January 23, 2018

September 11, 2014 at 5:00 p.m
Fields Institute, Room 230

University of Chicago

The Source of Financial Crisis


There have been four waves of banking crisis in the last thirty years, each has involved three, four, or more countries; each country has experienced a sharp decline in prices of securities and most have had dramatic falls in the price of their currency. The first wave was in 1982 and involved Mexico, Brazil, Argentina, and ten other developing countries. Japan and two of the Nordic countries--Finland and Sweden--were engulfed in the second wave in the early 1990s; the banking crisis in Norway was several years earlier. The Asian Financial Crisis that began in July 1997 was the third wave; Mexico had a crisis at the end of 1994. The fourth wave occurred in September 2008 and involved the United States, Britain, Iceland, Ireland, Spain, and then Greece and Portugal.

One of the unique features of the last thirty years is the strong overlap between banking crises and currency crises. Ninety percent of banking crises have occurred together with a currency crises, the borrowers have defaulted on foreign loans and the price of the countries' currency has declined, often sharply. And every currency crisis has occurred with a banking crisis.

My stylized model for this pairing is as follows. Every country that has experienced a banking crisis had previously experienced an economic boom. Moreover nearly every country that has experienced a boom before its crisis had experienced an increase in cross border investment inflows. When a country's currency is floating, changes in its current account balance must be continuously equal with different signs. The invisible hands are at work, the increase in the price of the country's currency and the increase in household wealth together explain the increase in the country's current account deficit. If the induced increase in the country's current deficit appears to be smaller than the autonomous increase in its capital account surplus, the market in the country's currency will not clear; the price of its currency or the price of securities or both prices will continue to increase until the market clears.

Moreover, every banking crisis that I have studied has occurred when the lenders became increasingly cautious about extending more credit to the borrowers. A banking crisis occurs when the flow of credit to a group of borrowers declines, and a currency crisis occurs when the flow of credit is from foreign lenders. The decline in the price of the currency as the currency crisis develops intensifies the banking crisis because the domestic currency counterpart of liabilities denominated in a foreign currency increase.

The data on the changes in the prices of currencies and the impact of cross border investment flows on national economies challenge the claims made by proponents of floating currencies in the 1950s and 1960s. They said changes in the prices of currencies would be gradual, some currencies have fallen off steep cliffs. They said the deviations between the market prices of currencies and the long run equilibrium prices would be smaller if currencies were allowed to float because the market prices of currencies would track the differences in inflation rates, instead these deviations have been many times larger. They claimed that there would be fewer currency crises; instead there have been many more currency crisis and they have been much more severe and have intensified banking crisis. They said that the uncertainty about the prices of currencies would insulate each country from shocks in other countries; instead the sharp variability in cross-border currency flows has led to the boom and bust cycle. They also claimed that uncertainty about the prices of currencies would not deter trade and investment (which obviously was inconsistent with their claim that uncertainty would insulate countries from shocks in other countries) but they never asked about the cost of hedging the uncertainty and who would bear these costs.

The monetary constitution for the gold standard was the "rules of the game", a descriptive model that summarized the how transfers of gold among countries would lead to a new equilibrium after a shock had led to payments imbalances. The Articles of Agreement of the International Monetary Fund was a monetary constitution, and proscribed certain changes in the prices of currencies. The current international monetary international monetary arrangement is dysfunctional because the sharp variability in cross border currency flows leads to boom and bust cycles.

About Robert Aliber

Robert Z. Aliber is a Professor Emeritus of International Economics and Finance at the University of Chicago. He is best known for his contribution to the theory of foreign direct investment. Aliber received a Bachelor of Arts degree from Williams College (1952) and Bachelor of Arts (1954) and a Master of Arts (1957) from Cambridge University. He received his Ph. D. from Yale University. He was appointed as an Associate Professor at the University of Chicago in 1964.

Aliber brought out the fifth and sixth editions and is preparing the seventh edition of Charles Kindleberger’s 1978 classic Manias, Panics and Crashes: A History of Financial Crises. Aliber predicted the Icelandic banking crisis months eighteen months before it happened.

In this talk, Aliber offers a unique and very different view on the cause of financial crises, discusses why banking crises are almost always occur together with currency crises, and why cross border investment flows should be moderated.