The logic of currency crises, National Bureau of Economic Research (NBER) Working Paper, no. 4640. Panico C., 2021, Sraffa’s monetary writings, objectivism and the Cambridge Tradition, in Sinha A., ed., A Reflection on Sraffa’s Revolution in Economic Theory, London: Palgrave Macmillan, Palgrave Studies in the History of Economic Thought, 419–449. Pigou A.C., 1917, The value of money, Quarterly Journal of Economics, 32, November, 38–65. Salant S., Henderson D., 1978, Market anticipations of government policies and the price of gold, Journal of Political Economy, 86 (4), 627–648. Sarno L., Taylor M.P., 2003, The Economics of Exchange Rates, Cambridge: Cambridge University Press. Sraffa P., 1922a, The bank crisis in Italy, Economic Journal, 32 (126), June, 178–197. Sraffa P., 1922b, Italian banking to-day, The Manchester Guardian Commercial, Reconstruction in Europe, Supplement, December 7, 675–676. Sraffa P., 1932a, Dr. Hayek on money and capital, Economic Journal, 42 (165), March, 42–53. Sraffa P., 1932b, A rejoinder, Economic Journal, 42 (166), June, 249–251. Stiglitz J.E., 2003, The Roaring Nineties: A New History of the World’s Most Prosperous Decade, New York: Norton and Company. White E.N., 2009, Lessons from the history of bank examination and supervision in the United States, 1863–2008, in Gigliobianco A., Toniolo G., eds., Financial Market Regulation in the Wake of Financial Crises: The Historical Experience, Banca d’Italia Workshops and Conferences, November, 15–44. Wilmarth A.E. Jr., 2020, Taming the Megabanks: Why We Need a Glass-Steagall Act, New York: Oxford University Press.

4. A financial crisis as a form of VUCA (volatile, uncertain, complex, and ambiguous situation)

2021) – but also reduced trust between partners (Hadjikhani and Johanson 2000), uneven development of different industries and countries (Dubrovski 2007), and social and political tensions (Cavusgil et al. 2021). The Covid-19 pandemic –­ a VUCA event – also resulted in some additional problems like social distancing, quarantines (Qamar and Child 2021), national lockdowns, travel restrictions, and other unexpected regulatory restrictions that came into force almost overnight (Etemad 2020; Vissak 2022b). For instance, indoor events were forbidden in some countries, and thus some service providers suddenly lost all income (Vissak 2022a). Moreover, as several trade fairs were canceled or postponed, this reduced firms’ turnover that usually found new customers at such events (Vissak 2022b). Thus, overall, Covid-19 can even represent the most extreme VUCA event of recent times. This was also stated by Cavusgil et al. (2021: 225): “Few things are more disruptive to business than large-scale, unexpected events, like the COVID-19 pandemic that affected nearly everyone on the planet in 2020/2021 … COVID-19 was without doubt the most destructive black swan event to hit the global business landscape in recent memory.” As a result of financial crises and other VUCA situations, an increase in business mortality could occur (Amankwah-Amoah et al. 2021; Dai et al. 2021; Etemad 2020). Moreover, recovering from some VUCA situations – like the Covid-19 pandemic – could take years (Bressan et al. 2021). Thus, according to several authors, firms should prepare for crises and other VUCA situations to reduce failure rates (Beaver and Ross 2000; Grewal et al. 2007; Lee and Makhija 2009; Shivdasani 2016). Both smaller and larger firms can be vulnerable to crises: the former are at risk due to having limited resources and capabilities and depending on a few main suppliers or customers (Fath et al. 2021; Klein and Todesco 2021), while the latter are endangered since they have more business ties in more countries, including those that were affected the most (Belhadi et al. 2021; Purnomo et al. 2021). Thus, firms of all sizes should become more resilient to survive crises or benefit from them (Evans and Bahrami 2020). Fiksel (2006: 16) defined resilience as “the capacity for an enterprise to survive, adapt, and grow in the face of turbulent change.”

Firms have always faced uncertainties and financial, commercial, political, and cultural risks (Cavusgil et al. 2021). As a result, they have also learned how to cope with them (Adobor et al. 2021). However, some events are less frequent and almost unpredictable, yet can affect firms considerably (Bahri Korbi et al. 2021). This entry focuses on how a financial crisis can be regarded as a form of VUCA: a highly volatile, uncertain, complex, and ambiguous situation (Bennett and Lemoine 2014; van Tulder et al. 2020). Because of these characteristics, it is not possible to state that something will never happen in the economy, or in firms’ local and international business activities (Qamar and Child 2021). During a crisis, different (almost) unpredictable developments are possible (Vissak 2013; Worley and Jules 2020). Thus, owners and managers could fail to correctly predict their firm’s future and achieve their initial plans (Oliveira et al. 2020; Vissak 2022a). Moreover, in a VUCA situation, firms could make wrong strategic choices as they might not fully understand what has caused such a crisis, when it could end, and how they could recover from it (Figueira-de-Lemos et al. 2011). Financial crises – and, thus, VUCA situations – have started to occur more often than in the past decades as the world has become increasingly interconnected: firms depend more on foreign suppliers and customers than before (Evans and Bahrami 2020; Hamel and Välikangas 2003; Mack et al. 2016; Schoemaker et al. 2018). Such crises have been associated with firms’ and countries’ liquidity problems (Garcia et al. 2021; Vissak 2013), changes in firms’ and countries’ export and import geography due to abrupt regulatory changes (Hamel and Välikangas 2003), trade wars (Cavusgil et al. 2021), and changes in consumer tastes (Hamel and Välikangas 2003; Vissak 2013) – such as a decrease of demand for non-essential and durable products (Hayakawa and Mukunoki 17

18  Elgar encyclopedia of financial crises

According to Linnenluecke (2017: 4), resilience is the ability “to respond more quickly, recover faster or develop more unusual ways of doing business under duress than others.” To become more resilient to various VUCA situations, firms should assess their principal vulnerabilities (Cavusgil et al. 2021) and become ready to make changes; however, they need enough resources to do so (Leppäaho and Ritala 2022). Thus, they need to accumulate slack resources during economic stability and growth periods (Marconatto et al. 2022). Moreover, it is vital to innovate (Garcia et al. 2021), learn how to use digital technologies (Klein and Todesco 2021; Troise et al. 2022), build strong network relationships (Cavusgil et al. 2021), and communicate their vision to the staff to build trust and get their support (Pandit 2021). Strategic agility, or “the ability to anticipate or respond quickly to external changes” (Troise et al. 2022: 1), is also important. Still, during the VUCA situation, it is normal to make “wrong” decisions; however, firms should learn from these mistakes and continue going forward (Vissak 2022b). Thus, managers should try to retain a positive mindset instead of panicking and becoming victims (Evans and Bahrami 2020). Several suggestions regarding how firms could achieve success or minimize losses during financial crises are offered in entry 37 of this Encyclopedia. A list of potential business opportunities that emerge during financial crises is provided in entry 25 of this Encyclopedia. Finally, entry 100 of this Encyclopedia gives an overview of how financial crises affect exporters. Tiia Vissak

Acknowledgment

This work was supported by the Estonian Research Council’s grant PRG 1418.

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Tiia Vissak

5. A modern Greek tragedy: the crises of 2009–2015

their trade was with other members, they were subject to differential economic shocks, intercountry labor mobility was low, and there was no supranational tax and transfer mechanism to shift resources automatically to regions performing poorly. In these circumstances, adopting a common currency presented two major disadvantages: the loss of independent monetary policy conducted by the European Central Bank (ECB) to respond to national conditions and the loss of exchange rate flexibility. Combined with inflexibilities in labor and product markets for several countries, this would lead to a loss of competitiveness, sizeable current account deficits, dependence on foreign capital, and vulnerability to sudden stops of capital inflows. During the Eurozone crisis, not only Greece but also Spain, Portugal, Ireland, and Italy came under severe financial pressure, and all of these, except Italy, had to seek emergency rescue funds.

Introduction

The Eurozone crisis erupted in 2009 and led several group members into financial distress, with bank failures, high unemployment, political upheaval, and externally enforced austerity measures as the price for bailouts. No country was buffeted as severely as Greece, which suffered a 27 percent fall in GDP, unemployment of 27 percent, and six governments in six years; it became the first developed country to default on a loan from the International Monetary Fund (IMF); and had to undergo three bailouts adding up to 326 billion Euros, more than 175 percent of GDP. Greece’s travails were partly due to inherent contradictions in establishing a common currency without a central fiscal authority for countries with very different economic conditions and partly due to circumstances specific to Greece. This essay will discuss these briefly in the next two sections before reviewing the events of 2009–2015 and drawing some conclusions.

Greece before the Euro

While members of the Eurozone were quite heterogeneous, with significant differences between a northern “core” and a southern “periphery,” Greece was a particular outlier. It was the poorest member, with a per capita GDP of 70 percent of the average. It had a long history of financial problems and had defaulted three times on external debt since it gained independence in 1829; in fact, it had been in default for about half its existence (Reinhart and Rogoff, 2009). The circumstances of these crises were quite similar: a government unable to collect enough tax revenue to meet expenditures, heavy borrowing from external financial markets, inability to repay, and foreign governments demanding austerity as the price of partial bailouts. Greece was also the only country in western Europe to have suffered through a civil war and a military coup in the post-World War II period; the scars from these left deep divisions that persist to this day. In the two decades before joining the Euro, Greece’s finances continued to be fragile, primarily due to government deficit spending (Mauro et al., 2013). The cause lay both on the expenditure side, as the government was reluctant to reduce subsidies and repeatedly agreed to excessive public sector wage increases, and on the revenue side, with inadequate tax receipts attributed to widespread tax

Euro and problems

When the Euro came into existence in 1999 as a common currency for most members of the European Union (EU), it generated a lot of excitement politically as another step in European integration. On the economic side, several benefits were seen: for consumers, increased price transparency and no more transaction costs for cross-border purchases and travel, and for businesses, the elimination of translation and economic risk due to changes in exchange rates. Some requirements had to be satisfied to join the Euro, specified in the Maastricht Treaty, which created the common currency. These included low inflation, a low debt-to-GDP ratio, and a budget deficit limited to 3 percent of GDP. For inflation-prone countries of southern Europe, this was seen as enhancing the credibility of economic policy. The member countries, however, did not satisfy the conditions for an optimal currency area (Mundell, 1961). While most of 21

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evasion. There was no external crisis during this period, as the deficits were financed domestically, often through monetization by the central bank. The subsequent inflation also reduced the burden of the rising public debt. The loss of competitiveness of Greek goods and services was limited by allowing the currency to depreciate steadily—the Greek drachma fell from 43 to the dollar in 1980 to 159 in 1990 and 365 in 2000.

Greece in the Eurozone

Greece had hoped to be among the founder members of the Euro. To qualify for membership, the Greek government embarked on a severe austerity program, which brought the budget deficit down from 9.7 percent of GDP in 1995 to 6.3 percent in 1998. As this was still well above the 3 percent limit, Greece’s application was rejected, and the Euro came into existence in January 1999 with 11 members. The government continued its budget cuts and, in 2000, satisfied the EU authorities that the conditions had been met. In January 2001, Greece became the 12th member of the Eurozone. Despite the austerity measures, membership was very popular; the finance minister described it as “an historic day which would place Greece firmly in the heart of Europe” (BBC, 2001). An economic boom followed admittance to the Euro (Figure 5.1). GDP rose from 141 billion Euros in 2000 to 242 billion Euros in 2008, while unemployment fell from 11.3 percent to 7.8 percent. The country attained a level of prosperity it had never seen before. A major driver was an influx of foreign capital. Since currency risk and government

Source:  Own illustration.

Figure 5.1

Greece GDP and unemployment

Animesh Ghoshal

solvency risk appeared negligible, financial markets initially provided easy access to credit. In anticipation of Greece adopting the Euro, the interest rate on long-term government bonds started falling in the mid-1990s and continued to fall. The premium over German bonds, a good measure of perceived risk, fell from 10 percent in 1995 to 0.2 percent in 2003; between 2005 and 2007, Greece could even borrow on slightly better terms than the United States (Figure 5.2). With easy credit available, Greece went on a debt-funded spending spree, including the most expensive Olympic Games, costing twice its estimated budget of 4 billion Euros. Public sector wages almost doubled between 2000 and 2010. External debt as a percentage of GDP rose from about 70 percent to 180 percent during the decade. The first sign of potential problems came in 2004. Since the restoration of democracy in 1974, Greece had two major parties alternate in office. In March 2004, the conservative New Democracy came into power, defeating the socialist PASOK, and almost immediately stated that the budget deficit for the previous year had been 3.2 percent of GDP, twice the preliminary figure issued by the previous government. It also issued revised figures showing the 3 percent ceiling to have been breached every year since 2001, drawing a harsh rebuke from the EU Commission. And in November, it admitted that its acceptance into the Eurozone was based on misrepresented official statistics. The finance minister placed all the blame on the previous government. He also declared that the deficit would be brought below 3 percent next year through spending cuts and

A modern Greek tragedy  23

Source:  Own illustration.

Figure 5.2

Long-term interest rates (10 year government bonds)

privatization of state-owned enterprises; this appeared to satisfy financial markets, as Greece continued to be able to borrow at minimal spreads over Germany. The global financial crisis, which began in the US in 2007 and spread worldwide by 2008, brought about a credit crunch that ended the era of easy credit. In October 2009, PASOK returned to power. In December, the budget deficit for the year was revealed to be 12.7 percent of GDP, rather than the figure of 6.7 percent projected earlier in the year (the figure was revised to 13.6 percent and finally to 15.2 percent). This admission led markets to question the long-term solvency of Greece (Ardagna and Caselli, 2014), and the interest rate on 10-year government bonds jumped from 4.8 percent in November to 5.5 percent in December and 6 percent in January. Abandoning its election platform of wage increases and additional welfare spending, the government announced harsh austerity measures, including a pay freeze and reduction in allowances for civil servants and increases in taxes on wealthy Greeks, as part of a plan to bring the deficit down to 8.7 percent the following year, and to the 3 percent limit by 2013. The markets, however, were not convinced. By April, the 10-year bond rate had jumped to 7.8 percent, and Greece found it increasingly difficult to get new loans or to roll over its existing debt. Unlike in the pre-Euro period,

borrowing from its central bank or inflating its debt was impossible; external loans were needed to pay salaries and pensions. The same month, the rating agency Standard and Poor’s downgraded Greek sovereign debt to junk status, and Greece, facing a debt of 300 billion Euros with an obligation to repay approximately 50 billion Euros by the end of the year, formally asked for a rescue package from the EU and the IMF.

The three bailouts

In May 2010, the IMF and Eurozone countries agreed to provide Greece with an emergency three-year loan totaling 110 billion Euros to prevent a default, which could undermine confidence in other heavily Eurozone countries with large debts. Greece undertook further austerity measures, including tax increases and pension cuts. The aid was to be released in tranches, conditioned on Greece meeting these targets. The agreement was met with widespread strikes and violent demonstrations, in which three people were killed. The same month, as jittery markets pushed up yields on bonds of several Eurozone countries, EU members and the IMF established a 750-billion-Euro stabilization fund to provide emergency loans to them. At the same time, the ECB began a program of buying bonds of troubled Eurozone members (not just Animesh Ghoshal

24  Elgar encyclopedia of financial crises

Greece) in secondary markets to “restore calm.” While the former seemed to violate a “no-bailout” clause in the Maastricht Treaty, and the latter raised concerns about the independence of the ECB, these measures were considered necessary to avert a run on the bonds of Ireland, Italy, Portugal, and Spain, and on banks holding these bonds. The initial reaction of financial markets was very favorable: 10-year Greek bonds saw yields tumbling from 12 percent to 8 percent, and those of the other countries involved had similar movements. However, the package only bought time without putting in place needed structural reforms (The Economist, 2010). The question of how Greece would repay its massive 300-billion-Euro debt remained unaddressed. Over the next year, it became clear that Greece‘s sovereign debt had reached unsustainable levels. Negotiations began between the government, private lenders, Eurozone authorities, and the IMF about an orderly restructuring. In October 2011, an agreement was reached in principle: bondholders would accept a 50 percent write-down, banks hurt by this would be recapitalized with help from the EU, Greece would receive another round of emergency loans, and would undertake to bring its debt-to-GDP ratio down to 120 percent. As the last part involved further budget cuts, there was strong opposition in Greece, and the prime minister was forced to step down. Two provisional governments led by non-political figures followed, and protracted negotiations continued. In early 2012, with continued social unrest and a deepening recession, another default threat loomed as Greece faced a bond repayment obligation of 14 billion Euros in March, and the long-term bonds’ yield spiked to 30 percent. After marathon negotiations, a second bailout agreement was finalized. Greece would receive a loan of 130 billion Euros from the stabilization fund and commit to the debt-to-GDP ratio of 120 percent. Private bondholders accepted an increased “haircut” to 53.5 percent and agreed to reduced interest rates on replacement bonds, involving a total write-off of about 100 billion Euros. Official lenders also agreed to reduce the interest rate on existing bailout loans, though the principal was not written down. The second bailout failed to restore confidence, particularly after the regular election held in May, where the two mainstream Animesh Ghoshal

parties suffered massive losses, and a majority voted for fringe parties opposed to the bailout and its conditions. No party could form a government; another election was called in June. As concerns about a Greek exit from the Euro arose, bank runs erupted, with 700 million Euros being withdrawn in a single day. The June election led to a coalition government headed by New Democracy, which reaffirmed its commitment to fiscal retrenchment. As the turmoil in financial markets continued and yields on Italian and Spanish bonds rose to dangerous levels, several countries were seriously discussing leaving the Euro. To alleviate such concerns, in July, the head of the ECB, Mario Draghi, vowed to “do whatever it takes” to preserve the Euro. The ECB followed up with an open-ended plan to buy bonds of distressed countries in unlimited quantities. This unprecedented step did stabilize markets, and yields on Greek (as well as Spanish and Italian) bonds began to fall. In April 2014, Greece returned to the international bond market for the first time in four years and raised 3 billion Euros in five-year bonds. Regaining investors’ trust was seen as the beginning of a return to normalcy. However, concerns remained about the sustainability of the debt, now owed primarily to the ECB, EU, and IMF, collectively (and in Greece, disparagingly) referred to as the “Troika.” Optimism was bolstered further when GDP rose in the second quarter after 16 consecutive quarters of decline. In early 2015, an election brought a populist party, Syriza, to power, on an anti-austerity platform of abandoning bailout agreements, renegotiating debt obligations, increasing the minimum wage, and increasing public spending. Once again, the prospect of a default loomed; this became urgent in the summer, when the government had repayment obligations of 1.6 billion Euros to the IMF on June 30 and 3.5 billion Euros to the ECB on July 20, without the means to meet them. There was increasing opposition from countries like Germany before agreeing to release further installments of relief funds. Prime Minister Alexis Tsipras walked out of negotiations, called a snap referendum on the creditors’ proposals, and urged Greeks to reject their “humiliating” conditions. On June 30, Greece missed its repayment and defaulted with the IMF—the first time this

A modern Greek tragedy  25

had happened with a developed country. At the same time, Greek banks faced a liquidity crisis. As worried Greeks withdrew cash, bank deposits fell from 160 billion Euros to 135 billion Euros in the year’s first half. While Greek banks needed further support, the ECB declined to increase its Emergency Liquidity Assistance beyond the 89 billion Euros already disbursed. The government imposed capital controls, closed banks, and limited ATM withdrawals to 60 Euros daily. The referendum, held on July 5, resulted in a massive rejection of the Troika proposals, with 60 percent of Greeks voting “No.” After five years of budget cuts, a fall in GDP of 25 percent, and a youth unemployment rate of 50 percent, voters strongly supported Tsipras’s anti-austerity stand. However, with the country running out of cash, Greece resumed negotiations with creditors and agreed to most of the conditions rejected a month earlier, involving taxes, pensions, labor market reform, and privatization. The government was also required to maintain a primary budget surplus, with revenues exceeding expenditures less interest payments. This opened the way for a third bailout in August, amounting to 86 billion Euros, to be disbursed over three years. As Greece was judged to have met the loan conditions, the funds were released as planned, and intermediate-term financing needs were covered. The last tranche was received in August 2018, and officials celebrated the end of the bailout. Of the 326 billion Euros received, 40 percent had been used to reduce debt to private creditors, 20 percent to recapitalize banks, and 40 percent went into general budget support (Chodorow-Reich et al., 2021). Economic growth had returned, albeit at a plodding pace, unemployment had fallen from its peak of 27 percent to 20 percent, and the budget was in primary surplus. Greece had returned to solvency, but at a great price; the length and severity of its depression were beyond anything experienced in post-World War II developed economies.

Moreover, a considerable debt overhang persisted, mainly owed to EU institutions and Eurozone governments. While multiple debt-relief negotiations had reduced the interest rate and lengthened the repayment period, official creditors were unwilling to write off any of the principal. The debt-to-GDP ratio remained close to 180 percent. Greece still had a long way to go. Animesh Ghoshal

References

Ardagna, Silvia S. and Caselli, F. (2014). The Political Economy of the Greek Debt Crisis: A Tale of Two Bailouts, American Economic Journal: Macroeconomics, 6(4): 292–323. BBC (2001). Greece Joins Eurozone, January 1. Chodorow-Reich, Gabriel G., Karabarbounis, L., and Kekre, R. (2021). The Macroeconomics of the Greek Depression, NBER Working Paper 25900. Council on Foreign Relations. (2018). Greece’s Debt Crisis Timeline. www​.cfr​.org/​timeline/​ greeces​-debt​-crisis​-timeline. Gourinchas, P.-O., Philippon, T., and Vayanos, D. (2016). The Analytics of the Greek Crisis, in NBER Macroeconomics Annual, ed. by Eichenbaum, M. and Parker, J.A., vol. 31, University of Chicago Press. Martin, F. and Waller, C. (2012). Sovereign Debt: A Modern Greek Tragedy, Federal Reserve Bank of St. Louis Review. Mauro, P. et al. (2013). A Modern History of Financial Prudence and Profligacy, IMF Working Paper 13/5. Mundell, R. (1961). A Theory of Optimum Currency Areas, American Economic Review, www​.aeaweb​.org/​aer/​top20/​51​.4​.657​-665​.pdf. Reinhart, C. M. and Rogoff, K. S. (2009). This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press. Reinhart, C. M. and Trebesch, C. (2015). The Pitfalls of External Dependence: Greece, 1829–2015, NBER Working Paper 21664. The Economist (2010). The Sad End of the Party, May 8. The Guardian (2018). Greece Emerges from Eurozone Bailout after Years of Austerity, August 20. Xafa, M. (2014). Sovereign Debt Crisis Management: Lessons from the 2012 Greek Debt Restructuring, CIGI paper No. 33.

Animesh Ghoshal

6.

Argentina’s 1989 crisis

1983, it grew from 8.3 to 46 billion dollars. The more significant part came from the 1978 stabilization policy called La Tablita (“the little chart”), a pre-gradual devaluation scale schedule combined with an external opening of financial and trade sectors. In the prevailing abundant, low-cost, international credit environment, large amounts of capital entered the country, pressing the national peso down, checking inflation, and cheapening imports. Even though Argentina had been ridden with inflation for several decades, the price structure became chaotic after a mega-devaluation and mega-tariff shock in June 1975 by the Minister of Economy Celestino Rodrigo, which infamously became known as the Rodrigazo. Nine months later, after the coup, the military immediately tried to tame inflation with traditional International Monetary Fund (IMF) counter-cyclical measures and support, but to no avail. From the so-called Rodrigazo, the country would live under what became known as a “high-inflation regime”: verging on a 100 percent year rate of minimum inflation, but in most years, well over that level. In this regime, agents adapted to inflation by applying indexation mechanisms. Fanelli and Frenkel (1990) explain that this means that “there is inflation in the present simply because there was inflation in the past.” Despite bringing down inflation, La Tablita was far from ending it. Hence, the peso appreciation became considerable, damaging domestic industrial goods. Amid repression and fueled by the 1978 World Cup victory, cheap imports and foreign tourism offered some respite. The foundations of the scheme, however, were highly frail. It depended on the continuous availability of cheap dollar credit in international markets, something challenging to happen. Thus speculation against the peso grew. Spurred on by higher dollar rates and made possible by financial openness, many agents thrived on the “financial bicycle.” To avoid the abrupt end of La Tablita, the government itself took external debt—mainly through state-owned companies—and made them available to speculative private agents or tried to gain their confidence by increasing the stock of international reserves. After the 1979 Volcker shock that raised dollar interest rates, the mounting dollar debt cycle became explosive. The dollar shortage led to a run on banks and a financial

Argentina’s July 9, 1989, Independence Day was historical for two opposing reasons. For the first time since 1928, a democratically elected president had been succeeded by another elected one—leaving aside Juan D. Perón’s reelection in 1952. But this much-longed-for event happened amid feared, raving hyperinflation. Stepping down was Raúl Alfonsín, who had become president on December 10, 1983 following a violent military government that had taken power with a coup on March 1976, the sixth since 1930. Social demand for democracy marked Alfonsín’s term. The military government had conducted a “Dirty War” that tortured, killed, and abducted (the “disappeared”) presumed insurrectionists while thousands of people had to flee. The massive and murky scale on which this was done (claims of disappeared people reached 30,000) left a deep mark on Argentine society. This included a surprise takeover of the Islas Malvinas (Falkland Islands) in April 1982, leading to a three-month war with the United Kingdom. Young, unequipped, and inexperienced soldiers were sent and left to themselves against a professional and modern army. Because of this situation, when Alfonsín started office, social tensions were profoundly strained. His victory was related to the strong commitment he had always expressed to democratic values. One of his crucial campaign promises was that those responsible for the violence in previous years would be brought to justice. In 1985 the nine leading figures of the military government were judged and condemned in the historical Trial of the Juntas, the only known case of this kind in coup-ridden Latin America. Nevertheless, in the 1980s, democracy was weak, and the threat of another coup seemed impending. The hope for democracy was intertwined with the economic legacy left by the military. The country’s external debt was the most severe economic impact of the coup. Although it was a big issue—especially after Mexico’s 1982 default on its debt, which affected the whole continent—in 1984, the actual situation was unclear. From 1976 to 26

A modern Greek tragedy  27

crisis in 1980, which the government had to save with rediscounts. The government established an official guarantee on deposits and, in February 1981, abandoned the Tablita schedule. Following an exceptional 10 percent devaluation of the peso, a new monthly devaluation chart was announced— greater than the original one, but insignificant in view of the accumulated appreciation in the exchange rate. In March 1981, it ended any kind of Tablita scheme and a new 30 percent devaluation was applied. Fanelli and Frenkel (1990) call 1981–1983 the period of “chaotic adjustment.” A swelling recession, escalating inflation, a fast devaluation, and an out-of-control external debt—with unpaid interest rolling it up—forced the military to look for a way out. In 1982, the Central Bank (CB) allowed private agents to convert its debt in dollars into pesos, with foreign exchange assumed by the government. This meant that practically all the private external debt was passed to the state in what became known as “the socialization of the debt.” Their peso payments to the state would become liquefied due to large devaluations in 1982 and 1983 and set off the inflation rate (165 percent and 344 percent, respectively). To make matters worse, the international increase in oil prices augmented external imbalance by deteriorating the terms of exchange. Finally, the balance of payments became structurally disrupted after the August 1982 Mexican moratorium cut off new foreign financing flows to Latin America. This led to a massive capital flight movement by private agents that Frenkel, Fanelli, and Sommer (1988) estimate to have been around US$ 10 billion. Most of the debt was accumulated in the two years that combined financial, exchange, and commercial liberalization. Between 1978 and 1980, it grew by US$ 15 billion. The extreme degree of indebtedness can be seen from the severe changes that some debt indicators underwent. The debt/export ratio jumped from 195 percent in 1978 to 405 percent in 1983. The relationship between financial services and exports went from 10.6 percent to 69 percent in the same period; the relationship between debt and the domestic product grew from 21.6 percent to 53.6 percent (Cepal, 1990). The combination of the harmful effects of the deterioration in international terms of trade and the sharp increase in international interest rates led to

a rapid and disorganized reversal of liberal policies. Controls were reintroduced over all external markets while adopting successive devaluations—some considerable—to cope with the serious external imbalance. In 1984, when Alfonsín started his government, 80 percent of the external debt belonged to the state. Canitrot (1992) explains that the social generalized moral rejection of the military experience and attributed “the economic difficulties to the intrinsic perversity of the authoritarian régime, so as to deny the objective existence of the crisis.” He also points out that outburst of democratic exaltations—not least by Alfonsín himself, who had rallied his campaign over the slogan “Under democracy you eat, educate and cure”—subordinated economy to politics. In particular, he stressed that this was the case with the external debt, which was “collectively qualified as a fraud.” The first economic team, under Bernardo Grinspun, tried to manage the economy without formally recognizing the presence of foreign debt; as it was considered illegitimate, it thought it would receive political treatment (Canitrot, 1992). As the future CB president José L. Machinea (1990) points out, the government was not aware of the depth of the crisis either. In September 1984, the government had to resort to the IMF and sign a stand-by agreement, which required a devaluation, increased public tariffs, and a restrictive monetary policy. However, this accelerated inflation and Grinspun resigned. These events would become part of what Canitrot calls a “learning process” of the severity of the situation by the government. Juan Sourrouille, the new Minister of Economy, seconded by Canitrot, tried a whole new outlook with the Austral Plan of June 1985. A new currency, the Austral (₳), was introduced with a nine-month price freeze on a pre-arranged relative price structure. A discount chart was applied to convert contracts from the old to the new currency to avoid substantial income transfers from the abrupt fall in inflation. A fiscal deficit of 2 percent of GDP was accepted but only financed with external resources, previously agreed with the IMF (Machinea, 1990). Public revenues would come from the Olivera-Tanzi effect on tax collection, a temporarily forced savings mechanism, and higher export taxes. The initial drop in inflation made the Austral very popular. It combined with the Trial of the Juntas. Also, with Alfonsín

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28  Elgar encyclopedia of financial crises

becoming a leading continental figure of democratic values, as gradually neighboring countries began leaving their military governments behind. Notably, this was the case of historical regional rival Brazil. Alfonsín and President José Sarney of Brazil made a historical reversal of bilateral relations with the 1985 Agreement of Iguazú, which paved the way to Mercosur in 1991. The 1986 World Cup victory even fueled this. But the foundations of the Austral were fragile. It managed a sharp fall in inflation (from 672 percent to 90 percent), but a persistently low inflation rate led to cumulated real public tariffs and exchange rate delayed adjustments. The price freeze was not renewed but replaced by periodic adjustments of those variables, while the government allowed free wage negotiation between companies and unions (Machinea, 1990). However, inflation accelerated and forced the authorities to increase the exchange rate and public tariffs. In August 1986, the government announced a policy of falling adjustment rates to save the plan. It attempted two new short freezes in 1987, which did not hold inflation. To make matters worse, a sharp drop in international exchange alongside a flood that destroyed much of the rural output hit the essential basis of the country’s exports. This forced a reduction of taxes to compensate the affected sectors. All this severely damaged the flimsy sustainability of the plan. The increase in tax revenues was central in its design to hold confidence that no money would be minted to cover public expenses. Also, the much-desired economic recovery after years of recession pushed imports up, leading to a drop in the positive external balance from US$ 4.5 billion in 1985 to just US$ 2.1 billion the following year. Coupled with the 1987 setbacks, it fell further to only US$ 540 million. All in all, this meant that Argentina could not obtain the necessary dollars to service its debt. The service account that year became negative, close to US$ 5 billion. Argentina had tried to resolve part of the debt problem by questioning the legality of the interest rates charged, with several regional countries facing a similar situation. The results of this line of action were rather grim, and the Baker Plan presented by the US government with the IMF sponsorship was not deemed satisfactory.

During the “chaotic adjustment period,” the CB used the expedient of financing public sector spending through different types of intervention in the financial sector, which sometimes became quite sizeable. This gave rise to what was called a “quasi-fiscal deficit.” The Austral Plan tried to restrict this intervention in financial and exchange markets. But by 1987, it reached back to monetary financing and absorption at increasing interest rates. The quasi-fiscal deficit between 1987 and 1989 represented more than US$ 6 billion (Cepal 1991). At the same time, political tensions reappeared. A military group rebelled during Easter 1987. This prompted a substantial civil response condemning the uprising. Tens of thousands kept a tense civic vigil rally while the president tried to sort out the situation without bloodshed. Finally, Alfonsín returned and famously told a jubilant crowd “that the house was in order.” Shortly afterward, Congress passed the law Obediencia Debida (Duly Obedience) and Punto Final (End Point). The first limited the responsibility of lower military ranks for human rights violations during the coup; the latter established a final date for any further legal accusations on the matter. Both were taken as concessions to quell the uprising. Consequently, the government lost considerable support and performed poorly in the 1987 mid-term legislative elections, which left most of the provinces in the hands of the opposition Peronist party. Traditionally having the most popular support, the Peronist party also had robust historical ties with the powerful Trade Unions, who organized several successful general workers’ strikes. Realizing its weakness, in April 1988, the government declared a moratorium on the service of foreign debt. This led to losing the support of the IMF. Hence, the only resource of fresh dollars left was the World Bank. The Spring Plan launched in August, as Canitrot (1992) explains, was “a stabilization program conceived with the modest purpose of avoiding the hyperinflationary outburst before the presidential election in May 1989.” Without being able to adjust public tariffs because of their inflationary effects and without being able to tax, the government made a price agreement with the leading companies, which resulted in the reduction of the value-added tax from 18 percent to 15 percent, implying

Hernán Eduardo Neyra and Andrés Ernesto Ferrari Haines

A modern Greek tragedy  29

a total loss of resources of 0.5 percent of GDP (Machinea, 1990). However, the electoral context itself was the main factor of instability. The three leading presidential candidates (including Eduardo Angeloz, from the official party) called for the exchange rate liberalization. Peronist Carlos Menem, who widely led the polls, defied any justification of restraint, stating that it would interrupt external payments for 3 to 5 years, cut taxes 50 percent and give out a salariazo (100 percent increase in wages), among other populist and nationalist measures. Thus, exchange rate and fiscal instability are combined with political uncertainty. According to Canitrot (1992), “in retrospect, the only chance of The Spring Plan to reach its goal resided in the remote chance of a reversal of election polls in favor of the official candidate. Otherwise, with a foreseeable triumph of the opposing candidate, announcing a populist and nationalist platform, an abrupt run of funds to the dollar was unavoidable.” This began to happen after the World Bank withdrew its support in January 1989. People started to turn their Australs into dollars. Facing a sharp drop in its reserves, the CB decided to withdraw from the market on February 6, and a liberated dollar began an upward path fueled by an uncertain political context. The consumer price index, around 7 percent per month during the last quarter of 1988, doubled in March 1989 and again in April. Two months later, it was out of control. Finally, amidst ravaging inflation in July, the transfer of political power was anticipated, starting a new political and economic process. In short, the financial crisis in the public sector deteriorated in 1989. Between March and May, several changes of economic ministers revealed how fragile the government was. The quasi-fiscal fueled the growing fiscal deficit. The lack of external credit exacerbated the need for minting and internal credit. However, the interest rates needed to sterilize the monetary stocks kept increasing. Hence the deficit in the BC’s accounts became as important, exceeding US$ 3,000 million in 1989. The outflow of deposits led M1 to represent just 1.4 percent of GDP (Cepal, 1991). The failed attempts to privatize several companies, the continuous erosion of public income due to inflation, the freezing of wages with high unemployment that intensified

social discontent, with some goods-shortage, additional power cuts due to droughts that affected the hydroelectric plants, and the appearance of looting in Greater Buenos Aires, all combined to fuel the severe crisis that arose from the lack of reserves in the CB. At the same time, the rising interest rates to demanded state bonds; the outflow of deposits to be dollarized from people desperate to preserve their purchasing power and the vast accumulated unpaid foreign debt interest fueled the ongoing crisis. The handover of command was planned for December, but the outlook for the next five months was chaotic. Hence, the succession was brought forward for July 8. With the change of government, inflation fell rapidly, but only momentarily. Amid prices still going out of control, a temporal confiscation of bank deposits was made, forcedly exchanging them with government treasury bonds (the Bonex plan). After two further hyperinflationary outbreaks between 1990 and 1991, new economic minister Domingo Cavallo could finally curb rising inflation with a radical currency board-style convertibility of the Austral to the American dollar. This was enhanced by the renegotiation of debt payments under the Brady Plan. These changes were part of a whole set of market-friendly structural reforms under the aegis of the Washington Consensus and the new liquidity in international financial markets. Altogether, they put the Argentine economy on a new course, despite not avoiding another crisis a decade later. Hernán Eduardo Neyra and Andrés Ernesto Ferrari Haines

References

Canitrot, Adolfo. “La macroeconomía de la inestabilidad.” Boletín Informativo Techint N°272. Buenos Aires, 1992. CEPAL. Indicadores Macroeconômicos de La Argentina. Buenos Aires, 1990. CEPAL. El déficit cuasifiscal: el caso argentino (1977–1989). Santiago de Chile, 1991. Fanelli, José Maria and Frenkel, Roberto. Políticas de estabilización e hiperinflación en Argentina. Buenos Aires: Tesis, 1990. Ferreres, O. J. Dos siglos de economía argentina: edición Bicentenario 1810–2010; Historia argentina en cifras. Buenos Aires: El Ateneo, 2010. Frenkel, Roberto, Fanelli, José Maria, and Sommer, Juan. “El proceso de endeudamiento

Hernán Eduardo Neyra and Andrés Ernesto Ferrari Haines

30  Elgar encyclopedia of financial crises externo argentino.” Documento CEDES N°2. Buenos Aires, 1988. Gerchunoff, Pablo and Cetrángolo, Oscar. “La estabilidad económica en democracia Política. Examen de una experiencia frustrada.” Mimeo. Buenos Aires, 1989. International Monetary Fund. “World Economic Outlook database.” Accessed April 19, 2021.

www​.imf​.org/​en/​Publications/​WEO/​weo​ -database/​2021/​April. Machinea, José Luis. “Stabilization under Alfonsín’s government: A frustrated attempt.” Documento CEDES N°42. Buenos Aires, 1990. World Bank. “Argentina.” Accessed April 19, 2021. https://​datos​.bancomundial​.org/​pais/​ argentina​?view​=​chart.

Hernán Eduardo Neyra and Andrés Ernesto Ferrari Haines

7. Asian financial crisis

exposed internal fragilities. The U.S. had a sub-prime crisis that was worsened by an undercapitalized and overleveraged financial system, including funding by European banks. The Euro debt crisis was triggered when European banks operating in the U.S. had to seek dollar funding. Still, it also exposed the European banks’ significant exposures to Southern European economies. Under the single Eurozone currency regime, the crisis Southern European countries could not devalue and had to undergo massive deflation and external aid from the Northern surplus countries. Thus, both the AFC and GFC were network crises, relieved only through central bank liquidity. All financial crises have common causes. Writing on the 1929 Great Crash, John Kenneth Galbraith (1954) concluded that “the economy was fundamentally unsound” with five weaknesses: the unequal distribution of income; corrupt corporate structure, including larceny; poor banking structure; and the dubious state of the foreign balance. Although each crisis economy shared these common weaknesses, each had pecuniary features that amplified the shocks. At first, the capital outflows were largely withdrawals by foreign banks or reversals of carry trades that tried to earn local currency-dollar interest differentials. But once the outflow started, local money followed, creating a massive domestic systemic liquidity crisis that central banks could not deal with because the outflows became self-reinforcing foreign exchange liquidity and solvency crises. Firesales (Schleifer and Vishny, 2011) of stocks, bonds, and real estate to meet liquidity needs caused solvency losses for borrowers and lenders alike, worsened by the initial IMF policy recommendations of tighter fiscal and monetary policies. The IMF used the traditional approach of addressing financial crisis through their “two gap” approach—cuts in fiscal spending to reduce the fiscal gap and monetary tightening by raising interest rates and devaluation to address the balance of payments gap. Unfortunately, these measures worsened the liquidity crunch and caused a market panic. Thus both internal and external mistakes allowed the contagion to spread later to Russia and Brazil, creating a global crisis for emerging markets. Although the blame initially fell on the victim countries for policy errors and locals

The Asian financial crisis (AFC) erupted in 1997 when Thailand floated the baht on July 1. Contagion quickly spread around the region, with a series of currency devaluations, rapid capital flight, and collapses of asset prices. As banks failed with large-scale corporate failure, assistance was sought from the International Monetary Fund (IMF) to help manage the crisis. Although the Mexican crisis forewarned Asian central banks in 1994, few anticipated the ferocity of the crisis nor its speedy contagion. The Indonesian rupiah lost 80 percent in value against the dollar in the first six months. The Thai baht and South Korean won were down by half, with the Malaysian ringgit down by over 40 percent. Speculative attacks against the Hong Kong dollar ended with a significant unorthodox but successful intervention in 2008 (Goodhart and Lu, 2010). The sudden capital flight exposed the domestic frailties of each crisis economy. Still, few recognized the interconnectivity of the Asian global supply chain with the U.S. dollar-based financial networks, plus new financial derivative instruments that turbocharged foreign exchange volatility. All the crisis economies operated nominally flexible exchange rates. Still, the region behaved like a U.S. dollar-linked zone by keeping extremely stable rates against each other and the U.S. dollar. This facilitated payments and transactions across the Asian global supply chain that linked Japan, the Four Dragons (South Korea, Taiwan, Hong Kong, Singapore), later the Four Tiger (Thailand, Malaysia, Indonesia, and the Philippines) economies, and after 1998, China. For example, the Malaysian ringgit was roughly MYR2.5 to 1 USD before the crisis, whereas the Thai baht and Taiwan dollar were 25 to 1 USD. But once one currency devalued, it caused price changes in all other currencies within the same supply chain. In effect, the AFC was a foreign exchange crisis where exchange rate disruption triggered massive capital outflows that collapsed the financial system and economy, exposing fragile political regimes. Therefore, the AFC was a precursor of the 2007/9 global financial crisis (GFC) that erupted 10 years later in the United States, Europe, and Japan, where capital flows 31

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blaming the IMF and foreign speculators, the roots of the AFC were deep structural issues related to the more significant post-bubble Japanese financial crisis and deflation (Sheng, 2009).

Perspectives on AFC Economics Before the AFC erupted, economists noted that those East Asian countries that maintained a close link with the U.S. dollar would confront the Mundell-Fleming Impossible Trilemma (Majaski, 2020). Nations could not simultaneously maintain a fixed foreign exchange rate, allow free capital movements with minimal exchange controls and conduct an independent monetary policy. When Japan built the Asian supply chain by shifting production to the East Asian neighbors, Japan provided considerable foreign direct investment and bank finance to local companies that were subcontractors to Japanese manufacturers that relocated to the Dragon and Tiger economies. Because the ultimate export market was to the United States, supply chain financing conducted in U.S. dollars facilitated payments and production flows, creating de facto pegging of local currencies against the dollar. Out of ten East and South Asian economies, only Singapore, Taiwan, China, and India escaped the AFC because Singapore maintained a flexible exchange rate. Taiwan, China, and India had exchange controls. Nevertheless, none could escape the collateral damage of contagion shocks to stock markets and overall economic slowdown. The Washington Consensus shaped the political economy in the 1990s from the Bretton Woods institutions (IMF, World Bank, and World Trade Organization) pushing for open markets with high transparency, prudent fiscal and monetary policies, and sound regulation. For example, the IMF blamed the AFC on victim economies having “denial syndrome”, with wrong macroeconomic policies, overvalued real estate markets, weak and over-extended banking sectors, poor prudential supervision, substantial private short-term borrowing in foreign currency, and “crony capitalism” that eroded good corporate governance and fostered corruption (Camdessus, 1997). Similarly, the Andrew Sheng

U.S. Treasury and market analysts attributed market panic to the lack of transparency and policy inconsistencies that eroded market confidence. Other economists blamed three dominant factors: financial-sector-weaknesses-cum-eas y-global-liquidity-conditions, problems in the external sector, and contagion running from Thailand to other economies (e.g., Goldstein, 1998). Radelet and Sachs (2000) emphasized that while there were underlying problems for the victim countries, the imbalances were not severe enough to justify the magnitude of outflows. They thought that panic of the international investment community, policy mistakes by Asian governments, and poorly designed international rescue programs deepened the crisis more than necessary. In contrast, Joseph Stiglitz (2007) argued that the AFC problems did not lie just with the victim countries but also in the global financial architecture. He concluded that the flaws in the global financial architecture needed urgent reforms. In particular, the reform must address two critical lessons: the need to address dangerous surges in short-term “hot” money and global financial architecture reforms that promoted stability and growth without looking after only the interests of international lenders. Excessive financial risks The leading blind spot for crisis economies and the international community was rapidly growing risks in the financial sector. As hot capital flowed in the early 1990s in search of yield, financial institutions became grossly undercapitalized. Corporate debt rose rapidly to speculate in the booming stock and real estate markets. Few watched the unsustainable net foreign liability position relative to foreign exchange reserves. Financial sector claims on the private sector jumped from around 100 percent of GDP in 1990 to over 140 percent in Malaysia, Thailand, and Korea. The Korean financial system exemplified the weaknesses. Assets of banks and other financial institutions amounted to 115 percent of GDP, compared with 29 percent for the Korean stock market. At the end of 1997, private sector credit was 121 percent of GDP, with 30 largest Korean conglomerates recording an average debt-to-equity ratio of 519 percent.

Asian financial crisis  33

Politics Financial crises often have political origins. Rival AFC interpretations centered around two versions: “crony capitalism” involving internal corruption, lax regulation, and bad corporate governance; and an external “financial panic triggering debt deflation” narrative that saw systemic flaws and external causes (Head, 2010). The first version stressed the role of large business conglomerates with substantial political clout in Korea, Thailand, and President Suharto’s family in Indonesia. Politicians and businesses benefited from the hot money inflows. Local businesses borrowed hugely from local banks without proper collateral and checks, thus exposing the banking system to large non-performing loans when the crisis came. Because local interest rates were higher than dollar rates, these corporations borrowed heavily in U.S. dollars, assuming that export incomes and asset prices would continue to rise. Thus, Korean chaebols, Indonesian conglomerates, Thai finance companies/business groups, and Malaysian businesses got into trouble once the currency was devalued. Once the giant borrowers failed, the banks and finance companies suffered runs, so the central banks faced failing banking systems even as the currency collapsed. The Indonesian crisis coincided with pending presidential elections and fears of regime change, accelerating capital flight from the rupiah to the dollar. An alternative political argument was that the international architecture was defective. If the crisis countries suffered a liquidity shock and each government’s debt position and fiscal deficits were not exceptionally large, the AFC would not have been severe if there were timely and sufficient bilateral and multilateral aid. Recognizing this as a supply chain crisis that affected her interests, Japan led the Association of Southeast Asian Nations (ASEAN) members to establish an “Asian Monetary Fund” but failed due to objections from the United States, Europe, and China. The largest IMF shareholders did not want another competitor to the IMF since the United States Treasury could influence the IMF loan conditionalities to push through reforms to eliminate “crony capitalism” and open up markets in line with the Washington Consensus. Unfortunately, such conditionalities had domestic political consequences

because they disrupted the vested economic and political interests. During the AFC period, the IMF provided Thailand, Indonesia, and Korea with a total of US$35 billion in financial support, plus helping mobilize an additional US$77 billion of supplementary financing from multilateral banks and bilateral sources. Malaysia refused to accept IMF conditionality and implemented exchange controls, sparking an internal political struggle between the Prime Minister and his Deputy/Minister of Finance. Links with Japan, Yen, and asset bubbles At the time, few analysts associated the AFC with the problems of the Japanese economy. This was corrected as more studies of Japan’s lost decade revealed the interconnections (Yoshino and Taghizadeh-Hesary, 2015). For example, the withdrawal of Japanese funds from Asia was closely associated with the Japanese banking crisis of 1997/98 (Himino, 2021). From 1992 to 2000, 110 deposit-taking institutions were dissolved, and Japan spent 17 percent of GDP dealing with Japanese non-performing loans (Nakaso, 2001). As authorities pressed the banks to recognize their NPLs on real estate and business loans, the shortage of capital after 1995 forced them to cut their dollar assets, which led to the pulling back of credit to Japanese and Asian companies in East Asia (Sheng, 2009). Japan also used a combination of loose fiscal and monetary policies that lowered interest rates domestically and allowed the Yen to depreciate. Radelet and Sachs (2000) identified how after the Yen’s devaluation against the dollar in 1994, each of the four Southeast Asian countries suffered real appreciation exceeding 25 percent. Paradigm shift The AFC also caused a significant reconsideration of mainstream economic and financial policy thinking, leading to reforms in several directions. Instead of looking only at flows, there was a shift in examining balance sheets (stocks analysis). Nomura Chief Economist Richard Koo (2014) highlighted how secular stagnation occurred through households and firms re-building their balance sheets after the asset bubbles burst. After the AFC, economists began to look also at network effects (Sheng, 2010; Haldane, Andrew Sheng

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2009). At the same time, analysts began associating financial crises with national security concerns. The U.S. Defense Department took an active interest when South Korea fell into financial crisis because it had U.S. troops stationed there (Hale, 2007). The most significant AFC impact was the demand of the emerging markets for greater representation and voice in international financial architecture reforms in preventing crisis (Crockett, 2007). As a result of the AFC, the G22 precursor of G20 was established to reform the IMF, set financial regulatory policies and standards, and coordinate broader economic policies better. This led to the creation of the Financial Stability Forum and more emerging market representation in the IMF in terms of voting power. The legacy of the painful, profound AFC lessons helped Asian economies to avoid the worst effects of the GFC in 2007/9 (ADB, 2017). Andrew Sheng

Haldane, A. 2009. Re-thinking the Financial Network. Speech by Andrew G. Haldane at the Financial Student Association, Amsterdam, April 28. Retrieved from www​.bis​.org/​review/​ r090505e​.pdf. Hale, D. 2007. The East Asian Financial Crisis. Goldman Sachs Asia Seminar, Malaysia, October. Head, J.W. 2010. The Asian Financial Crisis in Retrospect: Observations on Legal and Institutional Lessons Learned after a Dozen Years. East Asia Law Review, Vol. 5 (No. scholarship​ .law​ 1). Retrieved from https://​ .upenn​.edu/​cgi/​viewcontent​.cgi​?article​=​1040​&​ context​=​ealr. Himino, R. 2021. The Japanese Banking Crisis. Tokyo: Palgrave Macmillan. Koo, R. 2014. Balance Sheet Recession Is the Reason for “Secular Stagnation”. Voxeu. Retrieved from https://​voxeu​.org/​article/​balance​ -sheet​-recession​-reason​-secular​-stagnation. Majaski, C. 2020, November 22. Trilemma Definition. Investopedia. Retrieved from www​ .investopedia​.com/​terms/​t/​trilemma​.asp. Nakaso, H. 2001. The Financial Crisis in Japan during the 1990s: How the Bank of Japan Responded and the Lessons Learnt. BIS Papers References No. 6. Retrieved from www​.bis​.org/​publ/​bppdf/​ ADB. 2017. 20 Years after the Asian Financial bispap06​.pdf. Crisis: Lessons Learned and Future Challenges. Radelet, S. & Sachs, J. 2000. The Onset of the East ADB Briefs No. 85. Retrieved from www​.adb​ Asian Financial Crisis. In P. Krugman (ed.), .org/​sites/​default/​files/​publication/​367226/​adb​ Currency Crises (pp. 105–153). Chicago, IL: -brief​-85​.pdf. University of Chicago Press. Camdessus, M. 1997. The Asian Crisis and the Sheng, A. 2009. From Asian to Global Financial International Response: Address by Michel Crisis: An Asian Regulator’s View of Unfettered Camdessus. Institute of Advanced Business Finance in the 1990s and 2000s. Cambridge: Studies (IESE) of the University of Navarra, Cambridge University Press. Barcelona, Spain, November 28. Retrieved Sheng, A. 2010. Financial Crisis and Global from www​.imf​.org/​en/​News/​Articles/​2015/​09/​ Governance: A Network Analysis. Commission 28/​04/​53/​spmds9717. on Growth and Development Working Paper Crockett, A. 2007, September 6. Lessons from No. 67, World Bank. Retrieved from https://​ the Asian Crisis. Dinner remarks prepared for openknowledge​.worldbank​.org/​handle/​10986/​ the conference “The Asian Financial Crisis 27785​?show​=​full. Revisited: Challenges over the Next Decade”, Schleifer A. and Vishny, R. 2011. Fire Sales San Francisco, September 6. Retrieved from in Finance and Macroeconomics. Journal www​.frbsf​.org/​economic​-research/​files/​ of Economic Perspectives, Vol. 25 (No. 1), crockett​.pdf. pp. 29–48. Galbraith, J.K. 1954. The Great Crash 1929. Stiglitz, J.E. 2007, July 1. The Asian Crisis Ten London: Penguin Books. Years After. Project Syndicate. Retrieved from Goldstein, M. 1998. The Asian Financial Crisis. www​.project​-syndicate​.org/​commentary/​the​ PIIE, Policy Brief 98–1. Retrieved from www​ -asian​-crisis​-ten​-years​-after​-2007–07. .piie​.com/​publications/​policy​-briefs/​asian​ Yoshino, N. & Taghizadeh-Hesary, F. 2015. -financial​-crisis. Japan’s Lost Decade: Lessons for Other Goodhart, C. & Lu, D. 2010. Intervention to Save Economies. ADBI Working Paper 521. Hong Kong: Counter-Speculation in Financial Retrieved from www​.adb​.org/​sites/​default/​ Markets. Oxford: Oxford University Press. files/​publication/​159841/​adbi​-wp521​.pdf.

Andrew Sheng

8. Assessing reserve management during economic crises: lessons from Indonesia and Nigeria

omies from shocks by examining the cases of Indonesia and Nigeria, two oil-producing economies. Indonesia’s economy has benefitted from diversification away from its oil sector and financial deepening following successive crises. Nigeria, which is facing similar challenges, could seek to emulate some of Indonesia’s policies by embarking on a reform agenda that includes a credible free float of the naira and strengthened reserve management. There is a raft of policies to increase economic resilience in the face of such uncertainty, with the most important ones being on the real side, including diversification. Still, financial policies are also important, especially in the short term. There are means to protect an economy in times of uncertainty: countries that had built up their reserves fared better when capital inflows slowed between 2010 and 2015. And reserve management is key in resource-dependent economies because they are more vulnerable to commodity and oil price swings. Comparing the two economies of Indonesia and Nigeria is useful in that they are the largest economies in the South-East Asian and sub-Saharan African regions. Both are oil producers that have countered successive crises in differing ways.

In the aftermath of the 2008 global financial crisis, several advanced economy central banks started a period of unconventional monetary policy, some of which is still ongoing. The United States Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan were among those that embarked on quantitative easing (QE) in light of the fact that a number of these banks had started to approach the ‘zero lower bound’ in conventional policy interest rates. This form of QE was implemented through asset purchases, which facilitated direct injections of liquidity into the various sectors of the economy – the scale of which was unprecedented at the time. This increased global liquidity has led to, among other things, nearly a decade of low interest rates, and in some cases, negative real (inflation-adjusted) interest rates. Low US yields encouraged investors to seek higher returns at higher risk and catalysed investment flows into emerging and developing countries (Fratzscher et al., 2012; Forbes and Warnock, 2012). In some cases, in the past, these types of flows have led to higher short-term debt-to-reserves ratios that caused financial crises and sharp reversals in investment inflows (Benmelech and Dvir, 2013; Rodrik and Velasco, 1999; Calvo, 1995). In this entry, we compare two oil-producing economies, Indonesia and Nigeria, and draw lessons from Indonesia’s management of its crises. Since the 2008 global financial crisis, developing economies have been increasingly exposed to economic shocks. Increasingly open emerging and developing economies could be supported by central banks engaging in more proactive reserve management policy and financial deepening. This is particularly important for resource-producing economies that are vulnerable to oil and commodity price swings. This entry explores how policymakers can help shield their econ-

Reserve developments: key in crises management

To understand the significance of having adequate reserves in times of crisis, we first consider the South-East Asian (SEA) crisis, where the decline in reserves was as high as 40 percent (in Korea) between 1996 and 1997. The policy responses to the crisis played a significant role in rebalancing reserves and adjusting current-account imbalances as the economies recovered (Radelet and Sachs, 2000; Shrestha and Wansi, 2014). Their ongoing liberalization and increased openness to capital inflows – and outflows – increased the need for liquidity buffers (Edwards, 2005). Given this, the crisis led SEA countries to re-calculate the costs of not having reserves, changing the balance between those costs and the costs of holding them (Schroder, 2015). Within this context, oil-exporting economies have been particularly subjected to uncertainty. In addition to the US Federal Reserve raising its interest rates, the 35

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2014–2015 oil price decline constituted a terms-of-trade (TOT) shock that further exacerbated their balance-of-payment positions. For example, Nigeria’s specific vulnerability has been its high export dependence on petroleum. Moreover, its additional liquidity needs arising from the oil and commodity price decline were not adequately addressed through the central bank of Nigeria’s (CBN) reserve management, including through their sovereign wealth fund (SWF), the Nigerian sovereign investment authority (NSIA). We argue that emerging and developing country central banks should be more proactive in their reserve and exchange rate policies as their balance sheets become more exposed to global financial markets. This article explores the drivers of reserve accumulation, including the continued need for developing economies to self-insure against future crises. The successful re-accumulation of reserves after the SEA crisis was partly the product of financial deepening and maintaining undervalued exchange rates. We consider how exchange rate policies helped rebuild reserves following the SEA crisis and conclude that oil producers, such as Nigeria, which floated their currencies in order to stem reserve depletion, could look to Indonesia’s policy of smoothing currency volatility and building domestic financial breadth to aid recovery.

The Indonesian experience during the SEA crisis

The SEA crisis is essential to consider when considering reserve management, given that the particular economies that were hit by the crisis were rapidly growing and liberalizing their financial systems. As substantial investment inflows entered Indonesia, Korea, Malaysia, and Thailand, the region’s ‘boom cycle’ attracted more funds despite weak banking systems, poor corporate governance, and little domestic absorptive capacity to channel the foreign funds (Aghevli, 1999). Short-term debt was a key vulnerability within weak financial institutional systems (Edison et al., 1998; Cline, 2015). Widespread corruption and inadequate legal foundations were magnifying factors that had been ‘masked’ by the capital inflows preceding the crisis (Moreno, 1998; Radelet and Sachs, 2000). Phyllis Papadavid

The trigger for crisis transmission between the SEA economies was through their exchange rates. The devaluation of the Thai baht on 2 July 1997 triggered domino devaluations in Malaysia on 14 July 1997 and in Indonesia on 14 August 1997 (Carson and Clark, 2013). Concerns about successive economies’ macroeconomic and financial stability triggered expectation shifts that destabilized their (fixed and semi-fixed) exchange rate pegs and caused speculative currency attacks. The regional depreciations varied due to the speed of central banks’ intervention (Kihwan, 2006) and the types of capital controls that were put in place (Hasan, 2002). Indonesia’s economy was one of the worst hit, contracting by 14 per cent in 1998 and seeing the rupiah depreciate from Rp2,909 to Rp10,014 per US dollar between 1997 and 1998 (Radelet 1999). The SEA crisis illustrates the fact that, once the financial crisis hit and spread, the investment outflows associated with the speculative attacks were larger than the ability of any individual central bank to offset them with the reserves they had accumulated, counter currency weakness, or uphold their currency pegs. This underscores the unsustainable ‘trilemma’ of monetary independence, a fixed exchange rate, and mobile capital flows (Mundell, 1963), whereby unrestricted capital flows and independent monetary policy require flexible exchange rates. Most SEA economies introduced flexible exchange rates (except Malaysia’s) that triggered initial currency volatility in the real effective exchange rate (REER). Indonesia’s exchange rate volatility, in particular, in the post-crisis period exceeded the volatility of its reserves (Hernandez and Montiel, 2001). However, ultimately, the flexibility in the rupiah led to a stabilization in Indonesia’s foreign exchange reserves. A key feature of the crisis was that, although SEA foreign exchange reserves fell dramatically, the subsequent post-crisis recovery in foreign exchange reserves was even more notable. By the end of 1997, foreign exchange reserves had declined by 23 per cent, 31 per cent, and 40 per cent in Malaysia, Thailand, and Korea, respectively. However, owing to the reserve management and exchange rate policies employed, from 1998, Indonesia’s foreign exchange reserves increased from $17.4 billion to over $100 billion in 2008, with other SEA economies also seeing a significant accumulation.

Assessing reserve management during economic crises  37

Significant accumulation could also be seen in Thailand – its foreign exchange reserves peaked close to $200 billion, up from a low in July 1997 of $26 billion.

Nigeria’s oil-induced naira crises

Nigeria bore the brunt of a significant TOT shock stemming from the 2014/2015 oil price decline that had a knock-on effect on its export revenues. The decline in oil prices reflected several structural factors, including reduced demand from China and US energy independence (Papadavid, 2016). Following a 50 per cent decline between mid-2014 and mid-2015, the West Texas Intermediate measure of oil prices has hovered at around $40-$50 per barrel, down from its 2014 peak of $107 per barrel. Oil-producing economies, such as Nigeria’s, saw more considerable reductions in their foreign exchange reserve positions relative to oil-producing economies with freely floating exchange rates. The deterioration in domestic economic activity and foreign exchange revenues saw subsequent pressure on the naira exchange rate, leading to the eventual abandonment of the naira peg. Nigeria saw a 42 per cent reduction in its reserves from its 2008 peak. This was due to the fall in revenues and the CBN’s attempts at naira stabilization. Facing a depletion in its reserves, when Nigeria announced that it was abandoning its exchange rate peg (Central Bank of Nigeria, 2016a) it faced the common problem for a newly de-pegged currency: managing naira volatility along with the underlying question of where the naira will settle. Not all central banks can influence exchange rates, nor are they all good judges of where their currencies are reasonably valued. Following the de-pegging, the nominal effective exchange rate (NEER) has corrected to a level consistent with lower oil prices. Continued volatility in investment flows could create deviations in the exchange rate from its medium-term equilibrium value that can increase the risk of further crises (Gourinchas and Obstfeld, 2011) – a key risk for Nigeria. According to Nigerian stock exchange data, equity transactions were down 40 per cent in the period between January and September 2016 compared to 2015. Post-crisis reserve declines, both in the aftermath of the SEA crisis and after the oil price decline, underscore the importance

of reserve and currency management. In a situation of volatile currency moves, the SEA crisis showed that currency intervention could be an essential tool to smooth currency movements and, in some instances, help reaccumulate reserves. Bank of Indonesia (BI) used such a strategy to recover from the SEA crisis and continues to use the rupiah as a tool in its monetary policy mix (Warjiyo, 2013). Amid the ‘middle ground’ of managed exchange rates (Aizenman and Ito, 2011; Ostry et al., 2012) and the ‘fear of floating’ (Calvo and Reinhart, 2000), having been hard hit by the oil price decline, Nigeria continues to grapple with how it utilizes its exchange rate policy and its reserves management to rebuild its reserve position, for a sustainable economy.

The political economy of reserve management

This distribution of political power is important in an economy as it can determine the income allocated to reserves and a country’s exchange rate regime. The SEA crisis was significant in that it marked a turning point in reserve management in the SEA economies. Indonesia engaged in active reserve management policies to accumulate reserves, making its financial system resilient. Indonesia operated a currency and reserve management policy that critically supported the broader economy, whereas Nigeria has not successfully used its reserves to diversify into the non-oil sector. We discuss reserve management in the context of central bank financial independence and consider the political economy of Indonesia’s and Nigeria’s reserve management policies, respectively. Central bank independence is a key element of a country’s political economy. It endows the central bank with the power to make decisions free from political influence. Developing countries’ central bank independence is important to achieve the targets that they have set – such as price stability. In addition to legal or operational independence, building financial independence of developing country central banks (such as no monetary financing) is a key policy issue given the increasing impact of global financial volatility on banks’ balance sheets (Ivanovic, 2014). Some financial independence also represents the power and indePhyllis Papadavid

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pendence to allocate capital and to effectively carry out reserve management and exchange rate policies, particularly in times of crisis.

Indonesia’s political economy

Post-crisis exchange rate policies in SEA actively targeted recovery in real economic activity and in reserves. Collectively, they were broadly characterized as floating regimes, yet central banks actively smoothed the volatility in the NEER, resisted real exchange rate appreciation, and employed smoothing interventions consistent with a build-up of reserves. The resulting reserve accumulation and relative depreciation in the SEA REERs enhanced competitiveness and contributed to a recovery in real activity by encouraging exports (Hernandez and Montiel, 2001). As a result, SEA’s strong export growth (that outpaced its GDP growth at the time) led to sizeable current-account surpluses and foreign exchange reserve accumulation. During the 2008 financial crisis, increased independence and institutional strength meant that the BI was successful in its liquidity-based interventions to stabilize its financial system (Mustika et al., 2013). In 2008, BI instituted surveillance and monitoring of the banking sector’s internal capital adequacy. Crucially, its use of a bilateral swap facility with Bank of Japan, Bank of Korea, and Bank of China allowed it to stabilize its balance-of-payments position. Furthermore, BI engaged in a dual intervention (purchasing both rupiah and rupiah-denominated bonds) to increase liquidity in the commercial banking sector and stabilize the rupiah – notwithstanding the government’s contrary policy of issuing securities and tightening bank liquidity (International Monetary Fund, 2015). The mercantilist motive has been an important driver behind Indonesia’s reserve accumulation in past crises. In this respect, the political economy of Indonesia’s early exchange rate policy contrasts with Nigeria. Following the oil price shock of 1973, Indonesia’s exchange rate appreciation between 1974 and 1978 was equally as pronounced as Nigeria’s. However, fearing the impact of domestic costs on labour-intensive non-oil export sectors and having doubts about the sustainability of the ‘oil boom’ at the time, Indonesia devalued the rupiah Phyllis Papadavid

by 50 per cent. It subsequently allowed the currency to depreciate until it was devalued again in 1983. Crucially, Indonesia implemented a fiscal expenditure reduction before the fading of the second oil boom (Gelb, 1988). Since the SEA financial crisis, the region’s monetary authorities have increased their foreign exchange reserve holdings; there has also been a paradigm change in their behaviour towards more actively accumulating reserves (Aizenman and Marion, 2003; Filardo and Siklos, 2015). Although there had been an element of mercantilism in influencing Indonesia toward reserve accumulation, triggered by export competitiveness concerns (Dooley et al., 2003), the SEA crisis was significant in that it changed the incentives for reserve accumulation to being more precautionary; the intention being to reduce vulnerability to future crises (Brugger, 2015). From a political economy perspective, Indonesia’s sovereign wealth fund (SWF) has been a powerful investment tool to increase a country’s income, or its central bank reserves. It can be sourced from various economic sectors, including resource exports, privatizations, or balance-of-payment surpluses. Indonesia’s SWF, the Government Investment Unit (GIU), was established in 2007 and oversaw an estimated $500 million in assets. Like most SWFs, it is a state-owned investment fund managed by the Indonesian Ministry of Finance and invests in various asset classes, including equity, debt, infrastructure, and clean energy. Another SWF will likely control $320 billion in assets by 2019 and will replace the state-owned enterprise (SOE) ministry to manage and raise finance for Indonesia’s 199 largest SOEs (Braunstein and Caoili, 2016) – an effective means through which Indonesia’s government can increase strategic, or political, control via SOEs.

Nigeria’s political economy

CBN independence has been tested both on an operational and a financial level. Its independence was questioned when proposed legislation in 2012 would have forced it to submit its budget for approval to the national assembly. This would effectively bring the CBN under political influence (Stella, 2005). A second bill introduced in the lower house of Nigeria’s parliament proposed that board

Assessing reserve management during economic crises  39

members be allowed to be replaced with political appointees (Rice, 2012). The CBN has been subjected to often misguided political interference. President Buhari was quoted as opposing naira devaluation, stating that he would not ‘kill the naira’ in January 2016 (Wallace and Onu, 2016) aimed in part at protecting the purchasing power of Nigeria’s consumers and the sectors (oil and finance) that benefit from a strong naira. This intervention delayed the eventual transition to a more flexible exchange rate regime in mid-2016, costing the CBN further in terms of its foreign exchange reserves to defend the naira peg. Discussion around Nigeria’s political economy centres on its oil sector’s more narrowly defined economic benefits. Elements of authoritarianism persist in Nigeria’s institutions that foster a narrow set of interests, and ultimately, the government is still controlled by oil. A strong indication of this is that reserves were accumulated, rather than invested in protecting these concentrated interest groups. The decades-long dominance of the oil sector has benefitted ethnic majority elites at the expense of larger groups of ethnic minorities, including those from the oil-bearing Niger Delta region (Omeje, 2006). In the joint ventures operated by the federal government and foreign oil multinational companies, 90 per cent of employed personnel have been Nigerian nationals (Omeje, 2011). However, unlike in Indonesia, reserves were not diverted to support the non-oil sector. There is some evidence that more profound financial sector reform would support Nigeria’s economy, given that the banking sector has not contributed significantly to Nigeria’s growth and development. The link between the financial and the real sectors remains weak, given that Nigeria’s banks have focused on short-term lending rather than long-term investments in the real economy (Olusegun et al., 2013). This has been due to undercapitalization and non-performing loans, which increased 158 per cent between the end of December 2015 and June 2016 (Central Bank of Nigeria, 2016b). This falls, in large part, under the remit of the CBN and the Nigerian Deposit Insurance Corporation: both are Nigeria’s banking regulators and ensure the soundness and stability of the

financial system and license microfinance banks. From a political economy perspective, Nigeria’s SWF, the NSIA was primarily established to safeguard its oil wealth and was established in the later stages of the recent commodity and oil price boom, in May 2011, with seed funding of $1 billion. It aimed to build a savings base for the Nigerian people, enhance domestic infrastructure and provide stabilization amid crisis. It is designed to provide liquidity in times of economic distress. And yet, its structure might make decision-making difficult and lead to sub-optimal investment decisions and declines in Nigeria’s invested income. An example of this could be the rule that allows for discretionary withdrawals by the Ministry of Finance from the SWF. A second example of undue political influence in the management of the NSIA is the inclusion of the president of Nigeria and Nigeria’s 36 state governors in the NSIA governing council, making political autonomy and decision-making difficult in the light of some of the governors’ push for the decentralized distribution of the economy’s oil reserves (Nwankwo and Ikpor, 2014).

Global policies for sustainable investment

Several policy options could be explored at the global level that would build resilience against shocks. This is important in light of the fact that many countries have built up precautionary reserves to ‘self-insure’ in the absence of adequate global financial governance. Global policy options to support investment could include increasing the involvement of development finance institutions (DFIs), improving best practices for SWFs, and information exchange with the international finance sector. On this basis, options for expanding current initiatives to improve access to investment, and liquidity, are as follows: ● DFIs from both emerging and developed economies could help catalyse longer-term investment in less developed countries and help to ‘bounce back better’ (Griffith-Jones and te Velde, 2020) as they can be a key conduit between the private (and financial) sector and governments. The instruments that DFIs can Phyllis Papadavid

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help build would create domestic financial capacity and mitigate some of the financial and liquidity risks that vulnerable countries face during times of crisis. Introducing the institutional capacity for broader usage of financial derivative instruments would enhance the ability to scale up investments. ● The International Forum of Sovereign Wealth Funds (IFSWF) could strengthen its best practices for the conduct of SWF investment practices, particularly in their funding and withdrawals. SWFs help promote growth by undertaking cross-border investments and are central in their importance to achieving macroeconomic stability given their longer-term investments. All IFSWF GAPP (Generally Accepted Principles and Practices) countries should publicly disclose their specific policies and rules concerning funding and withdrawals from their SWFs and implement those rules according to particular earmarks and their respective fiscal budgets – to promote macroeconomic stability. ● The Bank for International Settlements (BIS), whose remit is to serve central banks in their pursuit of monetary and financial stability and to foster international cooperation, could engage in broader monitoring of high-frequency trading (HFT) in developing countries. The BIS markets committee has found that automated electronic trading, of which HFT is a part, can pose risks to market liquidity and functioning and needs to be monitored by policymakers (BIS, 2011). BIS markets analysis could include the transmission of HFT on developing countries’ macroeconomic stability. At a time when global economic growth is showing little sign of acceleration, and financial risks are elevated, the onus is on developed and developing country banks to employ tools that mitigate and counter financial shocks. One way to mitigate risks is to help economies further develop financial instruments to counter risk and scale up investment: DFIs could play an even more instrumental role in this process. Stronger global guidelines to ensure the accountability Phyllis Papadavid

of SWFs are important to explore as their assets under management grow. Economies managing multiple challenges, like Nigeria’s, should not delay institutional and macroeconomic reforms, such as diversifying its economy from the oil sector and moving to a more credible freely floating exchange rate regime.

Conclusion

Our analysis suggests that Indonesia’s policymakers realized the benefits of supporting the non-oil sector early on, around the global oil price shock of 1979, which then meant that their macroeconomic policies started to represent a wider range of economic interests. In contrast, Nigeria’s oil industry grew in its economic and financial dominance, with the benefits of the oil sector not being fully shared in the economy. These developments have had knock-on impacts on the domestic institutions whose aim is to manage financial shocks, such as their SWFs. Amid continued finance-led globalization, open emerging and developing economies will need to be more proactive in managing their domestic foreign exchange reserves to protect against shocks. Economies in recession, such as Nigeria’s, that are increasingly exposed to financial shocks should look to increase the breadth of their financial systems to effectively employ financial tools in aid of reserve accumulation, and to maintain freely floating exchange rates with currency interventions aimed solely at limiting volatility and disorderly market moves. Countries with managed or fixed exchange rates should question the cost of maintaining those regimes in terms of lost reserves and maintaining policy credibility. Phyllis Papadavid

References

Afiemo, O.O. (2013) ‘The Nigerian money market’. Understanding Monetary Policy Series No. 27. Central Bank of Nigeria. Aghevli, B.B. (1999) The Asian Crisis: Causes and Remedies. Washington, DC: International Monetary Fund. Aizenman, J. and Ito, H. (2011) The Impossible Trinity, the International Monetary Framework, and the Pacific Rim. Cambridge, MA: National Bureau of Economic Research. Aizenman, J. and Marion, N. (2003) ‘Foreign exchange reserves in East Asia: why the high

Assessing reserve management during economic crises  41 demand?’ San Francisco, CA: Federal Reserve Bank of San Francisco. Economics Letters 5(2). Bank for International Settlements (BIS) (2011) ‘High frequency trading in the foreign exchange market’. Basel: BIS. Benmelech, E. and Dvir, E. (2013) ‘Does short-term debt increase vulnerability to crisis? Evidence from the east Asian financial crisis’. Journal of International Economics 89: pp. 485–494. Braunstein, J. and Caoili, A. (2016) ‘Indonesia: the vanguard of a new wave of sovereign wealth funds?’ London School of Economics. Department of Government blog. Brugger, F. (2015) ‘Asia’s reserve accumulation: part of a new paradigm’. Working Paper 2015–03. Graz: Karl-Franzens- University Graz, Faculty of Social Sciences. Calvo, G.A. (1995) ‘Varieties of capital-market crises’. Washington, DC: Inter-American Development Bank. www​.iadb​.org/​res/​ publications/​pubfiles/​pubWP​-306​.pdf. Calvo, G.A. and Reinhart, C.M. (2000) ‘Fear of Floating’. Working Paper 7993. Cambridge, MA: National Bureau of Economic Research. www​.nber​.org/​papers/​w7993. Carson, M. and Clark, J. (2013) ‘Asian Financial Crisis’. www​.f​ederalrese​rvehistory​.org/​Events/​ DetailView/​51. Central Bank of Nigeria (CBN) (2016a) ‘Final Governor’s speech on New FX framework’. Abuja: CBN. Central Bank of Nigeria (CBN) (2016b) ‘Economic report, second quarter 2016’. Abuja: CBN. Central Bank of Nigeria (CBN) (2016c) ‘Financial stability report’. Abuja: CBN. Cline, W.R. (2015) ‘The financial sector and growth in emerging Asian economies’. Working Paper. Washington, DC: Peterson Institute for International Economics. Dooley, M.P., Folkerts-Landau, D. and Garber, P. (2003) ‘An essay on the revived Bretton Woods system’. Working Paper 9971. Cambridge, MA: National Bureau of Economic Research. Edison, H.J., Luangaram, P. and Miller, M. (1998) ‘Asset bubbles, domino effects and “lifeboats”: elements of the east Asian crisis’. Federal Reserve, International Finance Discussion Paper 606. Edwards, S. (2005) ‘Capital controls, sudden stops, and current account reversals’. Working Paper 11170. Cambridge, MA: National Bureau of Economic Research. Filardo, A. and Siklos, P. (2015) ‘Prolonged reserves accumulation, credit booms, asset prices and monetary policy in Asia’. BIS Working Paper 500. Basel: BIS. Forbes, K.J. and Warnock, F.E. (2012) ‘Capital flow waves: surges, stops, flight, and retrenchment’. Journal of International Economics 88(2): pp. 235–251.

Fratzscher, M., Lo Duca, M. and Straub, R. (2012) ‘A global monetary tsunami? On the spillovers of US quantitative easing’. CEPR Working Paper 9195. London: CEPR. Gelb, A. (1988) ‘Oil windfalls: blessing or curse?’ Washington, DC: World Bank/Oxford University Press. Gourinchas, P.-O. and Obstfeld, M. (2011) ‘Stories of the twentieth century for the twenty-first’. Working Paper 17252. Cambridge, MA: National Bureau of Economic Research. Griffith-Jones, S. and te Velde, D.W. (2020) ‘Development finance institutions and the coronavirus crisis’. ODI Briefing Paper, Overseas Development Institute, March. Hasan, Z. (2002) ‘The 1997–98 financial crisis in Malaysia: causes, response, and results’. Islamic Economic Studies 9(2): pp. 1–16. Hernandez, L. and Montiel, P.J. (2001) ‘Post-crisis exchange rate policy in five Asian countries: filling in the “hollow middle”’. Washington, DC: International Monetary Fund. International Monetary Fund (2015) ‘Indonesia: selected issues’. Washington, DC: IMF. Ivanovic, V. (2014) ‘Financial independence of central bank through balance sheet prism’. Journal of Central Banking Theory and Practice 2: pp. 37–59. Kihwan, K (2006) ‘The 1997–98 Korean financial crisis: causes, policy response, and lessons’. Washington, DC: International Monetary Fund. Moreno, R. (1998) ‘What caused East Asia’s financial crisis?’ FRBSF Economic letter. San Francisco, CA: Federal Reserve Bank of San Francisco. Mundell, R. A. (1963) ‘Capital mobility and stabilization policy under fixed and flexible exchange rates’. Canadian Journal of Economic and Political Science 29(4): pp. 475–485. Mustika, G. et al. (2013) ‘Did Bank Indonesia cause the credit crunch of 2006–2008?’ Review of Quantitative Finance and Accounting 44(2): pp. 269–298. Nwankwo, O.U. and Ikpor, I.M. (2014) ‘Sovereign wealth fund and challenges of fiscal federalism in Nigeria’. Journal of Economics and Sustainable Development 5(25): pp. 60–66. Olusegun, A. et al. (2013) ‘Impact of financial sector development on Nigerian economic growth’. American Journal of Business and Management 2(4): pp. 347–356. Omeje, K. (2006) ‘The rentier state, oil-related legislation and conflict in Nigeria’. Conflict, Security & Development 6(2): pp. 211–230. Omeje, K. (2011) ‘Oil conflict and accumulation politics in Nigeria’. Washington, DC: Wilson Centre. Ostry, J.D. et al. (2012) ‘Two targets, two instruments: monetary and exchange rate policies in emerging market economies’. Washington, DC: International Monetary Fund.

Phyllis Papadavid

42  Elgar encyclopedia of financial crises Papadavid, P. (2016) ‘Shockwatch bulletin: the triple transition of a slowing China, lower oil prices and a higher US dollar’. London: Overseas Development Institute. Radelet, S. (1999) ‘Indonesia: long road to recovery’. Cambridge, MA: Harvard Institute for International Development. Radelet, S. and Sachs, J. (2000) ‘The onset of the East Asian financial crisis’. Chapter 4 in Currency Crises. Cambridge, MA: National Bureau of Economic Research. Rice, X. (2012) ‘Nigeria’s central bank warns on autonomy’. Financial Times, 6 June. Rodrik, D. and Velasco, A. (1999) ‘Short-term capital flows’. Paper prepared for the 1999 ABCDE Conference at the World Bank.

Phyllis Papadavid

Schroder, M. (2015) ‘Mercantilism and China’s hunger for international reserves’. Working Paper 2015/04. Canberra: Australian National University. Shrestha, M.B. and Wansi, T.A. (2014) ‘Drivers of reserves accumulation in the south east Asian countries’. Working Paper 2/2014. Kuala Lumpur: The SEACEN Centre. Stella, P. (2005) ‘Central bank financial strength, transparency, and policy credibility’. IMF Staff Paper 2005/52. Washington, DC: International Monetary Fund. Wallace, P. and Onu, E. (2016) ‘Buhari curbs Nigeria central bank independence to save naira’. Bloomberg, 29 January. Warjiyo, P. (2013) ‘Indonesia: stabilizing the exchange rate along its fundamental’, BIS Paper 73. Basel: BIS. www​.bis​.org/​publ/​bppdf/​ bispap73​.htm.

9. Austrian School monetary explanation for the business cycle

Austrian School sees capital as specific and heterogeneous over time.1

Systemic nature of business cycles

The methodological differences between mainstream and Austrian economics are clear. Mainstream economics sees business cycles as human-made and correctible by man through expert macroeconomic fine-tuning to bring stability and job creation. This is the exact opposite of the Austrian understanding of the business cycle as a process of individual entrepreneurs (and firms) creating value through creative destruction. Another point of departure from the orthodoxy necessary to understand the Austrian School monetary explanation for the business cycle is an understanding of the nature of business cycles themselves. Austrian economists use an evolutionary starting point in understanding the business cycle. Business cycles are a ‘natural’ evolution of the economy and society resulting from a change in social structure from an agrarian economy to one of mass production. The agrarian crop cycle is the genesis of the business cycle (Selgin 2012) and therefore for subsequent business cycles in a society based on industrialization and mass production. Business cycles are a ‘natural’ property (Schumpeter 2008). Business cycles are evolutionary, not human-made, and thus are not correctible by people.

The Austrian School explanation for the business cycle, also known as the monetary explanation, derives from the work of Ludwig von Mises and Friedrich von Hayek. Hayek and Gunnar Myrdal were co-awarded the Nobel Memorial Prize in Economics in 1974 due to their ‘pioneering work in the theory of money and economic fluctuations and for their penetrating analysis of the interdependence of economic, social and institutional phenomena’ (Nobel Foundation 2021). The Austrian School varies from what is known as mainstream, orthodox, or neo-classical economics in that these more prominent socio-structural elements are included in economic analysis. The explanation described in this entry draws mainly from more recent Austrian School insight by Roger Garrison (2001) and George Selgin (2012). The monetary explanation is a general explanation for the business cycle. It has been used to help describe the Great Depression (Rothbard 1973), the Great Recession (Woods 2009), and, audaciously, all pre-Covid-era economic crises of the last century (Thornton 2019).

Deviations from neo-classical equilibrium economics

A different understanding of the role of central banking

Austrian School economics differs from the establishment orthodoxy in that it does not assume a full-employment or nominal GDP target in macroeconomic policy-making. This policy-making assumption worsens business cycle downturn effects. Mainstream equilibrium economics does not help explain ‘creative destruction’ (Schumpeter 2008) over the business cycle which occurs as inefficient and obsolete investment assets are replaced in a socio-economic process by new technologies and innovations leading to renewed economic growth and increasing standards of living. The Austrian School understanding of the business cycle encompasses a theory of increasing returns to scale based on an asset-specific capital structure in an economy over time. For the most part, orthodox economics assumes that capital is homogenous, fungible in time, and reducible to an ‘investment function’. In contrast, the

An orthodox accepted reason for the existence and role of a central bank2 is to provide liquidity (emergency funding) to the financial ‘system’ to lessen the unemployment effects of the downward portion of the business cycle. Central banks are intended to create stability by bailing out (providing liquidity to the owners of) assets which perhaps, given an understanding of the nature of creative destruction, would be better left alone to go through the bankruptcy process. In fact, this very monetary intervention prolongs and worsens the unemployment of what would otherwise be occurring within and corrected in a natural cycle. Selgin (2012) finds that one solution to this problem would be if we realize that central banks are more a source of instability rather than, as conventional 43

44  Elgar encyclopedia of financial crises

wisdom dictates, a source of stability. We find in a study of the first 100 years of the Federal Reserve system that the period of central banking in the United States has been one of greater macroeconomic instability than the period before the central bank’s creation in 1914 (Selgin et al. 2012).

Austrian explanation explained

The foundation of the Austrian School’s explanation of the business cycle relies on understanding two fundamental ideas: a ‘natural’ rate of interest in the Loanable Funds market and a concurrently emerged capital structure in society. The Loanable Funds Market is a market in which savers and borrowers exchange time preferences. Borrowers pay a rate of interest for access to loanable funds today, whereas savers earn this interest by forgoing access to these funds until tomorrow. The resulting equilibrium is depicted in Figure 9.1. A key point here is that absent central bank intervention, a ‘natural’ rate of interest (P*) at the equilibrium point emerges where the supply of loanable funds by savers equals the demand for loanable funds by borrowers. This is the point at which savings equals investment. Although what is shown here is a static equilibrium, the Austrian School method allows us to visualize this as a dynamic equilibrium. As long as savings equals investment, no matter what the economy’s growth rate, the market can be said to be in equilibrium.3 Concurrent with the emergence of the natural rate of interest in dynamic equilibrium, there also emerges a concurrent natural capital structure in society and in dynamic equilibrium. Q* represents this capital

structure in Figure 9.1. The capital structure emerges due to the investment decisions made by thousands if not millions of entrepreneurs seeking their highest returns based on this natural rate of interest. These entrepreneurial decisions are subjectively unique, given each entrepreneur’s own risk preferences and investment plans and local and limited knowledge at a given time and place (Hayek 1945). The natural rate of interest faced by each entrepreneur is the price signal for loanable funds that determine whether an individual plan is profitable under the local conditions in which the decision is being made. An example of an emergent capital structure is shown in Figure 9.2. The mining stage of production takes the longest to repay (with an expected greater profit due to the greater risk in more roundabout – longer – stages of production), around 30 years. Refining the raw materials takes 20 years to pay back, manufacturing 5 or 10 years, wholesale distribution one year, and retailing repays several times a year. The end result of this cumulative production process is consumption. The more roundabout the stages of production, the more efficient are production processes and the more society can consume, enabling increasing living standards. Central banks use monetary expansion during the downward portion of a business cycle to encourage investment and to reduce unemployment. This is accomplished by ‘printing money’ (or digital credits), reducing the interest rate to below the natural rate at which savings equals investment, or where the supply of loanable funds equals the demand for these funds absent state intervention. The new interest rate which emerges (P’) might be seen as a false price signal,

Source:  Own illustration.

Figure 9.1

The loanable funds market absent intervention

Cameron M. Weber

Austrian School monetary explanation for the business cycle  45

Note:  The capital structure example in this figure is from Weber (2010), from ideas in Garrison (2001) and based on Hayek (1933). The stages of production have been reversed along the X-axis in order to present the notion of entrepreneurs faced with outward investment decisions at time 0 (zero). Capital structure is subjective to the analyst, for example instead of mining (and land) as the original source of value we could use R&D and/or an innovation which leads to intellectual property rights or trade-secrets. Source:  Own illustration.

Figure 9.2

Capital structure absent intervention

signaling to entrepreneurs that a previously determined unprofitable plan is now profitable due to the now (artificially) lower interest rate. We now look at monetary manipulation’s effects on the economy over time through the lens of the capital structure concerning the business cycle to understand how this money manipulation exacerbates the natural business cycle. This analysis concludes that activist monetary policy by monopoly central banks makes unemployment greater than it would be during the downward portion of the cycle had there not been this monetary intervention. Investments that would not have been made are known as ‘malinvestment’. Malinvestment is investment that is ultimately found to be time-consuming and

wasteful and would not have been made absent a distortion of the interest rate price signal by a central bank. We show the quantity of malinvestment in Figure 9.3. The new lower interest rate sends a false price signal that entrepreneurs now believe longer-term investment plans are profitable.4 Investment is substituted out of medium-term stages of production into longer-term, more roundabout stages of production, investment that would not have been made absent from money manipulation. For example, during the lead-up to the Great Recession, malinvestment included investment in skyscrapers and housing. During the monetary bubble leading to the dot.com boom-and-bust, this included investment into new internet firms (which never became profitable). This distor-

Source:  Own illustration.

