Financial Crises
Contagion and Market Volatility

‘Financial Crises: Contagion and Market Volatility’ was the title of a conference organized jointly by CEPR and the World Bank and held in London on 8/9 May 1998. The organisers were Pierre-Richard Agénor (World Bank), Manmohan Kumar (Credit Suisse First Boston), David Vines (Institute of Economics and Statistics, Oxford, and CEPR) and Axel Weber (Universität Bonn and CEPR). The conference received support from Credit Suisse First Boston and the Global Institutions Program of the ESRC.

All 11 papers presented at the conference were concerned with explanations for the recent financial and economic instability in the East Asian economies, and the contagion effects which led to crises being transmitted throughout the region, beginning with Thailand in the summer of 1997.

The opening paper, ‘Volatility and Contagion in a Financially-Integrated World: Lessons from East Asia’s Recent Experience’, was presented by Stijn Claessens (World Bank) and written with Amar Bhattacharya, Swati Ghosh, Pedro Alba and Leonardo Hernandez. The paper provided an overview of financial vulnerability in East Asia, showing that structural inadequacies, more than inadequate macroeconomic fundamentals, played a major part in the build-up to crisis. In particular, insufficient supervision of financial sectors and lack of transparency in reporting were aggravated by undisciplined and uncontrolled foreign lending, leading to an unexpectedly large accumulation of short-term unhedged debt. These structural failings served to enhance the severity of the crisis, when it was eventually triggered, resulting in an impact on each individual economy that far exceeded the effect of the Mexican peso crisis of 1994–95.

The actual trigger appeared to be increasing pressure from external factors, when investors began to focus on the misalignment of the Thai exchange rate. An inadequate response by the domestic authorities eventually precipitated the first crisis, which spread further afield via bank-run-type behaviour in other economies in the region. The nature of the contagion effect was difficult to distinguish. Asset prices showed high correlations across the region over certain periods, but there was no clear evidence of whether these were the result ultimately of pure spillover, or of region-wide similarities in changes in fundamentals. The authors drew clear policy prescriptions from their analysis: to prevent the occurrence of crisis, structural reforms, together with diversified sources of external financing, are needed. Should a crisis be triggered, such measures will also help to speed up the process of recovery.

Michael Dooley (University of California, Santa Cruz) argued that most stories about the genesis of crisis were untestable and therefore irrefutable. Unrecorded financial flows were a historic feature of economies, such as that of Indonesia, and substantial expatriation of capital led to vulnerability to crisis. Japan, however, was a high-saving, high-growth economy whose government was unwilling to recapitalize. A question to be addressed was whether these economies were capable of recovering on their own, or whether substantial infusions of foreign capital were required to mend them. Sule Ozler (Koç University and UCLA) reiterated the lack of testable models of crisis, adding that the current debate replicated that following the debt crisis of the 1980s. The main difference was that the present situation involved large numbers of private borrowers and lenders rather than the government borrowing of the 1980s, leading to increased difficulties in monitoring of information and coordination of action. More theoretical and empirical work was needed on the nature and behaviour of crisis triggers.

‘Determinants of Emerging Market Currency Crises and Contagion Effects’ was presented by Manmohan Kumar (Credit Suisse First Boston) and written with William Perraudin and Uma Moorthy. The paper undertook an empirical analysis of monthly data on 32 emerging markets over the period January 1985–March 1998, seeking to determine the whether the probability of occurrence of crisis could be predicted by the behaviour of macroeconomic fundamentals. Most existing empirical studies were either case studies of single-crisis episodes, ‘signalling’ models where the behaviour of a fundamental – such as the real effective exchange rate or the ratio of debt to GDP – is seen as a signal of entry into crisis, or qualitative-response models using annual data.

