Essay on Europe: Theory of financial crises

Theorists, for example, Arestis and Baddeley (2001) focus their research on the efficiency of the international financial markets and they research the question why so many financial crises have happened since 1970s? Authors conclude that before that time the financial system was formed in accordance to Keynes’s thesis that “international capital mobility and rapid economic growth are incompatible”. The capital was better controlled and financial market was more strictly regulated. But since that time, since the liberalization of the financial market, the financial system has become much more instable and suffers from international debt and currency liquidity crises threatening the stability of the global economy. (Arestis and Baddeley, 2001)

Before considering ways of dealing with international financial crises, it is first necessary to understand why they arise, what role they play in international capital markets, and whether they can be detected.  There may be a range of fundamentals over which an economy is susceptible to crisis. The crisis mechanism lies in the self-fulfilling beliefs of international lenders and results in multiple equilibrium.

Diamond and Dybvig highlight the role of maturity mismatches in generating multiple equilibrium. (Chui and Gai, 2005) Banks have liquid liabilities (deposits), illiquid assets (loans), and are often in a position of having insufficient resources to meet all their commitments. If depositors reach the bank’s teller on a first-come, first-served basis, those who withdraw initially will receive more than those who wait. If no one believes the bank will fail, only those with immediate need for liquidity will withdraw their funds. Assuming that banks have sufficient liquid assets to meet these demands, there is no run. But on the other hand, if everyone believes that a banking collapse is about to occur, all depositors have an incentive to withdraw immediately. A second view of crisis emphasizes the importance of a secular deterioration in fundamentals, such as a declining level of foreign reserves or a downturn in the business cycle, as the key trigger. Runs need not be ascribed to the beliefs of market participants but can be explained, instead, by the very rationality of their expectations. Crises are never panic-based since, whenever investors run, they would do so even if others did not. The actual and expected deterioration of fundamentals (often in the form of uncontrolled credit expansion by the central bank) pushes the economy into crisis. When rational investors observe these leading indicators, the crisis is anticipated and brought forward to a point in time where speculators are unable to take advantage of arbitrage possibilities.

Summers (2000) indicates real-life crises contain elements of belief-driven and fundamentals-based attacks. In addition, Chui and Gai (2005) note the likelihood of crisis is often determined by the extent of fundamental weaknesses that call into question the sustainability of domestic policies.

Morris and Shin (1998) suggest that it is possible to resolve the problem of indeterminacy in beliefs, and capture the key elements of the two views of crisis. They highlight two shortcomings of multiple equilibrium models. (Chui and Gai, 2005) First, economic fundamentals are assumed to be common knowledge; and second, creditors are assumed to be certain about others’ behavior in equilibrium. Once disparities in the information sets of market participants are allowed, a creditor’s decision to withdraw depends on his private signal about fundamentals and his assessment of the probability that other creditors have received a better signal. If the signal is below a certain trigger value (determined in equilibrium), then it is optimal to run. And if a sufficient number of creditors have signals below the trigger value, a critical mass of withdrawals is reached starting a crisis.

The weaker the fundamentals, the more fragile the situation becomes in the sense that fewer participants are required to trigger a crisis.

Chui and Gai (2005) specifically indicate that the global games approach to the financial crises perfectly applicable to sovereign liquidity crises. The advantage of the global games approach is that it permits a unique mapping between the realization of economic fundamentals and the beliefs of creditors. This means that signals about fundamentals serve as a device that coordinates beliefs on a particular outcome. The coordination device is not some random sunspot, but a payoff-dependent variable that matters to investors. Since private signals cannot be directly observed, an abrupt shift from one equilibrium to another can still occur without any change in observable fundamentals.

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