Figure 9.3

Loanable funds market with central bank intervention

Cameron M. Weber

46  Elgar encyclopedia of financial crises

Source: 

Own illustration with ideas from Garrison (2001).

Figure 9.4

Change in capital structure with central bank intervention

tion of the capital structure due to interest rate manipulation is shown in Figure 9.4. It takes time to move investment from one production stage and from one production process to another. This asset specificity means that over time, there is malinvestment and consumer goods are now becoming more expensive as the new more roundabout (capital-intensive) production processes needed to meet consumer demand are not yet in place. So we now have both price inflation and malinvestment. There comes a point when central banks need to acknowledge this price inflation and take action to prevent further and increasing inflation to maintain their institutional credibility. This means that the expansionary monetary manipulation must either slow down or end. Investment is greater than savings during the malinvestment period due to the central bank’s money printing activities. When the expansionary monetary policy ends the artificially low-interest rate increases and tends to the higher natural rate, where savings equals investment. This interest rate increase now exposes that malinvestment in longer-term stages of production is no longer profitable. Entrepreneurs now seek to substitute out of these no longer profitable, more roundabout stages into more intermediate stages. However, asset specificity takes time to undo the malinvestment, especially during an economic downturn. Assets become stuck in these longer-term investments, exacerbating what would have been natural unemployment during what Austrian School economists see as a natural business cycle. For example, the loanaCameron M. Weber

ble funds invested by people who move to Nevada to build homes, or New York City to build skyscrapers, now become trapped in the short-term, exacerbating unemployment and preventing a more rapid recovery and upturn in the business cycle. Investment becomes trapped because there is no instantaneous change in the reformulation and implementation of entrepreneurial plans.

What is to be done?

We have already learned that we might understand that central banks are not a source of stability, but are instead a source of instability (Selgin 2012). Hayek (1990) argues for the ‘denationalization’ of money. In other words, we might allow competition against central banks for currency issues. However, like most with monopoly power, we tend to want to keep this monopoly power. For example, the U.S. Treasury declared that blockchain-based currencies are assets against which capital gains taxes must be paid (US IRS 2014). Cameron M. Weber

Notes 1.

2.

Capital theory is a long-standing point of interest amongst economists. In the entry I define capital as those resources that can be forward-invested due to clear property-rights over an asset. This value is subjective to those with these property rights and not determined objectively by a cost-of-capital or a book-value or set of plans. Only the entrepreneur facing the investment decision at a given time and place makes a capital-value decision based on alternative use of these resources. A central bank is ‘a bank possessing a national monopoly, or something approaching a national monopoly, of the right to issue circulating paper currency’ (Selgin 2012).

Austrian School monetary explanation for the business cycle  47 3. 4.

For an overview of the history of economic thought leading to the Austrian School ideas presented here, see Backhouse (2006). For example, if an investment plan was not deemed profitable at a cost of capital of 5 percent, lowering the rate to 4 percent for the same plan may now make it seem profitable.

References

Roger E. Backhouse (2006). ‘Hayek on Money and the Business Cycle’, in The Cambridge Companion to Hayek, edited by Edward Feser, New York: Cambridge University Press. Roger W. Garrison (2001). Time and Money: The Macroeconomics of Capital Structure, London: Routledge. F.A. Hayek (1931). Prices and Production, London: George Routledge & Sons. F.A. Hayek (1933). Monetary Theory and the Trade Cycle, London: Jonathan Cape. F.A. Hayek (1939). Profits, Interest and Investment, London: Routledge & Kegan Paul. F.A. Hayek (1945). ‘The Use of Knowledge in Society’, American Economic Review 35(4): 519–530. F.A. Hayek (1990). Denationalization of Money: The Argument Refined, An Analysis of the Theory and Practice of Concurrent Currencies, London: Institute of Economic Affairs. Nobel Foundation (2021). www​.nobelprize​.org. Murray N. Rothbard (1973). America’s Great Depression, New York: D. Van Nostrand.

Joseph A. Schumpeter ([1950] 2008). ‘The Process of Creative Destruction’, in Capitalism, Socialism and Democracy, New York: Harper Perennial, pp. 81–86. George Selgin (2012). ‘Central Banks as Sources of Financial Instability’, in Boom and Bust Banking: The Causes and Cures of the Great Recession, edited by David Beckworth, Oakland, CA: Independent Institute, pp. 339–353. George Selgin, William D. Lastrapes and Lawrence H. White (2012). ‘Has the Fed Been a Failure?’, Journal of Macroeconomics 34(3): 569–596. Mark Thornton (2019). The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century, Auburn, AL: Mises Institute. US Internal Revenue Service (US IRS). 2014. ‘IRS Virtual Currency Guidance: Virtual Currency Is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply’, March 15. www​ .irs​.gov/​uac/​Newsroom/​IRS​-Virtual​-Currency​ -Guidance. Cameron M. Weber (2010). Economics for Everyone, 2nd edition, Cameron Weber Publishing, http://​cameroneconomics​.ipower​ .com/​ebooks​.html. Thomas E. Woods Jr. (2009). Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse, Washington, DC: Regnery.

Cameron M. Weber

10. Bank and corporate balance sheet vulnerabilities and currency crises

will turn banks’ foreign-currency liabilities into claims on its foreign-currency reserves. Such vulnerabilities create the potential for self-fulfilling bank runs and currency crises. Burnside, Eichenbaum and Rebelo (2004) have also placed banks’ balance sheets at the origin of such twin crises due to government guarantees to foreign creditors. Such guarantees induce domestic banks to carry currency mismatches in their balance sheets in the form of foreign-currency liabilities and domestic-currency assets. Other models, such as Krugman (1999) and Aghion, Bacchetta, and Banerjee (2004, 2001), center on vulnerabilities stemming from corporate balance sheets. According to these models, countries with firms that rely heavily on foreign-currency debt are more prone to crisis since this financial fragility makes firms more vulnerable to domestic-currency depreciation. Such depreciations increase the domestic-currency value of foreign-currency debt of the corporate sector. This deteriorates firms’ financial health, reducing their access to funding, and negatively affecting investment as entrepreneurs become credit-constrained. This movement, in turn, causes the domestic currency to depreciate more, impairing firms’ balance sheets and further contracting private investment, therefore boosting the potential for an economic collapse of that country. This allows for the occurrence of self-fulfilling currency crises, resulting from a negative shift in expectations about the exchange rate. Highly leveraged firms, in particular, have the potential to compound these effects, as highlighted by Krugman (1999). In the context of currency crises, balance sheet weaknesses often manifest in four primary forms: maturity mismatches, currency mismatches, capital structure problems, and solvency problems. As Allen et al. (2002) explain, examples of maturity mismatches include situations when a firm’s liabilities are due in the short term while its liquid assets have longer maturities. The issue of currency mismatches has been commonly found in crisis episodes involving firms whose assets are in domestic currency and liabilities are in foreign currency. Capital structure deficiencies are related to a firm’s excess leverage. Finally, insolvency issues arise when the net present value of a firm’s assets is insufficient to cover its liabilities. The Asian crisis provides telling evidence

Balance sheet vulnerabilities are one of the striking characteristics of the 1997–98 Asian financial crisis.1 Despite their strong macroeconomic fundamentals, the countries at the core of the Asian crisis were marked by private sector entities with weak balance sheets and strong reliance on government bailouts. Currency mismatches, excessive leverage, low liquidity, and small profitability plagued the books of their banks and corporations. The existing two generations of currency crisis models could not explain these features. The first generation of models emphasized expansionary domestic credit and unsustainable fiscal deficits, along with insufficient foreign exchange buffers to cover the balance of payments needs, as the main factors that could lead to currency crises. Weak macroeconomic fundamentals and lack of political willingness to bear the costs of maintaining the exchange rate peg were seen by the generation of models that followed as conduits to multiple equilibria that prompted self-fulfilling speculative attacks on the currency. Inspired by the Asian experience, some third-generation models of currency crises brought the role of private balance sheets to the forefront, contributing to our understanding of the involvement of the banking and corporate sectors in the accumulation of vulnerabilities that led to the occurrence of that crisis as well as its severity. Some of these models investigate the role of the banking sector. For example, Chang and Velasco (2001, 2000b, 2000a) and Jeanne and Wyplosz (2003) focus on banks’ short-term liabilities that could make a country’s financial system internationally illiquid. This stems from banks’ excessive obligations in foreign currency (taking into account not only foreign-currency liabilities but, in fixed exchange rates, also liabilities denominated in domestic currency) relative to the amount of their international liquidity. Moreover, in a fixed exchange rate regime, a central bank acting as a lender of last resort 48

Bank and corporate balance sheet vulnerabilities and currency crises  49

of balance sheet weaknesses at the onset of the turmoil. For example, Corsetti, Pesenti, and Roubini (1999) note that, in the case of Korea, large conglomerates (chaebols) had, on average, substantial debt–equity ratios (by comparison with the US), with some in the thousands percent. A comprehensive balance sheet analysis considers individual firms and entire sectors (e.g., corporate and banking), and studies the interlinkages among them and how these sectoral balance sheet weaknesses interplay with underlying macroeconomic vulnerabilities at the country level. Importantly, consolidated balance sheets at the national level may not reflect vulnerabilities occurring at the sectoral level. For example, foreign currency-denominated debt across residents may net out at the consolidated level but not necessarily be free of external vulnerabilities, as pointed out by Allen et al. (2002). Another critical aspect contemplated by the balance sheet analysis is the transmission of vulnerabilities across sectors. For instance, overleveraged firms (especially in foreign currency-denominated debt) can weaken the balance sheets of banks that lend to them. As modeled by Caballero and Krishnamurthy (2001), banks in underdeveloped financial systems, like those found in many emerging markets, can magnify the severity of corporate-triggered shocks as they hold distressed firms’ assets as collaterals. Such assets are repriced at times of economic turmoil, weakening these banks’ capacity to do financial intermediation and negatively impacting real economic activity. Hence, this literature also contributes to understanding the severity of these crises. One of the advantages of this approach is that it considers the operation of balance sheet effects that are self-reinforcing in such a way as to aggravate the economic impact of these crises. Another advantage is that it advances the understanding of the connections between different types of crises and the consequent occurrence of combinations of crises, such as twin banking-currency crises, which, in turn, aggravates the crises’ effects on the real economy. This balance sheet approach motivates the search for leading indicators of currency crises other than macroeconomic fundamentals traditionally considered in the literature. Mulder, Perrelli, and Rocha (2016, 2012)

proposed early warning systems (EWS) that include indicators based on micro-level balance sheet data from the corporate sector and the banking sector (debt maturity structure, leverage, liquidity, and profitability), as well as macro balance sheet indicators (e.g., corporate and financial sectors debt to foreign banks).2 On a sample including the Asian crisis and other episodes in emerging market economies, these studies found balance sheet indicators (notably, maturity structure of debt, leverage, and corporate and financial sectors debt to foreign banks) to improve the performance of EWS by contributing to predict the likelihood of currency crises and to explain crisis depth. Moreover, their results support the idea that vulnerabilities stemming from corporate balance sheet fragilities are compounded via the banking sector. The understanding of such balance sheet fragilities allows one to draw policy implications regarding both crisis prevention and crisis management. One of the implications is that policymakers need to pay more attention to the private sector’s balance sheets, putting in place mechanisms that curb the accumulation of imbalances and vulnerabilities. This may entail policy measures directed both at the banking sector and also at non-financial firms to limit the accumulation of foreign-currency debt and avoid bank runs (e.g., Krugman (1999) and Chang and Velasco (2000b)). This literature also highlights challenges in dealing with crises stemming from balance sheet vulnerabilities. Chang and Velasco (2000a) underscore that, in a fixed exchange rate regime, the choice of the central bank as to whether or not to act as a lender of last resort to the banking system does not preempt a crisis but rather only determines the type of crisis that occurs— avoiding the collapse of the banking sector implies losses of international reserves and the consequent collapse of the exchange rate peg. The workings of such crises may call for the need for an international lender of last resort, as suggested by Chang and Velasco (2000b) and Jeanne and Wyplosz (2003), for example. The balance sheet approach to currency crises also warns about the effects of a policy response that chooses not to stabilize the exchange rate since letting the domestic currency depreciate further aggravates the balance sheet effects. This is the

Manuel Duarte Rocha and Roberto Accioly Perrelli

50  Elgar encyclopedia of financial crises

case, for example, of Aghion, Bacchetta, and Banerjee (2001), who conclude that the optimal policy response to avoid a currency crisis is to increase the nominal interest rate. Krugman (1999), however, also warns that while a policy that stabilizes the exchange rate precludes the balance sheet effects from domestic-currency depreciation, it cannot avoid a crisis from declining output as highly leveraged entrepreneurs face increased difficulty in accessing funds. Given this, the author suggests providing emergency credit lines that support funding to firms. Timely and comprehensive reporting of economic and financial indicators by individual firms is at the core of the balance sheet analysis. While this is more easily found in advanced economies, countries with less developed capital markets usually have large numbers of non-publicly listed companies. These firms are not subject to the same reporting standards of publicly listed firms, and thus their balance sheet fragilities may not be tracked as in other cases. In practice, limited reporting standards—either due to delays in data publication or thin coverage of private entities—may hinder the application of this approach in emerging markets and developing economies with acute external vulnerabilities and considerable susceptibility to crisis. However, continued financial deepening and capital market development in these countries will potentiate further the application of the balance sheet approach. Manuel Duarte Rocha and Roberto Accioly Perrelli

Allen, Mark, Christoph Rosenberg, Christian Keller, Brad Setser, and Nouriel Roubini. 2002. “A balance sheet approach to financial crisis.” IMF Working Paper No. 02/210. www​ .imf​ .org/​en/​Publications/​WP/​Issues/​2016/​12/​30/​A​ -Balance​-Sheet​-Approach​-to​-Financial​-Crisis​ -16167. Burnside, C., M. Eichenbaum, and S. Rebelo. 2004. “Government guarantees and self-fulfilling speculative attacks.” Journal of Economic Theory 119 (1): 31–63. https://​doi​.org/​10​.1016/​ j​.jet​.2003​.06​.002. Caballero, R. J., and A. Krishnamurthy. 2001. “International and domestic collateral constraints in a model of emerging market crises.” Journal of Monetary Economics 48 (3): 513–548. https://​doi​.org/​10​.1016/​S​0304–3932(​ 01)00084–8. Chang, R., and A. Velasco. 2000a. “Financial fragility and the exchange rate regime.” Journal of Economic Theory 92 (1): 1–34. https://​doi​.org/​ 10​.1006/​jeth​.1999​.2621. —. 2000b. “Liquidity crises in emerging markets: theory and policy.” NBER Macroeconomics Annual 1999 14: 11. https://​doi​.org/​10​.1086/​ 654376. —. 2001. “A model of financial crises in emerging markets.” Quarterly Journal of Economics 116 (2): 489–517. https://​doi​.org/​10​.1162/​ 00335530151144087. Corsetti, G., P. Pesenti, and N. Roubini. 1999. “What caused the Asian currency and financial crisis?” Japan and the World Economy 11 (3): 305–373. https://​doi​.org/​10​.1016/​S​0922–1425(​ 99)00019–5. Jeanne, O., and C. Wyplosz. 2003. “The international lender of last resort: how large is large enough?” In Managing Currency Crises in Emerging Markets, edited by Michael P. Dooley, and Jeffrey A. Frankel, 89–124. Cambridge, MA: National Bureau of Economic Research. Notes Krugman, P. 1999. “Balance sheets, the transfer problem, and financial crises.” International 1. For an example of an account of what happened in Tax and Public Finance 6 (4): 459–472. https://​ the Asian financial crisis, see Corsetti, Pesenti, and Roubini (1999). doi​.org/​10​.1023/​A:​1008741113074. 2. Together with traditional EWS macroeconomic Mulder, C., R. Perrelli, and M. D. Rocha. 2012. indicators. They also included institutional and “External vulnerability, balance sheet effects, legal indicators to capture the operational environand the institutional framework: lessons from ment faced by companies and banks. the Asian crisis.” International Review of Economics & Finance 21 (1): 16–28. https://​doi​ .org/​10​.1016/​j​.iref​.2011​.04​.002. References Aghion, P., P. Bacchetta, and A. Banerjee. 2001. —. 2016. “The role of bank and corporate balance sheets on early warning systems of currency “Currency crises and monetary policy in an crises: an empirical study.” Emerging Markets economy with credit constraints.” European Finance and Trade 52 (7): 1542–1561. https://​ Economic Review 45 (7): 1121–1150. https://​ doi​.org/​10​.1080/​1540496x​.2016​.1158545. doi​.org/​10​.1016/​S​0014–2921(​00)00100–8. —. 2004. “A corporate balance-sheet approach to currency crises.” Journal of Economic Theory 119 (1): 6–30. https://​doi​.org/​10​.1016/​j​.jet​ .2003​.06​.004.

Manuel Duarte Rocha and Roberto Accioly Perrelli

11. Belgium’s crises in the pre-World War I era

Générale and Banque de Belgique. The situation was worsened by the lack of a national bank that could have intervened and provided the necessary liquidity.3 In particular, the Banque de Belgique was unable to redeem its banknotes and eventually had to be bailed out by the Belgian government on December 17, 1838. The impact was severe. First, the value of banknotes fell by more than 50 percent and savings deposits decreased by more than 40 percent (Buyst and Maes, 2007; Chlepner, 1930). Second, the influential industrial company John Cockerill & Cie went bankrupt.4 Finally, stocks on the Brussels Stock Exchange decreased by more than 15 percent between 1838 and 1840 (Annaert et al., 2012). Because of the revolutionary uprising (and preceding crisis), Société Générale was forced to convert the debt of firms that were unable to fulfill financial obligations into equity. This transformed Société Générale into the first universal bank5 (e.g., Annaert and Verdickt, 2021; Chlepner, 1943, 1930; Deloof and Verdickt, 2022; Van Overfelt et al., 2009). On the other hand, Banque de Belgique became more risk-averse as a consequence of this crisis. They took the opposite approach to Société Générale, and stopped adding new firms to its investment portfolio, which did not help the recovery of the Belgian economy. The conflict was eventually resolved with the Treaty of London, signed on April 19, 1839 by Belgium, the Netherlands, and the concert of Europe. However, there were few structural changes in the Belgian economy. For instance, it took more than a decade before the National Bank of Belgium was established (in 1850). Second, Société Générale did not improve its liquidity position (Buyst and Maes, 2007; Chlepner, 1930). In conclusion, there was only one outcome of this crisis: the United Kingdom of the Netherlands recognized Belgium’s independence.

Since the revolution of Belgium between 1830 and 1831 (and its subsequent independence in 1832), there have been several financial crises in Belgium. In total, there were five major crises: 1838–40, 1870–76, 1885, 1900, and 1914 (e.g., Baron et al., 2021; Buyst and Maes, 2007).1 We focus on the three crises that arguably shaped the Belgian economy the most; that is, 1838–40, 1870–76, and 1914. In all of the crises, there was a military component that played a (minor) role. For instance, in 1838 there were military tensions between Belgium and the Netherlands. The outbreak of the Franco-Prussian War started in 1870. Finally, 1914 marked the onset of World War I. In these financial crises, Société Générale always played a significant role. In 1822, King William I of the United Kingdom the Netherlands created the Société Générale pour Favoriser l’Industrie Nationale (referred to as “Société Générale”). Its goal was to promote credit provision, act as an emission bank, and operate as the cashier in the Southern part of the Netherlands (now Belgium). Société Générale quickly became one of the most successful universal banks, mainly active in capital-intensive sectors, such as mining and railroads (Deloof & Verdickt, 2022; Van Overfelt et al., 2009). Since Belgium was one of the first nations in Europe to industrialize, there was a huge demand for capital.2 To diminish the bank’s increasing dominance, the Belgian government created Banque de Belgique as its main competitor (Annaert & Verdickt, 2021; Deloof & Verdickt, 2022).

1838

Initially, King William I did not accept Belgium’s claim to independence. Between August 2 and 31 in 1831, the Netherlands launched the “10-day campaign” to halt the Belgian revolution. Military tensions increased in December 1838. The pressures converted quickly into a banking panic. Indeed, the Belgian public demanded the repayment of deposits and the conversion of banknotes into gold and silver. This created severe liquidity problems for the Société

1870

Arguably the most important crisis in Belgium’s nineteenth century was the railroad crisis of the 1870s. This event coincided with the Franco-Prussian War of 1870–71. The immediate cause was the candidacy of Prince Leopold of Hohenzollern-Sigmaringen for the Spanish throne. The impact of this war was twofold. On the one hand, foreign 51

52  Elgar encyclopedia of financial crises

firms (and investors) fled to Belgium to raise new capital.6 On the other hand, the trade opportunities between Belgium and its neighboring countries took a slight hit. This conflict re-confirmed the devastating impact of military tensions and war on a country’s economy. Nevertheless, following the Franco-Prussian War, the Belgian economy was booming. As a consequence, investors became less risk-averse. However, the tipping point of this crisis occurred in 1875–76 with the demise of the railroad group Bassin Houillers du Hainaut, led by Simon Philippart.7 Simon Philippart is considered to be one of the essential entrepreneurs in Belgium’s nineteenth century.8 In 1868, he became the administrator of the railroad group; one year later, they had already created close to 28,000 km of railroad tracks in Belgium. In 1872, Philippart started the Banque Franco-Hollandaise and invested in other financial institutions, such as Banque Belge du Commerce et de l’industrie. In 1873, he attempted to acquire the Crédit Mobilier, which he financed by borrowing from numerous banking relations. This, however, failed. Not only did this lead to the bankruptcy of Banque Franco-Hollandaise, but it also created a banking panic. This, eventually, spilled over to other ventures in the Philippart group, such as Bassin Houillers du Hainaut (which got nationalized), but also dragged down Banque de Belgique, at that time the second largest universal bank. Two elements exacerbated the panic. First, the liquidity positions of universal banks were not adequate following the 1838 panic. Second, news emerged of embezzlement of securities belonging to clients and loans received upon debtor accounts under an assumed name by an official at Banque de Belgique. This led to the bankruptcy of Banque de Belgique, as well as Banque Centrale Anversoise and Union du Crédit de Bruxelles. It also spilled over to the financial markets. The stock market decreased by more than 30 percent between 1874 and 1878, and the default rates on corporate bonds reached 30 percent in this period. Again Société Générale played an important role. It attempted to rescue Banque de Belgique, Banque Centrale Anversoise, and Union Crédit de Bruxelles. The bank was assigned this role by Finance Minister Malou, a former banker. In turn, the National Bank of Belgium only was involved (officially) Gertjan Verdickt

in the rescue operation of Union Crédit de Bruxelles (Chlepner, 1930). This underscored the critical role Société Générale played in Belgium’s political and economic landscape.9 A bank was asked to rescue its most significant competitor, whereas the National Bank of Belgium did not do anything in this crisis to help (Banque de Belgique). The rescue eventually failed, and Banque de Belgique went bankrupt. This increased the leading position of Société Générale in the economy. For instance, Société Générale was among the only banks that did not follow the “unit bank system”, and had many subsidiaries throughout Belgium. Also, the bank could take a leading role in funding ventures for Belgian Congo (Buelens & Marysse, 2009; Deloof & Verdickt, 2022).

1914

Apart from the Belgian revolution, Belgium was never involved in any military conflict in the pre-World War I period. Nevertheless, there were spillover effects from wars abroad, through a decrease in trade opportunities or an increase in the likelihood of a military invasion. Between 1885 and 1914, several noteworthy conflicts created uneasiness in Europe; that is, the Serbia-Bulgarian conflict (1885), the Spanish-American War (1898), the Russo-Japanese War (1904–05), and the Second Moroccan Crisis (1911).10 The changing political landscapes intensified military tensions more.11 The two prominent alliances were the Triple Entente and Triple Alliance. The Triple Alliance was created through the Dual Alliance between Germany and Austria-Hungary. Initially, Russia and Italy joined in 1881 and 1882, respectively. Eventually, Russia backed out and joined France in 1893 and the U.K. in 1904. Belgium’s financial markets experienced both positive and negative consequences following a surge in war threats. First, there was a flight of foreign capital (or investors). From 1895 onwards, there was an increase in the French, Italian and Russian capital in Brussels. This helped Brussels establish itself as one of the most prominent financial centers in the world in the pre-World War I period. Second, the threat of war also slowed down the respective economies. An increase in danger is associated with a decrease in initial public offerings for Belgian and foreign firms (Verdickt, 2020). This implies that, although

Belgium’s crises in the pre-World War I era  53

the capital eventually came, the slower rate impacted the Belgian economy. Moreover, listed companies changed their dividend policy due to war tensions. The impact on Europe was severe. From a military viewpoint, it accumulated in the outbreak of the Great War. From an economic perspective, there was a slowdown in trade in the buildup to World War I, the stock market decreased remarkably, and the default rate on the corporate bond market increased up to 9 percent. In the aftermath of World War I, Brussels had a hard time hanging on to its leading position in the global financial markets and eventually surpassed other European nations (Chambers & Dimson, 2016). Gertjan Verdickt

Notes 1.

There were also some minor economic downturns, such as in 1856 and 1865 (see Buyst & Maes, 2007). 2. For instance, Belgium had the first railway on the European continent in 1835. 3. Before 1850, Société Générale and Banque de Belgique both acted as the country’s national bank. 4. John Cockerill, the founder of the company, was also one of the founders of Banque de Belgique. 5. In this era, universal banks were more than classic financial intermediaries. They used bank deposits to build up positions in various companies, and hence acted as a venture capitalists. Société Générale invested through two subsidiaries, one of which was “Mutualité Industrielle” (see, e.g., Annaert & Verdickt, 2021). Banque de Belgique invested through a subsidiary, “Actions Réunies”. 6. Belgium also had no taxation on company profits or dividends, in contrast to other countries. 7. The 1875–76 crisis is therefore sometimes dubbed the railroad crisis. 8. Initially, Philippart started his career in Fabrique Belge de Laines Peignées—a firm financed by his family and John Cockerill. 9. Buyst and Maes (2007) note that Société Générale was involved in almost all major crises in the nineteenth century. The exception was Banque de Crédit commerciale d’Anvers. However, the National Bank was also barely involved in this rescue. 10. In July 1887, The Economist wrote: “the general belief of Europe that was is improbable this year is probably well-founded; but we should not be wanting in our duty if we did not point out that lowering clouds are settling over Europe”. In 1912, The Economist reported: “The Ministerial declara-

tion, which is decidedly pessimistic as regards the prospects of peace in Europe, points out that all Powers guaranteeing Belgian neutrality may possibly be belligerents at once … Belgium is proposing to defined her own neutrality solely by her own troops”. 11. On May 8, 1912, Moniteur des Intérêts Matériels published an article on the increase in threat as a consequence of the Agadir Crisis (1912). They wrote: “the business world had suffered greatly from the conflict” and “the Franco-German agreement has kept the dance alive, however, it did not solve the existing danger”.

References

Annaert, J., Buelens, F., & De Ceuster, M. J. K. (2012). New Belgian stock market returns: 1832–1914. Explorations in Economic History, 49(2), 189–204. Annaert, J., & Verdickt, G. (2021). Go active or stay passive: Investment trust, financial innovation and diversification in Belgium’s early days. Explorations in Economic History, 79, 101378. Baron, M., Verner, E., & Xiong, W. (2021). Banking crises without panics. Quarterly Journal of Economics, 126(1), 51–113. Buelens, F., & Marysse, S. (2009). Returns on investments during the colonial era: the case of the Belgian Congo 1. Economic History Review, 1, 135–166. Buyst, E., & Maes, I. (2007). Central banking in 19th-century Belgium: was the NBB a lender of last resort  ? Financial History Review, 15(March), 153–173. Chambers, D., & Dimson, E. (2016). Financial Market History: Reflections on the Past for Investors Today. CFA Institute. Chlepner, B. S. (1930). Le marché financier belge depuis cent ans. Revue belge de Philologie et d’Histoire, 10, 295–296. Chlepner, B. S. (1943). Belgian Banking and Banking Theory. Cambridge University Press. Deloof, M., & Verdickt, G. (2022). Investing for the long-run: the rise and fall of Société Générale de Belgique, 1835–1988. SSRN. http://​dx​.doi​.org/​10​.2139/​ssrn​.4260774 Van Overfelt, W., Annaert, J., De Ceuster, M. J. K., & Deloof, M. (2009). Do universal banks create value? Universal bank affiliation and company performance in Belgium, 1905–1909. Explorations in Economic History, 46(2), 253–265. Verdickt, G. (2020). The effect of war risk on managerial and investor behavior: evidence from the Brussels Stock Exchange in the pre-1914 era. Journal of Economic History, 80(3).

Gertjan Verdickt

12. Bolivia—debt accumulation in the 1970s, hyperinflation in the 1980s

and Sachs 1990b, 166)), generating optimism and confidence in the Bolivian economy. The Banzer dictatorship supported itself not by undoing state capitalism but by using the state-capitalism model to benefit specific private agents. Buoyed by tin-price optimism, there were enormous flows of private lending at higher interest rates and shorter terms. Between 1975 and 1982, total external debt rose from 45 percent to 62 percent of GDP. Short-term debt rose from 12.7 percent to 20.3 percent of the total between 1970 and 1979. Concessional loans from official lenders shrank from 27 percent to 16 percent of the total. Nevertheless, GDP per capita growth slowed to 1.5 percent. Tin prices peaked in 1980. After a brief civilian interregnum, the brutal, drug-trafficking-financed military dictatorship of General García Meza led to international isolation and a sudden stop of capital flows. The tin-price spike and subsequent flood of short-term debt had fueled “an illusion [but] by 1980 that illusion had been shattered. Bolivia’s creditworthiness disappeared once again, and Bolivia found itself in a debt-rescheduling exercise with the banks two years before the outbreak of the global debt crisis” (Morales and Sachs 1990a, 216).

Introduction

Between September 1981 and September 1985, Bolivia’s consumer price index rose by 2.7 million percent. Unlike many hyperinflations, Bolivia’s hyperinflation was not associated with a war, a natural disaster, or a collapse in export earnings. Instead, it was the result of a slow build-up of financial pressure that the government could not solve in any satisfactory way besides the inorganic emission of the monetary base.

Causes

The hyperinflation of the 1980s was a repetition of similar dynamics, with a similar cast of characters, from the 1950s. In 1952 the Bolivian Revolution brought in a new generation of politicians who implemented popular reforms. By 1956 increased demand for spending and an inability to raise sufficient taxes led the administration of Victor Paz Estenssoro to cover the fiscal deficit with the inflation tax. The succeeding administration of Hernán Siles Zuazo implemented an orthodox, IMF-approved stabilization program, leading to a system that has been described as “state capitalism” (Morales and Sachs 1990c). It is helpful to contrast the late 1960s and the late 1970s. In the earlier period, GDP per capita growth averaged 4 percent per year, the fruit of previous investment (Morales and Sachs 1990b) and to high rates of investment financed by foreign aid: long-term concessional loans and grants from multilateral agencies. Importantly, this bout of prosperity cannot easily be ascribed to a commodity boom: prices of tin, Bolivia’s main export and the main source of tax revenue, fell slightly during this period (Morales and Sachs 1990b). The late 1970s, on the other hand, were marked by rapidly rising tin prices and by the dictatorship of General Hugo Banzer. Between 1972 and 1980, prices of tin rose by 370 percent (including a 150 percent spike in 1974 dubbed “miraculous” (Morales

Events

A decade of repressive politics led to pent-up demands from labor on the government, which could not be satisfied with borrowing. To retain access to international capital, the successive governments entered into a partial default, and debt service took up an increasingly large proportion of export earnings. Debt service/exports rose from 22 percent to 36 percent between 1976 and 1981 and 60 percent in 1982. Moreover, Bolivia had never developed sufficient taxing capacity (Otálora and Rosa 2002), and the economic crisis led to political instability: there were eight heads of state between July 1978 and October 1982. Out of options and faced with a 20 percent fall in tin prices, the Bolivian government resorted to inflation financing. Starting in 1980, monetary issuance accelerated. While it had averaged under 14 percent in 1978–79, at the end of the boom, the monetary base growth rate more than doubled to 33 percent in 1980–81 and to 230 percent in 1982. The new civilian government of Hernán Siles Zuazo (who, as president in the late 54

Bolivia—debt accumulation in the 1970s, hyperinflation in the 1980s  55

Source:  International Monetary Fund (2023).

Figure 12.1

Real tin price, world markets, 1980 = 1.0

1950s, had brought inflation down) began by decreeing the “de-dollarization” of Bolivian deposits. The government confiscated all bank deposits denominated in dollars and converted into Bolivian pesos. The measure was intended to increase the monetary base for seigniorage purposes. But, as it implied massive redistribution away from depositors, it led to disintermediation and eventually more extensive flight from the domestic currency. As reported by Mamani Flores (2018), dollar deposits stood at 20 percent of the total before the decree, dropped to zero immediately after, and rose quickly through hyperinflation to over 80 percent. At the start, Siles Zuazo was primarily supported by the Bolivian Workers’ Union (Central Obrera Boliviana, COB). In Bolivia’s system of state capitalism, keeping their support required higher spending. But tin prices stagnated, and the opposition of business associations limited the government’s taxing capacity. When the Siles government could not satisfy labor demands, the COB withdrew its support and increased its militancy, paralyzing the country with strikes. The budget deficit rose from 7.5 percent of GDP in 1981 to 14.2 in 1982 and 26.5 percent in 1984. Hemmed in by political pressure and unable to access international capital markets, the government once again resorted to seigniorage, and the monetary base grew by 1429 percent during 1984. Incapable of an economic solution, Siles Zuazo focused on political peace via monetary issuance. In the run-up to a new presidential election and financial disintermediation context, the monetary base grew by nearly

7000 percent in 1985. Bolivia met Cagan’s (1956) definition of hyperinflation (increases of the CPI of more than 50 percent per month) in eight of twelve months between October 1984 and September 1985, reaching a monthly peak of 183 percent in February 1985. Table 12.1

 

Annual inflation, Bolivia, 1977–87 (International Monetary Fund 2023) 12 months ending in September

1977

9%

1978

12%

1979

18%

1980

50%

1981

33%

1982

170%

1983

259%

1984

1085%

1985

23447%

1986

94%

1987

9%

Outcomes

The new government was headed by Victor Paz Estenssoro, who reversed his role in the 1950s. Paz Estenssoro addressed hyperinflation with a program dubbed New Economic Policy (NPE in Spanish). Issued on August 29, 1985, Decree 21060 involved a strictly orthodox program. The program included stabilization of the exchange rate, trade, and capital liberalization, fiscal austerity to reduce monetary growth, political suppression of Gabriel Xavier Martinez

56  Elgar encyclopedia of financial crises

labor and labor-market liberalization to bring about real wage cuts, and a strategy of return to international capital markets (Pastor 2019). The CPI, which had risen by 56.51 percent in September 1985, fell by −1.86 percent in October. The success of the stabilization program is due to several factors—first, a focus on international benchmarking anchored the price portion of the wage-price spiral. Concretely, after an initial devaluation, the government maintained a stable and predictable exchange rate through a dirty float. A stable exchange rate and trade liberalization generated competitive pressures that kept prices in line (Sachs 1986). Second, fiscal austerity was pursued through a political strategy of, on the one hand, reducing government spending through freezing public-sector wages, cutting public-sector employment (especially in state-owned enterprises), and weakening the miners’ union severely and, on the other, raising revenues through a value-added tax and the elimination of gasoline subsidies (Kehoe, Machicado, and Peres-Cajías 2018). These anti-labor measures proved popular (the militancy of the COB was widely blamed, inside and outside of Bolivia, for

leading to the hyperinflation) and they helped to anchor the wage portion of the wage-price spiral. Third, Bolivia sought to return to international capital markets. First, directly, by re-establishing relations with international lenders and multinational institutions and renegotiating its debt. Second, indirectly, through tariff unification, the elimination of import prohibitions, a flight-capital tax amnesty, the re-legalization of dollar deposits, and high real interest rates (Pastor 2019).

Conclusion

A month after the start of NPE, tin prices collapsed, falling by nearly 60 percent between October 1985 and May 1986. However, the focus on exchange-rate stability kept inflation expectations down and brought monthly inflation to almost zero in March 1986 and stabilized in the low single digits soon after. This episode shows that the cause of the hyperinflation was not the behavior of commodity prices but the weakness of the Bolivian state in responding to the demands placed on it. Arguably, the Bolivian crisis started in 1981 when the international community shut out Bolivia, and capital flows ended. At

Source:  International Monetary Fund (2023).

Figure 12.2

Monthly inflation, Bolivia, 1979–86

Gabriel Xavier Martinez

Bolivia—debt accumulation in the 1970s, hyperinflation in the 1980s  57

that point, the country’s weaknesses were exposed: the flaws of the state-capitalist model, the lack of tax capacity, and the overoptimism of the commodity boom. If fiscal discipline had been embraced at that point, hyperinflation would have been avoided. But fiscal discipline was impossible without political support—in the end, hyperinflation produced that support. Gabriel Xavier Martinez

References

Cagan, Phillip. 1956. The Monetary Dynamics of Hyperinflation. Studies in the Quantity Theory of Money. Chicago, IL: University of Chicago Press. International Monetary Fund. 2023. “IMF Data.” https://​data​.imf​.org/​?sk​=​4c514d48​-b6ba​-49ed​ -8ab9​-52b0c1a0179b. Kehoe, Timothy J., C. Gustavo Machicado, and J. Peres-Cajías. 2018. “The Case of Bolivia.” Federal Reserve Bank of Minneapolis Working Paper. Mamani Flores, Gregorio Reinaldo. 2018. “Bolivianización de la Economía Boliviana, 2000–2016.” Trabajo de Conclusión de Curso de Ciencias Económicas—Economía, Integración y Desarrollo, Ciencias Económicas, Universidad Federal de Integración Latino-Americana.

Morales, Juan Antonio, and Jeffrey D. Sachs. 1990a. “Aspects of Foreign Debt Accumulation, 1952–85.” In Developing Country Debt and Economic Performance, Volume 2: Country Studies—Argentina, Bolivia, Brazil, Mexico, 214–225. Chicago, IL: University of Chicago Press. Morales, Juan Antonio, and Jeffrey D Sachs. 1990b. “An Overview of Macroeconomic Performance.” Developing Country Debt and Economic Performance, Volume 2: Country Studies—Argentina, Bolivia, Brazil, Mexico, 159–174. Chicago, IL: University of Chicago Press. Morales, Juan Antonio, and Jeffrey D Sachs. 1990c. “State Capitalism and the Operation of the Public Sector.” In Developing Country Debt and Economic Performance, Volume 2: Country Studies—Argentina, Bolivia, Brazil, Mexico, 189–202. Chicago, IL: University of Chicago Press, 1990. Otálora, U., and Carmen Rosa. 2002. La política fiscal Boliviana entre 1975 y 1989. https://​ econpapers​.repec​.org/​paper/​risiisecd/​1990​ _5f002​.htm. Pastor, Manuel. 2019. Inflation, Stabilization, and Debt: Macroeconomic Experiments in Peru and Bolivia. London: Routledge. Sachs, Jeffrey D. 1986. The Bolivian Hyperinflation and Stabilization. Cambridge, MA: National Bureau of Economic Research.

Gabriel Xavier Martinez

13. Canada and the global financial crisis

six” combined with sound policy and regulatory oversight may be argued to have encouraged stability and a more conservative banking culture. With this in mind, the praise levied on Canadian banks should not be exaggerated. Canadian banks do not always behave better than their peers elsewhere in the world, nor are they above criticisms regarding meeting the needs of consumers or small and medium-sized enterprises (Livesey 2012). For some, Canadian banks are overly reliant, in fact, on the existing model of retail banking and not sufficiently prone to innovation (Meredith and Darroch 2017). Despite these more critical observations, Canada undoubtedly benefited from having a sound and stable banking sector.

Canada navigated the 2007–2008 global financial crisis well. The country was affected by market turbulence, yet the financial system overall remained resilient. Canada is one of a handful of countries, as such, where the crisis had a more limited impact. How is the Canadian experience explained? What are the causes of its success, and what are the lessons to be learned? This entry considers the traditional explanations about Canada’s performance and the limitations of these arguments. Ultimately, it shows that there was no Canadian exceptionalism (Dostie 2020). Resilience was the result of many factors and some good fortune.

Thoughtful policy, supervision, and regulation

The Canadian banking system

The Canadian success is also explained by good policy choices and the intense supervision and regulation of financial markets. The Bank Act is the primary legislation for banking in Canada, and it is reviewed every five years. The last major legislative overhaul took place in 2001 at the height of the globalization debate. Canadian policymakers sought, at the time, to provide for greater domestic competition and to ensure global competitiveness while still imposing various restrictions on the banking sector to limit possible excesses. The legislation also followed years of debate about potential mergers among four of the country’s six banks; the government turned down these mergers, though it is debatable whether it did so for political reasons or out of genuine concern regarding excessive concentration in the industry (Harris 2004). The legislation was subject to criticism that it continued to overly restrict banks’ ability to take advantage of the opportunities provided by the globalization of markets. In retrospect, it may have also shielded Canadian finance from some of the worst effects of the global financial crisis. The Office of the Superintendent of Financial Institutions (OSFI) is responsible for the prudential supervision and regulation of all federally regulated financial institutions in Canada and is usually deemed an effective regulator. The regulatory system anchored by OSFI is integrated, principles-based, and risk-centered (Savage 2014). Most signifi-

Historically, the Canadian financial system has been stable (Bordo et al. 2015; Calomiris and Haber 2014). At the time of the global financial crisis, the World Economic Forum had ranked Canada first out of 134 countries on the soundness of its banks (World Economic Forum 2008). A review of case law suggests that Canada may have experienced as few as 11 bank bankruptcies in its history (Ben-Ishai 2008) and none since 1991. The structure and organization of the market are considered the primary reasons explaining the country’s stability. Canada’s financial services sector is bank-based, with six chartered banks that form an oligopoly and dominate much of retail banking through an extensive network of bank branches. As Canada moved forward with deregulation starting in the late 1980s, Canadian banks also became dominant in the retail markets for investment and insurance. The resilience of Canadian banks has been attributed to their funding structure, which relies on depositors rather than wholesale funding (Huang and Ratnovski 2009). It has also been argued that Canadian banks are risk-averse and have robust risk management practices (Arjani and Paulin, 2013). Therefore, Canadian banks were exposed to the U.S. subprime market, where the crisis originated, but comparatively less than other global firms. Market concentration alone cannot be said to explain resilience. Still, the dominance of the “big 58

Canada and the global financial crisis  59

cantly, the regulator benefits from a strong working relationship with market actors, which allows it to solve problems quickly as they arise. While OSFI is criticized for its lack of transparency and accountability (Roberge and Dunea 2015), some present the opaqueness as key to explaining its success (Anand and Green 2012). Policy and regulatory performance are difficult to assess, and it would be erroneous to suggest that Canadian regulatory performance and standards were necessarily higher or better than elsewhere. While it is true that Canadian capital requirements were above international standards, Canadian banks, in practice, did not necessarily retain more capital than other firms that either went bankrupt or required government support internationally. However, policymakers and regulators were able to act promptly and creatively to address the crisis. When the stability of the system was most at risk, Canadian banks received up to $114 billion in total government support (including some support from the U.S. Federal Reserve); three banks – the CIBC, BMO, and ScotiaBank – received support exceeding the value of the company (Macdonald 2012). A second government regulator, the Canadian Housing and Mortgage Corporation, also purchased mortgages directly from the banks once they had been converted to mortgage-backed securities. This program would see the crown corporation purchase $69 billion of mortgages. These actions provided the required liquidity that banks and market actors needed to ensure that there would not be a market disruption. Policymakers and regulators were criticized for sleepwalking into the crisis (Harris 2010). Regulatory regimes, however, matter, and the Canadian experience demonstrates that sound practices can minimize risk-taking (Mohsni and Otchere 2018). What stands out is the governments and regulators’ ability to contain the crisis, keep market confidence, and provide for long-term stability.

The mortgage story

The Canadian mortgage story is quite different than that in the United States. While the federal government proceeded to loosen mortgage rules in the early years of the new millennium, allowing mortgages of up to 40 years with no downpayment (rules that have since been tightened anew), how the market

worked and still operates today is usually considered prudent (Schembri 2014; Crawford et al. 2013). Federally regulated lenders provide around 80 percent of mortgages in Canada; the large banks account for 65 percent of the market. There are few subprime mortgage providers in the country, so when the crisis hit, nonprime mortgages were only 5 percent of the market (Crawford et al. 2013). Without a sufficiently large downpayment, Canadians are also required to purchase mortgage insurance. The Canadian Mortgage and Housing Corporation provides most of this insurance; at the time of the global financial crisis, there was a single private insurance provider, whereas, at the time of writing, there are now two. Significantly, the insurance is provided to the lender, while Canadians who default receive little to no support. The Canadian mortgage market has been subject to financialization and securitization – at the time of the crisis, about 25 percent of mortgages were securitized (Mordel and Stephens 2015) – but much of it was through CHMC on mortgages that were insured (Walks and Clifford 2015). The global financial crisis came about because of failures in the U.S. subprime market; the market structure rendered such a scenario in Canada unlikely.

Post-crisis

There is no Canadian exception per se. There are many factors that, put together, help explain Canadian resilience. The political narrative associated with the global financial crisis emphasizes success. There is a sound argument to be made that Canada, indeed, reaped the benefits of a balanced approach in which practical and competent governmental intervention supported relatively competitive and fair financial markets. Furthermore, the Canadian government, including the Department of Finance, the Bank of Canada, and the various regulators, managed the crisis well. This story of Canadian success, however, needs to be nuanced. Canada was not entirely spared the effects of the crisis. Policymakers and regulators, as elsewhere, were caught off-guard by market developments. They were largely unprepared and had to react to events they had no control over. There were regulatory cracks in the financial system as evidenced by the third-party asset-backed commercial paper (ABCP) crisis (Halpern et al. 2016), a $32 Ian Roberge

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billion market that froze in August 2007 because it was thought to be tied to the U.S. subprime market. Although the industry was able to find a solution by agreeing to the issuance of new notes that would come to term nine years later, the crisis in the largely unregulated market demonstrated weaknesses in regulatory oversight and market conduct. The ABCP crisis is usually considered the most significant financial crisis in Canadian history. Thus, there are lessons for policymakers and market actors to learn from the global financial crisis. However, the constant reference to success has reinforced the pre-existing complacency regarding the soundness of the country’s financial system and required policy and regulatory adjustments (Roberge 2015). Over the last decade, policy and regulatory changes have been marginal. One such shift is OSFI’s emphasis on the implementation of Basel III. In so doing, the regulator has named all six of Canada’s big banks as systemically important. However, considering the rapid evolution of finance, there is a good argument that a more complete and thorough review is required. Financial services sector policy in Canada is not of political salience. As such, the extent to which the country is well prepared for the next crisis is difficult to determine and is likely to depend on the specifics of that crisis and how it unfolds. Ian Roberge

References

Anand, Anita, and Andrew Green. 2012. “Regulating Financial Institutions: The Value of Opacity.” McGill Law Journal 57 (3): 399–427. Arjani, Neville, and Graydon Paulin. 2013. Lessons from the Financial Crisis: Bank Performance and Regulatory Reform. No. 2013–4. Bank of Canada Discussion Paper, 2013. Ben-Ishai, Stephanie. 2008. “Bank Bankruptcy in Canada: A Comparative Perspective.” Banking and Finance Law Review 24 (3): 59–73. Bordo, Michael D., Angela Redish, and Hugh Rockoff. 2015. “Why Didn’t Canada Have a Banking Crisis in 2008 (or in 1930, or 1907, or …)?” The Economic History Review 68 (1): 218–243. Calomiris, Charles W., and Stephen H. Haber. 2014. Fragile by Design: The Political Origins of Banking Crises and Scarce Credit. Princeton, NJ: Princeton University Press. Crawford, Allan, Cesaire Meh, and Jie Zhou. 2013. “The Residential Mortgage Market in

Ian Roberge

Canada: A Primer.” Financial System Review 3 (53): 13. Dostie, Claude. 2020. “Le Canada et la crise financière: un retour critique sur la thèse de l’exception canadienne.” Politique et sociétés 39 (2): 27–48. Halpern, Paul, Christopher C. Nicholls, Poonam Puri, and Caroline Cakebread. 2016. Back from the Brink: Lessons from the Canadian Asset-Backed Commercial Paper Crisis. Toronto: University of Toronto Press. Harris, Stephen. 2004. “Financial Services Sector in Canada: Interests and the Policy Process.” Canadian Journal of Political Science 37 (1): 161–184. Harris, Stephen. 2010. “The Global Financial Meltdown and Financial Regulation: Shirking and Learning – Canada in an International Context.” How Ottawa Spends 2010–2011, edited by G. Bruce Doern and Christopher Stoney. Montréal: McGill-Queen’s University Press. Huang, Rocco, and Lev. Ratnovski. 2009. Why Are Canadian Banks More Resilient? Washington, DC: International Monetary Fund. Livesey, Bruce. 2012. Thieves of Bay Street: How Banks, Brokerages and the Wealthy Steal Billions from Canadians. Mississauga: Random House. Macdonald, David. 2012. The Big Banks’ Big Secret: Estimating Government Support for Canadian Banks during the Financial Crisis. Ottawa: Canadian Centre for Policy Alternatives. Meredith, Patricia, and James L. Darroch. 2017. Stumbling Giants: Transforming Canada’s Banks for the Information Age. Toronto: University of Toronto Press. Mohsni, Sana, and Isaac Otchere. 2018. “Does Regulatory Regime Matter for Bank Risk Taking? A Comparative Analysis of U.S. and Canada.” Journal of International Financial Markets, Institutions & Money 53: 1–16. Mordel, Adi, and Nigel Stephens. 2015. “Residential Mortgage Securitization in Canada: A Review.” Bank of Canada Financial System Review 39–48. Roberge, Ian. 2015. “Safe, But for How Long? Gauging the Harper Government’s Response to the Last Global Financial Crisis (and Canada’s Preparation for the Next One).”The Harper Record 2008–2015, edited by Teresa Healy and Stuart Trew. Ottawa: Canadian Centre for Policy Alternatives, www​.policyalternatives​.ca/​ publications/​reports/​harper​-record​-2008–2015 (accessed July 29, 2021). Roberge, Ian, and Dona M. Dunea. 2015. “Why Opacity Is Just Not Good Enough: The Effectiveness and Accountability of Canada’s Office of the Superintendent of Financial Institutions.” Building Responsive and Responsible Financial Regulators in the

Canada and the global financial crisis  61 Aftermath of the Global Financial Crisis, edited by Pablo Iglesias-Rodriguez. Cambridge: Intersentia, pp. 255–273. Savage, Lawrie. 2014. From Trial to Triumph: How Canada’s Past Financial Crises Helped Shape a Superior Regulatory System. University of Calgary School of Public Policy Research Papers 7 (15). Schembri, Lawrence L. 2014. “Housing Finance in Canada: Looking Back to Move Forward.” National Institute Economic Review. 230: R45–R57.

Walks, Alan, and Brian Clifford. 2015. “The Political Economy of Mortgage Securitization and the Neoliberalization of Housing Policy in Canada.” Environment and Planning A 47 (8): 1624–1642. World Economic Forum. 2008. The Global Competitiveness Report. Michael E. Porter and Klaus Schwab. Geneva. March 4. (weforum. org) (accessed July 28, 2021).

Ian Roberge

14. Canada’s asset-backed commercial paper crisis

Nonetheless, the paper was perceived in the Canadian market as secure. As such, notes had also been sold to retail investors. Third-party ABCP contained residential mortgages, credit card receivables, and credit default swaps. The immediate cause of the crisis was a maturity mismatch between the short-term notes of 30–60–90 days and their underlying assets, some of which were riskier derivative investments (Chant 2009). Coventree, Inc. was the biggest issuer of the paper. In an early August 2007 memo, the company observed that third-party ABCP had a small exposure to the US subprime market. Within a week of the memo, investors refused to roll over their notes. Liquidity providers, in turn, refused to support the conduits selling the assets, creating a situation in which the market was at risk of collapsing. These liquidity arrangements had restrictive triggering provisions, which proved insufficient to backstop the market as liquidity providers and conduits haggled about what constituted a market disruption. Trading was halted until the situation could be clarified to stem the crisis. The most notable aspect in the early phases of the crisis was how little was known about the market, including its size, the product, what it contained, and who owned it, even by those more directly involved. The second consideration concerns the supervisory and regulatory gaps exposed by the crisis. The third-party ABCP market was largely unregulated. Canada’s regulatory authority is divided, with prudential supervision and regulation conducted at the federal level by the Office of the Superintendent of Financial Institutions and market conduct regulated provincially via ten provincial regulators. There is no national securities commission. In this structure, the rise of the third-party ABCP market went largely unnoticed. The federal regulator had no reason to believe that prudential considerations were at play, while provincial regulators did not suspect market misconduct, of which there was, in fact, relatively little. Regulators likely should have been more attentive to the market (Harris 2010), although, in fairness, such an observation results from post-facto analyses of the crisis.

This entry reviews Canada’s 2007 third-party asset-backed commercial paper (ABCP) crisis (Halpern et al. 2016). Financial crises are context-based. Although this case is minor compared to other much more significant occurrences of market disruption, the third-party ABCP crisis is often referred to as the worst financial crisis in Canadian history. How and why did the crisis happen? How was it resolved? What are the lessons that were learned from it? Trading in the $32 billion third-party ABCP market was halted in August 2007 when concerns were raised that some of the paper contained US subprime mortgages. Although this concern was exaggerated, there was a need to act quickly to avoid a more extensive disruption and preserve market confidence. The story of this crisis is interesting in part because its resolution was industry-led with minimal government intervention. Canada was spared the brunt of the global financial crisis; however, the third-party ABCP crisis offered a prelude (admittedly with distinctive features) of what would unfold worldwide.

The market and the causes of the crisis

There are two primary considerations in explaining the Canadian third-party ABCP crisis. The first lies in the specifics of the market and in the way in which the crisis developed. The $116 billion Canadian ABCP market primarily operated through the country’s banks, so third-party ABCP accounted for just $32 billion of the overall market. The product was designed for institutional investors; the Caisse de dépots et placements du Québec, a pension and insurance fund and one of the country’s largest institutional investors held $16 billion worth of notes. DBRS, the sole Canadian credit-rating agency, had given the paper a Triple-A rating. Of interest, American credit-rating agencies had refused to rate the product because they deemed it overly opaque. 62

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The market-led resolution and the aftermath

Market actors orchestrated the response to the third-party ABCP crisis. It made creative use of the Companies’ Creditors Arrangement Act (CCAA) – Canada’s bankruptcy law – to facilitate and organize the adoption of the proposed resolution plan. When the market was frozen, governments refused to come to the aid of the sector and made it clear that the industry would need to find a solution on its own. The federal government and the provincial governments of Ontario, Québec, and Alberta would eventually agree to provide a financial guarantee as part of a backstop facility that was also partially industry-funded; the onus for resolution, however, fell to the industry and holders of the paper. In this context, the Pan-Canadian Investors Committee for Third-Party Structured Asset-Backed Commercial Paper was formed and tasked with finding a solution. The Committee was led by Purdy Crawford, a respected corporate lawyer, and composed of the various firms that were the most directly impacted. The resolution plan developed by the Committee, referred to as the Montréal Accord, centered on issuing new notes with extended maturity of up to nine years, allowing the underlying assets to come to term. The proposal received broad industry support. One of the difficult questions arising from this crisis was how to make individual investors whole, many of whom were not even aware before the crisis that they had the paper in their investment portfolio. The Montréal Accord included a controversial release for market participants. The release would avoid potentially lengthy court proceedings between market actors. Still, this was a contentious issue for retail investors because it also meant that no one would be held legally responsible for the crisis. The CCAA process required double-majority support for the plan. Double-majority support is a majority in the number of noteholders holding notes with a collective value of at least two-thirds of the total amount outstanding. Retail investors needed to be courted for plan approval and implementation. Following retail investor mobilization, two key dealer firms, Canaccord and Credential, promised to buy back in full their notes in return for investors’ support of the plan; Halpern et al. (2016) suggest that these firms likely obtained finan-

cial assistance from another market participant to be able to afford the buy-out. Of note, the National Bank and the Desjardins Credit Union, both primarily Québec-based, had already decided in the early days of the crisis to buy back their clients’ notes as the “right thing to do” and for reputational purposes. Retail investors were ultimately brought on board, paving the way to resolve the crisis. Following investor approval, the Montréal Accord was officially authorized by the court in January 2009. This led, in turn, to the application of the CCAA court-supervised insolvency processes for the third-party ABCP trusts allowing for the disbursement of the new notes and the launch of a secondary market. The crisis aftermath was relatively uneventful. Developing a secondary market allowed institutional investors to recoup some of their losses. The market picked up in 2013 when the underlying assets were sold separately, earning a higher return; the last notes came to term in 2017, closing the loop ten years after the crisis hit. There were few legal repercussions from the crisis. The main dealers settled outlying claims with regulators who used monies from the settlements to reimburse investors on a pro-rata basis. The total fines levied to securities dealers in administrative penalties and investigative costs exceeded $138 million; the National Bank paid the largest penalty of the seven dealers that were fined, agreeing to pay $75 million to the Québec regulator (Lamb 2009). For individual investors, the fine amounts were seen as insufficient, primarily because no one was being held to account for the crisis (Noble 2009). Coventree, Inc. refused to settle and was found by the Ontario Securities Commission to have breached disclosure requirements; the company’s two founders were also found personally responsible for consenting to the breaches.

Moving on

The third-party ABCP crisis in Canada was mainly resolved successfully. What are the major lessons that were learned from the crisis? The crisis served as a wake-up call for firms to reassess internal practices, yet it did not generate much in the way of system-wide considerations. The crisis led institutional investors to review their risk management and due diligence procedures and served as Ian Roberge

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a reminder of the need for portfolio diversification. Concerns regarding dealers’ fiduciary duty were also exposed. More globally, the third-party ABCP crisis is perceived as a purely Canadian crisis for which a uniquely Canadian solution was found. By all accounts, Purdy Crawford played a critical role in bringing together market participants to find a reasonable solution that would meet the needs of the actors involved and be in the general public interest. The crisis did not lead to a broader reflection regarding how markets operate or how supervisors and regulators exercise their responsibilities. Furthermore, DBRS was essentially let off the hook, though its behavior raises similar questions to those of the other credit-rating agencies during the global financial crisis. There was little market introspection and no policy or regulatory reform in response to the crisis. The third-party ABCP crisis, for instance, highlighted the lack of investor protection in Canada. Although unrelated, securities regulators considered but rejected in 2017 a “best interest” standard for dealers and advisors. Such a standard would have served, at a minimum, as another layer of protection for small investors. The third-party ABCP crisis is perceived as a fluke, which is unlikely to happen again. The post-script to the crisis reflects the broader complacency and lack of urgency in addressing the various issues the Canadian financial services sector faces. Ian Roberge

Ian Roberge

References

Chant, John. 2009. The ABCP Crisis in Canada: The Implications for the Regulation of Financial Markets, Expert Panel on Securities Regulation, January, Available at: www​ .expertpanel​ .ca/​ eng/​reports/​research​-studies/​the​-abcp​-crisis​-in​ -canada​-chant​.html. Accessed August 31, 2021. Halpern, Paul, Christopher C. Nicholls, Poonam Puri, and Caroline Cakebread. 2016. Back from the Brink: Lessons from the Canadian Asset-Backed Commercial Paper Crisis. Toronto: University of Toronto Press. Harris, Stephen. 2010. “The Global Financial Meltdown and Financial Regulation: Shirking and Learning – Canada in an International Context.” How Ottawa Spends 2010–2011, edited by G. Bruce Doern and Christopher Stoney. Montréal: McGill-Queen’s University Press. Lamb, Steven. 2009. “ABCP Fines Total $138 Million” Advisor’s Edge, December 22. Available at: www​.advisor​.ca/​news/​industry​ -news/​abcp​-fines​-total​-138​-million. Accessed August 31, 2021. Noble, Mark. 2009. “ABCP Investors Blast Settlement, Regulators.” Advisor’s Edge, December 22. Available from: www​ .advisor​ .ca/​news/​industry​-news/​abcp​-investors​-blast​ -settlement​ -regulators. Accessed August 31, 2021.

15. Central banks

the central bank also promotes and enforces by enabling an efficient and safe payment and settlement system and supervising the operations of commercial banks and other financial institutions. Central banks must also protect the economy from the emergence or aggravation of financial crises (Mishkin 1994). However, they cannot always do so as successfully as they would like (Buiter 2008). Even though we can already find substantial differences among the responsibilities, characteristics, and behavior when exploring the concept of modern central banking, their evolution over time was irregular as well (Ugolini 2017). The first institution recognized as a central bank is the Sveriges Riksbank, established in 1668, while the Bank of England, the benchmark for many other central banks, was founded in 1694. The early central banks were private entities that acted as financiers for the government, helping them fund their debt. This role was notably relevant in war when conflicts were primarily financed by borrowing from central banks, resulting in monetary expansion and galloping inflation. For instance, central banks kept interest rates low during WWII to ensure that governments could borrow to finance military spending. Since WWII, their preferred status as the government’s bank caused economic actors to perceive them as more secure, motivating other banks to lodge their deposits in the central bank, thus attributing to it a position of ‘bank for bankers’. In exchange for loans to the treasury, central banks were usually granted the monopolistic right to issue banknotes. This led central banks to take on a magnified role in payments and lending as well as a regulatory role since they needed to ensure the quality of borrower banks, for which they acted as lenders of last resort in the event of financial trouble. Both central banks and treasuries have coevolved, mutually supporting each other given their shared goals of economic and financial stability. Thus, the central bank acts not only as a bank but as a fiscal agent to the government. As the sole national currency issuer, it monitors its currency’s money supply and foreign-exchange value. Central banks’ responsibilities have evolved, and different central banks have different responsibilities. Given their power over the issuance of money and vast capital holdings, central banks were commissioned with the task of monetary policy. Governments

A central bank is an institution entrusted with various public policies to guarantee that economic agents can operate in a sound environment, promoting a path of steady growth through several operations at its disposal. Monetary policy encompasses the set of actions aimed at guiding the decisions that households and firms take, thus influencing relevant variables such as spending, investment, employment, inflation, or output. The central bank’s stance on monetary policy is usually developed following the mandates of representatives—these target specific objectives, such as stability of prices or maximum level of employment. We typically state that central banks mainly carry out monetary policy, but we may risk oversimplifying the many activities in which central banks participate. Thus, while maintaining the optimal monetary and financial conditions is paramount for the economy to achieve an optimal level of employment and production, central banks also target other relevant aspects of the economy. On the monetary side, the central bank aims to protect the economy from excessive price volatility that could damage real economic activity: stable prices facilitate future planning for consumers and producers. If prices rise too much, the currency loses value, and consumers lose purchasing power. However, if prices fall continuously, people may be tempted to delay consumption, assuming prices will keep dropping, thus slowing economic activity and leading to job destruction. The central bank also tries to smooth the business cycle with its policies and promote domestic economic stability, offsetting shocks to the economy. This stability comes, however, at a cost: the low volatility of both inflation and output may trick market participants into thinking that there is less risk in the economy than there is, as before the Global Financial Crisis (GFC) (Mishkin 2014). On the other side, a financial system is stable when households and firms can access the resources they need to participate in the economy without severe restrictions from the financial institutions or the market. The availability and cost of credit are products of the safety and soundness of financial institutions even in turbulent times, something that 65

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have asked them to develop those in coherence with other national economic policies (fiscal, incomes). With the opening of most economies, central banks have also been encouraged to act as links with foreign central banks and international financial institutions, cooperating in an international realm and even being asked to coordinate their policies with other countries since the increasing complexity of the financial structure also at the international realm increases the risk of transmission of shocks. Consumer protection is just the tip of the iceberg in this order of priorities. New endeavors include ensuring that electronic payments are made safely or investigating crypto-assets and technologies such as blockchain that may disrupt usual patterns of financial behavior and, thus, the way policy is conducted. In the same venue, the recent events of the Great Recession and the Covid-19 pandemic have called for extraordinary measures in central banks. And how exactly can central banks tackle all those functions they oversee? Besides the regulatory and research tasks mentioned above, central banks implement their policies using various tools. We have noted the peculiar relationship that central banks have with the government, as in some countries, their direct loans to the central government are the main (perhaps the sole) source of credit for the executive, and they are the bank where the treasury operations take place (e.g., collection of taxes). One of the most used tools of central banks is the regulation of minimum cash reserves that other banks must hold against their transaction accounts and other selected deposit liabilities. The central bank may even regulate the type of assets that commercial banks and other depository institutions must hold to encourage them to invest in those assets. Many influential central banks have nevertheless removed reserve requirements, moving to the more familiar instrument of influencing market interest rates. By raising or lowering the interest rate on reserve balances, the central bank sets a floor on the rates at which banks are willing to lend excess cash in their (required or excess) reserve balance accounts to private counterparties. To stabilize the international value of the national currency, international foreign-exchange operations try to prompt an adequate position of international reserves against the rest of the world. Nicolás Varela García

On a similar note, discounts (aka rediscounts)—i.e., loans to banks—on the discount or rediscount rate allow banks to experience liquidity pressures to meet seasonal or temporary needs. This backup source of liquidity that discount window lending represents promotes financial stability (Board of Governors of the Federal Reserve System 2021). In what is known as open market operations, reserves in the banking system may also be increased or decreased when securities issued or guaranteed by the treasury or other government agencies are bought or sold. The GFC motivated the development of a tool similar to open market operations, in which the assets are purchased in much larger volumes, influencing long-term yields, as opposed to the small, daily basis of conventional open market operations. That tool is known as quantitative easing and, together with forward guidance, constitutes what at the GFC were considered unconventional monetary tools (Bernanke 2020). The latter is communication about how monetary policymakers expect the economy and policy to evolve, which can take many forms and is critically intertwined with the institutional reputation of the central bank. Although these new monetary policy tools have proved to have moderate costs and risks, vigilance against risks to financial stability remains essential. Finally, although it’s an atypical measure due to its unequal impact on society, central banks may also regulate credit availability for particular purposes (such as hampering of nonessential imports). The fact that most of the countries affected by the GFC were high-income countries with strong institutions motivated not only the usage of unconventional policy measures (countries with a weak central bank cannot resort to those measures without risking credibility), but also a much faster response to the crisis (Laeven and Valencia 2010). Many works have attempted to inquire about the main drivers of financial crises, finding rising debt (Reinhart and Rogoff 2008), a sustained expansion of credit, growth of monetary aggregates, or unanticipated declines in inflation as precursors of crises. The unconventional monetary policy measures adopted during the crisis proved to be beneficial to the stabilization of the financial system (Nakaso 2013). For instance, quantitative easing may signal the long-term commitment of the central bank to keep short-term policy rates

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low1 (Bernanke 2020). That way, the GFC motivated a shift in the way central banks based their decisions, from a regime in which the monetary policy could be followed by the usual instruments (e.g., Taylor rule) to one in which policy rates respond to rules ampliated to take into account the financial condition of the economy (Martin and Milas 2013). Since the GFC, there has also been a worldwide increase in multi-agency financial stability committees (Edge and Liang 2019), with considerable heterogeneity among their governance structures. A key aspect of all these operational tools is the transmission mechanism from shocks to policy effectiveness. Because data and other information on the state of the economy are not available immediately, it can take time between the identification of a shock and the response from the central bank. A central bank that takes a financial regulatory and supervisory role is more likely to have institution-specific information necessary for its effective performance as a lender of last resort (liquidity or solvency problems in systemically important financial institutions). Still, it is more likely to be captured by vested financial sector interests (Buiter 2008). Both monetary and financial stability policies can benefit from information and analyses provided for whichever of them (Nakaso 2013). Additionally, changes in the stance of monetary policy affect the economy with a certain lag, which contributes to the economy being away from the target goals for a significant while. Even though their functions and operations have evolved, the main goals of central banking—to better serve commerce and government—can be traced back to its origins. Of particular importance was the confirmation during the crisis in the 1970s that politicians could not be trusted with monetary discipline. Such officials would never be willing to subordinate domestic priorities to the exchange rate, as tightening policy to head off inflation would alienate voters. As a result, central banks developed the power they hold today, mainly realized during the 1990s. By central bank independence, we represent the freedom of monetary policymakers from direct political or governmental influence in the conduct of policy, which has a variety of angles to it (Debelle and Fischer 1994). Goal independence means that there

are clearly defined policy goals established in the central bank’s charter. Instrument/ operational independence implies that the bank can choose how to achieve its mandated goals without impositions on, for instance, the extent to which it must lend to the government. Finally, we can consider financial and personal independence as means to prevent the government from appointing (and dismissing) members of the governing board or abusing its voting power (if any) on the board, as well as imposing budgetary control on the entity. Independent central banks appear to be part of the solution to the time-inconsistency and political-business-cycle problems to which discretionary economic policy is prone since short-term political considerations cannot sway an independent central bank. However, there may exist a trade-off between independence and accountability. This is why many central banks have been granted instrument and personal independence while preserving a role for the executive in establishing the goals of policy and monitoring the bank’s performance in achieving these goals, with it being legally obliged to account for its actions before the elected representatives. Nevertheless, unlike private corporations, modern central banks operate in the public interest and not necessarily for the profit maximization of shareholders.2 Measuring the degree of central bank independence is quite difficult since legal measures may not reflect the relationship between the bank and the government, especially in developing countries where legally established independence may not be fully honored in practice. History teaches us that central banks cannot take their powers for granted; initially established as private and independent entities, central banks have depended on the government to maintain their charters, although they commonly retained the freedom to choose their tools and policies. For many of them, independence was not granted until just before the twenty-first century, before which most central banks were nationalized and completely lost their independence, with their policies being dictated by the fiscal authorities—a situation we categorize as fiscal dominance. To achieve a trustworthy commitment to inflation targeting, the central bank needs to be fiscally disciplined, avoiding financing fiscal deficits by seigniorage. Nicolás Varela García

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Finally, closely related to independence is the pivotal aspect of credibility. A central bank also lacks credibility when it is not independent of political influence:3 a central bank that plays a quasi-fiscal role impairs its transparency and accountability (Buiter 2008). We can measure the degree of credibility of a central bank as the gap between the actual value of the policy variable (or the expectations about it) and the policy target. A credible central bank benefits from a ‘bonus’, in which economic agents believe in the entity’s commitment to its policies, allowing them to adapt their expectations faster. In contrast, an erosion of the central bank’s credibility may compromise its ability to implement monetary policy and, ultimately, its effectiveness (Nakaso 2013). While an unconditional commitment has a certain advantage in that it does not suggest that it will be abandoned and therefore is likely to have a larger effect on long-term interest rates (Mishkin 2014), it has the disadvantage that even if the circumstances change so that it would be better to abandon the commitment (feasible under a conditional commitment), the central bank may feel it cannot go back on its word and do so. There exists nevertheless a ‘paradox of credibility’ (Borio and White 2004), according to which a ‘too stable’ inflation rate may provide agents with an unrealistic sense of security, thus leading them to engage in more risky behavior that may prompt financial instability. Also, specific institutional bias, such as the moral risk implied by bailout pledges from either central banks, governments, or multilateral organizations may increase systemic4 risk. Some scholars (Blinder 2013) have argued that preserving central bank independence in times of financial crises is neither feasible nor desirable since cooperation between the central bank and the treasury is needed. Given that the usual long-time horizon of monetary policy evaporates and that when deciding which financial institutions are to be deemed to fail and which ones should be supported by the taxpayers’ money, political legitimacy is critically important. The question would then be when to disentangle said cooperation and re-assert the central bank’s independence regarding monetary policy. Financial stability committees usually broaden the political legitimacy of macroprudential policy by involving the ministry of finance, but that may introduce a tendency to delay taking Nicolás Varela García

action in response to building risks (Edge and Liang 2019). Also, macroprudential supervision is subject to more political pressure than monetary policy so it will not be as effective as monetary policy (Mishkin 2014). However, a short- and long-term balance must be reached since financial imbalances build up only gradually (Borio 2019). The level of regulation in the financial system is another issue for debate since lightly regulated entities may enhance stability against some shocks but possibly increase the vulnerability against others (Reinhart and Rogoff 2008). Reincorporating financial repression may prevent minor crises and precipitate a large one (Bordo 2018). Before the GFC, the standard view in both academia and central banks was that achieving price and output stability would promote financial stability (Mishkin 2014). Including financial stability as an extra objective of the central bank may damage its commitment to (flexible) inflation targeting (Woodford 2012); the latter should only be relegated to a second level in times of financial stress— during which the relationship between financial stability policy and monetary policy becomes more intertwined than ever (Nakaso 2013)—but retrieved immediately after the situation stabilizes. Easing monetary policy as a response to a financial crisis is counterproductive: it risks unanchoring inflation expectations, thus leading to high inflation. The central bank must have built credibility before, communicated the rationale for its monetary policy, and committed to refrain from its policy if the situation recovers its normal trend. Deteriorations in the sentiment portrayed by the communications (explicit or tacit) of central banks seem to signal deterioration in the financial cycle and drops in the monetary policy rates,5 so the ability of the central bank to communicate that there is a buildup in vulnerabilities with a considerable lead in the credit cycle may be able to reduce the likelihood of a banking crisis (Correa et al. 2021). The role of lender of last resort of the central bank, while preventing systemic risk and eventual financial crises, has the moral hazard risk of encouraging banks to take too much risk since they count on the central bank to bail them out if they get into trouble. This problem is more severe the larger the commercial bank is since they consider themselves ‘too big to fail’ (Mishkin 1994), and

Central banks  69

some scholars argue that lender-of-last-resort programs are not useful outside of a crisis and thus should not be viewed as part of normal monetary policy (Bernanke 2020). Central banks are one of the leading agents in promoting economic stability. For that same reason, the control to which they are subject is not only intense but crucial to determine the degree of policy effectiveness. Coordination of monetary and macroprudential policies becomes of greater value when all three objectives of price stability, output stability, and financial stability are pursued (Mishkin 2014). Nicolás Varela García

Borio, Claudio. 2019. ‘On Money, Debt, Trust, and Central Banking’. Cato Journal 39 (2): 267–302. Borio, Claudio, and William White. 2004. ‘Whither Monetary and Financial Stability? The Implications of Evolving Policy Regimes’. BIS Working Paper 147. Buiter, Willem H. 2008. Central Banks and Financial Crises. Discussion paper 619, Financial Markets Group, London School of Economics and Political Science. Correa, Ricardo, Keshav Garud, Juan M. Londono, and Nathan Mislang. 2021. ‘Sentiment in Central Bank’s Financial Stability Reports’. Review of Finance 85–120. Debelle, Guy, and Stanley Fischer. 1994. ‘How Independent Should a Central Bank Be?’ In Goals, Guidelines and Constraints Facing Monetary Policymakers, edited by Jeffrey C. Notes Fuhrer, 195–221. Federal Reserve Bank of 1. This is coherent with the fact that the announceBoston. ment of the second round of this program by the Edge, Rochelle M., and J. Nellie Liang. 2019. Fed was largely anticipated and had thus little New Financial Stability Governance Structures effect on Treasury yields (Bernanke 2020), and not and Central Banks. Finance and Economics least with the ‘taper tantrum’ panic that followed Discussion Series 2019–019, Washington, DC: the announcement of the tapering of quantitative Board of Governors of the Federal Reserve easing. System. 2. Most central banks in the world are today publicly owned. Laeven, Luc, and Fabian Valencia. 2010. 3. That is obviously not the only determinant of the Resolution of Banking Crises: The Good, credibility of a central bank. In fact, an argument the Bad, and the Ugly. IMF Working Paper, for circularity between credibility and financial International Monetary Fund. crises can easily be made. 4. The term systemic alludes to the contagion effect Martin, Christopher, and Costas Milas. 2013. ‘Financial Crises and Monetary Policy: from one part of the financial apparatus to the Evidence from the UK’. Journal of Financial whole system in a domino-like fashion. Stability 9: 654–661. 5. The specific financial stability governance framework of each central bank may affect the differ- Mishkin, Frederic S. 1994. Preventing Financial ential lag between communications and financial Crises: An International Perspective. Working cycle indicators. In fact, most financial stability Paper 4636, National Bureau of Economic committees are either advisory or serve just as Research. instruments for communication but have no tools at their disposal to implement macroprudential —. 2014. ‘Central Banking after the Crisis’. Series on Central Banking Analysis and Economic actions (Edge and Liang 2019). Policies (Central Bank of Chile) (19): 23–59. Nakaso, Hiroshi. 2013. ‘Financial Crises and References Central Banks’ “Lender of Last Resort” Function’. Remarks at the Executive Forum Bernanke, Ben. 2020. The New Tools of Monetary ‘Impact of the Financial Crises on Central Policy. Presidential address, American Bank Functions’. World Bank. 1–11. Economic Association. Blinder, Alan S. 2013. ‘Financial Crises and Reinhart, Carmen M., and Kenneth S. Rogoff. 2008. ‘Is the 2007 US Sub-Prime Financial Central Bank Independence’. Business Crisis So Different? An International Historical Economics 48 (3): 163–165. Comparison’. American Economic Review: Board of Governors of the Federal Reserve System. Papers & Proceedings 98 (2): 339–344. 2021. ‘The Fed Explained: What the Central Bank Does’. Vers. 11. About the Fed. August. Ugolini, Stefano. 2017. The Evolution of Central Banking: Theory and History. London: Palgrave Accessed April 1, 2022. www​ .federalreserve​ Macmillan. .gov/​aboutthefed/​the​-fed​-explained​.htm. Bordo, Michael D. 2018. ‘An Historical Woodford, Michael. 2012. Inflation Targeting and Financial Stability. Working Paper 17967, Perspective on the Quest for Financial Stability National Bureau of Economic Research. and the Monetary Policy Regime’. The Journal of Economic History 78 (2): 319–357.

Nicolás Varela García

16. Changes in commodity prices as the factor triggering financial crises

nomena as changes in consumption patterns, effects of technical progress (that can change demand for or supply of individual commodities or their substitutes), exploration and investment in new mineral deposits, investment in new production and transportation capacities, and so on. Cyclical factors relate to high capital intensity and a long investment cycle, at least in the case of non-agriculture commodities. During periods of high prices, the volume of investment increases, often in capacities characterized by relatively high marginal production costs. Once prices decline, such marginal capacities become loss-making, and investment in new capacities decreases due to their lower profitability and lower financial resources of sectoral investors. Commodity prices also depend on fluctuation in global aggregate demand because investment in commodity inventories or futures contracts has become an attractive opportunity for financial institutions. The attractiveness of commodity transactions has increased since the beginning of the twenty-first century due to low interest rates. The impact of changes in global macroeconomic conditions on commodity prices has been seen, among other events, during the global financial crisis of 2007–2009 and the COVID-19 crisis in 2020–2021. This means that commodity markets serve as one of the channels that transmit global macroeconomic shocks to the country level. Commodity price shocks considered exogenous by governments and central banks of small and medium-size economies result from the cumulative effects of monetary and fiscal policies worldwide, with the most impactful role of the largest economies such as the US, the European Union (EU), Japan, China, and India. Figure 16.1 shows a high degree of co-movement of commodity groups indexes since the beginning of the twenty-first century, which confirms the increasing role of fluctuation in global aggregate demand (the third factor). In some instances, large-scale changes in commodity prices led to financial crises in commodity-exporting or commodity-importing countries.

Changes in commodity prices, especially oil prices, have impacted the terms of trade of exporters and importers, their balance of payments, official foreign exchange reserves, exchange rates, inflation, budgetary revenue and fiscal balance, and the stability of the financial sector. Therefore, it cannot be surprising that significant fluctuations in commodity prices can lead to macroeconomic destabilization and financial crises.

Fluctuation in commodity prices

Most commodity markets have a relatively free global character, except for food and other agricultural commodities, which are subject to tariff and non-tariff barriers in many countries. Like any other market prices, commodity prices are not stable (Figure 16.1). Their fluctuations have been determined by the interplay of demand and supply forces, a substantial part of which has a non-market character. The latter concerns such institutions and instruments as supplier cartels,1 investment policies of state-owned or controlled producers (which play a dominant role in many countries), state licensing of private producers/suppliers, environmental policies, government-controlled strategic reserves of a given commodity, international sanctions affecting exports or imports, administrative price control/regulation, consumer and producer subsidies (especially in case of energy and food products), export taxes, regulations determining commodity use for consumer and producer purposes (for example, energy-saving regulations), and so on. Many such instruments of government interventions, even if aimed at smoothing market price fluctuations, frequently cause the opposite; that is, they increase their amplitude. Among the market forces contributing to price fluctuations, one can mention (i) structural changes in demand and supply (Borensztein and Reinhart 1994), (ii) cyclical factors, and (iii) changes in global aggregate demand. The first group consists of such phe-

Commodity dependence

The impact of commodity price changes on net commodity exporters’ macroeconomic 70

Changes in commodity prices as the factor triggering financial crises  71

Source:  IMF World Economic Outlook database, October 2021.

Figure 16.1

World commodity price indexes, 2016 = 100

Source:  World Bank’s World Development Indicators, last updated on November 23, 2021.

Figure 16.2

Total natural resources rents, percent of GDP, 2013 and 2016

and financial stability depends on the share of commodity production in the country’s gross domestic product (GDP), exports, and general government revenue. The larger this share is, the more vulnerable is a given economy

to commodity price changes. Among the various measures illustrating commodity dependence, the natural resource rent is the most synthetic. Marek Dabrowski

72  Elgar encyclopedia of financial crises

Figure 16.2 shows countries with the total resource rent (the sum of oil, natural gas, coal, mineral, and forest rents) exceeding 10 percent of GDP in 2013, the year of the highest commodity prices, and 2016 when these prices substantially declined. Above half of the global natural resource rent accounts for the oil rent. All countries pictured in Figure 16.2 belong to the group of emerging-market and developing economies (EMDEs), according to the International Monetary Fund (IMF) World Economic Outlook (IMF 2021) classification. Except for the Gulf states, all of them belong to low-income, lower-middle-income, and upper-middle-income groups, according to the World Bank classification.2 In non advanced economy, according to the World Economic Outlook (IMF 2021) typology, the share of total resource rent exceeds 10 percent of GDP, even in the case of such essential commodity producers as Norway, Australia, and Canada. Their economies’ high degree of structural diversification makes them less dependent on commodity price fluctuations. Individual countries’ vulnerability against commodity price shocks is illustrated by the difference between the total resource rent in 2013 and 2016. In several cases, it decreased by more than half which meant heavy income losses for high-rent countries.

Macroeconomic and financial turbulence caused by changes in commodity prices

In light of the above analysis, it is hardly surprising that substantial changes in commodity prices may cause severe macroeconomic and financial turbulences in countries dependent on commodity production and exports. Usually, the impact of price changes on commodity importers is negligible because of more diversified import structures. Nevertheless, at least one episode of rapid price increase (two oil shocks in the 1970s induced by the Organization of the Petroleum Exporting Countries (OPEC)) contributed to a severe macroeconomic destabilization in many net commodity importers. Below, we analyze three cases of macroeconomic and financial turbulences triggered by changes in commodity prices: (i) increase in oil prices in the 1970s, (ii) decline of oil prices in the mid-1980s, and (iii) decline of oil and other commodity prices in 2014–2015. Marek Dabrowski

Oil price shocks of the 1970s In the post-World War II period, nominal oil prices were almost stable, and real prices (adjusted for inflation) decreased. It changed in October 1973 due to a new round of Arab-Israeli conflict (the Yom Kippur War). The Arab members of OPEC launched the oil embargo against Israel’s allies – the US in the first instance. Simultaneously, they started to cut oil output. By the end of the embargo, in March 1974, the oil prices almost quadrupled – from US $3 to nearly US $12 for one barrel. Other factors contributed to the price shock, apart from the embargo and OPEC’s output reduction. First, it was a reduction of the oil output in the US. Second, abandoning the US dollar gold parity in August 1971 and the resulting dismantling of the Bretton Woods system of fixed but adjustable pegs led to the depreciation of the US dollar (the primary transaction currency on the oil market) against gold and other currencies and increasing inflationary pressures. It resulted in actual revenue losses for oil exporters, which they want to compensate. The second oil shock came in 1979–1980 due to the Iranian Revolution and then the Iran-Iraq war: both contributed to the substantial drop in output in two leading oil producers. Between 1979 and 1980, oil prices more than doubled to almost US $40 for one barrel. Other factors also contributed to the second shock, including global inflationary pressures after the first shock (see below) and oil price controls in the US that further depressed domestic production. Both oil shocks hurt oil importers (Cooper 1994). First, they led to substantial inflationary pressures in both advanced economies and EMDEs. Accommodative monetary policies that tried to compensate for the adverse effects of oil price shocks and protect employment and output transformed a one-off supply shock into persistently higher inflation. The 12-month inflation in the UK reached 27 percent in August 1975 and, once again, 22 percent in April 1980 (Wolf 2021). In the US, it peaked at 14.8 percent in March 1980.3 Eventually, output growth slowed down or even declined (stagflation), and unemployment increased. In several EMDEs, especially in Latin America, populist monetary, fiscal, and income policies to accommodate adverse oil

Changes in commodity prices as the factor triggering financial crises  73

price shocks led to very high inflation, hyperinflation, and financial crises. Most oil exporters, especially in the Middle East and North Africa (MENA) region, wasted windfall gains from the oil shock. Such gains were spent for military purposes, populist economic and social policies such as large-scale subsidies for food and energy products, socially motivated public sector employment, government investments in import-substitution projects, and other reasons. The commodity price collapse in the 1980s The 1980 price of nearly US$40 for one barrel was a peak level of that oil price cycle. In the subsequent years, oil prices gradually declined (Figure 16.1). Eventually, in July 1998, when the decreasing trend accelerated, they dropped to below US$10 for one barrel. Several factors were behind this trend: a gradual increase of oil production, especially in non-OPEC countries but also in Saudi Arabia (a swing producer), disagreement between OPEC members, recession in the leading advanced economies in the early 1980s that resulted from anti-inflationary policies, and progress in oil-saving technologies (Gately 1986). A dramatic drop in oil prices hit oil exporters (Dasgupta, Keller, and Srinivasan 2001), most of which were unprepared to meet such a shock. They spent all oil-related export proceeds in good years. Worse, some borrowed heavily against the expectation of further price increases, or at least their stabilization at a high level. A non-market character of many oil-exporting economies (the former USSR or those MENA and African countries that experimented with various models of socialism) caused the adjustment to lower oil prices even more difficult and costly. The Soviet Union became the most significant economic and geopolitical victim of this price shock. Low oil prices led to profound macroeconomic instability in 1987–1991 and political disintegration in 1991 (Gaidar 2010). Non-Gulf MENA oil exporters (Algeria, Iran, Libya, and Syria) and a few other large producers (Nigeria, Venezuela, Mexico) also experienced macroeconomic destabilization. These include balance-of-payments and debt service problems. Economic growth slowed down in the MENA region; non-oil producers were indirectly affected via regional trade,

capital flow, and labor remittance channels. Given the rapid population growth, real GDP per capita declined in the region in the 1980s (Abed and Davoodi 2003). Like the oil market, other commodity markets also experienced downturns in the 1980s. For example, copper prices collapsed by approximately half in the first half of the 1980s, which was one factor contributing to Chile’s financial crisis in 1982–1983 (Edwards and Cox Edwards 1991) and Zambia in the 1980s and 1990s (Barry 1991). Between 1987 and 1993, the collapse of coffee prices negatively affected the economies of Brazil, Colombia, and several countries in East and Central Africa (Boughton 2000). The commodity price collapse in 2014–20154 In many respects, the collapse of oil and other commodity prices in mid-2014 (Figure 16.1) brought back memories of the mid-1980s. It followed the period of record-high prices before and immediately after the global financial crisis of 2007–2009, which helped to expand the supply side and reduce demand (the cyclical factor). Changes in monetary policy (the beginning of the tightening cycle in the US) played a less prominent role compared to the early and mid-1980s. Metals prices declined by approximately half, and oil prices by more than half (Figure 16.1). Prices of agricultural commodities (food and non-food) also fell but less dramatically. Although oil and metal prices partly recovered in 2018, they remained well below the 2013 level until 2021. The decline of commodity prices generated a powerful macroeconomic shock for their exporters. However, the adverse effects were smaller as compared to the mid-1980s episode. Better macroeconomic fundamentals (Dabrowski 2019) and the accumulation of substantial monetary and fiscal buffers (large international reserves of central banks and sovereign wealth funds) in the boom period made commodity producers more resilient to adverse price shocks. Furthermore, in many countries, these buffers were large enough to launch aggressive countercyclical fiscal and monetary policies that mitigated the negative impact on the real sector. Figure 16.2 shows that in most oil-producing countries, growth in real GDP continued in the crisis period, albeit at a slower pace. Marek Dabrowski

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Nevertheless, a group of oil exporters such as Algeria, Azerbaijan, Kazakhstan, Malaysia, Nigeria, Russia, and Venezuela suffered from substantial depreciation of their currencies (Figure 16.3), a surge in inflation, and banking sector problems. In the case of Venezuela and Nigeria, these were consequences of overspending in the boom period and populist economic policies, in former Soviet Union countries – the effect of macroeconomic and financial fragility caused by past crises and poor business climate (Dabrowski 2016). The US and EU economic sanctions against Russia launched in 2014 in response to its annexation of Crimea and intervention in Donbas magnified the negative effect of oil price decline on this country. Marek Dabrowski

in the 1980s. Washington, DC: International Monetary Fund. www​.imf​.org/​external/​pubs/​ft/​ silent/​index​.htm​#evo. Cooper, Richard N. 1994. Boom, Crisis, and Adjustment: The Macroeconomic Experience of Developing Countries, 1970–90. A Summary. Washington, DC: The World Bank. https://​ documents​.worldbank​.org/​curated/​en/​ 424101468172128425/​pdf/​multi0page​.pdf. Dabrowski, Marek. 2016. “Currency Crises in Post-Soviet Economies: A Never Ending Story?” Russian Journal of Economics 2 (3): 302–326. https://​rujec​.org/​article/​27973/​ download/​pdf. Dabrowski, Marek. 2019. “Can Emerging Markets Be a Source of Global Troubles Again?” Russian Journal of Economics 5 (1): 67–87. https://​rujec​.org/​article/​35506/​download/​pdf/​ 295039. Dasgupta, Dipak, Jeniffer Keller, and T. G. Srinivasan. 2001. “Reform and Elusive Growth in the Middle-East: What Has Happened in the Notes 1990s?” MEEA Conference on Global Change and Regional Integration: The Redrawing of 1. The Organization of the Petroleum Exporting the Economic Boundaries in the Middle East Countries (OPEC) is the most powerful cartel of commodity exporters. and North Africa. London. 1–34. http://​ web​ 2. https://​datahelpdesk​.worldbank​.org/​knowledgebase/​ .worldbank​.org/​archive/​website01038/​WEB/​ articles/​906519. IMAGES/​KELLER​_D​.PDF. 3. https://​d ata​. bls​. gov/​p dq/​S urveyOutputServlet Edwards, Sebastian, and Alejandra Cox Edwards. (downloaded on May 16, 2021). 1991. Monetarism and Liberalization: 4. This subsection draws from Dabrowski (2016). The Chilean Experiment. Chicago, IL: The University of Chicago Press. Gaidar, Egor T. 2010. Collapse of an Empire: References Lessons for Modern Russia. Washington, DC: Abed, George T., and Hamid R. Davoodi. 2003. Brookings Institution Press. Challenges of Growth and Globalization in the Middle East and North Africa. Washington, Gately, Dermot. 1986. “Lessons from the 1986 Oil Price Collapse.” Brookings Papers on Economic DC: International Monetary Fund. www​ .imf​ Activity (2): 237–284. www​.brookings​.edu/​wp​ .org/​external/​pubs/​ft/​med/​2003/​eng/​abed​.htm. -content/​uploads/​1986/​06/​1986b​_bpea​_gately​ Barry, Frank. 1991. “Terms of Trade Collapse _adelman​_griffin​.pdf. and the Growth of Foreign Debt: Zambia’s Macroeconomic Crisis, 1970–1990.” Trocaire IMF. 2021. World Economic Outlook. Recovery during a Pandemic. Washington, DC: Development Review 29–42. www​ .trocaire​ International Monetary Fund. www​.imf​.org/​-/​ .org/​sites/​default/​files/​resources/​policy/​1991​ media/​Files/​Publications/​WEO/​2021/​October/​ -zambia​-debt​-crisis​.pdf. English/​text​.ashx. Borensztein, Eduardo, and Carmen M. Reinhart. 1994. “The Macroeconomic Determinants of Wolf, Martin. 2021. “The Return of the Inflation Spectre.” Financial Times. www​ Commodity Prices.” IMF Staff Papers 41 (2): .ft​.com/​content/​6cfb36ca​-d3ce​-4dd3​-b70d​ 236–261. doi: 10.2307/3867508. -eecc332ba1df​?segmentId​=​3f81fe28​-ba5d​ Boughton, James M. 2000. The IMF and the Silent -8a93–616e​-4859191fabd8. Revolution: Global finance and development

Marek Dabrowski

Changes in commodity prices as the factor triggering financial crises  75

Source:   IMF World Economic Outlook database, October 2018.

