Capital Flows and Crises

Published by EH.NET (August 2003)

Barry Eichengreen, Capital Flows and Crises. Cambridge, MA: MIT Press, 2003. xiii + 377 pp. $35 (cloth), ISBN: 0-262-05067-6.

Reviewed for EH.NET by Joseph R. Mason, Department of Finance, Drexel University.

Barry Eichengreen provides a thorough description of important theoretical and practical work in currency crises. At the same time, Eichengreen analyzes currency crises with the clarity of a sharp institutionalist, path dependent, historical perspective. In sum, the book seamlessly links contemporary theory and its (often contrasting) positions to valuable empirical findings, their applications, and policy relevance. Eichengreen’s book, therefore, fills an important niche in economics – a niche for literature that effectively relates theory and empirics to policy and practice.

Eichengreen’s book is divided into four main topic areas: a historical background; a summary of theoretical and empirical work in estimating the causes and effects of currency crises; case studies; and policy recommendations. The first two chapters provide the historical background. In those two chapters Eichengreen reviews the accepted understanding of the causes and effects of currency crises and how these may have changed over the twentieth century. Throughout this section, Eichengreen provides multifaceted perspectives of four major lending booms and subsequent collapses: 1880-1913; the 1920’s; the Mexican crisis of 1982; and the 1990’s. Each episode is described with respect to the underlying economic situation, the political context, the commercial context, the financial context, and mechanics of the crisis itself.

The next four chapters review theoretical underpinnings and empirical results related to cross-section and dynamic comparisons of the effects of capital account liberalization and the causes and effects of currency crises and contagion. These chapters include empirical work using common data sets to provide a meaningful comparison of a great deal of previously published empirical work. These chapters include investigations of not only the financial and economic antecedents of currency crises, but also of institutional preconditions. As a result, these chapters unify a lot of the existing work on currency crises and effectively present the trajectory of contemporary research in the area and directions for future investigation.

The next three chapters review in detail the four major lending booms and subsequent collapses. Chapter 7 reviews Argentina in 1890 and Mexico in 1994 by comparing the two. This approach also addresses outside opinions that currency crises have changed across the twentieth century. Eichengreen, however, suggests that differences between the two may be more a matter of institutional conditions affecting coordination in light of the crises rather than differences in fundamental causes of the events in question. The “… rescue of Baring Brothers in 1890 was designed to secure the stability of the London market,” with little regard to Argentina, whereas in 1995, attention was directed more toward rescuing Mexico rather than Wall Street financial institutions (p. 210).

Chapter 8 examines the case of the European Monetary System (EMS) crisis in 1992, the one example of a currency crisis affecting well-developed diversified economies. In the case of the EMS, it is widely believed that there existed more of a role for speculative attack and contagion (broadly defined) and less of a role for fundamentals than in Argentina and Mexico. Still, Eichengreen finds a strong role for fundamentals in at least ranking countries in terms of their ex ante vulnerability. Hence, although financial deregulation and capital account liberalization may at times provide an avenue through which even developed countries may be vulnerable to currency crises, there still exists a significant role for fundamentals in explaining even the EMS crisis. What is different about the EMS crisis is that the affected countries experienced higher growth rates than Mexico after the 1995 crisis. That higher growth is thought to be attributable to the EMS moving on “… from a hybrid exchange rate-cum-monetary regime to hard pegs (leading ultimately to monetary unification),” following the crisis (p. 249).

Chapter 9 examines the Asian crisis of 1998. This is perhaps the most intriguing of all, because of its perception as being composed of more complex “crises within crises,” brought about by cascades of contagion and speculative attack that reached from Thailand, through Japan, and ultimately to Russia and Latin America. Here, much of the transmission mechanism is thought to be due to institutional factors in the affected countries: bank-centric financial systems where banks are used as tools of industrial policy in an environment of crony capitalism and weak bankruptcy laws that fostered (and are still fostering) uncertainty about the timing and amount of eventual recovery.

The last two chapters introduce policy prescriptions toward currency crises. In practice, these include capital controls in Malaysia and capital flight taxes in Chile. While capital controls may be necessary in times of emergency, they are believed to be difficult to implement in a world of global capital markets and financial engineering. Furthermore, their effectiveness relies critically upon the sort of policy discretion that probably played a part in causing the crisis in the first place. Hence rule-based capital flight taxes imposed only on short-term investments are thought to be superior to overall capital controls.

At the end of the day, Eichengreen proposes that problems that lead to currency crises arise from what he calls “The Messy Middle,” that is, currency arrangements that lie between hard pegs and free floats. So the age-old question is, once development begins how do less-developed countries move from hard pegs to developed country floating currency arrangements without being attacked? Eichengreen gives six rules for the transition: (1) open the capital account only after financial markets have been liberalized and decontrolled; (2) first liberalize foreign direct investment; (3) then liberalize stock and bond markets; (4) rely on market friendly instruments for managing the capital account; (5) align domestic institutions and policies to the capital account regime; and (6) do not hold reserves as insurance against a crisis (they may in some cases cause an attack). Those rules, however, can be made more useful and effective if international financial institutions are strengthened and used to build markets that provide additional price signals and transparency.

Although some of papers included in the volume were written previously, none were published in academic journals. As is typical of the field of international finance, some of these papers were prepared for World Bank conferences or as white papers, or appeared in other disparate publications. Presenting these papers in a single unified volume that is accessible to outsiders is a significant contribution to the field of international finance. As mentioned above, the main contribution of this book is Eichengreen’s summary and synthesis of a great deal of work on currency crises in one clearly-written accessible volume. As such, the book will very likely become required background reading for a number of graduate courses in international finance.

Joseph R. Mason is an Assistant Professor of Finance at Drexel University’s LeBow College of Business, Fellow at the Wharton Financial Institutions Center, and Visiting Scholar at the Federal Reserve Bank of Philadelphia. Recent publications include: “A Real Options Approach to Bankruptcy Costs: Evidence from Failed Commercial Banks During the 1990s,” Journal of Business (forthcoming); “Fundamentals, Panics and Bank Distress during the Depression,” (with Charles Calomiris) American Economic Review (forthcoming); “Bank Asset Liquidation and the Propagation of the Great Depression,” (with Ali Anari and James Kolari) Journal of Money, Credit, and Banking (forthcoming); and “How to Restructure Failed Banking Systems: Lessons from the U.S. in the 1930s and Japan in the 1990s,” (with Charles Calomiris) in Privatization, Corporate Governance and Transition Economies in East Asia, Takatoshi Ito and Anne Krueger, eds. Chicago: University of Chicago Press 2003 (forthcoming).