Volume 5, Issue 2, April 2004

The Research Agenda: Craig Burnside on the Causes and Consequences of Twin Banking-Currency Crises

The Asian Crisis of 1997-98

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

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

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

EconomicDynamics Interviews Vincenzo Quadrini on Firm Dynamics

EconomicDynamics: In recent work with Claudio Michelacci, you started exploring the relationship between firm size and wages. What new insight have you obtained?

Vincenzo Quadrini: A well-known stylized fact in labor economics is that large firms pay higher wages than small firms. There are several studies in the theoretical literature that try to explain this fact. However, none of the existing studies investigate the role of financial constraints. In the joint work with Claudio Michelacci we ask whether financial factors can contribute to explaining the dependence of wages on the size of the employer.

Our interest in understanding the importance of financial factors for the firm size-wage relation is motivated by a set of regularities about the link between the financial characteristics of firms and their size. The view that results from the financial literature is that smaller firms face tighter constraints. It is natural then to ask whether the dependence of wages from the size of the firm could derive from the tighter financial constraints faced by small firms.

We study a model in which firms sign optimal long-term contracts with workers. Due to limited enforceability, external investors are willing to finance the firm only against collateralized capital. If the investment financed with external investors is limited--that is, the firm is financially constrained--the optimal wage contracts offered by the firm to the workers is characterized by an increasing wage profile. By paying lower wages today, the firm is able to generate higher cash-flows in the current period, which relax the tightness of the financial constraints. Because firms with tighter constraints operate at a sub-optimal scale--which then they gradually expand until they become unconstrained--small firms pay on average lower wages than large firms. At the same time, because constrained firms are the ones that grow in size, the model also captures the empirical regularity that fast growing firms pay lower wages. Through a calibration exercise we show that the model can generate a firm size-wage relation which is comparable in magnitude to the estimates obtained in the empirical literature.

The increasing wage profile raises the question of whether the firm may have the incentive to renegotiate the wage contract in later periods. The key modeling feature that prevents the firm from renegotiating the contract is the loss of sunk investment if the worker quits. This investment could derive from recruiting costs or training expenses that enhance the job specific human capital of the worker. The firm's loss of valuable investment endows the worker with a punishment tool which is not available to external investors. This allows the firm to implicitly borrow from workers beyond what it can borrow from external investors.

ED: You show that the liquidation of a firm in a long-term contract may occur even when the contract is renegotiated, and sometimes only when the contract is renegotiated. What does this imply for the design of corporate law, and in particular bankruptcy law?

VQ: A well established result in models with agency problems, is that more stringent punishments can support superior allocations. However, punishments may be time-inconsistent in the sense of being ex-post inefficient. For instance, in a financial relation between an investor and an entrepreneur characterized by information asymmetries, the threat of liquidation may be ex-ante optimal because it induces the desired action from the entrepreneur. However, after the entrepreneur's action has been taken and the firm's outcome observed, it may be inefficient to liquidate the firm. This implies that the liquidation threat is not credible and it will be renegotiated. This raises the question of whether an optimal financial contract would ever lead to the liquidation of a viable firm. In "Investment and Liquidation in Renegotiation-Proof Contracts with Moral Hazard" I show that the firm can still be liquidated in an optimal contract even if we impose the renegotiation refinement. In general, allowing for the renegotiation of contracts reduces the allocation efficiency because it makes more difficult to create incentives.

What does this imply for the design of corporate and bankruptcy law? In principle, there are some important policy recommendations.

The time-consistency problem outlined above would be avoided if the contractual parties could commit to not renegotiate the contract in future dates. If the policy maker could legally prevent the renegotiation of private contracts, the problem would also be avoided. This requires that when a contract prescribes the liquidation of the firm, the firm should be legally forced to exit and liquidate its assets. While this may seem paradoxical, this is what the theory suggests.

Of course, the time-consistency problem can also arise for the policy maker. When a firm would otherwise be inefficiently liquidated and the parties would have been willing to renegotiate, the policy maker would also prefer that the parties renegotiate. However, changing the current rules may undermine the credibility of all existing contracts. In other words, reputation considerations may limit the regulator's incentive to make exceptions.

These policy considerations seem at odds with standard bankruptcy laws. One of the main goals of bankruptcy law is to facilitate the renegotiation of contracts in order to prevent default or liquidation. However, although renegotiation may be ex-post desirable in the event of financial distress, it is never optimal ex-ante.

This conclusion also holds in the international context, that is, for borrowing and lending countries. The creation of an effective enforcement system, however, is extremely difficult in the international context.

