December 23 - Currency Crisis Models
The economics of currency crises has evolved through successive “generations” of models, each reflecting the historical experience and intellectual climate of its time. From the fixed exchange rate collapses of the 1970s to the financial crises of the 1990s and beyond, economists have sought to explain why speculative attacks occur, how they unfold, and what policy choices can prevent or exacerbate them. The three generations of models—spanning from mechanical balance-of-payments inconsistencies to self-fulfilling expectations and financial fragility—together trace a trajectory from deterministic to strategic and behavioural understandings of crises. Yet, in a modern world of complex capital markets and hybrid monetary regimes, each generation’s insights also reveals its limitations.
The first generation of currency crisis models emerged in the aftermath of the collapse of the Bretton Woods system and the Latin American debt crises of the early 1980s. These models, pioneered by Paul Krugman (1979) and based on the earlier work of Robert Flood and Peter Garber (1984), were grounded in the logic of macroeconomic inconsistency. Governments that financed persistent fiscal deficits through monetary expansion, while maintaining a fixed exchange rate, would eventually deplete their foreign exchange reserves. Rational speculators, anticipating this, would attack the currency pre-emptively, leading to a sudden collapse. In Krugman’s framework, the timing of the crisis was endogenous but the outcome inevitable: policy inconsistency mechanically led to a run on reserves once private expectations adjusted.
These models had the virtue of analytical clarity and were consistent with many experiences of the 1970s, such as the crises in Latin America and southern Europe. They explained currency collapses as the product of unsustainable fiscal or monetary policies and thus provided a clear prescription—policy discipline. However, their determinism was also their weakness. They could not explain why crises sometimes erupted despite apparently sound fundamentals, nor why speculative attacks often occurred in clusters. As global capital mobility increased in the 1980s and 1990s, it became clear that expectations themselves could trigger crises even in the absence of obvious imbalances.
This insight led to the second generation of models, most prominently associated with Maurice Obstfeld (1994, 1996). Here, the central innovation was to introduce multiple equilibria and the possibility of self-fulfilling crises. Governments faced a trade-off between defending the exchange rate—often at the cost of high interest rates and unemployment—and abandoning it to restore domestic stability. If investors believed that the government would devalue, they would attack the currency, forcing the government to do so; conversely, if confidence held, the peg could survive. The crisis thus became a coordination problem: expectations, not fundamentals alone, determined the outcome.
Second-generation models captured the speculative dynamics of the European Exchange Rate Mechanism (ERM) crisis of 1992–93, where economies such as the UK and Italy faced political and economic constraints that made maintaining fixed parities costly. They also underscored the role of credibility, communication, and political economy in monetary policy. Yet they too had limitations. While these models highlighted the self-reinforcing nature of expectations, they often assumed investors acted homogeneously and rationally, overlooking the institutional complexity of financial markets and the role of contagion across countries.
The third generation of currency crisis models, developed in the wake of the Asian financial crisis of 1997–98, incorporated these missing elements by linking currency crises to financial fragility and balance sheet mismatches. Economists such as Graciela Kaminsky, Carmen Reinhart, Guillermo Calvo, and Paul Krugman (1999) argued that weaknesses in domestic banking systems, excessive short-term foreign borrowing, and moral hazard created vulnerabilities that could trigger simultaneous currency and banking crises—so-called “twin crises.” In these models, the crisis was not merely about policy inconsistency or expectations, but about the interaction between capital flows, leverage, and liquidity. When confidence faltered, capital flight and collapsing asset prices reinforced each other, leading to systemic distress.
Third-generation models offered a more realistic account of modern crises, where financial globalisation and liberalised capital accounts amplified volatility. They also emphasised the role of private sector behaviour, including herd effects and balance sheet exposures in foreign currency. Yet their complexity made them less elegant analytically, and their policy implications—such as the need for capital controls or macroprudential oversight—often clashed with the prevailing orthodoxy of liberalisation. Moreover, even these models underestimated the role of shadow banking, derivatives, and cross-border liquidity that characterised later crises, including the global financial crisis of 2008.
In a modern context, the three generations of currency crisis models remain complementary rather than obsolete. The first generation’s focus on fundamentals is still relevant in economies with fiscal mismanagement; the second generation’s emphasis on expectations helps explain crises of confidence in pegged regimes; and the third generation’s attention to balance sheet effects informs the understanding of sudden stops and capital flight. Yet, as international finance becomes more complex and currencies increasingly float in managed regimes, the neat typologies of past models give way to hybrid forms of instability. Currency crises today are as much about global liquidity and financial architecture as about national policy choices—a challenge that even the most sophisticated models continue to grapple with.
References
Calvo, G. (1998). “Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops.” Journal of Applied Economics, 1(1), 35–54.
Flood, R. P. and Garber, P. (1984). “Collapsing Exchange Rate Regimes: Some Linear Examples.” Journal of International Economics, 17(1–2), 1–13.
Krugman, P. (1979). “A Model of Balance-of-Payments Crises.” Journal of Money, Credit and Banking, 11(3), 311–325.
Krugman, P. (1999). “Balance Sheets, the Transfer Problem, and Financial Crises.” International Tax and Public Finance, 6(4), 459–472.
Obstfeld, M. (1994). “The Logic of Currency Crises.” Cahiers Economiques et Monétaires, 43, 189–213.
Obstfeld, M. (1996). “Models of Currency Crises with Self-Fulfilling Features.” European Economic Review, 40(3–5), 1037–1047.
Reinhart, C. M. and Kaminsky, G. L. (1999). “The Twin Crises: The Causes of Banking and Balance-of-Payments Problems.” American Economic Review, 89(3), 473–500.
—
Prompt: Hi, can you write a 600 word essay on the economics and tradition of currency crises models. Focus on the three generations of models and where they come from, and what their short-comings are in a modern context, if any. Avoid bullet points and bold sections, but write a free-flowing essay. Use academic references if you want, in Cambridge notation, and list your references at the end.