The authors used a logistic regression model to determine the probability of crisis. Two distinct specifications were used to generate the dichotomous dependent variable, in order to evaluate the robustness of the model with respect to the definition of crisis as ‘sudden sharp depreciation’, against the definition of ‘unanticipated depreciation’. The regressors were chosen from among macroeconomic fundamentals, financial variables comprising both stocks and flows, policy-indicator dummies and regional dummies. The paper explicitly modelled contagion both as correlated-crisis effects and as regional-spillover effects. The model was evaluated by calculating profits accruing as a result of trading on markets for which a high probability of crisis was forecast.

Paolo Pesenti (Federal Reserve Bank of New York and NBER) regarded the paper as empirically useful in that the model took an ‘agnostic’ view of crisis but confirmed a key result: that careful examination of macroeconomic fundamentals can help forecast financial instability. The paper’s other contributions were in the use of high-frequency data, and in showing that economic growth and fiscal imbalance, such as budget deficit or public dissaving, were correlated with the occurrence of crisis. Andreas Fischer (Schweizerische Nazionalbank and CEPR) saw the paper more as an investigation of exchange-rate risk management from the point of view of a US investor than as an explanation of contagion or crisis. The dataset was impressive, but the analysis could be extended by, for example, allowing the definition of crisis to be endogenously determined. The role of conditionality between crises could also usefully be examined. Fischer also commented on the strikingly positive nature of the results, and suggested that parallels with other empirical work could be drawn more explicitly. Other contributions to the discussion pointed out the need for examination of the time-series properties of the flow variables and for more extensive out-of-sample estimation: for example, which crises did the model fail to predict?

Pierre-Richard Agénor (World Bank) and Joshua Aizenman (Dartmouth College) jointly presented ‘Volatility and the Welfare Costs of Market Integration’. Their paper examined the short-term costs incurred when increased foreign access to a country’s domestic financial system leads to increased vulnerability on the part of that country to financial-market volatility. Although such openness may be beneficial in the long run, welfare costs can be incurred in the short term through domestic market inefficiencies, notably inefficient intermediation, inadequate lending practices, large unhedged short-term foreign borrowing, inaccurate disclosure and ineffective supervision. In previous work, the authors had demonstrated how such imperfections could magnify an initial exogenous shock into a crisis in the domestic financial market. In this paper, they extended their model to consider the impact of volatility on financial-market integration.

The basic framework employed was one in which risk-neutral banks provide credit intermediation services to domestic agents. The authors contrasted the behaviour of borrowers and lenders under financial autarky, where domestic banks were the only source of credit, with their behaviour under financial openness. Greater openness was assumed to result in more intense competition among lenders; foreign lenders were also assumed to be more efficient than domestic credit sources as a result of greater experience in lending and of economies of scale. These efficiencies were reflected in lower costs of intermediation and lower mark-up. Opening up a market to capital inflow, however, can magnify the welfare cost of domestic distortions, thus overwhelming the existing capital infrastructure and leading ultimately to collapse. This insight was illustrated by the recent Asian experience of crisis: an economy that worked well while financially self-contained may fail to adjust quickly enough to sudden inflows of foreign capital, and, as a result of congestion externalities and domestic financial distortions, be precipitated into crisis by the shock of a relatively small capital inflow. It was therefore necessary to ensure that domestic distortions were dealt with before integration was sought.

David Begg (Birkbeck College, London, and CEPR) expressed the view that most of the theory in the paper was questionable, in particular, the use of the backward-bending interest rate/cost of credit curve. The paper should be extended to include consideration of incentive-compatibility and participation constraints. Borrowers’ and lenders’ expectations should also be incorporated explicitly into the model. Anne Sibert (Birkbeck College, London, and CEPR) added that domestic credit markets were characterized by asymmetric information, since an entrepreneur was likely to be better informed than the bank about the likelihood of default. Hence moral hazard and adverse selection were also important considerations. The role of legal restrictions on borrowing and lending likewise would be a useful addition to the model. The authors replied by saying that the backward-bending supply curve was not crucial to their argument. Their previous paper had explicitly modelled credit rationing and enforcement and agency costs, and these were also present in the current model. Marcus Miller (University of Warwick and CEPR) summarized the considerable ensuing discussion by saying that the authors had presented serious arguments against financial liberalization. Their paper had focused on ‘second-best’ arguments and opened up debate on their accuracy.

