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loan demand.
An increase in volatility of output leads to an increase in the lending rate and an
ambiguous effect on the amount borrowed.
APPLICATION
The Costs of Default
This application considers empirical measures of the costs of default from a recent Bank
of England study and other research.
Financial Market Penalties
■ Countries that default are excluded from further borrowing until the default is
resolved through negotiations with creditors.
● Default is associated with a downgrade in credit ratings and an increase in risk
premiums.
* Seven of eight nondefaulters had credit ratings of BBB+ or better; 12 of
* Nondefaulting countries were able to issue 70% to 100% of their
sovereign debt in national currency.
Broader Macroeconomic Costs and the Risk of Banking and Exchange Rate Crises
■ The default will damage the domestic financial system. This can lead to a banking
crisis.
● Domestic banks hold a large share of their bonds in government debt and may
● Banks may fail. Even if they survive, they will be in no position to make
loans. This reduced lending by banks limits investment activity and leads to
negative wealth effects, reducing consumption and output.
● The central bank may be under pressure to conduct a sterilized sale of reserves
and to act as a lender of last resort, expanding domestic credit.
* But a sterilized intervention is not sustainable. Once investors expect the
peg to break, reserves will decline further.
● Rising interest rates will further reduce investment, making it harder for
borrowers to honor private debts, further exacerbating the crisis.
Table 22-1 reports the costs of default crises in different scenarios (with and without
the banking and exchange rate crises). Default crises rarely occur without twin or triple
crises. When default crises occur alone, they are relatively short and the costs are
relatively low.
APPLICATION
The Argentina Crisis of 2001–2002
In earlier chapters, we have seen that both investors’ expectations and economic
fundamentals play a role in crises, often sparking twin or triple crises. In practice, it is
difficult to disentangle the role of self-fulfilling expectations from that of poor economic
fundamentals. This application considers Argentina’s default in 2002 in the context of the
debt and default model and the role of expectations versus fundamentals.
Background
■ The Convertibility Plan included a one-to-one peg against the U.S. dollar. This
helped Argentina recover from the 1991 hyperinflation.
■ The Argentine economy grew rapidly until 1998, with the government borrowing
large amounts at low interest rates. Argentina’s external debt rose.
■ The 1997 crisis in Asia led to an increase in emerging markets risk premiums,
Dive
■ Argentina’s public debt soared from 41% of GDP (1998) to 64% (2001).
Government tax revenues declined and social expenditures increased during the
recession.
■ Foreign creditors began to view government deficits as unsustainable, further
banks’ balance sheets.
■ The government was faced with three unpleasant choices:
● They could maintain the exchange rate peg. This implies cutting off the
expansion of domestic credit to honor the Convertibility Plan, pushing the
Crash
■ Fiscal compromise was impossible, as the two main political forces could not
agree.
● President Fernando de la Rúa controlled Buenos Aires, but the Peronist party
ran the provincial governments. The provinces collected the tax revenue and
spent it all rather than send any to the capital. Neither group was willing to
■ The IMF tried to act as the lender of last resort. Despite skepticism expressed by
the IMF staff, they approved one last big loan in August, but it didn’t last long.
■ Banks had been persuaded (to put the best face on it) into holding large amounts
of dollar-denominated government debt in 2001. The debt carried a high nominal
The End
■ Argentina’s economy was in the “vicious circle” dynamic described in Figure 22-
14.
■ The IMF offered a loan under very restrictive conditions. The government
declined to accept these conditions.
● The IMF announced they were cutting off additional credit to the government.
froze most bank deposits.
■ This triggered political unrest and threatened a coup. President de la Rúa fled the
country by helicopter. His numerous successors defaulted on the external debt
(the largest sovereign default until then), allowing the Argentine peso to float.
● The peso quickly devalued to 4 per U.S. dollar.
■ The lesson: Argentina tried to follow inconsistent economic policies. In adopting
a fixed exchange rate regime, Argentina’s government would have to accept the
risk of larger recessions, forego revenues from the inflation tax, and face limits on
the central bank’s role as a lender of last resort.
