Conference Explores Origins, Management of Financial Crises

• Pages: 260-262

Page 260

On July 11-14, the London-based Centre for Economic Policy Research (CEPR) and the Economic and Social Research Council's Global Economic Institutions Research Program sponsored a conference, in London and Cambridge, on the Origins and Management of Financial Crises. IMF participants included IMF First Deputy Managing Director Stanley Fischer, Paul R. Masson of the IMF's Research Department, and James M. Boughton, the IMF's Historian. The following is a summary of the conference based on a report by Boughton and Masson.

In the 1990s, the study of financial crises has taken on new urgency. The scale of recent crises and the speed with which they now arise pose challenges for analysts seeking to understand the dynamics of financial crises, and for policymakers hoping to avoid them.

A key question for those investigating the roots of currency crises is how to apportion causality. Do financial crises spring from dramatic changes in economic fundamentals? Are they more apt to result from self-fulfilling shifts in speculative behavior? Or do they stem from some combination of fundamental and self-fulfilling factors? The answers have implications not simply for understanding the origins of financial crises but also for devising more effective strategies to avoid or manage these crises.

Crisis Triggers: Fundamentals or Self-Fulfilling?

Timothy Kehoe of the University of Minnesota argued that even when economic fundamentals are relatively sound, extrinsic or noneconomic events- called "sunspots" by economists-can play a key role in altering market expectations about whether a government will be able to service its debts. On the basis of a model that focused on the ratio of government debt to GDP at various maturities, Kehoe suggested that the 1994-95 Mexican crisis was essentially the result of such a sunspot. Because this ratio was lower in Mexico than in some other countries, Kehoe rejected the possibility that fundamentals were unsustainable.

Kehoe maintained that the attack on the Mexican peso followed a relatively lengthy period in which the peso was "ripe for attack." Mexico's stock of short-term debt was high, and this left it vulnerable to a series ofPage 261 noneconomic shocks that provided the market with "bad news."Interest rates rose and the government's fiscal policy became unsustainable-events that Kehoe believed were rooted in the self-fulfilling speculative attack on the Mexican peso.

Some participants questioned this interpretation of events, pointing out that Mexico's fundamentals, including the real exchange rate and the current account, were not all that favorable at the onset of the crisis. Others ascribed greater weight to Mexico's banking sector problems, believing that they played a significant role in the crisis. In any case, some argued, it was impossible to distinguish between sunspot models and models that...