Figure 16.3

Oil producers: annual real GDP growth, in percent, 2013 and 2015

Source:  IMF International Financial Statistics.

Figure 16.4

Depreciation of oil exporters’ currencies between June 30, 2014 and September 30, 2015, US$ per local currency unit, percentage change

Marek Dabrowski

17. Chile: the 1973 economic crisis and the military coup

the economy stagnated (Valenzuela Feijóo 2006, p. 13). In 1971, the annual growth rate of GDP reached 8 percent, while some sectors experienced an outstanding performance: for instance, the manufacturing industry and commerce (13.6 percent and 15.8 percent, respectively). In addition, between 1970 and 1971, inflation decreased from 36.1 percent to 22.1 percent, the unemployment rate dropped from 5.7 percent to 3.8 percent, and the labor share in GDP amounted to 61.7 percent, around nine percentage points above its share in 1970. The economic policy behind this outcome included real wage increases (22.3 percent, average), rises in central government expenditures (36 percent in real terms), an expansionary monetary policy, and a price policy that comprised controls on the private sector and a freeze of tariffs and prices in the public sector (Larrain and Meller 1991, pp. 195–197). The economic upswing during Allende’s first year in office strengthened the political power of the governing coalition. In fact, in the 1971 municipal elections, Unión Popular broadened its electoral base, achieving more than 50 percent of the votes cast. However, despite Allende’s resounding victory and progressive policies, many indicators began to issue warning signals. Between 1970 and 1971, the budget deficit climbed from 3.5 percent of GDP to 9.8 percent, the international reserves dropped from $94 million to $163 million, the positive trade balance turned negative, the gross investment reduced its share to GDP from 23.4 percent to 20.8 percent, while the first signs of shortages began to appear during the second half of 1971. An apparent acceleration of the inflationary process showed that the following year could be quite different. As the economic imbalances worsened during 1972, and the administration could not control their most damaging effects (inflation, shortages, black market, rationing), the opposition—which was fragmented amongst several political parties—initiated a unification process. There was a debate in the coalition about what economic and political strategy should be followed. Some sectors suggested accelerating structural changes, while other members proposed a “tactical retreat”, including political deals with the less radical opposition forces. The last alternative was imposed in June 1972, with Orlando

The economic crisis that affected the Chilean economy in 1973, during the government of the leader of the leftwing political coalition “Unión Popular”, Salvador Allende (November 1970 to September 1973),1 resulted from both domestic and international factors. Its ample effects exceeded the economic sphere, as the crisis intensified the social conflicts until a bloody military coup overthrew the government on September 11, 1973. Allende ran for the presidency thrice (1952, 1958, and 1964). But in his fourth attempt, he became Chile’s first socialist president, defeating the center-right candidate, Jorge Alessandri. The leftwing economic program of the candidate of Unión Popular—a bloc of Socialists, Communists, Radicals, and some dissident Christian Democrats—included several structural transformations to honor its commitment: build a new social and economic system, the “Chilean Way to Socialism”, using the existing liberal democratic institutions. The initiatives encompassed, for example, the nationalization of critical areas of the economy—in particular, the copper mines, which were the primary national resource, as well as coal, nitrate, iron, and steel—the statization of industrial enterprises and the banking system, and the intensification of the agrarian reform. According to the government’s understanding, greater state control over the economic surplus would guide and command an ambitious development plan. This program would be applied in a unique environment, considering that workers and popular sectors were actively involved in public affairs. The Chilean economic trajectory during the period can be divided into two phases. The first phase lasted until mid-1972, when Pedro Vuskovic2 resigned as Minister of Economic Affairs and was replaced by Orlando Millas. It was a period of economic expansion driven by aggregate demand. The second phase lasted from mid-1972 until the coup d’état and can be characterized as “conservative”, where economic imbalances worsened and 76

Chile: the 1973 economic crisis and the military coup  77

Millas (member of the Communist Party) as the new Minister of Economic Affairs. The change did not improve the political or economic situation from 1972 to 1973. No substantial and lasting deal was made with the opposition. In the economic aspect, the growth of the fiscal deficit was unsustainable,3 as well as its financing through the Central Bank. On the other hand, the evolution of the inflation rate was explosive, reaching over 600 percent (annually) in 1973; the GDP expansion slowed down in 1972 and fell by more than 4 percent in 1973, the unemployment rate increased, the investment rate dropped, and Chile significantly reduced its international reserves in a scenario of current account deficit. In the 1973 legislative elections, Allende increased its representation in both the Senate and the Chamber of Deputies, despite the economic crisis. Beyond the fact that the opposition prevailed in the elections—and their parties still maintained a majority in both legislative houses—they did not obtain the two-thirds Senate majority that would have permitted to remove the president through an impeachment proceeding, which ended up radicalizing the sectors that encouraged a coup. The breakdown of democratic rule took place during an economic and unprecedented political crisis. Nevertheless, it should be noted that the coup against the democratically elected government in 1973 was actively promoted by domestic business elites threatened by Allende’s drive toward socialism. It was backed by the US government and American corporations (Harvey 2005, p. 7). Destabilizing actions ranged from trade boycotts and economic blockage to shortages of goods, food staples, rationing, and a fierce nationwide truck strike in 1972, disrupting Chile’s economy.

The end of the democratic regime, led by a brutal and corrupt dictator, General Augusto Pinochet, implied the reshaping of Chilean society through the implementation of neoliberal policies—the first neoliberal experience in Latin America— that implied the transformation of the economic and legal structure, but also the transformation of the society; and state terrorism, which involved violent repression of social movements and political organizations, while thousands of citizens were detained, tortured, executed, exiled, and/or disappeared. Juan M. Padín

Notes 1.

The coalition included the main left political forces, such as the Communist Party and the Socialist Party. Unión Popular won the presidential elections in 1970 by a wafer-thin margin (36.6 percent of the popular vote, only 1.3 percentage points above its main opponent). For this reason, it was necessary to guarantee a successful economic performance in order to consolidate its political power. 2. Pedro Vuskovic joined the United Nations Economic Commission for Latin America and the Caribbean (ECLAC) in 1950. In 1970, Vuskovic, then Director of the Development Division, left ECLAC to be appointed as Minister of Economic Affairs. 3. The budget deficit was driven by the public-sector wage bill, social security payments, and subsidies to the state-owned enterprises, among other factors. It should be noted that there was also a drop in tax collection.

References

Harvey, David. A Brief History of Neoliberalism. New York: Oxford University Press, 2005. Larrain, Felipe and Patricio Meller. “The Socialist-Populist Chilean Experience, 1970–1973.” In The Macroeconomics of Populism in Latin America, edited by Rudiger Dornbusch and Sebastian Edwards, 175–221. Chicago, IL: University of Chicago Press, 1991. Valenzuela Feijóo, José. “El Gobierno de Allende: Aspectos Económicos”. Aportes XI, no. 33(September–December 2006): 5–26.

Juan M. Padín

18. Chile’s 1981–83 crisis

Juntas de Abastecimiento y Precios (Larraín and Meller 1991). Believing that the Chilean economic structure was monopolistic, that income and political power were highly unequally distributed, and that production and consumption depended on foreign patterns and requirements, Unidad Popular aimed at dismantling capitalism. The ideology gave central importance to economic power and marginalized efficiency. Thus, food became scarce: wheat production, for example, fell from 1.3 million tons in 1970 to 0.7 million tons in 1973. A proposal to establish drastic food rationing through the neighborhood Juntas led to hoarding and popular resistance by white- and blue-collar workers (Larraín and Meller 1991). Closed to international capital markets, the government financed itself by increasing the monetary base (Figure 18.1). As annual inflation neared 600 percent, direct tax revenue collapsed (the Olivera-Tanzi effect). Amidst inflation, shortages, and poor administration, economic output shrank in 1972 and collapsed in 1973 (despite world copper prices doubling).1 Agriculture declined by 10.3 percent, and industrial output dropped by 7.7 percent. Central Bank international reserves shrank more than 80 percent from 1971 to 1973. Real wages fell to 67 percent (54 percent) of their 1970 level for blue-collar (white-collar) workers (Larraín and Meller 1991). On September 11, 1973, the military overthrew the democratic government and instituted a highly repressive political regime.

In the early 1980s, most of the Chilean banking sector failed. There are three common explanations: external shocks (a drop in capital inflows due to higher US interest rates and lower copper prices), macroeconomic-policy inconsistency (a sizeable real overvaluation due to exchange-rate-based stabilization and backward wage indexation), and inappropriate financial liberalization (including structural contingent subsidies, moral hazard, and poor regulation). These explanations hinge on the stabilization-cum-liberalization of the late 1970s being a sufficiently dramatic break from the socialist-populist policies of the early 1970s.

1970s economic environment: the socialist-populist experience, austerity, and liberalization

Chile’s experience in the 1970s laid the foundations for the 1981–83 crisis. After Salvador Allende was elected president in late 1970, he sought to intervene in every major economic sector. By the end, Allende’s government owned 100 percent of utilities, 85 percent of mining and banking, 70 percent of transportation and communications, 40 percent of industry, and all agricultural estates larger than 200 acres (Larraín and Meller 1991). It controlled trade through import restrictions and at least six exchange rates (Corbo 1985) and wholesale and retail distribution of essential commodities through neighborhood-level

Source:  Monetary and Fiscal History of Latin America, https://mafhola.uchicago.edu.

Figure 18.1

Inflation and monetary base, Chile, 1969–87

78

Chile’s 1981–83 crisis  79

Much socialist restructuring was undone: large amounts of land were returned to their previous owners or allocated to individual peasants; price and interest-rate controls were removed; trade and labor markets were liberalized (Corbo 1985). Focused on reducing inflation by slowing down the money growth rate (with the devaluation rate largely matching inflation), macroeconomic policymakers quickly brought the budget to surplus. The fiscal contraction (along with adverse external shocks, including an oil shock, a world recession, and a 40 percent drop in world copper prices) caused a 13 percent contraction in GDP in 1975. Impatient with stubbornly high inflation, the government changed its stabilization strategy in 1978, turning to an exchange-rate anchor (Corbo 1985; Edwards 1985). A crawling peg (the tablita) was established at a rate that was intentionally below inflation. Simultaneously, a 1979 legal change guaranteed full-backward indexation of wages. In the context of falling inflation, these two decisions contributed to a 26 percent real appreciation between 1975 and 1981 relative to the United States. At first, the stabilization program seemed to have succeeded. Inflation fell steadily. Between 1976 and 1981, annual real per capita GDP growth averaged 5.65 percent, and unemployment fell from 16.8 to 11.1 percent (Velasco 1991). However, there were indicators of vulnerability. Capital inflows and exchange-rate-based stabilization led to a substantial real appreciation. Financial exposure grew as the flood of funds over-

whelmed banks’ capacity to properly intermediate them while exchange-rate stability (and tight monetary policy) encouraged liability dollarization (Figure 18.2). The apparent victory of free-market ideology contributed to an atmosphere of “triumphalism” in which risks were not adequately weighed (Arellano 1985). Simultaneously, the government embarked on an extensive program of financial liberalization. Nearly all banks were auctioned off to private hands by February 1976. Credit ceilings were dismantled between January 1974 and March 1976, and interest-rate controls were removed. Reserve requirements were brought to a low, uniform rate by late 1980 (except for short-term funds, which had higher reserve requirements). In January 1978, foreign borrowing was allowed with the caveat that banks had to match foreign-currency deposits with like loans, but with no condition that they lend to borrowers with foreign-currency income or assets. Monetary authorities were concerned with capital-flow instability but could not provide a coherent theoretical basis for retaining capital controls, which were ultimately dismantled in April 1980 (De la Cuadra and Valdés, 1990). Capital inflows surged from less than 2 percent of GDP in 1976 to nearly 14 percent in 1981, attracted by high real interest rates. The evidence is that most of these inflows financed consumption expenditures and the non-tradable sector, contributing to a substantial real appreciation (Corbo 1985; Dornbusch 1984; Arellano 1985) (Figure 18.3).

Source:  Banco Central de Chile, www.bcentral.cl/web/banco-central/areas/estadisticas.

Figure 18.2

Inflation and depreciation, Chile, 1976–83

Gabriel Xavier Martinez

80  Elgar encyclopedia of financial crises

Source:  Banco Central de Chile, www.bcentral.cl/web/banco-central/areas/estadisticas.

Figure 18.3

Capital flows, Chile, 1973–84

Financial liberalization led to a significant increase in financial assets from 14.9 to 48.1 percent of GDP between 1973 and 1982. Contributing factors include foreign borrowing, which rose from US$ 5.3 billion at end-1977 to US$ 17 billion at end-1982. Second, a rapid increase in asset prices: the stock index rose by a factor of 13 between 1973 and 1980, and land prices by a factor of 12 between 1971 and 1981. Third, implicit deposit insurance and optimistic expectations encouraged depositors to keep their significant interest income in banks, leading to rapid capitalization (Arellano 1985). Increased saving (the theoretical prediction from financial liberalization (McKinnon 1973)) is not likely to have played a significant role: from a very low level in 1973, Chile’s national savings rose to less than its historical average. Bank credit boomed over 1973–82, from 4.4 to 61.7 percent of GDP, along with borrower and lender confidence. Bank privatization brought about or consolidated “economic groups”: cross-owned financial and non-financial companies. Lending to related parties often exceeded bank capital by a significant amount. In Banco de Chile (the largest bank), connected lending amounted to 19.7 percent of assets. In Banco de Santiago (the second largest), the amount was 45 percent (Larrain 1989). Connected lending was initially thought to be a strength, engendering trust in banks owned by a well-known conglomerate (De la Cuadra and Valdés 1990). But, as the Banking Superintendency was unable to regulate non-financial companies and as grupo Gabriel Xavier Martinez

firms evaded regulation when established, grupo firms compensated for high loan rates by investing in securities of related enterprises, masking their poor operating profit performance with high non-operating profits businesses. Their debt/equity ratio averaged 2.5, compared to 0.9 for non-grupo firms, masked by clever cross-ownership (Galvez and Tybout 1985). Much related lending financed the purchase of existing assets and construction loans. These grew from 1 percent of sectoral output in 1973 to 149 percent in 1982 (Arellano 1985).

Stages of prudential regulation in the 1970s and 1980s

Zahler (1983) holds that Chilean policymakers in the 1970s and 1980s tended to be of one mind. De la Cuadra and Valdés (1990), however, document substantial divergence among “free banking,” “state supervision,” and “old-school” policymakers who influenced different levels of government at various times. They single out the ministerial-level commitment to a controlled exchange rate and (non-independent) banking authorities’ desire to rein in liability dollarization. Approximately half of the loan portfolio was denominated in foreign currency but had no special loan-loss provision requirement (Arellano 1985). Banks and regulators lacked the expertise, personnel, or technology to assess the quality of loan borrowers (De la Cuadra and Valdés 1990). Right away, some policy mistakes were evident. A loophole in the law permit-

Chile’s 1981–83 crisis  81

ted informal finance companies (financieras). Legally recognized financieras had lighter regulations and lower capital requirements at first (Arellano 1985). Poorly coordinated interest-rate deregulation caused the collapse of the national savings-and-loans system (SINAP) in 1975 (De la Cuadra and Valdés 1990). Crucially, the government reneged on its promise to make SINAP’s depositors whole. This episode opened a short period of “free banking” with little regulation but no official deposit guarantees (De la Cuadra and Valdés 1990). Two years later, in January 1977, Banco Osorno failed along with several formal and informal financieras. To the public’s surprise, Banco Osorno’s depositors were fully covered (as were those of cooperative lending firms that failed later in 1977). It became evident that, for the government, banks were unlike butcher shops and could not be allowed to fail (cf. Diaz-Alejandro 1985). For the next three years, Chile combined a structural, subsidized guarantee of deposits with poor regulation amid a significant credit and economic boom. When Banco Español failed in early 1980 (taken over but not recapitalized by a private grupo), policymakers who believed in more substantial banking supervision were finally allowed to require banks to classify loans according to credit risk. In many cases, they found that banks lacked basic information about the identity of borrowers, the quality of the collateral, or the use to which funds had been put. Successive rounds of regulation up to August 1981 were evaded through shell companies or figureheads (De la Cuadra and Valdés 1990). Before 1980, implicit deposit insurance (coming from previous bailouts and the political power of economic groups) and regulators’ inability or unwillingness to regulate led to a steady but hidden deterioration of bank portfolios. Moral hazard arose after 1980 when in response to banking supervisors’ efforts to reduce the risk of failure, banks (through fraud, incompetence, or lack of learning) misrepresented their portfolios (De la Cuadra and Valdés 1990). Notably, the period was characterized by high real loan rates on short-term domestic-currency loans, averaging 32 percent (with a large spread over rates on variable-rate foreign-currency loans). Arellano argues that this forced bor-

rowers to choose between bankruptcy and a Ponzi scheme, mainly because “loans were very short-term and authorities insisted that interest rates would soon fall” (1985, p. 742). Moreover, to the extent that “debtors perceived this to be a generalized phenomenon whose solution was not microeconomic but macroeconomic,” they assumed that banks could not collect (1985, p. 743). Starting in 1981, as interest rates rose with world interest rates, many banks engaged in the rollover of bad debts (evergreening), creating a false demand for credit that crowded out good borrowers (Harberger 1984).

Financial crash of 1981

In early 1981, the US Federal Reserve started the second part of its anti-inflation effort, taking the short-term rate to nearly 20 percent and the world economy into recession. The failure of a major sugar refining company in May revealed the laxity of banking practices (it had borrowed heavily from its grupo) and raised expectations of a devaluation. In August, nominal wages suddenly increased by 22 percent (Banco Central de Chile 2022; Harberger 1984). Capital inflows peaked in the third quarter of 1981. Thus in November 1981, the banking authority intervened in eight financial institutions (four grupo banks and four financieras) and their guaranteed deposits. Capital inflows contracted from $400 million per month in 1981 to $100 million per month in 1982 (Montiel 2014). At first, the authorities attempted to maintain the 39 peso/ US dollar fixed exchange rate, expecting gold-standard-style self-adjustment (Corbo 1985; Harberger 1984). Central bank reserves and the monetary base thus fell. By May 1982, M1 had shrunk by 10 percent relative to its May 1981 peak. Unemployment rose to 20 percent, and economic activity collapsed, causing the authorities to devalue the currency in June 1982 rather than decree a nominal wage reduction (Harberger 1984). The June devaluation created expectations of further devaluations. The stock of reserves fell by a further $460 million (Corbo 1985), leading to an exchange-rate float and the removal of restrictions on exchange-rate transactions. An attempt to run a dirty float led to an additional loss of $450 million in reserves. In September, a crawling peg was established, starting at 66 pesos per Gabriel Xavier Martinez

82  Elgar encyclopedia of financial crises

dollar (pegging to a basket of currencies rather than just the US dollar); restrictions on foreign-exchange transactions and imports were reinstated. The 86 percent devaluation brought dollar debtors to bankruptcy (Velasco 1991). In response, the government created a preferential exchange rate for dollar-debt repayment, implicitly a subsidy. Non-performing loans rose from a fifth of bank equity in 1981 to four-fifths in 1982 to 1.6 times bank capital in 1983. Two other financial institutions were taken over and, together with the eight taken over in November, were subsequently liquidated. Depositors’ losses were covered (Montiel 2014). At this point, the collapsed financial institutions amounted to 14.5 percent of financial assets (Larrain 1989). Real GDP shrank by 11 percent in 1982, and the crisis expanded. On January 13, the government took over an additional five institutions, including the two largest banks (Chile and Santiago), putting 70 percent of the banking sector in government hands (Arellano, Cortazar, and Solimano 1987). Expecting the bailout, international lenders forced the government to absorb all private external debt. The government’s total debt stock rose from 17 percent of GDP in 1981 to 119 percent of GDP in 1986.

Successful resolution

Chile’s crisis-resolution process is often cited as a model. In April 1983, debts owed to intervened banks were restructured, financed with cheap Central Bank loans and a US$ 1.1 billion loan from foreign banks (Montiel 2014). A liquidity scheme allowed banks to spread out the losses from non-performing loans over several years and, in 1985, were recapitalized and reprivatized through selling public shares. Debt-for-equity swaps in government-owned enterprises brought the Chilean government’s public debt down to 50 percent of GDP by 1990. International Monetary Fund and World Bank agreements were reached in 1985. The crisis forced the government to backtrack on several free-market reforms temporarily. Relatively quickly, however, there was a return to fiscal discipline, an embrace of an export-led strategy, and a low real interest-rate target (Edwards 1999). Inflation Gabriel Xavier Martinez

peaked in mid-1983; real GDP per capita growth averaged 4.8 percent between 1983 and 1998. Chile had the good fortune of entering a financial crisis with a budget surplus (a combined 12.4 of GDP over 1979–81). In consequence, the Chilean crisis was not a public-debt crisis (like those of other Latin American countries at the time), the government could absorb significant losses and protect depositors, and it enjoyed greater credibility in restructuring negotiations. Finally, the 1986 banking law focuses on transparency and regulatory discipline (cf. Brock 1992; De la Torre 1997). Gabriel Xavier Martinez

Note 1.

www​ . macrotrends​ . net/​ 1 476/​ c opper​ - prices​ -historical​-chart​-data.

References

Arellano, José Pablo. 1985. “De la liberalización a la intervención: El mercado de capitales en Chile 1974–1983.” El Trimestre Económico 52 (3): 721–772. Arellano, José Pablo, Rene Cortazar, and Andres Solimano. 1987. “Chile.” Stabilization and Adjustment Policies and Programmes Helsinki: UNU-WIDER (Country Study 10). Banco Central de Chile. 2022. Base de Datos Estadísticos. Brock, Philip Lawton. 1992. If Texas Were Chile: A Primer on Banking Reform. Sequoia Inst. Corbo, Vittorio. 1985. “Reforms and macroeconomic adjustments in Chile during 1974–1984.” World Development 13 (8): 893–916. De la Cuadra, Sergio, and Salvador Valdés. 1990. “Myths and facts about financial liberalization in Chile: 1974–1982.” Documento de Trabajo, Institute of Economics, Universidad Católica de Chile (128). De la Torre, Augusto. 1997. “El manejo de las crisis bancarias: el marco legal ecuatoriano y posibles reformas.” CORDES. Diaz-Alejandro, Carlos. 1985. “Good-bye financial repression, hello financial crash.” Journal of Development Economics 19 (1–2): 1–24. Dornbusch, Rudiger. 1984. “External debt, budget deficits and disequilibrium exchange rates.” National Bureau of Economic Research Working Paper Series (1336). Edwards, Sebastian. 1985. “Stabilization with liberalization: An evaluation of ten years of Chile's experiment with free-market policies, 1973–1983.” Economic Development and Cultural Change 33 (2): 223–254.

Chile’s 1981–83 crisis  83 Edwards, Sebastian. 1999. “Crisis prevention: Lessons from Mexico and East Asia.” National Bureau of Economic Research, Cambridge, MA. Galvez, Julio, and James Tybout. 1985. “Microeconomic adjustments in Chile during 1977–1981: The importance of being a grupo.” World Development 13 (8): 969–994. Harberger, Arnold C. 1984. “La crisis cambiaria chilena de 1982.” Cuadernos de Economía: 123–136. Larraín, Felipe, and Patricio Meller. 1991. “The socialist-populist Chilean experience, 1970–1973.” In The Macroeconomics of Populism in Latin America, 175–221. University of Chicago Press. Larrain, Mauricio. 1989. “How the 1981–83 Chilean banking crisis was handled.” Working Paper Series (300).

McKinnon, Ronald. 1973. Money and Capital in Economic Development. Brookings Institution. Montiel, Peter. 2014. Ten Crises. Routledge. Velasco, Andres. 1991. “Liberalization, crisis, intervention: The Chilean financial system, 1975–1985.” In Banking Crises: Cases and Issues, edited by Tomás Baliño and V. Sundararajan, 113–174. International Monetary Fund. Zahler, Roberto. 1983. “Recent southern cone liberalization reforms and stabilization policies: The Chilean case, 1974–1982.” Journal of Interamerican Studies and World Affairs 25 (4): 509–562.

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19. Colombia during the financial crisis of the 1980s

Tovar 2022). This prohibition on foreign investment, which had a nationalist motivation, was in place since 1975 (Barajas, Steiner, and Salazar 2000; Junguito 2019; Hernández, Caballero-Argáez, and Tovar 2022). In this context of abundance and regulations, a group of Colombian banks perpetrated risky credit practices: loan concentration on few debtors, loans to members of the board, and loans to shareholders (Palacios 1985; Villegas 1990, 14; Hernández, Caballero-Argáez, and Tovar 2022). Some shareholders used the loans to play the stock market (Palacios 1985; Villegas 1990, 14; Hernández, Caballero-Argáez, and Tovar 2022). These practices occurred among private banks whose board membership was concentrated and had links with political power (Hernández, Caballero-Argáez, and Tovar 2022). Furthermore, some banks opened subsidiaries overseas throughout the 1970s. These subsidiaries were expected to raise funds in the international markets, exploit tax benefits from other countries, and avoid the regulations on foreign exchange that were in place in Colombia (Caballero-Argáez 1988). In addition, some subsidiaries used short-term loans from overseas to fund long-term loans in Colombia (Caballero-Argáez 2019). The expansion of the Colombian economy peaked in 1978 when GDP grew by 8.5 percent. After that, the Colombian economy slowed down, led by a collapse in inter-

Unlike in other Latin American economies, the crisis of the 1980s was mild in Colombia. GDP per capita only fell by 1.9 percent between 1981 and 1983. In fact, during the worst year of the crisis, real GDP still grew by 0.9 percent (Table 19.1). The crucial loser of the crisis was the financial sector: six banks, which accounted for 31 percent of the assets of the banking system, became insolvent (Hernández, Caballero-Argáez, and Tovar 2022). One of the six banks was liquidated, whereas the other five banks were bailed out and confiscated by the Colombian government (Caballero-Argáez and Urrutia 2006, 171). By the end of the crisis, most of the banking system, as measured by assets, was controlled by the Colombian government (Hernández, Caballero-Argáez, and Tovar 2022).1 Before the crisis, there was an economic boom distinguished by four features: (i) high export prices,2 (ii) strict regulation of exchange and interest rates, (iii) capital flow controls, and (iv) the prohibition of foreign investment in the banking sector (Caballero-Argáez 1988; Garay 1998; Caballero-Argáez and Urrutia 2006; Ocampo 2015, Perez-Reyna and Osorio-Rodriguez 2021; Hernández, Caballero-Argáez, and Table 19.1

Year with the lowest GDP growth during the crisis: Latin American countries Year

Annual GDP Growth

Colombia

Country

1982

+0.9%

Argentina

1985

−5.2%

Ecuador

1983

−0.3%

Brazil

1981

Chile

1982

−11%

Peru

1983

−10.4%

Venezuela

1980

−4.4%

Mexico

1983

−3.4%

Uruguay

1983

−10.3%

Paraguay

1983

−3%

Bolivia

1983

−4%

Panama

1983

−4.5%

Costa Rica

1982

−7.2%

Latin America and the Caribbean

1983

−2.5%

−4.3%

Source:  World Bank (https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?locations=CO-ZJ).

84

Colombia during the financial crisis of the 1980s  85

national coffee prices: 63 percent in real terms between 1977 and 1981 (Hernández, Caballero-Argáez, and Tovar 2022). In 1981, the year before the nadir of the crisis, annual GDP growth was 2.3 percent. In response to the reduction in coffee prices, the current-account balance moved from 2 percent of GDP in 1977 to −6 percent of GDP in 1981 (Ocampo 2015, 69). Nevertheless, the real exchange rate did not depreciate during this period (Ocampo 2015, 69). A possible explanation is that the reduction in exports was compensated by an increase in external debt from both the private and public sectors (Ocampo 2015, 72). The external public debt doubled as the fiscal deficit of the public sector moved from a small surplus in 1978 to a deficit of 5 percent of GDP in 1981 (Ocampo 2015, 68). Borrowing overseas became increasingly expensive as international interest rates soared throughout the late 1970s and early 1980s (Caballero-Argáez 2019). After Mexico defaulted on its sovereign debt in August 1982, borrowing overseas became very difficult for Colombian debtors, including the Colombian government (Caballero-Argáez 2019). Because of the reductions in capital inflows and export revenues, foreign currency became scarce: foreign exchange reserves fell 69 percent from 1981 to 1984, while the current-account deficit contracted from 6 percent to 2 percent (Ocampo 2015, 69, 72). Overall, 1982 was the worst crisis year, with GDP growing by 0.9 percent. The crisis had a major impact on the banking sector. Nonperforming loans grew from 2 percent to 12 percent of total loans during the crisis (Ocampo 2015, 101). Banks that had perpetrated risky credit practices incurred great losses (Palacios 1985; Hernández, Caballero-Argáez, and Tovar 2022). In addition, the Panamanian subsidiary of a Colombian bank used deposits from the public to bail out mutual funds managed by the business group that controlled the bank (Caballero-Argáez 1988). This subsidiary had more considerable losses than the subsidiaries of other banks when multiple mutual funds went bankrupt, international capital became expensive, and the Colombian peso depreciated throughout the early 1980s (Caballero-Argáez 1988). Raising capital for distressed banks during the crisis was hard: bank owners were on the

brink of insolvency, and equity financing was not profitable for other local investors (Palacios 1985). Furthermore, regulation prevented foreign banks from equity financing or buying Colombian banks. Since bank liquidations would have involved significant losses for depositors and further reductions in economic activity, the banks were bailed out by the government (Palacios 1985; Anzola and Arias 2009, 73). The legal framework that the government used for bailing out the banks was known as “oficialización.” During “oficialización,” the government injected capital in exchange for the property and control of the bank. Former shareholders lost their stocks without compensation (Hernández, Caballero-Argáez, and Tovar 2022). The government funded the bailout operation by issuing debt and money. At the time, the central bank was directed by a board appointed and controlled by the national government (Hernandez and Jaramillo 2017). The fiscal deficit of the government was growing due to increased expenditures and decreasing revenues, so the board authorized that part of the deficit be funded with money creation (Junguito and Rincón 2004; Hernandez and Jaramillo 2017; Perez-Reyna and Osorio-Rodriguez 2021).3 Bailing out banks cost between 3 and 6 percent of GDP (Caballero-Argáez and Urrutia 2006, 120; Honohan and Klingebiel 2003). This cost was much lower than in the Southern Cone of the Americas, where it was close to 40 percent (Ocampo 2014). The academic literature attributes Colombia's solid performance during the crisis to two factors: First, the net external debt of the government and private companies was low at the start of the crisis, relative to other Latin American countries (Devlin 1989, 53, 101, 180; Garay 1991, 613–620; Ocampo 2014; Ocampo 2015, 84–102). For example, Colombia accumulated foreign exchange reserves during the coffee export boom of the 1970s, so the external debt net of foreign exchange reserves in 1979 was very low at the start of the crisis (Ocampo 2015, 71). Second, capital controls were in place before and during the crisis (Ocampo 2014; Ocampo 2015, 71–73). In contrast to the Colombian case, the crisis in other countries of Latin America was characterized by sudden stops and current-account reversals in countries with high levels of net external debt

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and low capital controls (Ocampo 2014). Net capital flows in Latin America fell from 2 percent to −6 percent of GDP during the crisis (Ocampo 2014). The crisis-induced regulatory changes intended to attenuate future banking crises. Before the crisis, regulation on conflicts of interest was lax (Gallon 1986; Hernández, Caballero-Argáez, and Tovar 2022). Furthermore, capital requirements for banks did not consider loan quality (Ocampo 2015). In response to the crisis, the government and congress took the following measures: First, they enacted new prudential regulations to prevent conflicts of interest, financial statement manipulation, and excessive leverage (Palacios 1985; Ocampo 2015; Hernández, Caballero-Argáez, and Tovar 2022). Second, they created a system of deposit insurance funded by money creation (Palacios 1985; Anzola and Arias 2009, 64). Third, they created organizations and formal procedures for the intervention of banks in distress (Hernández, Caballero-Argáez, and Tovar 2022). Fourth, they eliminated restrictions on foreign investment in the banking sector to facilitate funding, privatization, and competition in the banking sector (Barajas, Steiner, and Salazar 2000; Hernández, Caballero-Argáez, and Tovar 2022). These regulatory changes, with some variations, persisted until 2022.4 Carlos Eduardo Hernández and Edwin López-Rivera

Notes 1. 2.

3. 4.

In turn, the share of banks on the assets of the financial sector was 74 percent in 1990 (Ocampo 2015). Frosts in Brazil almost tripled real coffee prices between 1975 and 1977. When the price of coffee peaked in 1977, coffee accounted for 65 percent of exports (Caballero-Argáez 2019; Hernández, Caballero-Argáez, and Tovar 2022). The fiscal deficit of the public sector, excluding financial institutions, was 7 percent of GDP in 1982 (Junguito and Rincón 2004). After further reforms in the early 1990s, deposit insurance is not funded with money creation but with government revenues and debt.

References

Anzola, Oscar, and Paola Arias. 2009. Crisis financiera colombiana en los años noventa: origen, resolución y lecciones institucionales. FOGAFIN y Universidad Externado de Colombia.

Barajas, A., R. Steiner, and N. Salazar. 2000. “The impact of liberalization and foreign investment in Colombia's financial sector.” Journal of Development Economics 63: 157−196. Caballero-Argáez, Carlos. 1988. “La experiencia de tres bancos colombianos en Panamá.” Coyuntura Económica 18 (1). Caballero-Argáez, Carlos. 2019. “Una visión retrospectiva de dos crisis financieras de los últimos cuarenta años en Colombia.” Desarrollo y Sociedad 133–165. Caballero-Argáez, Carlos, and Miguel Urrutia. 2006. Historia del sector financiero colombiano en el siglo XX: ensayos sobre su desarrollo y sus crisis. Bogotá: Editorial Norma. Devlin, Robert. 1989. Debt and Crisis in Latin America: The Supply Side of the Story. Princeton, NJ: Princeton University Press. Gallon, Gustavo. 1986. “Crisis y Reajuste del Esquema de Concertación Económica en Colombia 1980–1985.” Controversia (130): 51–80. Gamba-Tusabá, C., and J. E. Gómez-González. 2017. “La política monetaria durante los primeros años del Banco Central independiente: 1992–1998.” In Historia del Banco de la República 1923–2015, by J. D. Uribe, 411–435. Bogotá: Banco de la República. Garay, Luis Jorge. 1991. Colombia y la Crisis de la Deuda. Bogotá: CINEP. —. 1998. Colombia: estructura industrial e internacionalización 1967–1996. Departamento Nacional de Planeación. Hernandez, Antonio, and Juliana Jaramillo. 2017. “La Junta Monetaria y el Banco de la República.” In Historia del Banco de la República 1923–2015, by José Darío Uribe, 186−273. Banco de la Republica de Colombia. Hernández, Carlos Eduardo, Carlos Caballero-Argáez, and Jorge Tovar. 2022. “Tunneling when regulation is lax: The Colombian banking crisis of the 1980s.” Working Paper. https://​ssrn​.com/​abstract​=​4292215. Honohan, Patrick, and Daniela Klingebiel. 2003. “The fiscal cost implications of an accommodating approach to banking crises.” Journal of Banking & Finance 27 (8): 1539−1560. Junguito, Roberto. 2019. “El papel de los gremios en la economía colombiana.” Revista Desarrollo y Sociedad 103–131. Junguito, Roberto, and Hernán Rincón. 2004. La política fiscal en el siglo XX en Colombia. Banco de la República, Borradores de Economía. Ocampo, José Antonio. 2014. “The Latin American debt crisis in historical perspective.” In Life After Debt by Joseph Stiglitz and Daniel Heymann. Springer. —. 2015. Una historia del sistema financiero colombiano: 1951–2014. Portafolio.

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Colombia during the financial crisis of the 1980s  87 Palacios, Hugo. 1985. “La recuperación del sistema financiero.” Revista Del Banco De La República 58 (693): 3–51. Perez-Reyna, David. 2017. “Historia del Banco de la República: Crisis de 1999.” In Historia del Banco de la República 1923–2015, edited by José Darío Uribe, 186−273. Banco de la Republica de Colombia. Perez-Reyna, David, and David Osorio-Rodriguez. 2021. “The case of Colombia.” In A Monetary and Fiscal History of Latin America, 1960–2017, edited by Timothy J. Kehoe and Juan Pablo Nicolini. Minneapolis, MN: University of Minnesota Press. Urrutia, Miguel, and Jorge Llano. 2012. Los actores en la crisis económica de fin de siglo. Universidad de los Andes.

Villar, L., D. Salamanca, and A. Murcia. 2005. “Crédito, represión financiera y flujos de capitales en Colombia: 1974–2003.” Desarrollo y Sociedad 55: 167–209. Villar, Leonardo, and P. Esguerra. 2007. “El comercio internacional de Colombia en el Siglo XX.” In Economía colombiana del siglo XX, un análisis cuantitativo by Miguel Urrutia and James Robinson. Bogotá: Fondo de Cultura Económica, Banco de la República. Villegas, Luis Bernardo. 1990. El Sector Financiero 1980−1990. Superintendencia Bancaria de Colombia. Zárate, J. P., A. L. Cobo, and J. E. Gómez-González. 2012. “Lecciones de las crisis financieras recientes para el diseño e implementación de las políticas monetaria y financiera en Colombia.” Ensayos Sobre Política Económica 30 (69): 258–293.

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20. Colombia during the financial crisis of the late 1990s

At the same time, Colombian households became highly indebted in order to acquire housing. Mortgages increased from 8 percent to 13 percent of GDP between 1991 and 1997 (Echeverry 2001). The debt service of mortgages doubled in the same years (Echeverry 2001). In addition, house prices increased substantially during this period (Castaño et al. 2015). Hence, households were vulnerable to increases in interest rates and decreases in housing prices (Echeverry 2001). The second source of vulnerability was the high fiscal deficit of the national government, which grew from 0.2 percent to 5.2 percent of GDP between 1991 and 1998 (Junguito and Rincón 2004, 159). The sizeable fiscal deficit was the result of an increase in public spending, which in turn was the result of three factors: (i) the mandates of a new constitution enacted in 1991, (ii) expectations of increased revenues from an oil boom that was expected to peak at the end of the 1990s, and (iii) the attempts by the government to boost the economy through public spending in 1996 and 1997 when Colombia’s economy slowed down (Echeverry 2001). Up to 1993, expenditures grew at similar rates to revenues. After 1994, expenditures grew faster than revenues, which increased the fiscal deficit (Junguito and Rincón 2004; Perez-Reyna and Osorio-Rodriguez 2021). Consequently, government debt increased from 13 percent to 22 percent of GDP between 1994 and 1998, whereas interest payments increased from 1.2 percent to 2.9 percent (Junguito and Rincón 2004, 159). The fiscal deficit was funded primarily with internal debt, so when the international crisis hit, the government’s external debt was lower than at the start of the decade (Ocampo 2015, 110; Villar 2011; Perez-Reyna 2017). Hence, the government’s vulnerability to currency depreciation was relatively low. Nevertheless, the fiscal deficit was funded through debt in the domestic market, which contributed to an increase in internal interest rates, crowded-out private investment, induced private investors to borrow overseas, attracted capital inflows, and restricted the capacity of monetary policy to ameliorate the crisis (Echeverry 2001; Urrutia and Llano 2012, 75; Perez-Reyna and Osorio-Rodriguez 2021). In the aggregate, the boom in private consumption, public spending, and investment was funded by external debt and foreign

Between 1997 and 1999, annual GDP growth in Colombia decreased from 3.4 percent to −4.2 percent, while the unemployment rate increased from 10 percent to 16 percent. This crisis was triggered by the international financial crisis that affected Eastern Asia, Russia, Brazil, and Argentina between 1997 and 1999. This global crisis reduced oil prices, induced capital outflows, and increased the international interest rate for emerging countries (Urrutia and Llano 2012, 6–10; Perez-Reyna 2017; Caballero-Argáez 2019; Perez-Reyna and Osorio-Rodriguez 2021). These changes induced economic crises in countries that were vulnerable to external shocks. Colombia was vulnerable to external shocks for the following reasons. First is the high indebtedness of the private sector. At the start of the 1990s, Colombia liberalized its economy, deregulated its financial sector, discovered large oil reservoirs, and availed itself of low-interest rates in international markets (Barajas, Steiner, and Salazar 2000; Villar, Salamanca, and Murcia 2005; Caballero-Argáez and Urrutia 2006, 129; Zárate, Cobo, and Gómez-González 2012; Gamba-Tusabá and Gómez-González 2017). These factors induced a boom in consumption and investment in the private sector: private consumption grew at 6 percent per year between 1992 and 1995, whereas private investment grew at 20 percent per year between 1990 and 1994. The boom was funded from two sources: (i) net foreign direct investment, which increased from 1 percent to 4 percent of GDP between 1991 and 1997 (Gamba-Tusabá and Gómez-González 2017), and (ii) debt, both internal and external: the loan portfolio of the Colombian financial sector grew from 27 percent to 46 percent of GDP between 1991 and 1995, whereas the external debt of the private sector increased from 4 percent to 18 percent of GDP between 1991 and 1998 (Caballero-Argáez and Urrutia 2006, 129; Ocampo 2015, own calculations from page 110). Consequently, the private sector was vulnerable to increased international and domestic interest rates. The private sector was also vulnerable to a sudden depreciation of the Colombian peso. 88

Colombia during the financial crisis of the late 1990s  89

investment. Consequently, the balance of the current account fell from 5 percent in 1991 to −4 percent in 1998 (Gamba-Tusabá and Gómez-González 2017). Hence the Colombian economy was vulnerable to a sudden stop and current account reversal in the event of an international crisis. The Colombian economy started to slow down in 1996. For example, aggregate investment fell 12 percent that year and continued falling until 1999. The central bank reacted to this deacceleration by increasing the money supply. This expansionary monetary policy and an expansionary fiscal policy fueled a small, short-lived recovery (Echeverry 2001; Ocampo 2015, 111). The Asian, Russian, Brazilian, and Argentinian crises of 1997–1999 stopped the capital flows that were funding consumption, investment, and public spending (Villar, Salamanca, and Murcia 2005; Gamba-Tusabá and Gómez-González 2017; Perez-Reyna and Osorio-Rodriguez 2021). Consequently, the current account was reversed through lower private consumption and investment. Household consumption fell 5.4 percent in 1999, whereas aggregate investment fell 38.6 percent in the same year. The primary mechanism driving the current account reversal was a rapid increase in interest rates coupled with rapid depreciation of the Colombian peso. The increase in interest rates, coupled with the currency depreciation, forced many households and firms to default on their debts. The non-performing loans in the financial sector increased from 8 to 16 percent of the loan portfolio between 1997 and 1999 (Caballero-Argáez and Urrutia 2006, 143). Losses of financial companies amounted to 4 percent of their assets in 1999 and 2000 (Zárate, Cobo, and Gómez-González 2012). The financial companies most hindered by the increasing default rates were housing-focused banking institutions, public banks, small private banks, and banks with a low ratio of equity to assets (Caballero-Argáez and Urrutia 2006, 143; Gómez-Gonzalez and Kiefer 2009). Overall, 60 financial firms became insolvent, while the ratio between the financial sector loan portfolio and GDP fell by 13 percentage points (Caballero-Argáez and Urrutia 2006, 141, 149, 159). Eventually, the crisis triggered a wave of liquidations, mergers, and acquisitions that increased concentration and market power in the banking

sector (García-Suaza and Gómez-González 2010; Tovar, Jaramillo, and Hernández 2011; Gómez-González 2012). The crisis activated multiple interventions by governmental institutions. The Constitutional Court ruled that the interest rate of existing mortgages should not depend on market interest rates but on inflation (Urrutia and Namen 2012). While this ruling provided relief for households heavily indebted at variable interest rates, it also worsened solvency problems among housing-focused banking institutions (Urrutia and Namen 2012). Furthermore, the ruling induced banks to focus on commercial and consumption loans rather than on mortgage loans: the banking sector’s portfolio of mortgage loans decreased from 1999 until 2005, and only reached their pre-crisis levels in 2014.1 There is no consensus among scholars on the role of monetary policy in alleviating or worsening the crisis. A first mechanism is proposed by Echeverry (2001), who argues that the monetary expansion of 1997 increased the demand for foreign exchange during a series of speculative attacks on the Colombian peso that occurred in 1998 and 1999. However, Urrutia and Llano (2012, 23) argue that the monetary expansion was not significant enough to substantially increase the demand for foreign exchange. A second mechanism is proposed by Parra and Salazar (2000), Gómez-González and Kiefer (2009), and Ocampo (2015, 111). They argue that the central bank worsened the crisis by attempting to slow down currency depreciation through increases in its policy rate and sales of foreign reserves. However, other authors argue that these policy interventions were beneficial because they prevented a sudden depreciation, which would have aggravated the crisis due to the high indebtedness of the private sector, the lack of foreign exchange hedges in the Colombian market, and the lack of stand-by agreements with multilateral institutions at the start of the crisis (Urrutia and Llano 2012, 13 and 15; Perez-Reyna 2017). The central bank floated the exchange rate in 1999 after losing credibility on its capacity to defend the exchange rate (Urrutia and Llano 2012, 25 and 35). The crisis reduced tax revenues and oil royalties relative to their projected levels, increasing the need for additional public debt.

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The national government debt increased from 18 percent of GDP in 1997 to 30 percent of GDP in 1999 and 39 percent of GDP in 2000, crowding out private loans (Junguito and Rincón 2004, 159; Zárate, Cobo, and Gómez-González 2012). In the context of high interest rates, fiscal reform was urgent. Congress enacted a new tax on financial transactions, increased existing taxes, limited the growth of government spending, curbed transfers from the national government to regional and local governments, and restricted expenditures by regional and local governments (Junguito and Rincón 2004, 101–106). Despite these efforts, the national government’s debt reached 53 percent of GDP in 2002 (Junguito and Rincón 2004, 160). The organizations and procedures created in response to the previous crisis of the 1980s and the new tax on financial transactions proved useful in alleviating the crisis of 1999. The government was able to provide insurance to depositors, subsidize new loans to pay for non-performing loans, and bail out distressed banks (Parra and Salazar 2000). The total cost of bank bailouts was between 2.6 percent and 4 percent of yearly GDP. Between 50 percent and 70 percent of this amount was spent bailing out public banks (Caballero-Argáez and Urrutia 2006, 149–150). The financial sector became profitable again in 2001, the same year in which GDP reached its pre-crisis levels (Caballero-Argáez 2019). Carlos Eduardo Hernández and Edwin López-Rivera

Note 1.

Own calculations from figure 2 from Castaño et al. (2015). DANE and Banco de la República (series: Cartera total de sistema financiero - periodicidad mensual).

References

Barajas, A., R. Steiner, and N Salazar. 2000. “The impact of liberalization and foreign investment in Colombia’s financial sector.” Journal of Development Economics 63: 157–196. Caballero-Argáez, Carlos. 2019. “Una visión retrospectiva de dos crisis financieras de los últimos cuarenta años en Colombia.” Desarrollo y Sociedad 133–165. Caballero-Argáez, Carlos, and Miguel. Urrutia. 2006. Historia del sector financiero colombiano en el siglo XX: ensayos sobre su desarrollo y sus crisis. Bogotá: Editorial Norma.

Castaño, Jessica, Mariana Laverde, Miguel Morales, and Ana María Yaruro. 2015. “Índice de precios de la vivienda nueva para Bogotá: metodología de precios hedónicos.” In Política monetaria y estabilidad financiera en economías pequeñas y abiertas by J. E. Gómez-González and J. N Ojeda-Joya, 339–387. Bogotá: Banco de la República. Echeverry, Juan Carlos. 2001. Memorias de la recesión de fin de siglo en Colombia: flujos, balances y polí­tica anticíclica. Departamento Nacional de Planeación. Gamba-Tusabá, C., and J. E. Gómez-González. 2017. “La política monetaria durante los primeros años del Banco Central independiente: 1992–1998.” In Historia del Banco de la República 1923–2015 by J. D. Uribe, 411–435. Bogotá: Banco de la República. García-Suaza, A. s. F., and J. E Gómez-González. 2010. “The competing risks of acquiring and being acquired: Evidence from Colombia’s financial sector.” Economic Systems 34: 437–449. Gómez-González, J. E. 2012. “Failing and merging as competing alternatives during times of financial distress: Evidence from the Colombian financial crisis.” International Economic Journal 655–671. Gómez-Gonzalez, José E., and Nicholas M. Kiefer. 2009. “Bank failure: Evidence from the Colombian financial crisis.” The International Journal of Business and Finance Research 15–31. Junguito, Roberto, and Hernán Rincón. 2004. "La política fiscal en el siglo XX en Colombia." Borradores de Economía (Banco de la República) 318. Ocampo, José Antonio. 2015. Una historia del sistema financiero colombiano: 1951–2014. Portafolio. Parra, Clara Elena, and Natalia Salazar. 2000. La crisis financiera y la experiencia internacional. Boletines de Divulgación Económica, Bogotá: Departamento Nacional de Planeación. Perez-Reyna, David. 2017. “Historia del Banco de la República: Crisis de 1999.” In Historia del Banco de la República 1923–2015, edited by José Darío Uribe, 186–273. Banco de la Republica de Colombia. Perez-Reyna, David, and David Osorio-Rodriguez. 2021. “The Case of Colombia.” In A Monetary and Fiscal History of Latin America, 1960–2017, edited by Timothy J. Kehoe and Juan Pablo Nicolini. Minneapolis, MN: University of Minnesota Press. Tovar, J., C. Jaramillo, and C. E Hernández. 2011. “Risk, concentration and market power in the banking industry: evidence from the Colombian system (1997–2006).” Banks and Bank Systems 6: 49–61.

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Colombia during the financial crisis of the late 1990s  91 Urrutia, Miguel, and Jorge Llano. 2012. Los actores en la crisis económica de fin de siglo. Universidad de los Andes. Urrutia, Miguel, and Olga Marcela Namen. 2012. “Historia del crédito hipotecario en Colombia.” Ensayos sobre Política Económica 30: 282–306. Villar, L., D. Salamanca, and A. Murcia. 2005. “Crédito, represión financiera y flujos de capitales en Colombia: 1974–2003.” Desarrollo y Sociedad 55: 167–209.

Villar, Leonardo. 2011. “Comentario a La crisis internacional y cambiaria de fin de siglo en Colombia de Miguel Urrutia y Jorge Llano.” Desarrollo y Sociedad 67: 53–60. Zárate, J. P., A. L. Cobo, and J. E. Gómez-González. 2012. “Lecciones de las crisis financieras recientes para el diseño e implementación de las políticas monetaria y financiera en Colombia.” Ensayos Sobre Política Económica 30 (69): 258–293.

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21. Colombia during the Great Depression

loan portfolio of the banking system (Brando and Nodari 2020). There was a wave of liquidations, mergers, and acquisitions among commercial banks throughout the 1920s. However, by 1929, market concentration was still lower among commercial banks than mortgage banks: the top two commercial banks—Banco de Colombia and Banco de Bogotá—had a 49 percent market share (Brando and Nodari 2020). The Federal Reserve of the United States started to implement a tight monetary policy in 1928 that was imitated by other countries under the gold standard (Cogley, 2002). The resulting increase in international interest rates reduced the access of Colombian companies and governments to external credit. In 1928, the international financial media was warning of the Colombian government’s difficulties in servicing its debt (Ocampo 2015, 200). After the Wall Street Crash of 1929, access to international credit shut down almost completely (Ocampo 1987, 212). Net inflows of capital and interest switched from 39 million dollars per year in 1925–1929 to −19 million dollars per year in 1930–1934 (Ocampo 2015, 200). The government suspended capital payments on its external debt in 1931 and defaulted on its external debt from 1935 until World War II (Ocampo 2021, 75). A coffee price reduction aggravated the scarcity of foreign exchange. By 1933, the price of Colombian coffee was 63 percent lower than during its peak in 1926 (Ocampo 2015, 199). On average, the terms of trade in 1930–1934 were 23 percent lower than in 1925–1929 (Ocampo 2015, 200). Foreign exchange reserves fell 78 percent, and the price level fell 40 percent between 1928 and 1931, forcing the central bank to abandon the gold standard and impose exchange controls in 1931 (GRECO 2002; Meisel-Roca and Jaramillo-Echeverri 2017, 90; Ocampo 2021, 74). Overall, the real exchange rate with the United States depreciated 69 percent between 1930 and 1934 (Jaramillo-Echeverri, Meisel-Roca, and Ramírez-Giraldo 2016). The effect of the crisis on the real sector was not as high as in other countries, thanks to two factors: (i) an increase in export quantities that partially compensated for the fall in coffee prices (Meisel-Roca and Jaramillo-Echeverri 2017; Ocampo 2021, 73) and (ii) the growth of the nascent industrial sector, fueled by the depreciation of

The Great Depression triggered the largest economic crisis in Colombia since the civil war of 1899–1902. GDP fell 2.8 percent in 1930 and 3.5 percent in 1931 (GRECO 2002). A large economic boom preceded the crisis during the 1920s, fueled by increasing coffee exports, high coffee prices, and large capital inflows. GDP grew 7.4 percent per year between 1928 and 1932 (Ocampo 2021, 70). Coffee was the engine of economic growth during the first half of the twentieth century. Its share of exports was 70 percent at the end of the 1920s (Ocampo and Montenegro 1982). International coffee prices during the second half of the 1920s were high, and the passthrough from external prices to internal prices was also high (Ocampo and Montenegro 1982; Kalmanovitz and López 2006). High coffee prices fueled an economic boom in the second half of the 1920s, much in line with the strong relationship between coffee prices and the Colombian business cycle that was in place during the first half of the twentieth century (Kalmanovitz and López 2006, 97; Ocampo 2021, 68). An additional source of prosperity was an unprecedented access to international credit markets: net foreign loans amounted to US$200 million between 1926 and 1928 (Ocampo 2021, 68). Most of this credit went to national, regional, and local governments, but 14 percent of these loans went to Colombian private banks in 1926 (Posada 1989, 79). Bonds by the national government, regional governments, local governments, and public banks were traded in the New York Stock Exchange (Ocampo 1987, 199). The banking system had two market segments. Mortgage banks owned 43 percent of the loan portfolio of the banking system in 1929—more than double their share five years earlier (Brando and Nodari 2020). The mortgage market was distributed among three banks: Banco Hipotecario de Bogotá with 35 percent, Banco Hipotecario de Colombia with 34 percent, and Banco Agrícola Hipotecario with 31 percent (Brando and Nodari 2020). The latter was a public bank founded in 1925 (Brando and Nodari 2020). Commercial banks owned the remaining 57 percent of the 92

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the real exchange rate (Jaramillo-Echeverri, Meisel-Roca, and Ramírez-Giraldo 2016). Nevertheless, GDP fell 6 percent between 1929 and 1931, returning to its pre-crisis levels in 1933 (GRECO 2002). Fiscal policy maintained a conservative stance. Government expenditures as a share of GDP fell between 1928 and 1930, returning to their pre-crisis levels in 1931 (Junguito and Rincón 2004, 156). On the revenue side, the government increased tariffs on agricultural imports and processed foods, restricted the imports of some products, and imposed taxes on the exports of other products (Posada 1989, 89). With these measures, the government planned to redirect domestic demand over domestic production and minimize the loss of foreign exchange by the central bank (Posada 1989, 90). The fiscal deficit remained low, with a maximum deficit during the crisis of 0.8 percent of GDP in 1932 (Junguito and Rincón 2004, 156). The banking system was close to insolvency during the crisis (Caballero-Argáez and Urrutia 2006, 86). Loans and discount operations made by commercial banks fell from 10 percent of Colombian GDP in 1931 to 4 percent in 1934. This indicator remained well below pre-crisis levels until 1937 (Brando and Nodari 2020). However, Colombia did not experience major financial panics that caused bank runs during the 1930s. Commercial banks were not involved in bankruptcies or liquidations. Private mortgage banks were liquidated due to their sizeable external debt but transferred their assets and liabilities to public banks (Brando and Nodari 2020; Ocampo 2021, 73). Even without bankruptcies, the stock prices of the two largest commercial banks fell 80 percent between 1929 and 1932 (Brando and Nodari 2020). The crisis affected market and ownership structures in the banking industry. Foreign banks increased their market share, reaching an average of 53 percent of commercial loans between 1930–1931 and 1936–1937 (Brando and Nodari 2020). In addition, private mortgage banks gave their portfolio to public banks and closed (Brando and Nodari 2020). Furthermore, the government founded new banks. First, Caja Colombiana de Crédito Agrario or Caja Agraria, which specialized in agriculture, was founded in 1931 and second, Banco Central Hipotecario, which

specialized in housing, was founded in 1932 with funds from the central bank and the national commercial banks. In addition, the central bank authorized loan and discount operations directly with the public, specifically on agricultural pledge bonds issued by the emerging Almacenes Generales de Depósito (Brando and Nodari 2020). By 1934, the two leading public mortgage banks owned 51.4 percent of the loan portfolio of the bank system, whereas Caja Agraria held 3.5 percent, and Almacenes Generales de Depósito held 2.5 percent (Brando and Nodari 2020). The government would continue to gain market share in the banking market until the 1980s (Urrutia, Caballero-Argáez, and Lizarazo 2006). In summary, the Great Depression brought profound changes to Colombian banking, such as the liquidation of private mortgage banking, the contraction of commercial banking, the founding of a specialized public bank for agricultural credit, and the activation of auxiliary credit institutions such as the Almacenes Generales de Depósito. The post-crisis financial system emerged with the characteristics of a “mixed economy,” in which public banking became the primary source of commercial and mortgage credit in the financial market (Brando and Nodari 2020). Carlos Eduardo Hernández and Edwin López-Rivera

References

Brando, Carlos Andrés, and Nodari, Gianandrea. (2020). “Políticas bancarias durante la gran depresión: Colombia and México 1929–1937.” Análisis Político 33(100): 118–145. Caballero-Argáez, Carlos, and Miguel Urrutia. 2006. Historia del sector financiero colombiano en el siglo XX: ensayos sobre su desarrollo and sus crisis. Bogotá: Editorial Norma. Cogley, Timothy. 2002. “Monetary policy and the great crash of 1929: a bursting bubble or collapsing fundamentals?” In Rabin, J. (ed.) Handbook of Monetary Policy, Routledge. GRECO. 2002. El crecimiento económico colombiano en el siglo XX. Bogotá: Banco de la República. Jaramillo-Echeverri, Juliana, Adolfo Meisel-Roca, and María Teresa Ramírez-Giraldo. 2016. “La Gran Depresión en Colombia: Un estímulo a la industrialización, 1930–1953”. Cuadernos de Historia Económica y Empresarial; No. 39. Banco de la República.

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94  Elgar encyclopedia of financial crises Junguito, Roberto, and Hernán Rincón. 2004. “La política fiscal en el siglo XX en Colombia.” Borradores de Economía, 318. Banco de la República. Kalmanovitz, Salomón, and Enrique López. 2006. La agricultura colombiana en el Siglo XX. Bogotá: Fondo de Cultura Económica. Meisel-Roca, Adolfo, and Juliana Jaramillo-Echeverri. 2017. “Las políticas del Banco de la República durante un auge entre dos crisis.” In Historia del Banco de la República 1923–2015, edited by José Darío Uribe, 85–119. Banco de la República de Colombia. Ocampo, José Antonio. 1987. “Planes Antinflacionarios Recientes en la America Latina.” El Trimestre Económico 54 (September). Ocampo, José Antonio. 2015. “Crisis mundial y cambio estructural (1929–1945).” Historia Económica de Colombia by J.

A. Ocampo. Bogotá: Fondo de Cultura Económica-Fedesarrollo. Ocampo, José Antonio. 2021. Una historia del sistema financiero colombiano, 1870–2021. Bogotá: Asobancaria and Bancoldex. Ocampo, José Antonio, and Armando Montenegro. 1982. “La Crisis Mundial de los Años treinta en Colombia” Revista Desarrollo and Sociedad 7: 37–96. Posada, Carlos Esteban. 1989. “La gran crisis en Colombia: el periodo 1928–1933.” In Nueva Historia Económica de Colombia, edited by Alvaro Tirado Mejia. Mexico City: Editorial Planeta. Urrutia, Miguel, Carlos Caballero-Argáez, and Diana Lorena Lizarazo. 2006. “Desarrollo financiero y desarrollo económico en Colombia.” In Historia del sector financiero colombiano en el siglo XX by Miguel Urrutia and Carlos Caballero-Argáez, 19–60. Bogotá: Asobancaria and Grupo Editorial Norma.

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22. Crisis prevention and resolution

macroeconomies, exchange rate systems, and strong capital and external account management can help prevent future crises (Frenkel and Rapetti 2009). Countries, particularly those that have not fully liberalized their financial sectors, may choose to regulate capital flows to prevent crises. Chile and China have imposed capital controls to prevent excessive inflows and outflows from causing financial collapse. Empirical evidence supports this assertion. Broner and Ventura (2010) show that lowering capital controls results in instability and does not necessarily lead to investment or growth, as some have argued (see Blecker 1999). China’s capital controls have helped the country to maintain its exchange rate while continuing to grow, while Chile’s capital controls were arguably less successful when currency appreciation expectations rose. Adjusting reserve requirements may also help countries to check capital flows. Bussiere et al. (2015) show that countries with high reserves relative to short-term debt and some capital controls suffered less from the 2008–2009 global crisis. Prudential regulations can provide systemic banking oversight and improve banks’ risk management processes (BIS 2011). Countercyclical macroeconomic policy may be an essential tool in helping to prevent, contain, and resolve crises. This type of policy can dampen the boom–bust cycle and prevent the rise of asset price bubbles and other inconsistencies. Countercyclical policy includes both monetary and fiscal policy, as well as macroprudential regulation. Using monetary policy in pricking an asset price bubble can be dangerous, as sudden declining asset prices can throw an economy into a downturn. Therefore, the use of monetary policy along with macroprudential regulation can help dampen business cycles. Macroprudential regulation controls leverage ratios, loan-to-value ratios, and other capital buffers (Demirgüς-Kunt and Servén 2009). Countercyclical fiscal policy can help to bolster income and employment and can be used to increase government funds during booms by reducing debt-to-GDP ratios. Credit controls, including margin and minimum capital requirements, can help prevent capital loss during a downturn (Soros 2012). Such controls are necessary complements to monetary policy tools, which may be inadequate in fully controlling asset price

The Great Recession was a shock to Americans and Europeans, many of whom believed the West was inured to such financial fragility. The crisis also showed severe weaknesses in the financial structure and policy response of the European Union. Few orthodox scholars predicted an impending crisis. This is due to the incompatibility of orthodox economics with financial failures. For example, the efficient markets hypothesis holds that financial markets reflect all available information. Economists who believe financial crises are inevitable within the capitalist system are considered heterodox, as economic orthodoxy generally does not leave room for crisis creation. Karl Marx, frequently studied by heterodox scholars, wrote that capitalism is unstable and crisis-prone. John Maynard Keynes, Paul Baran, and Paul Sweezy also viewed capitalism as moving toward potential stagnation, leading to crisis. Hyman Minsky viewed finance as unstable due to excessive speculation. When the Great Recession began, many called upon the work of Minsky to better understand the collapse of finance in the US. Some preludes to crises include quick capital account and banking liberalization, accumulation of massive foreign-denominated debt as a developing country, and sudden significant gains in asset prices. While there was a growing asset price bubble in the financial sector, it went largely unnoticed. It was only after the fact that scholars uncovered evidence of financial fragility. Indicators of banking crises include central bank reserves and short-term nominal interest rates (Jing, de Haan, Jacobs, and Yang 2014); growth rates of loans-to-deposits and house prices (Lainà, Nyholm, and Sarlin 2015); and capital account openness (Qin and Luo 2014). After the crisis, regulators put into place additional macroprudential regulations to pinpoint anomalies in some of these indicators. Financial liberalization and innovation without appropriate risk control have been at the heart of numerous financial crises. Therefore, to prevent crises, financial liberalization should be implemented along with proper transparency and regulation. Stable 95

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bubbles. After the crisis, new institutions were created to oversee macroprudential regulation; these included the Financial Stability Oversight Council in the US, the European Systemic Risk Board, and the European System of Financial Supervisors in Europe. After a crisis begins, it must be contained. Usually, the only institution with the capacity and will to do so is the government, which may be forced to provide emergency liquidity, close or transfer financial institutions to bad banks, or impose other measures. Bagehot (1897) noted that containment in the case of a banking crisis usually means that financial institutions should have access to ample liquidity to prevent further credit constraints. In the case of a currency crisis, containment may require reducing pressure on the currency through currency devaluation or flotation. This must be carried out carefully since it can result in capital flight and an overall loss of economic confidence. Once the crisis is contained, existing problems need to be resolved to improve economic conditions. Resolution policies may include across-the-board incentives for loan loss write-offs, conditional government subsidized workouts of assets, debt forgiveness, the establishment of a government-owned asset management company, government-assisted sales of financial institutions, and government-assisted recapitalization (Calomiris, Klingebiel, and Laeven 2004). Some policies require institutions to supervise and enforce the policy mandate. The Nordic country crises were resolved using the nationalization of fragile banks. Toxic assets were separated from healthy assets, and the banks were recapitalized to improve their financial health (Dewatripont, Rochet, and Tirole 2010). The Great Recession was resolved to some extent through government-assisted sales of financial institutions. Resolution in a currency crisis is often carried out by imposing capital controls to restrict capital inflows or outflows. Capital controls were used in the Asian financial crisis to control outflows of short-term capital in Malaysia and Thailand and to reduce pressure on the currency. The International Monetary Fund (IMF) has played an important role in crisis resolution, extending credit to countries that experience short-term balance of payments Sara Hsu

problems. Credit is usually extended with conditionality, which is used to prevent creditor moral hazard (Bird 2007). The institution has become controversial due to the imposition of what are viewed as harsh conditions and lack of evidence about the positive impact of conditionality on growth. However, Kenneth Rogoff, former IMF Chief Economist, has argued that countries must face budget constraints even in hard times since running a budget deficit is unlikely to eventually stimulate growth enough to make up for the increased debt levels (Rogoff 2003). The Financial Stability Forum was replaced with the Financial Stability Board to prevent future global imbalances. The Financial Stability Board took over the tasks associated with the Financial Stability Forum to ensure international financial stability and reduce systemic risk. In addition to that, the Financial Stability Board must monitor and advise on market developments and on the meeting of regulatory standards, review policy development work of the international standard-setting bodies, set forth guidelines for the establishment of supervisory colleges, manage contingency plans for international crisis management, and collaborate with the IMF to carry out Early Warning Exercises (Financial Stability Forum 2009). Coordinated macroeconomic policies can also help alleviate future financial crises’ effects. Macroeconomic policy coordination can also help to stabilize exchange rates, preventing speculators from pulling money out of one country and placing it in another. Monetary policy coordination that changes interest rates among countries at the same time can halt this type of speculation (Blecker 1999). Macroeconomic policy coordination is challenging to carry out, as it requires political acceptance of the economic rationale behind the policy and acceptance of working with other nations. Macroeconomic policy coordination was considered in 1973 due to the oil price shock. This was not carried out, but it did result in the creation of an oil facility as an alternative to fiscal tightening (Meyer et al. 2002). Policy coordination was then attempted in 1985 and 1987 but was not highly effective. Global macroeconomic policy coordination was discussed after the Asian financial crisis, but it was not implemented at that time. Coordination was imple-

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mented to some extent in the wake of the Great Recession, which prevented some of the problems faced during the Great Depression (Eichengreen and O’Rourke, 2009). Ultimately, there is no replacement for strong, stable institutions and stabilizing government policies in preventing and resolving crises. Such institutions include supervised banks and effective taxation. Stabilizing government policies include macroprudential regulations. Complementary institutions, such as a functional legal system, well-regulated nonbank financial institutions, and an honest government, can create an environment conducive to reducing major financial risks and resolving crises successfully. Sara Hsu

Calomiris, Charles, Daniela Klingebiel, and Luc Laeven. 2004. A Taxonomy of Financial Crisis Resolution Mechanisms: Cross-Country Experience. World Bank Working Paper 3379. Demirgüς-Kunt, Asli and Luis Servén. 2009. Are All the Sacred Cows Dead? Implications of the Financial Crisis for Macro and Financial Policies. World Bank Policy Research Paper 4807. Dewatripont, Mathias, Jean-Charles Rochet, and Jean Tirole. 2010. Balancing the Banks: Global Lessons from the Financial Crisis. Princeton, NJ: Princeton University Press. Eichengreen, Barry and Kevin H. O’Rourke. 2009. A Tale of Two Depressions. www​.voxeu​.org. September 1. Financial Stability Forum. 2009. Financial Stability Forum Re-established as Financial Stability Board. Press Release, April 2. Frenkel, Roberto and Martin Rapetti. 2009. A Developing Country View of the Current References Global Crisis: What Should Not Be Forgotten and What Should Be Done. Cambridge Journal Bagehot, Walter. 1897. Lombard Street: of Economics 33: 685–702. A Description of the Money Market. New York: Jing, Zhongbo, Jakob de Haan, Jan Jacobs, and Charles Scribner’s Sons. Haizhen Yang. 2014. Identifying Banking Bird, Graham. 2007. The IMF: A Bird’s Eye Crises Using Money Market Pressure: New View of Its Role and Operations. Journal of Evidence for a Large Set of Countries. Journal Economic Surveys 21(4): 683–745. of Macroeconomics 43: 1–20. BIS. 2011. Capital Treatment for Bilateral Counterparty Credit Risk Finalized by the Lainà, Patrizio, Juhi Nyholm, and Peter Sarlin. 2015. Leading Indicators of Systemic Banking Basel Committee. June 1. www​.bis​.org/​press/​ Crises: Finland in a Panel of EU Countries. p110601​.htm. Review of Financial Economics 24: 18–35. Blecker, Robert. 1999. Taming Global Finance. Meyer, Laurence H., Brian M. Doyle, Joseph Washington, DC: Economic Policy Institute. E. Gagnon, and Dale W. Henderson. 2002. Broner, Fernando A. and Jaume Ventura. International Coordination of Macroeconomic 2010. Rethinking the Effects of Financial Policies: Still Alive in the New Millennium? Liberalization. www​.econ​.upf​.edu/​docs/​papers/​ International Finance Discussion Papers 723. downloads/​1128​.pdf. Bussiere, Matthieu, Gong Cheng, Menzie Chinn, Qin, Xiao and Chengying Luo. 2014. Capital Account Openness and Early Warning System and Noemie Lisack. 2015. For a Few Dollars for Banking Crises in G20 Countries. Economic More: Reserves and Growth in Times of Crises. Modelling 39: 190–194. Journal of International Money and Finance Rogoff, Kenneth. 2003. The IMF Strikes Back. 52: 127–145. Foreign Policy 134: 38–47. Soros, George. 2012. Financial Turmoil in Europe and the United States. New York: PublicAffairs.

Sara Hsu

23. Definition of banking crisis

do not determine any quantitative limit on the depletion of bank capital, they mainly consider government measures undertaken in response to a crisis and tend to count on supervisory sources. Kaminsky and Reinhart (1999) and Reinhart and Rogoff (2009) consider two criteria to identify banking crises. A systemic banking crisis occurs:

The frequency of banking crises both in developing and advanced countries has increased following the collapse of the Bretton Woods system in 1971 and financial liberalization policies implemented in the late 1970s and early 1980s. These crisis episodes caused significant economic and social costs for public sector and private investors in terms of growth, unemployment, public debt stock, and failure of financial and nonfinancial institutions. Therefore, there has been a growing interest of academics, policymakers, and international organizations, particularly following the outbreak of the Asian crisis of 1997–98 and the global financial crisis of 2007–08, in developing theoretical and empirical models to understand the occurrence of banking crises in an attempt to predict future crisis episodes. As stated by Laeven and Valencia (2018: 3), these efforts crucially depend on the proper identification of crisis dates. However, it is difficult to empirically identify banking crises because of the nature of the problem and the lack of appropriate data (Reinhart and Rogoff, 2009). Hence, researchers mostly rely on experts’ judgments on countries’ banking systems (Bell and Pain, 2000). Consequently, banking crises are usually identified on the basis of a combination of events such as the forced closure, merger, government takeover of financial institutions, bank runs, or the extension of government assistance to financial institutions. Simply put, dating banking crises is generally event-based and is typically founded on the available ex post figures related to banks’ losses and governments’ bailout costs (e.g., Kaminsky and Reinhart, 1999; Caprio and Klingebiel, 1999; Demirguc-Kunt and Detragiache, 2005; Laeven and Valencia, 2013, among others). As there is no consensus on defining a banking crisis, different classifications are employed in empirical studies. For Lindgren et al. (1996), systemic banking crises are identified if bank runs, portfolio shifts, bank failures, or large-scale government intervention occur. Caprio and Klingebiel (1996, 1999) and Caprio et al. (2005) define a systemic banking crisis as an event when all or most of bank capital is depleted. As they

1. If there are bank runs leading to the closure, merging, or takeover of one or more financial institutions 2. If there is no run, the closure, merging, takeover, or large-scale government assistance of one or more financial institutions marks the start of similar outcomes for other financial institutions. According to Borio and Drehmann (2009), a systemic banking crisis occurs in: 1. Countries where the government must inject capital in more than one large bank and/or more than one large bank fails, or 2. Countries that undertake at least two of the following policy operations: providing wholesale guarantees; buying assets; or announcing a large-scale recapitalization program. Like the early work, they do not set any quantitative limit on these criteria to date a banking crisis. Demirguc-Kunt and Detragiache (1998, 2000, 2002, 2005) employ more explicit quantitative measures to detect banking distress: 1. The ratio of nonperforming loans to total assets must exceed 10 percent 2. The government rescue operation must cost at least 2 percent of GDP 3. Large-scale nationalizations must occur 4. Extensive bank runs must take place or government emergency measures (e.g., deposit freezes, prolonged bank holidays, or generalized deposit guarantees) should be enacted in response to the crisis. Laeven and Valencia (2013, 2018) define a banking crisis as an event that should hold the following conditions: 1. Significant signs of financial distress in the banking system such as bank runs, substantial losses in the banking system, and/or bank liquidations 98

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2. Significant government measures in response to substantial losses in the banking system. They consider policy measures to be significant if at least three out of the following six measures are put into practice: (1) deposit freezes and/or bank holidays; (2) substantial bank nationalizations; (3) high bank restructuring gross costs (at least 3 percent of GDP); (4) extensive liquidity support (5 percent of deposits and liabilities to nonresidents); (5) significant guarantees put in place; and (6) significant asset purchases (at least 5 percent of GDP). Moreover, a banking crisis is supposed to be systemic when either (i) a country’s banking system presents substantial losses resulting in a share of nonperforming loans above 20 percent or bank closures of at least 20 percent of banking system assets; or (ii) fiscal restructuring costs of the banking sector exceed 5 percent of GDP. Nearly all empirical work, institutional or academic, on banking crises generally employs one of these banking crisis definitions. However, the event-based crisis dating methods are controversial and problematic, since they are founded principally on information about government actions in response to banking distress and depend on information taken from bank regulators and/or central banks (Boyd et al., 2009). Hence, these indicators are likely to identify the occurrence of a banking crisis too late (Von Hagen and Ho, 2007), since government intervention versus banking distress may arrive with some delay due to uncertainty about the actual extent of problems in the banking sector (Boyd et al., 2009), or too early because the worst of crisis may come later (Kaminsky and Reinhart, 1999). Moreover, as there are few objective standards for deciding whether a given policy intervention is “large” enough, it is difficult to determine the exact timing of banking crises (Von Hagen and Ho, 2007). Besides arbitrary criteria that define what a banking crisis is, a subjective judgment is also required to distinguish between periods of systemic and nonsystemic crises (Davis and Karim, 2008). Different banking crisis definitions across empirical studies lead to significant discrepancies in dating banking crises, as indicated in Eichengreen and Arteta (2002), Davis and

Karim (2008), and Boyd et al. (2009). For example, Boyd et al. (2009) show that only between 24.5 percent and 49.5 percent of crises are commonly indicated by these different crisis indicators. Thus, Boyd et al. (2009: 11) conclude that these widespread discrepancies across banking crisis classifications cast serious doubt about either the robustness or the comparability of many results obtained in a large empirical literature. Moreover, this problem also alters the significance of explanatory variables across empirical papers, thus, creating confusion for policymakers on what indicator to follow or consider in order to prevent future crisis episodes. To address the problems related to event-based crisis dating schemes, some authors, inspired by currency crisis indexes, develop aggregate banking crisis indicators. For example, Von Hagen and Ho (2007) build a “money market pressure index” through changes in the ratio of central banks’ lending to banks over bank deposits and changes in the short-term real interest rate. Ari (2012) employs an “index of financial fragility”, which consists of changes in bank loans granted to the private sector, changes in bank foreign liabilities, and changes in bank deposits. Ari and Cergibozan (2016) also use an “index of financial fragility”, which is composed of changes in the ratio of nonperforming loans over bank total loans, changes in the ratio of bank foreign deposits over bank total deposits, and changes in the ratio of bank profit (loss) over bank own equity. In all papers, like in the currency crisis literature, the index components are weighted by the inverse of their respective standard deviations to equalize their volatility and thus avoid the possibility of one of the components dominating the index. Furthermore, arbitrary thresholds in terms of the standard deviation and the mean of the index are specified. The crisis index is, thus, transformed into a binary variable which takes the value of 1 if a crisis occurs and 0 otherwise. Although dating banking crisis via the construction of composite indicators has advantages compared to the event-based crisis dating mechanism—especially for the empirical models that are intended to be “early warning”—this method has also some drawbacks such as arbitrary choice of the index components, ad hoc weighting, and Ali Ari

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threshold procedures. Thus, one may suggest combining various dating schemes that differ from the nature of the index’s components, their weights, and threshold levels to test for robustness. From this perspective, Ari et al. (2016) aim to assess the robustness of crisis dating schemes using six different crisis definitions and two different values of thresholds over the Turkish economy. Their results indicate significant inconsistencies in dating crises. This is mainly related to the choice of the index components and the threshold levels to a lesser extent. The above discussion suggests there is no “perfect” method to date banking crises. Hence, we need more academic and institutional efforts to improve and/or standardize crisis dating schemes for banking crises. Ali Ari

References

Ari, A. (2012). Early warning systems for currency crises: The Turkish case. Economic Systems, 36(3), 391–410. Ari, A., & Cergibozan, R. (2016). The twin crises: The determinants of banking and currency crises in the Turkish economy. Emerging Markets Finance and Trade, 52(1), 123–135. Ari, A., Cergibozan, R., & Demir, S. (2016). Dating banking and currency crises in Turkey, 1990–2014. In Munir, Q. (ed.), Handbook of Research on Financial and Banking Crisis Prediction through Early Warning Systems, Hershey, PA: IGI Global, 240–273. Bell, J., & Pain, D. (2000). Leading indicator models of banking crises: A critical review. Financial Stability Review, 9, 113–129. Borio, C., & Drehmann, M. (2009). Assessing the risk of banking crises: Revisited. BIS Quarterly Review, March, 29–46. Boyd, J. H., De Nicolo, G., & Loukoianova, E. (2009). Banking Crises and Crisis Dating: Theory and Evidence. IMF Working Paper, 09–141, Washington, DC. Caprio, G., & Klingebiel, D. (1996). Bank Insolvencies Cross-Country Experience. World Bank Policy Research Working Paper, 1620, Washington, DC.

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Caprio, G., & Klingebiel, D. (1999). Episodes of Systemic and Borderline Financial Crises. Washington, DC: World Bank Mimeo. Caprio, G., Klingebiel, D., Laeven, L., & Noguera, G. (2005). Banking crises database. In P. Honahan & L. Laeven (Eds.), Systemic Financial Crises, Cambridge: Cambridge University Press. Davis, E. P., & Karim, D. (2008). Comparing early warning systems for banking crises. Journal of Financial Stability, 4(2), 89–120. Demirguc-Kunt, A., & Detragiache, E. (1998). The determinants of banking crises in developing and developed countries. International Monetary Fund Staff Papers, 45(1), 81–109. Demirguc-Kunt, A., & Detragiache, E. (2000). Monitoring banking sector fragility: A multivariate logit approach. The World Bank Economic Review, 14(2), 287–307. Demirguc-Kunt, A., & Detragiache, E. (2002). Does deposit insurance increase banking system stability? An empirical investigation. Journal of Monetary Economics, 49(7), 1373–1406. Demirguc-Kunt, A., & Detragiache, E. (2005). Cross-country empirical studies of systemic bank distress: A survey. National Institute Economic Review, 192(1), 68–83. Eichengreen, B., & Arteta, C. (2002). Banking crises in emerging markets: Presumptions and evidence. In Blejer, M. I. & Skreb, M. (eds.), Financial Policies in Emerging Markets, Cambridge, MA: MIT Press, 47–94. Kaminsky, G. L., & Reinhart, C. M. (1999). The twin crises: The causes of banking and balance-of-payments problems. American Economic Review, 89(3), 473–500. Laeven, L., & Valencia, F. (2013). Systemic banking crises database. IMF Economic Review, 61(2), 225–270. Laeven, L., & Valencia, F. (2018). Systemic Banking Crises Revisited. IMF Working Paper, 18–206, Washington, DC. Lindgren, C. J., Garcia, G., & Saal, M. (Eds.) (1996). Bank Soundness and Macroeconomic Policy. Washington, DC: International Monetary Fund. Reinhart, C. M., & Rogoff, K. S. (2009). This Time Is Different: Eight Centuries of Financial Folly. Princeton NJ: Princeton University Press. Von Hagen, J., & Ho, T. K. (2007). Money market pressure and the determinants of banking crises. Journal of Money, Credit and Banking, 39(5), 1037–1066.