Ishac Diwan (World Bank) and Bernard Hoekman (World Bank and CEPR) presented ‘Competition, Complementarity and Contagion in East Asia’, in which they sought to examine the genesis of the series of crises affecting East Asian countries. These countries could be viewed either as competitors, by virtue of export similarity, or as complements, who exhibited similar – but not necessarily synchronous – patterns of economic development. These two factors acted as transmission channels for the spread of crisis within the region. It was possible that both factors had operated simultaneously: for example, the increasing regional importance of China and the weaknesses in the Japanese economy had each played their part in East Asia. However, it was necessary to disentangle them, as the ensuing ripple effects and stabilizing policy prescriptions were factor-dependent.

The paper identified three kinds of effects as possible channels for crisis transmission: an income effect and an investment effect, which were most affected by complementarity, and a substitution effect, which was most affected by competition. The authors then explored competitive and complementary behaviour empirically, looking at correlations in the growth of fundamentals such as GDP, investment, consumption and exports in East Asia with Japan and China and the role of foreign direct investment in the region, particularly its sources and composition.

Giancarlo Corsetti (Yale University and Università di Roma Tre) presented ‘What Caused the Asian Currency and Financial Crisis?’, a paper in two parts written with Paolo Pesenti and Nouriel Roubini. The first part of the paper, subtitled ‘A macroeconomic overview’, comprised a survey of East Asian indicators taking in fundamentals, such as current account imbalances, GDP growth, investment, saving and reserves, as well as the role of the banking system and moral hazard, and the role of political instability and uncertainty about economic policy. 

The second part of the paper, subtitled ‘Interpreting and modelling the crisis’, began by analysing the 1995–6 lead-up to the crisis. A detailed discussion of the 1997 crisis period, encompassing the initial financial distress, the spillover and contagion effects, the role of Japan and the state of current debate about the crisis, followed. Even though current explanations of crisis – the ‘first-’ and ‘second-generation’ models – might not appear to be able to explain the events in East Asia, it could be argued that these theories, if appropriately reformulated, still had explanatory power. The authors provided two extensions to these models: one looking at moral hazard in the context of bail-out promises and the behaviour of banks; the second focusing on currency crisis and contagion in a region comprising several countries. They discerned the roots of crisis in the combination of inconsistent government policy and an underdeveloped financial sector. These resulted in unsustainable patterns of investment; ensuing government mismanagement of a worsening situation did the rest.

Richard Portes (London Business School and CEPR) noted that financial crisis – which is generally marked by interactions between the foreign-exchange market, bank failures and debt default – was distinct from currency crisis. These effects had already been extensively modelled, especially in the case of speculative attacks. Portes asked how the models presented could be extended to identify and measure the effects of moral hazard and to model hyperinflation. What was the effect of pegging an exchange rate, and what were the safe limits on the exchange rate and the real exchange rate? He also noted that not even the IMF had correctly predicted this episode of crisis, and that the danger signs had been ambiguous, to say the least.

Jacques Olivier (HEC School of Management, Jouy-en-Josas, and CEPR) felt that clarity was needed in the definition of the model: for example, the authors proposed a deterioration in fundamentals as a mechanism for crisis, but also invoked multiple equilibria via a shift in expectations. The question of (un)sustainability also needed investigation. Olivier was not convinced by the figures presented in the paper that the deterioration of macrofundamentals had actually occurred. Finally, with respect to the second model presented in the paper, the assumption of perfect substitutability between exports from countries affected by the first and second waves of crisis and the absence of trade links within the region were not credible. Joshua Aizenman and Stijn Claessens pointed out that there were substantial differences in the economies and in the nature of financing in Japan, Korea and Thailand, which led to differences in the types of crisis endured by each country. Paul Masson (IMF) mentioned that a study of IMF advice to South East Asian countries was shortly to be published.

