Currency and Financial Crises of the 1990s and 2000s Assaf Razin Steven Rosefielde



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Post Crisis and Prospects

The EU similarly is suffering from protracted post-crisis adjustment distress, with one important twist. The adjustment burden has fallen asymmetrically on the PIIGS (Portugal,Ireland, Italy, Greece and Spain), threatening the viability of the Euro, and even EU survival. Labor and other factor costs escalated rapidly during the bubble years following the signing of the Maastricht Treaty(1992), accelerating after 1999 due to foreign capital inflows encouraged by the adoption of a common currency in the Eurozone. These speculative increases weren't matched by productivity gains vis-a-vis other member states, particularly Germany, making it extraordinarily difficult for PIIGS to cope with diminished post crisis aggregate effective demand. They cannot rely on the ECB (European Central Bank) to work efficiently as a lender of last recourse to floundering commercial banks. Their only residual instrument is fiscal policy, but decades of excess public spending have placed tight constraints on further debt accumulation forcing them to shoulder the quadruple burdens of high debt service, depression, mass unemployment and vanishing social services. PIIGS cannot depend on yet-to-be-developed EU financial institutions for government facilitated debt restructuring. EU government financial credits could have mitigated the sovereign debt problem. High unemployment likewise could have been ameliorated by stronger EU labor mobility, but none of these options were viable. The PIIGS consequently are compelled to resolve the disequilibrium roundabout restoring competitiveness through a painful process of factor cost reduction and productivity enhancement that is slow and risky. They could choose to default on their sovereign debt forcing creditors to share the burden, but might well find themselves ensnared in a vicious contractionary spiral without a fiscal antidote.47


   Some American states like California and Illinois face similar difficulties, but the depressive effects of reduced government spending are alleviated by superior labor
mobility and a more uniform distribution of factor costs and productivity across the
nation. Most importantly, America has well functioning federal fiscal institutions which can redistribute income across states. The United States has hardly gotten off scot free, but the greater flexibility of its governance system has forestalled the threat of disunion.

A great deal of water has flowed under the bridge in the past two decades. There were three distinct types of financial crisis: 1) a domestic money and credit implosion, where foreign investment and hot money played no significant role (Japan); 2) an insolvency and foreign reserves meltdown triggered by foreign hot money flight from frothy economies with fixed exchange rate regimes (developing Asian); where domestic speculative excesses were partly linked with foreign direct investment, and 3) a worldwide debacle rooted in reckless aggregate demand management and financial deregulation by a "partnership" of politicians, administrators, businesspersons and activists in significant part for personal gain that started in America, but spread almost instantaneously across the globe, mostly through international financial networks (except Asia where export shocks were primary). The last is the most dangerous, and most likely soon to recur because high rolling losers were compensated out of public funds,48 self-interested aggregate demand managers are unrepentant, and publics are dazed by fast talk. The least likely near term recidivists are developing nations like those in Asia which through bitter experience adopted flexible foreign exchange regimes and now maintain adequate foreign currency reserves, but over the longer term remain vulnerable to invasive moral hazard and social turmoil. Countries like China fall in the middle. On one hand, they are insulated against capital flight by stringent state controls, but on the other they are at high risk for destructive rent-seeking and turbulent domestic asset speculation. International financial laissez-faire which accompanied the second wave of globalization after the fall of the Bretton Woods system obviously has played an important part in two of the three financial crises surveyed, but is neither the only, nor the decisive aspect of the speculative equation as some have claimed.49 The greatest menace lies elsewhere with various "public-private partnerships" using all means fair and mostly foul to create favorable speculative financial conditions for their personal enrichment, which when combined with under regulated white hot money flows, Chinese dollar reserve hoarding and stealth protectionism in the best scenario will seriously degrade global economic performance, and in the worst culminate a Black Swan catastrophe.

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1 Derivative is a generic term for swaps, futures, options, and composites which don't have any intrinsic value (proprietary claims to interest, dividends or asset appreciation), their worth depending derivatively on promises to acquire, sell, swap and insure securities not yet owned. They take many forms including equity, foreign exchange, interest, commodity, credit [credit default swaps (CDS)], mortgage backed, and packaged derivatives. Simple, or common, derivatives are called "vanilla;" more complex instruments are dubbed "exotic." Their primary purposes are leveraging and hedging risk (e.g. traditional short sales) for personal portfolio management or speculation, but this has broadened into "shadow banking," where large institutions use derivative instruments to manage their financial operations. They serve legitimate business purposes, but also facilitate arbitrage as a business in itself (hedging business), and leveraged speculation [including gambling with other people's money (Nick Leeson, Barings Bank fiasco)]. All are traded either on exchanges, or over-the-counter, and bear "counterparty" risk as well as security risk because "promises" can be broken. "Performance" risk is another seldom considered problem, because even if promises are kept, ownership rights to the assets underlying derivatives like mortgage backed securities are often obscure and unenforceable. According to the Bank for International Settlements the total notional worth of derivatives worldwide was 684 trillion dollars in June 2008.







2 Dooley, Folkerts-Landau and Garber contend that the periphery undervalues its currency to foster export-led growth in order to facilitate the rural-urban employment process, and enabling technology transfer from the center, causing embedded trade and financial flow imbalances. See Dooley, et al. (2003) cf. Eichengreen (2004).