24. Determinants of banking crises Banking crises, either systemic or nonsystemic, lead to high economic costs for the public sector and private investors. As underlined by the International Monetary Fund (IMF) (1998), following a banking crisis the cumulative output losses reach 11.6 percent and the recovery takes more than three years. Hence, a large theoretical and empirical literature exists to understand the occurrence, determinants, and consequences of banking crises in order to predict and prevent future crises. Early theoretical models (e.g., Flood and Garber, 1981; Diamond and Dybvig, 1983) focused on the liability side of bank balance sheets to explain the occurrence of banking crises. This is mainly related to the banks’ “natural” role in transforming short-term deposits into long-term loans. This maturity mismatch makes banks vulnerable to bank runs. In countries that lack a deposit insurance scheme, depositors’ loss of confidence in the banking system leads to massive withdrawals from banks. Although banks hold required and/or excess reserves, it is difficult for the banks to match massive withdrawals. Hence, they try to liquidate assets at “fire sale” prices. However, in case of systemic banking problems and no financial assistance coming from the central bank and/or other monetary authorities, banks face a risk of bankruptcy following a sudden withdrawal of deposits. Thus, Diamond and Dybvig (1983) recommend that deposit insurance be implemented to prevent bank runs by calming depositors’ sudden shift of expectations. Some models (e.g., McKinnon and Pill, 1999; Chang and Velasco, 2000, 2001) have analyzed how poor bank asset quality and high bank indebtedness drive banks into liquidity shortages. The main elements highlighted in these models are inadequate regulation and lack of supervision of the banking system, moral hazard and excessive risk-taking created by government guarantees, and financial liberalization. The onset of a crisis is the result of excessive borrowing and overinvestment related to moral hazard in the context of implicit or explicit guarantees. Free capital mobility and domestic financial deregulation contribute to excessive capital

inflows, particularly through domestic banks, creating an environment conducive to the creation of speculative bubbles in the stock market and/or the real estate sector, but at the expense of rising risks of the banking system. The awareness of bank maturity and currency risks by foreign lenders puts an end to the euphoric sequence, generating the bursting of speculative bubbles, causing then the insolvency of domestic banks. The banking crisis leads then to a currency crisis, when massive capital inflows sharply reverse, resulting in losses of central bank reserves and a significant devaluation of the domestic currency. The devaluation leads in turn to the failure of more banks, forcing the authorities to act as a lender of last resort to preserve the integrity of the payments system. However, bank failures and, in parallel, the associated credit crunch result in a sharp fall in asset prices and economic output. On the other hand, empirical studies on banking crises cluster crisis determinants into four main groups, including macroeconomic, microeconomic, structural, and institutional (Goldstein and Turner, 1996; Honohan, 1997). The deterioration in macroeconomic indicators reduces profits of the banking sector and increases its risks. In this context, large-scale decreases in the real GDP growth rate, increasing inflation rates, credit expansion, high real interest rates, and large devaluations in domestic currency are mostly underlined in empirical papers (Eichengreen and Rose, 1998; Demirguc-Kunt and Detragiache, 1998; Hutchison and McDill, 1999; Von Hagen and Ho, 2007; Davis and Karim, 2008; Borio and Drehmann, 2009). Reinhart and Rogoff (2009) mentioned that recessions are mostly an amplification mechanism rather than a triggering factor, as we observed during the global financial crisis of 2007–08. This is because, when employees lose their jobs due to a recession, nonperforming loans increase, leading to a contraction in bank lending, which results in more output declines and credit problems. This leads to more banking problems, and so on. Increasing inflation rates push up uncertainty and interest rates in an economy, causing investors/consumers to limit and delay their investment and consumption decisions. Large devaluations in domestic currency are another important problem, particularly for banks which have large open positions. This is mostly the case in emerging markets in

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which banks generally borrow in foreign currencies from international markets to lend in domestic currency to local firms and households. Therefore, crises in financially open emerging countries are generally twin crises in which a banking crisis leads to currency crisis or vice versa. As for microeconomic factors, decreases in the ratio of bank reserves to bank liabilities (Eichengreen and Arteta, 2000), a decrease in the bank capital adequacy ratio (Barrell et al., 2010), liquidity problems (Barrell et al., 2010; Duttagupta and Cashin, 2011), increases in foreign currency deposits and low bank profitability (Duttagupta and Cashin, 2011), a decrease in bank concentration (Beck et al., 2007) are highlighted as the causes of financial fragility and banking crises. Moreover, as the frequency and the cost of banking crises have increased following financial liberalization practices, some empirical papers focused on the causality between these two concepts. As Reinhart and Rogoff (2013) emphasized, the increased capital abundance with the liberalization of capital movements causes prices to swell excessively in both asset and real estate markets. But a “sudden stop” à la Calvo (1998) in international credit flows following an external shock and/or a shift in investors’ expectations leads prices to return to their “real” values. Empirical studies within this framework (Caprio and Klingebiel, 1996; Kaminsky and Reinhart, 1999; Glick and Hutchison, 1999; Shehzad and De Haan, 2009) generally concluded that financial liberalization increases the likelihood of banking crises. In addition, as a result of increasing integration between countries due to financial globalization, countries become more vulnerable to external shocks and/or changes in global economic cycles. From this perspective, a slowdown in world growth rates (Eichengreen and Rose, 1998; Babecky et al., 2014) and a rise in world interest rates (Hardy and Pazarbasioglu, 1999) are highlighted as variables affecting the probability of a banking crisis in the domestic economy. Besides, increased interdependence and integration between countries augment the probability of transmission of a crisis from one country to another, as clearly observed during the global financial crisis (see Hasman, 2013 for a detailed analysis on contagion of banking crises). Some empirical papers (i.e., Santor, 2003; Dungey and Gajurel, 2015) Ali Ari

found that contagion is a factor explaining the likelihood of banking crises. In addition to macro, micro, and structural dynamics, several empirical studies examined the impact of institutional and political factors on banking crises. According to their findings, the probability of a banking crisis increases in economies with weak and inadequate institutional regulation and supervision mechanisms (Caprio and Klingebiel, 1996; Demirguc-Kunt and Detragiache, 1998). Also, an implicit or explicit deposit insurance, leading to excessive risk-taking of banks and their customers (moral hazard), stands out as an element that reduces the quality of bank loans, thus increasing the probability of a banking crisis (Hutchison and McDill, 1999; Eichengreen and Arteta, 2000; Demirguc-Kunt and Detragiache, 2002; Von Hagen and Ho, 2007). On the other hand, an increase in political instability and corruption in the country (Mehrez and Kaufmann, 2000) and restrictions on bank competition implemented by the government (Beck et al., 2007) are also found to play an important role in the onset of banking crises. Finally, some empirical studies analyze the relationship between currency and banking crises. In their inspiring work on twin crises, Kaminsky and Reinhart (1999) showed that banking crises generally play an important role in triggering the occurrence of currency crises, while currency crises mostly deepen banking crises. Glick and Hutchison (1999), another empirical paper on the relationship between currency and banking crises, confirmed the direction of causality from banking to currency crises. This generally happens when capital outflows lead to currency devaluation following bank failures. Babecky et al. (2014), on the other hand, showed that banking crises lead to both currency and debt crises. As observed during the global financial crisis of 2007–08, governments generally tend to save banks from a probable failure to avoid a systemic banking crisis. Thus, private sector debt is nationalized, increasing then public debt stock over GDP. Governments become unable to roll over the debt when financial markets are reluctant to renew their lending to the country. This brief analysis shows that as several factors may cause the outbreak of banking crises, it is difficult to prevent future crisis episodes. However, with adequate regulation and supervision, policymakers may limit the

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worsening of microeconomic factors, hence decrease the crisis probability. Besides, higher institutional quality and political stability leading to better macroeconomic performance may also decrease the likelihood of a banking crisis. Ali Ari

References

Babecky, J., T. Havranek, J. Mateju, M. Rusnak, K. Smidkova, & B. Vasicek (2014). Banking, debt, and currency crises in developed countries: Stylized facts and early warning indicators. Journal of Financial Stability, 15(C), 1–17. Barrell, R., E. P. Davis, D. Karim, & I. Liadze (2010). Bank regulation, property prices and early warning systems for banking crises in OECD countries. Journal of Banking & Finance, 34(9), 2255–2264. Beck, T., A. Demirguc-Kunt, & R. Levine (2007). Bank concentration and fragility. Impact and mechanics. In M. Carey & R. M. Stulz (eds.), The risks of financial institutions, Chicago, IL: University of Chicago Press, 193–231. Borio, C. & M. Drehmann (2009). Assessing the risk of banking crises: Revisited. BIS Quarterly Review, March, 29–46. Calvo, G. A. (1998). Capital flows and capital-market crises: The simple economics of sudden stops. Journal of Applied Economics, 1, 35–54. Caprio, G. & D. Klingebiel (1996). Bank insolvencies: Cross-country experience. World Bank Policy Research Working Paper, 1620, Washington, DC. Chang, R. & A. Velasco (2000). Banks, debt maturity and financial crises. Journal of Financial Economics, 51(1), 169–194. Chang, R. & A. Velasco (2001). A model of financial crises in emerging markets. Quarterly Journal of Economics, 116(2), 489–517. Davis, E. P. & D. Karim (2008). Comparing early warning systems for banking crises. Journal of Financial Stability, 4(2), 89–120. Demirguc-Kunt, A. & E. Detragiache (1998). The determinants of banking crises: Evidence from developing and developed countries. IMF Staff Papers, 45(1), 81–109. Demirguc-Kunt, A. & E. Detragiache (2002). Does deposit insurance increase banking system stability? An empirical investigation. Journal of Monetary Economics, 49(7), 1373–1406. Diamond, D. & P. Dybvig (1983). Bank runs, deposit insurance and liquidity. Journal of Political Economy, 93(3), 401–419.

Dungey, M. & D. Gajurel (2015). Contagion and banking crisis: International evidence for 2007–2009. Journal of Banking & Finance, 60, 271–283. Duttagupta, R. & P. Cashin (2011). The anatomy of banking crises in developing and emerging market countries. Journal of International Money and Finance, 30(2), 354–376. Eichengreen, B. & C. Arteta (2000). Banking crises in emerging markets: Presumptions and evidence. CIDER Working Papers, 2000, C00–115, Berkeley, CA. Flood, R. P. & P. M. Garber (1981). A systematic banking collapse in a perfect foresight world. NBER Working Paper, 691, Cambridge, MA. Glick, R. & M. Hutchison (1999). Banking and currency crises: How common are twins? Pacific Basin Working Paper Series, 1999, PB99–07. Goldstein, M. & P. Turner (1996). Banking crises in emerging economies: Origins and policy options. BIS Economic Papers, 46, Basel. Hardy, D. C. & C. Pazarbasioglu (1999). Determinants and leading indicators of banking crises: Further evidence. IMF Staff Papers, 46(3), 247–258. Hasman, A. (2013). A critical review of contagion risk in banking. Journal of Economic Surveys, 27(5), 978–995. Honohan, P. (1997). Banking system failures in developing and transition countries: Diagnosis and prediction. BIS Working Papers, 39, Basel. Hutchison, M. & K. McDill (1999). Are all banking crises alike? The Japanese experience in international comparison. NBER Working Paper, 7253, Cambridge, MA. IMF. (1998). World Economic Outlook. May, Washington, DC. Kaminsky, G. & C. Reinhart (1999). The twin crises: The causes of banking and balance of payment problems. American Economic Review, 89(3), 473–500. McKinnon, R. I. & H. Pill (1999). Exchange-rate regimes for emerging markets: Moral hazard and international overborrowing. Oxford Review of Economic Policy, 15(3), 19–38. Mehrez, Gil & Daniel Kaufmann (2000). Transparency, liberalization, and banking crisis. Policy Research Working Paper Series 2286, The World Bank. Reinhart, C. M. & K. S. Rogoff (2009). This Time Is Different: Eight Centuries of Financial Folly. Princeton NJ: Princeton University Press. Reinhart, C. M. & K. S. Rogoff (2013). Banking crises: An equal opportunity menace. Journal of Banking & Finance, 37(11), 4557–4573.

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Von Hagen, J. & T. K. Ho (2007). Money market pressure and the determinants of banking crises. Journal of Money, Credit and Banking, 39(5), 1037–1066.

25. Discovering business opportunities emerging from financial crises According to Eckhardt and Shane (2003: 336), entrepreneurial (or business) opportunities are “situations in which new goods, services, raw materials, markets and organizing methods can be introduced through the formation of new means, ends, or means-ends relationships.” This entry focuses on how firms can discover business opportunities during financial crises. Financial crises lead to innovations and changes – for example, in how firms source and sell their products (Ratten 2021) – and, through that, provide several business opportunities (Wang and Chen 2021). For instance, during some financial crises, demand increases for some products, which can motivate some firms to introduce new products or services into their portfolio. For example, during the Covid-19 crisis, some alcohol producers started offering hand sanitizers, fashion firms launched the production of face masks while furniture companies added protective screens to their product portfolio (Bivona and Cruz 2021; Davidsson et al. 2021; Sarkar and Clegg 2021; Vissak 2022a, b). During financial crises, demand for some firms’ existing products or services can also increase considerably: for instance, during the Covid-19 crisis, people had to stay at home more or start working from home due to various restrictions, and this increased demand for home-related products (Vissak and Francioni 2020) and various digital services (Zahra 2021). In addition, some construction companies gained due to the increased need for hospital buildings, while alcohol producers started selling more spirit as it is an essential component for hand sanitizers (Sarkar and Clegg 2021; Vissak 2022a). Demand for more durable products also increased during the pandemic (Tokarz et al. 2021). Financial crises can also help firms discover new export opportunities (Sarkar and Clegg 2021). For instance, if such crises result in supply chain disruptions and ordering from other continents becomes more

complicated, as in the Covid-19 crisis, then this can help some firms to find new customers from neighboring countries (Juergensen et al. 2020; Tokarz et al. 2021; Vissak and Francioni 2020). Moreover, some firms can find more customers from their home market (Wang and Chen 2021). In addition to the above, the Covid-19 pandemic has resulted in accelerated digitalization (Amankwah-Amoah et al. 2021a; Ghauri et al. 2021; Ratten 2021) – for example, developing online sales platforms (Vissak 2022a) but also establishing new practices for working from home (Amankwah-Amoah et al. 2021b). Such opportunities can also be used after the pandemic, and thus, firms providing the necessary hardware and software will continue benefitting from increased demand (Gurkov and Shchetinin 2022; Lungu et al. 2021). Moreover, financial crises can offer favorable opportunities to acquire less successful firms (Wang and Chen 2021), adjust the firm’s business model (Lungu et al. 2021; Sarkar and Clegg 2021), and receive additional support from state or regional support agencies (Vissak 2022a). It is not always easy to discover new business opportunities: having a particular mindset might be useful. For instance, Ates and Bititci (2011: 5604) stated that resilient firms should have the “ability to anticipate key opportunities and events from emerging trends, constantly adapting and changing, rapidly bouncing back from disaster and remaining stable in a turbulent environment.” Orengo-Serra et al. (2021) and Rodriguez-Sanchez et al. (2021) mentioned the importance of flexibility and adaptability and the ability to react quickly to the changing environment, while Kuckertz and Brändle (2022) emphasized that managers should understand that growth during crises is possible. Being entrepreneurial is also essential as such people “will generally categorize more situations as holding strengths and opportunities because the positive attributes (and potential outcomes) of a situation are naturally more salient to them” (Palich and Bagby 1995: 428). In radically uncertain environments, predicting future outcomes is very difficult (Grégoire and Cherchem 2020). Thus, effectual firms – those that ask “‘What can I do?’ based on the means at hand rather than ‘What should I do?’ based on a predictive analysis” (Sarasvathy et al. 2014: 73) – can react to

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uncertainties more effectively than rigid firms that follow causal (plan-driven) logic (Vissak et al. 2020). Negative perceptions – like fear and anxiety – can also inhibit the discovery of business opportunities (Loan et al. 2021). In addition to being mentally ready to discover new business opportunities during financial crises, firms’ managers and owners also need to develop their and their staff members’ capacities and capabilities to react to them (Rodrigues et al. 2021). For instance, they should become more creative and innovative (Vissak 2022a), and develop skills necessary for reacting to future business opportunities (Pettit et al. 2010). Although discovering new business opportunities is important, and for that, firms may need to spend considerable time and other resources, there is also some evidence of firms that found more customers for their existing products or services during financial crises without the need to make radical changes in their mindsets, capacities, or ways of doing business. The outcome also depended on whether in their sector, the situation became more or less favorable during the financial crisis (Davidsson et al. 2021; Purnomo et al. 2021). Thus, making considerable changes does not always guarantee success, and not doing anything new does not always lead to failure: the opposite can also occur (Vissak 2022b). As financial crises affect many firms negatively, it is also important to understand such effects. An overview of potential negative (but also positive) impacts on exporters’ activities is given in entry 100 in this Encyclopedia, while suggestions about how firms could minimize losses during crises are provided in entry 37. Finally, entry 4 helps to elucidate the nature of financial crises. Tiia Vissak

Amankwah-Amoah, Joseph, Zaheer Khan, Geoffrey Wood, and Gary Knight. “COVID-19 and Digitalization: The Great Acceleration.” Journal of Business Research 136 (2021b): 602–11. https://​doi​.org/​10​.1016/​j​.jbusres​.2021​ .08​.011. Ates, Aylin, and Umit Bititci. “Change Process: A Key Enabler for Building Resilient SMEs.” International Journal of Production Research 49 no. 18 (2011): 5601–18. https://​doi​.org/​10​ .1080/​00207543​.2011​.563825. Bivona, Enzo, and Margarita Cruz. “Can Business Model Innovation Help SMEs in the Food and Beverage Industry to Respond to Crises? Findings from a Swiss Brewery during COVID-19.” British Food Journal 123 no. 11 (2021): 3638–60. https://​doi​.org/​10​.1108/​BFJ​ -07–2020–0643. Davidsson, Per, Jan Recker, and Frederik von Briel. “COVID-19 as External Enabler of Entrepreneurship Practice and Research.” BRQ Business Research Quarterly 24 no. 3 (2021): 214–223. https://​doi​.org/​10​.1177/​ 23409444211008902. Eckhardt, Jonathan T., and Scott A. Shane. “Opportunities and Entrepreneurship.” Journal of Management 29 no. 3 (2003): 333–49. https://​doi​.org/​10​.1177/​014920630302900304. Ghauri, Pervez, Roger Strange, and Fang Lee Cooke. “Research on International Business: The New Realities.” International Business doi​ Review 30 no. 2 (2021): 101794. https://​ .org/​10​.1016/​j​.ibusrev​.2021​.101794. Grégoire, Denis A., and Naïma Cherchem. “A Structured Literature Review and Suggestions for Future Effectuation Research.” Small Business Economics 54 (2020): 621–39. https://​doi​.org/​10​.1007/​s11187–019–00158–5. Gurkov, Igor, and Ivan Shchetinin. “Grappling for Strategic Agility during the COVID-19 Pandemic: The Case of the Russian Subsidiary of a Large Multinational IT Company.” Review of International Business and Strategy 32 no. 1 (2022): 57–71. https://​doi​.org/​10​.1108/​RIBS​ -02–2021–0030. Juergensen, Jill, José Guimón, and Rajneesh Narula. “European SMEs amidst the COVID-19 Crisis: Assessing Impact and Policy Responses.” Journal of Industrial and Business Economics 47 no. 3 (2020): 499–510. https://​ Acknowledgement doi​.org/​10​.1007/​s40812–020–00169–4. This work was supported by the Estonian Kuckertz, Andreas, and Leif Brändle. “Creative Research Council’s grant PRG 1418. Reconstruction: A Structured Literature Review of the Early Empirical Research on the COVID-19 Crisis and Entrepreneurship.” References Management Review Quarterly 72 no. 2 Amankwah-Amoah, Joseph, Zaheer Khan, and (2022): 281–307. https://​doi​.org/​10​.1007/​ Ellis L.C. Osabutey. “COVID-19 and Business s11301–021–00221–0. Renewal: Lessons and Insights from the Global Loan, Le Thi, Duong Cong Doanh, Ha Ngoc Thang, Ngo Thi Viet Nga, Pham Thanh Airline Industry.” International Business Van, and Phan Thanh Hoa. “Entrepreneurial Review 30, no. 3 (2021a): 101802. https://​doi​ Behaviour: The Effects of the Fear and .org/​10​.1016/​j​.ibusrev​.2021​.101802.

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Discovering business opportunities emerging from financial crises  107 Anxiety of Covid-19 and Business Opportunity Recognition.” Entrepreneurial Business and Economics Review 9 no. 3 (2021): 7–23. https://​ doi​.org/​10​.15678/​EBER​.2021​.090301. Lungu, Anca Elena, Ioana Andreea Bogoslov, Eduard Alexandru Stoica, and Mircea Radu Georgescu “From Decision to Survival: Shifting the Paradigm in Entrepreneurship during the COVID-19 Pandemic.” Sustainability 13 no. 14 (2021): 7674. https://​doi​.org/​10​.3390/​ su13147674. Orengo-Serra, Karen L., and María Sánchez-Jauregui. “Coping with Earthquakes and COVID-19: A Perspective of Customer Relationship Management.” Estudios Gerenciales 37 no. 159 (2021): 318–31. https://​ doi​.org/​10​.18046/​j​.estger​.2021​.159​.4435. Palich, Leslie E., and D. Ray Bagby. “Using Cognitive Theory to Explain Entrepreneurial Risk-taking: Challenging Conventional Wisdom.” Journal of Business Venturing 10 no. 6 (1995): 425–38. https://​doi​.org/​10​.1016/​ 0883–9026(95)00082​-J. Pettit, Timothy J., Jospeh Fiksel, and Keely L. Croxton. “Ensuring Supply Chain Resilience: Development of a Conceptual Framework.” Journal of Business Logistics 31 no. 1 (2010): 1–21. https://​doi​.org/​10​.1002/​j​.2158–1592​ .2010​.tb00125​.x. Purnomo, Boyke Rudy, Rocky Adiguna, Widodo Widodo, Hempri Suyatna, and Bangun Prajanto Nusantoro. “Entrepreneurial Resilience During the Covid-19 Pandemic: Navigating Survival, Continuity and Growth.” Journal of Entrepreneurship in Emerging Economies 13 no. 4 (2021): 497–524. https://​doi​.org/​10​.1108/​ JEEE​-07–2020–0270. Ratten, Vanessa. “COVID-19, Entrepreneurship, and Small Business.” In COVID-19 and Entrepreneurship: Challenges and Opportunities for Small Business, edited by Vanessa Ratten, 1–13. New York: Routledge, 2021. https://​doi​.org/​10​.4324/​ 9781003149248–1. Rodrigues, Margarida, Mário Franco, Nuno Sousa, and Rui Silva. “Covid 19 and the Business Management Crisis: An Empirical Study in SMEs.” Sustainability 13 no. 11 (2021): 5912. https://​doi​.org/​10​.3390/​su13115912. Rodriguez-Sanchez, Alma, Jacob Guinot, Ricardo Chiva, and Álvaro López-Cabrales. “How to Emerge Stronger: Antecedents and Consequences of Organizational Resilience.” Journal of Management and Organization 27 no. 3 (2021): 442–59. https://​doi​.org/​10​.1017/​ jmo​.2019​.5. Sarasvathy, Saras, K. Kumar, Jeffrey G. York, and Suresh Bhagavatula. “An Effectual Approach

to International Entrepreneurship: Overlaps, Challenges, and Provocative Possibilities.” Entrepreneurship Theory and Practice 38 no. 1 (2014): 71–93. https://​doi​.org/​10​.1111/​etap​ .12088. Sarkar, Soumodip, and Stewart R. Clegg. “Resilience in a Time of Contagion: Lessons from Small Businesses during the COVID-19 Pandemic.” Journal of Change Management 21 no. 2 (2021): 242–67. doi: https://​doi​.org/​10​ .1080/​14697017​.2021​.1917495. Tokarz, Barbara, Eloiza Kohlbeck, Fernanda Hänsch Beuren, Alexandre Borges Fagundes, and Delcio Pereira. “Systematic Literature Review: Opportunities and Trends to the Post-outbreak Period of COVID-19.” Brazilian Journal of Operations and Production Management 18 no. 2 (2021): e20211146. https://​doi​.org/​10​.14488/​BJOPM​.2021​.030. Vissak, Tiia. “Serial Nonlinear Internationalization before and during the Covid-19 Pandemic: Case Study Evidence from Estonia”. In International Business in Times of Crisis. Tribute Volume to Geoffrey Jones, Progress in International Business Research 16, edited by Rob van Tulder, Alain Verbeke, Lucia Piscitello, and Jonas Puck, 273–288. Bingley: Emerald, 2022a, https://​doi​ .org/​10​.1108/​S174​5–88622022​0000016014. Vissak, Tiia. “The Impacts of Covid-19 on Estonian Firms’ Internationalization: Foreign Market Entries, Exits and Re-entries.” In Foreign Exits, Relocation and Re-Entry: Theoretical Perspectives and Empirical Evidence, edited by Jorma Larimo, Pratik Arte, Carlos M. P. Sousa, Pervez N. Ghauri, and José Mata, 36–56. Cheltenham: Edward Elgar, 2022b, https://​doi​ .org/​10​.4337/​9781800887145​.00009. Vissak, Tiia, and Barbara Francioni. “Re-internationalization Forms and Impact Factors: Four Cases.” Problemy Zarządzania – Management Issues 28 no. 1 (2020): 27–53. https://​doi​.org/​10​.7172/​1644–9584​.87​.2. Vissak, Tiia, Barbara Francioni, and Susan Freeman. “Foreign Market Entries, Exits and Re-entries: The Role of Knowledge, Network Relationships and Decision-making Logic.” International Business Review 29 no. 1 (2020): 101592. https://​doi​.org/​10​.1016/​j​.ibusrev​.2019​ .101592. Wang, Simeng, and Xiabing Chen. “Capitalizing on Opportunities during the Covid-19 Pandemic: Business Transitions among Chinese Immigrant Entrepreneurs in France.” Journal of Chinese Overseas 17 no. 2 (2021): 293–317. Zahra, Shaker A. “International Entrepreneurship in the Post Covid World.” Journal of World Business 56 no. 1 (2021): 101143. https://​doi​ .org/​10​.1016/​j​.jwb​.2020​.101143.

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26. Early warning systems (EWS) of currency crises Currency crises are disruptive events that have long attracted the attention of scholars, policymakers, market agents, and the general public. The extensive damaging financial and real economic effects of such events have motivated the search for indicators that identify vulnerabilities that may lead to a currency crisis and, hence, contribute to predicting their occurrence and facilitating their prevention. Although the search for such indicators started earlier, the surprise and profound effects of the 1994–95 Mexican crisis and the 1997–98 Asian crisis brought additional motivation for developing early warning system (EWS) models.1 These models differ along various dimensions, including the set of indicators and the methodological approaches to assess their performance. The starting point of any EWS is the definition of a crisis event. The literature has adopted various methods for that task. For example, while Frankel and Rose (1996) look exclusively at the exchange rate behavior (i.e., large currency depreciations), other studies adopted a definition based on a broader view of speculative pressure on the foreign exchange market. Since authorities may defend a currency from speculative attacks by intervening in the foreign exchange market and/or resorting to contractionary monetary policy, currency crises have been largely identified based on indices of “exchange market pressure” that, in addition to exchange rate changes, also weigh in international reserve losses (as in, e.g., Eichengreen, Rose, and Wyplosz (1995), Kaminsky, Lizondo, and Reinhart (1998), Kaminsky and Reinhart (1999)) and increases in interest rates (as in Eichengreen, Rose, and Wyplosz (1995)), with crises being identified as large deviations of the exchange market pressure index from its mean. One of the methodologies used to assess the performance of indicators is based on event study analyses, as in Eichengreen, Rose, and Wyplosz (1995), Frankel and Rose (1996), and Kaminsky and Reinhart (1999), for example. It consists of analyzing the behavior of each of the various indicators for a given period (e.g., 18 months) before and

after crisis events and comparing it with their behavior in times of tranquility (non-crisis periods). This process allows for identifying variables that, ahead of crisis events, deviate substantially from their behavior during tranquil times. In this manner, this methodology provides a view of empirical regularities surrounding crisis events. Extending this approach, Kaminsky and Reinhart (1999) and Kaminsky, Lizondo, and Reinhart (1998) proposed using a methodology that extracts indicators’ signals for predicting crises. Their suggested “signals” approach defines a signal to be issued by an indicator when it deviates from its “normal” level past a specified threshold, considering the percentiles of each indicator’s country-specific distribution of observations over time. Since such signaling may fail to correctly anticipate a currency crisis, this approach balances the risks of incorrectly calling crises that do not ensue within the chosen 24-month period (i.e., false alarms) and the risks of not issuing a signal for crises that do ensue within that period (i.e., missed crises) by optimizing the threshold value to minimize each indicators’ noise-to-signal ratio (a ratio of false to good signals). Another approach is based on regression analysis. Frankel and Rose (1996) undertook an early such exercise by estimating a multivariate probit model for predicting currency crashes one year in advance, using annual observations for various indicators. In an influential study, Berg and Pattillo (1999) extended this contribution by integrating the approach of Kaminsky, Lizondo, and Reinhart (1998) in a multivariate probit analysis. More precisely, they estimated probabilities of a currency crisis occurring in the next 24 months based on probit regressions using, as explanatory variables, monthly indicators based on percentiles of the distribution of observations in each country. More recently, advanced machine learning techniques have been used as EWS to predict macroeconomic crises (IMF 2021), including currency crises (Basu, Perrelli, and Xin 2022). The approach encompasses regression-based models (such as lasso) and tree-based ensemble learning methods (like random forests). These methods are instrumental in handling complex data structures with heterogeneous, nonlinear, and time-varying interactions among the indicators in crisis episodes.

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Early warning systems (EWS) of currency crises  109

In assessing EWS, different aspects need to be taken into account. One of the distinctions considered in the literature regards the performance of the models in-sample versus out-of-sample. In the case of the former, the model’s performance is assessed solely based on the sample period used to construct it. However, the aim of EWS for detecting and preventing crises ahead of their occurrence motivates the additional assessment of performance out-of-sample. This consists in evaluating how well the model performs concerning the future. Moreover, upon providing a crisis probability, if this is above a chosen cut-off value (threshold), the model is said to emit a crisis signal. Therefore, the choice of such a cut-off value has implications for the number of crises not called and false alarms emitted. An EWS is expected to detect crises and avoid false alarms, as mentioned above. The performance of EWS models may, therefore, be evaluated for a whole range of cut-off values chosen to meet the policymaker’s goals—e.g., according to the tolerance of false alarms or the tolerance of crisis not called. An alternative metric is the area under the receiver operating characteristic curve, which measures the accuracy of a given model at various thresholds. This metric is commonly used to assess machine learning models’ performance in predicting crises. The quest for indicators derives from the theoretical understanding of the causes of currency crises and empirical assessments of past crises experiences. The range of variables considered in the EWS literature is vast, and the performance of individual indicators is varied, with significant variation over time and according to the crisis nature and the type of economy. Overall, the literature points to the empirical success of multiple indicators. In an early review of the empirical literature and results based on the signals approach, Kaminsky, Lizondo, and Reinhart (1998) note the success of some indicators—for example, international reserves, the real exchange rate, domestic credit, money, exports, and output. In an influential IMF study, Berg et al. (1999) emphasize the role of short-term external debt (as a ratio of international reserves), current account balance (over GDP), real exchange rate overvaluation, reserves growth, and export growth. As the empirical assessment of indicators continues to grow, so does

the diversity of indicators found to contribute to EWS—both at the macro and micro levels. Extending the latter model, Mulder, Perrelli, and Rocha (2012, 2016) uncovered the contribution of corporate and financial sectors’ balance sheet indicators, macroeconomic balance sheet and institutional environment, and legal indicators. The use of more complex techniques such as machine learning helps extract information from much larger sets of variables and their interactions than previous methodologies. Therefore, this literature is expected to continue to grow. Notwithstanding these advances in the literature, predicting currency crises remains challenging. First, these crises are infrequent events. Second, the indicators are often of low frequency (e.g., quarterly or annually), their time series are relatively short (less than 50 years), and the number of subjects (countries) is small. Third, the indicators often present a significant degree of multicollinearity, making it difficult to identify their marginal contributions to crisis forecasting. Fourth, predicting the exact timing of the crisis is challenging, as unforeseen events and self-fulfilling expectations may trigger them. Fifth, EWS are subject to the Lucas critique: when they work well, crises may be prevented, and thus it is challenging to assess their effectiveness as the counterfactual is not observed. Moreover, there are episodes of different natures within the class of currency crises, based on various vulnerabilities. Hence, indicators that may have successfully predicted past crises may not do so for the next. One of the main contributions of EWS is to inform governments and policymakers about the vulnerabilities in the underlying economic system and its macro-financial links that could eventually lead to a currency crisis. For instance, EWS could identify growing imbalances in the external sector or rising risks in the balance sheets of banks and corporations that, if unaddressed, would likely lead to a speculative attack on the currency. By thoroughly and timely examining the soundness of an extensive list of early warning indicators, policymakers could act pre-emptively—for example, by building buffers (such as foreign exchange reserves), changing the course of policies, or adopting specific regulations that reduce the probability of a crisis. For these reasons, EWS

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will undoubtedly continue to be an essential resource in international macroeconomics and finance. Manuel Duarte Rocha and Roberto Accioly Perrelli

Note

1. For a review of earlier models, see Kaminsky, Lizondo, and Reinhart (1998).

References

Basu, Suman S., Roberto A. Perrelli, and Weining Xin. 2022. “External Crisis Prediction using Machine Learning: Evidence from Three Decades of Crises around the World.” IMF Working Paper. Berg, A., and C. Pattillo. 1999. “Predicting Currency Crises: The Indicators Approach and an Alternative.” Journal of International Money and Finance 18 (4): 561–586. https://​doi​ .org/​10​.1016/​S​0261–5606(​99)00024–8. Berg, A., E. Borensztein, G. M. Milesi-Ferretti, and C. Pattillo. 1999. “Anticipating Balance of Payments Crises: The Role of Early Warning Systems.” In IMF Occasional Paper 186. Washington, DC: International Monetary Fund. Eichengreen, Barry, Andrew K. Rose, and Charles Wyplosz. 1995. “Exchange Market Mayhem: The Antecedents and Aftermath of Speculative Attacks.” Economic Policy 10 (21): 249–312. https://​doi​.org/​10​.2307/​1344591.

Frankel, J. A., and A. K. Rose. 1996. “Currency Crashes in Emerging Markets: An Empirical Treatment.” Journal of International Economics 41 (3–4): 351–366. https://​doi​.org/​10​.1016/​ S​0022–1996(​96)01441–9. IMF. 2021. “How to Assess Country Risk: The Vulnerability Exercise Approach Using Machine Learning.” International Monetary Fund, Technical Notes and Manuals TNM/21/03. www​.elibrary​.imf​.org/​view/​ journals/​005/​2021/​003/​article​-A000​-en​.xml. Kaminsky, Graciela L., and Carmen M. Reinhart. 1999. “The Twin Crises: The Causes of Banking and Balance-of-Payments Problems.” The American Economic Review 89 (3): 473–500. www​.jstor​.org/​stable/​117029. Kaminsky, Graciela, Saul Lizondo, and Carmen M. Reinhart. 1998. “Leading Indicators of Currency Crises.” Staff Papers (International Monetary Fund) 45 (1): 1–48. www​.jstor​.org/​ stable/​3867328. Mulder, C., R. Perrelli, and M. D. Rocha. 2012. “External Vulnerability, Balance Sheet Effects, and the Institutional Framework: Lessons from the Asian Crisis.” International Review of Economics & Finance 21 (1): 16–28. https://​doi​ .org/​10​.1016/​j​.iref​.2011​.04​.002. —. 2016. “The Role of Bank and Corporate Balance Sheets on Early Warning Systems of Currency Crises: An Empirical Study.” Emerging Markets Finance and Trade 52 (7): 1542–1561. https://​doi​.org/​10​.1080/​1540496x​ .2016​.1158545.

Manuel Duarte Rocha and Roberto Accioly Perrelli

27. Ecuador’s 1999 triple financial crisis Introduction

Ecuador gave up its currency in 2000 because policymakers feared it was on the brink of hyperinflation. Official dollarization ended a spiral of currency depreciation, borrower defaults, bank failures, deposit withdrawals, and flight from the currency. The exchange rate had risen by 355 percent between August 1998 and December 1999, causing the real value of foreign-currency debt to explode. Non-performing loans increased to more than half of the loan portfolio. Lacking an adequate crisis-resolution process, the authorities responded to deposit withdrawals with rapid monetization. Deposit withdrawals out of the banking system and the country, in turn, fueled even more significant exchange rate depreciation. By 2000, most banking assets were held by failed banks. Money issuance was used in place of orderly wind-downs or a credible deposit guarantee. The banking regulator lacked sufficient capacity and political independence (De la Torre and Mascaró 2011). The deposit-guarantee agency lacked personnel, legal protection, and funding, and it relied on the state Treasury to recapitalize the banks it took over (Jácome 2004). But the Treasury was effectively bankrupt as well. Until an anchor was found in dollarization, expectations and policy hurtled toward hyperinflation.

Causes

The Ecuadorian financial crisis resulted from many causes (Martinez 2006). A significant cause was an overoptimistic assessment regarding the consequences of reform and stabilization in 1992–1994. Following the Latin American financial crisis of the 1980s, the administration that began in 1992 implemented a series of reforms that were interpreted as a break from the past (cf. Kaune 1997). Inflation was cut in half, interest rates were liberalized, and the exchange rate was stabilized. An agreement with the Paris Club of creditors was reached, and a Brady deal reduced external public debt by nearly half. Capital inflows grew from 2 percent of GDP over 1989–92 to 5 percent in 1994. Credit to

the private sector doubled as a share of GDP to 30 percent. Even years later, key economic and financial actors expressed much trust and enthusiasm for the program’s linchpin, Vice-president Alberto Dahik (Fischer 2000). The highlight of financial reform was a May 1994 act founded on the principle of bank self-regulation (De la Torre 1997). At the end of 1994, many financial acquisitions and strategies were based on expectations of a “spectacular” 1995 and continually falling interest rates – expectations that, in retrospect, were unrealistic. Agents believed that Ecuador was close to “takeoff” and that it was Ecuador’s turn to experience a “miracle” (Martinez 2006, 12). Agents were particularly overoptimistic regarding the stability of the exchange rate. Crucially, the Central Bank’s new law and administration was well regarded for its professionalism, technical skill, and focus on exchange-rate stability. In the public’s eyes, the Central Bank dictated a path for the exchange rate, and it was followed – a remarkable feat in a country where very little else was predictable and inflation stabilization was incomplete. The predictable exchange rate and volatile price level combination led to increasing financial dollarization (cf. Ize and Yeyati 2003) (Figure 27.1). But this optimism was generally not justified. The 1992–1994 reforms failed to shore up regulatory weaknesses or deal with connected lending while it permitted the proliferation of undercapitalized financial institutions and unregulated offshore banking (De la Torre 1997; Jácome 2004). Political shocks required frequent shifts to an exchange-rate crawling band that was, in any case, incompatible with fiscal laxity. In 1995, a border conflict led to higher interest rates, a drought caused rolling blackouts, a political crisis put an end to reform, and financial distress brought about the failure of a dozen small finance companies and a large bank. The apparent calm of 1997–1998 was a missed opportunity to deal with fragilities. Two additional connected causes are bad regulation and moral hazard, both a product of poor institutions (Jácome 2004). The banking superintendence had little ability to require early corrective action. Risk management was nascent or non-existent. Problems (currency or maturity mismatches, concentrated lending, or Ponzi-level interest rates) could not be dealt with in a remedial fashion.

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Source:  Banco Central del Ecuador.

Figure 27.1

Financial dollarization, Ecuador, 1990–1999

Regulators lacked sufficient legal protection or political independence (Patiño 2001). Moral hazard played an important role. At the micro level, bank lending practices were rife with conflicts of interest (Pérez 2004). At the macro level, there was a history of bailouts. In the 1980s, the government exchanged dollar external private debts (the costly “sucretización” program) for sucre debts, thus protecting private borrowers from the consequences of the depreciation of the currency (Solimano 2002). In 1996, a large bank was bailed out in contradiction to the concept of “market discipline” ideology underpinning the system of self-regulation.1 It is natural to see the exchange-rate band as an implicit guarantee against depreciation. Finally, as Solimano (2002) points out, Ecuador is a country exposed to frequent and damaging external events. The 1980s brought an international financial crisis, devastating floods, an earthquake that stopped oil exports for six months, and the collapse of oil prices (Ecuador’s main export and primary source of government revenue). In 1995 war, drought, and politics ended the credit boom. In 1996, a politician nicknamed El Loco was elected president and was ousted six months later. In 1997–1998, international financial crises, a new oil price collapse, and a catastrophic El Niño event brought a fragile financial system to breaking point. In retrospect, the relative calm of 1992–1994 was an exception.

Events

Exports started shrinking in September 1997 due to the East Asian, Russian, and Brazilian crises. By July 1998, the price of Ecuador’s Gabriel Xavier Martinez

oil had fallen by more than 40 percent, and oil exports had shrunk by 44 percent. An unusually large 1997–1998 El Niño event (Trenberth et al. 2002) caused floods and widespread destruction of housing and infrastructure, especially in low-land agriculture. Disease affected shrimp production: banana and shrimp exports contracted by 60 percent. Simultaneously, emerging market crises led to a contraction in capital flows and cuts in credit (Solimano 2002). As expectations of a devaluation began to rise, the Central Bank raised the policy rate from 21 percent to 30 percent between August 1997 and March 1998. As this proved ineffective, a step devaluation was engineered in late March 1998. This action proved unable to release pressure on the exchange rate, and the policy interest rate continued its rise. Commercial banks that had lent heavily to the oil and agricultural sectors experienced mounting losses. The first failure came in April 1998 to a medium-sized bank that was heavily concentrated in the heavy-hit coastal region, Solbanco. A pattern of regulatory incompetence, uncertainty about deposit losses, and emergency liquidity support from the Central Bank was established (Jácome 2004). As President Mahuad took office in August, a medium-sized bank (Préstamos) was closed. The largest bank in the system (Filanbanco) sought emergency assistance in September. Attempting to release pressure on the financial system, the Central Bank allowed one more step devaluation and widened the band. By October 1998, the Central Bank had lost 27 percent of its September 1997 reserves.

Ecuador’s 1999 triple financial crisis  113

Source:  Banco Central del Ecuador and author’s calculations.

Figure 27.2

Exchange-rate pressure index, Ecuador, 1997–1999

September 1998 can be identified as the start of the crisis under a conventional measure of exchange-rate pressure (Eichengreen, Rose, and Wyplosz 1995); the currency lost 14 percent of its value, the Central Bank lost 10 percent of its reserves, and interest rates continued their upward climb (Figure 27.2). At the same time, public finances were in disarray. Oil revenues to the Treasury fell from 8.3 percent in 1996 to 4.5 percent of GDP in 1998 (while other sources of revenue remained constant). Because of higher interest expenses and the cost of reconstruction after the El Niño floods, overall expenses fell by only half as much as revenues. The fiscal deficit widened from 3.1 percent in 1996 to 6.2 percent of GDP in 1998. Ecuador accumulated nearly a hundred million dollars in arrears by end-1998 due to a rising interest burden, drastic loss of international market access, and stagnating GDP. At this point, under World Bank advice (Solimano 2002), the government proposed the creation of a deposit-guarantee agency (the AGD) to provide a blanket guarantee to nearly all liabilities of the financial sector. Healthy banks could take over unhealthy banks through purchase and assumption operations following a regulator-led restructuring period. The AGD would eventually be funded with insurance premia from the financial sector. In the meantime, and in the absence of support from international financial institutions (pending the negotiation of an International Monetary Fund (IMF) agreement), the AGD depended on Ecuadorian Treasury bonds (of dubious quality) to

provide capital to failed banks and on Central Bank credit (that is, inflationary finance) to provide liquidity. The law creating the AGD was approved on December 1, 1998, and on December 2, Filanbanco (14 percent of banking system assets) failed and was taken over. Political support for the AGD required abolishing the income tax and replacing it with a 1 percent tax on financial transactions. This move caused massive disintermediation out of the financial sector and dashed hopes of an IMF agreement. Monetary-policy interest rates reached 170 in January 1999 and stayed in the 100–130 percent range through February. At the same time, the Central Bank lost about one-third of its reserves, approximately the same amount as the Central Bank liquidity injections into the financial system (De la Torre and Mascaró 2011). Incapable of stemming the flood, the Central Bank abolished the crawling peg and allowed the currency to float on February 12, 1999 (Solimano 2002). The result was a 30 percent depreciation over the following four weeks. Monthly inflation reached 13.5 percent in March. The largest bank still in private hands, Progreso, had operated a high-interest rate policy and kept a loan portfolio heavily in dollars. It was perceived as being the next domino to fall. But the owner of the bank, who had made large campaign donations to President Mahuad, manipulated opposition figures and provoked a public demonstration to protect the bank from intervention (De la Torre and Mascaró 2011). Rather than closing Progreso, President Mahuad decreed Gabriel Xavier Martinez

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Source:  Banco Central del Ecuador.

Figure 27.3

Exchange rate and crawling band, Ecuador, 1995–2000

a two-day banking holiday while announcing that strong corrective measures would follow. The holiday was then extended to one week (March 8–12), at the end of which it was announced that (a) reputable external firms would be hired to conduct a thorough audit of the banking sector and (b) most deposits would be frozen (that is, withdrawals would not be permitted) for one year. Nearly all of the governing board of the Central Bank resigned in protest. The deposit freeze stabilized the currency temporarily. But the official refusal to distinguish between healthy and unhealthy banks undermined confidence in the system. The government lost all credibility as a result of its inability to propose clear measures at the end of the banking holiday, the inability of the regulators to identify the weak banks in the system they regulated, the long delay with which the audit results were released, and the perceived unfairness of locking depositors into a depreciating currency while protecting bankers (Figure 27.3). Depositors were undoubtedly aware of banks’ microeconomic weaknesses, as shown by their behavior over 1999. Deposit withdrawals hit undercapitalized banks particularly hard, despite cosmetic accounting and official announcements (Martinez 2003). The auditing firms announced their findings on July 30. They declared that six banks (including Progreso) were to be closed immediately while four other banks (three of which later closed) were to be put into enhanced monitoring. On August 25, President Mahuad announced a partial suspension of Brady bond payments (interest on uncollateralized bonds Gabriel Xavier Martinez

would be paid in full while other holders were invited to access the collateral). Bondholders disagreed with the unequal treatment and activated cross-default provisions, accelerating payment on the entire debt. On October 28, Ecuador further defaulted on Eurobonds and unilaterally rescheduled domestic debt (Sturzenegger and Zettelmeyer 2007). Rising oil prices and improved tax collection had raised government revenues substantially. Still, an exploding interest bill, the cost of rescuing the financial system, and infrastructure reconstruction brought the overall deficit to 5.9 percent of GDP. Political and legal pressure led to gradual deposit unfreezing. Given the public’s inability to believe in the solidity of the financial system (especially since failed banks were “rescued” with defaulted government bonds), further deposit withdrawals and pressure on the currency ensued, especially as the Central Bank responded by providing additional liquidity at first (Solimano 2002) (Figures 27.4 and 27.5). After eight months without a Central Bank president, a new board took over in November. It announced it would respond to the crisis with a vigorous defense, focusing on controlling inflation by limiting monetary aggregates’ growth. It laid the conditions by which this would happen: deposits would have to remain frozen, the banking superintendence would have to enforce controls against currency transactions, and the fiscal deficit could not exceed 2.5 percent of GDP (Banco Central del Ecuador 1999). Implicitly, it also announced an extremely tight monetary policy; the basic policy rate,

Ecuador’s 1999 triple financial crisis  115

Source: Banco Central del Ecuador.

Figure 27.4

Monetary base, Ecuador, 1997–1999

Source: Banco Central del Ecuador.

Figure 27.5

Non-performing loans, Ecuador, 1998–1999

Source: Banco Central del Ecuador.

Figure 27.6

Central Bank repo rate, Ecuador, 1998–2000

Gabriel Xavier Martinez

116  Elgar encyclopedia of financial crises

which had hovered around 60 percent since April, shot up to over 150 percent in late November (Figure 27.6). The policy was a move of desperation that would only make sense if impossible preconditions were met and made a recovery of the remaining financial sector impossible. Moreover, higher Central Bank policy rates meant it had to make larger payments on its own large stock of short-term remunerated liabilities, which it did by creating more money (Solimano 2002). By Friday January 7, after six weeks of a conventional inflation-focused policy, it was clear that the government had run out of options.

Outcomes

On Sunday January 9, President Mahuad ended the currency free-fall by announcing that Ecuador would adopt the dollar as its official currency. He did so against Central Bank advice, without political or multilateral support, without sufficient dollars on hand, and without meeting any of the conventional preconditions (De la Torre and Mascaró 2011; Fischer 2000). He would be removed from office by a popular coup twelve days later. His successor, Vice-President Gustavo Noboa, committed himself to continuing the dollarization process. Three months later, a series of supportive reforms were approved and an IMF agreement was reached. By midyear, Brady bonds, Eurobonds, and Paris Club debt had been renegotiated. By September, the national currency had ceased to exist. The Ecuadorian financial crisis caused GDP to fall by 7.3 percent in real terms. Open unemployment rose to 25 percent, and underemployment reached 50 percent: only a quarter of Ecuadorians had proper jobs as 2000 began. The poverty headcount increased by 21 percentage points between 1995 and 1999 to half the population. Out of 40 private banks in 1996, 17 had failed (including 6 out of the 10 largest), representing 55 percent of all bank assets. In real terms, deposit outflows out of the private banking sector amounted to 24 percent of domestic-currency deposits and 51 percent of foreign-currency deposits.

Conclusion

What caused the Ecuadorian financial crisis? Everything seemed to converge to make Gabriel Xavier Martinez

a different solution impossible. Excessive dependence on oil exports and massive public debt weakened the fiscal sector. Inadequate bank risk management and supervision and borrower exposure to depreciation made the financial system fragile (Solimano 2002). Incomplete financial liberalization and reform and a partially successful exchange-rate-based stabilization generated high expectations and risky behavior. The inability to correctly resolve bank deficiencies or failures promoted moral hazard (Martinez 2006). When in 1998 a remarkable series of external shocks were met with a poor policy response, the collapse became inevitable. Gabriel Xavier Martinez

Note

1. This episode created the public perception that authorities would intervene to rescue banks but, at the same time, the absence of an adequate framework created personal legal risk for the authorities and made them less likely to act vigorously (De la Torre and Mascaró 2011).

References

Banco Central del Ecuador. 1999. “Propuesta de Política Económica ante la Crisis.” Apuntes de Economía 7 (November). De la Torre, Augusto. 1997. “El manejo de las crisis bancarias: el marco legal ecuatoriano y posibles reformas.” CORDES. De la Torre, Augusto, and Yira Mascaró. 2011. “La gran crisis ecuatoriana de finales de los noventa.” Temas de Economía y Política, CORDES 20 (December). Eichengreen, Barry, Andrew K. Rose, and Charles Wyplosz. 1995. “Exchange market mayhem: the antecedents and aftermath of speculative attacks.” Economic Policy 10 (21): 249–312. Fischer, Stanley. 2000. “Ecuador and the IMF.” Accessed June 2, 2022. www​.imf​.org/​en/​News/​ Articles/​2015/​09/​28/​04/​53/​sp051900. Ize, Alain, and Eduardo Levy Yeyati. 2003. “Financial dollarization.” Journal of International Economics 59 (2): 323–347. Jácome, Luis I. 2004. “The late 1990’s financial crisis in Ecuador: institutional weaknesses, fiscal rigidities, and financial dollarization at work.” IMF Working Papers 2004 (012). Kaune, F. 1997. “Ecuador visto desde Wall Street.” Tendencias Económicas y Financieras, CORDES: 7–13. Martinez, Gabriel X. 2003. “Disciplina y percepción: dolarización de activos y maquillaje de capital en la crisis de 1999.” Cuestiones Económicas 19 (3–3): 103–133.

Ecuador’s 1999 triple financial crisis  117 Martinez, Gabriel X. 2006. “The political economy of the Ecuadorian financial crisis.” Cambridge Journal of Economics 30 (4): 567–585. Patiño, Maria Laura. 2001. “Lessons from the financial crisis in Ecuador in 1999.” Journal of International Banking Regulations 3 (1): 37–70. Pérez, Pedro Páez. 2004. “Liberalización financiera, crisis y destrucción de la moneda nacional en Ecuador.” Cuestiones Económicas 20 (1). Solimano, Andres. 2002. “Longer-term origins of Ecuador’s ‘Predollarization’ Crisis.” In Crisis and dollarization in Ecuador: Stability, growth,

and social equity, edited by Paul Beckerman and Andres Solimano, 17–80. Washington, DC: World Bank. Sturzenegger, Federico, and Jeromin Zettelmeyer. 2007. Debt defaults and lessons from a decade of crises. Cambridge, MA: MIT Press. Trenberth, Kevin E., Julie M. Caron, David P. Stepaniak, and Steve Worley. 2002. “Evolution of El Niño: southern oscillation and global atmospheric surface temperatures.” Journal of Geophysical Research: Atmospheres 107 (D8): AAC 5–1-AAC 5–17. https://​doi​.org/​10​.1029/​ 2000JD000298.

Gabriel Xavier Martinez

28. Egypt’s currency and financial crisis Egypt’s financial and currency crisis was triggered by the Arab Spring in 2011 and the global financial crisis of 2008 (Neaime 2010, 2012, 2016). At the onset of the crisis, millions of Egyptians took to the streets to protest against the regime of Hosni Mubarak. This was followed by a political crisis which brought to power Mohamad Morsi from the Muslim Brotherhood as president. Huge protests subsequently ousted Morsi in July 2013, and the Egyptian Armed Forces headed by Abdul Fatah al-Sisi suspended the constitution, appointed the head of the constitutional court as interim national leader, and called for early elections. In 2014, President Abdel Fattah el-Sisi won the presidential election and became the president of the Arab Republic of Egypt for a six-year term. Between 2011 and 2013, Egypt suffered its worst economic crisis since the Great Depression (Neaime 2015a, 2015b, 2017). Following the fall of Hosni Mubarak in 2011, Egypt experienced a severe fall in foreign direct investments (−50 percent), in exports, and in tourism revenues. The government also suffered from a drop in revenues generated by the Suez Canal related to the slowdown of global trade and the increasing oil prices that resulted from the 2008 global financial crisis. This caused a 60 percent drop in foreign exchange reserves, a 3 percent drop in GDP growth, and a fast devaluation of the Egyptian pound (EGP). With a budget deficit reaching 11.5 percent of GDP in 2014, the government halted subsidizing basic necessities, which caused a significant increase in food prices and shortages of fuel and gas. According to the Egyptian government, 25 percent of Egyptians were classified as living below the poverty line, and 24 percent just above it in 2014. Egypt needed to swiftly restore stability, restore tourism, and export revenues. All this was awaiting a much-delayed US$ 4.8 billion International Monetary Fund (IMF) loan, and a further US$ 12 billion in contingent loans from the European Union, which were both conditional on reforms. Despite all the economic and political challenges, the Central Bank of Egypt (CBE) first decided to maintain the EGP peg to the dollar by intervening on the foreign exchange

market using its foreign currency reserves. As a result, foreign exchange reserves at the CBE dropped from US$ 35 billion in 2009 to around US$ 15 billion by the end of 2011. To limit capital/foreign currency transfers abroad and the amount of dollars Egyptians could withdraw at the official exchange rate from banks, the CBE imposed a series of strict capital controls. For example, the CBE imposed a ceiling of US$ 100,000 on transfers abroad by individuals. The government also sought to deter purchasing US dollars on the black market by limiting dollar bank deposits to US$ 50,000 per month so that importers would be constrained in financing their imports. In 2012, concerns about social unrest and the country’s inability to meet its financing gaps induced international rating agencies to lower Egypt’s credit ratings on several occasions. Some policy makers and academics advised the CBE to devalue the currency in order to reduce the pressure on the foreign exchange reserves. However, the CBE understandably was aiming at avoiding further increases in “imported” inflation, at a time when Egypt suffered from double-digit inflation. Even though the CBE tried to maintain the exchange rate within a certain band, the EGP continued losing value against the dollar in the black market as importers started selling it within the context of capital controls put in place and given the limited access to sufficient dollars to finance imports. Capital controls started to be lifted in January 2014 allowing commercial banks to make one transfer per year in the amount of US$ 100,000. The only significant capital control measure that was not lifted was the US$ 50,000 monthly limit on cash deposits to cover imports of non-priority goods. Because of the appreciation of the US dollar against the EGP, as of January 2015 one dollar was equivalent to 8 EGP. Egypt’s national poverty rate reached 28 percent in 2015, up from 23 percent in 2010. On November 3, 2016, the CBE announced that it would float the Egyptian pound in an effort to boost exports and GDP growth rates. Subsequently, and after the floating of the EGP, Egypt initiated a comprehensive reform program supported by a US$12 billion IMF loan in a bid to restore macroeconomic stability and improve economic activity. In tandem, the government raised the deposit ceiling for importers of essential goods to US$ 250,000.

118

Egypt’s currency and financial crisis  119 Table 28.1

Selected macroeconomic indicators for Egypt: 2014–2020

Macroeconomic Indicators

2014

2015

2016

2017

2018

2019

2020

Real GDP change, %

2.9

4.4

4.3

4.1

5.3

5.6

3.6

Inflation rate, %

8.3

11.3

14

29.8

14.4

9.4

5.7

Interest rate, %

9.75

9.8

15.3

19.3

17.3

12.8

8.8

13.4

12.9

12.7

12.2

10.9

8.6

-11.3

-10.9

-12.5

-10.4

-9.4

-8

-7.9

Gross public debt, % of GDP

85.1

88.3

96.8

103.0

92.5

84.2

90.2

Current account balance, % of GDP

-0.9

-3.7

-6.0

-6.1

-2.4

-3.6

-3.1

International reserves, USD billion

12.0

13.3

20.9

33.2

38.6

40.7

41.2

International reserves, months of imports

2.2

2.6

3.9

5.7

5.9

5.8

6.0

Foreign direct investment, % of GDP

1.5

2.1

2.4

3.1

3.3

3.0

3.1

Exchange rate, per USD

7.07

7.71

10.07

17.83

17.8

16.8

15.81

Unemployment rate, % Budget deficit, % of GDP

8.3

Source:  CBE, Ministry of Finance, IMF, World Bank World Development Indicators.

However, moving to a floating exchange rate regime as part of a $12 billion IMF loan reform program did not boost Egypt’s exports and GDP growth instantaneously. While inflation increased significantly after the EGP was floated, GDP growth rates did not pick up in parallel as the manufacturing, agricultural, and service industries depended on the imports of raw materials in their production processes. In 2017, the annual inflation rate increased by 33 percent, leading to the most serious economic crises. By early 2018, some macroeconomic indicators and the exchange rate started to gradually stabilize (Table 28.1). The CBE’s net foreign exchange reserves increased by almost 50 percent from US$ 20.9 billion in 2016 to US$ 33.2 billion in 2017. The exchange rate stabilized at about EGP 17/US$ despite a dollar liquidity squeeze. While the GDP growth rate was up again to about 5 percent, interest and inflation rates were on the decline (Table 28.1). Egypt succeeded in lowering the debt-to-GDP ratio from 103 percent in 2017 to less than 85 percent in 2019, coupled with an improvement in the inflow of foreign direct investment up to 3 percent of GDP in 2019 (Table 28.1). By the end of 2017, the CBE announced that the currency crisis was under control. By March 2019, Egypt had received US$ 10 billion of the US$ 12 billion loan from the IMF. Egypt successfully implemented a first wave of macroeconomic and structural reforms that addressed a number of deep-seated macroeconomic issues. According to Table 28.2, those measures included: (1) Introduce a market-determined

exchange rate system; (2) Introduce a value-added tax (VAT); (3) Increase energy prices by removing related subsidies; (4) Cut food subsidies; (5) Roll out a program for increased spending on transportation for children, infant formula, and children’s medicines; (6) Ratify legislation on investment law, reducing regulations for starting a business; (7) Introduce capital controls (limits on dollar transfers); (8) Plan to expand key social safety net programs; (9) Reduce public sector expenditures (decreasing the public wage bill); and (10) Sell telecom licenses and land.1 Those measures helped to stabilize the economy, sustain growth, and pave the way for a more dynamic private sector’s participation in the economy. The real GDP growth rate reached 5.6 percent in 2019, up from 5.3 percent in 2018. Table 28.1 also shows improvements in the months of imports worth of foreign exchange, and in the deficit-to-GDP and debt-to-GDP ratios. Egypt’s external position has stabilized at broadly favorable levels, as foreign reserves reached US$ 41.2 billion in 2020. Simon Neaime and Isabelle Gaysset

Note 1.

The 2016 IMF US$ 12 billion loan was conditional on (a) US$ 6 billion being raised externally, (b) liberalization of the exchange rate (floating the Egyptian pound), (c) fiscal consolidation to lower budget expenditures (cutting fuel subsidies while expanding spending on vulnerable groups), (d) tax increases, (e) deep structural reforms (streamlining industrial licensing; providing financing to SMEs; decriminalizing insolvency; simplifying bankruptcy laws), and (f) lifting business regulations to spur economic growth.

Simon Neaime and Isabelle Gaysset

120  Elgar encyclopedia of financial crises Table 28.2

Conditions of IMF’s 2016 loan to Egypt Economic Issues Shortage of foreign exchange

Monetary

IMF 2016 Extended Fund Facility Conditionality Exchange rate liberalization

and low reserves

Limit increases in the money supply

Fixed exchange rates

Contain inflation and bring it down to mid-single digits over the medium term Strengthen government revenues

What Egypt Implemented Introduced a market-determined exchanged rate system     Parliament passed the value-added tax (VAT) Energy prices raised in November

High government deficit and Energy subsidy reform: cuts in fuel

2017 and June 2017, and subsidies

public debt

removed. Control the public sector wage bill Food subsidies to expand the coverage of

Fiscal

Takaful and Karama Increase social spending amounting to about 1 percent of GDP Strengthening social

Vocational training for youth

protection programs

cover subsidized transportation for children, infant formula, and children’s medicines Set up free school meals Streamline industrial licensing system Facilitate access to finance for small and

Structural

Low growth (2.5) and high

medium-sized enterprises

unemployment (12.7)

Reform bankruptcy law Make it easier for women to go into the workforce by increasing public nurseries Improve safety of public transportation

  The government cut food subsidies         Legislation on investment law ratified        

Source: IMF.

References

Neaime, S. (2015a). Twin Deficits and the Sustainability of Public Debt and Exchange Rate Egypt Central Bank’s official website: www​.cbe​ Policies in Lebanon. Research in International .org​.eg/​en/​Pages/​default​.aspx. Business and Finance, Vol. 33, pp. 127–143. Egypt’s Ministry of Finance’s official website: Neaime, S. (2015b). Sustainability of Budget https://​mof​.gov​.eg/​en. Deficits and Public Debts in Selected European International Monetary Fund’s International Union Countries. Journal of Economic Financial Statistics Database. https://​ data​ Asymmetries, Vol. 12 (1), pp. 1–21. .imf​.org/​?sk​=​4c514d48​-b6ba​-49ed​-8ab9​ Neaime, S. (2016). Financial Crises and Contagion -52b0c1a0179b​&​sId​=​-1. Vulnerability of MENA Stock Markets. Neaime, S. (2010). Sustainability of MENA Public Emerging Markets Review, 27, pp. 14–35. Debt and the Macroeconomic Implications of the Neaime, S. and I. Gaysset. (2017). Sustainability US Financial Crisis. Middle East Development of Macroeconomic Policies in Selected Journal, World Scientific, Singapore, Vol. 2, MENA Countries: Post Financial and Debt pp. 177–201. Crises. Research in International Business and Neaime, S. (2012). The Global Financial Crisis, Finance, Vol. 40, pp. 129–140. Financial Linkages and Correlations in Returns World Bank’s World Development Indicators and Volatilities in Emerging MENA Stock Database. https://​databank​.worldbank​.org/​ Markets, Emerging Markets Review, Elsevier. source/​world​-development​-indicators. Vol. 13 (2), pp. 268–282.

Simon Neaime and Isabelle Gaysset

29. Factors determining public debt sustainability The level of public (sovereign) indebtedness can be measured by gross or net debt, in absolute or relative figures, and cover the entire general government (GG) or its subsectors.1

Gross and net debt

tained GG net debt statistics for only 91 out of 196 countries. Nor does net public debt provide a complete picture of current and future sovereign solvency because of public financial assets’ varying quality and liquidity. In particular, government pension assets are illiquid, while loans to other countries are often granted based on political rather than economic criteria and are hardly recoverable. Table 29.1

According to the Government Finance Statistics Manual 2014 (IMF 2014, para.7.236), a total gross debt ‘consists of all liabilities that are debt instruments’. In turn, ‘a debt instrument is defined as a financial claim that requires payment(s) of interest and/or principal by the debtor to the creditor at a date or dates in the future’. This definition includes the following instruments: IMF’s special drawing rights (SDRs), currency and deposits, debt securities, loans, insurance, pensions and standardized guarantee schemes, and other accounts payable. Thus, ‘all liabilities in the GFS balance sheet are considered debt, except for liabilities in the form of equity and investment fund shares and financial derivatives and employee stock options’ (IMF 2014, para 7.237). A total net public debt is calculated as ‘gross debt minus financial assets corresponding to debt instruments’ (IMF 2014, para. 7.243). These financial assets include monetary gold and SDRs, currency and deposits, debt securities, loans, insurance, pension, standardized guarantee schemes, and other accounts receivable. Gross and net public debt can differ substantially. In particular, they concern official creditors (countries lending to others), commodity exporters who enjoy high-resource rents and can form sovereign wealth funds during commodity booms, and countries with large funded public pension schemes (Table 29.1). Using net debt instead of gross debt has both advantages and disadvantages. It seems conceptually and methodologically correct to consider both sides of the government’s balance sheet. Still, net public debt is not always easily measurable because of incomplete statistics on public financial assets. For example, the IMF World Economic Outlook statistical database as of October 2021 con-

Country

Countries with the highest difference between gross and net GG debt, % of GDP, 2020 gross debt net debt

difference between gross and net debt

Norway

41.4

−121.0

162.4

Japana

254.1

167.0

87.1

Canada

117.5

34.7

82.8

Cyprus

119.1

58.3

60.9

Lesotho

50.4

−2.1

52.4

Trinidad and Tobago

59.3

9.0

50.3

Oman

81.2

33.0

48.2

Brazil

98.9

62.7

36.2

Finland

69.5

33.6

36.0

133.9

98.7

35.2

Kazakhstan

26.3

−8.6

34.9

New Zealand

43.6

11.6

32.0

Sweden

37.3

5.5

31.9

Koreaa

47.9

17.4

30.4

Sloveniaa

79.8

49.5

30.3

Luxembourg

24.8

−5.3

30.1

Denmark

42.1

14.7

27.4

Austriaa

83.2

59.4

23.7

Australiaa

57.3

34.4

22.9

Panama

66.3

43.4

22.8

Switzerlanda

42.4

22.0

20.3

Chile

32.5

13.4

19.2

Germany

69.1

50.1

19.0

119.9

103.0

16.9

Saudi Arabia

32.5

15.9

16.6

Iceland

77.1

60.5

16.6

Estonia

18.5

2.5

15.9

US

Spain

Note:  = IMF staff estimate. Source:  IMF World Economic Outlook database, October 2021. a

General government and its components

According to GFS standards (IMF 2014, para. 2.76), the GG ‘consists of resident insti-

121

122  Elgar encyclopedia of financial crises

tutional units that fulfill the functions of government as their primary activity. This sector includes all government units and all nonmarket NPIs [nonprofit institutional units] that are controlled by government units’. Thus, the definition of the GG includes the following components: ● central or federal government; ● regional governments or governments of federal entities in the case of federal states; ● local authorities (municipalities, communes, counties, regions, and districts, among others); ● pension funds, medical insurance funds, and other social insurance funds at all governmental levels; and ● budgetary units and extra-budgetary funds, and organizations at all governmental levels. However, GG does not include central banks and other public sector corporations (financial and non-financial) (IMF 2014, 20). The indicator of the total gross debt of the GG illustrates total public indebtedness, regardless of the particular GG segment where it occurred. It is the only option for conducting cross-country comparative analyses without considering the constitutional and institutional specifics of the public finance systems in individual countries. It is also the best method to neutralize the effects of various creative accounting techniques, such as moving central government liabilities to extra-budgetary funds or autonomous government agencies. However, analysis of the debt of individual GG entities, such as the federal or central government, federal entities (states, provinces, or regions), municipalities, and pension or other social funds, may be helpful for internal purposes (especially for budget monitoring and control). It is also worth noting that the GG net debt-to-GDP measure does not include government non-financial assets such as real estate, public sector enterprises, government shares in commercial companies, natural resources, and license rights. Their market values can be substantial if well managed, and proceeds from their sale (privatization) can reduce gross and net public debt.

Marek Dabrowski

Absolute versus relative measures

Absolute amounts of gross and net debt are usually reported in national currencies. Liabilities in foreign currencies are converted into the national currency at an official exchange rate. These components of the total public debt may be undervalued in countries that do not have a convertible currency. Relative public debt measures allow for the possibility of cross-country comparisons and qualitative evaluations of the amount of debt burden. The most popular indicator is the gross or net debt ratio to GDP. This measure compares the amount of a country’s public debt to its economic potential. However, this indicator is far from perfect. First, as follows from historical analyses, the debt-to-GDP ratio is not the only factor determining a country’s fiscal and financial risk. A public debt crisis may occur at various levels of the public debt-to-GDP ratio (see below). Second, the analyzed measure relates stock (debt) to flow (GDP). From a methodological point of view, more correctly, it would be comparing public debt to the government’s wealth; that is, the stock of assets at its disposal. However, this would be extremely difficult, if possible, because most countries have no complete register of state-owned assets. Furthermore, a substantial part of these assets remains illiquid/unsaleable and, therefore, does not have a market value (see above). Third, the debt-to-GDP ratio is strongly pro-cyclical (i.e., it decreases in boom years and increases in times of recession or slowing growth). The latter has been observed, among others, during the global financial crisis of 2007–2009 and the COVID-19 crisis in 2020–2021. Pro-cyclicality relates to the construction of the indicator. In boom phases, the fiscal balance improves, contributing to a decrease in or slower growth of public debt (the numerator). However, the nominal GDP (the denominator) grows faster. Furthermore, in countries that borrow in foreign currencies, the amount of public debt denominated in the national currency (the numerator) decreases due to its appreciation. These trends work in the opposite direction during a financial crisis and recession. Moreover, some contingent public liabilities not included in public debt statistics, such as implicit guarantees to the

Factors determining public debt sustainability  123

banking system, may be called in as a result of a crisis, increasing the amount of the GG debt. As a result, the ability of the public debt-to-GDP ratio to predict the risk of a debt crisis and to assess a country’s macroeconomic and financial stability is limited. Attempts to eliminate its shortcomings may take different approaches: ● expanding the definition of public debt to include a portion of the contingent liabilities; ● comparing the nominal public debt (numerator) to a ‘potential’ GDP (denominator) rather than the actual GDP to weaken the pro-cyclicality factor; or ● replacing the GDP with another macroeconomic aggregate, such as total GG revenue (actual or potential). These proposals are not easy to implement and would require radical changes to public finance statistics – not just for a single country but also at the international level. At the same time, even their successful implementation would not eliminate the pro-cyclicality of public debt measures. For example, most existing methodologies for the estimation of ‘potential’ GDP are based on ‘filtering’ and extrapolating past GDP trends. However, the future trajectory of GDP growth may differ substantially from past trends (due to the limited regularity of business cycles). In turn, the amount of GG revenue also greatly depends on the business cycle. As a result, the dynamics of the changes in the public debt-to-revenue ratio do not substantially differ from the dynamics of the changes in the public debt-to-GDP ratio.

where: ● dt is the GG gross debt-to-GDP ratio at the end of period t ● dt–1 is the GG gross debt-to-GDP ratio at the end of period t–1 ● rt is the real interest rate in period t ● gt is the rate of growth of real GDP between t–1 and t ● pt is the ratio of the primary fiscal balance (deficit or surplus) to GDP in period t It follows from Equation 1 that an increase in the GG gross debt-to-GDP ratio can be explained by: ● the GG primary deficit (i.e., when a non-interest GG expenditure exceeds its revenue) and ● a real interest rate of GG borrowing that is higher than the growth rate of real GDP.

Equation 1 illustrates the pro-cyclical character of the public debt-to-GDP ratio discussed earlier. During a boom phase, the real GDP growth rate is higher, debt financing is more readily available (and is reflected in lower real interest rates), and the fast growth of budget revenue helps to improve the primary GG balance. During a recession, these indicators deteriorate, which leads to an increase in the public debt-to-GDP ratio. Furthermore, if financial markets have doubts about a government’s creditworthiness, the real interest rate increases rapidly, which worsens government solvency prospects. This kind of vicious circle of market expectations (a sort of multiple equilibria) was observed before many sovereign debt crises (e.g., Mexico in 1994, Russia in 1997–1998, Argentina in 2000–2002, Greece in 2009–2010, Ireland in 2010, Portugal in 2010–2011, Cyprus 2012–2013, or Lebanon Factors determining the dynamics in 2019–2020). of the public debt-to-GDP ratio Equation 1 does not directly determine the The relationship between an increase in GG role of inflation. Unexpected higher inflation gross debt, a GG primary deficit/surplus, can reduce the debt-to-GDP ratio by decreasthe dynamics of real GDP, and the real ing real interest rates. However, if financial interest rate of government borrowing can markets can predict higher inflation, they will be described by the following equation demand higher nominal yields on government securities in advance. (Escolano 2010): If a government borrows in foreign cur​r​ ​ ​gt​ ​ rency (a frequent phenomenon, in particular ( ) ​dt​ ​ ​−  ​dt​​ − 1​  ​=  _ ​ 1 ​+t   ​g​  ​​   ​dt​​ − 1​ − ​   ​ _       ​   ​ d   ​   ​ − ​     p ​   ​   ​  ​ 1 ​ t 1 ​+  g​ t​ ​ t​− 1 in emerging-market and developing econot

Marek Dabrowski

124  Elgar encyclopedia of financial crises

mies), Equation 1 should be augmented in the following way (Ley 2010):

● presence of contingent liabilities, especially in the banking and financial systems; ● government openness and transparency ​  D ​ h​ ​ ​+  ​eD​f ​  ​(2)​ – in particular, for the public debt man​D  = agement system and the availability of complete information on the country’s where: public debt; ● presence of fiscal rules, for example upper ● D is total GG debt limits on government expenditure (or their ● Dh is debt in the national currency annual increase), fiscal deficit, or public ● Df is debt in a foreign currency debt; ● e is the exchange rate (the price of a unit of foreign currency in the national currency) ● the financial reputation of the country, especially past episodes of default, high Equation 2 includes debt in foreign currencies inflation and hyperinflation, banking and takes account of exchange rate fluctuacrises, and the stability and reliability of tions. Depreciation of the national currency the national currency (Rogoff and Reinhart increases the debt burden while appreciation 2009, 25–33); decreases it. ● political stability and the political ability to make the decisions necessary for fiscal consolidation, and the predictability of Debt sustainability analysis a country’s economic policy; Several advanced and emerging-market ● presence or risk of the emergence of economies recorded a rapid increase of GG internal and external conflicts; this may gross debt-to-GDP after the 2007–2009 and substantially decrease the perception of 2020–2021 crises, reaching a very high level a country’s solvency; (Figure 29.1). It raises the question of public ● tax potential of the country and the availdebt sustainability and the risk of a public ability of non-tax sources of revenue, debt crisis. including rent revenue related to natural However, it is difficult to determine the resources; exact debt level threshold of sovereign ● level of financial market development and default risk. Problems with government solits liquidity; vency and access to financial markets can ● external demand for the country’s soveroccur at various gross debt-to-GDP levels eign debt and other financial instruments, (Table 29.2). Furthermore, the level of public and the international role of the national debt usually deteriorates after the start of the currency; this factor explains the readiness crisis due to a depreciating national currency, of financial markets to finance the high increasing interest rates, the costs associated level of public debt in the US, the UK, with bank restructuring, and a declining GDP. Japan, and the Euro area; and Apart from the debt-to-GDP level, the ● the situation in international financial following factors and circumstances may markets – specifically, changes in global determine the risk of a sovereign debt crisis: liquidity, investors’ mood, and investor responses to unexpected shocks. ● debt dynamics – rapidly growing debt creates an additional risk factor; In summary, each country must define its ● outstanding debt maturity – short maturity maximum level of public debt based upon can cause problems with debt rollover; its macroeconomic and credit history and ● availability of liquid financial assets (i.e., the experience of other countries while conthe difference between gross and net debt); sidering its particular situation. As the risk ● share of non-residents among creditors – of default is determined by many factors a high percentage may increase the risk and sometimes unpredictable circumstances of their sudden exit from sovereign bond (e.g., global shocks and panic in international markets in the case of a global or regional markets), maximum debt should be set at crisis; a relatively low level and incorporate a suffi● share of debt liabilities denominated in cient margin of safety. foreign currencies (significant in regards to Marek Dabrowski currency depreciation); Marek Dabrowski

Factors determining public debt sustainability  125

Note:  a = IMF staff estimate Source:  IMF World Economic Outlook database, October 2011.

Figure 29.1

Countries with the GG gross debt exceeding 100 percent of GDP, 2020

Table 29.2

GG gross debt before, during, and after public debt crises (selected episodes), percent of GDP

Country

t-3

t-2

t-1

t

t+1

t+2

Argentina

The year of the beginning of the crisis (t) 2001

34.1

38.9

40.8

48.0

147.2

125.2

Argentina

2020

57.0

85.2

88.7

102.8

Cyprus

2012

52.8

55.5

65.0

79.4

102.9

109.1

Greece

2010

104.0

110.3

127.8

147.5

183.9

162.0

Hungary

2008

60.2

64.2

65.2

71.2

77.4

80.2

Iceland

2008

68.9

70.7

68.4

110.4

128.8

133.1

Ireland

2010

23.9

42.5

61.8

86.2

110.5

119.7

Italy

2011

106.2

116.6

119.2

119.7

126.5

123.5

Latvia

2008

11.5

9.6

8.1

18.0

35.7

46.7

Lebanon

2020

149.2

154.0

171.1

150.4

 

Portugal

2011

75.6

87.8

100.2

114.4

129.0

131.4

 

 

 

Russia

1998

n/a

n/a

51.5

135.2

92.4

55.9

Serbia

2008

51.3

37.9

31.2

30.5

33.9

41.2

Slovenia

2013

38.3

46.5

53.6

70.0

80.3

82.6

Spain

2011

39.7

53.3

60.5

69.9

86.3

95.8

Turkey

2001

n/a

n/a

51.3

75.5

71.5

65.2

Ukraine

1998

n/a

n/a

28.9

46.5

59.0

43.8

Ukraine

2008

17.7

14.8

12.3

20.4

35.4

40.6

Ukraine

2014

36.9

37.5

40.5

70.3

79.5

79.5

Venezuela

2020

26.0

180.8

232.8

304.1

 

 

Zambia

2020

66.3

80.4

97.4

128.7

 

 

Zimbabwe

2008

33.1

39.4

44.7

61.1

58.7

47.6

Source:  IMF World Economic Outlook database, October 2021.

Marek Dabrowski

126  Elgar encyclopedia of financial crises

Note

1. This entry draws extensively from Dabrowski (2017).

References

Dabrowski, Marek. 2017. Fiscal Sustainability Challenges. Beau Bassin: LAP Lambert Academic Publishing. www​.morebooks​.de/​ store/​gb/​book /fiscal-sustainability-challenges/ isbn/978–3-330–06656–4?currency=EUR. Escolano, Julio. 2010. A Practical Guide to Public Debt Dynamics, Fiscal Sustainability, and Cyclical Adjustment of Budgetary Aggregates. Technical Notes and Manuals, Fiscal Affairs Department, International Monetary Fund,

Marek Dabrowski

Washington, DC: International Monetary Fund. www​.imf​.org/​external/​pubs/​ft/​tnm/​2010/​ tnm1002​.pdf. IMF. 2014. Government Finance Statistics Manual. Washington, DC: International Monetary Fund. www​.imf​.org/​external/​Pubs/​ FT/​GFS/​Manual/​2014/​gfsfinal​.pdf. Ley, Eduardo. 2010. Fiscal (and External) Sustainability. MPRA Paper, PREM, Economic Policy and Debt Department, The World Bank, Munich: Munich Personal RePEc Archive. https://​mpra​.ub​.uni​-muenchen​.de/​23956/​1/​ MPRA​_paper​_23956​.pdf. Rogoff, Kenneth S., and Carmen M. Reinhart. 2009. This Time Is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press.

30. Financial crises and financial regulation: what relationship? Introduction

Regulation and market behavior: rules of the game

This entry highlights the links between the global financial crisis (GFC) of 2007–2008 and the institutional and regulatory environment of financial systems in force since the late 1980s. The ultimate purpose is to point to relevant alternatives to strengthen financial regulation to mitigate financial instabilities and reduce the likelihood of systemic crises. In the wake of the GFC, there is growing theoretical and empirical support for the critical role of institutional architecture in the stability of financial systems (Calvo et al., 2018; Ringe et al., 2019). It is widely accepted that institutional design remains important in mitigating financial crises. This chapter argues that financial crises are often linked to the regulatory environment that determines the framework of action of market actors by erecting limits and prohibitions, establishing the standard rules of the game, imposing sanctions on behaviors that would violate these rules, and providing various incentives to push actors towards a particular type of strategy. In a broader sense, the functioning of markets is shaped and effectively conducted within a given institutional and regulatory framework. According to (interventionist or liberal) regulation, the rules that frame markets will provide means and incentives to individuals and institutions and then lead to (consistent/inconsistent) outcomes with the prerequisites for the systemic stability of the financial system. In order to present the premises of a relevant robust regulation, the chapter is developed through three sections. The first section puts forward the role that a given regulatory framework plays in the smooth functioning of markets. The second section gives an account of the evolution of the interactive financial markets dynamics and regulation through the cases of capitalism’s two great financial crises of the twentieth and twenty-first centuries. The third section is devoted to a conjectural exercise about possible alternatives to design a robust financial regulation apt to increase the resilience of economies to systemic crises.

Financial markets and regulation display very interactive evolutionary dynamics since they mutually influence each other and shape the functioning of the economy. On the one hand, financial markets are at the heart of a market economy as they provide tools/mechanisms to fund various economic activities (including speculation and gambling). Therefore, their smooth working is of the utmost importance and requires appropriate organization and management of the related infrastructures and the strategies of market players. This calls for a regulatory framework that might take public and private forms. On the other hand, financial operations are linked to private aims and strategies that generate continuous innovations that can significantly affect the conditions of economic growth and therefore deserve attention from public authorities. It is also worth noting that economic policies play a core role in the evolution of markets since they shape market participants’ strategies. For instance, Davis and Walsh (2016) argue that in the UK, the financialization process that transformed the economic dynamics into more speculative and short-term activities from the late 1980s onward was primarily encouraged and conducted under public authorities’ auspices. The liberal or restrictive rules that run markets are set up through specific regulatory policies that rely on various theories to implement different policies. The latter provides financial markets with a society-wide frame through laws, incentives, or financial and political support (even by creating favorable public opinion to ensure that citizens accept reforms). According to this, markets and market players design and implement their strategies within certain limits. Regulation can therefore be regarded as the art of ruling the behavior of (private and public) parties within the financial system and the economy to make the private-interest-related choices consistent with the systemic sustainability of the common good. In such a line, Searle (1969: 33) suggests a distinction between the regulative and constitutive rules:

127

128  Elgar encyclopedia of financial crises we might say that regulative rules regulate antecedently or independently existing forms of behavior; for example, many rules of etiquette regulate inter-personal relationships which exist independently of the rules. However, constitutive rules do not merely regulate; they create or define new forms of behavior. The rules of football or chess, for example, do not merely regulate playing football or chess, but as it were, they create the very possibility of playing such games.

In the same vein, Sinclair (2012: 150) relates the roots of the GFC to the rules in force and maintains that The rules make the game. The point is that the public and elite panic has focused on regulative rules and those who allegedly broke them. Nevertheless, this is not the problem with rating agencies or what has brought about the GFC. Constitutive rules have been damaged, which is why the crisis is so deep and so obviously challenging to the powers that be.

Therefore, one can state that general rules shape particular behaviors as general regulation shapes individuals’ strategies since it determines the scope of individual actions. The institutional/regulatory framework in force in financial systems should then be studied from a twofold perspective:1 ● the constitutive rules that define the rules of the game, and ● the regulatory rules that supervise the respect and the effective implementation of the rules. The first aim of any regulation is to ensure the viability of financial systems since the smooth functioning of financial markets is a prerequisite for sustainable economic operations. From this perspective, any relevant supervision framework has to be intrusive to give the supervisor the means and power to monitor financial market actions and effectively check that they follow the rules. An essential part of the regulation is the gatekeeper role of the public authority. The latter has to assess that the market institutions meet some criteria (governance and risk control) before operating in financial markets. This role might be tightened in a preventive/precautionary regulation framework, especially regarding financial innovations. For instance, the “gatekeeper” has to screen innovations Lyubov Klapkiv and Faruk Ülgen

before allowing new products/processes to be supplied in the market by private firms. Such an approval process might rely on a social utility test “that focuses on whether the product will likely be used more often for insurance than gambling. Other factors—such as a financial product’s effect on the efficient allocation of capital—may be addressed if the answer is ambiguous” (Posner and Weyl, 2013: 1307).2 However, the evolution of financial regulation does not follow a linear and upgrading path. It is often shaped according to prevailing economic and political wisdom. For instance, Akerlof and Shiller (2015) point to the evolution of financial systems that have taken a specific path in the 1980s and 1990s according to the liberal doctrine of efficient markets. The latter asserts that the most efficient way of organizing financial systems is to let markets organize themselves since the markets are assumed to endogenously develop optimal self-adjustment/ self-regulation mechanisms without requiring tight and restrictive public oversight. Therefore, from the late 1980s, the regulatory framework was reframed according to the self-regulation rule: The finance optimists think that complicated financial transactions are about benignly dividing up risk and expected returns in the best possible way among people with different tastes for them, just as children used to trade marbles or baseball cards. People are smart, especially in finance; the best way to police financial markets is to let them police themselves. As a notable example of applying this mantra to public policy, the Commodity Futures Modernization Act of 2000 enabled extraordinarily complicated financial products to trade with only minimal supervision. The markets, it was said, would police themselves. (Akerlof and Shiller, 2015: 8)3

Financial regulation marks a return to tighter and more restrictive models under the central bank or government recovery policies when liberalized financial markets generate fragile positions and the economies suffer from subsequent systemic crises. The two great crises, the first at the beginning of the twentieth century and the second at the beginning of the twenty-first century, were the stages for such plays, which saw very similar plays on the financial markets. As a result of the development of liberalized financial markets,

Financial crises and financial regulation: what relationship?  129

systemic crises occurred and endangered the functioning of capitalism as a whole. The public authorities then intervened by modifying market regulation to save the economies from “self-destruction”.