Holger Wolf (Stern School of Business, New York University and NBER) presented ‘The Spatial Properties of Capital Flows is Location Destiny?’ written with Swati Ghosh. Rational investor decisions have been invoked as determinants of the direction and magnitude of financial flows. In this paper, the authors sought to augment this set of predictors with geographical and spatial factors. They noted that, even though the volume of new private flows had increased enormously in the last decade, their destinations were highly concentrated within South East Asia and Latin America. Sub-Saharan Africa attracted very little.

The relevant spatial factors appeared to be cultural familiarity, distance and existing trade links. The result would be an alternative description of regional contagion effects, in that the negative dependence of flows on distance would affect all countries in a region in a similar fashion. A cross-sectional probit model was estimated, using as the dependent variable an access score defined as a ranking, based on a weighted average of access to bank lending, access to short-term finance and access to capital markets. A second measure of access was a ranking based on the average absolute net inflow of private capital as a percentage of GDP over the period 1990–5.

The explanatory variables used were relative population size, relative market size, real development stage and growth. Additional regressors were openness (export to GDP ratio for 1989), distance to the nearest G-7 economy, GDP-weighted average distance to the closest G-7 economy and continental dummies for Africa and Latin America. A series of probit regressions demonstrated that, even though location factors were correlated with access, the real development stage was the most important determinant of access; if this was controlled for, location effects did not add significantly to the model.

A classification tree approach was used to test for the presence of threshold effects, showing that location was a good predictor of access – hence Africa and Latin America had much lower access to world financial markets. Income per head provided a (slightly) better indicator of access than distance to the G-7 economies. The authors pointed out that the causal links between income per head and location were far from clear, although previous work in the empirical growth literature had shown significant negative continental effects on per head growth. Finally, the sources of capital flows were examined in an attempt to determine the characteristics that defined the choice of country of investment. The presence of ‘home bias’ was tested using regression in a modified gravity model framework. The elasticities of exports, foreign direct investment (FDI), loans, debt and equity were all negative with respect to distance and positive with respect to remoteness, market size of the recipient and development level. The cultural affinity variables were generally positive in effect but not as influential as the above variables.

Ian Marsh (University of Strathclyde and CEPR) considered that the assumed link between investment and information was correct, and that barriers to investment arising out of little or no information had been well documented. The authors were also correct in specifying location, rather than geographical distance, as a determinant of access, but the actual role of location was unclear. This raised some related questions: Why did Latin America have access in the nineteenth century, but no longer? What role does proxy investing play? And does the model provide a mechanism for the spread of ‘Asian flu’ from the ASEAN countries to the newly industrialized countries? Sule Ozler pointed out that former patterns of colonization were probably important determinants of access and had been well documented in the development literature.

‘Contagion and Trade: Why are Currency Crises Regional?’ was presented by Reuven Glick (Federal Reserve Bank of San Francisco) and written with Andrew Rose. Currency crises tended to be regional, yet neither the ‘first-’ nor ‘second-generation’ models explained this clustering pattern. Since trade patterns were regional, trade linkages offered an important natural source of explanations for currency contagion. The authors substantiated this hypothesis by examining the histories, and ensuing contagion effects, of three recent major crises: the 1992 EMS crisis, the 1994 Mexican peso crisis and the Asian crisis. They also drew on data from the currency-instability episodes surrounding the breakdown of Bretton Woods in 1971 and the collapse of the Smithsonian Agreement in 1973. In all, they used annual data from 161 countries, many of which were involved in none of the crisis episodes.

