Chapter 12
International Financial Crises
◼ Outline
Introduction: The Challenge to Financial Integration
Definition of Financial Crisis
Sources of International Financial Crises
Crises Caused by Macroeconomic Imbalances
Crises Caused by Volatile Capital Flows
Case Study: The Mexican Peso Crisis of 1994 and 1995
Domestic Issues in Crisis Avoidance
Moral Hazard and Financial Sector Regulation
Exchange Rate Policy
Capital Controls
Case Study: The Asian Crisis of 1997 and 1998
Domestic Policies for Crisis Management
Reform of the International Financial Architecture
A Lender of Last Resort
Conditionality
Reform Urgency
Case Study: The Global Crisis of 2007
Chapter 12 International Financial Crises 77
◼ Learning Objectives
After studying this chapter, students will be able to:
12.1 Define three types of crises.
12.2 Distinguish a crisis caused by economic imbalances from one caused by volatile
capital flows.
12.3 List and explain three measures countries can take to reduce their exposure
to financial crises.
12.4 Explain the need for reforms in the architecture of international finance and
international financial institutions.
12.5 Describe the main forces behind the global financial crisis that began in 2007.
◼ What Students Should Know after Reading Chapter 12
The primary goal is for students to understand the characteristics and economic results of an exchange rate
crisis and a banking crisis. Although financial crises have many characteristics, the chapter shows that they
usually refer to either a banking crisis (2007) or a currency crisis (Mexico’s case study). The Asian crisis
case study shows that it began as a currency crisis but quickly developed into a banking crisis as well. The
crisis might be caused by macroeconomic imbalances or it could be caused by volatile flows of financial
capital. Because each crisis is unique, there is not a “one-size-fits-all” solution to the problem of financial
crisis. Optimal solutions depend on the causes of the individual crises themselves. Students should
understand the roles played by domestic and international policymakers in crisis avoidance and the
significant macroeconomic problems they face once a crisis has begun. The chapter addresses the acute
moral hazard problem, the policy dilemma facing lending agencies, and ways of minimizing these
problems.
The chapter includes several case studies which build on each other, beginning with the “Tequila Crisis”
of the Mexican peso in 1994–1995, the Asian crisis of 1997–1998, and culminating in the global financial
crisis of 2007–2009. The later crisis is presented as having resulted from three microeconomic factors and
one macroeconomic factor. The micro-factors are global integration of financial markets, financial
innovation, and regulatory failure. The overarching macro-factor is the set of global imbalances that
developed in the wake of the Asian Crisis, as several high-savings countries began to systematically
78 Gerber • International Economics, Seventh Edition
particular attention to the IMF. Its past and present practices, lending policies, and conditions are included,
as are areas under discussion for future reform. A final section to the chapter addresses reasons for the lack
of progress on reform in the last decade.
◼ Suggested Writing Assignment
1. One of the most important concepts discussed in the text is the moral hazard problem. Even though
this problem cannot be eliminated completely, it can be reduced through various actions such as the
Basel Agreements.
Students find moral hazard very interesting and intellectually stimulating. Students may be asked to
submit a summary of these agreements (Basel I and II) using the Web site of the Bank of International
Settlements. Specifically, students may be asked to briefly explain the moral hazard concept and
summarize the three pillars of the Basel Agreements, which are:
a. Minimum capital requirement
b. Supervisory review process
c. Market discipline
2. An alternative writing assignment could involve the contagion effects of a financial crisis. Multiple
opinions on this topic exist. Some argue that there may not be any contagion effects of a financial
crisis. On the other hand, as is shown in the text, the moral hazard problem is very real and has a
◼ Answers to End-of–Chapter Questions
1. What is an international financial crisis, and what are the two main causes?
Answer: An international financial crisis is a financial disintermediation characterized by a
collapse in the value of a currency or a group of currencies and usually followed by a
Chapter 12 International Financial Crises 79
2. In the text, the point is made that the expectation of a crisis from volatile capital flows is sometimes a
self-fulfilling crisis. How can a crisis develop as the self-fulfillment of the expectation of a crisis?
Answer: At times, investors and portfolio managers look to each other for information about the
direction of markets. This creates a kind of herd behavior that can take over at critical
moments and intensify a small problem, turning it into a major crisis. This happens
3. What are three things countries can do to minimize the probability of being hit by a severe
international financial crisis?
