Financial Crises in the 1890s and the 1990s: Must History Repeat?

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THE 1990S HAVE seen three large international financial crises shake the world economy: the collapse of western Europe's Exchange Rate Mechanism (ERM) in the fall of 1992, the collapse of the Mexican peso in the winter of 1994-95, and the East Asian financial crisis of 1997-98. Other crises late in the decade, in Brazil and Russia, did not develop the scope or reach of these three, even though observers and central bankers at the time feared that their consequences could become even worse.(1) The European crisis resulted from a standoff in economic policy between the chancellor and the central bank of Germany, Europe's largest economy, over how to finance the enormous reconstruction expenditures required by the absorption of the former East Germany.(2) The standoff produced a monetary policy that was too tight for the rest of western Europe (and, indeed, too tight for Germany). Speculators bet that such tight monetary policies in other western European countries would prove unsustainable, and that political pressures in those countries to devalue their currencies against the deutsche mark would in the end prove irresistible. Speculating on the prospective collapse of the ERM thus became a classic one-way bet. Only even tighter monetary policies for the rest of western Europe could have provided an incentive not to speculate on the prospective rise of the mark, yet such policies had an even smaller chance of being politically sustainable in the long run.(3) In northern Europe, at least, the crisis looked self-fulfilling and self-generated: it was only the belief that macroeconomic policies would prove unsustainable in the end that made them inappropriate; in the absence of that belief, policies in those countries would in all likelihood have been sustainable and appropriate.(4) The second crisis, the collapse of the Mexican peso in the winter of 1994-95, did follow an episode in which monetary policy had been wildly, unsustainably expansionary throughout 1994. But this episode had been transitory, linked to the septennial redistribution of wealth and political favors by the corrupt Institutional Revolutionary Party as the outgoing president gave way to his chosen successor. Such a transitory burst of monetary expansion would not normally have been thought to have a significant impact on expectations. And whether the peso was overvalued in real terms as a result of this expansion depended on the long-run rate of flow of capital from the United States to Mexico. A high rate of inflow would require a relatively appreciated peso. Indeed, the two years leading up to the crisis had seen foreign exchange markets place at least as much upward as downward pressure on the peso's dollar value.(5) The third crisis, the Asian crisis of 1997-98, has so far proved impossible to fit neatly into the category of financial crises generated by macroeconomic instability. That crisis hit countries where the economic fundamentals were sounder and macroeconomic policies far less subject to criticism than was the case in either of the other two major crises. Their economies bore next to no resemblance to the picture painted by Paul Krugman of an economy vulnerable to currency crisis because it is pursuing unsustainable macroeconomic policies.(6) The economies of the Asian Pacific Rim hit by the crisis--Indonesia, Malaysia, Singapore, South Korea, Taiwan, and Thailand--had, as a group, achieved the fastest sustained rate of economic growth ever seen in any group of countries in any era.(7) Yet once investors in New York and elsewhere had decided that they had invested too large a share of their portfolios in Asia, the rapid shift in opinion and in capital flows had the same consequences as in Mexico and western Europe previously.(8) Practically every observer who commented on these successive waves of crises saw them as symptomatic of deep troubles in the structure of global finance. All agreed that if the financial system were properly structured and properly managed, we would not see so many severe crises following wave upon wave. …