Glick and Rose simulated a cross-sectional binary probit model, whose dependent variable was defined to be unity when a country underwent a given crisis episode. In each episode, the first country to be hit (the ‘ground-zero’ country) was identified. The regressors were a set of macroeconomic control variables and a ‘total’ trade index, which quantified the importance of the trade links between a country and the rest of the world, relative to its trade with the ‘ground-zero’ country. A ‘direct’ trade measure was also constructed to measure trade flows between each country and the ground-zero country. The usual ‘first-generation’ model macroeconomic indicators were supplemented by a measure of the degree of currency undervaluation, constructed as the export-share weighted sum of bilateral real exchange rates in relation to the currencies of all trading partners. Initial analysis showed that the difference in trade linkages between crisis and non-crisis countries was statistically significant, but that this was not true of the macroeconomic controls. These results were confirmed both when the analysis was extended using a multivariate probit model and when a wide variety of model checks were undertaken.

Finally, two continuous measures of crisis were calculated to examine the determinants of exchange-market pressure. The first measure was defined as the cumulative percentage change in the nominal devaluation rate with respect to the ground-zero currency for three, six and nine months following a crisis; and the second was a weighted average of the devaluation rate and the percentage decline in international reserves over the same time period. Regression of these measures on the same regressors as before supported the hypothesis that trade was a significant explanatory factor in the incidence of crisis. The policy implications clearly provided support for some form of international monitoring of trade.

Mark Taylor (University College, Oxford, and CEPR) agreed that the extent to which two countries competed in a third market was clearly a significant predictor of crisis. The policy implication, that surveillance should incorporate a regional facto was also clear. The authors’ well-executed econometric analysis would benefit, however, from some extensions: inclusion of other macroeconomic and financial variables, and explicit modelling of moral hazard and asset bubbles, as well as poor corporate governance and other developmental and cultural factors. There were also problems of identification: how to distinguish between a common shock, such as the ERM crisis, in which countries within a customs union were affected, and contagion. Gravity models could also provide useful insights. As a final point, why was the Australian dollar not affected by the Asian crisis, given the importance of Australian trade linkage with Asia?

Javier Suarez (CEMFI, Madrid, and CEPR) argued that, despite the paper’s clarity of exposition, the empirical challenge of identifying a ‘trade channel’ for contagion could not be based on the distinction between trade linkages and similar macroeconomic fundamentals. Strong fundamentals might serve as a defence against attack, but they were not necessarily the channel for the spread of crisis. Empirical identification of the contribution of these fundamentals to crisis was a different question from whether regional crises are caused or amplified by the operation of a contagion channel. Alternative possibilities were financial channels, via cross-border borrowing and lending, and information channels, based on agents’ observations of the behaviour of comparable countries. Indeed, the trade effects might be proxying regional dummies. The authors’ proposed empirical model was also difficult to interpret. Some kind of loss-function approach might be useful in imposing a structural context on the model. The chronology of crisis was fundamental to the model, leading to further problems with interpretation in the light of simultaneity and omitted-variable bias. More direct reference to both theoretical and structural models was thus called for.

‘A Theory of the Onset of Currency Attacks’ was presented by Hyun Song Shin (Nuffield College, Oxford and CEPR) and written with Stephen Morris. Multiple-equilibrium models of crisis incorporate as given the self-fulfilling nature of belief in the imminence of attack, but they do not seek to explain why switching occurs between equilibria, nor do they predict the timing of attack. The model presented in this paper sought to deal with these omissions. It relaxed the assumption of perfect observation of macroeconomic fundamentals by speculators, substituting differential information in its place. Fundamentals evolved according to a Brownian motion process, which speculators observed with noise, which was itself normally distributed.

The current state of the economy was observed perfectly only by the monetary authority. A continuum of speculators observed this as a noisy signal, but had perfect information about the past state of the economy. The willingness of the authorities to defend a currency peg was proportional to the state of the economy: a healthy economy was likely to be defended more strongly than an ailing one. The ferocity of the speculative attack needed to induce abandonment of the peg was therefore also directly proportional to the economy’s strength. If the peg were removed, the currency would depreciate by a known amount and would never revert to its original value. The behaviour of speculators was modelled as an incomplete information game. It was shown that even a slight deviation from perfect common knowledge of the fundamentals, i.e. a small amount of noise, would result in outcomes substantially different from those arising out of perfect common knowledge. The authors also demonstrated that multiple equilibria could arise only out of an extreme lack of common knowledge among speculators.

