It certainly seems a mystery why episodes of financial crises and contagion recur, in spite of the major costs associated with crises that would seem to provide a sufficient motivation for avoiding them. But based on historical experience, there appears to be little hope that during the good times, future generations of sovereign borrowers or investors will remember that the four most expensive words in financial history are “this time it’s different.”

Kaminsky, Reinhart, and Vegh, The Unholy Trinity of Financial Contagion, 2003, p.20-21

It has long been known that financial intermediaries whose liabilities are guaranteed by the government pose a serious problem of moral hazard… they had every incentive to play a game of heads I win, tails the taxpayer loses

Paul Krugman, What happened to Asia?, 1998

Egalitarian values of the late twentieth century seek to ensure equal opportunity to economic participation, regardless of gender (or race). What may have once been an economic rationale for employers to prefer men has been outdated by the knowledge-based technology of the post-industiral period. This puts more of a premium on the power of workers’ brains than of their muscles.

Unequal Pay for Women and Men, p.1, Joshi and Paci, 1998

One common empirical finding is that the labour demanded for unskilled workers is more elastic than for skilled workers. In other words, for any given percentage increase in the wage, the cut in employment will be larger for unskilled workers than for skilled workers. An interesting interpretation of this result is that employment is inherently more unstable for unskilled workers than it is for skilled workers.

Labour Economics, G. Borjas, 2013, p.112

On the whole, it seems that Democratic Presidents are more conducive to economic growth than Republicans. Of course, one should not draw causation from this data. But, it is interesting given the preconceptions within the US that the Republicans are a party of economic prosperity.

“Over the medium run, significant parts of output movements surely reflect not aggregate demand shocks and sticky prices, but changes in the growth rate of the economy’s productive capacity. There is no reason for monetary and fiscal policy to try and prevent those movements.”

David Romer, Advanced Macroeconomics, 2012, p.527

Brief Notes On Twin Crises

Why do banking crisis and currency crisis so often coincide?
The effects of a banking crisis can be summarised as a “financial distress resulting in the erosion of most or all of aggregate banking system capital” (Bordo et al, 2001). A currency crisis (also known as a balance of payments crisis) can generally be summarised as “a forced change in parity, abandonment of a pegged exchange rate, or an international rescue” (Bordo et al, 2001) of the currency. Both have detrimental effects to the economy, which are exacerbated when they occur together. The dual occurrence of a banking crisis and a currency crisis is deemed a ‘twin crisis’.

To understand the cause of twin crises it is important to study their history. Under Bretton Woods currency crises were common, but banking crises were very rare. The exogenous control of the exchange rate removed the conflicting policy decision between currency control and domestic policy for the central bank

However, the departure from Bretton Woods reintroduced this trade off for central banks. Kaminsky and Reinhart (1999) provide data to suggest that this resulted in an equally high number of currency crises (per year), in combination with a large increase in the number of banking crises. More importantly, the number of twin crises increased.

The literature concerning these crises does not conform to a single opinion regarding their causes. On the whole, there are two conflicting schools of thought. Firstly, there are those who consider financial crises to occur as a result of poor fundamentals in the economy. This is known as the fundamentals school. Secondly, there are those who consider financial crises the result of investor speculation. This is known as the self-fulfillment school.

Kaminsky and Reinhart (1999), who themselves subscribe to the fundamentals school, provide an overview of the potential causation of twin crises. Firstly, they present Stoker’s (1994) view that currency crises cause banking crises. Stoker’s model is based around a country with a fixed exchange rate. Under such a system any shock to the exchange rate is dealt with using central bank reserves. Therefore, a negative external shock will decrease reserves and restrict the credit available in the economy. This can lead to bankruptcies, etc, which will undermine the central bank’s asset base and cause a banking crisis.

Secondly, they present Velasco’s (1987) model that banking crises cause currency crises. Velasco argues that an overcommitment to the domestic economy by the central bank in a time of crisis, for example a large increase in the monetary base, will lead to an increasingly worthless currency. This is an example of poor fundamentals in the economy.

Finally, there are those who consider banking and currency crises to have similar causes. Kaminsky and Reinhart (1999) use the example of the “exchange-rate-based inflation stablization plan…of Mexico in 1987”. Such programs are often fueled by domestic banks borrowing on foreign financial markets. If financial markets deem this borrowing unsustainable, there is likely to be a speculative attack on the currency. This will trigger a currency crises and a simultaneous banking crisis, as asset markets crash. This example feeds into the self-fulfillment school.

Bibliography

• Reinhart, Carmen M, 2009, “This time is different: eight centuries of financial folly”, Princeton, Princeton University Press
• Reinhart and Kaminsky, 1999, “The Twin Crises: The Causes of Banking and Balance-of-Payments Problems”, American Economic Review, vol. 89, issue 1999, pp. 473-500
• Bordo, M.D., B. Eichengreen, D. Klingebiel, and M.S. Martinez-Peria, 2001, Is the Crisis Problem Growing More Severe?, Economic Policy, vol. 16

“We economists must recognise not only the limits of our discipline to prescribe inequality causes, but also the limits on the ability of our discipline to prescribe policy responses”

Mankiw, N Gregory, 2013, Defending The One Percent, Journal of Economic Perspectives, vol. 27, issue 3, pp. 21-34

The Thinking Behind Western Austerity

Can fiscal consolidation be done well? Given we live in an age of austerity, this seems like a question that applies to us all. The paper below offers a fantastic insight into the thinking behind most Western austerity packages. I’d thoroughly recommend this paper to anyone with an interest in the practical results of austerity.

Click to access c12853.pdf

Pop-Economics

Two of my best friends study Physics. They regularly complain about the credibility and accuracy of ‘pop-science’. On more than one occasion they’ve asked me whether ‘pop-economics’ annoyed me, but I’ve never really been able to think of any examples of ‘pop-economics’. Honestly, I didn’t really think it existed. But, its just hit me. Pop-economics is just politics.