The last year has seen a severe financial crisis in Asia. But the last two decades have been punctuated by a whole series of more or less extreme financial crises. These have included foreign exchange crises such as the turmoil in the Exchange Rate Mechanism of the European Monetary system in 1992, banking panics as in Finland, Norway and Sweden in the late 1980's, and early 1990's, crises following the collapse of asset price bubbles as in the dramatic rises in Japanese real estate and stock prices in the late 1980's and their reversal in 1990, and finally crises attributable to sovereign insolvencies such as the debt crisis of the 1980’s.

The GEI programme has collaborated in a number of meetings on financial crises and Asia over the course of the previous year. Some of these are discussed in the article by David Vines on page * of this Newsletter. The first of these meetings was a joint ESRC-CEPR conference held in Gonville and Caius College Cambridge and the Bank of England, London, on "The Origins and Management of Financial Crises", in Cambridge on 11/12 July 1997, and in London, on 14 July 1997. This brought together leading researchers in the field to examine the nature and policy implications of such crises. The conference was organised by William Perraudin (Birkbeck College, London, Bank of England, and CEPR) and received funding from the Bank of England, the CEPR and the ESRC Global Economic Institutions Research Programme.

A number of the papers from the conference are due to appear in the Economic Journal. This report summarises the contents of the papers and the discussion of them at the meetings.

The conference began with a presentation by Stephen Morris (U. Pennsylvania) of joint work with Hyun Shin (Oxford University) entitled "Unique Equilibrium in a Model of Self-Fulfilling Currency Attacks". A theme of recent work on currency crises has been the distinction between self-fulfilling crises and those triggered by changes in fundamentals. Self fulfilling crises are those in which the value of the economy can suddenly jump form a good equilibrium to a bad one (ie the currency can suddenly devalue) without any change in fundamentals. Morris argued that this feature of many models is unsatisfactory. He showed that the possibility of self-fulfilling crises is extremely sensitive to assumptions that agents have common information. Introducing a small degree of noise and slight transactions costs into a stylised model of a currency attack, Morris showed that a unique equilibrium results in which the exchange rate peg collapses if an only if fundamentals exceed a certain level. In discussing the paper, Anne Sibert (Birkbeck College, CEPR) suggested that the Morris-Shin analysis requires strong assumptions about agents’ rationality (i.e., that they consider what other agents know about what they know about what others know, and so on). Also, the presence of transactions costs is crucial to the argument whereas these are tiny in typical foreign exchange markets.

The theme of self-fulfilling versus fundamentals crises was continued by Timothy Kehoe (University of Minnesota) in his presentation of "Modeling Mexico’s 1994-95 Debt Crisis". Kehoe stressed the importance of analysing macro question within fully specified equilibrium models. His study traces the events and factors that made Mexico vulnerable to a crisis and formalizes the notion of herd behaviour on the part of investors. A crucial feature of the crisis according to Kehoe was the very short-term nature of the Mexican government debt. In commenting on the paper, Patrick Honohan (Economic and Social Research Institute, Dublin, and CEPR) queried the fact that agents including the government which were presumed in Kehoe’s analysis to exhibit very sophisticated behaviour were nevertheless so misguided in their selection of debt maturities. He also questioned whether some of the arguments were strictly applicable to Mexico since, in the model failure, to repay debt imposed very substantial costs whereas Mexico had been comprehensively bailed out by the IMF and the US authorities.

The paper presented by Paul Masson (IMF) entitled "Was the French Franc Crisis a Sunspot Equilibrium?" (written jointly with Olivier Jeanne) continued the discussion in a related theme. It examined the extent to which speculation against the French Franc in 1992-93 reflected a genuine deterioration in fundamentals. Masson argued that by including the possibility of shifts between multiple temporary equilibria, models like theirs could explain why volatility in financial markets often appears far greater than that explicable by changes in fundamentals. Applying their model empirically, Jeanne and Masson find that it is able to fit quite closely the behaviour of devaluation premia extracted from French Franc-Deutschemark interest rate differentials. In his discussion, Frederic Mishkin (Federal Reserve Bank of NY) suggested that the paper tended to echo the French view that there was nothing fundamentally wrong with the French economy at the time of the crisis. However, he argued, events in Germany and particularly German commitment to the Franc-Deutschemark had shifted at this time. Also, so-called fundamentals were very difficult to measure since they might consist of political developments not captured in the economic data employed by Jeanne and Masson. Although the paper was worthwhile academically, it might be dangerous in the wrong hands as it might be used by policy-makers to evade their responsibilities.