Evolution of financial regulation in the face of crises

From the historical perspective of the twentieth to twenty-first centuries, financial regulation mechanisms have been incessantly changing, moving mainly from tight regulation to loose regulation (liberalization) and vice versa. Such changes were conditioned by the permanent turmoil (crisis) in financial markets, starting from the Great Depression of 1929–1933 and ending with the GFC of 2007–2008. In response to each new challenge, governments tried to reform financial regulation to ensure the stability of financial systems. After the Great Depression, the New Deal legislation was implemented. It was an answer to the collapse of the system that the creation of state-chartered affiliates had partly caused by national banking associates, which allowed them to operate in capital market activities that were forbidden to them under Federal legislation (Kregel, 2010: 10). According to the Glass-Steagall legislation (Banking Act of 1933; see Federal Reserve Bank of St. Louis, 1933), commercial banking and investment banking were separated to minimize the risk-taking behavior of financial institutions. Section 16 of the Glass-Steagall Act prohibited dealing with securities, and due to Section 21, securities companies were not allowed to take deposits (Banking Act of 1933; see Federal Reserve Bank of St. Louis, 1933). At the same time, the New Deal brought a few critical aspects to financial markets. Federal Deposit Insurance Corporation was created to insure bank deposits through polling money from the banks and a flourishing environment for the banks as their activity was protected against nonbanking competitors. However, this provided monopoly protection to ensure the stability of financial institutions, rather than the protection of the financial functions they were supposed to provide to the nonbank business sector (Kregel, 2010: 7). The other important aspect, introduced by the Federal Reserve Board in 1933, was Regulation

Q that prohibited interest-bearing demand accounts. Banks were not allowed to pay interest to their customers holding checking accounts as this could push the unduly risky investment and lending policies so that they could earn enough income to pay the interest. This limitation was lifted in 2011 as the US regulator considered it one of the 2007–2009 financial crisis factors. The main tighten phases in regulation were the consequences of the “hard times” in financial markets: the deeper the turmoil, the more radical the changes. However, it had the opposite effect that was visible after the 1970s when the well-functioning market lets the public’s guard down toward substantial liberalization for the participants. However, the stable structure of the financial system as a legacy of World War II and the financial conservatism—developed as a consequence of the Great Depression (which together ensured the stability of the economies)—lost their significance over the years with the influence of renewed market-friendly approaches. These approaches (such as Chicago Monetarism, New Classical Economics, and Consensus economics) mainly rely on the hypotheses of efficient free markets that assume that instabilities are due to exogenous shocks and must be studied as random events and not as a result of free-market mechanisms. As a result, from the late 1960s, banks started to use court interpretation to avoid the restrictive limitations of the Banking Act of 1933. The deregulation of the 1970s and 1980s created a new financial system structure where banks could engage in securities activities with speculative purposes. On the one hand, these changes provided a financial system with more flexibility, bringing significant benefits to market participants with an open approach to innovative market practices. On the other hand, more complex and speculation-led strategies were developed, and market positions became less stable and more prone to crises. Notwithstanding recurrent and rampant crises due to financial market evolution toward more liberal frameworks over the 1980s-1990s, the Gramm-Leach-Bliley Act (Financial Services Modernization Act) was signed in 1999. Because of this Act, financial institutions (banks, insurance companies, securities) could integrate their operations through affiliation. Such legislative Lyubov Klapkiv and Faruk Ülgen

130  Elgar encyclopedia of financial crises

liberalization brought a significant change into the financial market: traditional commercial banks engaged in securitization and short-term collateralized lending. According to the Levy Institute, Gramm-Leach-Bliley Act was one of the leading causes of creating financial conglomerates that are “too big to fail” (Levy Institute, 2011). In some sense, this can be regarded as a Schumpeterian process of evolution: good conditions support the appearance of weak participants (primarily if the government uses the monetary tools to support market participants), and the next ensuing phase is the incremental weakness of such system fed by growing imbalances. Schumpeter argues that under some conditions, capitalism can self-recover. Intensive government interference can worsen the situation unless there is a “pathological” depression risk. This moment is the core signal for a public regulator to put in motion its instruments. Schumpeter then writes: “The case for government action in depression remains, independently of humanitarian considerations, incomparably stronger than it is in recession” (Schumpeter 1939: 162). Schumpeter, therefore, places the focus on the inability of capitalism to develop stably and advocates for public action to stabilize its endogenous disequilibrium dynamics: “This inability of capitalism to police itself is as striking as its inability to protect itself … But it is largely this inability that produces crises as distinguished from mere depressions” (1939, p. 660). Schumpeter also notices the role of the central bank, and monetary and fiscal policy in covering the economic depression. In a depression, only a comprehensive fiscal policy but not an expansive monetary policy is an efficient remedy; it might nevertheless be healthier in the long run because a too-long dose of a budget deficit as a stimulant can make a country dependent on this kind of drug-like a “morphinist” (Legrand and Hagemann, 2017: 26). It is worth noting that legislative thinking of the 1980s to 2000s was (and still is, notwithstanding the systemic negative consequences of the 2007–2008 GFC) market-friendly and tended to influence economic processes at a low level of intervention, only to the extent that would be necessary to stimulate economic growth. The legislation also affects financial market mechanisms (through legal acts and central bank policy) and the particiLyubov Klapkiv and Faruk Ülgen

pants’ strategies. However, the legislative initiative in the financial market is undertaken mostly only in those areas where the market directly affects the real economy. Greenspan assumes that detailed rules and standards are both burdensome and ineffective, if not counterproductive and that the main regulatory rule must be to ensure that effective risk management systems are in place in the private sector to foster financial innovation without imposing restrictions that inhibit it (Ülgen 2013: 240). The conviction, expressed publicly by many leading economists, that the functioning of the economic system is well understood and can then be self-regulated (Lucas, 2003; Bernanke, 2004), proved to be mistaken. The vision of lasting macroeconomic stability (the so-called “Great Moderation”) was identified with a better quality of monetary policy and better management of several processes in the economy. However, the prevailing certainty encouraged increased lending to the economy by the financial sector. The Basel II capital requirements model recommended before the crisis, which was designed to ensure the solvency of institutions in the event of losses, was pro-cyclical. When a loss occurred, there was no buffer to cover it—banks either had to raise new capital quickly or sell some assets and reduce lending. By choosing the second option, they further increased the scale of fluctuations in the economy, potentially increasing the risk of the slowdown becoming a crisis. It shows the connection between instability and regulation. As Ülgen (2013: 239) mentions: “Accumulated fragilities may come from unfettered and ill-framed financial liberalization that leads financial institutions to implement innovations which reveal to be detrimental to the sustainability of debt-financing economic development”. This (liberal) regulatory tendency has led to the structural evolution of the whole financial system allowing various uncontrolled and loosely supervised market activities and innovations and has overtaken the regulatory system. Unfortunately, it resulted in the 2007–2008 GFC. In the face of such a systemic catastrophe, the US government signed the Emergency Economic Stabilization Act of 2008 to mitigate the spread of the negative consequences of the turmoil. This Act had to immediately provide US financial markets with authority and facilities to restore liquidity and stability. The main idea of this step

Financial crises and financial regulation: what relationship?  131

was to buy and insure certain types of troubled assets (primarily mortgage-backed securities) by the federal government through the Troubled Asset Relief Program (TARP). TARP was created “to purchase and to make and fund commitments to purchase, troubled assets from any financial institution, on such terms and conditions as are determined by the Secretary” (Emergency Economic Stabilization Act 2008: 3). Under TARP rules, the government authority to purchase troubled assets was limited to $700 billion. As the testimony by Paulson (one of TARP’s authors) before the Senate Banking Committee mentions: “this bold approach will cost American families far less than the alternative—a continuing series of financial institution failures and frozen credit markets unable to fund everyday needs and economic expansion” (Paulson, 2008). The relief program caused an ongoing discussion about the fairness of such a rescue mechanism that had to be funded by American taxpayers. Krugman noticed that this plan could not solve the main problem of the crisis—lack of capital, but break the vicious circle of deleveraging. Furthermore, the federal government hugely overpaid for the assets it bought, giving financial firms, their stockholders, and executives a giant windfall at taxpayer expense (Krugman, 2008). According to the Congressional Budget Office (Congressional Budget Office, 2020), about $442.5 billion of the $700 billion was already distributed, and $1.4 billion will be paid in the future. Most money was directed at preventing foreclosures on home mortgages, a bailout for American International Group, and the automotive industry. Regarding its primary aim, the Treasury acquired $205 billion in shares of preferred stock from 707 financial institutions. The total government subsidy costs were estimated at $31 billion (Congressional Budget Office, 2020). In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) was implemented. This Act had to regulate the functioning of bank holding institutions and nonbank financial companies. Its primary focus was directed to the entities that were “too big to fail” to securities holding companies and the financial regulation architecture. Due to Dodd-Frank regulation, bank holding companies with total consolidated assets of US$50 billion or more were subject to

more stringent prudential standards; nonbank financial companies that meet specific criteria and all securities holding companies were subject to prudential standards and oversight by the Federal Reserve Board (Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010). The main aim of this Act was to improve transparency, and accountability among financial entities, with a concentration on “too big to fail”, to get bailout payments right, and for the other purpose in the area of consumer protection. A decade after Dodd-Frank’s implementation, the benefits of this regulation as a source of higher transparency are under discussion. The disclosure of the information about the payments for the executives in the “too big to fail” companies “neither indicates whether the CEO is overpaid, whether governance mechanisms are well-functioning (or malfunctioning), nor whether the CEO is well-incentivized to do what is in shareholders’ best interests” (Muth, 2021: 508). Criticism also relates to the very high costs of Dodd-Frank’s realization and service. Among the positive effects of the Dodd-Frank Act on the financial market were the regulation of the rating agencies and higher requirements for their responsibility (for this purpose, the Office of Credit Rating was created). In this context, the Act simplified the sue track against the dishonest rating agency for the investors. Another essential implementation was conferring on Federal Deposit Insurance Corporation the “Assistance to Individual Institutions” role in case of failure to handle the liquidation process. The crisis from the US financial market transmitted its effects to the European Union (EU) banking system. However, it is worth noting that EU financial entities were more limited in risk-taking behavior thanks to the transparency of their activity with special purpose entities as determined by the International Accounting Standard (IAS). According to the consolidation principles, IAS 27 “Special purpose entities (SPEs) should be consolidated where the substance of the relationship indicates that the SPE is controlled by the reporting entity [SIC-12]” (IAS 27). To ban the possibility of saving the capital on vehicles and limit any regulatory arbitrage in the case of special purpose entities, Basel II was implemented in 2007 in the EU. In 2009, the Basel Committee on Lyubov Klapkiv and Faruk Ülgen

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Banking Supervision introduced new measures to improve the quality of Tier 1 capital: ensuring adequate capital charges for banks’ trading books; strengthening the banks’ risk management and disclosure practices; supplementing the risk-weighted measures with a leverage ratio; dealing with counterparty credit risk posed by over-the-counter derivatives; reducing systemic risk; eliminating opportunities of regulatory arbitrages; improving managers’ incentive structures and increasing transparency (Miele, 2011: 292). Therefore, searching for relevant alternative ways of framing financial regulation became a crucial research and policy field.

New directions for old issues: a holistic approach to financial regulation—from market-friendly regulation to macroprudential framework

It is usually assumed that the primary purpose of financial regulation is to mitigate the likelihood (and the effects) of systemic risks without inhibiting the free functioning of markets and the innovative dynamics of private initiatives. However, the regulatory approach that has been in force since the 1980s focuses instead on individual risks. It supposes that if the soundness of individual institutions is properly assessed through transparent disclosure and self-regulation mechanisms, systemic stability of markets would be achieved. Therefore, even “fashionable stress tests” are conducted individually. In contrast, systemic risk is somewhat related to the evolution of the whole system, regardless of the individual situation of each market participant. The quality of financial markets’ regulatory mechanisms has traditionally been judged by safety and stability criteria. However, as Minsky stated, the capitalist economy cannot be stable: “the tendency to transform doing well into a speculative investment boom is the basic instability in a capitalist economy” (Minsky, 1982: 66). The instability can then be regarded as a result of the evolution of endogenous dynamics of capitalism. From this perspective and in line with the Schumpeterian analysis of capitalist economy evolution, Minsky advocates for a “big government” to organize markets in a socially coherent way and to contain their Lyubov Klapkiv and Faruk Ülgen

development within the limits of sustainability. Big government can then be regarded as an overall regulatory framework consistent with the issues stemming from the weaknesses of financial markets (Minsky, 1986). Various regulatory models have been developed and discussed since the GFC. They often focus on macroprudential regulation (Maddaloni and Scopelliti, 2019) and an integrated regulatory framework under the oversight of a common central regulator, a central bank, or a board of financial supervisors (Nier, 2009; Calvo et al., 2018; Ringe et al., 2019). Armour et al. (2016: 778) consider vertical and horizontal dimensions of financial regulation. The horizontal dimension is about the allocation of subject-matter jurisdiction between: ● an institutional model (allocating regulatory responsibility according to the legally permissible activities of each type of institution—banks, insurers, broker-dealers); ● a functional model depending on the type of business activity (banking, insurance, securities); ● an objective-based model (regulatory responsibilities according to specific goals such as stability, market efficiency, and consumer protection). A possible alternative might be a unified regulator overseeing all these different perspectives (like the former UK Financial Services Authority). The vertical dimension is a question of determining the hierarchy of powers between various regulatory agencies and the efficiency of interventions to fight systemic shocks. The aim is to avoid regulatory cacophony and the inefficiency of the lack of well-defined responsibilities and oblige regulators to take action quickly and precisely without referring interventions to one another. In the USA, since the Dodd-Frank Act of 2010, the Financial Stability Oversight Council has sought to promote financial stability through interagency coordination and information-sharing amongst US regulatory authorities (including the Fed, Securities and Exchange Commission, Office of the Comptroller of the Currency, Office of Financial Research, and Consumer Financial Protection Bureau). In the UK, the Prudential Regulation Authority is in charge of micro-

Financial crises and financial regulation: what relationship?  133

prudential regulation of banks, insurance companies, and other investment firms. In contrast, the Financial Policy Committee is responsible for macroprudential oversight, both under the authority of the Bank of England. The European System of Financial Supervision, built in 2011 in the aftermath of the GFC, follow a largely institutional division of responsibility shared among the European Securities and Markets Authority (ESMA), European Banking Authority (EBA), and European Insurance and Occupational Pension Authority (EIOPA).4 At this point, the core issue is the coordination and cooperation between different regulatory agencies and levels. The regulatory framework might be built on various parts, public and private, according to the aims and characteristics of the issues they are intended to deal with at their level of responsibility. However, a more comprehensive vision to overhaul financial system rules seems necessary to prevent regulatory cacophony. In this vein, Bernanke (2009) maintains that the financial system must be regulated holistically, as a whole, to avoid some of the failures that led to the 2007–2008 GFC.5 However, the regulatory changes do not seem to be structurally strengthened more than 12 years after the global meltdown. For instance, in the case of the EU financial framework, Ringe et al. (2019: iii) note that rather than moving to a holistic approach, the post-crisis reforms upgraded the previous supervisory colleges to EU agencies, resulting in the three sectoral bodies, EBA, ESMA, and EIOPA: “The major risk of such a sectoral architecture is that separate agencies may fail to recognize any cross-sectoral problems and risks that are evolving, may fail to adequately address financial conglomerates, and may more generally encounter fundamental challenges in adopting a more holistic approach to financial regulation and supervision”.6 Indeed, the holistic approach to financial regulation is global system supervision, a macroprudential-led oversight framework that should seek to frame and implement regulatory rules and supervision tools beyond the individual institutions’ safety related to microprudential concerns and market-relying self-regulation. For instance, the International Association of Insurance Supervisors (IAIS, 2019) adopted in 2019 a holistic framework to support global financial stability by assess-

ing and mitigating systemic risk in the global insurance sector. IAIS expects to build the holistic approach on three components, the supervisory material (macroprudential supervision and crisis and resolution planning), a global monitoring exercise (collective discussion and assessment of potential systemic risk in the sector), and implementation assessment (global and coordinated in-depth verification of supervisory practices). Another complementary direction might also be related to a more precautionary regulatory approach that could rely on preventive rules and measures to reduce the scope of market strategies that could have systemic effects. The environmental policies built on the precautionary principle might provide some possible options in terms of the regulatory framework (Ülgen, 2019). Lyubov Klapkiv and Faruk Ülgen

Notes 1.

For the sake of simplicity, we do not distinguish between constitutive and regulatory rules. We call both “financial regulation”. However, in the literature, the constitutive rules are usually called “regulation” and the regulatory rules “supervision”. 2. For further developments, see the third section. 3. Akerlof and Shiller (2015) give the example of the magician’s trick to show that the efficient market mantra is not true: “Another way to make money in finance is not to sell people what they really want. Remember the magician’s trick: he puts a coin underneath one of three jars, swirls them around, and then opens them all up. The coin is gone. But where is it? Voilà: it is in the hand of the magician. And that is what can also happen in the world of complicated finance. Figuratively, we buy a security that entitles us to whatever coin will appear when the cups are uncovered. But then in the swirl of complicated finance, somehow the coin is transferred to the magician’s hand, so that when the cups are turned over, we get nothing”. 4. For a comprehensive presentation of these frameworks, see Armour et al. (2016). 5. One of the wide-ranging reforms the GFC has provoked is the creation of a regulator to oversight markets and firms that could generate systemic risks through their size and interconnectedness with each other. This urgent change came into the picture in the wake of the failure of Lehman Brothers and the government takeover of American International Group which were brought down mainly because of losses generated by their speculative and often unregulated operations in global financial markets. 6. The authors of this entry are currently working on a large-scale research project about the systemic effects of financial conglomerates—with diversified activities in insurance, securities and banking markets—on systemic stability.

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134  Elgar encyclopedia of financial crises

References

Krugman, P. (2008), “Cash for Trash”, The New York Times, www​.nytimes​.com/​2008/​09/​22/​ Akerlof, George A. and Shiller, Robert J. (2015), opinion/​22krugman​.html. Phishing for Phools: The Economics of Legrand, M. and Hagemann, H. (2017), “Business Manipulation and Deception, Princeton, NJ: Cycles, Growth and Economic Policy: Princeton University Press. Schumpeter and the Great Depression”, Journal Armour, J. et al. (2016), Principles of Financial of the History of Economic Thought 39(1): Regulation, Oxford: Oxford University Press. 19–33. Bernanke, Ben S. (2004), “The Great Moderation”, Levy Economic Institute of Bard College (Levy Remarks by the Governor Ben S. Bernanke Institute) (2011), “Minsky on the Reregulation at the meetings of the Eastern Economic and Restructuring of the Financial System: Association, Washington, DC, February 20. Will Dodd-Frank Prevent ‘It’ from Happening Bernanke, Ben S. (2009), “Financial Reform to Again?” Research Project Report, www​ Address Systemic Risk”, Remarks by Ben S. .levyinstitute​.org/​pubs/​rpr​_04​_11​.pdf. Bernanke, Chairman Board of Governors of the Lucas, R. (2003), “Macroeconomic Priorities”, Federal Reserve System before the Council on American Economic Review, 93: 1–14. Foreign Relations, Washington, DC, March 10. Maddaloni, A. and Scopelliti, A. D. (2019), “Rules Calvo, D. L., Crisanto, J. C., Hohl, S., and and Discretion(s) in Prudential Regulation and Gutiérrez, O. P. (2018), “Financial Supervisory Supervision: Evidence from EU Banks in the Architecture: What Has Changed after the Run-Up to the Crisis”, ECB Working Paper Crisis?” FSI Insights on policy implementation, Series, No. 2284, May. April 8, Bank for International Settlements. Masciandaro, D., Pansini, R. V, and Quintyn, M. Congressional Budget Office (2020), “Report on (2011), “The Economic Crisis: Did Financial the Troubled Asset Relief Program”, March. Supervision Matter?” IMF Working Paper No www​.cbo​.gov/​system/​files/​2020–03/​56266​ W.P./11/261. -CBO​-TARP​-2020​.pdf. Miele, M. (2011), “The Financial Crisis and Davis, A. and Walsh, C. (2016), “The Role of Regulation Reform”, Journal of Banking the State in the Financialisation of the U.K. Regulation 124: 277–307. Economy”, Political Studies 64(3): 666–682. Minsky, Hyman P. (1982), Can “It” Happen Dodd-Frank Wall Street Reform and Consumer Again? Essays on Instability and Finance, Protection Act (2010), “Summary of Key Armonk, NY: M.E. Sharpe. Provisions”, Public Law no. 111–203. Minsky, Hyman P. (1986 [2008]), Stabilizing an Debevoise & Plimpton LLP. www​ .govinfo​ Unstable Economy, McGraw-Hill: New York. .gov/​content/​pkg/​PLAW​-111publ203/​pdf/​ Muth, K. (2021), “Keeping Score: Dodd-Frank PLAW​-111publ203​.pdf. Section 953(b) Reporting Ten Years Later”, The Emergency Economic Stabilization Act (2008), John Marshall Law Review 53(3): 497–508. Public Law 110–343, 110th Congress, www​ Nier, E. W. (2009), “Financial Stability .congress​.gov/​110/​plaws/​publ343/​PLAW​ Frameworks and the Role of Central Banks: -110publ343​.pdf. Lessons from the Crisis”, IMF Working Paper Federal Reserve Bank of St. Louis (1933), Banking WP/09/70, April 2009. Act of 1933, https://​fraser​.stlouisfed​.org/​files/​ Paulson, Henry M. (2008), “Recent Actions docs/​historical/​congressional/​1933​_bankingact​ Regarding Government Sponsored Entities, _confrep254​.pdf. Investment Banks and Other Financial Ferri, P. and Minsky, H. P. (1992), “Market Institutions”, www​.treasury​.gov/​press​-center/​ Processes and Thwarting Systems”, Structural press​-releases/​Pages/​hp1153​.aspx. Change and Economic Dynamics 3(1): 79–91. Posner, Eric A. and Weyl, E. Glen (2013), International Accounting Standards-IAS 27 “An FDA For Financial Innovation: (2008), “Consolidated and Separate Financial Applying the Insurable Interest Doctrine to Statements”, www​.iasplus​.com/​en/​standards/​ Twenty-First-Century Financial Markets”, ias/​ias27. Northwestern University Law Review 107(3): International Association of Insurance Supervisors 1307–1358. (IAIS) (2019), “Explanatory Note on Holistic Ringe, W.-G., Morais L. S. and Muñoz, D. R. Framework for the Assessment and Mitigation (2019), “A Holistic Approach to the Institutional of Systemic Risk in the Insurance Sector”, Architecture of Financial Supervision and November 14. www​.iaisweb​.org/​page/​news/​ Regulation in the E.U.”, European Banking press​-releases​-prior​-to​-2014​#. Institute Working Paper Series, October 9. Kregel, J. (2010), “Is This the Minsky Moment for Schumpeter. J. A. (1939), Business Cycles: Reform of Financial Regulation?”, The Levy A Theoretical, Historical and Statistical Economics Institute Working Paper no. 586, Analysis of the Capitalist Process, New York: www​.levyinstitute​.org/​pubs/​wp​_586​.pdf. McGraw-Hill Book Company.

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Financial crises and financial regulation: what relationship?  135 Searle, J. R. (1969 [2011]), Speech Acts: An Essay in the Philosophy of Language, Cambridge: Cambridge University Press, 34th printing. Sinclair, Timothy J. (2012), “Institutional Failure and the Global Financial Crisis”, in Wyn Grant and Graham K. Wilson (Eds), The Consequences of the Global Financial Crisis: The Rhetoric of Reform and Regulation, Oxford: Oxford University Press: 139–155.

Ülgen, F. (2013), “Is the Financial Innovation Creative? A Schumpeter Destruction Reappraisal”, Journal of Innovation Economics & Management 1(11): 231–249. Ülgen, F. (2019), “An Institutionalist Framework for a Consistent Financial Regulation”, Journal of Economic Issues 54(2): 432–439.

Lyubov Klapkiv and Faruk Ülgen

31. Financial crises in Spain after Bretton Woods: 1977 and 2008 crises 1977–2020

in this period. Below, we explain the main sequence of events and drivers of these two most severe crises.

1977 crisis

The Bretton Woods (BW) system, established after the Second World War, was dissolved in 1971. It marked the end of the dollar’s convertibility into gold, and from 1973 the major currencies began to float against each other. Floating exchange rates and the elimination of capital controls reinforced international financial flows in a context of abundant liquidity favored by the accumulation of petrodollars due to the rise in oil prices in 1973 and 1979. In addition, many countries underwent a process of financial deregulation. The main result was increased financial instability, with more banking and twin (currency and banking) crises than in the BW period (Bordo et al. 2001). The situation was even worse in Spain. First, in the post-BW period, crisis frequency1 was high in Spain by international standards.2 In this period, Spain suffered five financial crises: 1977, 1982, 1991, 1995, and 2008. However, as the Spanish literature on crises generally holds that the banking problems of the mid-1980s resulted from the 1977 banking crisis, the 1977 and 1982 financial crises will be taken together here. Second, crisis severity has been higher in Spain since 1973 than in previous periods. The two most severe and longest financial crises to occur since 1850 happened in 1977 and 2008. Finally, in the post-BW era, the Spanish financial crises remained severe by international standards. Laeven and Valencia (2018) provide a database on banking crises for the period 1970–2011, in which they present a median value of the output loss (computed as the cumulative loss in income relative to a pre-crisis trend) for 147 crises of −23 percent. The two abovementioned Spanish financial crises resulted in an output loss above the Laeven and Valencia median values: −25.97 percent in 1977 and −27.33 percent in 2008 (Betrán and Pons 2017). Financial liberalization and external imbalances lie at the root of the higher frequency and severity of the Spanish financial crises

The 1977 crisis began as an economic and industrial crisis that gave rise to financial turmoil. From the end of the 1950s, Spain opened up timidly to the international markets, although economic growth was mainly based on domestic demand. Spanish exports remained weak, while imports (raw materials and capital goods) increased due to rapid industrialization in the 1960s. The result increased external imbalances, which shot up further with the oil crises of 1973 and 1979 because oil imports represented around two-thirds of total energy consumption. Moreover, unlike in the 1960s, tourism revenues and migrant remittances did not cover trade deficits. These large external imbalances resulted in a currency crisis in which the exchange rate deteriorated between 1974 and 1985 from 58 pesetas/dollar to 160 pesetas/dollar. Initially, the government tried to smooth the oil crisis’s impact on price intervention, but the crisis was deeper than the government had predicted. Consequently, Spain suffered a currency crisis and substantial growth in the public deficit, which led to a fiscal crisis (Betrán and Pons 2017). Inflation and unemployment rates skyrocketed. Inflation peaked at 25 percent in 1977 and 1,200,000 people lost their jobs between 1977 and 1981. In addition to rising oil prices, the Spanish economy faced other domestic problems. Technical obsolescence, lack of competitiveness, and an overdependence on credit put industrial companies in a precarious situation when the oil crisis broke out, leaving many firms unable to survive. The crisis was transmitted from the industrial to the banking sector through two mechanisms. First, the crisis spread through an increase in failed industrial firms and unpaid clients (with an increase in non-performing loans-to-total loans from 1.1 in 1973 to 3.3 in 1981 and 5.40 in 1984). Second, a stock market crash caused a marked deterioration of the balance sheets of those Spanish banks with large industrial portfolios (Cuervo 1988). Financial problems exacerbated the economic distortions in the real sector. During the BW years, Spain was quite similar to other

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Financial crises in Spain after Bretton Woods  137

countries in terms of its monetary regime, with a fixed exchange rate and capital controls. Following the collapse of BW, Spain switched to a floating exchange rate regime in 1974. Capital controls, however, were in effect until the late 1980s. In this period, the Bank of Spain—which had been entirely subordinated to government interests during the BW era—began to assume a modern central bank’s role. After a period of financial repression during the Franco dictatorship, Spain, like other European countries, embarked on a learning process to implement monetary policy that was not without its difficulties. In the Moncloa Pacts, an economic and political agreement was passed in 1977 to stabilize the economy during Spain’s transition to democracy. Monetary policy and the liberalization of financial markets became explicit targets. However, the serious economic difficulties and the state’s continuous calls for finance from the Bank of Spain limited the Bank’s autonomy to implement monetary policy (Martín-Aceña 2017). In terms of financial regulation and structure, in the 1970s, Spain had a tightly regulated financial system and a concentrated banking sector in which the Big Five banks achieved a dominant position. However, protectionist rules and institutions were incompatible with entry into the European Community, and to pursue that goal, it was necessary to dismantle them progressively. The liberalization process received a major boost starting in 1974. The main changes included implementation of more flexible regulation that allowed greater branch expansion (in 1975 there were 7,218 bank branches and only three years an increase of around 36 percent from 1970 to 1976) and financial assets expansion (the ratio of financial assets to GDP rose from around 1.5 in 1968 to 2.12 in 1977). Some rules that distinguished between banks and savings institutions were eliminated (although some important ones were maintained). The second wave of financial reforms started in 1978 when the authorities approved new banks, and foreign banks were allowed to set up in Spain (although with strong restrictions; for example, they could not open more than three offices). The reform also allowed more flexible interest rates. The process ended in 1987/88 with the deregulation of the different

interest rates and commissions and removal of barriers to entry to foreign banks. All these changes increased banking competition (Caminal et al. 1993) but also financial instability. As banks were not used to operating in a competitive environment, in this new context, their main reaction was to expand their geographical and business areas, leading to an increase in operational costs. The problem was that liberalization was not accompanied by appropriate prudential regulation and supervision (Poveda 2012), and banking and credit growth was coupled with bank mismanagement, leading to a large number of risky, speculative, and even illegal banking practices (Cuervo 1988). When the 1977 banking crisis occurred, monetary authorities were forced to introduce the necessary mechanism to tackle banking problems and increase supervision (Cuevas and Pons 2020). The main impact of the 1977 crisis was on the banking sector (Table 31.1). In total, 63 banks out of 110, representing 20 percent of banking system deposits, experienced solvency problems, and this crisis was categorized as one of the so-called recent “Big Five Crises” by Reinhart and Rogoff (2008). Although the crisis started in smaller, younger banks (90 percent of the banks that were involved in the crisis had been founded between 1973 and 1978), in 1982/1983, it eventually affected Rumasa, a large industrial holding company with 20 banks, as well as Banco Urquijo, an industrial bank that was among the eight biggest banks in Spain (Cuervo 1988). The final result was a banking restructuring that led to an increase in concentration (because the larger banks purchased those banks in difficulties) and strengthened the regulatory framework. The cost of the crisis for the period 1977–1985, measured as the contributions of the public and private sector in order to deal with the banking crisis, was estimated by Cuervo (1988) at 6 percent of GDP (Table 31.1); that is, not far off the median of 6.8 that Laeven and Valencia (2018) calculated for their sample of crises from 1970–2011. Despite the serious macroeconomic consequences of the 1977 crisis, currency manipulation (with devaluations in 1976, 1977, and 1982) allowed Spain to mitigate to some extent the negative effects of the crisis. Concha Betrán and María A. Pons

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2008 crisis

The 2008 crisis occurred after a period of rapid growth (mainly driven by the construction sector) accompanied by a decline in competitiveness that began in the mid-1990s (Escrivá and Correa 2010). This economic growth was sustained by foreign private debt and large current account deficits (Betrán and Pons 2017, 2019). External imbalances were the result of (a) a continuous decline in competitiveness that produced trade deficits, (b) an expansion in internal demand, especially in the real estate sector, and (c) the entry of foreign capital after joining the euro in a period of capitalist globalization and low interest rates that accentuated the growth in credit and the debt of households and non-financial corporations (which rose from 94 percent to 191 percent of GDP in the period 2000–2007 (Bank of Spain 2017)). Entry into the European Economic and Monetary Union was good for the growth of the Spanish economy since it helped attract investment capital at lower interest rates; however, it also meant the loss of certain policy instruments, particularly the monetary and exchange rate policies. Financial liberalization was also behind the 2008 crisis. From the last decade of the twentieth century until 2007, there was a new wave of deregulation to encourage competition by allowing banks and savings banks to carry out the same operations. Moreover, re-regulation was aimed at adapting the financial sector to conform to the EU. As in the 1970s and 1980s, the main result was strong competition fueled by technological change, globalization, and EU integration. This strong competition produced a fall in banking interest margins that from 1997 to 2006 decreased by 41 percent (in contrast to a decrease of only 24 percent in the Eurozone). Increased competition prompted the restructuring of the banking sector through bank mergers.3 Moreover, banks reduced their branch network and the larger banks had an international expansion, mainly in Latin America (Berges, Ontiveros, and Valero 2012). Saving banks, however, had limitations to internationally expand4 and in this competitive market, they adopted an aggressive geographic expansion process. Moreover, in a context of low interest rates and increasing housing prices,5 saving banks supplied credit demand, especially in the building sector (mortgages and loans to real Concha Betrán and María A. Pons

estate) and real estate risk in their portfolios went from 32.7 percent in 1997 to 62 percent in 2007 (Jimeno and Santos 2014). Illegal banking practices and imprudent management were also common in savings banks.6 Although saving banks supervision was in the hands of regional governments, a conflict of interest became apparent because regional governments also controlled these financial institutions. The international context (the bursting of the US housing bubble in 2007) was crucial in bursting the Spanish bubble and the associated banking problems. The Spanish economy was very dependent on external financing and in the years preceding the crisis Spain was the recipient of large capital flows. When the international crisis erupted, it triggered a reversal in international capital inflows and restricted Spanish banks and the government’s access to international markets (Jimeno and Santos 2014). The 2008 crisis was a banking crisis that mainly afflicted the savings banks (Table 31.1), although other banks were also exposed to toxic real estate assets (defaults on mortgages and loans to property developers) and most of them kept repossessed properties, which were overvalued, on their balance sheet. The crisis led to the disappearance of the savings banks (there were 45 savings banks in 2007 and only two in 2010) and the restructuring of the Spanish financial system as savings banks were merged with or acquired by other entities and transformed into new commercial banks. The crisis affected around 35 percent of total financial assets and around 50 percent of total loans and deposits (Martín-Aceña, Martínez-Ruiz, and Pons 2013). The burst of the housing bubble and the problems with savings banks (due to their involvement in the construction sector) produced a credit crunch (Table 31.1). This reduced investment and had a strong impact on job destruction. Worsening economic conditions (particularly the large rise in unemployment rates, which peaked in 2012 at 25.8 percent) had a direct impact on public finances (sparking a sovereign debt crisis) as a consequence of the drop in public revenues and the increase in expenses linked to unemployment insurance programs and the adoption of some measures aimed at counteracting the contraction of private demand (Conde-Ruiz and Martínez-Ruiz 2020). As

Financial crises in Spain after Bretton Woods  139 Table 31.1

Impact of the 1977 and 2008 crises

Type of financial intermediaries affected

1977

2008

Small and medium-sized banks

Savings banks

63 banks

14 savings banks received financial aid and

by the crisis Number of financial intermediaries affected Non-performing loans

4 were merged The highest rate in 1984 (5.4%)

The highest rate in 2012 (10.43%)

Credit crunch: change in the credit-to-GDP −11.91 %

−16.05%

ratio from the crisis year to the year with the lowest ratio (%) Output loss (%)

−25.97

−27.33

Cost of the crisis as % of GDP

1977–1981 (6%)

2008–2013 (5–9%)

Source:  Betrán and Pons (2017).

a result, Spain passed from a fiscal surplus of 2 percent of GDP in 2007 to a deficit of 4.4 percent in 2008. There are no accurate estimates of the total cost of the crisis intervention, but the most optimistic estimates suggest that from 2008 to 2014, it was around 5 percent of GDP, not far off the estimates for the 1977 crisis; other estimates put it at around 9–10 percent of GDP (clearly above the 1977 crisis) (Betrán and Pons 2017). In this crisis, Spain’s membership in the Eurozone prevented it from using the monetary instruments needed to tackle the crisis. In particular, in 2008 Spain had lost the exchange rate policy as a consequence of being in the euro zone and could not devalue the currency. Instead, it turned to an “internal devaluation” (austerity measures and wage adjustment) to increase competitiveness and correct its external position and public sector problems. By contrast, being in the euro area averted a “real” currency crisis. To sum up, the 1977 and 2008 crises were multiple crises (banking, currency, stock market, and debt crises). They happened in a period of floating exchange rate regimes, with capital controls in 1977 (which disappeared in 1982) and without capital controls in 2008. In 1977 and 2008, Spain had large external imbalances (related to trade deficits and foreign capital inflows) following a period of economic growth that fed the growth in loans, especially after joining the EU. In both crises, there was an international shock (the 1973 and 1979 oil crises, the 2007 US subprime mortgage crisis, and the 2010 euro crisis) that precipitated the crisis and facilitated a sudden stop after a period

of capital bonanzas. Financial liberalization without an efficient supervisory system and globalization were also factors in both crises, facilitating banking expansion and credit growth (more notably in the 2008 crisis). In both cases, the Bank of Spain acted relatively rapidly after the crisis to introduce new institutions and a wide array of instruments. However, the resolution to each crisis differed and was conditioned by the different monetary policy regimes: whereas the peseta’s depreciation was used as a key shock absorber in 1977, it was no longer possible in 2008. Concha Betrán and María A. Pons

Notes 1.

Frequency is measured as the number of years with a crisis as a percentage of the total number of years. 2. For the period 1973–1997, Bordo et al. (2001) calculated a frequency of 12.2 percent for a sample of 56 countries. In Spain, the frequency for the period 1973–2000 rises to 14.8 percent. 3. During the 1980s and 1990s, there was a process of banking concentration. For example, as a result of different mergers, BBVA was created in 1991 and Banco Santander Central Hispano (BSCH) in 1999. 4. Savings banks did not have adequate mechanisms to increase their own resources and consequently were not large enough to operate internationally. 5. The strong demand for housing was stimulated by low interest rates, economic expansion, the financial sector competition, the influx of immigrants, and housing purchases by non-residents (Carballo-Cruz 2011). 6. Savings banks have a long history as non-profit entities. However, as a consequence of deregulation, mainly the 1985 Reform, regional and local governments started to exercise considerable control over the way they were run, and local politicians used savings banks to pursue their local objectives, sometimes with ruinous consequences (Santos 2014).

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References

Bank of Spain (2017): Report on Spain’s financial and banking crisis, 2008–2014. Madrid: Banco de España. Berges, A., Ontiveros, E., and Valero, J. (2012): “The internalization of the Spanish banking system”, in J.L. Malo de Molina and P. Martín-Aceña (eds.): The Spanish financial system: Growth and development since 1900. Madrid: Banco de España, pp. 347–382. Betrán, C. and Pons, M. (2017): “Two great banking crises and their macroeconomic impact compared: Spain 1976/77 and 2008”. Journal of Iberian and Latin American Economic History 35 (2), pp. 241–274. Betrán, C. and Pons, M. (2019): “Understanding Spanish financial crises severity, 1850–2015”. European Review of Economic History 23 (2), pp. 175–192. Bordo, M., Eichengreen, B., Klingebiel, D., and Martínez-Peria, M.S. (2001): “Financial crises. Lessons from the last 120 years. Is the crisis problem growing more severe?”. Economic Policy 32, pp. 53–82. Caminal, R., Gual, J. and Vives, X. (1993): “Competition in Spanish banking”, in Dermine, J. (ed.): European banking in the 1990s. Oxford: Blackwell Business, pp. 271–321. Carballo-Cruz, F. (2011): “Causes and consequences of the Spanish economic crisis: Why the recovery is taken so long?” Panoeconomicus 58 (3), pp. 309–328. Conde-Ruiz, J.I. and Martínez-Ruiz, E. (2020): “2008: Spain in the eye of perfect storm”, in C. Betrán and M. Pons (eds.): Historical turning points in Spanish economic growth and development, 1808–2008. London: Palgrave Macmillan, pp. 195–230. Cuervo, A. (1988): La crisis bancaria en España, 1977–1985: causas, sistemas de tratamiento y coste. Barcelona: Ariel.

Concha Betrán and María A. Pons

Cuevas, J. and Pons, M.A. (2020): “1977: Hopes fulfilled—Building democracy in turbulent economic times”, in: C. Betrán and M. Pons (eds.): Historical turning points in Spanish economic growth and development, 1808–2008. London: Palgrave Macmillan, pp. 159–194. Escrivá, J.L. and Correa, M. (2010): “Competitividad y sector exterior en España”. Anuario Internacional CIDOB, pp. 321–331 Instituto Nacional de Estadística, several years. Jimeno, J.F. and Santos, T. (2014): “The crises of the Spanish economy”. SERIes. V.5 (2), pp. 125–141. Laeven, L., and Valencia, F. (2018): “Systemic banking crises database: An update”. IMF Working Paper, WP/18/206. Martín-Aceña, P. (2017): “The Banco de España, 1782–2017: The history of a central bank”. Estudios de Historia económica 73, pp. 1–83. Martín-Aceña, P., Martínez-Ruiz, E., and Pons, M.A. (2013): “Siglo XXI: recesión y crisis financiera”, in, P. Martín-Aceña, E. Martínez-Ruiz, and M.A. Pons (ed.): Las crisis financieras en la España contemporánea, 1850–2012. Barcelona: Crítica, pp. 241–294. Poveda, R. (2012): “Banking supervision and regulation over the past 40 years”, in J.L. Malo de Molina and P. Martín-Aceña (eds.): The Spanish financial system: Growth and development since 1900. Madrid: Banco de España, pp. 219–271. Reinhart, C. and Rogoff, K. (2008): This Time Is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press. Santos, T. (2014): “Antes del diluvio: The Spanish banking system in the first decade of the euro area”. Columbia Business School Research Archive. March. Tena, A. (2005): “El sector exterior”, in A. Carreras and X. Tafunell (coords.), Estadísticas Históricas de España. Madrid: Fundación BBVA, pp. 573–644.

32. Financial crises in the Ottoman Empire The Ottoman Empire (1300–1922) reigned for over six centuries due to a fiscal system that prioritized sustaining a strong military and financing wars. Although the Ottomans expanded their territories with a successful conquest policy, especially in the first three centuries, supporting the land and naval forces and financing wars could cause heavy burdens on the treasury. Also, pre-modern warfare became more costly and less rewarding gradually (Özvar 2019). In addition, the Ottoman economy relied heavily on taxes based on agriculture, and the unforeseeable aspects of the agricultural economy caused tax and budgetary problems in the long lifespan of the Ottoman Empire. Accordingly, the Ottoman economy suffered from significant fiscal distress and balance deficits at various stages. It managed to sustain both global monetary crises and domestic hardships by both methods well known to the pre-modern states and novel ones. Foreign loans caused the default in the nineteenth century.

The classical age

The first known fiscal crisis was a military uprising known as the “Buçuktepe” incident in 1446. The reason behind the rebellion was the setback in the payment of salaries of soldiers and the debasement. The Janissaries got a raise in their salaries, and the uprising ended (Özcan 1992). Mehmed II’s reign saw many debasements, and after his time, no such scale debasement occurred in Ottoman history until the 1584–86 debasements. A reason behind Mehmed II’s debasement policy was the global scarcity of silver. This is one example of a worldwide crisis affecting the Ottoman economy, and it is followed by the changes in international trade routes, which reduced Ottoman customs revenues in time. In the sixteenth century, the flow of silver from the Americas caused fluctuations in prices worldwide, yet its effect on the Ottoman economy was limited (Pamuk 2000). Still, the Ottoman fiscal situation was in distress in the last two decades of the sixteenth century because of long wars against Iran and the Habsburgs on two different fron-

tiers. In helping to fund the wars and balance the budget, a large debasement occurred in 1584–86. This caused another soldier uprising which was a reaction to debasements: the “Beylerbeyi” incident in 1589. Although the Ottomans sought debasements frequently afterward, no such dramatic ones were seen until Mahmud II’s reign (1808–39). During the lifespan of the Ottoman Empire, the silver density in Ottoman piasters fluctuated from 1.035 grams to 0.0083 grams (Pamuk 2000). In summary, the debasements created an income base (a passive tax) for the state, yet the prices had a high tendency to rise afterward. Social unrest and even coups took place following the debasements. Still, the Ottoman governing elites had to use this medicine for short-term relief. Debasements affected salaried officials, especially the military, merchants, and guild members. When the Ottoman state minted new and reduced-value silver coins, they sometimes kept it a secret in order not to cause distress. When the Janissaries recognized the debasement, it generally resulted in a rise in their salaries, coupled with inflation. Another important problem with debasement is that it harms monetary stability. The Ottomans suffered from monetary instability in the first half of the seventeenth century caused by debasements. The seventeenth-century Ottoman Empire is known for crises (Faroqhi 1994). The Little Ice Age in the seventeenth century destroyed several monarchs and dynasties in various parts of the world. The Little Ice Age impacted the Ottoman lands, especially in Anatolia. The crops were very scarce, and many migrations occurred from villages to urban lands. It was one of the main reasons for the emergence and continuation of the revolts known as the “Celali revolts” throughout the seventeenth century (White 2011). In this era, a severe problem in collecting taxes occurred, and the state revenues dropped drastically. Exports in Ottoman lands increased, and some exported products such as textiles disturbed Ottoman production. Changes in trade routes resulted in a decrease in Ottomans’ customs revenues as well. Ottoman budgets tended to a deficit in the seventeenth century. Adding long sieges and enduring wars in this century, it is right to acknowledge this era as the age of crises. For example, in 1656, the “Çınar” revolt broke out in the capital İstanbul because of the unsettled payments

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of the soldiers who returned from the siege of Crete. In general deficit situations, the first resort of Ottoman fiscal bureaucrats was to apply to the personal treasury of the Sultan. The Ottoman treasury consisted of two different main bodies. The main treasury was the first institution to collect revenues and allocate payments. When the main treasury fell into deficit, the personal treasury of the Sultan “the inner treasury” interceded (Tabakoğlu 2006). This treasury helped settle many crises before they began in the Ottoman classical age. The inner treasury lost its effect and shrank after the sixteenth century. After that, the Ottoman governing elites usually resorted to debasement and imposing new taxes. What made Ottomans different from their contemporaries might be their innovative ways of attracting domestic borrowing. For example, they institutionalized tax-farming and expanded the duration of revenue collection of each taxable unit to a lifetime. This enabled the treasury to collect a down payment which was set by auctioning each tax revenue along with equal annual installments. The Ottomans introduced the system of malikane (Genç 2000) in the last decade of the seventeenth century mainly to fund against enduring crusades after the Siege of Vienna. A century later, a new fiscal hardship emerged on the eve of a new war against Russia, and the Ottoman bureaucrats invented a new domestic borrowing called esham (Genç 2000). Ottomans issued security bonds in the form of dividends of high-revenue custom duties. Investors pay an amount in cash to withdraw annually with a certain markup until the bondholder’s death. This innovation proved to be successful in creating a high demand in the beginning. Apart from such measures, the Ottoman government used the wealth of their top officials or at least expected them to sponsor some military campaigns and initiatives in extraordinary times of fiscal hardships. Even in some cases, precious metals and jewelry in the palace were used to provide funding. The Ottoman fiscal body resisted such troubles by transforming and adapting its system to the new conditions. Unlike their European counterparts, the Ottomans never loaned money from external sources until 1854. They had their bankers collaborating with the governing elite like state officials and helped sustainment of domestic borrowing. Mehmet Akif Berber

Pre-modern economies did not have business cycles. Yet, a genuine aspect of the Ottoman fiscal system was to show an imbalance in budget payments. The state collected a significant portion of the taxes based on a solar calendar. However, the government paid salaries to the state officials and soldiers and made other expenses based on the lunar calendar. Since the two calendars have a different number of days in a year, a junction was irredeemable. The solar calendar has 365 days, while the lunar calendar has 354 days a year. This 11-day difference adds up to a year every 33 years. That same year, the state had to pay a salary two times while collecting once. As a precaution against this problem, the Ottoman treasury manipulated coin exchange rates to create an 11-day extra income in every fiscal year. This was a sort of taxation reserve (Tabakoğlu 2016). The Ottomans named the residual years “sıvış yılı” (Sahillioğlu 1999) which means “skip year”. The fiscal skip years in the history of the Ottoman Empire were 1448, 1481, 1513, 1546, 1578, 1612, 1644, 1677, and 1710 and they coincided with essential incidents in the Ottoman Empire. The Ottoman government overcame the balance problems caused by the lack of unconformity in the calendar until the eighteenth century. However, one treasury official penned a treatise to deal with the situation in the eighteenth century. This treatise was then put into action, and the Ottoman calendar was rescheduled for some government expenditures and salaries of the military. The reason for such immediate action was probably the accumulation of fiscal problems in the eighteenth century. They also tried to reform the accounting system (i.e., changing the salary dates). The fiscal skip year crisis affected Ottoman budget deficits, yet they cannot be the sole cause of financial crises. Their potential influence on the fiscal system is limited since they affect certain taxes, and these taxes cover no more than a third of the total Ottoman income.

The nineteenth century

The nineteenth century is named the longest century (Ortaylı 1987) of the Ottoman Empire because of the radical changes and reforms in administration and institutions. The fiscal apparatus was no exception. In this century, Ottoman budget deficits continued to exist in the same way. Alongside renouncing pre-

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vious classical measures and the tax-farming system in the Tanzimat Era, the Ottoman elites abolished the policy of debasement in 1844. Starting with the nineteenth century, the most dramatic debasements occurred until this decree (Pamuk 2000). The Ottoman Bank was established in 1840, with the primary goal of controlling the newly issued banknotes (Eldem 1999). Another significant development was foreign loans in this century. The Ottomans had experience in domestic borrowing and even invented new methods for this purpose. The Ottoman Porte issued new domestic bonds called sergi along with esham. In addition, the state continued to lend from domestic bankers in this era as well. Yet, the most important financial event in the nineteenth century was the default caused by external loans. Borrowing from European countries that were religious and political enemies of the empire for centuries added more to the burden. Ottomans tried reinstating banknotes and bonds to collect funds from domestic investors and promulgated new taxes to finance the desperate wars and social unrest in the nineteenth century. All these measures could not prevent the obvious outcome, and the Ottomans had to ink the first external loan agreement in 1854 (Clay 2000). Beforehand, the Sultan did not endorse a similar external borrowing attempt in 1851 despite the government’s inability to pay the officials’ wages. The Porte even had to pay a fee for its cancellation. Additionally, the Ottomans attempted to get loans from other countries to finance the war with Russia in 1787, but it was not implemented. English and French states, who were the allies of the Ottoman Empire in the Crimean War, had an impact on the Ottoman elites entering the international loan market. The first loan opened the door for Ottoman external loans, eventually becoming the first measure to help with fiscal difficulties in the following decades. The Ottoman government issued loans in European finance centers such as London and Paris with the help of big banker intermediaries. Although the Ottoman state was on the winning side of the war, the first loan did not suffice for the expenses of the war. Thus, the state had to sign a new loan in 1855. The tax of Egypt and customs of Syria and Smyrna were presented as collateral/

recognizance to the loan to attract investors since the loans were deemed risky. From 1854 to 1874, the Ottoman state agreed on 15 loans. The agreed amount usually differed from the face value, and an interest rate was applied. In the Ottoman currency, £T238.773.272 Ottoman liras were in debt, and Ottomans received £T127.120.220 liras in their treasury (Küçük and Ertüzün 1994). In total, most of these loans were used for budget deficits, to recall the failed banknote system (kaime) and to pay the earlier loans. Less than 10 percent of the money was used for infrastructure investment, the railway construction in Rumelia. On the other hand, the Ottomans stipulated their tax revenues as collateral, which could put the fiscal situation at risk. The loans did not prove to be successful in the end. The budget deficit in 1875 was at a significant level. The Ottoman state had to pay 14 million lira for their loans while dealing with a revolt in the Balkans which necessitated more money for military expenses. After the Sultan’s approval, the Ottoman grand vizier consulted other high officials and issued a decree on October 6, 1875. In this decree, the Ottoman state announced that it could not settle the debt and declared a moratorium. They would pay half the payment in cash and issue another loan bond at a 5 percent interest with a five-year maturity. The collateral for the new loan would be salt, tobacco, cattle tax, and Egypt revenues. This decree caused unrest among the European creditors who held Ottoman bonds. The bondholders protested in masses and called for their countries to pressure the Ottomans. The Ottoman elite announced some interim measures and explanations, yet they could not calm the protests. The Ottoman state was determined to conduct a new decree, and they acted. However, the Ottoman state had to declare a complete default in 1876 when the war with Serbia erupted. After the fault in payments, creditors and their countries demanded that a commission should supervise the Ottoman treasury. Sultan Abdulhamid II ascended to the throne at that critical moment. Abdulhamid II stated that the debt relation was not between the states and could be solved by negotiations with the representatives of the investors. There was a dispute between the representatives of England and France, and thus the negotiation process took Mehmet Akif Berber

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longer. Meanwhile, the Ottoman–Russia war started in 1877. During the negotiations, creditors insisted on establishing a commission to oversee Ottoman fiscal situation and revenues. With the Berlin Treaty that finished the Russian war with a decisive Ottoman defeat, the Ottoman state guaranteed the creditors to redeem their debt. One of the treaty’s articles was to establish an international commission to oversee such debt. The commission would advise the Ottoman government on fiscal matters. This decision caused unrest among people in the Ottoman lands, especially the bankers of Galata, a group of people whom the Ottoman state often appealed to demand domestic loans. These bankers declared that this directly intervened in the state’s finances. Ottoman high officials instated a fiscal commission to check the revenues and balances of the state. The Commission aimed to inspect the treasury and prepare a budget to pay the foreign debt. It became clear that there was also significant internal borrowing from the Galata bankers and the Ottoman Bank. The domestic parties agreed and signed the plan. The total debt was reduced and was required to be paid in ten years in equal installments. The assigned security was composed of different tax revenues: duties of spirits, stamp, and marine products from Istanbul; silk tithe from Istanbul, Edirne, Samsun, and Bursa; salt and tobacco monopolies (Al 2009). The domestic creditors were to institute an administration to oversee these six revenues. The administration was to collect the revenues, deduce the yearly installment from it and pay the external debt with the residual. The contract could be annulled if the Ottoman state could find a better way to redeem the debt in less than ten years. European creditors did not like this idea, and Western media blamed the Ottomans for turning this situation into a national case. In the first year of operations, the administration proved successful, which changed the tide with the Europeans, who demanded the transfer of administration to their side. Western diplomats put pressure on the Ottoman government using other leverages, including invasion. Therefore, the Ottoman governing elite issued a note of payment to the creditors on October 23, 1880. According to this plan, the Ottoman state allocated the aforementioned six units of revenue along with some other revenues. A bank of the creditors’ choosing was to maintain the revenues. The bank would first Mehmet Akif Berber

pay internal debts and then foreign loans. A right to control of the Ottoman state was recognized. During the liaison which started on September 13, 1881, the European creditors demanded to establish an international commission to oversee the allocated revenues, and the Ottoman Porte rejected it. Later on, the creditors agreed to elect a council of representatives. The agreed-upon articles were then issued as a regulation by the Ottoman state known as the “Muharrem Decree” of December 20, 1881 (Tunçer 2015). This decree covered all the debts except 1854, 1855, 1871, and 1877 because they were considered Egypt’s tribute as collateral. The debt amounted to £T219.938.559 Ottoman lira (nominal value was approximately £191 million) and was reduced to £T125.250.943 (£97 million) and classified into four groups A, B, C, and D. The Ottoman government required the bondholders to change old bonds with new ones. An amount of £T945.894 debt was then reduced because bondholders did not exchange the old bonds. With exceptional debts mentioned above, total debt was equal to £T141.505.309 (£106 million) liras. Moreover, an international commission was established to proceed with the plan. The commission included representatives of English, French, German, Austrian, Italian, Dutch, and Ottoman bondholders (one for each nation). It was named Düyun-ı Umumiyye-i Osmaniyye—The Ottoman Public Debt Administration Council (OPDA). English and French representatives were authorized with the presidency of the council. With this development, the Ottoman state prevented direct Western intervention in both political and military aspects. The Ottoman state continued to apply for external loans after the default. The OPDA’s successful administration of collecting revenues and realizing payments increased the Ottoman Empire’s credibility in financial spheres and enabled them to lend in an advantageous position. Most of these loans were developmental credits and were redeemed regularly. During the First World War (1914–18), the Council stopped paying the citizens of enemy states. After the war and the collapse of the Ottoman Empire, the new republic of Turkey continued to pay the debt partially until it was covered in 1954. Mehmet Akif Berber

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References

Al, Hüseyin. “Debt and the Public Debt Administration”. In Encyclopedia of the Ottoman Empire, edited by Gábor Ágoston and Bruce Alan Masters, 180–183. New York: Facts On File, 2009. Clay, Christopher. Gold for the Sultan: Western Bankers and Ottoman Finance 1856–1881: A Contribution to Ottoman and to International Financial History. London: I.B. Tauris, 2000. Eldem, Edhem. A History of the Ottoman Bank. Istanbul: Ottoman Bank Historical Research Center, 1999. Faroqhi, Suraiya. “Crisis and Change, 1590–1699”. In An Economic and Social History of the Ottoman Empire 1300–1914, edited by Halil İnalcık with Donald Quataert, 412–636. Cambridge: Cambridge University Press, 1994. Genç, Mehmet. Osmanlı İmparatorluğunda Devlet ve Ekonomi. İstanbul: Ötüken Neşriyat, 2000. Küçük, Cevdet and Tevfik Ertüzün. “Düyûn-ı Umûmiyye”. In TDV İslâm Ansiklopedisi. İstanbul: TDV, 1994. Ortaylı, İlber. İmparatorluğun En Uzun Yüzyılı. İstanbul: Hil Yayın, 1987. Özcan, Abdulkadir. “Buçuktepe Vak’ası”. In TDV İslam Ansiklopedisi. İstanbul: TDV, 1992. Özvar, Erol. “Transformation of the Ottoman Empire into a Military-Fiscal State:

Reconsidering the Financing of War from a Global Perspective”. In The Battle for Central Europe: The Siege of Szigetvár and the Death of Süleyman the Magnificent and Nicholas Zrínyi (1566), edited by Pál Fodor, 21–64. Boston, MA: Brill, 2019. Pamuk, Şevket. A Monetary History of the Ottoman Empire. Cambridge: Cambridge University Press, 2000. Sahillioğlu, Halil. Studies on Ottoman Economic and Social History. Istanbul: Organisation of the Islamic Conference Research Centre for Islamic History, Art and Culture (IRCICA), 1999. Tabakoğlu, Ahmet. “Osmanlı Devletinin İç Hazinesi”. In Osmanlı Maliyesi: Kurumlar ve Bütçeler, edited by Mehmet Genç and Erol Özvar, 51–56. İstanbul: Ottoman Bank Historical Research Center, 2006. Tabakoğlu, Ahmet. Osmanlı Mâlî Tarihi. İstanbul: Dergah Yayınları, 2016. Tunçer, Ali Coşkun. Sovereign Debt and International Financial Control: The Middle East and the Balkans, 1870–1914. London: Palgrave Macmillan, 2015. White, Sam. The Climate of Rebellion in the Early Modern Ottoman Empire. New York: Cambridge University Press, 2011.

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33. Financial crises in Turkey Turkey has faced several financial crises since its foundation in 1923. Currency crises in 1946, 1958, and 1970, and a twin (currency and debt) crisis in 1977–80, are the best examples. However, the frequency of crises dramatically rose following the liberalization process implemented through the 1980s, as indicated by the crises of 1994, 1998–99, 2000–01, 2008–09, and 2018–20. Here, we aim to investigate the causes and consequences of the recent financial crises that occurred in the Turkish economy. Turkish authorities employed significant devaluations of up to 200 percent in 1946, 1958, and 1970 to increase external competitiveness, knowing that Turkey had serious debt problems due to unsustainable current deficits. The severe financial crisis in 1977–80 could be associated with both domestic and external problems such as the oil crises in 1973 and 1979, leading to an increase in current deficits and hence, in parallel, a rising debt stock; the embargo against Turkey following the embarkment to Cyprus in 1974, disrupting the growth process and causing high inflation rates; and increasing political instability, preventing the good conduct of economic policies (Ari and Cergibozan, 2014). Following this severe twin crisis, Turkish authorities adopted a radical structural reform program in 1980, primarily supported by the International Monetary Fund and the World Bank. Through the program, policymakers put into operation an outward-looking and free-market-based mode of regulation to settle macroeconomic imbalances by improving economic and financial efficiency and attracting foreign capital. This large structural reform program achieved an initial success (Rodrik, 1990) as the triple-digit inflation rates lowered to 40 percent on average, export revenues increased by an annual average rate of 10 percent, and the economy recorded relatively high growth rates of 5.5 percent on average in the period of 1981–89. Nevertheless, this early success was overwhelmed by the occurrence of severe financial crises in 1994, 1998–99, and 2000–01, leading to significant consequences in terms of high interest rates,

large reserves losses, currency depreciations, excessive output losses, and failure or nationalization of nearly thirty domestic banks. It seems that these crises occurred due to a combination of several factors. Continuous deterioration of macroeconomic fundamentals, a highly vulnerable banking sector, and an unstable and fractional political environment created all the ingredients of a crisis-prone economic structure (Akyuz and Boratav, 2003; Boratav and Yeldan, 2006; Ozatay and Sak, 2002). Current deficits were high (more than 4 percent of GDP) before the outbreak of Turkish financial crises in 1994, 1998–99, and 2000–01. Because of the high dependence of Turkish production on imported intermediate goods and raw materials, increasing economic growth generally leads to high current deficits. This structural problem worsened following the liberalization of capital movements in 1989. Because excessive short-term capital inflows due to high real interest rates result in overvaluation of the domestic currency which consequently lowers the competitiveness of exporting firms. In order to offset current deficits, the country needs more capital inflows that constantly increases the foreign debt stock. This naturally amplifies the country’s vulnerability to external shocks (Ari and Cergibozan, 2018). Moreover, except for some short-lived improvements in 1995 and 1998, the Turkish economy recorded an increasing trend of budget deficits during the 1990s, mainly due to substantial subsidies granted to exporting firms, an inefficient tax system, a large informal economy (which may reach up to 40 percent of GDP according to Us, 2004), off-budget expenditures of the central government, high fluctuations in the growth rate, and increasing interest payments on public debt. The deficits (on average 8 percent of GDP over the 1990s) led in parallel to an increase in public sector borrowing requirements (12 percent of GDP in 2001) and public debt stock (Ari, 2010). Furthermore, inflation rates followed an increasing trend from the 1980s (around 40 percent) to the 1990s (on average 65 percent). Large budget deficits, a high money supply, inflationary expectations of economic agents, and institutional factors such as the politically dependent Central Bank of Turkey (CBRT) are the main reasons for the chronic Turkish inflation from 1975 to 2004 (Yilmaz and Ari,

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2013). This unstable and uncertain economic framework consequently caused high real domestic interest rates, low private investments, and relatively modest growth rates. On the other hand, capital account liberalization, by facilitating banks’ borrowing in international capital markets, allowed for rapid growth in lending, but at the expense of constant increases in bank open positions and nonperforming loans (more than 25 percent of total loans in 2001). Moreover, poor supervision and regulation of the system, since the Banking Regulation and Supervision Agency (BRSA) was effectively established in May 2001, and close connections between bank conglomerates and political authorities contributed to excessive risk-taking behavior in the sector. Furthermore, the entry of new financial institutions and the large role of state-owned banks in the system amplified the weaknesses of the banking sector. Interventions of political authorities in the management of public banks and using banks’ assets to finance public deficits deteriorated their balance sheets, thus increasing their borrowing requirements. In addition, the full deposit insurance system implemented following the 1994 crisis to restore confidence in the banking system created moral hazard problems. This structure incited banks and their depositors to take on excessive risks to get higher profits (Ari, 2012). Although the financial crises of 1994, 1998–99, and 2000–01 occurred in a similar deteriorated economic and financial environment, the triggering factors were different. A sharp decrease in Turkey’s credit rating in early 1994 by Standard & Poor’s and Moody’s—related to increasing short-term advances from the CBRT to offset budget deficits that highly augmented money supply and inflationary expectations—played a triggering role in the occurrence of a currency crisis (Celasun, 1998; Ozatay, 2000). The currency crisis negatively affected the banking sector, largely exposing it to currency and liquidity risks. Hence, the Saving Deposit Insurance Fund (SDIF) took control over three small-scale banks. The crisis then spread to the real sector as economic growth plunged by more than 5 percent, inflation rates exceeded 100 percent, and external debt to GDP ratio nearly doubled from 30 percent to 55 percent. Turkish authorities were able to control the crisis only with the announcement

of a stand-by program with the IMF in April 1994. The program yielded a short-lived improvement in terms of inflation, budget balance, and economic growth during 1995–97. However, the generalized deficiency of investors toward emerging markets following the 1997–98 Asian and the 1998 Russian crises resulted in substantial capital outflows from Turkey. Note that the Russian crisis affected much more of the Turkish economy, since Russia was one of Turkey’s main importers. This worsened once more the country’s macroeconomic and financial fundamentals. Following the economic recession and financial instabilities, eight other banks were transferred to the SDIF from late 1998 to late 1999. Turkish authorities unveiled another IMF-supported program in January 2000 to rebuild economic stability and decrease chronic high inflation rates. This exchange-rate-based disinflation program created a positive atmosphere as capital inflows accelerated (US$15 billion in 2000), interest rates sharply decreased from 80 percent to 40 percent, and private consumption sharply increased with low-cost bank credits. However, sharp increases in private consumption mainly met by imports deteriorated the trade balance. Besides, the rise of short-term debt associated with the failure to achieve privatization goals increased the tensions in the Turkish money market. Hence, international investors became reluctant to renew their credits. Furthermore, the strong exposure of the banking system to currency mismatches and credit and default risks enhanced doubts on the program’s sustainability. Consequently, domestic interest rates sharply rose, leading to the failure of two small-scale banks in October 2000 and of Demirbank (the fifth biggest bank in the Turkish banking system) in December. The CBRT largely bailed out the illiquid banks to avoid a systemic banking crisis. However, economic agents were reassured on December 6th, with the IMF’s Supplemental Reserve Facility of US$7.5 billion. Nevertheless, the deterioration of the financial structure of the public banks and banks transferred to the SDIF and their massive requirements for short-term credits increased interest rates again in January 2001. This unstable and uncertain context led invesAli Ari

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tors to question the program’s sustainability, which collapsed in February 2001 following the public disclosure of a political disagreement between the Prime Minister and the President of the Republic. The crisis led to negative economic and social consequences: economic growth decreased by more than 5 percent, the unemployment rate increased to above 10 percent, the inflation rate rose to 70 percent, budget deficits and public sector borrowing requirements reached record levels (12 percent of GDP), domestic and foreign debt nearly doubled, banks recorded massive losses and more banks were transferred to the SDIF. Stabilization and restructuring efforts—that is, effective fiscal and monetary management, strengthened banking regulation and supervision, adoption of a floating exchange-rate regime, and an inflation-targeting strategy, implemented following the severe 2001 crisis in the framework of another IMF-backed program—restored some economic and financial stability. To be more precise, inflation decreased from 70 percent in 2001 to single digits in 2004, budget deficits fell from 12 percent of GDP in 2001 to 2 percent in 2016, which helped to reduce public debt from 80 percent of GDP in 2001 to 35 percent in 2016, and output constantly increased (around 5 percent on average), except for the 2008–09 crisis period. This performance is worth underlining since Turkey was able to reduce high chronic inflation rates and increase economic growth. This growth process was inclusive since income inequality, measured by the Gini coefficient, declined. Still, more importantly, poverty was reduced by more than half, access to high-quality health, education, and municipal services expanded, and income gaps between regions narrowed (OECD, 2014). On the other hand, the restructuring and recapitalization of the banking system after the 2000–01 crisis also explains why the Turkish financial system showed resilience to the 2008–09 global financial crisis. The strengthened regulatory framework accompanied by BRSA’s conservative banking practices and tight supervision prevented local banks from taking excessive risks like those taken in the US and the Eurozone (Ari, 2018). In addition, the effective monetary policy implemented by the CBRT during the global crisis played an important role in limiting the Ali Ari

negative impacts of the crisis (Kara, 2016). One should also note that the 2008–09 crisis adversely affected the real economy, as the country recorded a recession of nearly 5 percent of GDP and high unemployment rates of 14 percent in 2009. Despite this, Turkey had a quick recovery; in 2010 and 2011, the GDP growth rate exceeded the 9 percent level, owing to a strong policy framework and excessive capital inflows. Despite these achievements, Turkey could not resolve its main structural vulnerabilities over the last two decades. Excessive current deficits (6 percent of GDP on average from 2002 to 2021), high unemployment rates (on average superior to 10 percent from 2002 to 2021), a highly indebted private sector (gross foreign debt stock superior to US$350 billion in 2020), a growing savings-investment gap, and increasing inflation rates (inflation has reached double digits from 2018 onwards) remain sources of vulnerability for the Turkish economy. Recent domestic and international political uncertainty (e.g., the failed coup attack in July 2016, the change of political system in 2017, the war in Syria, the deteriorated relations with Turkey’s long-term Western allies, the Covid-19 pandemic, and the Russia-Ukraine war) do not help reduce economic problems. As mentioned above, Turkey has a long-term problem with current deficits, mainly related to its dependence on imported inputs and low-value-added production. As higher growth rates lead to higher current deficits, Turkey needs more capital inflows, which requires real domestic interest rates increases. When interest rates are not set high enough, the country faces challenges in attracting foreign capital (as over the last three years), which puts pressure on the domestic currency. The Turkish lira (TL) depreciation then increases the foreign debt burden for financial and nonfinancial corporations. On the other hand, as the external demand has been weak from European trade partners, particularly since 2011, the contribution of net exports to real growth has been close to zero. Hence, the country has relied on domestic demand fueled by externally financed bank loans to the private sector to increase economic growth. This policy shift has created three important consequences. First, the growth rate has barely reached 3 percent on average (from 2012 to 2021), which is far below the long-run growth trend of the

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Turkish economy (4.5 percent from 1923 to 2021). As a result, unemployment rates remain high. Second, the domestic demand-driven growth has resulted in inflationary pressures. Note also that constant domestic currency depreciation since 2018 (TL has depreciated more than 250 percent over the last three years) contributes to increases in inflation rates via exchange-rate pass-through. Third, the externally financed domestic demand has led to banking sector problems. Bank open positions (bank foreign-exchange assets can only cover 25 percent of foreign-exchange liabilities), liquidity risks, and nonperforming loans have all recently increased. To exit the financial crisis, Turkish authorities have employed expansionary fiscal policies, resulting in higher budget deficits approaching 5 percent of GDP. This is critical since the fiscal balance is considered to be the last anchor for the Turkish economy when other macroeconomic indicators have been deteriorating. This is a challenging issue for Turkish policymakers, particularly in a highly uncertain global environment due to Covid-19 combined with domestic political risks. Hence, Turkey has faced external financing problems that have led to a recent depletion of international reserves of the CBRT in 2020 (the CBRT’s net reserves fell below zero in 2020). This has naturally increased dollarization in the Turkish economy as the ratio of foreign-exchange deposits over total deposits has recently reached 55 percent. To conclude, Turkey needs to implement some structural reforms to decrease the frequency of financial crises. To that end, policy measures are necessary to limit dependence on imported inputs, increase private savings, and improve labor productivity. Recently, Turkish authorities have taken some measures in that order: voluntary pension accounts, introduced in 2003, have become mandatory in 2016 for employees working in both public and private sectors. Moreover, Turkish authorities have started to provide subsidies for private investments in renewable energy production in 2015 which could reduce the country’s over-dependence on imported energy sources and support sustainable economic growth under environmental considerations in the long run. On the other hand, further financial development would contribute to the diversity and efficiency of the financial system and even-

tually enhance macroeconomic and financial stability by lowering reliance on foreign borrowing (IMF, 2017). This is confirmed by some empirical papers whose results indicate a long-run positive relationship between financial development and economic growth in Turkey (Arac and Ozcan, 2014; Ari and Cergibozan, 2018). In this sense, stronger institutions, by providing better protection of property rights, creditor rights, and information, and higher regulatory quality and the rule of law, are necessary for greater financial development and, hence, higher economic growth (Sahay et al., 2015). Ali Ari

References

Akyuz, Y. & K. Boratav (2003). The making of the Turkish financial crisis. World Development, 31(9), 1549–1566. Arac, A. & S. K. Ozcan (2014). The causality between financial development and economic growth: The case of Turkey. Journal of Economic Cooperation and Development, 35, 171–198. Ari, A. (2010). Crises Financières Turques dans un Monde Globalisé: Développement d’un Système d’Indicateurs d’Alerte, Saarbrücken: Editions Universitaires Européennes. Ari, A. (2012). Early warning systems for currency crises: The Turkish case. Economic Systems, 36(3), 391–410. Ari, A. (2018). Financial openness, financial stability, and macroeconomic performance in emerging markets: A comparative perspective. In A. F. Aysan, H. Karahan, M. Babacan, & N. Gür (eds.), Turkish Economy between Middle Income Trap and High Income Status, London: Palgrave Macmillan, 151–169. Ari, A. & R. Cergibozan (2014). The recent history of financial crises in Turkey. Journal of European Theoretical and Applied Studies, 2(1), 31–46. Ari, A. & R. Cergibozan (2018). Sustainable growth in Turkey: The role of trade openness, financial development, and renewable energy use. In M. Yulek (ed.), Industrial Policy and Sustainable Growth, Dordrecht: Springer, 435–456. Boratav, K. & E. Yeldan. (2006). Turkey, 1980–2000: Financial liberalization, macroeconomic (in)stability, and patterns of distribution. In Taylor, L. (ed.), External Liberalization Asia, Post-Socialist Europe, and Brazil, Oxford: Oxford University Press, 417–455. Celasun, O. (1998). The 1994 currency crisis in Turkey. World Bank Policy Research Working Paper, 1913, Washington, DC.

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150  Elgar encyclopedia of financial crises IMF. (2017). IMF Country Report: Turkey. 17–35, Washington, DC. Kara, A. H. (2016). A brief assessment of Turkey’s macroprudential policy approach: 2011–2015. Central Bank Review, 16, 85–92. OECD. (2014). OECD economic surveys: Turkey. Paris. Ozatay, F. (2000). The 1994 currency crisis in Turkey.  The Journal of Policy Reform, 3(4), 327–352. Ozatay, F. and G. Sak (2002). Banking sector fragility and Turkey’s 2000–01 financial crisis. In S. M. Collins & D. Rodrik (eds.), Brookings Trade Forum 2002, Washington, DC: Brookings Institution Press, 121–160.

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Rodrik, D. (1990). Premature liberalization, incomplete stabilization: The Ozal decade in Turkey. NBER Working Paper, 3300, Cambridge, MA. Sahay, R. et al. (2015). Rethinking financial deepening: Stability and growth in emerging markets, IMF Staff Discussion Note, 15–08, Washington, DC. Us, V. (2004). Kayitdisi ekonomi tahmini yontem onerisi: Turkiye ornegi. Türkiye Ekonomi Kurumu Tartışma Metni, 2004/17, Ankara. Yilmaz, A. & A. Ari (2013). Gevsek parasal gostergeler ve enflasyon hedeflemesi stratejisi altinda enflasyonla mucadele: 2001–2011 Turkiye deneyimi. Marmara Iktisadi ve Idari Bilimler Dergisi, 34(1), 11–31.

34. Financial crises, their forms, interrelations between them, and crises’ origins The notion of a financial crisis is frequently used in academic and policy analyses and debates but rarely defined in terms of its exact meaning: which kind of events it refers to and their common characteristics. Here we define a financial crisis as a sudden decline in confidence in the ability of a government, central bank, and financial sector to pay back their liabilities on committed terms. Such a broad definition includes all types of monetary and financial systems instability. There are four primary forms of financial crisis: (i) banking/non-banking financial institutions’ crisis; (ii) public debt crisis; (iii) balance-of-payments crisis, including currency crisis as one of its sub-forms; and (iv) high inflation or hyperinflation. One can find in economic literature other, but not fundamentally different, classifications. For example, Claessens and Kose (2013) also distinguish four categories: (i) currency crises; (ii) sudden stops—that is, balance-of-payments crises; (iii) debt crisis; and (iv) banking crisis. In turn, Ishihara (2005) proposes seven types of financial crises: (i) liquidity-type banking crises; (ii) solvency-type banking crises; (iii) balance-of-payments crises; (iv) currency crises; (v) debt crises; (vi) growth rate crises; and (vii) financial crises. In my earlier publications (Dabrowski 2003, 2019), a narrower classification was presented (without high inflation and hyperinflation). Banking/non-banking financial institutions crisis refers to actual or potential bank runs or failures that induce commercial banks (or non-banking financial institutions) to suspend the internal convertibility of their liabilities, for example paying back deposits, interbank loans, or insurance premiums. A public debt crisis occurs when a government cannot service its foreign and domestic debt. A balance-of-payments crisis involves a structural imbalance between a deficit in the current account (absorption) and capital and financial accounts (sources of financing) that leads to a currency crisis after international reserves are exhausted. In turn, a currency crisis is defined as a sudden decline in confi-

dence in a given currency, usually leading to a speculative attack against it.1 Finally, high inflation or hyperinflation means the failure of a central bank to deliver on a price stability mandate, that is, guarantee a stable real value of its liabilities (currency in circulation and deposits held by a central bank). For analytical and policy purposes, conceptual definitions of the financial crisis and its forms require operationalization, that is, choosing macroeconomic and financial indicators and their numerical thresholds, which help diagnose the occurrence of the crisis episode. In the literature, there is no single operational definition of a financial crisis; authors prefer their criteria (Eichengreen, Rose, and Wyplosz 1994; Frankel and Rose 1996; Kaminsky, Lizondo, and Reinhart 1998; Ishihara 2005; Claessens and Kose 2013). In their historical overview of financial crises, Reinhart and Rogoff (2009, 4–14) choose two annual inflation rates (20 percent or higher and 40 percent or higher) as the thresholds identifying inflation-type of crisis and yearly depreciation of the domestic currency of 15 percent or more (against the US dollar or other relevant anchor currency) as the criterion of a currency crash. In the case of banking and public debt crises, they use outright default, an event-type definition. Balance-of-payments crises can be detected by either substantial depreciation of a domestic currency, a decline in a central bank’s international reserves, or both (Dabrowski 2003). Various sectors of a national economy and segments of a country’s financial system (government, central bank, banks, and non-banking financial institutions) remain in close interdependence. Therefore, specific forms of the financial crisis are interrelated and often happen simultaneously or with short time lags. As a result, one can observe twin, triple, and quadruple crises. The causality and sequence of events go in various directions. Let us give some examples: ● A banking crisis can lead to a public debt crisis due to the government’s financial support to banks and other financial institutions in distress, for instance in the form of their recapitalization or providing far-going guarantees to their liabilities. One example is Ireland’s “twin”

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crisis (starting from a banking crisis in 2008–2009 and evolving into a public debt crisis in 2010–2011). A banking crisis can also lead to a balance-of-payments crisis, currency crisis, and high inflation/hyperinflation due to massive liquidity support provided by a central bank, or a flight from domestic currency (currency substitution)— see Dabrowski (2019). The Bulgarian banking crisis of 1996–1997, which quickly evolved into a currency crash and hyperinflation, can serve as an example. Public debt crisis can lead to a balance-of-payments and currency crisis and high inflation/hyperinflation. Such effects can be caused by capital outflow and monetization of public debt by a central bank. The Russian financial crisis in August 1998 is an example of such a transmission mechanism. Public debt crisis can lead to the insolvency of banks and other financial institutions, which hold large amounts of defaulted government bonds (banking crisis). Such a spillover was observed, among others, during the Greek debt crisis of 2010–2015. Restructuring of Greek sovereign debt in 2012 also put in distress banks in neighboring Cyprus, which held large portfolios of Greece’s government bonds (Cheng 2020). A currency crisis increases a sovereign debt burden if part of government bonds is denominated in foreign currency. On the other hand, in the case of bonds denominated in domestic currency, lenders may require higher yields, which increases interest payments or even stop purchasing these bonds. Such effects have been observed in several emerging-market economies, which suffered from abrupt currency depreciation. The currency crisis also poses a severe challenge to banks and non-banking financial institutions if they hold open currency positions (that is, their liabilities in foreign currency exceed their foreign currency assets). However, even if banks follow prudential norms and avoid currency mismatches, they are exposed indirectly to the negative consequences of a large-scale domestic currency depreciation because their corporate and household borrowers remain primarily unhedged. There were plenty of cases

Marek Dabrowski

when the currency crisis led to a banking crisis in emerging-market economies, for example, in Latin America in the 1980s and 1990s or countries of the former Soviet Union in 1998–1999, 2008–2009, or 2014–2015. ● Capital outflow, one of the symptoms of a balance-of-payments crisis, can trigger a banking crisis. ● Higher inflation is also one of the consequences of currency crisis via a passthrough effect from international prices to domestic ones. The strength of this effect depends, among others, on the degree of the economy’s openness and structure of its imports: a higher share of consumer goods and services in total imports increases a passthrough coefficient, other things being equal. Banking crises result from either solvency, or liquidity problems, or both. Bank insolvency is caused by imprudent lending, leading to a large share of nonperforming loans. Such practices include, among others, excessive financing of real estate and stock market operations, accepting currency mismatches in own financial operations and those of borrowers, keeping too large portfolios of government bonds (in case of sovereign default risk), and connected and politically motivated lending. Credit boom and associated euphoria encourage imprudent lending by underestimating borrowers’ risk—see, e.g., Asriyan, Laeven, and Martin (2018). The fundamental roots of liquidity crises originate from a fractional-reserve banking system (Mishkin 2019) and maturity mismatches between bank assets (predominantly long-term) and liabilities (primarily short-term). Therefore, any confidence crisis in a bank’s ability to pay back its liabilities on demand (even if it is solvent) can lead to a massive withdrawal of deposits beyond the available bank’s liquid assets. Troubles of any single bank may lead to a market panic and run on the entire banking system in a given economy. Imprudent fiscal policy, expenditure exceeding revenue and excessive public sector borrowing, is a fundamental cause of a public (sovereign) debt crisis. However, it is difficult to determine the exact debt-level threshold of sovereign default risk. The mainstream economic literature has thoroughly analyzed the causes of

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balance-of-payments and currency crises. Historically, three generations of theoretical models have followed the respective rounds of currency crises (mostly in emerging-market economies) since the 1970s. The first-generation models were developed by Krugman (1979) and Flood and Garber (1984), among others, in response to a series of currency crises in Latin America in the 1970s and early 1980s and focused on the inconsistency between the exchange-rate peg and expansionary macroeconomic policies. In these models, the central bank accommodates changes in domestic money demand through purchases or sales of international reserves. Therefore, if domestic credit expansion (typically caused by monetization of a fiscal deficit) exceeds the money demand, international reserves will decline at the rate of credit expansion, ultimately leading to their depletion. Furthermore, once they understand that the collapse of an exchange-rate peg is unavoidable, economic agents will trigger speculative attacks to avoid losses or earn speculative gains. Thus, the moment of a currency crash can be hastened relative to the pace of reserves depletion under “normal” circumstances (mechanism of multiple equilibria). In the second-generation models (Obstfeld 1994, 1995; Drazen 1999) developed after speculative attacks against the Exchange Rate Mechanism in Europe (ERM1) in 1992 and the Mexican peso in 1994, the government can choose between defending an exchange-rate peg and abandoning it. The latter choice could be justified, for example, by the expected output/employment losses caused by the high interest rates required to stop speculative attacks on the currency. Economic agents are unsure which option will be chosen, which creates room for uncertainty and various market-game strategies. Therefore, the behavior of economic agents is determined not only by their perception of macroeconomic fundamentals (as in the first-generation models) but also by the expected reaction by the government. The experience of the Asian crises in 1997–98 led to a third-generation of models. They focus on the moral hazard driven over-borrowing by large but poorly regulated banks, other financial institutions, and non-financial corporations (see McKinnon and Pill 1996; Krugman 1999; Corsetti,

Pesenti, and Roubini 1998a, 1998b, 1998c). According to these models, the economic agent may expect a government rescue operation for a large bank or corporation with good political connections (or too big to fail for systemic reasons) when they face solvency problems. Therefore, part of the private sector over-borrowing can be understood as implicit government debt (a contingent fiscal liability), which the central bank will eventually monetize. Marek Dabrowski

Note

1. A historical phenomenon of currency debasement—that is, reduction of the precious metal content of coins—can be referred to as the category of currency crisis, leading inevitably to inflation (see Reinhart and Rogoff 2009, 6).

References

Asriyan, Vladimir, Luc Laeven, and Alberto Martin. 2018. “Credit booms and information depletion.” VoxEU. December 15. Accessed October 6, 2021. https://​voxeu​.org/​article/​credit​ -booms​-and​-information​-depletion. Cheng, Gong. 2020. The 2012 private sector involvement in Greece. ESM Discussion Paper Series, European Stability Mechanism. www​ .esm​.europa​.eu/​sites/​default/​files/​esmdp11​.pdf. Claessens, Stijn, and M. Ayhan Kose. 2013. Financial Crises: Explanations, Types, and Implications. IMF Working Paper, Washington, DC: The International Monetary Fund. Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini. 1998a. Paper Tigers? A Model of the Asian Crisis. NBER Working Paper, National Bureau of Economic Research. doi: 10.3386/ w6783. Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini. 1998b. What Caused the Asian Currency and Financial Crisis? Part I: A Macroeconomic Overview. NBER Working Paper, National Bureau of Economic Research. doi: 10.3386/w6833. Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini. 1998c. What Caused the Asian Currency and Financial Crisis? Part II: The Policy Debate. NBER Working Paper, National Bureau of Economic Research. doi: 10.3386/ w6834. Dabrowski, Marek. 2003. “Currency crises in emerging-market economies: An overview.” In Currency Crises in Emerging Markets by Marek Dabrowski, 1–28. Boston, MA: Kluwer Academic Publishers. Dabrowski, Marek. 2019. “Can emerging markets be a source of global troubles again?” Russian

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154  Elgar encyclopedia of financial crises Journal of Economics 5 (1): 67–87. https://​rujec​ .org/​article/​35506/​download/​pdf/​295039. Drazen, Allan. 1999. Political Contagion in Currency Crises. NBER Working Paper, National Bureau of Economic Research. doi: 10.3386/w7211. Eichengreen, Barry, Andrew K. Rose, and Charles Wyplosz. 1994. Speculative Attacks on Pegged Exchange Rates: An Empirical Exploration with Special Reference to the European Monetary System. NBER Working Paper, National Bureau of Economic Research. doi: 10.3386/w4898. Flood, Robert and Peter Garber. 1984. “Collapsing exchange-rate regimes: Some linear examples.” Journal of International Economics 17 (1–2): 1–13. Frankel, Jeffrey A. and Andrew K. Rose. 1996. Currency Crashes in Emerging Markets: Empirical Indicators. NBER Working Paper, National Bureau of Economic Research. doi: 10.3386/w5437. Ishihara, Yoichiro. 2005. Quantitative Analysis of Crisis: Crisis Identification and Causality. World Bank Policy Research Working Paper, Washington, DC: World Bank. Kaminsky, Graciela, Saul Lizondo, and Carmen M. Reinhart. 1998. “Leading Indicators of Currency Crises.” IMF Staff Papers 45 (1): 1–48. doi: 10.5089/9781451974515.024.

Marek Dabrowski

Krugman, Paul. 1979. “A model of balance of payments crises.” Journal of Money, Credit, and Banking 11 (3): 311–325. Krugman, Paul. 1999. “Balance sheets, the transfer problem, and financial crises.” International Tax and Public Finance 6 (4): 459–472. McKinnon, Ronald I. and Huw Pill. 1996. “Credible liberalizations and international capital flows: The ‘overborrowing syndrome’.” In Financial Deregulation and Integration in East Asia by Takatoshi Ito and Anne O Krueger, 7–42. Chicago, IL: University of Chicago Press. Mishkin, Frederic S. 2019. Economics of Money, Banking and Financial Markets, 12th Edition. New York: Pearson. Obstfeld, Maurice. 1994. The Logic of Currency Crises. NBER Working Papers, National Bureau of Economic Research. doi: 10.3386/ w4640. Obstfeld, Maurice. 1995. Models of Currency Crises with Self-Fulfilling Features. NBER Working Paper, National Bureau of Economic Research. doi: 10.3386/w5285. Reinhart, Carmen M. and Kenneth S. Rogoff. 2009. This Time Is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press.