Harald Uhlig (CenTER, Tilburg University, and CEPR) thought the paper was bound to become a classic. The key result was that, in a ‘second-generation’ model, the addition of even a small amount of noise in speculators’ information could lead multiple equilibria to collapse into a single equilibrium – a surprising and non-trivial result. The underlying intuition was that, with asymmetric information, speculators lost common knowledge of the underlying fundamental uncertainty and, hence, the possibility of coordination. Multiplicity of equilibria might perhaps be restored by some other mechanism, such as sunspots or a crisis in a neighbouring country. There was a possible connection with Krugman’s 1996 suggestion that multiplicity could be ruled out with deteriorating fundamentals. Finally, the paper should be viewed as a perturbation analysis for small noise levels, rather than as a stochastic theory of the onset of speculative attack. For Paolo Vitale (LSE) the paper’s objective was to clarify the link between differential information and speculative attack and to study the timing of attack. One of the pieces of differential information that could emerge was the ‘type’ of the monetary authority and its response to attack. The policy implications were that authorities needed to be less clear about their objectives, and must also be ready to regulate the degree of uncertainty and differential information by means of signalling devices, such as ‘cheap talk’.

‘The Portfolio Flows of International Investors’ was presented by Paul O’Connell (Emerging Markets Finance, LLC) and written with Kenneth Froot and Mark Seasholes. This was an empirical paper, investigating the effects on prices when international investors were net buyers of equities in domestic markets. The existing literature suggested that the net impact of foreign investors on local markets was to push up prices. The data used to test this hypothesis comprised daily international portfolio flows of client institutions of a single major US custodian bank, covering 46 countries over the period 1994–8. Cross-country correlations revealed that the data exhibited stronger positive correlation across regions than across individual countries, and that there was a considerable degree of trend-chasing behaviour. Differences were apparent in the behaviour of emerging and developed markets: in the former, inflows could forecast positive returns, whereas in the latter, returns could become negative.

Principal component analysis found that a regional factor – the ‘common-flow’ component – accounted for a considerable proportion of the co-movement, but that a country-specific effect was also at work. Variance ratios were used to examine persistence in flows. There appeared to be high persistence in emerging markets, with shocks being associated with increased levels of future inflows over a considerable period of time. The US market, however, demonstrated little or no persistence. Finally, a two-equation vector autoregression was used to test for the value of returns in predicting flows in the future, over and above the contribution of lagged flows. There was little support overall for the hypothesis that emerging-market inflows were a result of an informational disadvantage among foreign investors.

Mark Salmon (City University, London, and CEPR) commented that the paper was difficult to read because it compressed a huge amount of work. The dataset was also very large, but only incorporated equity flows. The statistics were mostly descriptive, and would benefit from incorporation of conditional distributions of the data. The ‘heat map’ used to summarize information on the correlations warranted the use of structure-seeking algorithms to elicit further patterns in the correlations. The ‘common-flow’ component did not seem to account for enough of the correlation. Co-integration analysis was a possible alternative to principal component analysis. The persistence of order flow was not an easy result to interpret – again, study of the integration structure of the data or of autocorrelation functions could provide clues. The VAR model was also heavily restricted, but without offering justifications.

Manmohan Kumar found the paper a useful investigation of the relationship between flows and returns. The dataset had considerable value, but should be extended to include information on debt as well as equity. Useful work had been done by the authors on definitions of settlement. Kumar asked what proportion of the data related to emerging markets and how the net flows were scaled by market capitalization. It was possible, however, that generalizations made across emerging markets could lead to misleading results, and that more disaggregation might be desirable. The analysis should be extended to cover the portfolio aspects of, and institutional constraints on, investment.