Alan Sutherland (University of York, CEPR) returned to the debate on fundamentals versus self-fulfilling crises in his paper, "Currency Crises and the Term Structure of Interest Rates". The point he developed was that typical models of fundamentals crises viewed such events as triggered when observable, macroeconomic variables crossed some threshhold at which a currency peg, say, became unsustainable. Since the threshhold would generally be some way away at any date prior to a crisis, the devaluation premium and hence the very short run interest rate differential should be zero. If a crisis were totally unexpected, on the other hand, as is often assumed with self-fulfilling crises, short term interest rate differentials would be non-zero. In his comments, Thierry Pujol (World Bank) argued that Sutherland’s analysis needed to be supplemented with risk premia. In the run up to a crisis, these could be significant and time-varying.

In a paper entitled "Market Crashes and Informational Avalanches", In Ho Lee (University of Southampton) presented an application to financial markets of recent research on herding. Lee’s basic argument was that if agents arrived to trade sequentially and learn from past trades, a sequence of poorly-informed agents would significantly influence general market sentiment, leading to mispricing. When sufficient information accumulated, the mispricing could unravel quickly, generating a so-called informational cascade. This kind of model could explain a sequence of a boom (based on public information), a period of euphoria, followed by a panic apparently triggered by a relatively small event. In discussing the paper, Hayne Leland (University of California at Berkeley) set out the stylised facts associated with equity market crashes and agreed that Lee’s approach could explain most of them. The fall in volatility that followed crashes and their increasing globalisation were not obviously consistent however, and the dependence of Lee’s results on the presence of transactions costs was less convincing, he said.

Franklin Allen (University of Pennsylvania) presented joint work with Douglas Gale on "Bubbles and Crises". The main point of the Allen-Gale analysis was that if financial intermediaries issuing debt capital may have incentives to invest excessively in risky assets, pushing up their market price compared to that of safer investments. In a dynamic model, this could result in unsustainable upward movement in asset prices. The government could postpone but not avoid an eventual crash by expanding the real money supply. In his comments, Sudipto Bhattacharya (LSE) suggested that the model’s assumption that bank owners cannot directly invest in either the risky or the riskless technology was very strong. He also thought that cycles in the model were driven by the central bank’s manipulation of the real money supply rather than more intrinsic feature of the analysis. Two period models were unlikely to supply fully satisfactory explanations of cycles in real activity in his view.

William Perraudin (Birkbeck College, Bank of England, CEPR) put forward an analysis of the macroeconomic implications of default by governments entitled "A Fiscal Theory of Inflation with Sovereign Debt" (joint with Turalay Kenc and Paolo Vitale). The paper builds on recent work by Sims, Woodford and others tracing through the implications for price determination of unsustainable fiscal policies. The possibility of future default was likely to place upward pressure on consumer prices if agents expected credible fiscal policies after default had occurred. If policies lacked credibility even after default, the results could be quite different, with an absence of price pressure before default and with the realisation of default being deflationary. In his discussion, David Begg (Birkbeck College, CEPR) questioned the Sims-Woodford approach to fiscal and monetary policy which the paper took as starting point.

Hali Edison (Federal Reserve Board, Washington) and Marcus Miller jointly presented their paper, "The Hong-Kong Handover: Hidden Pitfalls". Edison and Miller argued that the Hong-Kong economy could be subject to financial crises which the new communist authorities might be slow to counter. But the paper contains analysis which is more general than this - it attempts to provide insight into financial crises by applying a model of credit crunches recently proposed by Kiyotaki and Moore. The authors posited that, in such a model, a negative productivity shock could result in lower land values, weaker collateral and a contraction in bank credit, which in turn amplified the effect on capital investment causes by the initial productivity shock. If appropriate action were not taken by the authorities, significant real costs could result. The discussant Ron Anderson (University of Louvain) took a much more optimistic view of prospects for the Hong Kong transition. Hong Kong’s banking system is quite advanced, he argued, and the picture of credit strictly limited by collateral did not obviously square with the wealth of opportunities to raise capital. Self-correcting market mechanisms could help to eliminate crises.

Andrew Rose (University of California, Berkeley, and CEPR) gave the first of a series of empirical papers given at the conference. This was titled "Contagious Currency Crises", a paper joint with Barry Eichengreen and Charles Wyplosz. Using an extensive data set from industrial countries, Rose and his co-authors examine contagion effects between currency crises in different countries. In particular, they seek to distinguish between competing explanations of such contagion, namely that the countries concerned are closely linked through trade or that their macroeconomic situations are similar at the time of the crisis. Perhaps surprisingly, the authors found that trade links appear to be the more important source of contagion. Commenting on the paper, Stanley Fischer (IMF) praised its topicality, coming as the presentation did at the time of the onset of the contagion problem in Asia. Some other commentators wondered, however, whether the apparent importance of trade links in spreading contagion might simply be substituting for geographical proximity.