35. Financial liberalization, the capital surge, and the 1994–1995 peso crisis Suppose the efficiency and productivity effects of market reforms cannot make up for the loss of growth potential during the 1980s. What about their impact on external capital inflows and the prospects for increasing the accumulation rate by these means? Would the shift in the market-state balance bring about a permanently higher flow of external savings, significantly greater than historical rates that would allow an increase in the accumulation rate? Such was the optimistic outlook of many observers who, in the early 1990s, believed that Mexico, a model reformer and successful emerging market, would turn into a Latin-American economic miracle. Recall that in August 1990, the Mexican government announced its plan to re-privatize the banking sector that had been expropriated during the López Portillo administration, thus deepening the financial liberalization reform. This announcement further boosted optimistic expectations, optimism that became rampant when the North American Free Trade Agreement (NAFTA) was signed in 1993. Market reforms, along with progress in NAFTA’s negotiations and favorable external developments, such as the fall in foreign interest rates, contributed in three main ways to a capital surge from 1990 to 1993. The first was the liberalization of domestic financial markets.1 The second was a drastic reduction in the country’s risk premium— an improved image of Mexico as a “good place to invest”—which resulted from the debt relief agreement, the fall in international interest rates, and the repayment of foreign debt financed by the significant privatization revenues of 1991–92. The third, which interacted with the reduction of country risk, was the real appreciation of the peso and the very high interest rates that prevailed in the initial stages of the disinflation program of late 1987. The size and composition of capital inflows, heavily biased toward short-term portfolio investments, had three consequences on the economy. First, the continuous appreciation

of the real exchange rate that was taking place during a radical trade liberalization produced a profit squeeze in the tradable goods sectors of the economy with negative consequences on investment (Ros, 2001). Second, because of the difficulties in intermediating massive capital inflows, an allocation of resources biased toward consumption rather than investment (Trigueros, 1998) reinforced a decline in the private savings rate. Third, an increasing financial fragility, which resulted from the concentration of the inflows in highly liquid assets and the excessive expansion of domestic credit for consumption purposes, accompanied a progressive deterioration of the banking system’s balance sheets (Trigueros, 1998). Financial fragility was also the result of the lack of experience of the new bankers that soon became evident. Indeed, the average rate of return in the banking sector fell from its average of 50 percent in 1987 to 12 percent in 1994, while the proportion of non-performing loans steadily increased. With banks progressively borrowing more in foreign capital markets to lend domestically, their vulnerability to exchange rate movements was exacerbated. These trends should have been a legitimate concern for economic policy. They were not. By 1993, the current account deficit reached 6–7 percent of GDP, and by early 1994, the capital surge was over. Thus, throughout 1994 the massive current account deficit was financed through the depletion of international reserves. Clearly, there was an incorrect diagnosis by the government of the causes of the macroeconomic disequilibria, as it was considered that the pressure on the reserves and dilemmas of policymakers were temporary and would be corrected without the need for a depreciation of the exchange rate. Thus, no significant depreciation of the exchange rate was implemented because it would rekindle inflation and give “alarming signs to the market”, augmenting capital flight and triggering a balance-of-payments crisis. In any case, such policy was steady but surely perceived as non-sustainable by investors in Mexico’s capital and money markets. During the year, the Bank of Mexico allowed increases in the interest rates on CETES and Tesobonos. It increased the guarantees on the rates of return on government paper denominated in foreign currency. Nevertheless, the foreign exchange reserves kept being

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depleted, ultimately forcing macroeconomic policy to be perceived as unsustainable. At the end of 1994, scarcely a year after NAFTA came into effect, the Mexican economy was in the midst of a financial crisis and on the brink of the worst recession since the great depression of the 1930s. Moreover, the country had been experiencing instability and political violence throughout 1994, starting with the armed revolt of the Zapatistas in January (the same day that NAFTA came into effect). The boom-and-bust cycle that culminated with the banking crisis of 1994–95 was a consequence, at least partly, of excessive reliance on financial deregulation and capital market liberalization (Clavijo and Boltvinik, 2000; Lustig, 2002; OECD, 2002). The result from that cycle was a bankrupt banking system whose bailout—through Fobaproa—added some 20 percentage points of GDP to the public debt and left those households and firms, primarily small and medium enterprises, with no access to foreign finance, virtually without access to bank credit. Indeed, the current balance sheet of commercial banks—now subsidiaries of foreign financial institutions—shows that loans that used to make up more than 80 percent of its assets now only represent less than 12 percent. Moreover, in recent years, the total annual amount of bank credits granted to private firms as a proportion of GDP oscillates around 15 percent, one of the lowest in Latin America. Paradoxically, this progressive and acute weakening of the banking system’s financial intermediation functions happens at the same time that the profits they generate are a significant proportion of the total profits of the foreign financial corporations that own them. Ironically, the banking sector returned to acute credit rationing, a characteristic of the era of financial repression that preceded the financial liberalization of the late 1980s. Moreover, this situation has become more worrying given the constraints that have been increasingly put by the macroeconomic reform process on development banks to grant credit to the private sector directly. The

lack of credit has become a major obstacle— especially for small and medium firms—that severely constrains their investment possibilities and thus increases their long-run growth. It has also reinforced the dual structure of the productive sector. In entry 83 of this Encyclopedia, we look at this and other causes of the poor growth performance of the economy in the post-reform period.2 Juan Carlos Moreno-Brid and Joaquín Sánchez Gómez

Notes

1. Ros (1994) studied the determinants of capital inflows and found that the opening of the bond market is the main determinant of the “change in asset preferences” during this period. 2. This entry is based on Moreno-Brid and Ros (2009). More details are found within the book.

References

Clavijo, F. and J. Boltvinik (2000), La reforma financiera, el crédito y el ahorro, in Clavijo, F. (ed.), Reformas Económicas en México 1982–1999. Lecturas del Trimestre Económico 92. Mexico City: CEPAL, Estrategia y Análisis Económico, Consultores, S. C., Fondo de Cultura Económica. Lustig, N. (2002), México. Hacia la reconstrucción de una economía. Mexico City: El Colegio de México y Fondo de Cultura Económica. Moreno-Brid, J.C. and Ros, J. (2009), Development and Growth in the Mexican Economy: A Historical Perspective, Oxford: Oxford University Press. OECD (2002), OECD Economic Surveys: Mexico. Paris: OECD. Ros, J. (1994), Foreign exchange and fiscal constraints on growth: a reconsideration of structuralist and macroeconomic approaches, in Dutt, A. (ed.), New Directions in Analytical Political Economy. Aldershot: Edward Elgar. Ros, J. (2001), Del auge de capitales a la crisis financiera y más allá: México en los noventa, in Ffrench-Davis, R. (ed.), Crisis Financieras en Países “Exitosos”. Mexico City: CEPAL-McGraw-Hill. Trigueros, I. (1998), Flujos de capital y desempeño de la inversion: México, in Ffrench-Davis, R. and Reisen, H. (eds.), Flujos de Capital e Inversión Productiva: Lecciones para América Latina, Mexico City: CEPAL-McGraw-Hill.

Juan Carlos Moreno-Brid and Joaquín Sánchez Gómez

36. Financial stability in the insurance sector: the case of the American International Group, AIG Introduction

Features of the AIG financial structure

The 2007–2008 global financial crisis (GFC) has cast doubt on the ability of liberalized financial markets to function stably over the long term and called into question the positive contribution of financial innovations to economic activity. Many and various factors have played a role in such an evolution (low interest rates, easy and available credit, loose regulation, and toxic mortgages leading to high-risk financial operations on innovative processes and products). In the aftermath of the GFC, attention was focused on the banking sector, as it was the most important source of instability in the financial market.1 During 2008–2012, the Federal Deposit Insurance Corporation (FDIC) closed 465 failed banks (Federal Deposit Insurance Corporation, 2021). The largest amount of the bailout (about USD $182 billion) was given from the US Federal government to the American International Group (AIG), one of the biggest insurance companies in the US insurance market. The insurance sector is usually considered as a less important player in the financial market (total assets held by European Union (EU) banks in 2019 were 49.3 trillion euros, and total assets of the EU insurance sector – 12.706 trillion euros) (European Central Bank, 2020; European Insurance and Occupational Pensions Authority, 2020) and strongly regulated. However, the case of AIG shows that the role of insurance companies in the generation and diffusion of instability is underestimated. We can also presume that the insurance sector remained under-regulated after the decade. The collapse of AIG was a combination of holes and breaches in the regulation mechanisms and a lack of appropriate law, which permitted the rise of some elements of fraud in the functioning of insurance markets.

The first issue that must be discussed is AIG’s organizational structure. Before the GFC, AIG was a complex, diversified, unitary thrift holding company (financial conglomerate) with different business lines (life and property-casualty traditional insurance, retirement, financial services, and asset management). Its common stock was listed on the New York, Ireland, and Tokyo Stock Exchange markets. In the risk-focused examination of the Office of Thrift Supervision2 in the USA in 2007, the soundness of the conglomerate was assessed in a highly positive way: “The company has strong capital and earnings, ample organic cash flow, and continued access to the capital markets. The company provides effective strategic, managerial, and capital support to all of its subsidiaries” (Office of Thrift Supervision, 2007). In 2007, AIG was the largest insurance company in the world as measured by stock market value. According to its financial report, in 2007, AIG had $1.061 trillion US dollars in assets, $6.20 billion US dollars net income, and 74 million customers worldwide. As an insurance company, AIG was regarded as a robust model of the supervisor risk-based capital requirements. The ranking agencies have affirmed the financial strength and credit rating of this company by rating AIG “Aaa” (Moody’s since 1986), and AAA (S&P since 1983). A special AIG Financial Product Corporation (AIGFP), a subsidiary of AIG Group, was created as a diversification strategy involving AIG in non-insurance activities (capital markets). AIGFP was focused on a variety of over-the-counter derivatives, structured finance transactions, and innovative financial products that usually involve operations on international forex exchange and commodity, energy, credit, and equity markets. The subsidiary issued credit default swaps (CDS) that were out of insurance supervision, without any initial collateral or other provision for loss, as they were treated as non-insurance activities. The rationale for the CDS was related to the investment-risk management of super-senior tranches of multisector Collateralized Debt Obligations (CDOs), backed by subprime mortgages. CDS had to guarantee debt obligations for its purchaser, who was not an “owner” of the “default”

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loan. Based on the issuer’s (AIG) high rating, CDS became an instrument for speculation with potential for losses and gains among financial institutions and other investors. In exchange for a stream of premium-like payments, AIGFP agreed to reimburse the investor in such a debt obligation in case of any default. This credit default swap protection made the CDOs much more attractive to potential investors because they appeared to be virtually risk-free, even though they could provoke huge exposures for the credit default swap issuers if significant losses did occur (The Financial Crisis Enquiry Commission, 2011: 132). Among the primary buyers of CDS protection was Goldman Sachs. In the middle of 2005, AIGFP continued to issue CDS protection on the subprime contracts and Alternative A-paper mortgage markets. The total share of these operations was about 80 percent of the entity’s business portfolio.

Problems rising and causes multiplying

However, problems arose in the middle of 2007. According to the CDS terms, the collateral calls could be triggered even if there were no actual cash losses in, for example, the super-senior tranches of CDOs upon which the protection had been written. Some owners of AIG’s CDS made the collateral call official by forwarding an invoice requesting billions of dollars. Requests were presented by Goldman Sachs ($1.8 billion US dollars), Société Générale ($40 billion US dollars), and UBS ($67 billion US dollars) (see Goldman Sachs, 2010). The AIGFP recorded an operating loss of $11 billion US dollars in 2007, primarily due to the unrealized market valuation losses related to the AIGFP CDS portfolio, written principally on the super-senior tranches of multisector CDOs (AIG Annual Report, 2007: 36). Many weaknesses allowed such a fragile evolution. Some of them are worthy of mentioning. First, there were the housing mortgage bubble and the unsustainable rise in housing prices that were partly consequences of irrational government policies, related to two phenomena: a strategy of generating a new growth sector (housing market) after the dotcom collapse in the early 2000s. The US Federal government encouraged minorLyubov Klapkiv and Faruk Ülgen

ities to take on mortgages to become the owners of their homes, and the banks to grant credit to minorities at much easier conditions. There was a lack of public will to stop risky subprime lending and securitization. Second, financialization under the wave of opening up and liberalization of financial markets led to a new phenomenon that we call “too big to be managed and supervised”. The structure of AIG as a financial holding company that included diversified activities should have required equal attention to each of its subsidiaries. The securities-lending subsidiaries had been purchasing mortgage-backed securities, using cash raised by lending securities that AIG held on behalf of its insurance subsidiaries. At the same time, the CDS that securities-lending subsidiaries issued as over-the-counter derivatives were outside the insurance regulator’s supervision and out of effective oversight of the Federal Reserve. Third, the AIG board management has been involved in the process of (cognitive dissonance related) ignorance, self-confidence, and intentional transgression. In 2007, the company’s $79 billion US dollar derivatives were exposed to CDSs, including $64 billion US dollars in subprime mortgages; therein, $19 billion US dollars was written on CDOs, predominantly backed by risky BBB-rated collateral (FCIC, 2011: 268). Top management continued to sell the CDS even after strong warnings and was unaware or did not care that the products contained collateral call provisions. The incentives to continue generating speculative, high rent-seeking operations were so attractive. However, this is not an irrational strategy but a common behavioral feature of market players. Referring to the market players’ leveraged lending practices, Charles Prince, the former chairman and chief executive officer of Citigroup Inc., said in July 2007 that as long as the music was playing, market players had to get up and dance. They were still dancing until the music stopped, when things would be complicated in terms of liquidity.3 Fourth, collateral asset values were overestimated because of high confidence that there would not be defaults on any of the bond payments that AIG’s swaps insured. According to the AIG primary internal models, the probability of default was about 99.85 percent.4 At the same time, AIG Financial Products relied on an actuarial model that did not provide a tool for monitoring the CDOs’ real market

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value. According to a Goldman Sachs private estimate, in 2007, the average decline in the market value of AIG’s bonds was about 15 percent (Goldman Sachs, 2010). It was a signal that, on the one hand, the price of AIG bonds was overestimated at the outset, which created an asset price bubble that drove the market to irrational demand. On the other hand, the subsequent market price corrections proved the failure of such a protection mechanism as it was designed. Fifth, at a more global level, the generalized lack of transparency of the balance sheets of major financial institutions and the high level of interconnections among different institutions have generated systemic risk and contagion in financial markets. The interlocking relationships between big financial institutions in the case of AIG may have had a dramatic spillover effect, as its risk exposures were concentrated among the 12 largest international banks (both American and European) across a wide array of product types (bank lines, derivatives, securities lending, etc.) in the amount of $1 trillion US dollars (FCIC, 2011: 347). This could spill over to the banking system, causing an increase in EU banks’ (counterparties’) capital requirements with a negative indirect influence on the European banking system. The main channels of the connections between AIG and the financial units (commercial banks, investment banks, and other financial institutions) were counterparty credit relationships on CDS, and other activities such as securities lending. As AIG was considered an institution that is “too big to fail”, it cost the government about $180 US billion to rescue (FCIC, 2011: 352). However, these features did not receive enough attention from the regulator before the rise of systemic difficulties. Sixth, one might suspect generalized ignorance and fraud from rating agencies about the appropriateness of their ratings of CDS and mortgage-backed securities. Therefore, it is not surprising that when difficulties arose in markets, the rating of AIG’s debts was sharply downgraded. These factors reflect the lack of fair business relations and transparent communication in financial markets, breaking the trust and calling into question the organization’s consistency and management of market activities about the social utility of those institutions

and their ability to contribute to systemic stability.

Regulatory weaknesses still holding

The case of AIG has pointed not just to the greedy speculation behavior that prevailed among institutions’ strategies but also to the negative results of the irrational public policy concerning the regulatory framework of holding companies’ monitoring and control. This question is not only posed for the period before the GFC but also in the aftermath of the turmoil. In the wake of the GFC, the US Treasury spent about $182 billion US dollars to bail out AIG, while the latter paid out about $165 million US dollars for executives’ bonuses (Amadeo, 2020). The so-called market incentives were irrational and perverse. Another crucial issue is legislation, since government intervention was defined as “unconstitutional” and “illegal”. In return for an $85 billion US dollar loan from the Federal Reserve Bank of New York,5 the government took about 79.9 percent of AIG’s shares (Stempel, 2017). The government also appointed 2 of its 13 directors. The avoidance of bankruptcy using taxpayers’ money was a cornerstone of this deal, but there were two main reasons for this government decision: ● it could no longer condition financial assistance on the willingness of AIG’s creditors to accept discounts or other losses in underperforming or closing out their contracts with AIG; ● as AIG was an international company that collected one-third of its revenue from East Asia, the government had some complications with reorganizing the business processes at the international level. Besides, the long-term character of AIG’s life insurance contracts made the instant arrangement almost impossible (Congressional Oversight Panel, 2010). All participants of the rescue process understood the threat that AIG posed to the economy and that the bankruptcy raised financial market fragility, higher borrowing costs, lower levels of household wealth, and substantially poorer economic performance (Congressional Oversight Panel, 2010: 106). As one of the biggest players in the insurance Lyubov Klapkiv and Faruk Ülgen

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(and financial) market, the bankruptcy of this company may cause systemic risk within financial markets in the US and the rest of the world. The systemic risk between AIG and other participants of the financial market could be transmitted by the: ● high number of sold CDSs on CDOs; ● AIG’s commercial paper to money market mutual funds; ● default of the life, health, and property-casual insurance coverage due to policies signed under declining credit and insurance ratings; ● loss of investors’ confidence and trust in the financial market in general. The AIG case generates a few issues that should be institutionally dealt with to prevent similar situations in the future: (1) There is always a conflict between public interest and private interest. The scope of the public interests must limit private interests to ensure systemic stability beyond the micro perspectives. Stability of the financial sector is a public good that the law must protect. (2) Accountability and transparency are crucial elements within the market economy. (3) Each participant in the financial market must be responsible for the losses (such as private entities – rating agencies, companies, and public supervisors). (4) Public financial support (“rescue”) has to have clear criteria and legal background to prevent moral hazard among private entities. AIG creditors didn’t share the financial responsibility that reinforced moral hazard among the rest of the market players. There were better alternatives, such as a private–public hybrid solution, but the government decided to use a public bailout. The AIG bailout was questioned in 2012 when AIG shareholders (Maurice “Hank” Greenberg) launched a trial against the US government. The question was about the borders of government intervention into private business. The claim included two aspects: the first one was about the excessive amount of money that AIG was forced to pay to its counterparties under the pressure of FRBNY and gave a profit for FRBNY in Lyubov Klapkiv and Faruk Ülgen

the shape of a two-thirds share of the residual recommendations from AIG’s CDS contract and mortgage-backed securities. The second charge deals with the stock split (20:1 reverse stock split of common shares) that served as an end-run around the common shareholders’ vote by freeing up common shares that could be issued to the Trust (Starr International, 2012). AIG shareholders lost the case, but it created a critical view on the “socially beneficial bailouts” since the government’s role as a bailout monopolist gives it leverage over recipients, which lends itself to abuse (Casey and Posner, 2015: 6). Our point is that financial regulation has no clear legal framework for pessimistic scenarios. Lyubov Klapkiv and Faruk Ülgen

Notes 1.

A pivotal role in the diffusion of the crisis was attributed to American International Group (AIG), Bear Stearns, Citigroup, Countrywide Financial, Fannie Mae, Goldman Sachs, Lehman Brothers, Merrill Lynch, Moody’s, and Wachovia. 2. The AIG Holding was not regulated by the common insurance regulator but by the Office of Thrift Supervision (OTS). OTS supervised holding companies as well as thrift institutions. This led OTS to provide consolidated supervision for such well-known firms as General Electric (GE), AIG Inc., Ameriprise Financial, American Express, Morgan Stanley, and Merrill Lynch. 3. See Sanati (2010) and FCIC (2011). 4. The model was constructed by Gary Gordon (FCIC, 2010: 18). 5. 43.8 billion US dollars through Maiden Lanes II and III, and 49.1 billion US dollars in investments from the Treasury.

References

Amadeo, K. (2020), “AIG bailout, cost, timeline, bonuses, causes, effects. Why it made Bernanke angrier than anything else in the recession”, www​.thebalance​.com/​aig​-bailout​-cost​-timeline​ -bonuses​-causes​-effects​-3305693. American International Group (2007), Annual Report 2007. www​.aig​.com/​content/​dam/​ aig/​america​-canada/​us/​documents/​investor​ -relations/​2007​-annual​-report​.pdf. Casey, A. and Posner, E. (2015), A Framework for Bailout Regulation, University of Chicago Coase-Sandor Institute for Law & Economics, Research Paper no. 724, http://​dx​.doi​.org/​10​ .2139/​ssrn​.2564259. Congressional Oversight Panel (2010), The AIG rescue, its impact on markets and the government’s exit strategy, US Government Printing Office.

Financial stability in the insurance sector  161 European Central Bank, Consolidate Banking Starr International co., individually and derivData, 2020, https://​sdw​.ecb​.europa​.eu/​ atively on behalf of American International browseExplanation​.do​?node​=​9689685. Group, inc., plaintiff, v. Federal Reserve Bank European Insurance and Occupational Pensions of New York, defendant, American International Authority, Balance sheet, 2020, www​ .eiopa​ Group, inc., Nominal defendant. (S.D.N.Y. .europa​.eu/​tools​-and​-data/​insurance​-statistics​_en. Nov. 19, 2012). Supreme Court, No. 13–316, Federal Deposit Insurance Corporation, Failed https://​casetext​.com/​case/​starr​-intl​-co​-v​-fed​ Bank List, 2021, www​.fdic​.gov/​resources/​ -reserve​-bank​-of​-ny​-3. resolutions/​bank​-failures/​failed​-bank​-list. Stempel, J. (2017), “Court denied shareholder Goldman Sachs (2010), Valuation & Pricing claim against AIG bailout case led by Starr’s Related to Initial Collateral Calls on Greenberg”, Insurance Journal, www​ Transactions with AIG, www​.goldmansachs​ .insurancejournal​.com/​news/​national/​2017/​05/​ .com/​media​-relations/​in​-the​-news/​archive/​ 09/​450396​.htm. response​-to​-fcic​-folder/​valuation​.pdf. The Financial Crisis Inquiry Commission (FCIC) Office of Thrift Supervision (2007), Holding (2010), Interview of Gary Gordon, https://​ company report of examination, https://​ fcic​-static​.law​.stanford​.edu/​NARA​.FCIC​ fcic​-static​.law​.stanford​.edu/​cdn​_media/​fcic​ .2016–03–11/​SCREENED​%20Interviews/​ -docs/​2007–06–11​%20OTS​%20Holding​ 2010–05–11​%20Transcript​%20of​%20Gary​ %20Company​%20Report​%20Of​ %20Gorton​%20Interview​%20by​%20D​ %20Examination​%20of​%20AIG​.pdf. %20Noonan​_1​.pdf. Sanati, C. (2010), “Prince finally explains his The Financial Crisis Inquiry Commission (FCIC) dancing comment”, The New York Times, April (2011), The Financial Crisis Inquiry Report, 8, https://​dealbook​.nytimes​.com/​2010/​04/​08/​ January 2011, www​.govinfo​.gov/​content/​pkg/​ prince​-finally​-explains​-his​-dancing​-comment. GPO​-FCIC/​pdf/​GPO​-FCIC​.pdf.

Lyubov Klapkiv and Faruk Ülgen

37. Firms’ ways to deal with financial crises A financial crisis can result in a corporate crisis, defined as “a short-term, undesired, unfavourable and critical state in a company which has derived from both internal and external causes and which directly endangers the further existence and growth of the company” (Dubrovski 2007: 333). To survive such situations or even benefit from them, firms can use different ways of dealing with financial crises. This entry provides an overview of what firms could do to achieve this both in the case of having and not having financial difficulties. If firms encounter financial difficulties during a crisis, they can temporarily or permanently reduce costs (Vissak 2013). To achieve this, firms can reduce their number of employees (Amankwah-Amoah et al. 2021). Moreover, they can consider adjusting working hours and using more part-time employees (Purnomo et al. 2021), and reducing salaries (Fath et al. 2021) or other – for instance, rental (Vissak 2013) – costs (Calabrò et al. 2021). In addition, they can postpone their investments until the end of the crisis (Vissak 2022b). Moreover, firms with financial difficulties can apply for governmental support (Acciarini et al. 2021; Fath et al. 2021; Vissak 2022a), get a loan (González and Pérez-Uribe 2021), or involve venture capitalists (Gunasekaran et al. 2011). If firms do not have financial difficulties – for instance, if they have accumulated slack resources or were not affected considerably during the crisis – they do not necessarily have to reduce costs. Instead, they could consider innovating and investing substantially in research and development activities (Lee et al. 2009; Schoemaker et al. 2018). Such investments could be necessary for developing new products or services (Vissak 2022b), improving existing products’ quality (Kottika et al. 2020), or otherwise adjusting existing products or services (Baber and Ojala 2021; Heinonen and Strandvik 2020; Rapaccini et al. 2020). In turn, this can help firms emphasize their products’ or services’ uniqueness (Kottika et al. 2020) and enter more profitable customer segments (Sarkar and Clegg 2021) and, through that, reduce the pressure on prices.

Increasing efficiency and productivity can also help firms survive crises, but this can be costly if they have to invest in new production equipment (Anakpo and Mishi 2021; Jaklič and Burger 2020) to improve labor productivity or asset utilization (Pettit et al. 2010). On the other hand, sometimes, discontinuing less efficient activities can also enhance firms’ overall efficiency (Vissak 2022a). Moreover, in some cases, shortening the supply chain can help them achieve this goal (Acciarini et al. 2021). To deal successfully with financial crises, firms should also develop new and strengthen their existing network relationships (Fath et al. 2021; Purnomo et al. 2021; Wang et al. 2005). For instance, additional or backup partners would be necessary when current partners have problems (Acciarini et al. 2021). These new partners can be located in the home country or abroad. Firms should also be open to new or additional export opportunities: they could find additional foreign customers in their existing export markets or enter new foreign countries (Kottika et al. 2020; Vissak 2022a). To retain some of their turnover and keep existing or new customers, some firms can also start offering considerable discounts; however, this can be risky as it might become difficult to increase prices after the crisis (Vissak 2022a). Sometimes, less costly measures are sufficient, like active communication and information-sharing with partners (Pettit et al. 2010). Investing in digitalization can be useful for firms (Jaklič and Burger 2020). Firms can use various digital solutions to analyze their activities (Rapaccini et al. 2020) and communicate with customers and other business partners (Anakpo and Mishi 2021). Moreover, some online channels help advertise the firm’s products (Vissak 2022b) and sell them to local and foreign customers (Sarkar and Clegg 2021). In addition, the Covid-19 pandemic demonstrated the usefulness of digital solutions for successful remote working (Fath et al. 2021). Still, managers should keep in mind that to achieve successful digitalization, it is not enough to buy new technology or acquire apps: it is also important to develop employees’ digital (Acciarini et al. 2021) and other – for instance, communication – skills (Pettit et al. 2010). Managers should also understand that it is not always enough to start making changes during crises: they should prepare for them

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during more favorable periods. Thus, for instance, they should begin accumulating slack resources as this helps them cover losses during the next crisis (Yeganeh 2021). In addition to financial reserves (Marconatto et al. 2022), they might need reserve production capacity (Pettit et al. 2010) and stock materials (Rapaccini et al. 2020) during the following crises. Finally, firms should learn from their own mistakes and from more successful firms (Vissak 2022a) and increase their psychological readiness for future crises. For instance, they should try to predict future crises (Pettit et al. 2010) and discuss their firm’s potential responses to them (Acciarini et al. 2021), detect their firm’s potential weaknesses (Ma et al. 2018), and, if necessary, consider changing their business focus more toward services (Rapaccini et al. 2020). They should also keep in mind that there is no “best for all” strategy to survive financial crises as all firms are unique: thus, some firms can succeed although they did not do anything to deal with the crisis, while some can fail despite considerable efforts (Vissak 2022b). Still, financial crises do not always affect all firms negatively. An overview of some potential positive impacts on exporters’ activities is provided in entry 101 in this Encyclopedia, while several potential business opportunities emerging during financial crises are listed in entry 25. Entry 4 discusses the nature of financial crises and explains why it is not easy to select the best strategy for dealing with crises. Tiia Vissak

Anakpo, Godfred, and Syden Mishi. “Business Response to COVID-19 Impact: Effectiveness Analysis in South Africa.” Southern African Journal of Entrepreneurship and Small Business Management 13, no. 1 (2021): 1–7. https://​doi​.org/​10​.4102/​sajesbm​.v13i1​.397. Baber, William B., and Arto Ojala. “Change of International Business Models during Covid-19.” In Covid-19 and International Business: Change of Era, edited by Marin A. Marinov and Svetla T. Marinova, 100–109. New York: Routledge, 2021. https://​doi​.org/​10​ .4324/​9781003108924. Calabrò, Andrea, Hermann Frank, Alessandro Minichilli, and Julia Suess-Reyes. “Business Families in Times of Crises: The Backbone of Family Firm Resilience and Continuity.” Journal of Family Business Strategy 12, no. 2 (2021): 100442. https://​doi​.org/​10​.1016/​j​.jfbs​ .2021​.100442. Dubrovski, Drago. “Management Mistakes as Causes of Corporate Crises: Countries in Transition.” Managing Global Transitions 5, no. 4 (2007): 333–54. Fath, Benjamin, Antje Fiedler, Noemi Sinkovics, Rudolf R. Sinkovics, and Bridgette Sullivan-Taylor. “International Relationships and Resilience of New Zealand SME Exporters during COVID-19.” Critical Perspectives on International Business 17, no. 2 (2021): 359–79. https://​doi​.org/​10​.1108/​cpoib​-05–2020–0061. González, Ana Cristina, and Miguel Ángel Pérez-Uribe. “Family Business Resilience under the COVID-19: A Comparative Study in the Furniture Industry in the United States of America and Colombia.” Estudios Gerenciales 37 no. 158 (2021): 138–52. https://​doi​.org/​10​ .18046/​j​.estger​.2021​.158​.4423. Gunasekaran, Angappa, Bharatendra K. Rai, and Michael Griffin. “Resilience and Competitiveness of Small and Medium Size Enterprises: An Empirical Research.” International Journal of Production Research 49, no. 18 (2011): 5489–509. https://​doi​.org/​10​ Acknowledgment .1080/​00207543​.2011​.563831 This work was supported by the Estonian Heinonen, Kristina, and Tore Strandvik. Research Council’s grant PRG 1418. “Reframing Service Innovation: COVID-19 as a Catalyst for Imposed Service Innovation.” Journal of Service Management 32, no. 1 References (2020): 101–12. https://​doi​.org/​10​.1108/​JOSM​ Acciarini, Chiara, Paolo Boccardelli, and Mario -05–2020–0161. Vitale. “Resilient Companies in the Time of Jaklič, Andreja, and Anže Burger. “Complex Covid-19 Pandemic: A Case Study Approach.” Internationalisation Strategies during Crises: Journal of Entrepreneurship and Public Policy The Case of Slovenian Exporters During the 10, no. 3 (2021): 336–51. https://​ doi​ .org/​ 10​ Great Recession and Covid-19 Pandemic.” .1108/​JEPP​-03–2021–0021. Teorija in Praksa 57, no. 4 (2020): 1018–41. Amankwah-Amoah, Joseph, Zaheer Khan, and Kottika, Efthymia, Ayşegül Özsomer, Pernille Ellis L.C. Osabutey. “COVID-19 and Business Rydén, Ioannis G. Theodorakis, Kostas Renewal: Lessons and Insights from the Global Kaminakis, Konstantinos G. Kottikas, and Airline Industry.” International Business Vlasis Stathakopoulos. “We Survived This! Review 30, no. 3 (2021): 101802. https://​doi​ What Managers Could Learn from SMEs Who .org/​10​.1016/​j​.ibusrev​.2021​.101802.

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164  Elgar encyclopedia of financial crises Successfully Navigated the Greek Economic Crisis.” Industrial Marketing Management 88 (July 2020): 352–65. https://​doi​.org/​10​.1016/​j​ .indmarman​.2020​.05​.021. Lee, Seung-Hyun, Paul W. Beamish, Ho-Uk Lee, and Jong-Hun Park. “Strategic Choice during Economic Crisis: Domestic Market Position, Organizational Capabilities and Export Flexibility.” Journal of World Business 44, no. 1 (2009): 1–15. https://​doi​.org/​10​.1016/​j​.jwb​ .2008​.03​.015. Ma, Zhenzhong, Lei Xiao, and Jielin Yin. “Toward a Dynamic Model of Organizational Resilience.” Nankai Business Review International 9, no. 3 (2018): 246–63. https://​doi​.org/​10​.1108/​NBRI​ -07–2017–0041. Marconatto, Diego Antonio Bittencourt, Emidio Gressler Teixeira, Gaspar Antônio Peixoto, Kadigia Faccin. “Weathering the Storm: What Successful SMEs Are Doing to Beat the Pandemic.” Management Decision 60 no. 5 (2022): 1369–86. https://​doi​.org/​10​.1108/​MD​ -11–2020–1507. Pettit, Timothy J., Jospeh Fiksel, and Keely L. Croxton. “Ensuring Supply Chain Resilience: Development of a Conceptual Framework.” Journal of Business Logistics 31, no. 1 (2010): 1–21. https://​doi​.org/​10​.1002/​j​.2158–1592​ .2010​.tb00125​.x. Purnomo, Boyke Rudy, Rocky Adiguna, Widodo Widodo, Hempri Suyatna, and Bangun Prajanto Nusantoro. “Entrepreneurial Resilience during the Covid-19 Pandemic: Navigating Survival, Continuity and Growth.” Journal of Entrepreneurship in Emerging Economies 13, no. 4 (2021): 497–524. https://​doi​.org/​10​.1108/​ JEEE​-07–2020–0270. Rapaccini, Mario, Nicola Saccani, Christian Kowalkowski, Marco Paiola, and Federico Adrodegari. “Navigating Disruptive Crises through Service-Led Growth: The Impact of COVID-19 on Italian Manufacturing Firms.” Industrial Marketing Management 88 (July 2020): 225–37. https://​doi​.org/​10​.1016/​j​ .indmarman​.2020​.05​.017. Sarkar, Soumodip, and Stewart R. Clegg. “Resilience in a Time of Contagion: Lessons

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from Small Businesses during the COVID-19 Pandemic.” Journal of Change Management 21, no. 2 (2021): 242–67. doi: https://​doi​.org/​10​ .1080/​14697017​.2021​.1917495. Schoemaker, Paul J.H., Sohvi Heaton, and David Teece. “Innovation, Dynamic Capabilities, and Leadership.” California Management Review 61, no. 1 (2018): 15–42. https://​ doi​ .org/​ 10​ .1177/​0008125618790246. Vissak, Tiia. “Impact of the Global Crisis on the Internationalization of Estonian Firms: A Case Study.” In Emerging Economies and Firms in the Global Crisis, edited by Marin A. Marinov, and Svetla T. Marinova, 292–313. New York: Palgrave Macmillan, 2013. Vissak, Tiia. “Serial Nonlinear Internationalization before and during the Covid-19 Pandemic: Case Study Evidence from Estonia.” In International Business in Times of Crisis. Tribute Volume to Geoffrey Jones, Progress in International Business Research 16, edited by Rob van Tulder, Alain Verbeke, Lucia Piscitello, and Jonas Puck, 273–88. Bingley: Emerald, 2022a. https://​ doi​.org/​10​.1108/​S174​5–88622022​0000016014. Vissak, Tiia. “The Impacts of Covid-19 on Estonian Firms’ Internationalization: Foreign Market Entries, Exits and Re-entries.” In Foreign Exits, Relocation and Re-Entry: Theoretical Perspectives and Empirical Evidence, edited by Jorma Larimo, Pratik Arte, Carlos M.P. Sousa, Pervez N. Ghauri, and José Mata, 36–56. Cheltenham: Edward Elgar, 2022b. https://​doi​ .org/​10​.4337/​9781800887145​.00009. Wang, Hui-mei, Hengchiang Huang, and Pratima Bansal. “What Determined Success during the Asian Economic Crisis? The Importance of Experiential Knowledge and Group Affiliation.” Asia Pacific Journal of Management 22 (March 2005): 89–106. https://​doi​.org/​10​.1007/​ s10490–005–6419–3. Yeganeh, Hamid. “Emerging Social and Business Trends Associated with the Covid-19 Pandemic.” Critical Perspectives on International Business doi​ .org/​ 10​ 17 no. 2 (2021): 188–209. https://​ .1108/​cpoib​-05–2020–0066.

38. Fiscal policy and financial instability Introduction

Macroeconomic stabilization policies, particularly fiscal and monetary tools, are often deployed to deal with economy-wide financial instability. Fiscal policy can contribute to financial stability by increasing government expenditures or reducing tax revenues to stabilize output, incomes, and demand during an economic downturn. Fiscal stabilization can result from discretionary policy-making, where governments actively decide to increase spending or lower taxes. In contrast, government revenues and expenditures will also change independent of any discretionary action – via the automatic fiscal stabilizers. Automatic fiscal stabilizers are the reaction of the budget to economic fluctuations in the absence of government action. These result from structural features of taxation and social transfers within tax codes and social legislation. If economic activity weakens, taxation revenue will automatically decline (as the community’s income falls). At the same time, government spending would increase (as more people are eligible for unemployment benefits and other welfare support). This automatic fiscal stimulus, associated with the budget moving into deficit (or the surplus falling), cushions the slowdown in economic activity. Automatic stabilizers cause the budgetary balance to move so that it acts counter-cyclically. Usually, the larger the public sector, the more significant the automatic stabilizers, and the more effectively the economy is shielded from economic fluctuations. Recently, doubts have been raised about the effectiveness of discretionary fiscal fine-tuning to achieve cyclical smoothing. Surpluses did not match budget deficits in downturns in booms leading to a continuous build-up of public debt ratios. It proved politically easier to use expansionary rather than contractionary policies – it was always more popular to cut taxes than to raise them – so there was a bias for continuing deficits. With long implementation lags, policymakers’ discretionary reaction proved inflexible so that when policies finally had an effect, the economic circumstances often changed. Fiscal

policy then could become a pro-cyclical measure, exacerbating instability, rather than a stabilizing element. By contrast, automatic stabilizers were judged to operate symmetrically over the cycle. These automatic stabilizers were directly linked to the economy’s structure and could respond quickly and transparently. A view emerged that only automatic stabilizers are generally required to stabilize economies, and there was no need to engage in additional discretionary fiscal policy-making for stabilization purposes. The virulence and depth of financial crises over the last two decades have fundamentally challenged that view.

The demise of discretionary stabilization policy

The view that discretionary fiscal policy was an effective tool for cyclical stabilization collapsed in the second half of the 1970s in an era of declining economic performance and rapid accumulation of public debts. A range of factors led to the abandonment of discretionary stabilizers. Theoretical and empirical developments in the economics profession played a role. Post-war studies of the United States seemed to show that, at best fiscal policy was only weakly stabilizing. New theoretical concepts such as ‘Ricardian equivalence’ were used to show that deficit spending was ineffective for stimulating output. Consumers anticipated future tax increases to pay the ensuing public debt and reduce consumption accordingly. In turn, contractionary fiscal policy may be expansionary due to effects on financial markets and saving behavior. If expectations of the future were ‘rational’, the economic actors would anticipate policy effects and take action now that might well nullify the intentions of fiscal policy – the policy ineffectiveness proposition. Reinforcing these theoretical debates were disappointing stabilization experiences. Stabilization policy, it was argued, could be the source of economic instability. Economists increasingly turned to a new sub-discipline of the profession – the economics of politics – to explain these developments (Drazen 2000; Buti et al. 2002; Burger 2003; Pitt et al. 2004). It studies political incentives and institutions and how conflicting interests are aggregated into public policy. There may be political cycles in policy instruments,

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such as soft fiscal policy before elections, and the nature of political institutions influences fiscal performance. For example, multiparty coalition governments may be poor at reducing budget deficits, especially those with short-expected tenure. In these circumstances, institutional restrictions on government, such as rules-based fiscal policy, may be required. Binding fiscal rules are needed to counter political bias and spend-thrift politicians. These rules limit and discipline vested interests. This would minimize the role of discretionary economic management. We saw a significant retreat from discretionary policy for short-run stabilization purposes in policy circles. In the 1980s and 1990s, balanced budget propositions and stability pacts were aimed at restricting policymakers’ discretion.

Fiscal illusion?

Attempts to restore fiscal sustainability have not always worked well in practice. William Easterly (1999) provides convincing evidence showing that attempts by governments to reduce the fiscal deficit or public debt may be illusory. Responses to the pressures for fiscal austerity include budget gimmickry, such as the sale of public assets. There are short-sighted cuts in public health measures in the name of fiscal austerity. Another popular and short-sighted approach is to cut public investment. A further area cut is to reduce operations and maintenance spending, allowing these assets to deteriorate hurts future government revenue and defers more lavish infrastructure spending to the future. It also tends to redirect spending to projects that disburse slowly, whatever the long-run costs of the project or delays addressing problems such as financial crises in banks, adding to the cost of the eventual payout by the government. A fiscally irresponsible government can frustrate any attempt to control its finances through constraints on the conventional budget deficit.

Can automatic stabilizers deal with financial instability?

Given the perceived political constraints on discretionary fiscal policy, the automatic stabilizers seem more flexible and work more quickly than the discretionary ones. The automatic stabilizers represent a preJohn Lodewijks

dictable and systematic response, setting out rule-like mechanisms for changes in spending and taxes. Yet one concern is that the size of automatic stabilizers has declined since the 1980s. Countries have been curbing the effectiveness of automatic stabilizers as they reduce transfer mechanisms and cut taxes and the number of tax brackets. There is room to strengthen old automatic stabilizers and develop new ones. Perhaps consumption taxes are efficient stabilizers. For expenditure programs, we need a temporary stimulus that disappears once the economy has returned to normal such as Federal grants to states based on excess unemployment. Devising mechanisms yielding temporary stimulus that would self-terminate as recovery ensued – based on unemployment trigger mechanisms – is challenging to policymakers. A more pressing limitation is that automatic stabilizers may not have sufficient size and impact to make much of a dent in the contractionary effects of a sizeable financial shock. In such circumstances, accommodative monetary policy is usually the immediate response involving substantial cuts in interest rates, quantitative easing, and unconventional monetary policy (Kuttner 2018). However, once interest rates have been driven down to almost zero, monetary policy may no longer be a viable corrective in times of recession. There is no alternative but expansionary and discretionary fiscal policy. Policymakers responded to the Global Financial Crisis using substantial, large doses of direct support to the financial system, low interest rates, vastly expanded central bank balance sheets, and massive fiscal stimulus. Substantial fiscal stimulus packages were enacted, of the order of five percent of GDP in advanced countries. One consequence of public sector bailouts of troubled financial institutions (and countries) has been rising government indebtedness, sometimes called the sovereign debt crisis. Despite this, it is evident that discretionary fiscal policy in times of financial crisis is very much back on the policy agenda. John Lodewijks

References

Alesina, Alberto et al. (2000), ‘Symposia on Fiscal Policy’, Journal of Economic Perspectives, vol. 14, no. 3, Summer, pp. 3–74. Blanchard, O., G. Dell’Ariccia, and P. Mauro (2010), ‘Rethinking Macroeconomic Policy’,

Fiscal policy and financial instability  167 Journal of Money, Credit and Banking, vol. 42 (supplement), no. 6, pp. 199–215. Burger, Philippe (2003), Sustainable Fiscal Policy and Economic Stability, Edward Elgar, Cheltenham. Buti, Marco, Jurgen von Hagen, and Carlos Martinez Mongay (2002), The Behaviour of Fiscal Authorities: Stabilization, Growth and Institutions, Palgrave, New York. Cohen, Darrel and Glenn Follette (2000), ‘The Automatic Fiscal Stabilizers: Quietly Doing Their Thing’, Economic Policy Review, Federal Reserve Bank of New York, April, with commentary by Olivier Blanchard, pp. 35–74. Drazen, Allan (2000), Political Economy in Macroeconomics, Princeton University Press, Princeton, NJ. Easterly, William (1999), ‘When Is Fiscal Adjustment an Illusion?’, Economic Policy, Vol. 28, April, pp. 57–86. Fatas, Antonio and Ilian Mihov (2001), ‘Government Size and Automatic Stabilizers: International and Intranational Evidence’, Journal of International Economics, vol. 55, no. 1, October, pp. 3–28. Fatas, Antonio and Ilian Mihov (2003), ‘The Case for Restricting Fiscal Policy Discretion’, Quarterly Journal of Economics, vol. 118, no. 4, November, pp. 1419–1447.

Gali, Jordi and Roberto Perotti (2003), ‘Fiscal Policy and Monetary Integration in Europe’, Economic Policy, vol. 18, October, pp. 535–572. Kuttner, Kenneth N. (2018), ‘Outside the Box: Unconventional Monetary Policy in the Great Recession and Beyond’, Journal of Economic Perspectives, vol. 32, no. 4, Fall, pp. 121–146. Perry, Guillermo (2003), ‘Can Fiscal Rules Help Reduce Macroeconomic Volatility in the Latin America and Caribbean Region?’, World Bank Policy Research Working Paper 3080, June, pp. 1–24. Persson, Torsten and Guido Tabellini (2000), Political Economics: Explaining Economic Policy, MIT Press, Cambridge, MA. Pitt, Joseph C., Djavad Salehi-Isfahani, and Douglas W. Eckel (eds) (2004), ‘The Production and Diffusion of Public Choice Political Economy’, The American Journal of Economics and Sociology, Special Invited Issue, vol. 63, no. 1, January, pp. 1–271. Reinhart, C., V. R. Reinhart, and K. Rogoff (2012), ‘Public Debt Overhangs: Advanced Economies Episodes since 1800’, Journal of Economic Perspectives, vol. 26, no. 3, 69–86. Whalen, Charles and Jeffrey Wenger (2002), ‘Destabilizing an Unstable Economy: The Market Failures Issue’, Challenge, Nov.–Dec.

John Lodewijks

39. Global capital flows and financial instability Introduction

In a well-functioning market economy, markets should provide the incentives that lead individuals to do what is in society’s interest. Joseph Stiglitz (2010) contends that financial crises have indicated that financial markets have failed to perform their essential societal functions of managing risk, allocating capital, and mobilizing saving while keeping transaction costs low. Financial markets did not allocate capital to its most productive use, where the highest returns to society. Instead, they misallocated capital, and engaged in excessive risk-taking and lending to those that could not repay, leading to a situation where private rewards were unrelated to social returns. Indeed, banks performed so poorly at credit assessment and mortgage design that they have put the entire economy at risk. Stiglitz lays the primary responsibility for recent global financial instability on financial markets and institutions for reckless lending leading to a significant private-sector-led misallocation of financial resources. The financial sector, he says, circumvented regulations and accounting standards, created excessive risk, encouraged excess debt, excessively focused on short-term returns, and received excessive executive pay that had little relation to performance. Financial engineering led to complex products that those selling and buying did not understand the risk implications. Poor corporate governance, apparent conflicts of interest, perverse incentives, and externalities meant that private rewards were not well aligned with social objectives. The financial sector redistributed wealth rather than created new wealth and provided little social benefit. The Government has had to repeatedly save financial markets from their own mistakes. These issues are paramount in an era of volatile global capital flows.

Global capital flows and the Asian financial crisis

Since the late 1980s, many Asian developing economies have experienced surges in capital

inflows. The surges were most prominent in the countries that later experienced the most potent effects of the Asian crisis. Only a tiny fraction of this inflow came from direct foreign investment. The remainder was portfolio investment or investment mediated through the banking sector. This private capital inflow was driven by the speculative tendencies of investors, particularly in commercial real estate, and resulted in a rampant increase in domestic asset prices. The rise in asset prices induced further capital inflows. Much of the collateral the banks accepted for foreign loans was real estate and equities, assets whose prices contained a significant ‘bubble’ element. As much of the capital inflow was short-term, the banks were borrowing short and lending long. The Asian financial institutions of affected countries were ill-equipped to deal with globalization’s sudden capital inflows. The banks were poorly regulated, and standards of loan appraisal were generally inadequate. When the bubble burst, the foreign capital departed as quickly as it had come in, leaving plunging currencies and unsustainable debt-to-equity ratios as asset prices collapsed. It can be argued that the cause of the crisis was domestic financial sector weakness which permitted over-investment in the property sector of these Asian economies through excessive foreign borrowing at short maturities. A related concern is the need for more substantial prudential supervision. Banks generally appear to take risks above those taken by other firms. This then suggests the need to raise bank capital to asset ratios. However, pressing concerns also relate to developing derivatives and other highly levered financial intermediaries, such as hedge funds and bank proprietary trading departments, which are programmed to quickly move large capital pools between different financial markets. The unpredictability and instability of large flows of loans, portfolio, and other non-equity capital are vital concerns. What stands out are the unexpectedly large adverse effects on real variables (output, employment, and firm insolvency) that can occur when a fragile under-regulated financial sector with inadequate prudential supervision is exposed to volatile and large capital injections. Asset prices can exhibit bubble behavior and crash quite precipitously, and

168

Global capital flows and financial instability  169

the contagion impacts countries far from the source of the initial financial instability.

Hedge funds

The activities of the large macro hedge funds are increasingly scrutinized as they often appear the strategic players in international currency speculation, hence a primary reason for countries to contemplate capital controls. Sebastian Mallaby (2010) provides a sympathetic account of hedge fund behavior in multiple countries, while others worry that the misadventure of a single wayward hedge fund might take the world economy close to the precipice of financial disaster. Hedge funds are left mostly unregulated as speculative vehicles for high-net-worth individuals and institutional investors. Hedge funds typically have high minimum investment requirements of several million dollars and can operate with leverage ratios of 20 to 1. The returns can be impressive, as are the risks taken in speculating in foreign currencies, and the effects on small developing countries can be catastrophic. There is particular concern about the vulnerability of small banking and financial systems to such speculative behavior. The aggregate size of banks in Argentina, Thailand, or Indonesia falls in the range of a small regional U.S. bank, so only marginal shifts of funds in massive international financial markets can overwhelm the absorptive capacities of these countries’ banks. However, even in the U.S., financial supervision did not prevent the Savings and Loan debacle in the 1980s and the collective failure of some of the largest commercial banks. Respectable major U.S. banks have lent to small, incredibly risky hedge funds. Improving financial supervision and stronger regulations to control banks’ foreign exposures and taxes on short-term capital inflows through special reserve requirements might be an option. Another option is organized social action that occurred in early 2021 with crowd-sourced attacks on hedge funds where many small investors targeted stocks that hedge funds have gone short on, driving up the prices to force the funds to cover their losses.

The Global Financial Crisis and global capital flows

The main characteristics of the Global Financial Crisis are well known, but the underlying pre-condition for its occurrence, associated with significant capital inflows, is less well understood. We know that speculative booms, often in real estate and stock markets, and excessive debt accumulation, are basic features of most crises. In this case, housing was the source of the crisis combined with a new innovative financial product – subprime mortgage-backed securities. The housing market became a focus of intense speculative interest. The housing asset price exceeded its fundamental value and led to excessive debt accumulation as investors borrowed money to buy into the boom. The excessive debt accumulation by households, the financial sector, and corporations was essential to the story. However, the key impetus to these events was that economies were awash with investible funds looking for profitable opportunities. Much of these funds entered the U.S. initially from China. Countries that persistently run current account surpluses need to insulate their exchange rates from appreciating and making their exports less competitive. Through capital outflow exceeding capital inflow, running capital and financial account deficits can sterilize the impact of foreign exchange earnings on exchange rates by parking those funds in other countries. That keeps liquidity levels high and interest rates low in the recipient country. The U.S. was awash with funds, precipitating the over-investment in housing. Foreign capital also flowed in from Europe to exploit the rise in housing asset prices, which played a vital role in the ensuing Euro-crisis. Similarly, the abundance of petro-dollars in the 1980s, a result of the Organization of the Petroleum Exporting Countries (OPEC) oil price rises caused by the transfer of funds from the Middle East to the U.S., provided the excess liquidity for over-investment in Latin America and the consequent debt crisis and debt defaults in that region.

Conclusion

Unregulated global financial flows are now viewed more cautiously after various financial crises. The size and importance of the economy’s financial sector have been quesJohn Lodewijks

170  Elgar encyclopedia of financial crises

tioned, and perhaps more resources should flow to industries that create wealth rather than redistribute it. Technological innovation, not financial engineering, provides a modern economy’s dynamism and it is entrepreneurs rather than fund managers that raise our living standards. Indeed, stronger prudential regulation of financial markets and institutions is required to avoid financial engineering that leads to products so complex that those selling and buying them do not understand the risk implications. Poor corporate governance, clear conflicts of interest, perverse incentives, and externalities meant that private rewards were not well aligned with social objectives. Countries are now more closely monitoring many vulnerability indicators. Vulnerability indicators include the ratio of short-term foreign-currency-denominated debt to foreign exchange reserves at the macroeconomic level, the extent of real exchange rate appreciation, and the current account deficit. There is a need to monitor the balance sheets of the financial and corporate sectors’ sectors at more disaggregated levels. In particular, maturity mismatches between short-term liabilities and longer-term liquid assets, borrower foreign currency-denominated liabil-

John Lodewijks

ities compared to domestic currency assets, and debt-equity financing ratios need to be watched. Generally, there is a necessity to monitor foreign currency exposure of corporate and financial sectors and to implement an enhanced regulatory oversight of highly leveraged institutions. The inherent instability and volatility which characterizes real-world international capital markets cannot be dismissed. John Lodewijks

References

Akerlof, George A. & Robert J. Shiller. (2009). Animal Spirits. Princeton, NJ: Princeton University Press. Cohen, Stephen S. & J. Bradford DeLong. (2010). The End of Influence. New York: Basic Books. Lewis, Michael. (2011). Boomerang: The Meltdown Tour. New York: Allen Lane. Mallaby, Sebastian. (2010). More Money Than God. London: Bloomsbury. Rajan, Raghuram G. (2011). Fault Lines. Princeton, NJ: Princeton University Press. Roubini, Nouriel and Stephen Mihm. (2011). Crisis Economics. New York: Penguin. Stiglitz, Joseph. (2010). Freefall. London: Penguin. Studwell, Joe. (2013). How Asia Works. New York: Grove.

40. Global imbalances and global recession Introduction

Global imbalances were frequently debated before the global crisis in 2007–2008. The term “global imbalances” mainly elaborates on large economies’ external imbalances that cause global breakdowns. Here, the term external imbalances imply current account imbalances and huge financial-capital flows at the global scale. Global imbalances are not a new phenomenon in economic history. There are many periods when the trade balance between countries has diverged since the nineteenth century. International capital mobility has shown diverse trends throughout recent history. Starting in the 1870s until the First World War, international trade and finance were at very high levels, and there were no economic and political barriers in front of them. The technological improvements in communication and transportation accelerated such flows. Although during the interwar period, the countries implemented autarky policies, which continued until the 1970s, along with the end of the Bretton Woods system, the capital flows increased tremendously, and the countries’ creditor and debtor roles in international trade changed. Since the 1980s, a new period of globalization emerged, so that a neoliberal environment for freer trade and financial capital developed intensively. In recent decades, while the U.S. economy has run high trade deficits, other large countries such as China, Japan, and Germany have shown large trade surpluses. This captures the picture of global imbalances before the crisis in 2007–2008. Hence there have been serious problems. This global country trade structure divergence highlights many related issues, such as different growth models, capital flows, and excessive consumption and borrowing. Many researchers emphasize that capital flows to the U.S. from savers in emerging economies resulted in a glut of cheap money. The inflation of financial assets in the U.S. bubble was sustained by capital flows from these countries. That is, an excess of saving over investment in emerging market countries—showing itself in the trade surplus—flowed to the trade deficit

countries, especially to the U.S. This, in turn, led to lower interest rates and naturally more loans were given, which in turn drove more consumption, mainly in the U.S. This mechanism, triggered by global imbalances, planted the seeds of the global financial crisis. This is the main argument of the global imbalances view.

Global imbalances in the world

The global imbalances in the 2000s were mainly related to the U.S. trade deficit, which was almost equal to the rest of the world’s trade surplus. Table 40.1 gives the U.S. goods trade deficit concerning regions in 2007, the peak year before the global crisis. It indicates that the U.S. ran trade deficits with all large countries and regions. Several countries run persistently large trade surpluses in their trade with the U.S. These countries are primarily Germany, Japan, China, Taiwan, and South Korea. Their main feature is that they followed an export-led growth model. Hence there is a link between their growth strategy and the U.S. economy. The U.S. economy provides the external demand for these countries and urges them to invest more in U.S. treasury bonds. Table 40.1

A decomposition of the U.S. goods trade deficit in 2007 $ billion

Percentage

Total

–808.8

100

Pacific Rim

–372.3

46.0

China

–258.5

32.0

Canada and Mexico

–143.0

17.7

European Union

–110.2

13.6

Organization of the Petroleum

–117.2

14.5

192.4

23.8

Exporting Countries (OPEC) Other

Source:  International Monetary Fund.

Figure 40.1 shows that the global economy has mainly three different economic groups: the U.S. economy, balanced trade economies, and export-led economies. The Pacific Rim (including China) and the Euro area (especially Germany) are export-led economies. They run trade surpluses with the U.S. and other balanced trade countries. The U.S. has a trade deficit with balanced trade and export-led economies. The net result is that the U.S. has a trade deficit, the export-led

171

172  Elgar encyclopedia of financial crises

Source:  Own illustration.

Figure 40.1

Structure of global imbalances

economies have a large trade surplus, and the balanced trade economies have an approximate trade balance. Global imbalances create gross capital inflows and outflows. In the U.S., as the deficit side, there is an excess of investment over domestic savings, but on the surplus side, there is an excess of savings over investment in emerging Asian countries. This leads to an accumulation of U.S. assets in the surplus countries. In this way, they financed the U.S. deficit. During the 1980s and the early 1990s, these imbalances did not change too much, but it increased about two-fold since the second half of the 1990s. Figure 40.2 shows the development of the current account deficit (in absolute terms), starting with the U.S.’s mid-1990s. It reached the highest value, which was 5 percent, in 2006. According to Blanchard and Milesi-Ferretti (2009), the widening current account deficit in the U.S. until 2006 resulted from two distinct developments in different regions. One of these stems from where the U.S.’s international investment excess over saving during a robust economic growth in the 2000s until the crisis. Another is the development

after the Asian crisis in 1997. After the crisis, the Asian countries’ investment motivation declined; hence saving exceeded their investment. Consequently, the investments of the U.S. were financed by the saving of the Asian countries. The saving and investment patterns in different countries provide information to trace these countries’ capital flows and current account positions. Over the past decade, while East Asian countries and oil producers as trade surplus countries have had high and rising savings with respect to their investments, the U.S. as a trade deficit country has had lower and falling savings with respect to its investments. There are deeper forces behind these huge shifts in global patterns of saving, investment, and capital flows. Three fundamental changes can explain these developments. The first was the shift toward economic liberalization. Political and economic developments changed the closed and highly regulated economies and transformed them into liberalized economies. One of the most significant changes was the opening-up policies followed by China after 1978, under the leader-

Source:  Dettmann (2014).

Figure 40.2

Ensar Yılmaz

Current account/GDP in the U.S. (absolute values)

Global imbalances and global recession  173

ship of Deng Xiaoping. Margaret Thatcher’s and Ronald Reagan’s coming to office in 1979 and 1980 respectively began a serious change in the high-income countries, including financial deregulation. This was a rise of global capitalism, hence accelerating international trade. The second source of global change was the advances in transportation and communication technologies, such as more advanced container ships and fast information transmission via the internet. These significant developments have significantly reduced transportation costs and increased information transmission worldwide. That, in turn, created the opportunity for the fast growth of export-oriented manufacturing, mainly from China, and export-oriented information technology services, mainly from India. The third source of the change is the physical relocation of production from developed countries to low-cost-producing countries. This was accompanied by the shift in saving behavior of emerging economies, which pursued savings-and-export-surplus growth strategies. After the Asian financial crisis of 1997–1998, the crisis-hit countries changed their investment and saving behavior. In the oil-exporting countries, the income from higher oil prices, which were mainly generated from higher demand from China, led to a rise in savings.

Global imbalances and distinct growth models

After the Second World War, as Palley (2012) points out, the global economic system saw three main economic regimes that describe the main characteristics of the global economy. During 1945–1979, a free trade regime existed, and tariffs were declining. In the following period, 1980–2000, a neoliberal globalization regime came out. This trade regime turned into the current China-centric globalization regime. Foreign trade was roughly balanced from 1945 to 1979 because policymakers did not desire large deficits for macroeconomic reasons. However, policymakers were not interested in constraining trade deficits during the neoliberal period, and large companies benefited from this development. Along with intensifying globalization during the neoliberal period, the U.S.’s production base

weakened. Thus the deindustrialization of the U.S. economy accelerated. Furthermore, manufacturing production was relocated to emerging market economies. This development damaged the foreign tradable goods of the U.S. This is the supply-side explanation of the increasing trade deficit in the U.S. arising from globalization. However, there is also the demand side of this development. It is mainly increasing consumer demand in the U.S. Developing countries did not increase their domestic consumption and based their growth on an export-led strategy. These developments are associated with the fact that the countries have followed distinct growth models. While some countries applied the debt and consumption-led growth model, others applied the export-led growth model. In this sense, we categorize the countries displayed in Table 40.2. According to this, diverse core and peripheral countries in the world economy followed debt-led and export-led growth models. While core countries, the U.S. and U.K., used the debt-led growth model, peripheral countries such as Greece, Ireland, Portugal, and Spain in Europe applied a similar growth policy. The core and peripheral countries also followed the export-led growth strategy. While Germany, Austria, and Japan followed this strategy, China, regarded as a peripheral country in this sense, has also been growing with the same strategy. Table 40.2

Core Periphery

Debt-led and export-led growth models Debt-led

Export-led

U.S., U.K.

Germany, Japan

Greece, Ireland, Portugal, Spain

China

There are diverse reasons for choices of growth models by the countries in Table 40.2. Germany’s export-growth strategy came out after unification and the introduction of the Euro. The European peripheral countries’ debt-led structure mainly originated from financial liberalization that accompanied European integration. The export-led growth in the Southern Asian countries was a response to the crisis in 1997. They emphasized accumulating foreign currency reserves because of the problems they experienced during the crisis. China’s export-led growth Ensar Yılmaz

174  Elgar encyclopedia of financial crises

strategy is also related to its desire to accumulate foreign reserves. While the countries following debt-led growth strategies experienced higher consumption shares of their national income, export-led economies had higher consumption shares. In the countries where consumption share increased, household debt also increased drastically. While household debt declined in Germany from 2000 to 2008 by 11 percent points of GDP, it rose by 26 percentage points in the U.S. and 28 percentage points in the U.K. In peripheral Europe, the increases were even sharper. In Ireland, it rose by 61, and in Spain by 33 percentage points (Stockhammer, 2012).

Global imbalances and the global recession

All developments in the global system we defined above can help us determine theoretical and empirical links between global imbalances and crises, particularly during the global crisis in 2007–2008. Here, we discuss some of the factors underlying global imbalances that led to the crisis in 2007–2008. In the late 1990s, the U.S. and U.K. domestic demand grew faster than national production. This was likely associated with appreciating their currencies and China’s entry into the global markets by producing low-cost products. Along with increased domestic consumption and investment in deficit countries like the U.S. and U.K., demand for loans also expanded significantly, underpinning the global credit boom. Many U.S. and U.K. loans were used to purchase houses and financial assets rather than productive areas. Hence, even though capital flows contribute to credit growth, they are not entirely responsible for it. In contrast to growing domestic demand in deficit countries, it remained low in the surplus countries for a long time. The domestic demand in these countries was mainly repressed through stagnant wage policies despite workers’ increased productivity. Thus wages in these countries lagged behind productivity. This also happened in the U.S., as in the surplus countries. Nevertheless, in contrast to the U.S., the surplus countries did not encourage households to increase consumption by borrowing. Instead, they relied on foreign demand to avoid insufficient domestic demand, thus exporting their products. Ensar Yılmaz

Hence, as Bernanke (2007) argued, the U.S. current account deficit could not be understood with only U.S. developments. Even the increased loans in the deficit countries such as the U.S. or the U.K. were related to how the surplus countries used their surpluses. Bernanke mentioned that they invested surpluses and savings in financial markets in advanced countries, especially the U.S. in the 1990s and 2000s, rather than in productive domestic investment. Here we should express that large and persistent current account deficits, while sometimes benign and sustainable, require scrutiny. Trade deficits may not be the true source of a problem. There can be capital flows to a country, even if it does not have current account deficits. There are several respects in which these patterns are inconsistent with the view that global current account imbalances played a critical role in the crisis. First, although the global capital flows increased tremendously since the 1990s, from around 10 percent of world GDP in 1998 to about 30 percent in 2007, they have been among the developed countries. Even if the trade share of the developed countries in total world trade declined, the capital flows increased drastically (Lane and Milesi-Ferretti, 2008). By comparison, flows between, or from, emerging economies were much smaller. However, the saving glut view sees emerging markets as the main drivers of global financial conditions. Second, it is striking that the U.S.’s capital flows mainly originated from European countries rather than emerging countries. About 50 percent of total capital flows to the U.S. came from Europe in 2007. The U.K., a trade deficit country, is the source of more than half of this capital inflow. Furthermore, roughly one-third of capital inflows to the U.S. came from the Eurozone, which had approximately balanced trade in itself. This amount was more considerable than the capital inflows coming from China and Japan, running large surplus countries. Therefore the role of these two countries and oil-producing countries in financing the trade deficits and credit boom in the U.S. is not that significant. Third, current accounts did not dominate in determining financial flows into the United States before the global crisis. It is seen that gross capital flows into and out of the U.S. have expanded independently of current account balances since the early 1990s. The

Global imbalances and global recession  175

increase in net claims in the U.S., which mainly shows the current account deficit, was about three times smaller than the change in gross claims. Thus the global capital flows exceeded the movements in capital account balances. Therefore, even if there were no trade deficits in the U.S. during the 1990s and 2000s, there would be large foreign inflows in the U.S. financial markets. Fourth, gross capital flows have a more critical role than net capital flows. Thus, net capital flows do not capture the degree of damage when there is a disruption in capital flows. The fall in gross capital flows becomes much more than net capital flows during crises. When the global crisis started in 2008, net capital flow declined marginally, but the gross capital fell tremendously. This mainly stemmed from the fall in flows between advanced economies. For example, in 2008, net capital inflows fell only marginally in the U.S.—just about $20 billion—gross inflows fell roughly $1.6 trillion, a decline of approximately 75 percent from their 2007 level. This decline mainly occurred in the U.S. and Europe and reversed abruptly in both directions. However, the gross inflows from China and Japan continued. Therefore it seems that capital flows from Asia were a stabilizing force during the crisis (Borio and Disyatat, 2011).

Concluding remarks

In recent decades, the countries, to a significant extent, have diverged in their foreign trade as surplus and deficit countries. This became detrimental to the functioning of the global economy. However, its solutions are hard to find due to its asymmetric character arising from different incentives in the current account deficit and current account surplus countries. Since there are no self-correction mechanisms to truncate these tendencies, we need global economic policy coordination. This is not just related to trade policies but also associated with immense capital flows. To understand the probable detrimental effects of global imbalances, the balance of payments developments at a global scale should be traced up in terms of both savings-investment perspectives and financial-capital perspectives.

To cope with the current global imbalances in the short run, we can employ some policies. These policy suggestions aim to induce surplus and deficit countries to act in a way to reduce global imbalances. In the long run, there must be a sounder and more resilient international monetary system. This requires international cooperation. No country can avoid negative externalities that spread around the world. Ensar Yılmaz

References

Bernanke, Ben (2007). Global Imbalances: Recent Developments and Prospects. Bundesbank Lecture, Berlin, Germany. www​.federalreserve​ .gov/​newsevents/​speech/​bernanke20070911a​ .htm. Blanchard, Olivier, and Gian Maria Milesi-Ferretti (2009). Global Imbalances: In Midstream? IMF State Position Note SPN/09/29. Washington, DC: International Monetary Fund. Borio, Claduio, and Piti Disyatat (2011). Global Imbalances and the Financial Crisis: Link or No Link? BIS Working Paper No. 346. Bank for International Settlements Dettmann, Georg (2014). Global Imbalances: Fractures in the World Monetary System. Doctorate Thesis, University of Verona. Lane, Philip, and Gina Maria Milesi-Ferretti (2008). The Drivers of Financial Globalization. American Economic Review: Papers and Proceedings 98(2): 327–332. Lin, Justin Yifu (2013). Against the Consensus: Reflections on the Great Recession. Cambridge: Cambridge University Press. Palley, Thomas (2012). From Financial Crisis to Stagnation: The Destruction of Shared Prosperity and the Role of Economics. Cambridge: Cambridge University Press. Reinhart, Carmen, and Vincent Reinhart (2009). Capital Flow Bonanzas: An Encompassing View of the Past and Present. In J. A. Frankel and C. Pissarides (Eds.), International Seminar on Macroeconomics 2008. Chicago, IL: University of Chicago Press. Stockhammer, Engelbert (2012). Financialization, Income Distribution and the Crisis. Investigación Económica / Escuela Nacional de Economía, Universidad Nacional Autónoma de México 71(279): 39–70. Yılmaz, Ensar (2020). Understanding Financial Crises. Routledge Frontiers of Political Economy. London: Taylor & Francis Ltd.

Ensar Yılmaz

41. Global pandemic and stock market volatility of Asia-Pacific countries Introduction

The Covid-19 pandemic is one of the largest public health crises and economic shocks worldwide which has affected the global financial markets (Sadiq et al. 2021, p. 4). The pandemic has negatively affected the unprepared global economy and led to uncertainty on global stock markets (Engelhardt et al. 2021, p. 5). The rapid outbreak of Covid-19 has triggered great uncertainty to the global economy, and the panic caused by the uncertainty has also spread among the global financial markets, increasing its volatility (Iyke 2020, p. 2284). Many empirical studies have tried to evaluate the impact of the pandemic on many aspects of the economies across the world including the volatility of stock markets. However, as Engelhardt et al. (2021, p. 6) argue, most of these studies focus on the impacts of the pandemic on specific stock markets, while there are only a few studies examining the impact on global stock markets. Besides that, in general, most of the studies that analyze the impact of Covid-19 have focused on the developed economies and ignored many other economies such as the major Southeast Asian countries (Kumar et al. 2021, p. 6). Sadiq et al. (2021, p. 17) is among the few studies that examined the impact of Covid-19 on emerging stock markets in seven of the Southeast Asian countries using a ST-HAR-type Bayesian posterior model and the Covid-19 pandemic Fear Index as measurement for the pandemic outbreak. In this entry, we examine the impact of the Covid-19 pandemic on the volatility of major stock markets in the Asia-Pacific countries, namely China, India, Indonesia, Japan, Malaysia, and Thailand, following Kumar et al. (2021, p. 3). Unlike in the literature, especially Sadiq et al. (2021, p. 10), this study uses the daily growth in Covid-19 confirmed

cases to measure the pandemic and analyzes the data using ordinary least squares (OLS) regression. Furthermore, the study takes into account that naturally different stock markets may be affected differently by the pandemic, therefore it examines the impact on each country’s market index.

Data and methodology Data This entry uses daily data from the day when the first Covid-19 case was confirmed in the respective country to July 8, 2020 for the main stock market indices of six major Asia-Pacific countries as shown in Table 41.1. The data are collected from different sources, namely the website of www​ .investing​ .com for the stock market index and the EU Open Data Portal for data on daily Covid-19 confirmed cases. Finally, the data of country-level control variables (democratic accountability, uncertainty avoidance, and investment freedom) are obtained from the international country risk guide database, Hofstede et al. (2010, pp. 56, 96), and Heritage Foundation (2020). Table 41.1

List of stock market indices in the Asia-Pacific region

No.

Country

Index

1

China

FTSE China

2

India

FTSE India

3

Indonesia

Jakarta SE Composite Index

4

Japan

FTSE Japan

5

Malaysia

FTSE KLCI

6

Thailand

SET Index

Methodology In order to examine the relationship between Covid-19 and stock market volatility, we specify a panel regression model with robust standard error. The regression includes the country-level and time fixed effects where the time effect is month following the studies of Erdem (2020, p. 6) and Engelhardt et al. (2021, p.5). The regression is as follows:

176

Global pandemic and stock market volatility of Asia-Pacific countries  177 Table 41.2

Descriptive statistics

Variable

Observations

Mean

Median

Std. Dev.

Minimum

Market volatility

918

0.014

0.011

0.012

0.000

Maximum 0.129

Growth in confirmed cases

784

1.010

1.008

2.031

0.045

18.991

Democratic accountability

685

3.848

4

1.528

1.5

6

Uncertainty avoidance

685

53.188

40

22.436

30

92

Investment freedom

685

49.562

55

16.676

20

70

Note:  The descriptive statistics are for the period from the first Covid-19 case confirmed in a country to July 8, 2020.

​MV​C,t   ​  ​=  ​aC​  ​ ​+  ​β11 ​  ​ LnG ​CC,t​ ​  (​− 1)​ ​ ​+  ϵ​ C,t ​  ​ K

​M ​VC,t ​  ​  ​=  ​αC​  ​ ​+  β ​ 11 ​  ​ LnG ​CC,t​ ​  (​− 1)​​ ​+  ​∑  ​   ​βk​ ​ ​XkC,t ​  ​ K​=1

T​− 1

​  ​ ​​+  ​∑​ ​  ϵ​ t​ ​ ​Mt​ ​ ​+  ​ϵC,t t​=1

K

​MV​C,t   ​  ​=  ​αC​  ​ ​+  ​β11 ​  ​ ​LnGC​C,t​   (​− 1)​ ​ + ​   ​∑  ​   ​βk​ ​ X ​ kC,t ​  ​ K​=1

T​− 1

​  ​ +  ​​  ​∑  ​  ​ ​ϵt​ ​ ​Mt​ ​ ​+  ϵ​ C,t t​=1

T​− 1

​  ​ ​LnGC​C,t​   (​− 1)​​ + ​   ​∑  ​  ​ ​ϵt​ ​ ​Mt​ ​ ​MV​C,t   ​  ​=  ​αC​  ​ ​+  ​β11 t​=1

T​− 1

​  ​ ​​  ∑ +  ​   ​  ​ ​ϵt​ ​ ​Ct​ ​ ​+  ϵ​ C,t t​=1

where the c and t subscripts show country and day, respectively. αc is a constant term. Dependent variable, MV, shows stock market volatility in country c on day t, while LnGC presents growth in Covid-19 confirmed cases. Xkc,t is a vector of country-level control variables which are democratic accountability, uncertainty avoidance, and investment freedom meant to control for the variation in stock market returns across countries. Mt is a set of monthly fixed-effects dummies to control for monthly international factors. Ct is a set of country fixed-effects dummy variables. Ɛc,t is an error term. The study variables are measured following many other studies. The dependent variable, market volatility, is measured as the five-day moving average volatility of stock market following Erdem (2020, p.7) and Engelhardt et al. (2021, p.6), while the independent variable, which is LnGC (growth in Covid-19 confirmed cases), is measured following Engelhardt et al. (2021, p. 6). The control variables are measured following the studies of Ashraf (2020, p. 5) and Nomran and Haron (2021, p. 11).

Empirical results Data description Table 41.2 reports the descriptive statistics on the variables. The minimum value of stock market volatility is 0.000 and the maximum value is 0.129, which indicates a significant market volatility during the sample period. The minimum values of the growth in confirmed cases, democratic accountability, uncertainty avoidance, and investment freedom are 0.045, 1.5, 30, and 20, while the maximum values are 18.991, 6, 92, and 70, respectively. Regression results Table 41.3 presents the panel pooled OLS regression results for the impact of Covid-19 on stock market volatility in Asia-Pacific countries. The findings of Models 1, 3, and 4 suggest that stock market volatility is positively and significantly affected by the growth in Covid-19 confirmed cases at 10 percent, 10 percent, and 5 percent significance levels, respectively. These results are in line with many studies that examine stock market volatilities following the Covid-19 pandemic such as Erdem (2020, p. 8) and Engelhardt et al. (2021, p. 7).

Further analysis

This study conducts a further analysis which takes into account that different stock markets may be affected differently by the global pandemic. Tables 41.4 and 41.5 present the findings of the panel data tests with specific country dummy variables. The findings show that stock market volatility of Malaysia followed by Japan was less volatile compared to the major stock markets in Asia-Pacific

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countries, while the stock markets in India, Thailand, and China, respectively, were extremely volatile relatively to other stock markets during the global pandemic.

Conclusion

The Covid-19 pandemic is the largest public health crisis and economic shock in recent times that has affected the economies as a whole and the financial markets in particular. The pandemic has negatively affected the unprepared global economy and led to uncertainty on global stock markets. For that, this entry aims to examine the impact of Covid-19 on the stock market volatility of major Asia-Pacific countries using daily data from the day when the first Covid-19 case was confirmed in a country to July 8, 2020. The findings suggest that stock market volatility reacts significantly positive to the increase in the number of Covid-19 confirmed cases. Further, it is found that stock market volatility of Malaysia followed by Japan was less volatile compared to other major stock markets in the Asia-Pacific countries, while stock markets in India, Thailand, and China, respectively, were extremely volatile compared to other stock markets during the Covid-19 pandemic. The findings of this study have important policy implications for investors in the Asia-Pacific region to understand and predict the behaviour of stock markets during pandemic crises. Naji Mansour Nomran and Razali Haron

Naji Mansour Nomran and Razali Haron

References

Ashraf, Badar Nadeem. 2020. “Stock Markets’ Reaction to COVID-19: Cases or Fatalities?” Research in International Business and Finance 54: 101249. https://​doi​.org/​10​.1016/​j​ .ribaf​.2020​.101249 Engelhardt, Nils, Krause, Miguel, Neukirchen, Daniel, and Posch, Peter N. 2021. “Trust and Stock Market Volatility during the COVID-19 Crisis.” Finance Research Letters 38: 101873. https://​doi​.org/​10​.1016/​j​.frl​.2020​.101873 Erdem, Orhan. 2020. “Freedom and Stock Market Performance During Covid-19 Outbreak.” Finance Research Letters, 36: 101671. doi: 10.1016/j.frl.2020.101671. Heritage Foundation. 2020. Index of Economic Freedom. www​.heritage​.org/​index/​about. Accessed July 12, 2020. Hofstede, Geert, Hofstede, Gert Jan, and Minkov, Michael. 2010. Cultures and Organizations: Software of the Mind. McGraw-Hill, New York. Iyke, Bernard Njindan. 2020. “The Disease Outbreak Channel of Exchange Rate Return Predictability: Evidence from COVID-19.” Emerging Markets Finance and Trade 56(10): 2277–2297. https://​doi​.org/​10​.1080/​1540496X​ .2020​.1784718. Kumar, Ashish, Badhani, K. N., Bouri, Elie, and Saeed, Tareq. 2021. “Herding Behavior in the Commodity Markets of the Asia-Pacific Region.” Finance Research Letters 41: 101813. https://​doi​.org/​10​.1016/​j​.frl​.2020​.101813. Nomran, Naji Mansour, and Haron, Razali. 2021. “The Impact of COVID-19 Pandemic on Islamic Versus Conventional Stock Markets: International Evidence from Financial Markets.” Future Business Journal 7: 33. Sadiq, Muhammad, Hsu, Ching-Chi, Zhang, YunQian, and Chien, Fengsheng. 2021. “COVID-19 Fear and Volatility Index Movements: Empirical Insights from ASEAN Stock Markets.” Environmental Science and Pollution Research: 1–18. https://​doi​.org/​10​ .1007/​s11356–021–15064–1​.

Global pandemic and stock market volatility of Asia-Pacific countries  179 Table 41.3

Panel regression on the impact of Covid-19 on the stock market volatility of the Asia-Pacific region

Variable

Stock market volatility

Ln GC Democratic accountability

(1)

(2)

(3)

(4)

0.060*

0.045

0.060*

0.060**

(0.060)

(0.225)

(0.054)

(0.049)

 

0.041

0.030*

 

(0.101)

(0.098) 0.005***

Uncertainty avoidance

 

0.004** (0.014)

(0.001)

Investment freedom

 

-0.010***

-0.013***

(0.000)

(0.000)

 

 

Month fixed effects

No

No

Yes

Country fixed effects

No

No

No

Yes

-4.465***

-4.333***

-4.497***

-4.604***

(0.000)

(0.006)

(0.000)

(0.000)

760

546

546

546

Countries

6

6

6

6

R-squared

0.003

0.022

0.396

0.417

Constant Observations

Yes

Notes: The regression results are for the period from the first COVID-19 case confirmed in a country to July 8, 2020. ***, **, * represent statistical significance at 1 percent, 5 percent, and 10 percent levels, respectively. p-values are given in parentheses. The panel pooled OLS regression is heteroskedasticity robust standard errors.

Table 41.4

Panel regression with specific countries dummy variable

Variable China

Stock market volatility 0.136**

 

 

 

 

 

0.166***

 

 

 

 

0.090

 

 

 

-0.117**

 

 

-0.380***

 

(0.017) India

 

(0.005) Indonesia

 

 

(0.225) Japan

 

 

 

(0.028) Malaysia

 

 

 

 

(0.000) Thailand

 

 

 

 

 

0.137** (0.025)

Month fixed effects

Yes

Yes

Yes

Yes

Yes

Yes

-4.639***

-4.596***

-4.596***

-4.552***

-4.596***

-4.639***

(0.000)

(0.000)

(0.000)

(0.000)

(0.000)

(0.000)

654

654

654

654

654

654

Countries

6

6

6

6

6

6

R-squared

0.358

0.361

0.355

0.358

0.391

0.359

Constant Observations

Notes: The regression results are for the period from the first COVID-19 case confirmed in a country to July 8, 2020. ***, **, * represent statistical significance at 1 percent, 5 percent, and 10 percent levels, respectively. p-values are given in parentheses. The panel pooled OLS regression is heteroskedasticity robust standard error. China, India, Indonesia, Japan, Malaysia, and Thailand are country dummy variables that take the value “1” if the stock market index is from that respective country, and “0” otherwise.

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180  Elgar encyclopedia of financial crises Table 41.5

Panel regression with specific countries dummy variable and Covid-19 confirmed cases

Variable Ln GC China

Stock market volatility 0.061*

0.060*

0.059*

0.062**

0.056*

0.061**

(0.050)

(0.058)

(0.060)

(0.048)

(0.066)

(0.048)

0.127**

 

 

 

 

 

0.214***

 

 

 

 

0.063

 

 

 

-0.133**

 

 

-0.372***

 

(0.038) India

 

(0.001) Indonesia

 

 

(0.446) Japan

 

 

 

(0.017) Malaysia

 

 

 

 

(0.000) Thailand

 

 

 

 

 

0.173**

Yes

Yes

Yes

Yes

Yes

Yes

-4.725***

-4.666***

-4.666***

-4.618***

-4.665***

-4.698***

(0.000)

(0.000)

(0.000)

(0.000)

(0.000)

(0.000)

546

546

546

546

546

546

Countries

6

6

6

6

6

6

R-squared

0.366

0.374

0.362

0.368

0.398

0.368

(0.048) Month fixed effects Constant Observations

Notes: The regression results are for the period from the first COVID-19 case confirmed in a country to July 8, 2020. ***, **, * represent statistical significance at 1 percent, 5 percent, and 10 percent levels, respectively. p-values are given in parentheses. The panel pooled OLS regression is heteroskedasticity robust standard error. China, India, Indonesia, Japan, Malaysia, and Thailand are country dummy variables that take the value “1” if the stock market index is from that respective country, and “0” otherwise.

Naji Mansour Nomran and Razali Haron

42. Great crises of the twentieth and twenty-first centuries: a Schumpeterian perspective on financial innovations Introduction

This entry provides a comparative study on the roots of the two great crises of contemporary capitalism: the Great Depression of the 1930s and the Great Crisis of 2007–2008. To this end, we draw upon the Schumpeterian analysis of the evolutionary dynamics of a capitalist economy and put forward the characteristics of financial innovations as a significant source of instability leading to systemic crises. A twofold assertion might be put forward behind the Schumpeterian analysis of great crises related to financial innovation dynamics. On the one hand, financial innovations have to be distinguished from entrepreneurial innovations since their sources, aims, and consequences are sensibly different from those of the real dynamics of markets concerning their systemic effects on capitalist economies. Financial innovations are regarded as instability-generating change processes. In contrast, entrepreneurial innovations are assumed to be sources of positive economic development since they have nurtured the evolution of capitalism throughout the history of modern societies. On the other hand, financial innovations reflect an institutional transformation of markets that may lead to reckless finance and threaten economic viability. The main argument is that financial innovations are not intended to improve economic activities' financing conditions but rather generate new sources and ways of “making money from money” in a short-sighted, speculative way. In other words, (real) entrepreneurial and financial innovations do not have the same rationality or convergent intentions. Financial innovations and, more generally, financial market dynamics often result in reckless finance and systemic troubles when they develop in a loosely regulated environment. These troubles are straining the resilience

and stability of the economy. The negative consequences on the viability of markets inevitably call for massive government intervention and reflect the Minskyan dynamics of the evolution of capitalism, understood as a genetically unstable economy that requires specific regulatory frameworks. Such an analysis is obviously in opposition to the late twentieth century works that refer to Schumpeter to support the financial liberalization and innovation wave of the 1990s as a growth-enhancing reform process (Greenspan 2005).1

From the Great Depression and innovation dynamics

The Great Depression of 1929–1933 in the US had a long-term influence on twentieth-century economic thinking. It revealed serious shortcomings in the neoclassical approach to capitalist economies and the functioning of markets. Recurrent crises in the US and Europe in the aftermath of the Great Depression pose a crucial question about the ability of free-market-based capitalist societies to avoid systemic economic instabilities. Joseph Schumpeter is among the great economic thinkers who sought to understand and explain the roots of the Great Depression and subsequent instability. At the center of his theory was the cyclical dynamics of capitalism, mainly relying on innovations. Schumpeter considers the development of capitalism as an evolutionary process of continuous waves of innovation, each replacing the technological and organizational features of the previous ones, usually in a positive way, to generate a creative destruction process. The new waves bring novelty that destroys the existing structures in favor of recent creations. This process cannot be assumed to lead to a steady-state economic equilibrium that results in macro-stability. It is a continuous change process that instead moves forward in an unbalanced way and causes instability. Continuous innovations come from within; they are endogenous changes, the very dynamics of capitalism, disrupting any possible equilibrium situation and pushing the entire system beyond its existing boundaries. Compared with the previous state of the world, a new level of possible state can be sought through more progressive innovations in a rush for novelties (and opportunities)

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without ever reaching a stabilizing equilibrium path of evolution. If any, an equilibrium point might only be possible if the economy enters a steady-state configuration and then loses momentum! Innovations are assumed to provide the innovator – the Schumpeterian entrepreneur – with advantages in the market’s competitive struggle and enable them to obtain higher profits and dominant market positions. Profits will decrease as the innovation is imitated or replicated by other enterprises. Thus, real boom-and-bust cycles, which are supposed to rest on entrepreneurial innovation dynamics mainly, come into the picture and determine the path of economic development. These Schumpeterian hypotheses are, to date, a remarkable source of inspiration for much research on economic growth and depression cycles. Indeed, various works refer to the Schumpeterian creative destruction dynamics to study capitalism’s cyclical and unstable behavior. For instance, Francois and Lloyd-Ellis (2003) argue that decentralized decision-makers argue that cyclical fluctuations result from independent actions. Fluctuations would result from the expectations of entrepreneurs (the so-called “animal spirits” and innovations that would provide the impetus for expansion and slowdown). From another angle, Nordhaus (2021) maintains that economic dynamics rely on the evolution of technology innovations and that rapid growth in information technology and artificial intelligence would cross some boundaries,2 leading to a cascade of improvements through the economy that would allow economic growth to rise rapidly. To explain the roots of the Great Depression, one must look at the institutional conditions of that time. According to Schumpeter, “time series never tell the whole tale and must be supplemented by a detailed historical account of what happened in the economic organism” (1946: 2). The beginning of the twentieth century was a third stage of the industrialization process (transition from agricultural to industrial society) that brought many discoveries in physics and chemistry. Industrial development was furthered by the increasing domestic and foreign demand for goods and services (the population of the continental US increased from 76 million in 1900 to 107 million people in 1921) (United States Census Bureau). World War I also stimulated high foreign demand for products from the Faruk Ülgen and Lyubov Klapkiv

US industry. By the 1920s, the US produced almost 40 percent of global manufacturing output, 60 percent of world steel production, and 80 percent of cars registered worldwide3 (Grubler, 1995: 52). The United States had an overwhelming advantage in the traditional manufacturing sectors and the newest industries such as automobile, oil and gas, mining and quarrying, and agricultural machinery. Still, such a growing production of goods was suffering from insufficient and insolvent external demand. To counterbalance such a constraint, the US government introduced, as early as 1920, a model of inflationary economic growth that allowed for price support and increased exports. However, these policies have provoked profound distortions in different industries since they have also affected the productive sector’s innovation processes. One might argue that the breakdown of 1929–1933 was not a sudden, unprecedented shock, as the intensity of the depression had “to be in some way proportional to the intensity of the preceding progress” (Schumpeter, 1991: 351), as well as to the evolution of the productive activities and the institutional and political environment. Along with the historical and institutional picture, capitalism is assumed to develop through an endogenous process that Schumpeter calls the natural process of “self-healing” of capitalism as a part of the “creative destruction” process. The latter would serve to eliminate inefficient activities and strengthen successful enterprises. The depression is that period by which economic life adapts itself to the changes brought about by the preceding prosperity. It is, as Juglar was the first to point out, the reaction of the economic organism to what happened in the period of prosperity, or, to put it still another way, it is the attempt of economic life to reach a new state of equilibrium embodying the new conditions created by prosperity. (Schumpeter, 1931: 5)

During this period, companies must reorganize themselves and adapt (Schumpeter, 1939: 162). At the same time, Schumpeter distinguishes between the concepts of “depression” and “crisis”. The latter phenomenon would arise from the influence of some specific factors that are assumed to be exogenous to the real dynamics of capitalism (such as

Great crises of the twentieth and twenty-first centuries  183

some financial dynamics) since the (positive) innovations that hit and push forward the economy are assumed to come from real-sector entrepreneurs. Therefore, the depression of 1929–1933 was not a “normal” phenomenon in Schumpeter’s sense since it was not a real cycle movement but an instability mainly due to reckless finance: “the excesses of speculation and loose banking methods make the thing much worse than it otherwise would be” (Schumpeter, 1941: 350). The transition from an agricultural to an industrial society was just a background of the economic depression. The influence of external factors on the process of evolution modifies depression into a pathological event, such that previous business entities are destroyed without creating new ones. Ideally, such entities should adapt and survive the depression stage in a real economic environment. In this vein, Schumpeter (1946) notices some peculiar determinants of the Great Depression: 1. Speculative mania of 1927–1929: Although stock and land speculation is a “natural” or even “necessary” feature of economic prosperity, Schumpeter focuses on “mass psychology” with financial capital and abnormal investment practices.4 2. The weaknesses of the United States banking system and its lack of effectiveness: Three bank epidemics during the crisis brought, intensified, and transmitted paralysis through all sectors. The banking sector could not stand up to instability and prevent it from spreading. 3. The mortgage situation and overindebtedness: During the second decade of the twentieth century, borrowing and lending continuously fed the demand for goods: “during the twenties, households habitually overspent their current receipts from firms’ or that the algebraic sum of household savings was negative throughout, the deficit being covered by borrowing and by drawing upon speculative gains” (Schumpeter, 1946: 2). The fear of losing their houses gets depression moving because of the mass psychological effects upon the community. One can draw upon this Schumpeterian analysis to understand the roots of the 2007–2008 turmoil.

