Since 1990 economists have watched the collapse of fixed or managed exchange rate regimes in a diverse set of countries that includes, among others, Sweden, Mexico, Thailand, Korea and Turkey. There is disagreement about the causes of these crises, but there is widespread agreement that these currency crises were somehow linked to banking crises that occurred at roughly the same time in each country. This "twin crises" phenomenon was identified by Kaminsky and Reinhart (1999). They argued that in the 1970s, worldwide, there were 26 balance-of-payments crises and 3 banking crises, but only one instance of these crises being coincident. On the other hand, among the 50 balance-of-payments crises and 23 banking crises that occurred after 1980, 18 were coincident. My recent research, most of which has been joint with Martin Eichenbaum and Sergio Rebelo, investigates the causes and consequences of these crises.

The Asian Crisis of 1997-98

At the end of June 1997 the Asian crisis began with the collapse of Thailand's fixed exchange rate regime after weeks of market speculation. At the time, we were intrigued. The standard explanation for speculative attacks--that they reflect profligate fiscal policy--had an obvious shortcoming when applied to Thailand: its government was running a budget surplus and had done so for several years. As events unfolded, more exchange rate regimes in Asia collapsed, and in each case, the governments in question had been running surpluses, or at worst small budget deficits.

In standard "first generation" currency crisis models, such as those of Krugman (1979), Flood and Garber (1984), Obstfeld (1986), Calvo (1987), Wijnbergen (1991), and Calvo and Végh (1998). Ongoing fiscal deficits lead to sustained reserve losses and to the eventual abandonment of a fixed exchange rate. In these models ongoing deficits and rising debt levels precede the collapse of a fixed exchange rate. Since neither deficits nor rising debt levels were observed prior to the crisis in Asia, this led many observers to argue that standard models were inadequate, and that the crises arose from self-fulfilling expectations on the part of speculators.

We were not so sure. Each of the Asian economies that suffered through a currency crisis also experienced a banking crisis. A consequence of these financial crises was that the governments in Asia bore the cost of bailing out failing banks, either by recapitalizing them, or by closing them and honoring their debts. Thus, in Burnside, Eichenbaum and Rebelo (2001a) we argue that the Asian currency crises were caused by fundamentals, in particular, the large prospective deficits associated with government bailout guarantees to failing banks. The expectation that seigniorage revenues would finance these future deficits led to the collapse of the fixed exchange rate regimes.

Our model has a distinctly first generation flavor in that fiscal deficits ultimately financed by seigniorage revenues play a key role in triggering the crisis. A key insight of our work, however, is that the deficits need not precede the currency crisis. The currency crisis can occur in anticipation of later deficits. Thus, a crisis can appear to be unlikely--in the sense that fiscal policy looks healthy prior to the crisis--yet occur.

Could agents in the Asian economies anticipate the coming deficits? We argued that they could on the following basis: in most of the Asian economies that experienced currency crises the banking sector was in trouble prior to the crisis. In Korea and Thailand, especially, the stock market capitalization of the financial sector had been in sharp decline for over a year. Given the scale of the problem, agents could readily anticipate that governments would step in and bear the cost of cleaning up the mess.

General equilibrium dynamics play an important role in the solution of our model. First, like most currency crisis models, ours is explicitly dynamic: equilibrium prices are determined by solving a system of first order conditions that includes a dynamic Euler equation for money balances. Second, unlike many currency crisis models, ours explicitly requires that the government budget constraint be satisfied: this endogenizes at least some aspects of the money supply path, and ensures that the anticipation of future deficits plays a key role in driving the crisis.

The Post-Crisis Government Budget Constraint

Our prospective deficits model suffers from two important shortcomings:

1. It predicts that there should be a significant rise in seignorage revenue after a currency crisis.
2. It predicts that currency crises will be followed by substantial inflation to the same extent that they lead to rapid depreciation of the local currency.

This evidence led us to ask the following questions: If not using seigniorage, how do governments pay for the fiscal costs associated with twin banking-currency crises? What are the implications of different financing methods for post-crises rates of inflation and depreciation? Can first generation models be reconciled with the facts?