ED: In your work with Charles Himmelberg, you show that entrepreneurs in young firms should be compensated with options, but that options should be less and less used as firms mature and grow. CEO compensation is the subject of intense criticism these days in the US, partly due to large option packages. Does this mean that current CEO compensations are inefficient?

VQ: Of course, if we believe that the recent corporate scandals were caused by the compensation structure of managers, then there must be something wrong with this structure. It is true that recent managerial compensations have been dominated by generous stock options and/or stock grants. However, this does not mean that options are not useful to create the right managerial incentives. The recent corporate scandals only show that the options offered to managers were not well designed. And probably this was caused by a misunderstanding about the fundamental agency problems between managers and investors.

In the type of models I have been working with, the agency problems derive from the non-observability of the manager's use of the firm's resources. In these models, the incentive for the manager is to under-report the firm's performance because this allows him or her to divert some of the firm's resources. Consequently, to prevent the manager from under-reporting, his or her compensation must rise when the performance of the firm is good. One way to achieve this outcome is with the use of stock options. But if the rewards for good outcomes are excessive, then the manager starts to have the opposite incentive, that is, to inflate the firm's performance. In this sense, the problem with recent managerial compensation does not derive from the use of options per se, but from their "excessive" use.

References

EconomicDynamics Forum: Patrick Kehoe on Whether Price Rigidities Matter for Business Cycle Analysis

Second, do these rigidities play an important role in determining the magnitude and persistence of deviations from trends of the major aggregates? I think that a fair answer has to be that the verdict is still out. There are several uphill battles, both empirical and theoretical that need to be won before anyone can claim to have demonstrated the price rigidities are important. Let me turn to these challenges.

Challenges for sticky price enthusiasts

A. Empirical: Observed price stickiness is short

On the empirical side Bils and Klenow (2003) and Klenow and Krystov (2003) have dug up some interesting BLS data on individual goods price that shows that a key feature of the data is

• The average time between price changes is relatively short, about 4 months

B. Theoretical: Existing sticky price and sticky wage models don't generate enough persistence

On the theoretical side there is one key challenge:

• Despite any claims to the contrary, existing models of sticky prices cannot generate anywhere near the level of persistence in output seen in the data.

The new work by Golosov and Lucas (2003) raise an even greater challenge for sticky price models. Their work is motivated by some of the empirical work of Klenow and Krystov who find the following at the level of an individual retailer, like a store.

• The average size of price increases in the data is about 9%.

This type of reasoning motivates Golosov and Lucas to construct a model with fixed costs of changing prices with large idiosyncratic shocks at the level of the individual retailer along with aggregate monetary shocks. They then compare the persistence of output in their state-dependent pricing models to that of a Calvo-type model with an exogenously specified timing of price changes that is so popular in the literature. They find that they get about 1/5th of the amount of persistence that a Calvo model does with the same average time of price changes.

The intuition for this result is that in their state dependent model, when a money shock hits the retailers that endogenously choose to change their prices are the ones whose prices are the most out of whack. Thus, the retailers that don't change their prices are the ones for whom not changing is not a big deal "in terms of output loss" anyway. Hence, the model generates very little persistence. The obvious conjecture is that even if we try to load up the model with all kinds of bells and whistles that go under the rubric of real rigidities the 1/5th rule will approximately hold up. That is, once the sticky price literature squarely confronts the micro data on price changes replacing the Calvo pricing with a fixed cost model, it will find that the persistence of output is cut by a factor of 5. I would also conjecture that if researchers forthrightly confront this problem they will give up on the current strand of sticky price models.

C. Doubtful Claims of Success

There is some recent work that claims that existing sticky price and sticky wage models can generate as much persistence as there is in the data. I take issue with these claims. My issues can all be summarized as follows: The literature that claims success, lowers the bar from 10 feet to 2 feet, jumps over it and then declares victory. Here is how the bar is lowered.