To the Great Crisis and financial innovations: does the history rhyme?

In the 1970s, Hyman Minsky, a Ph.D. student of Schumpeter in the late 1940s at Harvard, put forward the hypothesis of financial instability (fragility) and, on its basis, explained several crises that have occurred over the past 100 years. The concept is based on the following thesis. The capitalist economy is a monetary economy that relies on a continuous debt-creation process to finance productive and speculative activities. Its internal dynamics rest on a financial structure that is “genetically” prone to crises – an endogenously unstable system (Minsky, 1992). This “financial instability hypothesis” also explains the Great Crisis of 2007–2008. The usual biases admitted during previous crises came forward in the behavior of the companies, public supervisors, and consumers. According to Minsky, economic dynamics heavily depend on investments in the entrepreneurial sector and how they are financed (Minsky, 1983). At the beginning of the upward phase of the business cycle (in the recovery phase), hedge finance prevails. The current cash inflows of firms are sufficient to pay off debt, including interest on it. This funding regime primarily results from firms’ reliance on domestic funding rather than external funding. This is because, during the recovery phase, the memories of the recent depression are still fresh in the mind of economic agents. Therefore, the lenders’ and borrowers’ risks are still felt too high, and prudent decisions prevail on actors’ strategies. However, these memories are gradually fading, partly because the national income generated by investment in a secured funding regime is increasing. The estimated level of risk of the lender and the borrower starts to decrease. Keynes (1936: 128) also notes: “During a boom the popular estimation of the magnitude of both these risks, both borrower’s risk and lender’s risk, is apt to become unusually and imprudently low”. During such a euphoria, firms are actively switching to external financing of capital investments. In a shortage of reserves, financial institutions can satisfy the “investment” demand of firms for money through financial innovations (Minsky, 1957). Faruk Ülgen and Lyubov Klapkiv

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After a while, a situation arises in which the cash receipts of many firms are sufficient only to pay interest on debts, but they are not enough to cover these debts (that is, to pay off part of the principal amount of debt). To avoid going bankrupt, firms are forced to take out new loans to repay old ones. Minsky named this funding regime “speculative finance”. When interest rates rise or firms’ cash inflows fall, speculative financing is inevitably transformed into Ponzi finance, in which these earnings are not enough even for regular interest payments. In such a situation, the only way out is to increase the debt to pay off old loans. For instance, in 1974–1975, the real estate investment trusts in the US involved households and investors in such “Ponzi” schemes. If speculative financing is characteristic of the boom phase, then Ponzi financing leads to the transition of the economy from this phase to the recession phase. This is because sooner or later, firms using the “Ponzi” financing regime will be unable to obtain new loans either because of the high value of the lender’s risk (reflecting the pessimism of financial institutions) or due to a general lack of financial resources when the market expectations about the sustainability of cumulated imbalances worsen. If, in order to obtain these resources, firms begin to sell their production assets, this will lead to a decrease in the demand-price for them, the level of investment, and, consequently, to an economic crisis. Such a crisis can be deepened by a high level of borrower risk (resulting from which firms’ investments will be less than the amount that could be financed using their internal sources), especially if the demand-price for productive assets falls below their supply price. Indeed, in this latter case, nothing but a collapse of the investment process will occur, with the whole market moving to the same side (supply side). The money market then dries up. According to Minsky’s theory of the financial stages of capitalism, the robust financial system (characterized by a high degree of liquidity in the balance sheets of economic units) changed qualitatively in the early 1970s toward increasing fragility. This was unveiled by the sequences of deep recessions in 1966, 1969–1970, and 1974–1975 in the US, UK, and German economies, and in 1997–1998 in East Asian countries and during the Great Financial Crisis in 2007–2008. Faruk Ülgen and Lyubov Klapkiv

This new phase of capitalism is mainly characterized by structural changes in financial market organization and regulation, the so-called financial innovations. Minsky assumes these changes to be the principal sources of system-wide crises experimented in the post-World War II era. They are also relevant to understanding and explaining the ongoing global financial (and economic) turmoil. From a Schumpeter-Minsky perspective, a few radical changes may then be put forward in this aim: 1. A paradigm shift in banking and finance. This shift leads to increasing income from securities transactions at the expense of long-term relationships between banks and real-sector borrowers. In Western advanced capitalist economies, the traditional banking of the Fordist real growth era of the 1950s to 1960s is transformed into a speculative-investment-securitization machine. Operations with a speculative character started to prevail in banking activity, especially after the liberalization of financial regulation in the early 1980s. These changes generated new rent opportunities for banks as well as for investors. The rapid growth of speculative rent operations involved most economic agents in a growing tendency toward short-sighted euphoric decisions about their credit abilities.5 Bubbles, manias, and speculative exuberance are periods of euphoria that produce attractive opportunities thanks to price increases (especially financial asset prices) greater than what would be justified by market fundamentals. They also provoke systemic booms of large scale that could result in systemic financial crisis, involving people in generalized panic and market crash (Aliber and Kindleberger, 2015). 2. Rise of a new capitalism variety, the “money manager capitalism”. This shifts competition from the manufacturing sector to the financial industry. The real economy is then largely incorporated within a worldwide speculation-based and low-real-growth machinery. This, in turn, perverts the socio-economic focus of innovations. Innovations initially aimed at reducing costs or increasing manufacturing resource efficiency are now used to maximize return on capital. Owners of financial capital began to compete for the

Great crises of the twentieth and twenty-first centuries  185

most profitable financial and commodity segments in the short run. Most often, the interests of financial capital do not coincide with real social needs, disturbing the social rationality of the production structure. Under the influence of external factors and manipulation of social opinion, demand for selected products and services, bringing the highest profits, became prevailing over market behavior. Therefore, social utility measured at market prices and interest rates points to most speculative activities. 3. Active use of financial innovation as a source of “bridge financing” (securitization). Minsky already showed in 1957 that in case of a shortage of reserves, financial institutions meet the “investment” demand of firms for money through financial innovation (Minsky, 1957). However, it is worth noting that in the financial liberalization era of the 1990s to 2000s, financial innovations did not meet the financial needs of a growing real productive economy but generated new opportunities to ensure high financial returns, despite low and stagnant wage incomes. On one side, consumption has been supported by further and massive debt creation without sustainable improvement of middle-class income. On the other side, the generalized increase of securitization operations in financial markets showed the ambiguity of its advantages regarding the increasing burden of new risks. The main advantage of securitization is that it reduces limits to bank initiatives to create credits (there is no immediate need for bank capital), for the credits do not absorb bank reserves (Minsky, 1984). Consequently, the banking system is freed from some regulatory restrictions. However, as the financial crisis proved, innovations can provoke instability because: “A need by holders of securities who are committed to protect the market value of their assets (such as mutual or money market funds, or trustees for pension funds) may mean that a rise in interest rates will lead to a need by holders to make position by selling position, which can lead to a drastic fall in the price of the securities” (Minsky, 2008: 3). Similar dynamics were at work in the rise of instabilities during the financial

liberalization period of the 1990s-2000s. Indeed, the financial crisis of 2007–2008 showed that financial innovations nurtured the process of economy-wide financialization that reduced the share of real entrepreneurial activities, transformed the economy into a speculative rent machine, and generated systemic crises (Ülgen, 2019). 4. Perverse regulatory changes. In this picture, the regulatory framework is loosened in favor of market-relying and micro-rationality-based self-regulation mechanisms (such as banks’ internal ratings-based models of self-assessment and rating agencies’ assessment practices through market contract schemes). The motto was: no government regulation can do better than the market self-adjustment capacity (see Barredo-Zuriarrain, Ülgen, and Radonjić (2020) for a comprehensive analysis of such a theoretical and political stance). Greenspan (2002) states, “The extent of government intervention in markets to control risk-taking is, at the end of the day, a tradeoff between economic growth with its associated potential instability and a more civil but less stressful way of life with a lower standard of living”. Therefore, the public power voluntarily becomes less active in implementing stabilization policies. In the global context, the main factor in spreading financial fragility worldwide is the lack of regulations and rules limiting international financial flows (Wolfson, 2002: 396). Comparing the US economy under the conditions in 1974–1975 and 1929–1933, Minsky admitted that over 1974–1975, countries “exhibited more resilience as government’s involvement in the economy was much greater and more effective” (Minsky, 1978: 20). However, since the late 1970s, the sharp reduction in government intervention in the economy led to a structural de-industrialization in major mature economies. One of the adverse effects of this process was the 2007–2008 systemic crisis with persistent unemployment and cumulated disequilibria (Ülgen, 2019: 135). Although beyond the scope of this entry, another point of interest is related to international linkages among domestic economies Faruk Ülgen and Lyubov Klapkiv

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that are increasingly integrated into global financial markets and debt-financing operations. The example of the East Asian countries showed that the high dependency of domestic markets on foreign capital (mostly borrowed in USD) could have a positive influence but in a stable environment. On the contrary, amid weaknesses and cumulated imbalances that emerging and developing economies usually suffer from, financial integration might be a source of instabilities. For instance, in the wake of the increase in stock market prices and domestic currency devaluation, Asian countries suffered speculative capital outflows whose average cost is estimated at around 10 percent of the GDP in the region. The problem with solvency decreased as currency exchange collapsed by 30 percent (Цветков, 2012: 425).

unstable environment. In the case of such a “swing”, the government plays the role of the brake. It is worth mentioning that every point of instability in the financial market is different: “what is an apt legislated structure at one time becomes inept as time goes by” (Minsky, 1994: 3). Among the factors that had to be considered are the fast growth of new institutions and instruments and the third millennium’s ability to communicate and compute (Minsky, 1994: 3). As seen from the last decades, these factors are also mentioned as a reason for the 2007–2008 crisis. The government’s after-crisis strategy must include at least three elements: monetary, fiscal, and financial market. Minsky (2008: 21) documents that government intervention in 1975 had two directions to prevent depression in the US:

Concluding remarks: appropriate regulation to fight against recurrent systemic crises

1. Big Government’s fiscal policy (the massive federal deficits in the recessions directly affected income, sustained private financial commitments, and improved the composition of portfolios); and 2. Lender of last resort (refinancing was aptly executed by the Federal Reserve System gathering private and public bodies within the recovery process).

Schumpeter and Minsky have both argued that a big government was necessary for the sustainable functioning of capitalism. Schumpeter put this idea forward in his analysis of the 1929 Great Crisis and Minsky in his analysis of the post-World War II recurrent crises in the US and Western economies to assess the conditions required to stabilize (endogenously unstable) markets in a relevant way. However, as Hospers (2005: 33) states: “The Schumpeterian philosophy on state intervention will sound ambivalent”. Indeed, there is not only one answer to the rational level of government regulation (intervention). It depends on the situation and moment that is in the focus of the regulation process. Following the Crisis Hypothesis (Minskyan Financial Instability Hypothesis), “under certain conditions, national emergencies call forth extensions of governmental control over or outright replacement of the market economy” (Higgs, 2013: 39). From the historical perspective, during and after the wars and financial crisis in the twentieth and twenty-first centuries, the demand for government regulation increased. It is a natural “instinct” to be unstable; the system and its participants are looking for stabilizing, pervasive, and strong visible “hand”. No entity of the financial system can go back to stability by itself, as it is affected by the Faruk Ülgen and Lyubov Klapkiv

This analysis is obviously in a Schumpeterian vein since Schumpeter (1939: 410–437, 683, 987, 1027; 1934: 112, 235, among others) argued in favor of “big government” supporting the continuous functioning of the economy against “wild excesses” of financial markets that usually result in a systemic crisis like the 1929–1933 Great Crisis that the Banking Act of 1933 aimed at giving a structural answer. Public rescue decisions often had a political character, so they were so sensitive in the sense of rationality. “Public–private partnership” was the US Treasury Department’s strategy for keeping the financial markets stable in 2007–2008. It created a new market with government loans and guarantees for troubled assets. The plan offered what Stiglitz calls a “win-win-lose proposition”; that is, a win for banks, a win for investors, and a loss for taxpayers. Stiglitz (2009) argued that the plan encourages investors to bid in this market of high uncertainty and socialize the losses that can occur: “Perhaps it’s the kind of Rube Goldberg device that Wall Street loves clever, complex and nontransparent, allow-

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ing huge transfers of wealth to the financial markets”. Minsky (2008) maintains that it could be possible to stabilize the unstable capitalist economy if consistent regulatory rules are implemented in financial markets. Several directions might be imagined in this aim. One of the first steps is that government stabilization policies must be rational to limit public guarantees on the debts of private entities. Full-cover public guarantee seeds biases among private companies about public rescue obligation. An example of such a policy is the Emergency Economic Stabilization Act of 2008, which was signed to mitigate the bankruptcy of American companies. Early estimates for the total cost of the bailout to the government were as much as $700 billion (Tracy, Steinberg, and Demos, 2014). In response to the evolutionary process, state regulation and market self-regulation must be mutually strong. Without a strong state, market institutions become a chaotic set of unfair entities of private self-interest that hinder each other’s development. Without a robust and well-regulating market represented by sound individual entrepreneurs and businesses as such, the state loses its ability to defend public interests and support the evolution of society: The new authority, which will replace the existing complex of authorities, needs to be sensitive to the evolutionary character of our economy and financial structure and to be independent of the particular interests of the constituent elements of the existing and ever-changing banking and financial structure: an authority whose domain is the entire financial structure will not see its role to be the defense of particular vested interests in the financial structure. (Minsky, 1994: 3)

Rational public policy is an essential element of Minsky’s theory. Government action is an unavoidable determinant of capitalist evolution; policy affects the details and the general character of the economy. Thus, “economic policy must be concerned with the design of institutions as well as operations within a set of institutions” (Minsky, 2008: 7). Moreover, shaping the economy requires the definition of objectives. No price mechanism or other “invisible hand” can be invoked to ensure

optimal economic welfare, only a social system shaped by individual and collective choices. Faruk Ülgen and Lyubov Klapkiv

Notes 1.

See Ülgen (2013) for a critical account on these approaches. 2. At such a point, the rate and breadth of technological change would be so great that it could be labeled “the singularity” (Nordhaus, 2021: 302). 3. The total number of the registered motor vehicles in the US increased from 2,445,000 in 1915 to 7,505,000 in 1920 (United States Census Bureau). 4. Later, economics literature would label this process as “Minsky’s moment”. See, for instance, Ferri (2019). 5. The households became, through the subprime mortgage euphoria in the 2000s, especially in the US, very engaged speculators since they had the possibility to buy a house without repayment during the first years of mortgage (whereas their income level was not suitable for this kind of high-debt operation) and to expect price increases on their “speculative” house investments by several times in a few years. In this way, the popular stock-holder capitalism of the early 1980s in the UK and the US was transformed into a society-wide popular mortgage speculator capitalism.

References

Aliber, R.Z. and Kindleberger C. (2015), Manias, Panics, and Crashes: A History of Financial Crises, London: Palgrave Macmillan. Barredo-Zuriarrain, J., Ülgen, F. and Radonjić, O. (2020), “Fallacies of market-friendly financial regulation conducted by the Federal Reserve in the 1990s and 2000s”, Journal of Post Keynesian Economics 43(4): 540–575. Ferri, P. (2019), Minsky’s Moment: An Insider’s View on the Economics of Hyman Minsky, Cheltenham: Edward Elgar Publishing. Francois, P. and Lloyd-Ellis, H. (2003), “Animal spirits through creative destruction”, The American Economic Review 93(3): 530–550. Greenspan, A. (2002), “Regulation, innovation, and wealth creation”, remarks before the Society of Business Economists London, England, September 25. Greenspan, A. (2005), “Economic flexibility”, remarks Before the National Italian American Foundation, Washington, DC, October 12, www​.federalreserve​.gov/​boarddocs/​speeches/​ 2005/​20051012/​default​.htm. Grubler, A. (1995), “Industrialization as a historical phenomenon”. In R. Socolow, C. Andrews, F. Berkhout, and V. Thomas (Eds), Industrial Ecology and Global Change, Cambridge: Cambridge University Press: 23–42.

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188  Elgar encyclopedia of financial crises Higgs, R. (2013), Crisis and Leviathan: Critical Episodes in the Growth of American Government, Oakland, CA: The Independent Institute. Hospers, G. (2005), “Joseph Schumpeter and his legacy in innovation studies”, Knowledge, Technology and Policy 18(3): 20–37. Keynes, J.M. (1936 [2018]), The General Theory of Employment, Interest, and Money, London: Palgrave Macmillan. Minsky, H.P. (1957), “Central banking and money market changes”, Quarterly Journal of Economics 71(2): 171–187. Minsky, H.P. (1978), “The financial instability hypothesis: A restatement”. http://​ digitalcommons​.bard​.edu/​hm​_archive/​180. Minsky, H.P. (1983), “The financial instability hypothesis: An interpretation of Keynes and an alternative to ‘standard’ theory”. In J.C. Wood (Ed.), John Maynard Keynes: Critical Assessments, London: Macmillan. Minsky, H.P. (1984), Can “It” Happen Again? Essays on Instability and Finance, Armonk, NY: M. E. Sharpe, Inc. Minsky, H.P. (1992), “The financial instability hypothesis”, The Levy Economics Institute Working Paper No. 74, May, www​.ucm​.es/​data/​ cont/​media/​www/​pag​-41460/​The​%20Financial​ %20Instability​%20Hypothesis​%20Minsky​.pdf. Minsky, H.P. (1994), “Issues in bank regulation and supervision”, Hyman P. Minsky Archive Paper 72, http://​digitalcommons​.bard​.edu/​hm​ _archive/​72. Minsky, H.P. (2008), Stabilizing an Unstable Economy, New York: McGraw-Hill. Nordhaus, W.D. (2021), “Are we approaching an economic singularity? Information technology and the future of economic growth”, American Economic Journal: Macroeconomics 13(1): 299–332. Schumpeter, J.A. (1931), “The theory of the business cycle”, Keizaigaku-Ronshu (The Journal .netmode​ .ntua​ of Economics) 4: 1–18, www​ .gr/​~ktroulos/​pub/​papers/​Schumpeter​,​%20J​ .A​.​%20​%281931​%29​_Theory​%20of​%20the​ %20Business​%20Cycle​.PDF.

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Schumpeter, J.A. (1934 [1961]), The Theory of Economic Development, Cambridge, MA: Harvard University Press. Schumpeter J.A. (1939), Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist Process, London: McGraw-Hill Book Company. Schumpeter, J.A. (1941), “An economic interpretation of our time: The Lowell Lectures” (reprinted 1991 in Joseph A. Schumpeter: The Economics and Sociology of Capitalism, edited by R. Swedberg, pp. 339–400, Princeton, NJ: Princeton University Press). Schumpeter, J.A. (1946), “The decade of the twenties”, The American Economic Review 36(2): 1–10. Schumpeter, J.A. (1991), “Can capitalism survive?” In R. Swedberg (Ed.), Joseph A. Schumpeter: The Economics and Sociology of Capitalism, Princeton, NJ: Princeton University Press: 298–315. Stiglitz, J.E. (2009), “Obama’s ersatz capitalism”, The New York Times, www​.nytimes​.com/​2009/​ 04/​01/​opinion/​01stiglitz​.html. Tracy, R., Steinberg, J., and Demos, T. (2014), “Bank bailouts approach a final reckoning”, The Wall Street Journal, December 28, www​ .wsj​.com/​articles/​ally​-financial​-exits​-tarp​-as​ -treasury​-sells​-remaining​-stake​-1419000430. Цветков, В. (2012), Циклы и кризисы: теоретико-методологический аспект, Москва; СПб: Нестор-История. Ülgen, F. (2013), “Is the financial innovation destruction creative? A Schumpeterian reappraisal”, Journal of Innovation Economics & Management 11: 231–249. Ülgen, F. (2019), “Innovation dynamics and financialisation: Is another regulation possible to re-industrialise the economy?” Journal of Innovation Economics & Management 29: 133–158. United States Census Bureau. Statistical Abstract of the United States: 1920, www​.census​.gov/​library/​publications/​1921/​ compendia/​statab/​43ed​.html. Wolfson, M. (2002), “Minsky’s theory of financial crises in a global context”, Journal of Economic Issues 36(2): 393–400.

43. Hyman Minsky (1919–1996) American economist Hyman Minsky is perhaps best known for his work on financial instability, explaining how and why financial crises were an intrinsic feature of a dynamically unstable capitalist system. Born in 1919, his New York Times obituary offers a glimpse into his formative academic years. Hyman Philip Minsky, who was born in Chicago, graduated from George Washington High School in upper Manhattan. He received a bachelor’s degree in mathematics at the University of Chicago in 1941, but influenced by Henry Simon, a revered economist, he shifted fields and received a doctorate in economics at Harvard in 1954, specializing in finance. (Uchitelle, 1996)

Beyond Henry Simon, Minsky’s intellectual influences included many of the leading economists at the time. At Harvard, he studied under Joseph Schumpeter and Wassily Leontief, worked as a teaching assistant for Alvin Hansen, and as a research assistant on Raymond Goldsmith‘s study of savings (Arestis and Sawyer, 2001). Other influences include Paul Douglas, Oscar Lange, and Frank Knight (Papadimitriou and Wray, 1997), and in his work he “made considerable use” of the work of John Maynard Keynes (Whalen, 2001). For much of his career (from 1965 to 1990), Minsky was a professor of economics at Washington University in St. Louis and was responsible for establishing the Levy Institute’s research programs in Monetary Policy and Financial Structure and The State of the U.S. and World Economies, which now houses the Minsky Archives (Levy Institute, n.d.). As reported in the Levy Institute’s biography of Minsky, earlier faculty appointments included Carnegie Tech (now Carnegie Mellon University) and Brown University. From 1957 to 1965, Minsky was an associate professor of economics at the University of California, Berkeley. In 1996, Minsky was awarded The Association for Evolutionary Economics Veblen-Commons Award in recognition of his significant contributions to evolutionary institutional economics.1 His work was motivated by a belief in the “flawed nature

of unregulated macroeconomic activity” and their inherent instability (Minsky, 1980, 1982, 1986, 1992, 1993, 1996). He sought to explain this dynamic instability by integrating the insights of both Joseph Schumpeter and John Maynard Keynes. Minsky‘s contribution lies in extending Schumpeter‘s forces of creative destruction in products and manufacturing processes to financial firms (Whalen, 2001, 808). “Nowhere is evolution, change, and Schumpeterian entrepreneurship more evident than in banking and finance, and nowhere is the drive for profits more clearly the factor making for change” (Minsky, 1993, 106 as cited in Whalen, 2001, 808–809). While many of Minsky’s ideas may be generalized to other economies at an advanced stage of capitalism, Minsky focused on analyzing the institutions and dynamic behavior of the American economy (Minsky, 1986, 1993, 1996). The capitalist dynamics undergirding Minsky‘s views of financial instability and crises are what many refer to as Minsky’s “Wall Street paradigm” – a framework that emphasizes a financial theory of investment. Intricate, complex, and occurring in historical time, Minsky carefully tracked the dynamics of output prices, debt, and asset values concerning financial market conditions (including expectations, institutional realities, and policy stances) that affected the availability of external financing. Against a backdrop of an unknown future (Minsky, 1996), Minsky describes in detail over various articles and books how a prolonged economic expansion encourages investors (through rising optimism and a recession of any memory of previous hardship) to replace their expectations of a normal business cycle with the expectation of ongoing expansion. The expectations of continuing profits, in turn, encourage businesses to take on greater debt. In addition to a rising scale of debt in proportion to profits, financial innovation rises. Where initially, firms and investors are cautious about the amount of funds they borrow and on what terms, borrowers become much less wary as the expansion continues and optimism spreads. At some point throughout a boom period, either the central bank initiates actions designed to slow the economy, or the evolution of debt payments eventually exceeds

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profits, thus limiting the borrower’s ability to service their debt (see Whalen, 2001, 819, n.1; Dymski, 1997). Either event introduces a reversal of fortunes, some of which can be abrupt. “When overindebted investors are forced to sell even their less-speculative positions to make good on their loans, markets spiral lower and create a severe demand for cash – an event that has come to be known as a ‘Minsky moment’” (Levy Institute, n.d.). As Arestis and Sawyer (2001, 414) aptly summarize it, the “financial instability hypothesis” “holds that over a period of good times the financial structures of a dynamic capitalist economy endogenously evolve from being robust to being fragile, and that once there is a sufficient mix of financially fragile institutions, the economy becomes susceptible to debt deflations.” Minsky characterizes the transition of business financing through three stages – hedge, speculative and Ponzi financing. Marking the cycle is borrowing to finance low-risk real investment at the outset (hedge financing) through financing with the hope that profits will be forthcoming (speculative financing) to more distressed financing to service debt (Ponzi financing) at the height of it. As more funds are borrowed for shorter periods and shorter loans are rolled over, loan payments become increasingly more dependent on the delivery of capital gains. Movements in interest rates and profits across the course of the financing cycle drive and are driven by this evolution in financial fragility. Over time, a given economic slowdown that eliminates capital gains and lowers business profits threatens the overall system. “Thus,” wrote Minsky, “after an expansion has been in progress for some time, an event that is not of unusual size or duration can trigger a sharp financial reaction” (Minsky 1982, 121). On the downswing, a debt-deflation spiral of the type discussed by Fisher (1933) eliminates credit, and drags down the economy, investment, production, and employment. To stabilize the inherently unstable capitalist economy, Minsky advocated for the active involvement of a big government. He favored the active use of counter-cyclical policy intervention by a government “big enough to ensure that swings in private investment lead to sufficient offsetting swings in the govern-

Brenda Spotton Visano

ment’s deficit so that profits are stabilized” (Minsky, 1986, 296–297). Brenda Spotton Visano

Note

1. Veblen-Commons Award. The Association for Evolutionary Economics: https://​afee​.net/​?page​=​ institutional​_economics​&​side​=​veblencommons​ _award.

References

Arestis, P., and Sawyer, M. C. 2001. “Minsky, Hyman P. (1919–1996).” In A biographical dictionary of dissenting economists. 2nd ed. Edited by Arestis, P., and Sawyer, M. C., 411–417. Cheltenham: Edward Elgar Publishing. Dymski, G. A. 1997. “Deciphering Minsky’s Wall Street Paradigm.” Journal of Economic Issues, 31, no. 2: 501–508. Fisher, I. 1933. “The Debt-Deflation Theory of Great Depressions.” Econometrica, 1, no. 4: 337–357. Levy Institute. n.d. Hyman P. Minsky, Levy Institute website, www​.levyinstitute​.org/​about/​minsky. Minsky, H. P. 1980. “Capitalist Financial Processes and the Instability of Capitalism.” Journal of Economic Issues 14, no. 2: 505–523. Minsky, H. P. 1982. Can “It” Happen Again? Essays on Instability and Finance. Armonk, NY: M.E. Sharpe. Minsky, H. P. 1986. Stabilizing an Unstable Economy. New Haven, CT: Yale University Press. Minsky, H. P. 1992. “The Financial Instability Hypothesis.” The Jerome Levy Economics Institute, Working Paper No. 74 (May). Available at www​.levyinstitute​.org/​pubs/​wp74​ .pdf. Minsky, H. P. 1993. “Finance and Stability: The Limits of Capitalism.” Jerome Levy Economics Institute Working Papers No. 93. Available at http://​dx​.doi​.org/​10​.2139/​ssrn​.141121. Minsky, H. P. 1996. “Uncertainty and the Institutional Structure of Capitalist Economies.” Journal of Economic Issues 30, no. 2: 357–368. Papadimitriou, D. B., and Wray, L. R. 1997. “A Tribute to Hyman P. Minsky.” Journal of Economic Issues, 31, no. 2: 491–492. Uchitelle, L. 1996. “H. P. Minsky, 77, Economist Who Decoded Lending Trends.” The New York Times (Oct. 26). Available at www​ .nytimes​ .com/​1996/​10/​26/​us/​h​-p​-minsky​-77​-economist​ -who​-decoded​-lending​-trends​.html. Whalen, Charles J. 2001. “Integrating Schumpeter and Keynes: Hyman Minsky’s Theory of Capitalist Development.” Journal of Economic Issues 35, no. 4: 805–823.

44. IMF and World Bank remedies for financial instability Introduction

Developing or emerging market economies may be faced with economic instability in the form of either or both external and internal imbalance. The former is manifested in a balance of payments crisis, a falling currency, and unsustainable foreign debt obligations. The latter may involve a stagnant or declining economy, high inflation, and large government budget deficits. In these circumstances, member countries may seek financial support from the world’s two main multilateral aid and financial institutions, the World Bank and the International Monetary Fund (IMF). The World Bank lends money and provides expertise for various sectoral activities, including agriculture, energy, transportation, education, health and nutrition, and urban development. It also pays a lot of attention to helping countries improve economic policies. A significant part of its lending is for structural adjustment, namely loans to support reforms rather than specific investments. The IMF allows member countries to borrow, subject to agreed-upon conditions on their economic policies. Adherence to these conditions and reforms is, in many cases, a prerequisite to obtaining other larger public and private loans. A Structural Adjustment Program (SAP) provides loans to countries on the condition that they undertake a combination of economic policy reform measures to improve long-term economic growth outcomes. These programs link disbursements of funds to the meeting of specified conditions (performance criteria) negotiated with the member country’s government. While these programs are often negotiated in the context of financial crisis and attempt to restore balance of payments viability and macroeconomic stability, they are geared toward increasing international competitiveness and improving economic efficiency in using domestic resources. Often a country in financial distress has waited too long before asking for assistance from the IMF and World Bank. By that stage, economic turmoil is widespread, and

unpalatable economic remedies are needed to rectify the situation. This may involve a menu of higher interest rates, government spending cuts and higher taxes, and the abolition of various subsidies on consumption items. Often the country’s government will not have the support to implement these policies alone and can use the conditionality requirements of these two institutions to deflect criticisms. Nonetheless, the policies are unlikely to be popular, so the programs are highly controversial. The SAPs, in addition to contractionary macroeconomic policies, often include trade liberalization measures requiring fewer foreign trade restrictions. These include reducing or abolishing tariffs and quotas on imports, a less restrictive stance towards foreign investment, a more realistic exchange rate, and capital account liberalization that reduces controls on any form of capital flows across national boundaries. The internal market-oriented structural reforms promote the deregulation of domestic markets and the privatization of government enterprises.

Capital account liberalization

Emerging market economies have been strongly encouraged by international institutions like the IMF to open their markets to international capital flows (this is often called capital account liberalization). Proponents of liberalization suggest that it will lead to a more efficient global allocation of investment, improve opportunities for risk diversification and impose greater discipline on domestic policymakers. However, empirically, there is little evidence that growth or investment is higher in more financially open economies. It may be the case that a more open capital account positively affects growth only after a country has achieved a certain degree of economic development. Sound macroeconomic policies and improved institutions and governance, including robust legal and supervisory frameworks, are important in attracting less volatile capital flows and reducing a country’s vulnerability to crisis. If financial crises occur, the response of international institutions like the IMF has been to argue that the principal cause of the crisis was domestic financial sector weakness which permitted overinvestment. They state that since the neglect of financial sector reform got these countries into trouble, such

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reform has to be the centerpiece of the recovery package. It is then argued that banks and finance companies must either be closed down or recapitalized to meet international capital standards. Foreign ownership limits, they suggest, should be liberalized in the financial sector and supervision and regulation strengthened.

Trade liberalization

In 1960 less than one-sixth of the countries in the world had open trade policies. Most countries had trade restrictions such as high tariff rates (taxes on imports) and extensive nontariff barriers (such as quotas restricting the physical quantity of specific imports allowed into a country). In addition, the official exchange rate often exceeded the black-market exchange rate, and governments exercised monopoly controls on exports and other trade-related matters. By 2000, three-quarters of the countries in the world had removed many of these impediments and were now open to international trade. This remarkable transformation highlights the importance of trade liberalization in the global economy. What precipitated the extensive trade liberalization that occurred? Much of the credit is usually given to the 60 years of multilateral trade negotiations that have resulted in ever-lower trade barriers under the auspices of the General Agreement on Tariffs and Trade (GATT). In the context of developing countries, a series of country studies sponsored by the World Bank, the Organisation for Economic Co-operation and Development (OECD), and the National Bureau of Economic Research demonstrated that trade barriers imposed significant costs. In contrast, trade openness appeared to be associated with improved economic performance. While trade barriers in manufacturing have fallen extensively, the trade liberalization agenda has expanded its scope and consequently run into considerable difficulties and claims about unfairness in trade negotiations (Watkins and Fowler 2003). Nongovernment organizations have advocated “social clauses” in trade liberalization agreements relating to child labor, human rights, the environment, wages, and other conditions.

John Lodewijks

The effectiveness of SAPs

The IMF has staunchly defended the economic policies they have recommended to the crisis-affected countries. They argue that the causes of financial crises are internal or home-grown, reflecting underlying structural distortions and macroeconomic imbalances. Using high interest rates temporarily was essential to correct the excessive competitive devaluations in the crisis countries. Insolvent financial institutions had to be closed down, and belt-tightening was crucial. The critics argue that countries, under pressure from the IMF and the U.S. Treasury, liberalized their capital markets too rapidly before the appropriate regulatory structures were in place. Hence financial instability was inevitable. The IMF needed to boost demand by loosening, not tightening, monetary and fiscal policies. The use of high interest rates, even temporarily was contractionary, while insolvent financial institutions that closed down were later sold to foreign interests at bargain-basement valuations (Stiglitz 2002). Hence the effectiveness of SAPs as a remedy for financial and other economic crises is a hotly debated issue. One issue relates to the speed of the structural adjustment required. Should all of these policies be implemented immediately or only gradually? Many economists argue that gradual reforms are needed to minimize short-term costs, such as business failure and unemployment. Further issues relate to the sequence of liberalization. In general, trade liberalization should precede financial liberalization, domestic financial liberalization should precede external financial liberalization, and direct investment liberalization should precede portfolio and bank loan liberalization (capital account liberalization). There is also considerable disagreement on the benefits of trade liberalization policies (Rodrik 2017). The success of the East Asian countries with export-led growth suggests that some selectively determined degree of government intervention played a key role.

Conclusion

The results are mixed on the overall effectiveness of World Bank and IMF-enacted remedies for financial crises. Often the results depend on the characteristics of the specific country concerned. Countries have

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generated a variety of responses to similar policies. This seems to reflect the importance of institutional, social, and historical differences between countries. The most damning critique of the IMF/World Bank remedies has come from some of their own “insiders.” The latter found that despite the implementation of large numbers of financial rescue packages and structural reform, there was no perceptible improvement in economic growth in the developed world (Easterly 2001, 2006, 2014). Moreover, many of the “remedies” previously imposed on developing countries during the Global Financial Crisis were abandoned for precisely the opposite macroeconomic policies decades later (Stiglitz 2010). The question remains as to whether the international organizations have learned from the lessons of the past. Indeed, the rhetoric seems to suggest that there has been a fundamental transformation in terms of loan conditionality. The impacts of SAPs on social sectors and the poor have been particularly troublesome, and the IMF and World Bank have attempted to incorporate social safety nets into their programs. There is now more awareness of the social consequences of macroeconomic adjustment, particularly the long-term effects on the economic growth of cuts in spending on public health and education. Debt restructuring is also now regarded more sympathetically, as is the acknowledgment that too many policy-related conditions were imposed on countries. There has also been an acceptance that greater inequality may inhibit economic growth. The critics question whether the changed rhetoric on social inclusiveness and inequality has been incorporated into loan conditionalities (Forster et al. 2019; Kentikelenis et al. 2016). The IMF’s own 2018 Review of Program Design and Conditionality indicated that the number of structural conditions had risen again. Moreover, regarding the responses to financial crises, the IMF under-

estimated fiscal multipliers and overestimated the benefits of program conditionality. In the context of a global pandemic, sustainable development challenges, and human rights concerns, these international institutions may be challenged to transform their agenda and policy direction more seriously. John Lodewijks

References

Easterly, William. (2001) The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics, Cambridge, MA: MIT Press. Easterly, William. (2006) The White Man’s Burden: Why the West’s Efforts to Aid the Rest Have Done So Much Ill and So Little Good, Hampstead: Penguin. Easterly, William. (2014) The Tyranny of Experts: Economists, Dictators, and the Forgotten Rights of the Poor, Hampstead: Basic Books. Forster, Timon, Alexander E. Kentikelenis, Bernhard Reinsberg, Thomas H. Stubbs, & Lawrence P. King. (2019) “How structural adjustment programs affect inequality: A disaggregated analysis of IMF conditionality, 1980–2014,” Social Science Research, Vol. 80, May, pp. 83–113. Kentikelenis, Alexander E., Thomas H. Stubbs, & Lawrence P. King. (2016) “IMF conditionality and development policy space, 1985–2014”, Review of International Political Economy, Vol. 23 No. 4, pp. 543–582. Rodrik, Dani. (2017) Straight Talk on Trade: Ideas for a Sane World Economy, Princeton, NJ: Princeton University Press. Stiglitz, Joseph E. (2002) Globalization and Its Discontents. New York: W.W. Norton & Company. Stiglitz, Joseph E. (2010) The Stiglitz Report: Reforming the International Monetary and Financial Systems in the Wake of the Global Crisis. New York: The New Press. Watkins, Kevin, & Penny Fowler. (2003) Rigged Rules and Double Standards: Trade, Globalization, and the Fight Against Poverty, Oxford: Oxfam.

John Lodewijks

45. Income inequality before the Great Depression and Global Recession Introduction

There has been a long tradition in economics that emphasizes the effects of distribution on economic processes, seen in Smith, Ricardo, Marx, and Keynes’s works. Economists, especially those belonging to Marxist and Post-Keynesian schools, continue to search for the implications of income inequality. However, interest in income distribution issues declined during the post-Second World War; this was mainly due to the fall in inequality during this period. Hence, mainstream economists have not given an important role to income distributional considerations in explaining financial crises. However, in recent years, especially after crises, the feature of that interest has evolved into an analysis of its effects on macroeconomic variables such as unemployment and growth. These ideas have started to infiltrate mainstream economics. Starting in the 2000s, especially after global crisis in 2008, some mainstream economists have been concerned with the reasons and effects of increasing income inequality. They have begun to debate more and more on the role of income inequality in developing the crisis. In line with this, they had also focused on whether increased inequality before the Great Depression of 1929 and the Great Recession of 2007–2008 contributed to the emergence of both crises.

Income inequalities before the Global Depression and Global Recession

The financial crisis of 2007–2008 has induced researchers to search for similarities between the Great Depression of 1929 and the Great Recession of 2007–2008. Most of them point out that the common tendencies in both cases were low-level interest rates, deregulation, and increasing financialization. However, such reasoning requires a more profound analysis. There were also several vital distinctions in the economies that experienced great crises in

1929 and 2008. One of these is, for example, that the share of the government expenditures was only 3 percent of national income in 1929 while it was much more than this, around 22 percent, in 2008 in the US. Another difference was the degree of financialization and financial speculation. It was much more widespread in the 2000s compared to the late 1920s. The speculation was concentrated in real estate in the 2000s, and in the stock market in the late 1920s. Historically the three significant periods of inequality in the US were 1860–1900, 1914 to the late 1920s, and the 1970s–2000s. In two of these three high-inequality periods, crises occurred. In these two periods, the economic state seemed prosperously high. The economic growth rate and unemployment were 4.7 percent and 3.7 percent per year on average, respectively, during the period 1922–1929, and the growth rate between 1993–2007 averaged 3.25 percent and 5.2 percent, respectively. However, in both periods, the productivity increase exceeded that in wages. This created critical distributional instabilities. As seen in Figure 45.1, income inequality peaked before the Great Depression and the Great Recession crises. In 1928 the top 10 percent obtained 49 percent of the total income. Then we know that the deepest recession in history occurred in the US. Nearly 80 years later, before the global crisis in 2007, the top 10 percent share reached its peak, which was 49.7 percent (The US Congress Joint Economic Committee, 2010). Similar trends are also seen in other income shares of the wealthiest 5 percent, 1 percent, and 0.1 percent. Furthermore, Phillips (2002, p. 11) mentions that the number of millionaires increased from 7,000 in 1922 to 30,000 in 1929. The reduction in corporate taxes and marginal income tax (from 65 percent to 32 percent) intensified the inequalities. Similarly, the real income of lower-income groups declined in the decades leading up to 2008. İn both periods, the top income groups obtained higher shares, especially the top groups. The share of the top 0.01 percent went up from 1.7 percent to 5 percent in the 1920s and from 0.9 percent to 6 percent in the 2000s (Wisman and Baker, 2011, p. 66). Wisman and Baker (2011) also show that productivity increases significantly exceeded the increases in wages on the way to both

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Income inequality before the Great Depression and Global Recession  195

Source:  The US Congress Joint Economic Committee (2010).

Figure 45.1

The income share of the wealthiest in the US (percent)

crises, leading to a decline in labor’s share and a rising share of capital. During the 1920s, stagnation of wages partially originated from labor-saving technological innovations, mainly in manufacturing, which caused a demand shift from unskilled to skilled labor. Labor-saving technologies displaced less skilled labor. Hence wages declined relatively. This is also seen in the fact that even though the increase in manufacturing production was about 64 percent during the decade, the number of workers remained relatively unchanged. Similarly, during the last three decades before the crisis in 2007–2008, the increase in wages significantly lagged the rise in productivity because of labor-saving technologies and increasing international trade that destroyed domestic manufacturing jobs. Decreasing wage share, thus increasing capital share, naturally resulted in the rising saving of the wealthy and inducing them to be involved in more financial transactions.

Theoretical debate on links between income inequalities and crises

Here we look at theoretical explanations of the links between income inequalities and financial crises. We can categorize these theoretical views into mainstream and non-mainstream theories.

Mainstream theories In contrast to non-mainstream economists, mainstream economists do not accept that crisis is inherent to market economies. They claim that economies have equilibrium tendencies. The forces of demand and supply will work out as an invisible hand that regulates them. Hence in this view, crises do not occur in normal circumstances. They are anomalies rather than inherent tendencies. Based on this tradition, the neoclassical theory argues that markets perform efficiently with fully informed agents maximizing their utilities. Hence crises are not the results of systemic miscalculations realized in real and financial markets. They result from governmental distortionary interventions or unexpected external shocks to the economic system, such as natural disasters. In this sense, the crises are not endogenous, thus not originating from internally determined forces. Hence, inequality is simply the result of the variation in productivity and will not have destructive effects on the economy. However, even though the general convention in the mainstream regarding financial crises has not changed much, along with the subprime crisis, some mainstream economists have questioned the assumptions used, and prominent economists have acknowledged that income inequality can trigger crises. Raghuram Rajan was one of the first economists that put forward a theoretical link between inequality and the global crisis in 2007–2008. Rajan (2010) argued Ensar Yılmaz

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that there had been a great transformation in skill-biased technology that changed the trends in inequality, deepening inequalities in the economy. To counteract this inequality, the US government induced lending to households with lower incomes. This expanded the credit volume in the economy. This was also supported by low interest rates and partially financed by increasing capital inflows, especially from China. This process’s eventual outcome was over-indebtedness, which any economy could not sustain for a long time, increasing systemic risk in the system that facilitated the emergence of the crisis. Parallel to Rajan, other economists like Roubini (2011), Reich (2010), Stiglitz (2009), and Milanovic (2010) also reject the mainstream view that asserts no connection between inequality and aggregate demand. For example, in line with Rajan, Milanovic argues that politicians were eager to intervene in the disturbing problem of middle-income stagnation and wanted to ease borrowing constraints of the lower-income groups to increase their consumption. Similarly, Stiglitz (2009) also thinks that aggregate demand would not be enough without the loose monetary policy during the post-2001 period due to the stagnation of wages. Expansion of credits allowed the people in the US to consume beyond their income. They caught up with their richer peers to maintain their consumption status. This reasoning resembles the view of Veblen’s conspicuous consumption. Hence increased consumption risked the sustainability of demand and increased debt in the economic system. Daron Acemoglu (2009) also participated in this debate. He asserts that politics drove both inequality and the financial crisis. Hence there is coexistence, not causation between inequality and the financial crisis. Acemoglu argues that politicians consider the interests of the rich minority rather than the poorand middle-income majority. The policies implemented generally favored the rich— rather than low- and middle-income groups. According to him, financial deregulation policies were implemented before the crisis in 2007–2008. In this sense, inequality leads to increased financial instability through a self-reinforcing process: (i) increasing inequality causes the expansion of political power of the wealthy; (ii) they use this power to design financial structures in their favor; Ensar Yılmaz

(iii) this creates further financial fragility and increasing inequality; and back to (i). Some mainstream authors also acknowledge that the high inequality levels in the US and the high levels of global inequality were also important in the emergence of crises. For example, Vandemoortele (2009) focuses on this relation. In his view, withinand between-country inequality are mutually reinforcing. While within-country inequality led to an aggregate demand problem, global inequality contributed to the balance of payments imbalances (unequal capital flows and the accumulation of reserves). In this sense, debt-led and export-led growth models were responses to income inequalities in different countries, which in turn created global imbalances, as described in more detail in entry 40 in this Encyclopedia. All of these have played an essential part in the run-up to the crisis. Non-mainstream theories Although research on the impact of changes in distribution on economic processes has a long history in economics, the topic became somewhat out of fashion in the last quarter of the twentieth century. However, Marxists and post-Keynesians debated the possible negative impacts of income inequality. Marxist economists mainly explain crises through three different arguments, moving from Marx’s studies. The first group of Marxists argues that crises stem from problems during the accumulation process. During this process, at a later stage, increasing real wages due to workers’ unionized power or the increasing scarcity of workers reduces profits. This is called the profit squeeze theory. The second group of Marxists explains crises as the result of the tendency for the profit rate to fall, which is inherent to the capitalist system. This is called the tendency of the rate of profit to fall. The third group argues that crises stem from the realization of surplus value leading to overproduction or underconsumption. In all these versions of Marxist crisis theory, distribution is a critical conception because all of them are associated with the class conflict between labor and capital. The Marxists who support the view of falling profits point out that capitalist economies enter crises because the degree of exploitation declines when they use more constant capital when the ratio of constant capital to surplus value increases. The profits

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are falling because harsh competition among capitalists expands capital accumulation through increased investments. Hence the falling profits are not the results of growing worker resistance or rising real wages even though they fasten this process. In this sense, inequality is the outcome rather than the cause of crises. However, the proponents of the profit squeeze paradigm claim that an increase in inequality is not the cause of the crises but rather a decline in inequality are the cause of crises. This argument is striking. It mainly means that an expanding scale of production leads to more employment. This strengthens the bargaining position of the workers. This, in turn, lowers the capitalists’ profits and leads to less capital accumulation. Moreover, this leads to a crisis. The overproduction/underconsumption theory is the only relevant Marxist theory that directly considers income inequality as the main cause of capitalist crises. In this view, the surplus value is not realized. Thus capitalists cannot sell their products because there is insufficient demand to meet this. Competition among capitalists themselves pushes them to produce more. To increase their profits, they attempt to reduce wages. As a result, capitalists are constrained by effective demand due to the increased supply of products and the fall in demand. This results in crisis. As another heterodox approach, post-Keynesian approach also focuses on income inequality in financial crises. The proponents of the approach start their analysis by distinguishing between functional and personal income distribution. As they mentioned, the functional income distribution is vital for class analysis. It shows how workers and capitalists share total production in an economy. However, personal income distribution describes income inequality among individuals on aggregate demand in the economy. From a functional distribution perspective, the direction of change in real wages can affect the whole economy’s functioning in different ways. For example, there can be positive and negative effects of an increase in real wages in an economic sense. Higher wages mean higher demand and production because the marginal propensity to consume is much higher for workers than for capitalists. Hence firms make more investments and hire more workers (Palley, 2010). However,

at the same time, the increase in wages may decrease capitalists’ profits because firms will have fewer incentives to invest, leading to less accumulation. Therefore the net effect depends on economic circumstances. The change in personal income distribution has similar effects in terms of affecting the level of demand. However, it is not directly concerned with the production cost effect of wages. Increasing inequality can devastate consumption because lower-income groups have higher marginal propensities than the rich. We know that mainstream economists focus on the cost aspect of wages. Hence, in their view, a fall in wages positively affects production and employment. However, the post-Keynesians argue that wages have a dual role: demand effect and cost effect. A fall in the share of wages, reflecting an increase in inequality, reduces the total demand because the households’ marginal propensity to consume is higher than the rich. This is a demand effect. However, the cost effect plays a role: due to the fall in wages, the production cost will be lower, and the profitability will go up. The decline in unit costs will also increase international competitiveness and, therefore, higher net exports. The net effect will be the combined effect of all these three factors. Suppose there is a big difference between marginal propensities to consume of workers and capitalists. In that case, an increase in wages will positively affect total demand, low sensitivity of investment to profitability, and a low sensitivity of exports and imports to relative prices. This regime is called wage-led; otherwise (thus, if it has a negative effect), it is called profit-led. The question is how the world economy grew before the crisis in 2007–2008 if there was a general stagnation in the wage share. This case can be explained by two growth models: (i) debt-led growth model in the advanced countries like the US and UK and in emerging economies and (ii) export-led growth model in countries like Germany, Japan, and Nordic countries and countries like China and some East Asian countries. Hence both the debt-led and the export-led growth strategies were followed simultaneously in the world during the same period. It seems that both growth strategies aimed to avoid the persistent stagnation of demand due to declining wages. Ensar Yılmaz

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Post-Keynesians also draw attention to the issue of inequality in a financialized system. Income inequality may not be apparent in a highly financialized system because consumption inequality is not prevalent since lower-income groups have easy access to credits. Hence they become more overindebted due to the greater availability of loans. However, even though this situation may seem stable, a large debt burden cannot be sustained, and debtors are forced to save more (deleveraging) and consume less. Furthermore, this is likely to lead to a debt-burdened recession and cause a crisis.

Concluding remarks

Many scholars have emphasized the importance of inequality in the emergence of the Great Depression of 1929 and the Global Recession of 2007–2008. To them, economic inequality triggered a policy response that ultimately resulted in these economic crises. Inequality is the natural outcome of capitalism. Inequality creates too many problems, one of which is facilitating crises and increasing their burden for the vulnerable. Hence as widely recognized in recent years, more egalitarian income distribution is critical for society. For this, it is necessary to reverse the actual level of wealth concentration and income inequality to solve the inherent problems of capitalism. Ensar Yılmaz

Ensar Yılmaz

References

Acemoglu, Daron (2009). Thoughts on Inequality and the Financial Crisis. World Bank/IMF Conference on Financial Regulation. May. Milanovic, Branko (2010). The Haves and the Have-Nots: A Brief and Idiosyncratic History of Global Inequality. New York, Basic Books. Palley, Thomas (2010). America’s Exhausted Paradigm: Macroeconomic Causes of the Financial Crisis and Great Recession. New School Economic Review 4(1): 15–43. Phillips, Kevin (2002). Too Much Wealth, Too Little Democracy. Challenge 45: 6–20. Rajan, Raghuram (2010). Fault Lines: How Hidden Fractures Still Threaten the World Economy. Princeton, NJ: Princeton University Press. Reich, Robert (2010). Aftershock: The Next Economy and America’s Future. New York: Knopf. Roubini, Nouriel (2011). The Instability of Inequality. Project-Syndicate. www​.project​-​ -syndicate​.org/​commentary/​the​-​-instability​-​-of​ -​-inequality. Stiglitz, Joseph (2009). The Global Crisis, Social Protection, and Jobs. International Labour Review 148(1–2): 1–13. The US Congress Joint Economic Committee (2010). Income Inequality and the Great Recession. Vandemoortele, Milo (2009). Within-Country Inequality, Global Imbalances, and Financial Instability. Desk Study for Netherlands Ministry of Foreign Affairs, Overseas Development Institute, London. Wisman, Jon, and Barton Baker (2011). Rising Inequality and the Financial Crises of 1929 and 2008. Working Paper No. 2011-01. American University, Department of Economics. Yılmaz, Ensar (2020). Understanding Financial Crises. Routledge Frontiers of Political Economy. London, Taylor & Francis Ltd.

46. India’s balance of payments crises Introduction

Like many developing countries, India has suffered several balance of payments crises since independence. However, India’s experience has been different from Latin America’s: due to prudent monetary policies, inflation has generally been under control, and there has never been a period of sustained high inflation. It has also been different from that of East Asian countries, as there has been no sudden reversal of large capital flows, and large devaluations have been rare. Except for the last one, the crises have been primarily due to external shocks, bad harvests, and distortions stemming from microeconomic mismanagement. The early crises were dealt with by fiscal tightening and trade controls, plus assistance from the International Monetary Fund (IMF), the World Bank, and a group of donor nations known as the Aid India Club. No substantial reforms were undertaken to address the root causes of the recurring balance of payments problems. However, the crisis of 1991 was so severe, with foreign exchange reserves down to two weeks of imports, that there was a fundamental change in economic policy and India’s economic fortunes. This entry will briefly discuss India’s economic policies, and the earlier economic crises, before focusing on the 1990–91 crisis and its aftermath.

Economic policies since independence

India’s first prime minister, Jawaharlal Nehru, who had been heavily influenced by British Fabian Socialists, aspired to have a socialist and self-sufficient economy. The former meant that the “Commanding Heights” of the economy—the most critical sectors—would be under state control. The latter involved import substitution or replacing imported products with domestic substitutes. A Planning Commission was set up, which produced a series of five-year plans, establishing production goals at industry and product levels. While legislation was enacted to move toward these goals, initially, the laws were

implemented pragmatically. In one of Nehru’s first economic speeches as prime minister, he stated, “it is far better for the State to concentrate on certain specific, vital new industries than go about nationalizing many of the old ones” (Bhagwati and Panagariya 2013, 7). Accordingly, a large private sector was retained, as were foreign firms. Under the Industries Act of 1951, new investment in prioritized sectors was limited to public sector enterprises, but existing firms were allowed to continue operations. Import controls were also fairly relaxed for consumer and capital goods. Over time the controls became stricter, particularly after economic problems. Industrial licensing required firms in designated industries to obtain a license to expand capacity, move to a new location, or branch into new products. This was justified as an instrument of planning, “supposedly but wholly unrealistically to ensure that supply met demand” (Joshi and Little 1994, 37). Imports came to be stringently restricted: most consumer goods were banned, and industrial goods required import licenses. Allowed imports were subject to quotas and very high tariffs; the effective rate of protection in the late 1960s was estimated to be about 100 percent (Bhagwati and Srinivasan 1975). Exporters had to turn over their foreign earnings to the government at the official exchange rate. Banks were nationalized in 1969, followed by the oil, insurance, and coal industries. Foreign firms, including IBM and Coca-Cola, were pushed out. These measures produced a highly distorted economic structure. Incumbent firms in the public sector were effectively shielded from competition: industrial licensing protected them from domestic competition, while import controls kept foreign competition at bay. Indian firms, while highly inefficient by international standards, could thrive in the protected domestic market. In addition, several industries were reserved for small enterprises; large firms were not allowed to invest in these areas. Another distortion arose as an unintended consequence of laws intended to protect labor. Firms beyond a specific size faced onerous rules regarding working conditions and the ability to hire and fire; as a result, many chose not to expand and could not develop the scale needed to export, even when trade conditions were favorable. Two problems arose from these inefficien-

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cies. As exports lagged, India developed a chronic trade deficit, and average economic growth was limited to 3.8 percent between 1951–52 and 1987–88, far below that of East and South-East Asian countries. India was closing itself off from the world economy: exports and imports, which had each been about 6 percent of GDP in 1950–51, fell to 3 percent and 5 percent, respectively, in the mid-1960s.

Earlier crises

The five-year plans, aiming at rapid industrialization, required high levels of investment in heavy industry, which entailed significant imports of capital goods. In 1956–57, imports at $2 billion were 20 percent higher than planned, while exports ended up very close to the planned amount of $1.2 billion (Malenbaum 1957). Financing this trade deficit required India to use up half of its foreign reserves and brought about the first balance of payments crisis. The government responded with severe import restrictions as well as foreign exchange budgeting. Every transaction requiring the use of foreign exchange needed approval by a government agency. This also led to the tightening of investment licensing, as investment licenses were denied if a project required more foreign exchange than the agency was willing to allocate to it (Panagariya, 2008). Most of these controls continued for the next thirty years. In 1957–58, the economy contracted by 1.2 percent. In the 1960s, following brief wars with China (1962) and Pakistan (1965), India increased defense expenditures from 1.6 percent of GDP to 3.2 percent, creating large fiscal deficits. Two poor monsoons in successive years, and the consequent reduction in food grain production of 20 percent, led to double-digit inflation and a need for food imports. The balance of payments deteriorated sharply and faced low foreign exchange reserves and dependence on foreign assistance; the rupee was devalued from 4.75 to the dollar to 7.5 in 1966. The devaluation was politically unpopular, widely condemned as a surrender to external pressure, and contributed to future governments’ unwillingness to devalue the currency when necessary. There was also considerable fiscal tightening, with cutbacks mostly in capital rather than current Animesh Ghoshal

expenditures (Joshi and Little 1994, 50). GDP fell by 3.7 percent. Following a split in the ruling Congress party in 1969, the prime minister, Indira Gandhi, turned to increasingly populist policies, including nationalization of banks, insurance companies, and wholesale food trade, as well as tighter regulation of the private sector and controls on foreign investment. After a decisive election victory and a successful war with Pakistan in 1971, Mrs. Gandhi enjoyed great popularity, and macroeconomic caution was set aside. Fiscal deficits, monetary expansion, and a poor harvest in 1972–73 led to inflationary pressures. These difficulties were compounded by the oil shock of 1973–74, which raised the price of crude oil—a major import—by 300 percent and were primarily responsible for a 40 percent deterioration in the terms of trade. The oil import bill rose from $414 million in 1972–73 to $900 million the following year— an amount greater than the foreign exchange reserves. The ensuing crisis was addressed by aid from the Organization of Petroleum Exporting Countries (OPEC) and multilateral agencies and stringent fiscal and monetary tightening. Foreign exchange reserves were not drawn down, and the currency’s external value remained relatively stable, with the rupee falling from 7.74 to the dollar to 8.38. GDP contracted by 0.3 percent. Inflation in India continued to be higher than in its trading partners. Still, during the 1970s, the exchange rate regime was adjusted to prevent the currency from becoming overvalued. Following the 1971 delinking of the US dollar from gold and the adoption of floating exchange rates by most industrial countries, India retained a fixed rate but switched from a dollar peg to a pound peg. Subsequently, as the pound depreciated significantly against the dollar, so did the rupee, without explicit devaluation, which would have been politically very difficult. In 1975 the pound was replaced by a basket of currencies, with the peg being adjusted slowly, without a sharp change. Against the dollar, the rupee decreased from 7.50 in 1971 to 8.66 in 1981 and 17.50 in 1990. This “devaluation by stealth” has been praised for keeping India’s exports competitive (Joshi and Little 1994, 56); in fact, India was one of the few developing countries to exhibit a clear long-term downward trend in real exchange rates (Edwards 1989, 104). Despite continued

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pervasive exchange controls, the premium for dollars on the parallel or black markets—an indicator of the degree of distortion—fell from a peak of 120 percent in the mid-1960s to 20 percent in the mid-1970s (Pick’s Currency Yearbook). In the late 1970s, India entered a period of political uncertainty. The Congress party, which had won every election since independence, was voted out in 1977 and replaced by an unstable coalition. Internal disputes virtually paralyzed the government, which was faced with both internal and external shocks. The internal shock was, as often, due to a bad harvest. A drought in 1979 led to a decline in food grain production of 18 percent and a sharp increase in inflation. At the same time, the second oil shock of 1979–80, which doubled the price of crude oil, led to a 33 percent deterioration in the terms of trade. The cost of oil imports rose from $2 billion to $7 billion, and the current account, which had been close to being balanced, went into a deficit of $3 billion. The deficit was financed by a massive loan of SDR 5 billion (approximately $7 billion) from the IMF, the largest single loan to a country at the time. For the first time, the government also borrowed from foreign commercial banks. The crisis led to the sharpest recession India has experienced, with the GDP falling by 5.2 percent.

The buildup to the 1990–91 crisis

India’s economic performance improved considerably in the 1980s. Some businesses were released from industrial licensing, the import regime was liberalized, particularly for capital goods, and business taxes were reduced. The rupee, though still controlled, was allowed to fall a bit faster, moving from 8.66 to the dollar in 1981 to 12.37 in 1985 and 17.50 in 1990. The real exchange rate depreciated steadily, boosting exports, which grew at 10 percent a year. As the old policy framework for controls was still maintained (it being considered too politically risky to publicly change policies that had been in place for more than a generation), these measures have been labeled “liberalization by stealth” (Panagariya 2008, 78). Partly due to these reforms, economic growth, which had been about 3.5 percent a year in the 1960s and 1970s, rose to 5 percent in the

1980s. However, as indicated in the standard Mundell-Fleming model, fiscal expansion under conditions of low capital mobility led to current larger account deficits, which were not matched by capital inflows (Cerra and Saxena 2002, 400), and foreign exchange reserves declined to an alarmingly low level. Economic growth picked up to 10.4 percent in 1988–89, but this was driven by an unsustainable fiscal expansion. The budget deficit rose from 6 percent of GDP in the early 1980s to 9 percent in 1989–90, and as it was increasingly monetized, began to affect prices and the balance of payments. The public debt to GDP ratio, an important factor in the perception of a government’s ability to repay debt, which had been below 40 percent until the 1980s, rose to 80 percent. The current account deficit, which had been 1.7 percent of GDP in 1980–81, doubled to 3.4 percent. External debt tripled from $21 billion (12 percent of GDP) to $63 billion (24 percent) over the same period, and an increasing share of the debt was from commercial banks rather than concessional sources. As a result, the debt service ratio rose from 9 percent to 27 percent (World Bank). All of these led to multiple downgrades in India’s credit ratings. While the economic situation deteriorated due to the fiscal and current account deficits, the country entered into another phase of political uncertainty, with four prime ministers in a two-year span. In the election of 1989, a seven-party coalition came to power. The fiscal deficit was recognized as unsustainable, and plans were announced to reduce it by 1 percent of GDP in the 1990 budget. However, a pre-election promise to write off farmers’ debts, on top of existing subsidies for electricity, fertilizer, fuel, and loss-making state-owned enterprises made this unattainable. Because of shifting alliances in the parliament, the first government lost its majority within a year. After less than six months, a second government resigned but stayed on as a caretaker. A new general election was called, then postponed due to the assassination of Rajiv Gandhi, the Congress leader and a former prime minister. When the election was finally held in June 1991, Narasimha Rao of the Congress party became prime minister, heading another minority government. Animesh Ghoshal

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The crisis

During this period of turmoil, corrective action on the economy was delayed or ignored. Iraq’s invasion of Kuwait in August 1990, and the subsequent Gulf war in early 1991, were a blow to the Indian economy when it was already on the verge of crisis. The direct effects were twofold: a rise in oil price, the most significant import, and a drying up of remittances from Indian workers in the region, which had become a substantial contributor to the current account. The Gulf crisis raised the price of crude oil by 30 percent, a much smaller increase than during the oil shocks of 1973–74 and 1979–80, and India’s terms of trade declined by 4 percent. Nevertheless, it occurred when macroeconomic conditions were highly fragile. According to the World Bank, the timing rather than the size of the oil shock made its impact so severe (World Bank 1995, 13). The rising oil price adversely impacted $1.3 billion on the trade balance; the capital account also deteriorated sharply as foreign lending dried up. Foreign exchange reserves, which had already been depleted to $3.5 billion (seven weeks of imports) in July 1990, fell by a billion dollars in the next three months, despite a withdrawal of $660 million from India’s IMF reserve tranche— the amount that can be drawn without conditions. In January 1991, a loan of $1.8 billion was obtained from the IMF, but this proved inadequate to deal with a current account deficit, which had risen to $10 billion. The government tightened import restrictions and allowed the rupee to fall faster, with a depreciation against the dollar of 19 percent between August 1990 and May 1991. However, the balance of payments remained precarious, and foreign exchange reserves fell from $2.3 billion in March to $1.4 billion in April, covering less than a month of imports. To meet liquidity needs, the government took the unprecedented step of pledging gold reserves to obtain a loan of $200 million from the Union Bank of Switzerland. The transaction took the form of a sale of 20 tons of gold, with a repurchase provision, at a 6 percent interest rate. Despite never defaulting, India’s economic conditions had deteriorated to such an extent that the UBS insisted on the gold being physically transferred, which was airlifted in great secrecy. Animesh Ghoshal

Outcome

The new government came to office on June 21, during a full-fledged economic crisis. Narasimha Rao, the incoming prime minister, recognized the gravity of the situation. In his first speech to parliament, he signaled not only macroeconomic stabilization but also structural reforms to remove microeconomic distortions: “We are determined to address the problems of the economy in a decisive manner … This government is committed to removing the cobwebs that come in the way … We will work towards making India internationally competitive, taking full advantage of … opportunities offered by the evolving global economy” (Bhagwati and Panagariya 2013, 27). A respected economist, Manmohan Singh, was appointed finance minister and embarked on a drastic change in direction in his first budget on July 24: Trade was liberalized, with import licensing ended for capital and intermediate goods, and tariffs were slashed, with the maximum rate falling from 355 percent to 110 percent. Export subsidies were removed. Industrial licensing was relaxed, with controls remaining in only a few industries. Foreign investment was made more welcome. The rupee was devalued from 20 to 25 per dollar (the exchange rate regime was subsequently changed from an adjustable peg to a managed float). A process of privatization of state-owned enterprises began, reversing 40 years of expansion by the public sector. (Panagariya, 2008, pp. 103–107)

In addition, to address the macroeconomic imbalance, fiscal measures were taken to reduce the budget deficit from 9 percent of GDP to 6 percent. Another gold sale and repurchase agreement was arranged in July to meet immediate obligations with the Bank of England and the Bank of Japan, for $407 million, again with the gold being physically transferred to London. The government also negotiated with the IMF and secured an intermediate-term loan of $2 billion, with obligations to continue reforms in the fall of 1991. A structural adjustment loan of $500 million was also obtained from the World Bank to support reforms aimed at liberalizing the economy and making it more

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open to both domestic and foreign competition (World Bank 1995).

Subsequent developments

The economy, and the balance of payments, responded well to the “shock treatment”; the loans from UBS, the Bank of England, and the Bank of Japan were redeemed by the end of 1991. Macroeconomic stabilization efforts reduced the primary deficit and reduced the debt to GDP ratio below 70 percent over the next five years. The most significant long-term impact of the Rao-Singh reforms came from the structural changes mentioned in the previous section. Economic growth picked up dramatically, to 7 percent over the next two decades. A more open trade regime and a flexible (though managed) exchange rate led to sharp increases in both imports and exports, with India becoming much more integrated into the world economy: the trade (imports plus exports) to GDP ratio rose from 16 percent in 1991 to 25 percent in 2000, and 36 percent in 2020. By another measure, the share in world merchandise exports rose from 0.5 percent in 1990 to 1.6 percent in 2020, and in commercial service exports from almost nothing to 4 percent. Although still showing regular deficits, the current account has been balanced by capital inflows, and reserves have grown steadily from $1.4 billion at the height of the crisis to $40 billion at the end of the decade and to $640 billion in 2021. Foreign direct investment, which was close to zero in 1990–91, grew to $4 billion in 2001 and reached $73 billion in 2020. Though economic problems remain, there has not been another balance of payments crisis since 1991, and India remained unscathed during the Asian crisis of 1997. Perhaps most significantly, the reforms spurred by the crisis have led to a significant dent in India’s poverty, with the percentage below the offi-

cial poverty line falling from 40 percent in 1990 to 20 percent in 2019. Animesh Ghoshal

References

Bhagwati, J., and Panagariya, A. (2013). Why Growth Matters, Public Affairs. Bhagwati, J., and Srinivasan, T.N. (1975). Foreign Trade Regimes and Economic Development: India. National Bureau of Economic Research. Bhattacharjee, S. (2010). How WB, IMF, got India to adopt reforms in 1991. Indian Express, Sep. 17. Cerra, V., and Saxena, S.C. (2002). What Caused the 1991 Currency Crisis in India? IMF Staff Papers 2002, 004. Corden, W.M. (2002). Too Sensational: On the Choice of Exchange Rate Regimes, MIT Press. Edwards, S. (1989). Real Exchange Rates, Devaluation, and Adjustment: Exchange Rate Policies in Developing Countries, MIT Press. Fleming, J.M. (1962). Domestic Financial Policies under Fixed and under Floating Exchange Rates. IMF Staff Papers. Ghoshal, A. (2006). Anatomy of a currency crisis. International Journal of Emerging Markets 1(2). Joshi, V., and Little, I.M.D. (1994). India: Macroeconomics and Political Economy, 1964–1999. World Bank. Krugman, P. (1979). A model of balance of payments crises. Journal of Money, Credit and Banking 11(3): 311–325. Malenbaum, W. (1957). The economic crisis in India, Economic Weekly, July 6. Mundell, R. (1963). Capital mobility and stabilization policies under fixed and flexible exchange rates. Canadian Journal of Economics and Political Science 29(4): 475–485. Panagariya, A. (2004). India in the 1980s and 1990s: A triumph of reforms. IMF Working Paper. Panagariya, A. (2008). India: The Emerging Giant. Oxford University Press. Pick, F. (1975). Pick’s Currency Yearbook. New York: Pick Publishing Corporation. World Bank (1991). India: Policies for Adjustment and Growth, Country Economic Memorandum. World Bank (1995). Project Completion Report: India Structural Adjustment Loan/Credit.

Animesh Ghoshal

47. Inequality created by active monetary policy

side of the economy. For our purposes, we hold the volume variable constant. There are many definitions of the quantity of money. Following Fisher (1911), we determine the money supply to be cash in circulation (money), demand deposits, and other We first define what “inequality” is as related near-money such as money market funds.2 to monetary policy. For our purposes, we will The aggregate value of this money and define the “poor” as those with less dispos- near-money is the quantity of money. We will start with the “Keynesian” model. able income and the “rich” as those with more disposable income. The poor spend a greater Keynesians envision that an increase in the percentage of their income on the means of money supply (holding volume constant) will existence in the product markets, whereas the increase both the price and output on the rich have more disposable income to invest real side, increasing national income (GDP) in the asset markets. Any (monetary) policy and therefore reducing unemployment (in the that harms the poor and helps the rich can short term). This is shown in Figure 47.1. This can be juxtaposed with the be identified as regressive because it creates inequality. We will find that monetary policy “Monetarist” model of the economy, where becomes increasingly active after each period an increase in the quantity of money affects only the price level (P) and not real output of financial crisis.1 (Q). This is Milton Friedman‘s famous that “inflation everywhere and at all The classical equation of exchange dictum times is a monetary phenomenon”. For the and the quantity theory of money Monetarists, Keynesian fine-tuning is fruitWe distinguish between three models less since it only generates inflation (in the of monetary effects on the economy. The long term); see Figure 47.2. We see the seeds models represented are purposely abstracted of why active monetary policy is regressive. ideal types; the historical debates are more If increasing the money supply does not affect subtle than presented here (e.g., Blaug 1990; output (which might help with employment White 2012). The purpose is to juxtapose the opportunities for the poor) and only affects models to gain concise differing views of prices, then the inflation caused by monetary the results of expansionary monetary policy. policy reduces the purchasing power of the All three models use the classical equation poor relative to that of the rich. Inflation can of exchange which relates the “money side” be seen as an invisible regressive tax. of the economy to the “real side” of the The third model is the “Austrian School”. economy. For Austrian economists, an increase in the money supply does not affect the real ​MV  ​=  PQ (​ classical equation of exchange)​ economy. Expenditures measure the real economy for real goods and services during The money supply (M) times the volume at a given year. These are flow variables measwhich this money supply turns over (V) is ured over a discrete time period. On the other equal to the price level in the economy (P) hand, Austrian economists believe that monetimes the real goods and services produced tary expansion affects stock variables, such as over a given period (Q). The left-hand side real estate and land, the stock market, and the of the equation is the money side of the art market, rather than having a full effect on economy and the right-hand side is the real the real economy. The value of asset markets

Source:  Own illustration.

Figure 47.1

Keynesian ideal-type interpretation of the classical equation of exchange

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Inequality created by active monetary policy  205

Source:  Own illustration.

Figure 47.2

Monetarist ideal-type interpretation of the classical equation of exchange

is cumulative; thus, activist monetary effects in the Austrian view are longer lasting than either the Keynesian or Monetarist views of periodized flow variables.

Cantillon effects

The effect of central bank monetary manipulation on the economy is not instantaneous. It does not affect all prices and quantities equally, geographic areas, and people, at the same time and in the same way. The effects of monetary manipulation are particular to a time and place. This means money is not neutral as is often accepted because newly created money takes time to wind its way through the economy. Money is neutral neither toward its Keynesian output effects in the real economy, nor its Monetarist inflationary effects in the real economy. Because money is not neutral, there are (regressive) distribution effects due to active monetary policy. We need to follow the new money as it goes through the economy to understand these distributional effects further. Richard Cantillon is one of the first to describe the concept of money non-neutrality (Cantillon 1755). We will start by using one of his examples. Let’s assume there is an island nation with a gold standard under autarky, which opens up to travelers. The travelers go to the capital city center, bring in gold money, and start paying for lodging, food, and entertainment at the prevailing local prices.3 Those merchants, craftspeople, and entrepreneurs at the city center who exchange with the travelers “touch” this new money before it makes its way through the rest of the economy. Those who first touch this money find they have a greater purchasing power, and thus perceived savings before more general price increases infuse their way through the economy. Those earlier in the new money circulation pattern will see their income rise relative to the rest of the population; they

become “rich” as defined earlier. As per the Austrian view, these now rich will be better able to afford investment in the asset markets than the rest of the population.4 Those who touch the money next (for example, those employed by or supplying the inn where the travelers are staying) also see an increase in relative living standards because the new money has not yet caused a rise in the prices for subsistence consumption. As the new money makes its way through the economy, it is decreasingly used for investment in factors of production (the Keynesian view) or asset markets (the Austrian view). It causes increasing prices (the Monetarist view) for subsistence for the poor, who touch this new money last. During periods of monetary expansion after a financial crisis, asset market values and consumer prices rise. Active central bank monetary policy is regressive because an increase in the money stock helps the rich, who have an increase in disposable income (cash holdings), enabling investment in asset markets, and harms the poor, who now pay more for the means of subsistence. “When all consequences of the inflation are consumed, a transfer of wealth between social groups has taken place” (von Mises 1990, 73). Von Mises finds that under a gold standard, the owners of the mines touch the new money first by creating it. Today it is central banks with a near-monopoly on the issuance of paper fiat money (and treasury departments when central banks buy government bonds) who touch new money first by creating it. Those with access to the central bank’s discount window (or the beneficiary of central bank-financed fiscal stimulus by treasury departments) touch the money next. Given local investment climates, this new money makes its way to either the asset markets or investments in production factors and then to general inflation. The general conclusion is that those who touch new money first become wealthier than Cameron M. Weber

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those who touch it later after it has become price inflationary. Given near-monopoly power on behalf of central banks in money issuance and with a mandate for fine-tuning the economy during the business cycle and especially after financial crises, those interests with ties to the central banks and treasury departments (the rich) gain at the expense of the poor with this active monetary policy.

Classical Lender of Last Resort

In Lombard Street (1873) Bagehot laments that England has a central bank but, given the central bank, he writes of what rules a central bank should follow. Bagehot finds that central banks might become the Lender of Last Resort to help minimize financial crises. During times of liquidity problems, which could be from exogenous shock or endogenous business cycles, central banks should make loanable funds available to financial intermediaries at penalty rates of interest for short periods and only for institutions with good collateral. These conditions are necessary to prevent the creation of moral hazard where institutions lose the incentive to properly manage their assets because they know they can access below-market loanable funds (“easy money”) at the central bank. This “emergency” lending at penalty rates of interest with good collateral for the short term would be the only role for a central bank under proscribed rules as a Lender of Last Resort. A central bank that follows these rules might not have an “active” monetary policy.

The period of active monetary policy

Only with the rise of economic science as a profession in the twentieth century, the creation of the Federal Reserve system in the United States in 1914, and the widespread adoption of Keynesian economics in the late 1930s do we see the creation of active monetary policy. This is evident in the Federal Reserve and the European Central Bank mandates. These mandates are not based on limiting principles as in Bagehot’s classical theory. Today’s central banks are given discretionary power to meet certain interventionist goals. These goals may not be compatible. Cameron M. Weber

The Federal Reserve’s mandate is to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates” (Steelman 2011). The European Central Bank mandate is as follows. To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty on the Functioning of the European Union, Article 127 (1). “Without prejudice to the objective of price stability”, the Eurosystem shall also “support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union”. These include inter alia “full employment” and “balanced economic growth”. (European Central Bank 2021)

The technical difference in mandates between the two is that the Fed has a dual mandate of both price (and interest rate) stability and employment creation, whereas the ECB prioritizes price stability, all things being equal. The reason that the later ECB charter differs from the that of the Fed is that the dual mandate is criticized for its incompatible goals. The monetary tool for creating employment, especially after financial crisis is expansionary monetary policy, which we have learned is inflationary (and regressive due to the non-neutrality of money and therefore Cantillon effects). One can either have a policy of employment creation based on easy money, or a policy of price stability, not both. The Fed goals of price stability and employment creation, the dual mandate, are incompatible.

Money supply growth as active monetary policy

We find how monetary policy is becoming increasingly active (and thus increasingly regressive) by historically examining the increase in the money supply in the United States.5 From 1960 until the August 2007 housing-bust financial crisis interventions, the quantity of money increased from around $100 billion to $2 trillion, adding around $2 trillion in reserves over these 47 years. The growth of reserves was slow and steady until the Fed reacted to the housing market crash. From August 2007 until February 2020, before the Covid-era interventions, we see

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an increase of reserves to around $4 trillion, doubling in 14 years the reserves of the previous 47 years. Then from the initial Covid-era interventions in March 2020 until July 2021, we find that the quantity of money increased to around $20 trillion, adding $16 trillion to the money supply in just 18 months. More than twice the money supply created in the previous 50 years was created in just 18 months. We see the Cantillon effects in that the major US stock market indexes all doubled in the first 18 months of the Covid era, and we find another rapid increase in housing prices in certain places. We also find that inflation has increased during the Covid era, starting along the supply chain, as expected, and then to a more general price-level increase.

Entangled macroeconomic policy

Post-World War II, monetary policy becomes increasingly tangled with fiscal policy as part of more active central bank policy. From the Fed and ECB charters, we have seen the Keynesian view of macroeconomic intervention, which expands from reducing unemployment during economic downturns and financial crises to meaning employment “maximization” and “full employment”. In 1946, the US Employment Act mandated that the federal government use fiscal policy to reduce unemployment. This was expanded in 1978 with the Full Employment and Balanced Growth Act. The Fed is increasing the use of reserves management to keep interest rates lower than they would be, absent central bank intervention. This policy of central bank low-interest rate or near-zero interest rate policy for an unprecedented length of time began in 2007 after the housing market-created financial crisis. These continually below-market rates enable the US government to borrow funds at historically low rates for a prolonged period. During the post-war period, the market yield on US Treasury 10-year bonds was consistently above 3 percent. Since 2007, the US government borrowing rate has averaged less than 2 percent.6 US Treasury debt levels have increased dramatically. At the beginning of 2007, the historically cumulative publicly held US Treasury debt-to-GDP level is around 60 percent.7 US government fiscal “stimulus” in reaction to the housing bust increases debt rapidly to around 100 percent

of GDP by 2013. This rapid expansion of debt is intensified with the Covid-era fiscal interventions when the debt-to-GDP ratio increases from around 110 percent to more than 120 percent in the first 18 months of the Covid era. This is the highest debt-to-GDP ratio since World War II. We find more active monetary policy in monetizing the federal debt of the United States after the housing-created financial crisis. This is shown by an increasing quantity of US Treasury debt purchased and held by the central bank.8 At the beginning of 2007, the historically cumulative Treasury debt held by the Fed was around $750 billion after a slow and steady increase from almost $0 in 1970. After the housing-crash interventions beginning in 2007, the Fed was holding around $2.6 trillion in treasury debt securities in early 2020. After the first 18 months of Covid-era interventions, the central bank holds around $5.6 trillion in government debt. This doubles net Fed purchases from an unprecedentedly high level after the earlier housing-bust policy reactions. By the end of the first 18 months of the Covid era in 2021, the Fed was holding 21 percent of US government debt, up from 14 percent the year before.9 There have been no budget surpluses since 2001 after the easy money policies began in reaction to the dot-com boom-and-bust financial crisis. State debt is not being paid down during the upward portion of the business cycle as in the Keynesian theory. Politicians prefer to spend for current programs and bailouts (and votes) rather than increase unpopular taxes. Deficit financing is passed along through increasing debt and expected higher taxes to future generations.10 This is regressive intergenerationally.

Two channels for an increase in the quantity of money

An increase in the quantity of money has two channels. The first is investment into the real economy, which, according to Keynesian theory, can increase employment by increasing national income growth through investment. The second channel, as described by the Austrian School, states that an increase in the money stock first directly affects the asset markets such as the real estate and stock markets. Money quantity increases have less Cameron M. Weber

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of an effect on investment into increasing the productivity of the factors of production and therefore improving the living standards of the poor who cannot afford to invest in asset markets.11 Despite whichever channel is predominant at a given time and place, an increase in the quantity of money, in the long run, is inflationary, which means the poor have to pay more for the means of existence than they would have had to absent this intervention. There are many proposals for reducing the discretionary power of central banks and, relatedly, for limiting active monetary policy, which creates inequality. These include central banks returning to rule-based policy such as increasing the money supply at the same rate as national income growth and limiting central banks to the classical Lender of Last Resort rules. Recommendations also include allowing competition against central bank near-monopoly on creation of the money supply, such as accepting alternative currencies as legal tender for tax payments and as a means-of-exchange or even free-banking. Cameron M. Weber

Notes 1.

See entry 9 in this Encyclopedia on how central banks may exacerbate business cycles and financial crises. 2. Near-money is money held at a financial institution with zero maturity, meaning the money is accessible (almost) immediately. 3. In modern times it is not of course travelers with gold who inject money into an economy, but rather central banks in reaction to financial crises. 4. Cantillon (1755) uses an example of those touching the new money first as investing in art, paintings in particular. Real-estate and stock markets were not of course as developed in Cantillon’s time as they are today. 5. Monetary aggregate measure “M1”. Data from the St. Louis Federal Reserve Bank’s FRED data series. 6. Data from FRED, “Market Yield of U.S. Treasury Securities at 10-Year Contract Maturity”. 7. For reference a maximum 60 percent debt to GDP ratio was one of the requirements to join the nascent Euro monetary zone in the late 1990s and early 2000s.

Cameron M. Weber

8.

Data from “Federal Debt Held by Federal Reserve Banks (FDHBFRBN)”, St. Louis Federal Reserve Bank’s FRED data series. 9. US GAO (2021). 10. See US GAO (2021) for a historical perspective on the unsustainability of the United States welfare state. 11. That Cantillon effects are greater than employment effects is a finding in one of the first Federal Reserve research papers to acknowledge that active monetary policy is regressive (Bartscher et al. 2021), who find that, “Over multi-year time horizons, the employment effects are substantially smaller than the countervailing portfolio effects”.

References

Walter Bagehot (1873). Lombard Street, London: Henry S. King & Co. Alina Bartscher, Moritz Kuhn, Moritz Schularick, and Paul Wachtel (2021). Monetary Policy and Racial Inequality, Staff Report No. 959, Federal Reserve Bank of New York, January. Mark Blaug (1990). Economic Theory in Retrospect, fifth edition, New York: Cambridge University Press. Richard Cantillon (1755). Essay on the Nature of Trade in General, translated, edited and with an introduction by Antoin E. Murphy, Indianapolis, IN: Liberty Fund. European Central Bank (2021). “Objective of Monetary Policy”, www​.ecb​.europa​.eu/​mopo/​ intro/​objective/​html/​index​.en​.html. Irving Fisher (1911). The Purchasing Power of Money, New York: Macmillan. Aaron Steelman (2011). “The Federal Reserve’s ‘Dual Mandate’: The Evolution of an Idea”, Federal Reserve Bank of Richmond, www​ .richmondfed​.org/​publications/​research/​ economic​_brief/​2011/​eb​_11​-12. US Government Accountability Office (US GAO). 2021. “The Nation’s Fiscal Health: After Pandemic Recovery, Focus Needed on Achieving Long-Term Fiscal Sustainability”, .gao​ .gov/​ GAO-21–275SP, March 23. www​ products/​gao​-21–275sp. Ludwig von Mises (1990 [1938]). “The Non-Neutrality of Money” in Money, Method, and the Market Process, selected by Margit von Mises, edited with an introduction by Richard M. Ebeling, Norwell, MA: Kluwer, pp 69–77. Lawrence H. White (2012). The Clash of Economic Ideas: The Great Policy Debates and Experiments of the Last Hundred Years, New York: Cambridge University Press.

48. Inflation Inflation is defined as a continuous increase in the general level of prices in an economy. This concept has been the subject of countless debates, from its proper definition to its causes, consequences, and appropriate responses by authorities to curtail its risks. The complementarity between price and financial stability is unclear in terms of policies. Prices are the payments made in exchange for goods or services. There are two basic alternatives to make those payments: through other goods (barter) or a different medium of exchange, money. In a barter economy, the price system is as straightforward as it gets: a certain amount of the owned good is exchanged for a certain amount of the desired good—all individuals are consumers and producers at the same time—with that ratio being determined by the meeting of the subjective valuations that both participants make about the relative abundance or scarcity of each good, the labor put into it, and other elements.1 However, such an economy poses the major limitation that all individuals’ needs regarding the goods (volume, characteristics) must meet in time, since it is rather difficult either to defer payments (goods will not have a constant value) or to store wealth (many goods are perishable). The usage of money resolves those problems since it can serve as a store of value while introducing a cost into the exchange: that money’s relative price to both goods may vary.2 The traditional view of inflation is that more money is required to obtain the same amount of goods; equivalently, an inferior amount of goods is obtained from the same amount of money.3 Whether there is a rise in the price of the desired good or a decline in the value that can be exchanged, money has lost value relative to the good. Given that both phenomena are two sides of the same coin, we nowadays understand that inflation refers exclusively to the rise in the general level of prices. We must nevertheless be aware of this duality.