Paul Masson (IMF) presented his paper on ‘Contagion: Monsoonal Effects, Spillovers and Jumps between Multiple Equilibria’, in which several concepts of contagion were defined and distinguished. First, policies undertaken by industrialized countries may have similar effects across several emerging markets. These Masson termed ‘monsoonal effects’. Second, a crisis in one emerging market could affect others via changes in macroeconomic fundamentals, e.g. devaluation could trigger changes in competitiveness. These were ‘spillovers’. Third, a crisis in one country might trigger a crisis in another, for reasons not explainable by fundamentals. This was ‘true’ contagion, which requires the existence of self-fulfilling expectations and multiple equilibria.

Most previous work on multiple equilibria or sunspots had considered countries in isolation. Here Masson developed a model of two emerging markets to illustrate the role of multiple equilibria and contagion in the transmission of crisis. Given simple assumptions, he derived conditions for the existence of multiple equilibria in the first (‘home’) country, which depend on expectations of the future levels of the trade balance, external debt and reserves. Jumps between these equilibria were stochastic, with a simple Markov probability structure. Contagion was defined as an increased probability of moving to a ‘bad’ equilibrium in the ‘home’ country following a crisis in the other country. This definition of contagion permitted the explanation of a move between equilibria to be drawn from microeconomic reasons, such as the revision of expectations or the investment behaviour of financial institutions. The model could be extended to demonstrate ‘monsoonal’ and ‘spillover’ effects, as well as by the introduction of trade interactions.

The paper considered the empirical evidence of recent crisis episodes and suggested extensions to the basic model, in particular, the role of rollover risk, banking-sector distortions and risk-averse investors. The model could be useful in constructing early-warning indicators of balance-of-payments crises and to identify countries vulnerable to multiple equilibria. Issues connected with the stochastic nature of jumps, and with jump probabilities, were subjects for future research.

Axel Weber commented that the model was simple but rich in possibilities, opening up the possibility of time-series approaches to the study of speculative attack. Another innovative feature was the Bayesian approach used to model the evolution of probabilities. The model would be easy to generalize to three or more countries. More clarity was needed, however, about whether shocks were permanent or transitory in nature. Other possibilities for extension included investigation of the parts played by FDI and the capital account, together with intertemporal aspects. Marcus Miller distinguished between crises which were contemporary in effect, and contagion effects and the mechanisms generating them. The appeal of multiple equilibrium models lay in the fact that they could account for crises not anticipated by the market. Masson’s model resembled Obstfeld’s 1994 model of a ‘bad’ market, but was more appropriate to emerging-market economies. Miller remarked on the role of interest rates as a crisis trigger, and on the relationship with bank-run models. The paper by Morris and Shin, aready presented at the conference, showed that collapse was inevitable.

Peter Brandner (Oesterreichische Nationalbank) pointed out that there could be problems in distinguishing between the three kinds of effects defined in the paper. Bad fundamentals were essential to the occurrence of crisis, in addition to monsoonal and spillover effects. The link to the trade balance, and issues of interest-rate parity, could also usefully be explored. The choice of equilibrium, and memory effects on this choice, could be of interest: for example, was there asymmetric movement between equilibria? Modelling of transition probabilities could be performed by means of Markov-switching methods.

Marcus Miller (University of Warwick and CEPR) presented ‘Asset Bubbles, Domino Effects and ‘Lifeboats’: Effects of the East Asian Crisis’, written with Hali Edison and Pongsak Luangaram. The paper began by describing the historical and economic background to the crises in Korea, Indonesia and Thailand, showing that crisis was triggered by speculative attacks on overvalued currencies and extended into a downward spiral in other financial markets. The paper employed the framework suggested by Kiyotaki and Moore (1997) to analyse how a scramble for liquidity in credit-constrained markets could move a financial system from boom to bust. Following Krugman (1998), the role of financial intermediaries, and the prices of land and other assets, were seen as crucial to an understanding of the Asian crisis.