Postscript
■ Since 2001, there have been no major crises, with many countries building up
foreign exchange reserves.
■ The IMF’s handling of crises from 1997 to 2001 led many to question its
abandon the only international release valve.
H E A D L I N E S
Is the IMF “Pathetic”?
This article considers the IMF’s role and effectiveness as a lender of last resort.
Background:
■ Following the Asian crisis in 1997 and Argentina’s crises in 2001, politicians
have continued to blame the IMF for the extent of the crises.
■ Korea and other East Asian countries have responded by stockpiling currency
Key points:
■ John Lipsky said, “It’s ironic to my mind that people say the fund isn’t needed
anymore because nothing in the global financial system is broken at the moment.”
■ His column argues that both the IMF and World Bank are needed.
● The IMF was not set up to handle crises in the 1990s, but it can be called upon
to improve the situation.
● Persistent global imbalances suggest the IMF may be needed in the near
future.
Discussion questions:
■ As private financial flows increase in volume, do you believe the IMF will have
the financial resources to serve as a lender of last resort for advanced economies?
■ The end of the column cites persistent U.S. current account deficits and the fact
that several emerging markets have stockpiled reserves to avoid future currency
4 Case Study: The Global Macroeconomy and the Global Financial
Crisis
Since the year 2007, the global economy has experienced two major adverse events. The
first, the Global Financial Crisis, lasted from 2007 to 2009. The subsequent Great
Recession was still having an impact several years later. (According to the NBER, the
recession officially ended in June 2009. Teaching Tip 4 gives you an opportunity to let
your students see what makes a recession.)
This chapter applies the tools developed in the textbook to study these dual crises.
There are three major topics:
and policy responses
3. How the global economy can recover from this shock
Backdrop to the Crisis
Forecasting events that have already occurred is fairly easy. Policymakers do not have
this luxury. By definition, they must look to the future. While some analysts recognized
potential problems, their analyses were largely ignored by policymakers.
Preconditions for the Crisis The crisis was mainly caused by investments whose market
prices unexpectedly declined. This implies savings were not allocated wisely. Where did
these savings originate and what was their eventual destination?
The source of the savings were emerging market (EM) economies that ran current
problem of global imbalances. The high level of savings in the EMs was called the
savings glut. Evidence of the glut is simple: real interest rates were very low. For causes,
we will examine policies in the EM countries. Their consequences will be determined by
looking at the uses of these funds in the DM economies.
As was discussed in earlier chapters, the increase in EM savings was simply a matter
The nature of the financial account flows was also unusual. Initially, the EM
governments acquired official foreign assets. These flows were far larger than private
sector financial flows. Economists described this as capital flowing uphill from poorer to
wealthier countries. (Most economic models available at that time predicted a flow in the
opposite direction: downhill.)
In the DM countries, the initial impact was an increased demand for government
securities. This naturally increased the prices of those securities and lowered the yields.
outcome is not required in the real world. Some observers noted the resemblance to many
How many times have we heard, “It’s different this time”? And almost every time,
it’s not different at all. Apparently, economists are victims of hubris just like everyone
Exacerbating Policies and Distortions Why did these flows from EM to DM countries
increase so markedly between 2004 and 2007? And why did they lead to such bad results
across such a broad range of countries? At this point, it’s difficult to provide a definitive
answer. But there are five analyses that are very plausible:
1. The EM countries deliberately maintained undervalued exchange rates. This
promotes exports, leading to a balance of trade surplus and a corresponding financial
outflow. Unfortunately, there is little empirical evidence to support this hypothesis.
