Understanding Crises

Chi-Wa Yuen
University of Hong Kongy
February 12, 2003

Abstract
Di¤erences across various generations of crisis models suggest that all unhappy
families are di¤erent, to the extent that each requires a separate case study. While
such ad hoc modelling approach has strong explanatory power (because that is precisely
what it is designed for), it lacks generality and predictive power— making it di¢ cult
to design common preventive measures to avoid the crises. For progress in scienti…c
discovery, what we need is to identify the empirical regularity behind these crises. In
other words, it is probably more useful to think of crises as being all alike (rather than
all di¤erent) and try to document their common patterns for the sake of economic
explanation and prediction.

Background note prepared for the 2nd Three-Country Conference, “Seeking Stable and E¢ cient Finan-
cial System,” at the University of Tokyo on February 14, 2003— in my capacity as visiting professor and
designated representative of Guanghua School of Management, Peking University, China. Thanks are due
to the conference participants for useful comments and discussion. A slightly di¤erent version of this note
was later published as a postscript in Lok-Sang Ho and Chi-Wa Yuen (eds.), Exchange Rate Regimes and
Macroeconomic Stability, Kluwer Academic Publishers, 2003.
y
Correspondance: School of Economics and Finance, University of Hong Kong, Pokfulam, Hong Kong.
[Phone: (852) 2859-1051; Fax: (852) 2548-1152; E-Mail: cwyuen@hku.hk]
 Understanding Crises

Most papers in the crisis literature attach a signi…cant role to the choice of exchange-
rate regimes by a country as a determinant of its macroeconomic performance and of its
likelihood of being subject to an economic crisis. As a matter of fact, most crises that have
occurred around the world in the recent decades seem to be related to currency values in one
way or another. This is perhaps the reason why theoretical models built prior to the onset
of the Asian …nancial crisis (AFC)— so-called “…rst-generation”(based on fundamentals á la
Krugman 1979) and “second-generation”(based on self-ful…lling expectations á la Obstfeld
1996)— are models of currency crises, and why, at the beginning of the AFC following the
collapse of the Thai baht and the Korean won, it was misconceived as just another currency
crisis (of the self-ful…lling variety).
As the crisis unfolded, however, it became obvious that, unlike currency crises, the
AFC arose more from banking and …nancial problems in the process of …nancing business
investment than from exchange-rate problems. Since then, quite a few theories— so-called
“third-generation”models— have been proposed to understand its sources and consequences,
viz., moral-hazard-driven investment (Krugman 1998), …nancial fragility (Chang and Velasco
2000), and balance-sheet implications of currency depreciation (Krugman 1999). (See also
Kaminsky and Reinhart 1999 for a related discussion of the twin crises.) As Krugman
(2003) argues, balance-sheet e¤ects are now widely believed to be the most crucial element
behind the AFC. In particular, if …rms are highly leveraged with debt denominated in foreign
currency, then anything that triggers a massive capital out‡ow will result in a depreciation
of the domestic currency and thus an increase in the …rms’ debt burden. As a result, the
net worth of the …rms will be reduced, limiting their ability to borrow funds to …nance their
new investment. The resulting investment and output collapse will validate the capital ‡ight
and make the crisis self-ful…lling.
Any balance sheet has two sides: assets and liabilities. While third-generation models
stress the liability side as a constraint on the …rm’s ability to invest, Krugman (2003) has
also examined how the asset side can exert a similar constraint in what he calls a “fourth-
generation” model of the crisis yet-to-occur. In particular, in the presence of an imperfect
capital market, the …rm’s ability to borrow funds to …nance its investment would depend
on the value of the collateral it can provide, which depends in turn on whether there are
enough other …rms expected to invest as well. Any decline in investor con…dence would
cause a drop in asset prices, hence a fall in the values of collaterals, leading to a collapse in
investment and output that validates the fall in con…dence and asset prices and renders the
crisis self-ful…lling. To make things even worse, the output collapse could lead to de‡ation
(in both asset prices and goods prices), making it more burdensome for the …rm to service
its debt. This is especially likely to take place in an economy facing a liquidity trap as in
the case of Japan, where the nominal interest rate is already close to the zero-bound and
cutting the interest rate would not be a viable monetary-policy option to avert the crisis.
The commonalities and di¤erences among the …rst three generations of crisis-models
are succinctly summarized by Krugman (2003):

“... In the original crisis models a currency crisis was something that was
deserved, predictable, and harmless. That is, it was caused by the government’s
pursuit of contradictory and unsustainable policies; given this, it had to hap-
pen, and indeed had to happen at a particular time; and since it only made the
fundamentals visible, the crisis did not actually damage the economy. With the

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 Understanding Crises

second-generation models it becomes much less clear that the crisis is deserved,
and it becomes unpredictable, though it is still mostly harmless. With the third-
generation models, crises become a clearly bad thing— largely because they are no
longer mainly about monetary policy. Indeed, ..., the depreciation of the nominal
exchange rate becomes more a symptom than a fundamental aspect of these crises
...”

In fact, the fourth-generation model is a lot like its third-generation cousins except that
domestic asset prices replace the exchange rate as a key linkage in …nancial crises— so that
these crises can occur even in economies with capital and/or foreign-exchange controls.
According to the logic of these models, the government may sometimes be able to do
something to prevent some of these crises. But the policy measures that are called for would
in general be model-speci…c and vary from case to case.