In "International Portfolio Investment Flows", Michael Brennan (University of California, Los Angeles, and London Business School) presented joint work with Henry Cao. The paper, which combines theoretical and empirical analysis, seeks to explain shifts in international portfolios when domestic investors have an informational advantage over foreigners. New information makes foreigners revise their priors about the state of the domestic economy more than home investors. This asymmetry then generates investment flows between the two groups. Jose Marin Vigueras (Universidad Pompeu Fabra, Barcelona) discussed the paper positively though he questioned the inclusion of noise traders in the model and saw the empirical results as slightly less favourable to the authors’ hypoetheses than they did themselves.

Berry Wilson (Federal Communications Commission) presented "Mexico’s Banking Crisis: Devaluation or Diversification Problems?" a paper joint with Gerard Caprio and Anthony Saunders. The authors present a sectoral analysis of the after-shocks from Mexico’s financial crisis on domestic industry and then examine the implications for the banking system. Mexico’s economic problems since the crisis appear to be intimately tied up with the parlous state of its banks and the question is whether this could have been avoided if they had possessed better diversified portfolios. In his discussion, Michael Dooley (University of California, Santa Cruz) asked why should we care about crises? Often, they represented the common sense of the market overcoming inconsistent, unsustainable policies by governments. However, the after effects of crises could be considerable and merited study. This was precisely the focus of the Caprio-Wilson-Saunders piece.

Finally, Andrew Powell (Central Bank, Argentina) presented his paper "On Central Banks and their Lender of Last Resort Function: "Constructive Ambiguity" and "Cheap Talk"". The essence of his argument was that, in managing financial crises, central banks used their lender of last resort facility in a non-transparent, unpredictable way in order to improve the outcome. In a series of game theoretic models of bank bailouts, Powell showed that numerous equilibria could result but that mixed strategy equilibria in which the central bank randomized were often better. In discussing, Jonathan Thomas (University of Warwick) suggested that the main interest of Powell’s analysis lay in his dynamic models. He questioned some of Powell’s arguments about which equilibria were most likely, arguing that the lender of last resort might do better by trying to enforce equilibria that Powell saw as implausible.

The conference continued in the Bank of England with a talk by William Perraudin (Birkbeck College, London, Bank of England, and CEPR) on "Policy Lessons from the Cambridge Conference". Perraudin organised his discussion into three areas, all of crucial significance to policy-makers: (i) the nature of financial crises, i.e. what is the underlying source and how they propagated; (ii) how can crises be predicted; and (iii) how should crises be managed? On the nature of financial crises, two basic themes ran through the papers presented in Cambridge, first that crises in different markets are closely connected and second the extent to which it makes sense to distinguish crises caused by fundamentals or self-fulfilling beliefs. Even if it is difficult to identify the two types of crisis empirically, (Jeanne-Masson, Kehoe, Sutherland), the distinction is useful since it suggests different kinds of policy response. Several papers (Allen-Gale, Lee) shed light on the nature of crises by suggesting specific analyses of mechanisms generating crises. These include the tendency of firms to take on debt and then overinvest in risky assets in fixed supply (Allen-Gale), or information cascades that may arise if investors ignore their private information and herd together. Examples of two different types of empirical analysis of crises had been presented at the conference, reduced form forecasting models (Eichengreen-Rose-Wyplosz paper) and semi-structural models for extracting information from market prices (Jeanne-Masson paper). In discussing the management of crises, Perraudin stressed the importance of examining the consequences of crises (Edison-Miller, Powell, Caprio-Saunders-Wilson, Kenc-Perraudin-Vitale papers).