In Burnside, Eichenbaum and Rebelo (2003a and 2003b) we address these questions. Our answer to the first question is that after currency crises governments finance themselves with a menu of different types of revenue. The problem with the standard theories is that they assume, for convenience, that governments face a simple choice between making explicit fiscal reforms (such as raising tax rates or making social programs less generous) to defend a fixed exchange rate, or printing money and abandoning a fixed exchange rate. We show that, apart from seigniorage revenue, governments have access to other types of revenue that are depreciation-related. First, as in the fiscal theory of the price level--exposited by Sims (1994), Woodford (1995), Dupor (2000), Cochrane (2001), Daniel (2001a, b) and Corsetti and Mackowiak (2002)--they can deflate the dollar value of outstanding nonindexed debt. Second, governments can benefit from what we call "implicit fiscal reforms." These reforms arise from changes in relative prices that are outside the government's direct control. For example, if the government purchases mainly nontraded goods, its expenditure, measured in dollars, will decline if the dollar price of nontraded goods declines as the result of a crisis. While this will also be true for revenue, the government may be a net beneficiary of the crisis depending on the exact structure of its budget. Also, government transfers that are indexed to the CPI decline in dollar value if inflation lags behind depreciation. Our empirical evidence--gleaned from case studies of Mexico, Korea and Turkey--suggests that these additional forms of depreciation related revenue are more important than seigniorage in some crisis episodes.

To answer the second and third questions we use variants of our prospective deficits model in which the government budget constraint is more realistically specified. In Burnside, Eichenbaum and Rebelo (2003a) we use a simple reduced form model featuring a Cagan money demand function, and a government budget constraint that allows for nominal debt and nonindexed government transfers. In Burnside, Eichenbaum and Rebelo (2003b) we develop a general equilibrium model with two goods, and a government budget constraint that allows for (i) nominal debt, (ii) transfers that are indexed to the CPI (not the exchange rate), (iii) government purchases of goods and services, the dollar value of which is affected by changes in relative prices, and (iv) taxes that are proportional to economic activity. Using these models we show that the ways in which governments finance themselves after crises have important consequences for inflation and depreciation outcomes. Furthermore, we show that our extended first generation models can be reconciled with the facts as long as PPP only holds for traded goods at the producer level, and as long as we allow for sticky nontradable goods prices.

Our results can be understood as follows. Suppose the banking crisis imposes a fiscal cost, x dollars, on the government. One way the government could pay for this new burden would be through explicit fiscal reforms. If these explicit fiscal reforms raise x dollars of revenue, the model predicts that a currency crisis will be prevented. On the other hand, if the government raises less than x dollars of revenue through explicit fiscal reform, it must abandon the fixed exchange rate regime.

Suppose that all government debt is denominated in dollars, that all goods in the economy are tradable, and that PPP holds. In this case, the only source of additional revenue to the government is the printing press. To the extent that the government prints money the currency will depreciate and, given PPP, there will be a similar amount of inflation.

On the other hand, suppose that the government has a substantial amount of outstanding debt that is denominated in units of local currency. Then, as the currency depreciates, the dollar value of this debt declines. In this way, the government raises revenue implicitly, and does not need to print as much money. This makes the model more consistent with the facts in two ways: seigniorage becomes less important and post-crisis inflation is also lower. Unfortunately, the model becomes less consistent with the facts in that the model also predicts less depreciation.

Now suppose the government spends more on nontraded goods than it raises in revenue by taxing nontraded goods production (or consumption). In this case, the government's budget balance--measured in dollars--will improve, the greater is the decline in the dollar price of nontraded goods after a crisis. As long as PPP only holds for traded goods and nontraded goods prices are sticky in response to the currency crisis, the government raises even more implicit revenue. For this reason, less money is printed, and there is even less inflation. However, the model is fully consistent with the facts because there will be substantial depreciation. Why? Money demand must rise, in equilibrium, to match the money supply. When money demand is proportional to the nominal transactions volume--say as in a cash-in-advance model--and some prices are sticky, the prices that are flexible adjust more in equilibrium. In our model, when nontraded goods prices are sticky, the producer price of tradables, which, by PPP, is equivalent to the exchange rate, rises more than it would if nontraded goods prices were flexible.

For simplicity we assume that nontraded goods prices remain fixed for some period of time after the crisis, and then rise in proportion to traded goods prices. In a general equilibrium model with explicit price-setting behavior these dynamics might be different, but we think they would be similar, as long as the path for nontraded goods prices implied by the model was realistic.

All of this suggests that first generation models can be rendered consistent with the observed paths of inflation and depreciation after recent currency crises, but only if we model the government budget constraint carefully.