The roots

Different theories have historically competed to identify the origins of inflation and thus provide the appropriate policies to contain

it. The preeminent ones are the demand-pull and the cost-push approaches.4 Even before economics became a discipline of its own, philosophers had already studied the effect of money supply on prices (Azpilcueta 1965) which is one of the main drivers of demand-pull inflation. This idea crystallized in what is today known as the quantity theory of money, accurately represented by the quantity equation: M*V = P*T; i.e., a matching between money (monetary units times number of turnovers per unit of time) and goods (price of goods times number of transactions). Applying to that equation the assumption that V and T (substituted for Y in its nominal-income variant) are constant in the long run, then any rise in the growth rate of the money supply will be translated into inflation. In fact, in the modern view of the equation, V and Y are considered to be stable and predictable over the long run, so if we translate the equation into growth rates (m + v = p + y) then inflation can only be originated ‘by a more rapid increase in the quantity of money than in output’ (Friedman 2006). This resulted in the notion that ‘inflation is always and everywhere a monetary phenomenon’. Another essential economic relationship on which the demand-pull view is constructed is based on the work of Phillips (1958), which found a notable correlation between unemployment and money wage rates, which sowed the seeds for two later versions of the original relationship: the expectations-augmented Phillips curve (for the short run) and the non-accelerating inflation rate of unemployment (NAIRU, for the long run). The other main view, the cost-push approach, reverses the monetarist causation and states that inflation runs from price changes to money supply changes. Price changes are motivated by social pressures; if, for instance, a union advocates for a rise in its members’ wages, that will spur other unions to do likewise, thus spawning an inflationary wage-price spiral through the economy. Instead of controlling the expansion of monetary aggregates, this proposal calls for prices and income policies to avoid the tensions that force costs up in the first place. The consensus nowadays is that while excessive money creation leads to a sustained rise in the general level of prices, temporary fluctuations can be ascribed to non-monetary causes,

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a compromise between both approaches. Technological advances and trade integration have also exerted persistent downward pressure on inflation (Borio 2019).

Measurement

Once we have settled the definition of inflation as the rise of prices, the question of identifying inflationary processes becomes much easier. There are two basic approaches to it, each of which applies to different scenarios. On one side, the Consumer Price Index (CPI) identifies the evolution of the prices of goods and services, usually on a monthly basis, in a representative, standard consumption basket that is nevertheless updated to reflect changes in consumer behavior. If we are interested in measuring the evolution of the cost of living in an economy, the percentage change of the CPI is the inflation rate that we watch. On the other side, the GDP deflator identifies variations in prices of all goods in the economy, which may be useful if we consider items that are not in the typical consumption basket: e.g. capital goods or defense spending. It is calculated as the ratio between the nominal GDP and its real counterpart: since nominal GDP is a measure of the total output produced in the economy at its current prices and real GDP is the one that uses a certain base level of prices, it is straightforward that the ratio between both gauges the evolution of prices. Both the CPI and the GDP deflator should be adjusted for seasonality pricing (prices of certain goods experiencing recurring trends over different seasons, e.g. scarves or Easter eggs). In some specific instances, we may use alternative indicators of inflation. The most commonly used, core inflation, identifies underlying long-term inflation by ignoring transitory, short-run price shocks— essentially food and energy—and offers a much less volatile assessment than headline inflation. However, since this measure does not accurately represent the cost of living, it would be difficult for the public to accept that the central bank may use that as an indicator, so most formulate their objectives in headline inflation.

Nicolás Varela García

The ramifications

As happens with other economic phenomena, a positive inflation rate will at the same time favor and damage different actors. This is because a decline in the purchasing power of money implies that it takes more monetary units to buy the same good, whatever the reason. That is good news for debtors (i.e., borrowers of which the government may be a part) since the real interest rate that they will have to pay for their loans (r = i - p) will be lower. By contrast, creditors (lenders) will be in a worse position, not just because of the high inflation but also by the adverse selection of borrowers that lowering the real cost of borrowing leads to. Together with moral hazard problems, adverse selection poses a major problem during financial crises, with financial markets becoming ‘unable to efficiently channel funds to those who have the most productive investment opportunities’ (Mishkin 1994). Asymmetric information is also critical in one of the factors prompting financial crises: bank panics, during which depositors rush to withdraw from all banks, solvent and insolvent, being unable to tell them apart. In a context of high inflation, individuals that live on a fixed nominal income (e.g., retirees whose pensions are not indexed to CPI) will experience a loss of purchasing power avoided by those whose (variable) incomes may better adjust for the inflation path.5 Yet, even if their incomes are adjusted, in such a scenario agents may not be able to differentiate between movements in relative prices attributed to shifts in the exchange relationship between goods (their relative valuations) and those merely related to the inflationary process itself, so the information that they exploit to make their decisions will be altered and lead to a loss of allocative efficiency. Other minor inefficiencies are expected. These include those arising from the costs that some companies incur when changing prices, menu costs, or from the trips that savers make to the bank due to interest-bearing accounts offering a better balance than cash, shoe leather costs. Although high levels of inflation are not desirable, deflation6 (continuous decline in prices) is not advisable either since it leads to a decrease in economic activity due to consumers delaying their purchases in anticipation of a price decline. Even though defla-

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tionary trends have been more pronounced in financial crises recessions than in normal business cycle downturns, the anti-deflationary post-World War II policies lessened this relationship (Jordà, Schularick, and Taylor 2011). During a financial disruption, the decline in asset values causes the value of collateral to fall so that the problems of adverse selection and moral hazard worsen, which causes economic activity to contract (Mishkin 2014). Dynamics and expectations about prices are therefore critical since mild, unforeseen inflation rates might be just as pernicious as higher, expected ones. An unpredictable inflation rate implies that agents in the economy will not be able to project their future purchasing power with some degree of certainty and, therefore, will be reluctant to save and invest. Suppose they believe that prices will keep rising in the immediate future. In that case, consumers may accelerate their expenditure on certain goods, hoping to save money on their future expenses, pushing up demand which, if not met by supply, will drive inflation up in what we call a ‘self-fulfilling prophecy’. Consumers may also hoard nonperishable commodities as stores of wealth rather than money7 expecting the value of the former to be stabler. When inflation rates achieve excessively high levels, the situation is self-reinforcing: money buys fewer goods, so people will be reluctant to use it, pulling it out from the economy and driving prices even higher. If the state of affairs reaches extreme levels, agents may even stop using their currency at all and move to a foreign, more solid currency (dollarization) or, in the most severe scenario, resort to barter. The conclusion, as Fischer (1993), Barro (1995), and others have consistently established, is that high inflation levels are incompatible with economic growth and/or smooth business cycles. The relationship between inflation and financial crises is anything but straightforward and seems to be evolving. At first, we understood that aggregate price shocks were a significant driver of financial instability (Bordo, Dueker, and Wheelock 2003), so inflation-targeting policies could reduce the probability of financial crises. However, rather than assets prices or external imbalances, other scholars (Jordà, Schularick, and Taylor 2011) found out that excessive credit

growth was indeed the key predictor for financial instability, on a much higher level than money creation. Finally, the association between credit booms, asset-price booms, and serious financial (banking) crises has been found out to be quite weak (Bordo 2018), claiming also against the obsession with financial stability that may motivate a new wave of financial repression—government policies restricting financial intermediation— that may head off a few minor crises but also precipitate a larger one. The fact that a credit-driven asset-price boom caused the most recent financial crisis is no guarantee for the future. While it is difficult to establish a unidirectional causal relationship between financial crises and general macroeconomic stability and thus to unequivocally state what should policy regarding financial stability focus on, price stability and financial stability are generally believed to be complementary (Borio 2019).

Trimming inflation

How can the issue of inflation be resolved? The consensus is that a low, stable, and predictable level of inflation is optimal for an economy. A slight degree of inflation is usually targeted since it prevents consumers from delaying purchases—otherwise, they would wait for lower prices—fueling aggregate demand. To achieve that, we must be aware not only of the approach to inflation that we are following8 but also of the tools we have at our disposal and their operationalization. Whether we employ a fixed exchange rate, price-setting, income policy, or monetary policy to influence inflation expectations, we must decide how our decisions will be made, whether at will or derived from fixed guidelines. Kydland and Prescott (1977) advocated for clear, difficult-to-change policies that would not worsen economic instability. Assuming we pursue the usual goals of economic policy (high employment, stable prices, and economic growth) if the policy is known in advance, agents can count on it to make their present and future-discounted decisions, so the economy is not subject to arbitrary decisions that could exacerbate fluctuations. Even in environments in which policy is followed ‘mechanically’, policy rules are difficult; responsive rules seem to work better than discretion (Taylor 1993), Nicolás Varela García

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arguably because there is an immense difference in the effects that anticipated and unanticipated changes in the policy variables have on targeted indicators (Lucas 1996). Regarding financial stability, while financial regulation can, to a certain degree, shield the sector from shocks (Bordo, Dueker, and Wheelock 2003), it also involves some costs: government intervention may decrease economic efficiency by bailing out firms that deserve to fail (Mishkin 1994). Those costs make a monetary policy limiting price volatility a much preferable means of promoting financial stability. However, even though monetary policy is definitively a tool not to be obviated in the face of financial contractions, its usage must be balanced. An overly aggressive monetary policy easing might risk unanchoring inflation expectations, thus leading to higher inflation (Mishkin 2009) and undoing the medium-term stabilization of inflation expectations achieved after the inflation-targeting framework adopted in the 1990s. The central bank has to be cautious about its level of credibility, its communication strategy, and the possibility of refraining its policies if the situation goes back to normal levels. It needs to be fiscally disciplined (not financing fiscal deficits by seigniorage) to be credible for its commitment to inflation targeting. Prior to the Global Financial Crisis, central banks were reluctant to include financial stability in their monetary policy decisions, arguing either that those crises were difficult to predict or that even when they could identify them it was unclear what monetary policy could do to influence the buildup of risks to financial stability. While having financial stability as another objective of monetary policy might risk the credibility of the commitment towards inflation targeting, other proposals (Woodford 2012) have pointed out that it is indeed not any different than the tension between inflation stabilization and output-gap stabilization. The conclusion is that only at times of particular financial imbalance should the additional goal become a quantitatively significant factor in policy deliberations, thus only risking the credibility of the commitment to inflation targeting at a minimum. As of today, thanks to the evolution of research, the policy answer to the inflationary question is not just a matter of deciding Nicolás Varela García

which alternative should be employed but rather how to combine different rules to create a stable framework that will influence inflation expectations provided the monetary authority, the central bank, is credible. Financial stability must be understood as complementary to the usual goals of price and output stability without undermining the credibility of the authorities’ commitment to those goals. Nicolás Varela García

Notes

1. I strongly encourage the reader to dig into the literature on the theory of value, of which I follow here an extremely condensed, moderate view. 2. The actual high volatility of cryptocurrencies erodes their eventual role as unit of account and means of payment (Borio 2019). 3. Clearly, I am only considering the exchange from money to the consumption good, obviating how the consumer obtains their money. 4. Consult Friedman (2006) for a historical review. 5. Inflation is usually argued to represent a tax on savings, since it decreases their purchasing power. 6. Other conceptually close terms belong to the same lexical field. Disinflation is a reduction in the (positive) inflation rate, usually the target of quantitative tightening. A persistently high (or even accelerating) level of inflation is categorized as hyperinflation, while stagflation alludes to the situation in which an economy experiences a high level of inflation together with high unemployment and sluggish economic growth. 7. The Mundell-Tobin effect states that in inflationary environments people swap their holdings from money balances to other assets, thus pushing interest rates down. 8. For instance, an anti-inflationary policy that targets indiscriminately all prices may also prevent wages (the price of labor) from rising.

References

Azpilcueta, Martín de. 1965. Comentario resolutorio de cambios. Madrid: Consejo Superior de Investigaciones Científicas. First published in 1556. Barro, Robert J. 1995. Inflation and economic growth. Working Paper 5326, National Bureau of Economic Research. Bordo, Michael D. 2018. ‘An Historical Perspective on the Quest for Financial Stability and the Monetary Policy Regime’. The Journal of Economic History 78 (2): 319–357. Bordo, Michael D., Michael J. Dueker, and David C. Wheelock. 2003. ‘Aggregate Price Shocks and Financial Stability: The United Kingdom 1796–1999’. Explorations in Economic History 40: 143–169.

Inflation  213 Borio, Claudio. 2019. ‘On Money, Debt, Trust, and Central Banking’. Cato Journal 39 (2): 267–302. Fischer, Stanley. 1993. The role of macroeconomic factors in growth. Working Paper 4565, National Bureau of Economic Research. Friedman, Milton. 2006. ‘The Counter-Revolution in Monetary Theory’. Issues in Monetary Policy: The Relationship between Money and the Financial Markets, 171–183. First published in 1970 as IEA Occasional Paper 33. Jordà, Òscar, Moritz Schularick, and Alan M. Taylor. 2011. ‘Financial Crises, Credit Booms, and External Imbalances: 140 Years of Lessons’. IMF Economic Review 59 (2): 340–378. Kydland, Finn E., and Edward C. Prescott. 1977. ‘Rules Rather than Discretion: The Inconsistency of Optimal Plans’. Journal of Political Economy 85 (3): 473–492. Lucas, Jr., Robert E. 1996. ‘Nobel Lecture: Monetary Neutrality’. Journal of Political Economy 104 (4): 661–682.

Mishkin, Frederic S. 1994. Preventing financial crises: An international perspective. Working Paper 4636, National Bureau of Economic Research. —. 2009. Is monetary policy effective during financial crises? Working Paper 14678, National Bureau of Economic Research. —. 2014. ‘Central Banking after the Crisis’. Series on Central Banking Analysis and Economic Policies (Central Bank of Chile) (19): 23–59. Phillips, A. William. 1958. ‘The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957’. Economica 25 (100): 283–299. Taylor, John B. 1993. ‘Discretion versus policy rules in practice’. Carnegie-Rochester Conference Series on Public Policy 39: 195–214. Woodford, Michael. 2012. Inflation targeting and financial stability. Working Paper 17967, National Bureau of Economic Research.

Nicolás Varela García

49. International banking regulation

Basel II

National and international banking regulation is a learning-by-doing process. Until the late 1980s, there was no global banking regulation existing. As a response to the Latin American debt crisis, during which many Latin American countries were no longer able to serve and repay their foreign-currency debt with western banks, the Basel Committee on Banking Supervision (BCBS) at the Bank for International Settlements drafted the Basel Capital Accord on behalf of the Governors of G10 central banks.

Basel I

The Basel Capital Accord (BCBS 1988) of 1988 became the compulsory standard for internationally operating credit institutes in most jurisdictions. It introduced capital requirements based on different risk weights for the cross-border exposure of credit institutes. The Basel Capital Accord was relatively simple as risk weights and capital requirements were allocated according to only three criteria: namely, membership in the Organisation for Economic Co-operation and Development (OECD) (OECD/non-OECD), maturity of claims (short/long), and debtor categories (sovereigns, banks, corporates). For all exposure against debtors from non-OECD members and short-term claims on banks, the assigned risk weight was 100 percent, with a capital requirement of 8 percent of these claims. In contrast, claims on sovereigns that were members of the OECD held a risk weight of zero, implying an absence of risk and repayment certainty. Any exposure of OECD member credit institutes and short-term exposure of non-OECD members required a 20 percent risk weight. The uniform standard of the Basel Capital Accord was easy to apply by both banks and banking regulators due to its rule-based approach. The Basel Capital Accord was amended in 1996 to respond to the Mexican currency crisis in 1994. It included capital requirements for risks arising from changing market prices such as foreign exchange rates, commodities, and interest rates (BCBS 1996).

The major impulse to revise the Basel Capital Accord was the Asian financial crisis 1997–1998. The BCBS drafted a revision of the old Basel Capital Accord, outlined in three so-called consultative proposals in 1999, 2001, and 2003, to introduce more risk-sensitive standards for international active credit institutes. According to the proposals for Basel II, capital requirements for exposures should also reflect the individual debtor’s different risks and not only the debtor category as stipulated in the uniform standard of the old Basel Capital Accord, now Basel I. After repeated postponements, the Basel Committee on Banking Supervision finally adopted Basel II in 2004, and more than 100 jurisdictions implemented it after that (BCBS 2005). While Basel I rested on only one pillar, the Basel II Accord extended banking regulation to three pillars, introducing more risk-sensitive minimum capital requirements (pillar one), strengthening of the supervisory review process (pillar two), and enhanced public disclosure commitments to enforce market discipline (pillar three). While the second and third pillars aim to enable both supervisory authorities and market participants to sanction a single bank in case of non-compliance with financial regulations or market failure, the first pillar aims at changing credit expansion to prevent a systemic failure of banking systems. Basel II changed pillar one in three areas. First, it introduced more differentiated capital requirements. Basel II assigns different risk weights to not only different debtor categories and different maturities similar to Basel I but different individual debtors within the same debtor category. Basel II obliged credit institutes to use their own internal or external risk assessments by rating agencies to calculate capital requirements for individual exposure. Second, Basel II approved three approaches to measure credit risks; i.e., the standardized approach, the internal ratings-based (IRB) foundation approach, and the IRB advanced approach. The standardized approach is a modified version of the Basel I standard. Credit institutes would use external ratings to assess credit risks. Basel II assigns different risk weights, starting with 0 percent for triple-A sovereigns up to 150 percent for cor-

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porates below BB- and below B- for all other debtors, and different capital requirements between 0 to 12 percent to the different borrower grades based on the external ratings. However, all international active credit institutes use their own risk estimation systems. Thus, they apply one of the IRB approaches with up to nine borrower grades for performing loans and two for non-performing loans. These credit institutes need to fulfill specific standards and demonstrate compliance with their supervisory authority, such as the existence of minimum data observation periods of five years for probability-of-default (PD) and seven years for loss-given-default (LGD) and exposure-at-default (EAD) calculations. Credit institutes using the IRB foundation approach calculate the PD and get operational values for other risk components from their national supervisory authority. Credit institutes adopting the advanced IRB approach will calculate all those risk components themselves. Basel II does not allow a parallel use of different approaches by one bank, though a parallel use of different approaches by different banks operating in one country is possible. Thus, compared to Basel I, Basel II introduced more risk-sensitive capital requirements, which terminated the uniform standard in international banking regulation. It created a wider spread of borrower grades, risk weights, and capital requirements. More importantly, the risk-sensitive capital requirements contradict the original function of capital requirements (Metzger 2010). Bank’s equity does not prevent the emergence of non-performing loans but prevents non-performing loans from resulting in the bank’s insolvency. Suppose a credit institute has correctly estimated the credit risk at the time of credit granting. In that case, the interest rate will reflect this risk and generate sufficient financial resources to cover losses resulting from the credit risk, including arrears. If, however, the credit institute has underestimated the risk at the time of credit granting, then the interest payment will be too low to cover the losses resulting from the credit risk. Thus, a credit institute has to rely on its equity precisely when its risk assessment at the time of credit granting turns out to be wrong later. In contrast, when capital requirements are risk-sensitive, as Basel II suggested, the equity is too low when the risk

materializes. In sum, Basel II created a structural underprovision of capital for credit institutes and thus reduced their capacity to absorb shocks from their asset side. In addition, the risk-sensitive capital requirements of Basel II increased the pro-cyclical lending of credit institutes. They enhanced underlying boom–bust cycles and herding behavior during a financial crisis. The application of the IRB approaches reinforces the pro-cyclical tendency of bank lending, most obvious in the bust period, when capital requirements may skyrocket to 47 percent of the exposure for sovereigns with triple-C ratings while reaching the top score of 12 percent within the standardized approach and only 8 percent in Basel I for the same debtor category and risk (Metzger 2006). Thus, within the bust Basel II increases the credit crunch compared to Basel I or the standardized approach. Moreover, Basel II was drafted behind closed doors, excluding countries of the Global South, although they were at the heart of financial crises, which triggered the revision of international banking regulation (Metzger 2006; Ward 2002). Finally, Basel II changed pillar one by including an operational risk into underlying capital requirements. Operational risk is a risk from computer failures, data security breaches, poor documentation, corruption, and fraud, to name a few. However, Basel II might experience a conflict of interest for the credit institute when properly and adequately considering its operational risk. If self-assessed operational risk were higher than the industry’s average, then a disclosure of that higher operational risk by higher capital requirements would result in higher refinancing costs. Thus, Basel II sets an incentive to keep operational risk lower than perceived to forego higher costs for equity and refinancing. Other market participants cannot assess whether the presented operational risk and thus the underlying equity is adequate until risk occurs.

Basel III

In contrast to Basel I and Basel II, the kick-off of large-scale endeavors to reform international banking regulation was due to a financial crisis in advanced countries. Many advanced countries’ banking sectors displayed widespread systemic risk, involving Martina Metzger

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too-big-to-fail financial institutes, requiring unprecedented monetary and fiscal policy intervention. This included conventional and unconventional monetary policy such as quantitative easing, bailouts of financial institutes, and economic stimulus packages. The Global Financial Crisis started in the USA with the subprime crisis; due to high cross-border exposure between financial institutes, there was strong and rapid spillover to financial institutes in other advanced countries. The Global Financial Crisis course displayed widespread regulation flaws and supervisory failure. There was an instant consensus that financial market architecture had to be revised; thus, subsequent reform initiatives quickly started. A second distinctive feature of Basel III initiatives is that countries of the Global South were sitting at the table from the beginning. Emerging market economies had gone through the global financial turmoil not only better in terms of financial and macroeconomic stability than expected, taking into account their former crises performances, but also better than G7 countries. Accordingly, in 2009 the G7, which until then constituted the unchallenged major international policy coordination group on global macroeconomic and financial issues, gave way to the G20. This group had displayed a rather dozy performance most of the years since coming into existence directly after the Southeast Asian currency crisis in 1999. It was the G20 that managed the regulatory response on the global level by delegating tasks to the Financial Stability Board. While the G20 brings together financial ministries and central banks, the FSB additionally involves more member countries, financial regulatory and supervisory authorities, international financial institutions, and standard setters. The FSB functions as the central coordination forum on financial market topics between the various institutions and organizations dealing with these matters under the auspices of the G20. Basel III is a regulatory framework consisting of several documents covering various issues for all three pillars (see BCBS Basel III website: www​.bis​.org/​bcbs/​basel3​.htm). Significant reforms, though, focused on pillar one, e.g., minimum capital requirements (quantity, quality, leverage ratios), risk coverage (for instance, revised IRB framework, significant exposures, output floor, to name Martina Metzger

a few) and liquidity (liquidity coverage ratio, net stable funding ratio) with transitional implementation arrangements stretching until 2027 (BCBS 2017a). Basel III requires an increased quantity and quality of capital requirements to mitigate the pro-cyclicality in credit supply in the boom, increase the loss-absorbing capacity of banks’ equity in the bust, and limit systemic risk accumulation equally in both boom and bust. Basel III introduced five new capital buffers (capital conservation buffer, counter-cyclical buffer, systemic risk buffer, global systemic institutions buffer, and the other systemic institutions’ buffer). Credit institutes are required to build these up in good times and can deplete them in stressful times. As the capital conservation buffer is compulsory for all banks, the minimum capital amount will increase from 8 percent to 10.5 percent of risk-weighted assets (BCBS 2017b). Furthermore, the qualitatively higher Tier 1 capital will rise. Tier 1 capital consists of Common Equity and additional Tier 1 capital. Common Equity is a bank’s core capital and includes common shares, retained earnings, and other types of accumulated income. On the other hand, additional Tier 1 capital consists of assets, which banks can quickly convert into equity when needed and can participate in loss absorption. Tier 2 capital is less reliable than Tier 1 capital. Tier 2 capital includes (innovative) hybrid capital with very limited or even non-existent loss-sharing capacity (Metzger 2010). In addition, Basel III reduced the risk sensitivity in both the standardized and IRB approach for credit risk assessment (BCBS 2017a, 2017b). Finally, banks need to cover more risks as, for instance, securitizations and off-balance sheet items, which had been at the heart of the Global Financial Crisis. The consideration of macroprudential supervision is entirely new in international banking regulation, though practiced widely by emerging markets (Metzger and Taube 2010). Until the Global Financial Crisis outbreak, advanced countries’ regulatory authorities and policymakers perceived their financial sectors as stable and crisis-resilient. Accordingly, these regulatory authorities applied only microprudential supervision, deducting from simple compliance of individual financial market institutions with rules and regulations the absence of systemic

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risk in their financial sectors. However, the Global Financial Crisis proved this approach utterly wrong. As Janet Yellen (2010), the then-former Vice Chair of the Federal Reserve System, stated: It is now clear that our system of regulation and supervision was fatally flawed. Despite volumes of research on financial market metrics and weighty position papers on financial stability, the fact is that we simply didn’t understand some of the most dangerous systemic threats. Looking back, I believe the regulatory community was lulled into complacency by a combination of a Panglossian worldview and benign experience. The notion that financial markets should be as free as possible from regulatory fetters had evolved into the conviction that those markets could, to a very considerable extent, police themselves … we appeared to have entered a new era of stability. We even gave it a name: the Great Moderation. We were left with the mirage of a system that we thought was invulnerable to shock, a financial Maginot Line that we believed couldn’t be breached. We now know that this sense of invincibility was mere hubris.

Basel III introduced macroprudential supervision to better monitor systemic risk and detect system-wide financial instability, with a particular focus on institutional interconnectedness of financial intermediaries (for instance, the notorious link between originators and special purpose vehicles), risk correlation among financial intermediaries, and the ability of financial institutes to cope with financial and economic shocks. In the course of Basel III, many jurisdictions widened the mandates of their regulatory authorities to include systemic risk and macroprudential supervision. Some jurisdictions even created various macroprudential institutions, particularly the Eurozone. Concluding, Basel III undertakes steps in the right direction; e.g., the quantitative increase and the qualitative improvement of capital, more comprehensive coverage of risks, and some revision of pro-cyclical features, as well as the acceptance of systemic risk as a notion also for advanced countries financial markets and the introduction of macroprudential supervision (Herr et al. 2019). However, the most critical flaws in Basel III are the risk-weighted capital requirements, their pro-cyclical effects and the structural

underprovision of capital in a systemic meltdown, though less pronounced than in Basel II. Still unresolved is which indicators are the most meaningful to capture the accumulation of systemic risk; this uncertainty limits the effectiveness of forward-looking macroprudential supervision. Moreover, there is a widespread unfinished regulatory agenda as for instance, the cross-border cooperation and cross-border resolution of banking failures, stricter regulation of hedge funds, over-the-counter derivative markets, and credit-rating agencies, and less pro-cyclical global accounting standards, but also measures to deal with non-cooperative jurisdictions and general questions of burden-sharing of financial crises costs. Martina Metzger

References

BCBS—Basel Committee on Banking Supervision (1988), International Convergence of Capital Measurement and Capital Standards, Basel. BCBS—Basel Committee on Banking Supervision (1996), Overview of the Amendment to the Capital Accord to Incorporate Market Risks, Basel. BCBS—Basel Committee on Banking Supervision (2005), International Convergence of Capital Measurement and Capital Standards: A Revised Framework, Basel. BCBS—Basel Committee on Banking Supervision (2010), Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems (December), Basel. BCBS—Basel Committee on Banking Supervision (2017a), High-Level Summary of Basel III Reforms (December), Basel. BCBS—Basel Committee on Banking Supervision (2017b), Basel III: Finalising Post-Crisis Reforms (December), Basel. BCBS—Basel Committee on Banking Supervision, Basel III: International Regulatory Framework for Banks, www​.bis​.org/​bcbs/​ basel3​.htm (accessed on August 1, 2022). Herr, Hansjörg, Metzger, Martina, and Zeynep Nettekoven (2019), Financial Market Regulation and Macroprudential Supervision in EMU: Insufficient Steps in the Right Direction, in: Herr, Hansjörg, Priewe, Jan, and Andrew Watt (eds.), Still Time to Save the Euro: A New Agenda for Growth and Jobs with a Focus on the Euro Area’s Four Largest Countries, Berlin: SE Publishing in cooperation with Hans-Böckler-Stiftung, 2019, pp. 103–122.

Martina Metzger

218  Elgar encyclopedia of financial crises Metzger, Martina (2006), Basel II – Impacts on Metzger, Martina, and Günther Taube (2010), The Developing Countries, Intervention: Journal of Rise of Emerging Markets’ Financial Market Economics Vol. 3, No. 1, pp. 131–150. Architecture: Constituting New Roles in the Metzger, Martina (2010), Stellungnahme zum Global Financial Governance, BIF Working Entwurf eines Gesetzes zur Umsetzung der Papers on Financial Markets (October). geänderten Bankenrichtlinie und der geänder- Ward, Jonathan (2002), Is Basel II Voluntary ten Kapitaladäquanzrichtlinie (Drucksache for Developing Countries? Financial Regulator 1720 vom 17. Mai 2010) im Auftrag des Vol. 7, No. 3, pp. 51–58. Finanzausschusses des Deutschen Bundestages Yellen, Janet L. (2010), Macroprudential (English: Opinion on behalf of the Financial Supervision and Monetary Policy in the Committee of the Bundestag, the German Post-Crisis World, Speech at the Annual Federal Parliament, on the Draft Law on the Meeting of the National Association for Business Implementation of the Amendment of the Economics, Denver, Colorado (October 11). Capital Requirements Directive (Bundestag www​.federalreserve​.gov/​newsevents/​speech/​ yellen20101011a​.htm (accessed on August 1, printed paper of 17th May 2010)). www​.hwr​ -berlin​.de/​fileadmin/​portal/​Dokumente/​Prof​ 2022). -Seiten/​Metzger/​21​_Dr​_​_Martina​_Metzger​.pdf (accessed August 1, 2022).

Martina Metzger

50. Italy and the 1992 crisis of the European Monetary System The European Monetary System (EMS) was established in 1979 as the first monetary and currency policy coordination system in the then European Community. It was the first step toward Economic and Monetary Union (EMU), negotiated in Maastricht and implemented during the 1990s, resulting in the introduction of the euro, the common currency today adopted by the majority of the European Union (EU) member states. The “road to Maastricht” was not an easy one and the signature of the Treaty of Maastricht almost coincided with the near collapse of the EMS. Italy was one of the EMS members more dramatically affected by the crisis. That experience was a neglected warning for the problems Italy would have for staying in the EMU a decade later. The situation that touched Italy in 1992–93 was the first example of a structural crisis resulting from membership in communitarian agreements for a common monetary policy. The combination of internal deteriorating economic conditions, external constraints, and the influence of member states’ interaction in an unbalanced system make the EMS case a special case study to compare with today’s problems in the Eurozone. In addition, the 1992–93 crisis redefined the position of the Italian economy in the EU context, undermining the credibility of the Italian government’s commitment to respecting European agreements. Finally, the temporary advantages and competitiveness gained by the Italian economy due to the crisis and the following lira devaluation generated hostility for further monetary integration among Italian economic and political actors because it would curb those advantages. This hostility still feeds anti-Europeanism and opposition against the euro in Italy today. The 1992–93 EMS crisis in Italy could be defined as a balance of payment crisis that culminated in a currency crisis inside a regionally arranged fixed-rate currency regime. This definition stresses the relevance of the system rigidity and the political nature of the arrangement in determining the

crisis. The specific weaknesses of the Italian economy made Italy the weak link in the chain and the place where the crisis started. The EMS was created in 1979 as a reaction to the international monetary instability that followed the end of the Bretton Woods agreements and to the Carter Administration’s so-called benign neglect of monetary affairs in Europe. In its early years, the EMS was a monetary system with fixed but adjustable exchange rates that regrouped the members of the European Community. Each government was committed to keeping the national currency exchange rate with the other EMS currencies within a strict oscillation band, respecting a central parity established by the EMS members. So, if the exchange rate between two currencies exceeded the lower or higher limit of the fluctuation band, the central banks in charge of the two currencies had to intervene to return the exchange rate within the established fluctuation band. Unfortunately, it was unclear if the intervention was a duty of the central bank in charge of the devaluating currency, or of that with a revaluating currency, or both. The system was not very sophisticated, and governments had no strict macroeconomic parameters to respect (as today in the EMU). However, fundamental economic parameters (e.g., inflation rate, interest rates, capital fluxes) had a relevant impact on the currency markets. They drove the central banks’ efforts to keep the interlocked exchange rates stable in the oscillation bands and influenced the competitiveness of national products in communitarian partners’ markets. Consequently, the divergence between inflation rates could alter the terms of trade and generate tensions in the financial markets and on exchange rates. Similarly, divergence in interest rates could activate hot-money flows capable of undermining the balance of payment stability. During the early years of EMS’s existence, exchange rates were fixed but adjustable. So, when tensions emerged in the currency market about the value of specific currencies and when some countries had to face excessive stress to keep their currency in the exchange rate grid, EMS member countries could agree to adjust the bilateral exchange rates. This possibility granted a certain flexibility to the early EMS and made it capable of balancing the rigidity of a fixed-exchange system. Also, until December 31, 1989, Italy was permitted to keep a wider oscillation

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band (±6 percent instead of ±2.25 percent) to counterbalance the weakness of the Italian economy. During the second half of the 1980s, mainly because of France’s pressures, the EMS moved toward the so-called “Hard EMS.” Adjustments in the parity grid were still possible, but they were abhorred. Then, the system lost the flexibility needed to face the poor performance of some member states in managing their currency and their balance of payments. The Hard EMS became a regional fixed-exchange system deprived of central governance because of the lack of a European central bank. EMS members unofficially renounced the possibility of agreement on adjustments in the parity grid. Unfortunately, fundamental economic indicators in the member states diverged, and keeping the bilateral parities became more and more difficult. So, the economic conditions in countries like Italy that had higher inflation rates and less competitiveness in international trade deteriorated. When the dissolution of the communist system in Central and Eastern Europe made possible the reunification of Germany, tensions in the EMS exploded. The German financial needs for reconstruction in Eastern Germany pushed higher the interest rates and facilitated short-term funds reallocation toward Germany. At the same time, the German government faced two colliding policy aims in the monetary and financial policy field. The first was contributing to keeping stable and safeguarding the EMS, avoiding increasing interest rates on EMS member states’ bonds. The second was accelerating unification and the reconstruction of Eastern Germany’s economy. The Kohl government decided for the latter, and the EMS was destabilized. Later, the shift toward the Hard EMU and the financial strains of German reunification hit the Italian economy hard. Italy’s problems in staying in the EMS and the deterioration of its economic fundamentals are clearly described in Talani (2017, 151–167). In particular, higher inflation than in the major EMS partners’ countries, loss of competitiveness in export-oriented industrial production, and the compression of profit rates made the Italian position untenable in the mid-term without a strict commitment of the EMS partners to support the Italian currency. The markets clearly perceived this. Roberto Di Quirico

There were at least two other elements to undermine the sustainability of the Italian membership in the EMS. The first was the internal political situation of the country. The recession caused by the exchange rate rigidity imposed by the Hard EMS and the scandals started by the “Mani pulite” inquiry were undermining the government coalition led by the Christian Democrats and responsible for decades of corruption and budget mismanagement. So, the political side was unable to react to the mounting crisis. Then, the Italian lack of credibility worsened. The second was the liberalization of capital circulation in the EMS decided in 1988. Italy’s capital circulation liberalization was completed in 1990. Free capital circulation favored hot-money fluxes between EMS members attracting capital toward countries with higher interest rates. This was the case with Italian public bonds. These fluxes fed inflation in Italy and reduced Italian economic competitiveness further. Also, dependence on external funds made it difficult to defend financial stability in case of sudden outflows of investments in Italian bonds. Italy was easily destabilized by the retirement of foreign investments (in particular short-term financial investments in Italian bonds) because of the precarious situation of the public budget and balance of payments. When international interest rates started to increase due to the German call for funds to finance reunification, Italy was compelled to offer higher interest rates to avoid funds outflows. This worsened Italy’s weak financial position and amplified the mounting balance of payment crisis that generated the following currency crisis. The EMS agreements included arrangements for credit facilities between the central banks of the member states. Theoretically, the central bank of a country that is unable to defend its currency’s bilateral parities can call for help from other central banks of the EMS to obtain credits and use them for open-market operations. More specifically, a country whose currency is devaluating toward another currency can ask the central bank that manages the revaluating currency to lend it a certain amount of the revaluating currency. Later, this currency will be sold to buy the devaluating currency and stabilize its exchange rate with the revaluating currency. Unfortunately, the weaker currencies were all devaluating toward the Deutsche Mark. So, the German central bank was called to

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support weak currencies such as the Italian lira. When it became clear that Germany was no more disposed to sacrifice internal price stability to support weak currencies in the EMS, speculators attacked the lira. After a failed attempt to adjust the lira exchange rate in the EMS grid supported by Germany but opposed by France, Italy devalued 7 percent on September 13, 1992. Three days later, the Italian lira and the British pound exited the EMS. Being a transformation economy, Italy gained by low import costs and revaluation of the currencies of its European commercial partners. Devaluation helped Italian industries to regain competitiveness in the following years. The US dollar depreciation and cheap oil also helped to keep Italian import prices low. An almost spectacular economic recovery happened in the year 1993–1996. At the same time, a stricter budget policy permitted primary surpluses in the government budget. However, this was not enough to solve the dramatic problem of public debt in Italy that continued undermining the stability of the Italian economy in the mid-term. When the EMU was nearly completed, Italy had to decide whether to apply for admission to the Eurozone and the euro. In contrast, the other member states had to consider admitting Italy. The experience of Italy in the EMS and its crisis suggested staying out of the Eurozone. Still, the never-resolved problems of Italian public debt and the advantages of low-interest rates on public bonds that the government could gain from membership drove the latter to ask for admission. Meanwhile, the experience of the post-1992 crisis and the regained competitiveness of Italian products on the EU market suggested Italy’s commercial competitors (mainly Germany) support Italian membership in the Eurozone. Roberto Di Quirico

Suggested reading

The most important and updated study of the EMS creation is E. Mourlon-Druol, A Europe Made of Money: The Emergence of the European Monetary System (Ithaca, NY: Cornell University Press, 2012), while a classical study about the EMS working is W. H. Buiter, G. Corsetti, and P. A. Pesenti, Financial Markets and European Monetary Cooperation: The Lessons of the 1992–93 Exchange Rate Mechanism Crisis (Cambridge: Cambridge University Press, 1997). Other important information (in particular data about bilateral parities and realignments) can be found in A. Apel, European Monetary Integration 1958–2002 (London: Routledge, 1998). A detailed description of the Italian situation just before the EMS crisis and some mechanisms favoring the lira exit from the EMS comes from L. S. Talani, The Political Economy of Italy in the Euro: Between Credibility and Competitiveness (London: Palgrave Macmillan, 2017). Other important information about the political negotiations during the 1992 crisis can be found in D. Marsh, The Euro: The Battle for the New Global Currency (New Haven, CT: Yale University Press, 2009). A reconstruction of the mechanism of foreign fund inflows that feed inflation in Italy can be found in P. Della Posta, “A Model of Currency Crises with Heterogeneous Market Beliefs,” The North American Journal of Economics and Finance: A Journal of Financial Economics Studies 45 (2018): 182–195.

References

Talani, L. S., The Political Economy of Italy in the Euro: Between Credibility and Competitiveness (London: Palgrave Macmillan, 2017).

Roberto Di Quirico

51. Italy and the Eurozone crisis The international financial crisis that started in the USA with the fall of Lehman Brothers touched Europe and the European Union (EU) through banking channels. Many European banks were involved in the derivatives business and at risk of collapse. Meanwhile, in some countries, a housing bubble similar to the American one put the stability of all financial institutes at risk, including those not involved in the derivatives market. So, the international crisis manifested itself in the EU in the first phase in which the banking and financial sector was the most endangered. The transformation worsened the troubles from the USA in the inter-EU financial relations generated during the 2000s due to the Economic and Monetary Union and the introduction of the euro. Interconnections between the EU national financial systems and money transfer from Central European countries (mainly Germany) to peripheral countries (primarily the Mediterranean ones) increased dramatically during the 2000s. They made the system more subject to a liquidity crisis. So, when the international crisis arrived, the whole system was affected independently by the involvement of national financial entities in the derivatives market and the housing bubble. European governments clearly understood the lesson of the 1930s crisis and supported their banks with public money. However, some countries had a fragile budgetary equilibrium that came to be in danger under the pressure of the public support of the banking system and the reduction of fiscal entries. This situation was more problematic in those countries with high public debt. So, doubts about the sustainability of some EU countries’ public debts emerged, particularly when Greece was revealed to be close to default. This generated a new phase of the EU crisis, called the sovereign debt crisis, as part of a more general Eurozone crisis. The Greek crisis dismantled the basic assumption that boosted the Europeanization of the national financial markets in the 2000s when investors and banks considered the risk of default almost non-existent in the Eurozone countries, and the bonds of Eurozone countries almost as trustworthy as the German

ones. So, a limited premium on the interest paid on non-German bonds was sufficient to attract investors. The Greek crisis revealed that this assumption was invalid and that bonds issued by highly indebted countries were much more exposed to default than expected. The EU was then ready to enter the second phase of the international crisis, those in which governments that saved their banks from bankruptcy became themselves at risk of default. This possibility was more evident for a group of countries originally denominated PIGS (Portugal, Ireland, Greece, Spain). Italy joined the club quickly, and the potential impact of an Italian default made the country the core of the mounting Eurozone crisis. Italy was the third largest economy in the Eurozone, and its public debt was the largest one in a nominal term in the area. So, an eventual default or just the collapse of Italian bond prices was not simple to manage either for the EU institutions or other member states involved in its rescue. Moreover, the Italian economy suffered a decline that had started decades earlier and was exacerbated by the national currency’s abandonment of joining the euro. Finally, the rise in power of the Berlusconi government undermined Italy’s credibility on the main financial markets. The government was internationally discredited by Berlusconi’s style of government and the long list of scandals and judicial procedures against him when the new government entered into charge. The previous Berlusconi governments were remembered as Eurosceptic and poorly compliant with the EMU rules and duties, particularly fiscal and budgetary aspects. So, skepticism arose in international financial markets about the capability of the new Italian government to solve the Italian problems and reduce public debt as required by the EU. Doubts emerged about the sustainability of Italian public debt in the long term. In summary, Italy suffered a double crisis of long-term economic decline and short-term credibility amplified by the international situation, which endangered the stability of the whole Eurozone. During the initial phase of the Eurozone crisis, when banks were mainly affected, Italy benefited from the marginal position of its leading banks in the Eurozone financial system. Italian banks’ involvement in the derivatives business was limited, and their main problems regarded liquidity reduction and the affiliated banks in Central-Eastern

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Europe. However, the most dangerous menace to Italian banks’ stability came from their portfolios, and the considerable quantity of Italian government bonds contained therein. The composition of Italian banks’ portfolios was not surprising. Government bonds were considered the surest investments because of the supposed impossibility of an EMU member-state default. So, they were a very convenient tool for gaining interest in reserves and short-term funds. Besides, many clients of the Italian banks invested their savings in government bonds. So, banks managed bonds for their clients and acted as intermediaries between clients and the secondary markets. However, the relevance of Italian bonds in banks’ portfolios made their balance sheets and liquidity strictly dependent on the bond price on the secondary market. Consequently, a fall in Italian bonds price on the secondary market could endanger banks’ liquidity and reliability as debtors in the interbank’s capital market. Depreciation of Italian bonds could embitter the credit crunch still at work in Italy because of the liquidity reduction caused by the American crisis. Finally, during the 2000s, non-Italian banks in the Eurozone (mainly the French ones) invested in Italian bonds because of the attractive interest rates and accumulated substantial amounts of Italian bonds in their portfolios.1 So, French and German banks were affected when doubts emerged about the sustainability of Italian public debt and Italian bond prices declined on the secondary market. The problems of Italy endangered the stability of the whole European financial system. The primary signal of the falling trust for Italian bonds was the spread on the secondary market between the prices of Italian 10-year bonds and their German equivalent. The spread enlargement demonstrated a diverging attitude of the investors toward the Italian and German bonds. German bonds were considered safer and more reliable. Hence the amplification of the spread indicated the continuous reduction of trust in Italian bonds and fed further depreciation of them on the market.2 This amplified the difficulties of Italian banks and, consequently, those of the Italian firms in finding credits (both at home and abroad) at a price that did not reduce

their competitiveness. At the same time, the Italian budget was endangered by a double challenge. The tax collection decreased because of the economic crisis, while the government had to pay more to support the banking system. When increasing public debt became difficult due to the Eurozone crisis and the reduced affordability of Italian bonds, a complex budgetary and balance of payment crisis emerged in Italy due to the joining of pre-crisis weaknesses of the Italian economy and the new financial problems that arose. Italian public debt and bonds were the pivotal elements of the Italian crisis and the crucial connection between it and the Eurozone crisis. Reducing public debt and regaining credibility was a difficult job. Despite the resignation of the Berlusconi government in November 2011 and the call to former EU commissioner Mario Monti to create a new government, there was a lack of trust in Italian bonds and the possibility of recovery. Also, public debt reduction was not a credible option during a crisis. It appeared evident that a reduction in public spending could generate a negative multiplier that would reduce tax revenues more than public debt. Thus, acting on bond prices and allocation was the only strategy that could enable results. This was the strategy adopted by the European Central Bank (ECB) in the early phase of the Eurozone crisis, resulting in a partially hidden renationalization of Italian public debt.3 The ECB’s action to save the Eurozone (and Italy in particular) was based on collecting bonds on the secondary market. The fall of their prices was partly due to the needs of investors to regain liquidity and partly to doubts about Italy’s ability to pay its debts. Collecting bonds on the secondary market ensured they were still sellable and avoided a run to dismiss them from investors’ portfolios. The evidence that the ECB supported the Italian bond markets also reassured non-Italian investors about the saleability of these bonds. The combined effect of collection and reassurance finally permitted the Italian bond prices to stabilize. However, this was feasible only by freezing bonds in “friendly” portfolios. Initially, the ECB granted funds to non-ECB financial actors to do it, particularly to Italian banks that were financed to renationalize government bonds. Later, the European Stability Mechanism Roberto Di Quirico

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(ESM) was created to help EMU members purchase their bonds.4 Finally, the launch of the ECB Quantitative Easing program permitted the ECB to accumulate government bonds of the EMU member states, buying them on the secondary market. The ECB also permitted neutralization of the mounting balance of payments crisis that Italy suffered due to the retirement of short-term loans and investments mainly by German investors. The crucial instrument the ECB used for sterilizing hot-money outflows was the TARGET2 system.5 This system permitted the European Monetary Union members to balance debits and credits with the ECB. Since 2011 an enormous amount of money had accumulated in the TARGET2 balances representing a massive retirement of funds from Italy and Spain and an equivalent return of funds into German accounts. However, the official creditor of Italy was the ECB, while the German creditors of the ECB maintained the balances on the TARGET2 system granted by the ECB. So, credits retired by non-Italian investors from Italian banks and firms became credits toward the ECB for the foreign investors and debts with the ECB for the Italians. The combined action of bond purchases and debt sterilization in the TARGET2 system allowed a crisis to be kept under control, risking destroying the whole EMU. However, these solutions were temporary, while solving the crisis required a more incisive arrangement. Again, it was the ECB action that was to be crucial in containing the Italian crisis. The “whatever it takes” speech by Mario Draghi revealed the adamant determination of the ECB governor to defend the EMU and stop the Eurozone crisis. Then, the core of the problem remained: to keep the Italian bonds market stable, contain the spread, and ensure that Italian banks remained solvent. This was possible because of the quantitative easing program. At the same time, the TARGET2 system continued to act as a buffer for funds retirement from Italy.6 The Italian crisis was contained but not resolved thanks to the ECB action. Italian debtor balances in the TARGET2 system continued to grow for years, and the spread never returned to the pre-crisis minimum. Besides, the governments that followed Berlusconi’s could not solve the structural problems that curbed the Italian economy’s competitiveness and were the main reason Roberto Di Quirico

for the Italian crisis. In particular, the obsolescence of Italian production, the technological gap, and the fragility of the Italian banking system continued to prevent the Italian economy from being competitive. At the same time, the public debt remained very high. The fiscal policies adopted to reduce it were poorly effective and mainly centered on cuts to expenses instead of reforms and reorganization of the budget as required by the European Commission. Roberto Di Quirico

Notes 1.

Referring to the Bank of International Settlements, the New York Times in May 2010 estimated Italian debts toward France as 511 billion US dollars while the debt toward Germany was 190 billion US dollars (New York Times, “Europe’s Web of Debts”, May 1, 2010). Probably a large part of the French assets were government bonds, while the German credits were short-term funds and commercial credits. 2. The spread between the 10-year Italian bonds and the equivalent German bonds was usually lower than 100 points before the 2008 crisis. Later it increased but remained under 200 points until June 2011, when it skyrocketed to more than 500 points due to the dramatic situation that culminated with the resignment of Berlusconi’s government. See Zoli (2013). 3. On the renationalization of Italian public debt, see Minenna et al. (2016), 142–150. 4. The European Stability Mechanism (ESM) was decided in 2011 and created with a Treaty in early 2012. It is a financial entity funded by the ECB. Among its functions is collecting public bonds of the EMU member states on the secondary market. 5. The Trans-European Automated Real-Time Gross Settlement Express Transfer System 2 (TARGET2) is the system used by the ECB and the national central banks to manage the intra-EU money transfer. 6. Italy’s TARGET2 balances moved from a credit of 3.4 billion euros at the end of 2010 to a debt of 191 billion euros at the end of 2011 and remained between 200 and 250 billion euros during 2012–15. Later Italy’s debtor balances almost doubled to 491 billion euros in 2018. This demonstrates that the Italian structural crisis was not resolved by the end of the Eurozone crisis. See ECB Statistical Data Warehouse (https://​sdw​.ecb​.europa​.eu).

Suggested reading

On the unbalances and the pre-crisis problems of the Italian economy, a vital explanation comes from S. Blavoukos and G. Pagoulatos G., “The Limits of EMU Conditionality: Fiscal Adjustment in Southern Europe,” Journal of Public Policy 28, no. 2 (2008): 229–253; R. Di Quirico (2010), “Italy and the

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Global Economic Crisis,” Bulletin of Italian Politics 2, no. 2 (2010): 3–19. A general picture of the Eurozone crisis, its causes, and the transmission mechanisms toward Southern European countries comes from R. Di Quirico, Europe Apart: History and Politics of European Monetary Integration (Florence: European Press Academic Publishing, 2020). A more specific analysis of the Italian situation, the Italian structural problems before the 2008 crisis, and the nature of Italy’s involvement in the Eurozone crisis can be found in J. Hopkin, “A Slow Fuse: Italy and the EU Debt Crisis,” The International Spectator: Italian Journal of International Affairs 47, no. 4 (2012): 35–48; E. Jones, “Italy’s Sovereign Debt Crisis,” Survival 54, no. 1 (2012): 83–110; L.S. Talani, The Political Economy of Italy in the Euro: Between Credibility and Competitiveness (London: Palgrave Macmillan, 2017). A crucial study about the financial mechanisms of instability transmission in the Eurozone is M. Minenna et al., The Incomplete Currency: The Future of Euro and Solutions for the Eurozone (Chichester: John Wiley & Sons Ltd, 2016). Here, the

Italian case is studied in detail, and crucial information is given about the ECB strategy to face the Italian crisis. Other relevant data about the financial flows that characterized the Eurozone crisis are in A. Hobza and S. Zeugner, “The ‘Imbalanced Balance’ and Its Unravelling: Current Accounts and Bilateral Financial Flows in the Eurozone,” Economic Papers 520 (July 2014), Brussels: European Commission. Finally, the spread issue and data about the timing of the Italian sovereign debt crisis can be found in E. Zoli, Italian Sovereign Spreads: Their Determinants and Pass-Through to Bank Funding Costs and Lending Conditions, IMF Working Paper (2013).

References

Minenna, M. et al., The Incomplete Currency: The Future of The Euro and Solutions for the Eurozone (Chichester: John Wiley & Sons Ltd, 2016). Zoli, E., Italian Sovereign Spreads: Their Determinants and Pass-through to Bank Funding Costs and Lending Conditions, IMF Working Paper (2013).

Roberto Di Quirico

52. John Maynard Keynes (1883–1946) One of the few economists to lend his eponym to a revolution in economic theory and policy, the influence of John Maynard Keynes on Western economic thinking has been considerable.1 Debating the extent of Keynes’ unique influence has become an industry itself. The noted historian of economic thought, Robert Dimand (2010, 305), orients Keynes’ place in the rich tradition of modern macroeconomics simply. “Many contributed to the emergence of modern macroeconomics from its rich heritage of business cycle analysis and monetary theory, but Keynes’s General Theory altered the focus and the basic analytical framework of the field.” Born in 1883 in Cambridge, England, Keynes’ formal education included Eton College (1897–1902) and King’s College, Cambridge (1902–1904) to which he returned as a Fellow in 1909. Keynes’ career spanned a variety of endeavors. Among his many accomplishments, he was editor of the Economic Journal (1911–1945), secretary of the Royal Economic Society, and director of the New Statesman. He worked for the British government in the Treasury and the India Office, was chairman of the National Mutual Life Assurance Society (1921–1938), and managed an investment company. He served on the Economic Advisory Council and the Committee on Finance and Industry (Schumpeter, 1946). A prolific writer, the Collected Writings of John Maynard Keynes is 30 volumes in length. In his Treatise on Money ([1930] 1971), Keynes explains the financial side of the business downturn. As Leijonhufvud (2009, 742–743) summarizes, Keynes assumes an initial equilibrium disturbed by a decline in expected future revenues from present capital accumulation. Firms cut back on investment, and as activity levels decline, direct some part of cash flow to the repayment of trade credit and of bank loans. As short rates decline, banks choose not to relend all these funds but instead to improve their own reserve positions. Thus, the system shows an increased demand for high-powered money and a decrease in the volume of bank money held by the non-bank sector.

The key to understanding how a crisis can come about for Keynes lies in understanding why, at times, a shock leading a decline in expected future business revenues can be large enough so as to thwart the economy’s self-adjusting mechanism. To understand his views on the relationship between expectations and aggregate demand in a monetary economy prone to financial crises, the reader of Keynes might start with his widely cited 1936 work (Keynes [1936] 1973a), The General Theory of Employment, Interest and Money. The economic process as envisioned by Keynes in this and earlier writing was one in which “investment opportunity flags and savings habits nevertheless persist,” (Schumpeter 1946, 62), demonstrating that for Keynes, “the economic system is not self-adjusting to full employment after large negative demand shocks” (Dimand 2012, 111). The General Theory in which Keynes locates crises has been described succinctly as one constructed on four building blocks (Dimand 2010, 301). First, the goods market equilibrium condition, with the level of income, not just the interest rate, bringing saving and investment into equality, with the multiplier as the corollary for changes in spending and income. Second, the money market equilibrium condition, with money demand (liquidity preference) a function of national income and the interest rate. Third, the volatility of private investment, reflecting shifting long-period expectations about a fundamentally uncertain future. Fourth, Keynes analyzed why the labour market does not clear … Taken together, Keynes’s synthesis yielded a theory of the role of aggregate demand in determining the level of employment and real output in a monetary economy, not just prices and nominal income.

Distinguishing features of the macroeconomy envisioned by John Maynard Keynes include the informational environment in which these shocks occur and to which these shocks contribute is inescapably deficient. Information is not just incomplete; it is unknown and, most critically, unknowable. Sources of this uncertainty include the unknowable effects of significant technological innovation, the interdependencies of preferences, and the scale of an investment in the diffusion of it. Fundamental uncertainty and how actors behave in the face of that uncertainty lie

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at the core of Keynes’ macroeconomics. Keynes intended to articulate his macroeconomic framework to explain contemporaneous events better than prevailing classical theory. Keynes’ treatment of uncertainty—as distinct from probability—appears clearly and familiarly in his chapter on the state of long-term expectation of the General Theory. Investment is a function of both his marginal efficiency of capital (investment demand schedule) and the “state of confidence,” where confidence is “how likely we rate the likelihood of our best forecast turning out quite wrong … The state of confidence is relevant because it is one of the major factors determining the … investment-demand schedule” (Keynes [1936] 1973a, 148–149). True or fundamental uncertainty is the environment that obtains yielding Frank Knight’s ([1921] 1964, 225–226) “estimate” for which “there is no valid basis of any kind for classifying instances.” Sources of uncertainty in Keynes’ General Theory include the uncertainty derived from innovation. In his examples of investments to illustrate the “extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made,” Keynes ([1936] 1973a, 149) chooses primarily large investment projects which represented investments in innovations—railways, mines, patent medicines, and trans-Atlantic Ocean liners. Recognition of the complexities inherent in forecasting prospective asset yields based on analytical factors alone was apparent to Keynes. The more difficult it is to estimate future profitability, the more factors other than discounted future profits weigh in an investor’s calculation of the related asset’s price. As with all voting opportunities, a crowd mind may develop independently of the objective facts of the situation. Where opinion can influence the outcome, no numerical value can be assigned to the probability of that outcome. In examining the prospective yield of capital assets, Keynes introduces the complication of market psychology and the importance of “conventional valuation.” Keynes’ allowance for the interdependency of choices is most easily seen in his allegory of the beauty contest. In his description, Keynes ([1936] 1973a, 156) allows for an interdependency that creates space for meaningfully strategic behavior—with participants

competing on at least a third degree of reasoning: “where we devote our intelligences to anticipating what average opinion expects the average opinion to be.” Keynes explicitly believed that this strategic behavior influences stock market investment. “As the organization of investment markets improves, the risk of the predominance of speculation [as forecasting market psychology] does, however, increase. … Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes the average opinion to be; and this national weakness finds its nemesis in the stock market” (Keynes [1936] 1973a, 158–159). As a dynamic version of Keynes’ extrapolative behavior in the face of uncertainty, we have a situation where optimism becomes the guiding norm in the present. As Keynes ([1937] 1973b, 114, with original emphasis) states: 1. We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto. In other words we largely ignore the prospect of future changes about the actual character of which we know nothing. 2. We assume the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects, so that we can accept it as such unless and until something new and relevant comes into the picture. 3. Knowing that our own individual judgement is worthless, we endeavour to fall back on the judgement of the rest of the world which is perhaps better informed. That is, we endeavour to conform with the behaviour of the majority or the average. The psychology of a society of individuals each of whom is endeavouring to copy the others leads to what we may strictly term conventional judgement. A second feature differentiating Keynes from the classical theorists is how financial instruments can have real effects. For Keynes, money was clearly and familiarly a “hedge” against future uncertainty as an alternative liquid asset in an agent’s portfolio. Beyond simply explaining the presence of an alternative asset in which to diversify one’s portBrenda Spotton Visano

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folio, the notion of liquid hedges against an uncertain future explains the variety of financial instruments developed over the course of the history of finance capitalism. The desire to reduce uncertainty and spread risk has motivated innovation in the liquid claims on real assets themselves. Keynes’ awareness of the potential contradiction in using money as a speculative hedge applies more broadly. What is liquid for the individual will not be so for the group. What reduces uncertainty for the individual may not always do so for the group. Coping with uncertainty entails taking active measures to reduce it and defaulting to an extrapolation of the present situation to guide current actions in the face of residual uncertainty. Keynes argues that investors may nonetheless be willing to speculate on an uncertain outcome if the commitment made is liquid. “For the fact that each individual investor flatters himself that his commitment is ‘liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk” (Keynes [1936] 1973a, 160). The telescoping of investor horizons feeds back, placing a greater managerial emphasis on current profits and capital gains than would otherwise be placed. The result is a greater impatience and shiftability of capital. The deterioration of the quality of relevant information, a loss of information in the conversion to liquid claims, and the telescoping of investor horizons create a potential instability in financial equities where none would exist in the underlying real assets. Decisions to invest in private business of the old fashioned type were, however, decisions largely irrevocable, not only for the community as a whole, but also for the individual. With the separation between ownership and management which prevails to-day and with the development of organized investment markets, a new factor of great importance has entered in, which sometimes facilitates investment but sometimes adds greatly to the instability of the system. … [T]he Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual (though not the community as a whole) to revise his commitments. (Keynes [1936] 1973a, 151)

Financial instruments facilitate the transfer of claims on ownership of income streams and Brenda Spotton Visano

assets directly. The importance of a financial contract offering a liquid form of generalized purchasing power in providing the direct portfolio benefit of that hedge against uncertainty is familiar to all who have studied Keynes’ General Theory. Keynes attributes his understanding of the real effects of money to Irving Fisher. “As it is, so far as I am concerned, I find, looking back, that it was Professor Irving Fisher who was the great-grandparent who first influenced me strongly towards regarding money as a ‘real’ factor” (Keynes [1937] 1973b, 202–203n). Keynes planted the economic and psychological seeds of a financial crisis in the preceding boom. Optimism and investment in significant capital assets via liquid claims on these assets combine to propel the economy forward and upward but paradoxically create a somewhat tenuous situation vulnerable to sudden shifts in sentiment. The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well panelled board room and a nicely regulated market, are liable to collapse. (Keynes [1937] 1973c, 114–115).

Keynes was skeptical that any short-term interventionist government policy could fine-tune the economy. While countercyclical monetary policy is unlikely to be practical since central banks are unable to break the “vicious circle” of the state of confidence that keeps interest rates too high, countercyclical fiscal policies too are “not easy to devise at short notice schemes … on a really large scale” ([1936] 1973a, 364). Instead, for Keynes, only a “comprehensive socialization of investment” could provide the means of securing and sustaining full employment. Public works and other longer-term investments in the economy by the government are, instead, needed for stabilizing the economy. It is not the ownership of the instruments of production which is important for the State to assume. If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary. Moreover,

John Maynard Keynes (1883–1946)  229 the necessary measures of socialization can be introduced gradually and without a break in the general traditions of society. ([1936] 1973a, 378).

Notably, though, for Keynes, “finance can amplify fluctuations but … financial developments are endogenous to the fluctuations in real activity that are due to other causes” (Leijonhufvud 2009, 742). We would have to wait for Hyman Minsky to articulate more fully Keynes’ ideas of how the process of business financing introduces an “inherent tendency to general speculative boom” (Leijonhufvud 2009, 742). Brenda Spotton Visano

Note 1.

See biographies by Moggridge (1980, 1992) and Skidelsky (1983, 1992, 2000).

References

Dimand, R. W. 2010. What Keynesian revolution? A reconsideration seventy years after the General Theory. In Keynes’ General Theory after Seventy Years, edited by R. W. Dimand, R. A. Mundell, and A. Vercelli, 287–311. London: Palgrave Macmillan, International Economic Association conference series No. 147. Dimand, R. W. 2012. The roots of the present are in the past: The relation of postwar developments in macroeconomics to interwar business cycle and monetary theory. In Keynes’ General Theory: Seventy-Five Years Later, edited by T. Cate. Cheltenham: Edward Elgar Publishing. Keynes, J. M. [1930] 1971. A Treatise on Money. 2 vols. Reprinted in Collected Writings of John Maynard Keynes, vol. V: A Treatise on Money:

The Pure Theory of Money, edited by E. Johnson and D. Moggridge. London: Macmillan. Keynes, J. M. [1936] 1973a. The General Theory of Employment, Interest and Money. Reprinted in Collected Writings of John Maynard Keynes, vol. VII, edited by D. Moggridge and E. Johnson. London: Macmillan. Keynes, J. M. [1937] 1973b. “The General Theory of Employment,” Quarterly Journal of Economics 51: 209–223. Reprinted in The General Theory and After: Part II Defence and Development, vol. XIV of the Collected Writings of John Maynard Keynes, edited by E. Johnson. London: Macmillan. Keynes, J. M. [1937] 1973c. The General Theory and After: Part II. Defence and Development, Collected Writings of John Maynard Keynes, vol. XIV edited by D. Moggridge and E. Johnson. London: Macmillan. Knight, F. [1921] 1964. Risk, Uncertainty and Profit. New York: Augustus M. Kelley. Leijonhufvud, A. (2009). Out of the corridor: Keynes and the crisis. Cambridge Journal of Economics, 33, no.4, 741–757. Moggridge, D. E. 1980. Keynes. London: Macmillan. Moggridge, D. E. 1992. Maynard Keynes: An Economist’s Biography. London: Routledge. Schumpeter, J. A. 1946. John Maynard Keynes 1883–1946.  The American Economic Review, 36, no.4, 495–518. Skidelsky, R. 1983. John Maynard Keynes. Volume 1: Hopes Betrayed, 1883–1920. London: Macmillan. Skidelsky, R. 1992. John Maynard Keynes. Volume 2: The Economist as Saviour, 1920–1937. London: Macmillan. Skidelsky, R. 2000. John Maynard Keynes. Volume 3: Fighting for Britain, 1937–46. London: Macmillan.

Brenda Spotton Visano

53. Joseph Alois Schumpeter (1883–1950) Joseph Schumpeter is widely known for his work on entrepreneurship as the engine of the capitalist economy. He is most often associated with his ideas of innovation and creative destruction as shaping the process by which the capitalist economy is propelled forward. Born in Austria in 1883, Schumpeter’s early career included appointments as a professor of economics at the Universities of Chernovsty (variously Chernivtsi, Czernowitz) (1909–1911), Graz (1911–1918), and Bonn (1925–1932). He emigrated to the United States, where he held the George F. Baker Professor of Economics at Harvard University (1935–1950).1 He served as President of the American Economic Association in 1948. The archives at Harvard summarize his scholarly output and contributions simply.2 “In fifteen books and pamphlets, over 200 articles, book reviews, and review articles, Schumpeter furthered the understanding of business cycles, the role of the entrepreneur, capitalist development, and the use of mathematics in economics.” Several scholarly works have sought to chronicle his many contributions, including two major biographies produced by Allen (1991) and Swedberg (1991). Early to mid-career, Schumpeter (1912, 1939) focused on defining and explaining the capitalist economy as a cycle of activity, building on Mikhail Tugan-Baranovsky’s and Clément Juglar’s explorations of business cycles linking credit and fixed investment (Legrand and Hagemann, 2007). For Schumpeter (1939), entrepreneurial activity could interrupt a Walrasian equilibrium by introducing innovations with the financial sector mobilizing the funds necessary to finance the innovations. Innovations as the “fundamental impulse” of the “capitalist engine” included new goods, new methods of production or transportation, new markets, and new forms of industrial organization. For Schumpeter, this process of credit-financed innovation intrinsic to the dynamic workings of the economy was a process of “creative destruction.” “The opening up of new markets, foreign or domestic, and the organizational development from

the craft shop to such concerns as U.S. Steel illustrate the same process of industrial mutation—if I may use that biological term— that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism” (Schumpeter, 1942, 83). This process of creative destruction is in essence, competition “to create market power and acquire quasi-rents” (Dimand, 2012, 109). The concept shares many features in common with Minnie Throop England’s (1913, 346) notion of “promotion” as “efforts to procure capital goods to enlarge industries and to establish new ones” and the driving force of economic crises, which Schumpeter acknowledged in later works (Dimand, 1999). The spread of innovation to more entrepreneurs erodes profits, which explains the turn from economic upswing to downswing. Schumpeter’s business cycle (1939) was a blend of short (three- to four-year) inventory cycles (Kitchin, 1923), medium (8- to 11-year) investment cycles (Juglar; see Legrand and Hagemann, 2007), and more extended (45- to 60-year) cycles driven by technological change; i.e., Schumpeter’s “Kondratieffs” (Garvy, 1943). In this way, Schumpeter explained booms and busts as an integral part of the capitalist economic process driven by entrepreneurial activity in investment and technological advances. For Schumpeter, financial crises were not peculiar occurrences but an inevitable part of the competitive capitalist process. Schumpeter attributed to Juglar “the discovery that what the former generations had called ‘crises’ were no disconnected events but merely elements in a more deep-seated wavelike movement. The crises are nothing but turning points from prosperity into depression, and it is the alternation between prosperity and depression which is the really interesting phenomenon” (Schumpeter, 1931, 6; as cited in Legrand and Hagemann, 2007, 49). While the turnaround from boom to bust would always cause crises and pose a hardship, the extreme and prolonged devastation experienced in the early 1930s was explained by Schumpeter as essentially the unhappy coincidence of the convergence of the three underlying cycles in real economic activity (Legrand and Hagemann, 2017, 248). His

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later works made other significant contributions, most notably to the history of economic thought with his magisterial History of Economic Analysis (1954), published posthumously. Brenda Spotton Visano

Notes

1. Papers of Joseph Alois Schumpeter, Harvard University archives. https://​hollisarchives​.lib​ .harvard​.edu/​repositories/​4/​resources/​4124. For a richly textured biography, see Morgenstern (1951). 2. Biographical note on Joseph Alois Schumpeter. Papers of Joseph Alois Schumpeter Harvard University archives. https://​hollisarchives​.lib​ .harvard​.edu/​repositories/​4/​resources/​4124.

References

Allen, R. L. 1991. Opening Doors: The Life and Work of Joseph Schumpeter. 2 vols. New Brunswick, NJ: Transaction. Dimand, R. W. 1999. “Minnie Throop England on crises and cycles: A neglected early macroeconomist.” Feminist Economics, 5, no. 3: 107–126. Dimand, R. W. 2012. “The roots of the present are in the past: The relation of postwar developments in macroeconomics to interwar business cycle and monetary theory.” In Keynes’ General Theory: Seventy-Five Years Later, edited by T. Cate. Cheltenham: Edward Elgar Publishing. England, M. T. 1913. “Economic crises.” Journal of Political Economy, 21, no. 4: 345–354. Garvy, G. 1943. “Kondratieff’s theory of long cycles.” The Review of Economic Statistics, 25, no. 4: 203–220.

Juglar, C. [1862] 1889. Des crises commerciales et de leer retour periodique en France, en Angleterre et aux Etats-Unis. Paris: Guillaumin et Cie, second edition 1889. Kitchin, J. 1923. “Cycles and trends in economic factors.” Review of Economic Statistics, 5, no. 1: 10–16. Legrand, M. D. P., and Hagemann, H. 2007. “Business cycles in Juglar and Schumpeter.” The History of Economic Thought, 49, no. 1: 1–18. Legrand, M. D. P., and Hagemann, H. 2017. “Retrospectives: Do productive recessions show the recuperative powers of capitalism? Schumpeter’s analysis of the cleansing effect.” Journal of Economic Perspectives, 31, no. 1: 245–256. Morgenstern, O. 1951. “Joseph A. Schumpeter.” The Economic Journal, 61, no. 241: 197–202. Schumpeter, E. B. 1950. “Bibliography of the writings of Joseph A. Schumpeter.” The Quarterly Journal of Economics, 64, no. 3: 373–384. Schumpeter, J. 1939. Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist Process. 2 vols. New York: McGraw-Hill. Schumpeter, J. 1942. Capitalism, Socialism and Democracy. New York: Harper. Schumpeter, J. 1954. History of Economic Analysis. London: George Allen and Unwin. Schumpeter, J. [1912] 1983. The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle. New Brunswick, NJ: Transaction. Swedberg, R. 1991. Schumpeter: A Biography. Princeton, NJ: Princeton University Press.

Brenda Spotton Visano

54. Lebanon’s perfect storm Between 2007 and 2009, the world economy was hit by a series of overlapping crises. The first was financial, a crisis in the subprime mortgage market in the United States. This crisis then gradually extended to other developed countries’ financial sectors and then turned into a global financial crisis. This global economic crisis has affected most developed and developing countries with varying degrees of intensity. Prior to the financial crisis, and partly parallel to it, there was a period of global food and fuel price increases. These commodity price increases worsened the subsequent recessionary impact of the financial collapse. The global financial crisis adversely affected the Middle East and North Africa (MENA) region (Neaime 2010, 2012, 2016). Countries largely depending on exports and relying primarily on remittances and tourism were affected the most. According to the World Bank’s (2011) report, economic growth for the more diversified MENA countries declined by about two percentage points in 2009, from a robust 6.5 percent GDP growth in 2008 to 4.5 percent in 2009. The crisis in Europe, particularly, and the collapse of crucial export markets provoked sharp declines in the exports of MENA countries such as Egypt, Jordan, Morocco, Tunisia, and to a lesser extent Lebanon (Neaime 2015b). At the same time, remittances and tourism revenues (important foreign income sources supporting household consumption and job creation in these countries) declined by 5 percent. According to the same World Bank report and despite continuing infrastructure development programs, the growth rate of developing oil exporters and Gulf Cooperation Countries declined by three percentage points in 2009, from 4.6 percent in 2008 to 1.6 percent in 2009. Given its limited integration in the global economy, the MENA region grew out of the crisis rather quickly and as early as 2010. Regional real GDP grew close to 5.0 percent in 2010, 3.5 percent in 2011, and 4.0 percent in 2012. Increased commodity prices and external demand improved production and exports in many regional economies. In addition, some countries’ government fiscal and

monetary stimulus packages played a crucial role in boosting economic and financial recovery. While Lebanon’s banking sector was not affected by the crisis, it benefited from a significant US$ 20 billion in capital inflows right after the crisis. Banque du Liban (BdL) should have abandoned its exchange rate peg to the US dollar and moved to a flexible exchange rate system. It is well known that commercial banks’ resilience to the global financial crisis was because 70 percent of their assets were in the form of Certificates of Deposits and Lebanese Government Treasury Bills and Bonds with no exposure to international financial markets. The high exposure to government debt subsequently led to a banking crisis and a total loss estimated at US$ 80 billion when the government defaulted on its external debt in March 2020. Lebanon’s macroeconomic fundamentals are the worst among the MENA countries mentioned above. Lebanon is the third most indebted country in the world, after Japan and Greece, with a debt-to-GDP ratio estimated at 190 percent in 2020 and a gross public debt of US$ 100 billion (Table 54.1). Lebanon’s debt and its service are becoming unsustainable (Neaime 2008, 2015a; Neaime and Gaysset 2017). Lebanon’s fiscal policies have produced a large-scale debt, inequality, and chronic twin deficits inflated by rampant corruption. The country imports vastly more goods and services than it exports. While the current account deficit was over 25 percent of GDP in 2019, the budget deficit was estimated at 15 percent of GDP by the end of 2019 (see Table 54.1). Finally, GDP growth has been near 1 percent since the start of the Syrian crisis in 2011, with a severe 34 percent contraction in 2020, down from US$ 53 billion to US$ 34 billion. Lebanon’s current macroeconomic fundamentals can be summarized as follows. The country’s exchange rate has been fixed since the mid-1990s at Lebanese Pounds (LBP) 1507/US$ and has depreciated to 10,000 LBP/ US$ in 2020. By the end of 2019, Lebanon’s GDP was estimated at US$ 53 billion, with an estimated rate of growth in 2020 estimated at −34 percent. The current account deficit stands at US$ 15 billion per year and has been, on average, 25 percent of GDP between 2015 and 2019, the highest amongst all MENA countries during the last three decades. The total government budget in 2019 stood at

232

Lebanon’s perfect storm  233 Table 54.1

Selected macroeconomic indicators for Lebanon: 2014–2020

Macroeconomic Indicator/Year Real GDP change, percent Inflation rate, percent of end of period

2014

2015

2016

2017

2018

2019

2.5

0.2

1.5

0.9

−1.9

−6.7 7

−0.7

−3.4

3.1

5

5.6

Interest rate, percent end of period

10

10

10

10

10

 

Unemployment rate, percent

6.35

6.31

6.26

6.18

6.1

6.04

Budget deficit, percent of GDP

2020 −25 150.4   −

−6.2

−7.5

−8.9

−8.6

−11.3

−10.5

Gross public debt, percent of GDP

138.3

140.8

146.2

149.7

154.9

174.3

190

Current account balance, percent of GDP

−28.8

−19.9

−23.5

−26.3

−28.2

−26.5

−14.3

International reserves, USD billion

39.5

38.7

43.3

43.5

40.6

38.2

17.4

International reserves per months of imports

16.8

17.2

18.9

18.8

17.1

17.7

–

5.9

4.3

5.0

4.7

4.8

4.3

1500

1500

1500

1500

1500

1500

Foreign direct investment, percent of GDP Exchange rate, LBP per one USD

−15.1

– 9000

Source: IMF and World Development Indicators (2020). Lebanon’s Central Bank and Ministry of Finance.

US$ 13.8 billion, with government revenues at US$ 11.6 billion (or 21 percent of GDP) and government expenditures at about US$ 17.8 billion (or 160 percent of government revenues). Therefore, the government budget deficit in 2019 amounted to US$ 6.2 billion or 10.5 percent of GDP and US$ 8.5 billion in 2020 or 15.4 percent of GDP (Table 54.1). Government revenues decreased by about 20 percent in 2019, widening even further the budget deficit. Before the government debt default in 2020, the government foreign currency debt (Eurobonds) stood at US$ 32.6 billion in 2020 (or 37 percent of total debt). It was held by local banks (US$ 20 billion) and international investors (US$ 12.6 billion). In comparison, government debt denominated in LBP amounted to US$ 54.5 billion (or 63 percent of total debt) and is mainly held by the BdL (US$ 30 billion) and local commercial banks (US$ 18 billion). The central bank’s foreign reserves are currently estimated at US$ 15 billion. They include US$ 15 billion in commercial banks’ reserve requirements. This means that today, the central bank can no longer pay for the country’s strategic imports (oil, wheat, and medicine). More importantly, commercial banks’ total exposure to BdL and the government is estimated at US$ 125 billion or about 71 percent of total banks’ assets. This significant exposure to the government led to the downgrade of Bank MED, Audi Bank, and BLOM bank to the SD (selective default) category by several rating agencies, including Standard and Poor’s. The recent government debt default will lead to the bankruptcy or mergers of several com-

mercial banks, depending on their relative exposure to the government debt, with a significant loss of the banking sector’s deposits estimated at US$ 80 billion. The recent default of the Government on its external debt and the exposure of Lebanon’s commercial banks to the sovereign—with an estimated 70 percent of total assets invested in either Treasury bills or bonds or Certificates of Deposits—have caused a severe banking crisis coupled with bank panics. For the past few decades, a dysfunctional electricity system, poor tap water quality, and solid waste mismanagement have constituted examples of an inefficient system delivery by the authorities to the people of Lebanon. Finally, the estimated 1.5 million Syrian refugees in Lebanon have only exacerbated Lebanon’s fiscal/infrastructure problems, the cost of which was recently estimated by the International Monetary Fund (IMF) to be around US$ 25 billion since 2012. With the above in mind, the economic, financial, banking, political, and social crises of significant magnitude have unfolded rapidly in Lebanon since October 2019. Unlike other recent crises in emerging and mature economies, the current crisis is embedded in Lebanon’s corrupt political, financial, and economic systems. The essence goes back to the Lebanese authorities’ ill-guided economic/financial decisions since 1990, coupled with unsustainable government borrowing and a Ponzi Scheme, widespread corruption, and cronyism, which have benefited Lebanon’s political elite and have produced the current perfect storm. The WhatsApp tax, which ignited the protests Simon Neaime and Isabelle Gaysset

234  Elgar encyclopedia of financial crises

in October 2019, became an emblem of the need to stop corruption. The domino effect of such a crisis which is now translating into sovereign debt, banking, and currency crises, affects all sectors of society and has already wiped out the middle class, with poverty rates climbing to 60 percent of the total population. Lebanon is entering the current crisis with the worst macroeconomic fundamentals among the recent crisis-stricken countries, with chronic twin deficits inflated by rampant corruption, a fixed exchange rate regime, and an ineffective monetary policy. Therefore, there is no room for any quantitative easing scenario to ease the liquidity squeeze that the country is currently experiencing. During the various financial and debt crises, countries with more substantial fiscal positions and space entering the crisis and those with more flexible exchange rate regimes suffered minor losses in GDP and painful austerity measures. While extraordinary fiscal and quasi-fiscal actions taken to support the financial sector during and in the aftermath of the crises have helped lessen output losses over the medium term, no fiscal space, a high debt-to-GDP ratio, and high budget and current account deficits mean that Lebanon has zero fiscal space to deal with the current crises. In many cases, notably among the advanced economies most severely affected by the 2008 global financial crisis, the recovery measures combined central bank monetary policy actions (discretionary quantitative easing and fiscal stimulus), IMF support, and financial sector operations (bank balance sheet stress tests, government guarantees of banking sector liabilities, purchases of toxic assets from banks, and capital injections). These tools are not at the disposal of Lebanon’s Ministry of Finance or BdL. Moreover, the particular mix of monetary (quantitative easing and central banks’ balance sheet expansion with purchases of Government Treasury Bills and Bonds) and fiscal policy tools used across emerging and mature economies are absent in Lebanon. BdL, and during the current crisis and instead of acting as the lender of last resort and extending liquidity facilities to commercial banks at zero interest rates, was offering lending facilities to commercial banks at an extraordinarily high interest rate of 20 percent. Preventing and managing financial and debt crises represent one element of the shock architecSimon Neaime and Isabelle Gaysset

ture that consists of several lines of defense (Caballero and Krishnamurthy 2002, 2003). The first is national public instruments, such as currency reserves, fiscal buffers, or the development of local currency bond markets to boost resilience against external financial shocks. These tools are either inexistent or have already been depleted in Lebanon. The second group includes mechanisms to prevent crises (e.g., framework including the Financial Stability Board or international debt monitoring and assessment tools) and manage shocks (e.g., countercyclical lending by regional and national development banks and EU shock-absorbing schemes), which are also ineffective in Lebanon. Contrary to what the Lebanese authorities believe, Lebanon is not equipped to deal independently with the current crisis and will most likely resort to seeking help from the IMF and the World Bank. In most recent crises cases, the IMF has alleviated the effects of financial crises by closing (part of) the financial gap that resulted from sudden stops in capital, the drop in export revenues, remittances, foreign direct investment and taxes, and the drying up of private lending to concerned countries. The size of the IMF financial support package depends on the country’s quota and the strength of the reform measures. It could sometimes be up to five to ten multiples of a given country’s quota. While Lebanon’s quota is about US$ 880 million, total IMF support could reach US$ 5–8 billion if the program is well grounded and supported by the Lebanese authorities based on a bold proposed reform and adjustment/austerity program. Even if Lebanon receives the entire US$ 8 billion, this is now considered to fall short of the US$ 30 billion urgently needed to circumvent the complete collapse of Lebanon’s economy. In 2016, Egypt received more than four times its quota in financial support from the IMF but under tight conditionality and reform program, while Argentina received support of more than 11 times its quota. More importantly, the IMF’s presence will be a conduit to other donors’ support, multilateral and bilateral, as well as private investors. It will unlock the US$ 11 billion pledged to Lebanon in the context of the CEDRE conference to improve its infrastructure. Finally, the Lebanese authorities should propose such a reform program backed by serious analysis

Lebanon’s perfect storm  235

and credible people from within and outside the government backing up such a program. Simon Neaime and Isabelle Gaysset

References

Caballero, R., and Krishnamurthy, A. (2002). A dual liquidity model for emerging markets. American Economic Review, 92, 33–37. Caballero, R., and Krishnamurthy, A. (2003). Excessive dollar debt: Financial development and underinsurance. The Journal of Finance, 58, 867–893. Neaime, S. (2008). Twin deficits in Lebanon: A time series analysis. Lecture and Working Paper Series No. 2. Institute of Financial Economics, American University of Beirut. Neaime, S. (2010). Sustainability of MENA public debt and the macroeconomic implications of the US financial crisis. Middle East Development Journal, World Scientific, Singapore, 2, 177–201.

Neaime, S. (2012). The global financial crisis, financial linkages and correlations in returns and volatilities in emerging MENA stock markets. Emerging Markets Review, 13 (2), 268–282. Neaime, S. (2015a). Twin deficits and the sustainability of public debt and exchange rate policies in Lebanon. Research in International Business and Finance, 33, 127–143. Neaime, S. (2015b). Sustainability of budget deficits and public debts in selected European Union countries. Journal of Economic Asymmetries, 12(1), 1–21. Neaime, S. (2016). Financial crises and contagion vulnerability of MENA stock markets. Emerging Markets Review, 27, 14–35. Neaime, S. and I. Gaysset. (2017). Sustainability of macroeconomic policies in selected MENA countries: Post financial and debt crises. Research in International Business and Finance, 40, 129–140. World Bank. (2011). IEG (Independent Evaluation Group). Social Safety Nets: An Evaluation of World Bank Support, 2000–2010. Washington, DC, the World Bank Group.

Simon Neaime and Isabelle Gaysset

55. Liability dollarization Liability dollarization refers to borrowing in a foreign currency, a particular example of a currency mismatch (Armas, Ize, and Levy-Yeyati 2006; Eichengreen and Hausmann 2010). In the median country, 20 percent of deposits are denominated in a foreign currency (hereafter “dollars”), and dollar deposits constitute the majority in 20 countries, mostly transition or Latin American (Christiano, Dalgic, and Nurbekyan 2021). There is strong evidence that financial institutions avoid currency mismatches by matching the proportion of dollar assets to dollar liabilities. The consequence is that if non-financial agents borrow in dollars but earn and save in domestic currency (hereafter “pesos”), currency mismatch is transferred to borrowers. Liability dollarization raises the probability of a financial crisis if a depreciation reduces borrowers’ net worth (see Krugman 1999 and the literature that followed).

Causes

The most commonly cited explanation for why agents cannot borrow in pesos but instead borrow in dollars is a lack of credibility of the monetary authority (Jeanne 2005; De Nicoló, Honohan, and Ize 2005). A history of inflation or hyperinflation – coupled with incomplete credibility of the policymaker’s commitment to fighting inflation – produces high peso interest rates. With reasonably open capital markets, borrowing in foreign currency is substantially cheaper. Thus, if the expected devaluation of the peso is not too significant (either because it is deemed highly unlikely or likely to be small), the probability of default is lower when borrowing in dollars than when borrowing at high rates in pesos. Ize and Levy-Yeyati (2003) developed a formal model of this explanation. They modeled the choice between pesos and dollars as a portfolio allocation problem: agents want to maximize the average return and minimize the variance. The resulting share of dollars in the “minimum-variance portfolio” is a positive function of inflation variability and a negative function of the covariance of inflation and the devaluation rate. In other words, if agents expect inflation to be volatile and the exchange rate to be more stable than prices, they will use more dollars.

A second related line of explanation is a weakness of fiscal policy that leads to inflation financing (Calvo and Guidotti 1990). If the government cannot control its spending, has little taxing capacity, and has political control over the central bank, it may be tempted to use seigniorage to cover its deficits. Agents can observe these structural flaws and react by fleeing the domestic currency. Relatedly, allowing or encouraging dollar debt can be seen as a commitment mechanism on the part of the government by making the costs of devaluations prohibitively high (De la Torre, Levy-Yeyati, and Schmukler 2003). For example, the Mexican government issued dollar-denominated Tesobonos in early 1994 in a (futile) attempt to prove its commitment to the exchange-rate peg. A third explanation centers on weak institutions, especially those concerned with enforcing debt repayment in case of default (Chamon 2003; Chamon and Hausmann 2005; Aghion, Bacchetta, and Banerjee 2004; Broda and Yeyati 2006). This explanation emphasizes multiple equilibria. There is an equilibrium with low dollarization and a low probability of crises observed in countries with high and low levels of financial development. Countries with intermediate levels of financial development cannot guarantee that debts will be paid back. Suppose, in such a country, the monetary authority demonstrates a high commitment to exchange-rate stability (maybe as an inflation-fighting tool) at the expense of high or volatile peso interest rates. There is an equilibrium in which borrowers take on dollar debt if everyone else does. This debt is cheaper in the “good” equilibrium and is protected by a bailout in the “bad” equilibrium. A fourth related explanation centers on financial repression or, more generally, financial regulation that is simultaneously leaky and expensive to users of the financial system. In this case, domestic agents have the incentive and the ability to seek to escape the domestic financial system by using off-shore operations (more loosely regulated but managed by local bankers). The consequence is that dollarization can promote financial deepening in a high-inflation environment (De Nicoló, Honohan, and Ize 2005). Trade links are a fifth explanation (cf. Bleakley and Cowan 2008). Domestic agents are exporters and expect to earn dollars, so they may not perceive dollar debt as risky.

236

Liability dollarization  237

Mechanism

The coverage of their survey is substantial The mechanism at work is simple to explain. (nearly 500 publicly traded firms in five Suppose a domestic agent holds both dollar Latin American countries). However, insofar and peso assets and owes both dollar and peso as their data only comes from firms that tend to be exporters, their results may overstate liabilities. Then her wealth is the ability of borrowers to avoid currency ​   (​ ​AP​  ​ ​+  e ​A$​ ​)​ ​−  ​(​LP​  ​ ​+  e ​L$​ ​)​ ​(1)​ mismatches. ​W  = Bocola and Lorenzoni (2020) develop a model of liability dollarization in which or borrowing in a foreign currency is an optimal insurance mechanism (Jeanne 2005). ( ) ​   (​ ​AP​  ​ ​−  L ​ P​  ​)​ ​+  e​(​A$​ ​ ​−  ​L$​ ​)​ ​ 2 ​ Domestic savers protect themselves against ​W  = sudden depreciations by making dollar A depreciation of the peso pushes net worth deposits, transferring this risk to dollar bordown if ​A$​ ​