2 The United States maintained a too-easy monetary policy for too long a time
3. A third group points to the failure of regulation and supervision. According to
these analysts, the Fed, the ECB, the Bank of England, and many other central banks
4. Yet another set of economists point to government failure as a major cause.
Governments, this group argues, distorted private incentives. The U.S. government
implicitly backed Fannie Mae and Freddie Mac. Those two entities purchased and/or
guaranteed large shares of the U.S. mortgage market. When they went broke, the implicit
5. One more faction points to evidence of market failure. Irrational investors, the
instinct to follow the herd, imperfect information, asymmetric information, and any other
market failure buzz phrase you can think of—all are thrown into the large pot that
Summary Banking crises have been with us ever since there have been banks. It does not
matter whether the country is EM, DM, or some other M. While policymakers managed
to mitigate some shocks, the huge expansion of credit led to a shock so severe that the
available tools were simply inadequate.
Panic and the Great Recession
The financial collapse was marked by capital fleeing risk and seeking safety. In this
respect, the panic of 2007 was no different from most previous crashes. This time the
cause was a “deterioration” in the U.S. residential mortgage market. (We avoid
discussion of how the creditworthiness of “subprime mortgages” could deteriorate.)
A Very Modern Bank Run Given the 30:1 leverage ratio some investment banks were
using, it’s not surprising that a small decline in the prices of the underlying assets caused
enormous losses for those institutions. Loan markets froze as various financial
institutions realized that their soon-to-be counterparties were facing risks of unknown
timing and magnitude. Deposit insurance prevented conventional runs on banks. But
many banks relied on short-term loans, which became very expensive.
Financial Decelerators The combined effects of little liquidity and falling asset prices
hit the real economy hard. Policymakers around the world tried various combinations of
monetary and fiscal policy. Global investors sold any assets denominated in any currency
The End of the World Was Nigh U.S. stock markets hit bottom in March 2009. Taking
inspiration from the Book of Revelations, the S&P 500 bottomed out at 666. Three of the
five largest U.S. investment banks had failed or been acquired. The U.S. Treasury and
Congress started the Troubled Asset Relief Program (TARP), a $700 billion bailout fund.
Consumer and business confidence approached zero. Calm was restored by April.
Europe Germany probably fared the best of the European economies. The problem
countries were on the edges of the continent: the economic problems of Portugal, Ireland,
Greece, and Spain are shown in Figure 22-19. Italy was also in trouble. The acronym
PIIGS (Italy is the second I) was used to refer to this group of economies. It is no
coincidence that all these countries were members of the Eurozone. The Irish government
The Baltic countries—Estonia, Latvia, and Lithuania—chose to maintain their pegs to
the euro and watched their economies tank. Spain’s housing boom and bust was not as
large as Ireland’s. Portugal and Greece suffered from the more traditional problem of
huge budget deficits when the Great Recession caused tax revenues to vanish. (Greece
resort for banks.)
As of late 2010, the outcome in Europe was not clear. There was some doubt about
whether the euro could survive, with some commentators referring to its future in terms
like “northern euro” and “southern euro” (see Teaching Tip 5 for this chapter).
The Rest of the World The United States and Eurozone took the brunt of the collapse.
Japan, of course, is still mired in its 20-year-long slump, so it’s difficult to tell what
impact the financial panic had there. But emerging market economies recovered quickly.
5 Conclusion
The model of default offers several important insights. But larger questions about the
source of output volatility remain unanswered. If the source is bad institutional
frameworks in defaulting countries, the solution is to reduce the volatility by reforming
Conclusion: Lessons for Macroeconomics
As of late 2010, we simply could not tell how the crisis would play out. We needed more
research on institutional issues, especially details of financial market operations and how
they would affect the real economy. Once again, the economics profession has learned
TEACHING TIPS
Teaching Tip 1: The textbook raises an interesting issue: How many members of the
Eurozone are actually in compliance with the rules for membership (summarized in Table
21-3)? The IMF publishes its World Economic Outlook that includes annual estimates of
key economic data for most countries. (The full data set is available in Excel-compatible
Teaching Tip 2: The Excel workbook for this chapter includes two tables of interest
rates for 44 countries. One worksheet summarizes the 2009 data. The other is the raw
data table from the IMF’s International Financial Statistics database. It contains data for
the same countries from 2006 to 2009. This gives you a great opportunity to study UIP.
