Currency Crises: A Practitioner's View

The growing frequency and magnitude of currency crises during the last decades can be partially explained by the abandonment of the Bretton Woods system and increasing importance of international capital flows. It is even tempting to say that the magnitude and frequency of these crises have reached unknown levels. However, evidence shows that the impact of currency crises on the level of economic activity during the 1973-98 period was similar to the level experienced during the heyday of the gold standard and capital flows mobility, between 1880 and 1914. ¹ Nonetheless, this same evidence indicates that the frequency of currency crises has doubled since 1973 compared to the gold standard period. The higher frequency, magnitude of the devaluations linked to these crises, and contagion among emerging countries, and in some cases the developed world, have generated a considerable amount of research. Scholars, practitioners, and policymakers try to explain the causes of these crises. Most important, they attempt to extract valuable lessons for economic policy at the national and global level.

Since the seminal work of Paul Krugman, the growing body of literature that has tried to explain currency crises has been divided into three generations of models. ² Thus the explanations have varied among these different types of models, ranging from economic fundamentals to nonlinearities in government behavior that lead to multiple equilibria and, therefore, to problems associated with self-fulfilling speculation (herd behavior), information cascades, and the like, as well as to financial fragility in the banking sector, usually associated with short-term liabilities and poor regulatory policies. The explanations include several relevant variables such as the prospective deficits associated with financial system rescue packages, short-term public debt, political uncertainty, and—especially after the Asian crisis—lack of transparency, cronyism, investment subsidies, and so on.

The different explanations generate a variety of recommendations in terms of economic policy. These range from relatively obvious ones, like pursuing consistent monetary and fiscal policies, to those associated with the choice of the exchange rate regime or with the health of the financial system. On the other hand, in much the same way as the discussion on the financial system has emphasized not only solvency but also liquidity-related matters, the recommendations related to currency crises have stressed the importance not just of the amount of debt (solvency) but also of its maturity. Additionally, in the same way in which problems of liquidity and self-fulfilling prophecies have generated a now century-old discussion on the need for a lender of last resort and related moral hazard issues in the case of financial crises, a similar discussion has developed in relation to currency crises at the international level.

This paper reviews some of the lessons of recent currency crises, with special emphasis on the Argentine collapse. A discussion of details from the Argentine case follows, drawing from my personal experience as a policymaker who made key choices on the verge of the country's currency crisis. The paper concludes with a synthesis of the lessons learned.

Lessons from Previous Crises

An important characteristic of currency crises is that frequently the significance of old lessons increases with each new episode. To illustrate this point, this paper reviews some lessons that were learned with the currency and financial crises of the Southern Cone countries at the beginning of the 1980s. Among them: ³

• the attempts to stabilize the economy by reducing inflation through the use of the exchange rate as a nominal anchor usually result in an appreciation of the exchange rate;
• fixed exchange rates with considerable fiscal disequilibria do not just increase the current account deficit, they also create a perverse debt dynamic or, alternatively, a monetary expansion that precipitates the crisis;
• a similar effect on the current account deficit may be generated by an incorrect evaluation of the growth of future income...