The Kiyotaki-Moore model comprised two sectors: a credit-constrained, highly-leveraged small-business sector, and an unconstrained big-business sector. Small businesses relied on land for collateral; big businesses did not allow their total debt to exceed the value of land. The equilibrium was very fragile, in that the small-business sector was wiped out when land prices dropped even fractionally. The authors used this framework to examine land allocation and land prices after the bursting of an asset-price bubble, which originated in underregulated financial institutions, and after an unanticipated devaluation. The result of both of these phenomena proved to be a downward spiral in land prices. It might be possible to stabilize the equilibrium by temporary financing, designed to ensure the post-shock survival of borrowers and to avoid the ‘domino effects’ arising when the failure of ‘imprudent’ firms triggered failure of their ‘prudent’ counterparts. Such domino effects could operate cross-sectorally as well as across frontiers, resulting in a possible channel for contagion.

The policy implications of the model all concerned ways of preventing wholesale collapse, with its negative externalities, by keeping threatened firms afloat. The possibilities suggested included temporary financing, take-over by ‘prudent’ firms of their failing counterparts, transfers or debt write-offs, nationalization, and a temporary freeze or suspension of operation which acted as a ‘circuit breaker’.

Joshua Aizenman said that an as-yet-unresolved question was whether a bubble was really a boom-bust cycle. It was important to resolve this distinction, as financing done unconditionally could worsen a crisis. The ‘black box’ of financial imtermediation needed to be modelled, as well as openness in an economy. An interesting example of the interaction between political and economic factors was afforded by Korea through its chaebol and domestic bank cartels. In general, political economy could offer many useful insights into financial behaviour. Rebecca Emerson (Natwest Markets) agreed that very high levels of gearing and overinvestment had been features of the economies studied, but disagreed that they were only quasi-open. The model could be extended to make endogenous the probability of a bubble bursting, and the ability to borrow could be related to the discounted expected cashflows. Miller replied to the discussion by acknowledging the need for conditionality in temporary financing, as moral hazard was a particularly severe problem. The role of bubbles in the paper was to demonstrate the effects of a major shock, and moral hazard could be the actual mechanism for the creation of a bubble. The case of Japan, which had not taken decisive action to support firms wounded by the bursting of a massive asset-price bubble, would repay further study. 

Mike Dooley summed up the proceedings of the conference. He noted first that the opening paper (by Stijn Claessens et al) had summarized situations – such as foreign-exchange, banking or insurance crises – where a government ran out of money. An insolvent government had only one way to respond: by closing down banks and insolvent financial institutions. There were many – possibly too many – ways of modelling this simple fact.

The absence of clear fundamentals had led to the growth of multiple equilibrium models, of which there were many, but none were properly testable, not least because they did not ‘model’ the data. A return to fundamentals would be advisable in order to recheck whether any existing model would fit the data. Multiple equilibrium models may be mathematically interesting, but were probably unnecessary.

Taking up the issues of propagation of crisis and the policy implications, Dooley considered it likely that the problem in East Asia was of a similar magnitude to that in the United States in the 1930s. It was also likely to have long-lasting effects. Resolution of this problem could not be handled by the private sector alone. Higher levels of intervention were required to plug the huge unallocated economic losses within the affected economies. There was no market mechanism in place that could perform this task, as evidenced by the Latin American crisis, and the private sector would avoid any attempt to make it shoulder the burden.

In summary, it had to be admitted that the nature of crisis still eluded understanding and that governments could sink into bankruptcy for any number of reasons. It was not possible to identify culprits or to allocate blame, and it might be unwise to try. It was necessary to move on from asking ‘what happened?’ to ‘what to do?’ as the crisis was still happening. Perhaps the ‘best’ next step would be the construction of a new generation of ‘first-generation’ models.