128 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition
they may refuse further lending, forcing developing countries to bring their current account into balance.
These crises are driven by similar self-fulfilling mechanisms as exchange rate crises or bank runs (and are
often referred to as “sudden stops” when financial flows stop running to developing countries seemingly
without warning), and the discussion of debt default provides an opportunity to revisit the ideas of
currency crises and bank runs before a full-fledged discussion of the East Asian crisis.
It is important to recognize the different types of financing available to countries. Bond funding, bank
borrowing, or official lending can all provide debt-oriented funding, while foreign direct investment or
portfolio investment in firms can provide equity financing. In addition, countries can borrow in their own
currency or in another currency. The chapter discusses the problem of “original sin” where many countries
are unable to borrow in their own currency due to both problems in global capital markets and countries’
own histories of poor economic policies.
The next section of the chapter focuses on the experiences of Latin America. In the 1970s, inflation became
a widespread problem in Latin America, and many countries tried using a tablita, or crawling peg. The
strategy, though, did not stop inflation and large real appreciations were the result. Government guaranteed
loans were widespread, leading to moral hazard. By the early 1980s, collapsing commodity prices, a rising
dollar, and high U.S. interest rates precipitated default in Mexico followed by other developing countries.
After the debt crisis stretched through most of the decade and slowed developing country growth in many
regions, debt renegotiations finally loosened burdens on many countries by the early 1990s.
After the debt crisis appeared to be ending, capital began to flow back into many developing countries.
These countries were finally undertaking serious economic reform to stabilize their economy. The chapter
details these efforts in Argentina, Brazil, Chile, and Mexico, and also discusses how crisis unfortunately
returned to some of these countries.
Next, the chapter covers the success and subsequent crisis in Asia (Chapter 11 also touches on this subject).
The causes of success, such as high savings, strong education, stable macroeconomics, and high levels of
trade are considered. Some aspects of the economies that remained weak, such as low productivity growth
and weak financial regulation are also discussed. The crisis, beginning in August 1997, is explained in
detail along with its spread to other developing countries. The lessons of these years of growth and crisis
are summarized as: choosing the right exchange rate regime, the importance of banking, proper sequencing
of reforms, and the importance of contagion. A box then considers whether currency boards can make
fixed exchange rates more sustainable.
A box on international reserves and a case study on China addresses two connected issues which are often
controversial politically: the mass accumulation of international reserves (largely in the form of U.S.
Treasury Bills) by developing countries and the attempt by China to limit the appreciation of its currency.
The box points out that much of the reserves accumulation is connected to insuring against shifts in financial
flows (such as sudden stops of external financing) more than trying to insure against excess needs based
on trade flows (as was the case when financial flows were quite small). In addition to self-insurance, though,
some of the reserves accumulation is a by-product of sterilized intervention. The clearest example of this is
China. China has tried to limit appreciation of its currency to encourage export-led growth. This is done
in part with capital controls, but also through purchasing dollars and selling yuan to prop up the value of
the dollar. As we know from the II-XX model in Chapter 19, at some point, China will likely need to
appreciate or experience inflation. Limited appreciation has been allowed in the last two years, perhaps
as the start of this transition.
These experiences have emphasized the policy trilemma discussed in Chapter 20 and led to calls for reform
of the world’s financial architecture. The chapter next considers some of these, from preventative measures
to reduce the risk of crises, to measures that improve the way crises are handled (such as reforming the IMF).
Finally, the chapter concludes with a section on current debates in the growth literature, chiefly a discussion
of the relative importance of geography and institutions in driving income growth and levels.
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