Government Guarantees to Banking Systems and Self-Fulfilling Speculative Attacks

While much of the research I have just described focuses on models in which crises arise out of bad fundamentals in the banking sector, some of my other recent work has considered the possibility of self-fulfilling speculative attacks on fixed exchange rate regimes. In the models of prospective deficits that I have just described, a currency crisis occurs because the government bails out failing banks, and because the government finances part of the bailout with depreciation-related revenue. These models take the banking crisis as given, and work out the implications of the government's financing choices for equilibrium prices.

In Korea and Thailand, the banks were in trouble prior to the crisis. It is arguable, however, that these banks were exposed to exchange rate risk, and that the crisis caused their balance sheets to deteriorate even further. In other crisis episodes we see otherwise healthy banks which are exposed to exchange rate risk, mainly because they have dollar liabilities but do their lending in local currency. When a currency crisis occurs these banks fail. This leads us to ask two questions:

1. Why do banks expose themselves to exchange rate risk?
2. Does the fact that otherwise healthy banks are exposed to exchange rate risk open the door to the possibility of currency crises driven by agents' self-fulfilling expectations?

Again, the dynamic aspect of a bank's problem plays a key role. Bankers maximize expected payments to their shareholders but face uncertainty about the exchange rate. When there are no government guarantees, banks hedge because they face higher borrowing costs if they are exposed to exchange rate risk. These higher borrowing costs reflect the costs associated with bankruptcy. On the other hand, under government guarantees, a bank's creditors do not care if it is exposed to risk. Furthermore, banks actually have an incentive to take on risk: they want to leave nothing on the table in the bad state of the world.

In Burnside, Eichenbaum and Rebelo (2003c), we treat the probability of a currency crisis as endogenous. Using a model similar to the one I have just described we show that if the government does not issue guarantees, banks hedge, and self-fulfilling speculative attacks are impossible in equilibrium. On the other hand, if the government does issue guarantees, banks are exposed to exchange rate risk. Suppose, in this situation, agents come to believe that the fixed exchange rate regime will be abandoned. They will speculate against the currency, causing the central bank to float the currency. This will lead to the failure of the banks exposed to exchange rate risk. The government, in turn, will have to bail out the banks. If the government uses depreciation-related revenue to finance the bailout, the speculative attack on the currency is rational.

Finally, in Burnside (2004), I describe how the issuance of government guarantees combined with the methods by which these guarantees are financed affects the probability of a crisis taking place. I show that the greater the amount of revenue that can be raised through implicit fiscal reforms, the lower the probability of a crisis of a given magnitude. The reason is simple: the larger the potential implicit fiscal reforms, the less seignorage is required to finance the budget. Other things equal, the less money is printed the lower are the post-crisis rates of depreciation and inflation.

In sum, this research points to the importance of government policy and the government budget in currency and financial crises. Government guarantees can be seen as an important determinant of a country's exposure to self-fulfilling twin crises. Whether or not financial crises are self-fulfilling, guarantees impose significant fiscal costs on governments. Absent explicit fiscal reforms, paying for these costs requires that the government abandon a fixed exchange rate regime. The structure of the government's debt and budget act as important determinants of the outcomes for inflation and depreciation. In our models, these outcomes are determined by solving equilibrium models with forward looking pricing equations.

References

Burnside, Craig (2004): Currency Crises and Contingent Liabilities, Journal of International Economics, vol. 62, pages 25-52.

Burnside, Craig, Martin Eichenbaum and Sergio Rebelo (2001a): Prospective Deficits and the Asian Currency Crisis, Journal of Political Economy, vol. 109, pages 1155-1197.

Burnside, Craig, Martin Eichenbaum and Sergio Rebelo (2001b): Hedging and Financial Fragility in Fixed Exchange Rate Regimes, European Economic Review, vol. 45, pages 1151-1193.

Burnside, Craig, Martin Eichenbaum and Sergio Rebelo (2003a): On the Fiscal Implications of Twin Crises, in Michael P. Dooley and Jeffrey A. Frankel, eds. Managing Currency Crises in Emerging Markets. Chicago: University of Chicago Press.

Burnside, Craig, Martin Eichenbaum and Sergio Rebelo (2003b): Government Finance in the Wake of Currency Crises, NBER Working Paper No. 9786.

Burnside, Craig, Martin Eichenbaum and Sergio Rebelo (2003c): Government Guarantees and Self-Fulfilling Speculative Attacks. Forthcoming, Journal of Economic Theory.

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