In "From Suez to Tequila : The IMF as Crisis Manager" James Boughton (International Monetary Fund), analysed how the role of the IMF in coordinating responses to financial crises has evolved over time, from its earliest loans in 1944 to the exchange crisis that hit Mexico in December 1994. The author argued that the nature of financial crises has changed in this period and that the recent phenomenon of liquidity crises in emerging markets like Mexico and Thailand raised new challenges for the Fund. The new kind of crisis requires financial support by other governments or international agencies on a much larger scale and much more promptly than has been necessary in the past. In his discussion, Huw Evans (Bank of England) argued that the recent Mexican crisis had been a big surprise to the IMF, a fact which suggested need for greater and more sophisticated surveillance and perhaps greater transparency of Fund views. He argued that the IMF has various attributes which make it well fitted to coordinate international responses to crises. An important lesson of Mexico was that the IMF had to rethink its procedures for intervention and that conclusion was reflected in current discussions about changes in the Fund’s articles. In the active discussion that followed, Stanley Fischer (IMF) suggested that if conditionality were too strong, some countries might regard it as a stigma and not seek Fund help. Susan Strange (University of Warwick), argued that US interests were over-represented in some of the Fund’s decisions. Michael Dooley argued that the Fund should take an interest in countries’ debt management policies before crises occurred.

In "A Bankruptcy Procedure for Sovereign States" Marcus Miller (University of Warwick, CEPR), and Lei Zhang (University of Warwick) investigated whether a bankruptcy procedure could be developed for sovereigns that could reduce inefficiencies associated with potential defaults. The authors develop an analogy with corporate bankruptcy, employing a contingent claims model of asset valuation to analyse creditor races. Turning then to sovereign debt, Miller and Zhang quantify the costs of similar "free rider" problems, whereby individual bondholders have a substantial private incentive to grab a country’s assets. Jean-Jacques Rey (Banque Nationale de Belgique) remarked the G10 report on the subject had rejected a formal sovereign bankruptcy code but welcomed further studies of which the Miller-Zhang paper represented an example. He found some of the analogies drawn by the authors between corporate and sovereign bankruptcy to be exaggerated. The power to tax possessed by countries made a big difference as did the fact that `managers’ could not be changed nor assets repossessed. The danger was that introducing a code might swing bargaining power in favour of borrowers and hence reduce the willingness of banks to lend.

In "The Theory and Practice of Financial Stability" Andrew Crockett (Bank for International Settlements) identified important sources of market failure or instability in financial markets and the real economic costs such instability can impose. (This paper was reproduced in GEI Newsletter no 7 for September 1997.) Mr Crockett also discussed how official actions make markets work better and reduce the potential for instability. An understanding of the microeconomics of financial market behaviour is an important part of the policymaker's tool kit to facilitate intertemporal resource allocation decisions, he argued. In her discussion, Patricia Jackson (Bank of England) described the role the Bank of England had played in a couple of prominent banking crises, those associated with Barings Bank in the 1880s and mid 1990s. She stressed the practical assistance that a central bank must provide in managing the complex assets and liabilities of an insolvent institution even when public money is not being injected.

Morris Goldstein (Institute for International Economics, Washington) then presented his paper on "The Case for an International Banking Standard". Such a standard was needed, he argued, because developing countries are now more integrated with the world economy and there is an increased risk that banking crises in emerging economies will have unfavourable consequences for other countries. (The worries which the author expressed have been amply born out in the subsequent months.) Such spillovers provide an incentive for industrial countries to support an IBS. Goldstein also discussed such questions as (i) whether the IBS should be a unitary standard applicable to all countries, or a two-level standard with countries themselves deciding which level to adopt; (ii) what elements of banking supervision should an IBS include; and (iii) who should set the standard. Goldstein commented that an IBS would certainly not end banking crises but it might lower the frequency of serious problems. In his discussion, Gerard Caprio (World Bank) pointed out that supervision is the key to avoid the misallocation of capital and the banking crises.

In "Speculative Attacks on a Monetary Union?" Michael Dooley (University of California, Santa Cruz) examined the possibility of speculative attacks during a transition to full monetary union and more generally, possible conflicts between currency board arrangements for monetary policy and the exercise of a lender of last resort role by central banks. He focussed particularly on Argentina which he argued provides an interesting and unique case to review the interaction of a currency board and limited lender of last resort functions. According to Dooley, the basic problem was that certain resources were needed to back the currency in a currency board and confidence in the peg would be lost if these resources were committed elsewhere, for example to bail out banks. In his discussion, Pedro Pou (Central Bank Argentina) stressed that Argentina’s arrangements involved the agreement of contingent credit lines from a group of foreign commercial banks. This agreement meant that substantial extra resources would be available in the event of a banking crisis. In his view there was no basis for Dooley’s view that some sort of contradiction existed between these different policies.

In the last year, in the light of the Asian crisis, there has been much discussion of the nature of financial crises, i.e. what is the underlying source and how they propagated; of how can crises be predicted; and of how should crises be managed. All of these issues were raised at the meeting last August, and remain vitally important.