3 Bloomberg, Real Estate Economic Institute, Japan, Home Price Indices, as of March 18, 2009.







4 Westerners once knew this, but have forgotten. See Ruth Benedict (1946) Sword and the Chrysanthemum.







5 An hyper depression is any depression greater than the great American depression of 1929 ; see Maddison (2003) p.298.







6 Caballero, Hoshi and Kashyap contend the zombie banks crowd the market and the resulting congestion has real effects on the healthy firms in the country. They find the cumulative distortionary impact of investment and employment to be substantial. See Ricardo J. Caballero, et al. (2006) cf. Akiyoshi and Kobayashi (2008). For a detailed historical review of the Japanese banking crisis see Kanaya and Woo (2000).







7 Miyajima and Yafeh (2007). The authors find that small, undercapitalized firms were the primary victims of the credit crunch. These firms contribute little to Japanese productivity growth, undercutting the claim that the financial crisis caused Japan's two lost decades.







8 Paul Krugman contends that after Japan's bubble burst savings rose (consumption collapsed) and the natural interest rate (needed for full employment general equilibrium) turned negative, the money interest rate reached the lower bound of zero, rendering monetary policy impotent. The actual real interest rate immediately after the crash and for decades to come often was slightly positive; the combined effect of modestly falling prices(due partly to collapsed demand and retail liberalization in an otherwise keiretsu price-fixed environment), and a zero money interest rate. This created a small Keynesian output gap(albeit with negligible unemployment) that was addressed with fiscal deficit spending, but it is still possible to argue that deflation and a "liquidity trap" kept, and still keep Japan's GDP and employment below its full competitive potential. Krugman contends that Japan's "liquidity trap" was the first manifested since the Great Depression, and sends a signal to monetary authorities like Ben Bernanke to be alert to the danger. He recommends that Japan's and America's output gaps should be closed with quantitative easing (central bank purchase of medium and long term government securities) and nurtured inflationary expectations through a Phillip's mechanism. The suggestion is sound in principle (albeit controversial) for contemporary America. Japan's institutions prevent its economy from attaining natural output levels. There may be a gap between Japan's achieved and potential institutionally constrained GDP, but it's impossible to reliably measure these gaps. See Krugman (1998), Krugman (2010) cf. Stiglitz (2010) cf. Aoki and Saxonhouse (2000).

 Rosefielde (2010), www.ggdc.net/Maddison/oriindex.htm; Russia, China 1991-2008 (EU benchmark)

 It is unclear whether Krugman ascribes Japan's second lost decade 2000-2010 to his conjectured "liquidity trap."






9 Rosefielde (2010), www.ggdc.net/Maddison/oriindex.htm; Russia, China 1991-2008 (EU benchmark)







10 It is unclear whether Krugman ascribes Japan's second lost decade 2000-2010 to his conjectured "liquidity trap."







11 Japan's population growth had slowed noticeably by 1990, was still positive when its financial crisis hit. Deaths first began exceeding births in 2007, and the trend won't be swiftly reversed. Demographers are currently forecasting that more than one in three Japanese will be over 65 in 2055, with the working age cohort falling by over a third to 52 million. Immigration could alleviate the pressure, but the Japanese are resolutely opposed to it because of unvoiced fears of being inundated by the Chinese. The long term demographic prospect for China, including the possibility for expanded immigration mimics the Japanese pattern due to Deng Xiaoping's one child per family policy, and xenophobia. See Eberstadt (2007) and Eberstadt (2010).







12 Stiglitz (1996), Radelet and Sachs (1998), Rajan and Zingales (1998), and Fratzscher (1998). Rajan and Zingales contend that "hot" money in Asia is white hot, because in the absence of the rule of contract law, in a relationship based culture, short term foreign investors are especially wary.







13 Argentina's money supply contracted sharply because constitutionally its money base was tied peso for peso to its foreign reserves, which wreaked havoc on business activity when hot money fled the country under its fixed foreign exchange regime.







14 Angus Maddison, The World Economy: Historical Statistics, Geneva: OECD, 2003, Table C3-b, p.298.







15 Hong Kong's currency board, however, was successfully defended by massive foreign reserve sales, and purchases of private equities.







16 Maddison, Op.Cit.







17 Crony capitalism is a vague term often used to describe market economies, especially in the Third World, where business depends heavily on patronage in closed privileged networks of officials, relatives and friends that thrive even though under other circumstances their companies would fail the competitive test. These systems are considered morally hazardous, corrupt, inefficient and ripe for disaster. See. Pempel (1999).







18 The term Washington Consensus was coined by John Williamson in 1989 to describe ten standard reforms advocated in Washington DC for ameliorating crises and promoting sustainable growth in developing countries. These reforms include fiscal discipline, structural investments (in education, etc.), tax rationalization, market determined interest rates, competitive exchange rates, trade liberalization, privatization, deregulation and rule of law. See Williamson (2002) cf. Blustein (2001).







19 Stiglitz (2011) argues that controls can dampen the destabilizing effects of productive and financial regional and global integration. See also Lee and Jang (2010).







20 Vavilov (2010), Rosefielde’s (2011) “Review of Vavilov's, The Russian Public Debt and Financial Meltdown,” and Rosefielde (2005) cf. Shleifer and Treisman (2004). The only thing that really links Russia's 1998 financial crisis to Asia's is the demonstration effect. When the Asian bubble burst July 1997, Europeans started to reassess Russia's creditworthiness, after being assured by Anders Aslund, the IMF, World Bank and the G-7 that Russia had become a "capitalist market economy" on the road to recovery. The real story is that Yeltsin officials after scamming their own people innumerable times including the infamous 1996 "Loan for Shares" swindle of the millennium, began a massive issue of GKO (
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