The retreat to VARs

The reason macroeconomists are interested in nominal rigidities in the first place is that many think they play a key role over the business cycle in determining how the economy reacts to nominal shocks. (Here by nominal shocks I mean something a little broader than what people typically mean. I mean both the epsilons on the end of estimated policy rules and policy mistakes, defined as the difference between the observed systematic component of policy and the what would be the optimal systematic component of policy given a model.) Many of the sticky price enthusiasts have retreated from even claiming that their models can account for the overall business cycle patterns and instead retreat to the rather tiny component of the business cycle identified by a VAR to be attributable to the epsilon shocks on an estimated policy rule. (A notable exception to this pattern is the work by Bordo, Erceg and Evans 2000.) Thus, these macroeconomists replace the very interesting question of how much of the business cycle can monetary shocks in the presence of price rigidities account for, to the fairly much less interesting question of can our model reproduce the impulse response to a blip to the epsilon on the end of an estimated monetary policy rule. To drive this point home, note that if you plot the last hundred years of detrended GDP for the United States one event outshines all others: the Great Depression. All postwar business cycles look like little blips compared to the Great Depression. Almost all economists who have studied the Great Depression argue that broadly defined monetary shocks played a critical role in generating the depth and the length of the Depression. Indeed, one of the main forces spurring the Keynesian revolution is the perceived inadequacy of the simplest classical models without frictions to generate such a depression. The sticky price enthusiasts seem to shy away from building serious quantitative models that can generate the Great Depression. From the point of view of business cycle theorists, retreating to VARs and ignoring the Great Depression is amounts to saying that the game you want me to play is too hard so I am going to take my marbles and go home.

Making prices and wages stickier than they are in the data

Part of this work simply makes prices much more sticky than they are in the data--3 quarters instead of 1 quarter--and shows that these models generate about 3 times as much persistence as the existing models with one quarter. Somehow this work misses the point. Another part of this work claims that sticky wage models can generate much more persistence than sticky price models. That is not really true. Chari, Kehoe and McGrattan (2003) showed that if for the same degree of exogenous stickiness, sticky wage models and sticky price models generate similar degrees of persistence. What the literature on sticky wages actually does is simply increase the degree of exogenous stickiness for wages to be 3 times as much as it is for prices and argues that sticky wages generate more persistence. (See, for example, Bordo, Erceg and Evans (2000) and Christiano, Eichenbaum and Evans (2003).) The logic for having long exogenous stickiness for wages with labor contracts determined in a spot market is that many people receive only yearly changes in their nominal wages.

Punting on measuring stickiness in long-term relationships

The deeper problem with this literature is the idea that actual wage contracts in the U.S. economy are well approximated by a sequence of spot market transactions. For example, in our profession most assistant professors have fairly stable wages for about 7 years and at that time their wages jump up by varying degrees at tenure time. All assistants understand that if they work harder during those 7 years the probability distribution over their post-tenure wages increases. To an outside observer who naively models the situation as a sequence of spot-market trades it will look like wages are sticky. As was pointed out over 20 years ago, in a long term relationship the fact the changes to payment streams occurs in lumps in no way restricts the ability of the contract to achieve real outcomes. Before this literature can make any progress the issue of how best to use data to shed light on whether wages in long-term relationships are indeed sticky needs to be addressed.

D. Summary

In sum I think the following. The serious work on incorporating interesting price rigidities into serious dynamic stochastic equilibrium models capable of confronting the data is still in its infancy. Price rigidities may turn out to be important, but the current models we have for addressing them seem not very promising quantitatively. Currently, I see a large number of economists writing papers that takes the existing sticky price models as they stand and tries to use them to address a number of issues, especially policy issues. I think that this is not a productive use of time. A better use of time for the sticky price enthusiasts is to go back to the drawing board and dream up another version of the model that has a chance at generating the patterns observed in the Great Depression. Doing so may be difficult, but the payoff is worth it.

Reference

Review of Economic Dynamics: Letter from the Coordinating Editor

Gary Hansen
RED Coordinating Editor

Review: Mortensen's Wage Dispersion

In in latest book, Dale Mortensen reviews the evidence and the latest theoretical findings on a long standing puzzle: why would different firms pay differently for the same workers? Observable worker characteristics explain at most 30% of wage differentials across individuals. This raises doubts about the wage equation that yields such results, the efficacy of the standard competitive model or the functioning of labor markets.

There is now mounting evidence that firm size and industry matter. This may mean that imperfect competition is in order which would allow different firms to offer different pay policies. Also, explicitly modeling the frictions on the labor market may be needed. Mortensen addresses this by laying out a simple matching model with wage posting and demonstrates that this can leads to wage dispersion even when all firms and workers are identical. It is then shown how this model can be extended to various environments where firms differ along some dimension.

The model is then extended to an intertemporal setup, the Burdett-Mortensen model. Dale Mortensen then discusses empirical work done with co-authors on a Danish data set and shows that including productivity differences across employers allows the model to better match observed distributions. What these results imply in terms of workers flows and job tenure is the discussed in two further chapters.

This book in essential for anyone interested in some serious modeling of the labor market. It assembles the research frontier on labor search, both on the theoretical and empirical fronts.

"Wage Dispersion" was published in January 2004 by MIT Press.

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