1. First-generation crises can, for instance, be eliminated through better and more con-
sistent coordination of policy actions among di¤erent branches of the government—
either forcing the …scal authority to adopt contractionary actions to contain its growing
de…cits or allowing the monetary authority to abandon the …xed exchange-rate regime.
More generally, it requires correction (strengthening) of the “wrong” (weak) funda-
mentals that spark o¤ the crises.

2. In the case of second-generation crises, solutions to the in‡ation bias familiar from
the monetary-policy literature— viz., appointment of a conservative central banker,
imposition of a reputational constraint on or design of an incentive contract for the
central banker, and in‡ation targeting— can help alter the private sector’s devaluation
expectations and thus prevent self-ful…lling attacks on the country’s currency (see Yuen
2003).

3. Regarding third-generation crises of the balance-sheet variety, a large-scale …scal ex-

pansion that o¤sets the investment collapse can rule out the crisis equilibrium. Al-
ternatively, a temporary sharp monetary tightening may also do the job (but at the
expense of a drop in output) by supporting the value of domestic currency, hence al-
tering people’s depreciation expectations. For that matter, imposing capital controls
as a temporary emergency measure may work as well.

4. For fourth-generation crises, while a su¢ ciently large temporary …scal expansion can
eliminate the bad equilibrium, monetary expansion of the conventional type cannot.
In the presence of a liquidity trap (or zero nominal interest rate), monetary policy in
the form of in‡ation or price-level targeting is needed to create in‡ation expectations
among the private sector so as to drive the real interest rate below zero to stimulate
real activities.

Di¤erences across various generations of crisis-models point to “... the somewhat

disheartening fact that each wave of crises seems to elicit a new style of model, one that
makes sense of the crisis after the fact ...” (Krugman 2000). In a sense, it means that
all unhappy families are di¤erent, to the extent that each requires a separate case study.
But while such ad hoc modelling approach has strong explanatory power (because that is
precisely what it is designed for), it lacks generality and predictive power— making it di¢ cult

Chi-Wa Yuen 2
 Understanding Crises

to design common preventive measures to avoid the crises. After all, what is so special about
crises? In what sense are they di¤erent from depressions over a business cycle? For progress
in scienti…c discovery, what we need is to identify the empirical regularity behind these crises.
In other words, it is probably more useful to think of crises as being all alike (rather than
all di¤erent) and try to document their common patterns— so-called stylized facts— for the
sake of economic explanation and prediction.
By maintaining that “business cycles are all alike” in terms of comovements across
macro variables, Lucas (1977) has revolutionized thinking about business-cycle modelling
and stimulated the development of the calibration approach in general and of real business
cycle (RBC) models in particular. In principle, one could also apply a similar stochastic
dynamic general equilibrium approach to the analysis of crises, focusing on the statistical
properties (e.g., amplitudes, comovements, and persistence and phase shifts) of the major
macro aggregates over the “crisis or depression”phase of the business cycle. This approach
has recently been applied by Cole and Ohanian (1999) to analyze the Great Depression.
They …nd the period 1929-39 to be unique in the sharp decline (1929-33) and a slow recovery
(1934-39) in economic activity that conventional shocks can hardly explain. This suggests
that the approach can usefully be employed to distinguish unique events from more familiar
ones, before we decide whether the crisis in question is special enough to deserve scrutiny by
developing a new, unconventional approach.

Chi-Wa Yuen 3
 Understanding Crises

References
[1] Chang, Roberto, and Andres Velasco, “Financial fragility and the exchange rate
regime,”Journal of Economic Theory 92 (2000), 1-34.

[2] Cole, Harole L., and Lee E. Ohanian, “The Great Depression in the United States from
a neoclassical perspective,” Federal Reserve Bank of Minneapolis Quarterly Review 23
(Winter 1999), 2-24.

[3] Kaminsky, Graciela, and Carmen Reinhart, “The twin crises: The causes of banking
and balance of payments problems,”American Economic Review 89 (1999), 473-500.

[4] Krugman, Paul, “Crisis: The next generation?” in Elhanan Helpman and Efraim Sadka
(eds.), Economic Policy in the International Economy: Essays in Honor of Assaf Razin,
Cambridge University Press, 2003.

[5] __________, “Balance sheets, the transfer problem, and …nancial crises,” Inter-
national Tax and Public Finance 6 (1999), 459-472.

[6] __________, “Bubble, boom, crash: Theoretical notes on Asia’s crisis,” mimeo,
January 1998.

[7] __________, “A model of balance of payments crises,”Journal of Money, Credit,

and Banking 11 (1979), 311-325.

[8] Lucas, Robert E., Jr., “Understanding business cycles,” Carnegie-Rochester Series on
Public Policy 5 (1977), 7-29.

[9] Obstfeld, Maurice, “Models of currency crises with self-ful…lling features,” European
Economic Review 40 (1996), 1037-1048.

[10] Yuen, Chi-Wa, “Solutions (?) to the ‘devaluation bias’: Some preventive measures to
defend …xed exchange rates against self-ful…lling attacks,” in Elhanan Helpman and
Efraim Sadka (eds.), Economic Policy in the International Economy: Essays in Honor
of Assaf Razin, Cambridge University Press, 2003.

Chi-Wa Yuen 4