Answer: Governments can minimize the likelihood of, and the damage caused by, financial crises
by increasing the transparency of their policies and banking systems. Specifically, they
can minimize their likelihood by (1) adopting and maintaining credible and sustainable
4. Why are crises associated with severe recessions? Specifically, what happens during an international
financial crisis to create a recession in the affected country or countries?
Answer: There are at least two reasons why crises are associated with recessions. First, in addition
to the possible trigger(s) of the crisis, several economic problems and weaknesses often
are present at the time of a crisis. Unfortunately, most of the weaknesses don’t appear
until a crisis has already begun. Second, it is generally impossible to avoid a recession
5. What type of exchange rate is associated with a higher probability of experiencing a crisis? Why?
Answer: The type of exchange rate associated with a higher probability of experiencing a crisis
is a pegged exchange rate system called the crawling peg. With a crawling peg, the
pegged exchange rate involves regular (daily, or several times monthly) adjustments or
“devaluations” according to a set of indicators (for example, level of foreign exchange
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Copyright © 2018 Pearson Education, Inc.
presented in the text is the relationship between the real and nominal exchange rates,
given by the equation:
*
rn
P
RRP
=
.
Even though this system has had mixed success in controlling inflation, it is likely to cause
a financial crisis. For example, the monetary authority’s attempt to maintain a crawling
peg against the currency or currencies of its trading partner(s) may be difficult in the face
of high domestic inflation and market pressures resulting from wider variations in the actual
exchange rate. Another problem with the crawling peg is that it is politically difficult to
find a way to exit from the system if the exchange rate is (or thought to be) overvalued.
6. In a crisis not caused by macroeconomic imbalances, economists are uncertain whether a country
should try to guard against recession or try to defend its currency. Why are these mutually exclusive,
and what are the pros and cons of each alternative?
Answer: Economists are uncertain whether a country should try to guard against recession or try to
defend its currency in a crisis caused by non-macroeconomic imbalances such as sudden
capital flows. If policymakers decide to defend the economy by reducing interest rates,
this may cause further depreciations in the domestic currency. If domestic firms have debt
7. Explain the moral hazard problems inherent in responding to a crisis.
Answer: A moral hazard problem exists when one party involved in a transaction has both the
incentive and the ability to shift costs onto the other party.
For example, responding to a crisis with a lender of a last resort such as the IMF creates
incentives that both invite reckless behavior on the part of the country in crisis and bad
policies for the investors and host borrowing countries. If investors and the country in
8. Some people argue that the U.S. loans to Mexico in 1995 led to the East Asian crisis. Explain the
logic of this argument.
Answer: The main argument is that the United States created a moral hazard problem by bailing out
Chapter 12 International Financial Crises 81
Copyright © 2018 Pearson Education, Inc.
IMF might have warned these countries of their looming financial crisis, the countries’
authorities failed to aggressively reform their financial institutions, knowing that they
would get financial help from the IMF and industrial nations.
9. Some countries impose capital controls as a means of preventing a crisis. Evaluate the pros and cons
of this policy.
Answer: The issue of capital controls (usually accomplished by limiting the quantity of capital
transactions, taxing transactions, requiring advance notices and waiting periods, etc.) is a
slippery slope and an unsettled issue because there are potential benefits and costs
associated with this action. On the one hand, the use of capital controls helps minimize
10. How has the role of the IMF come under scrutiny in the recent discussion of reforms in the
international financial architecture?
Answer: As shown in Chapter 2 of the textbook, one of the roles of the IMF is to act as a lender of
last resort. There are two questions that are being raised on the role of the IMF as a lender
of last resort: First, what are the roles of a lender of last resort, and should there be any
rules governing its lending practices? Second, are there conditions that a lender might
impose on borrowers, and if so, what are they? By acting as the lender of last resort, the
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development banks (“mission creep”). As a result, several proposals are suggested to
reform and reduce the role of the IMF.
The other issues involve the conditions that the IMF could impose on countries facing
financial crises. These may include changes in fiscal, monetary, and trade policies and a
restructuring of the financial system and public enterprises. All of these infringe upon the
rights of any sovereign nation and generate significant opposition. Policy makers and
experts do not agree on the conditionality issue either. Some take the conditional ties as
being too punitive and too contractionary. Others think they are too lax and too generous.