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The Mayekawa Lecture:Puzzling over theAnatomy of Crises—
Liquidity and theVeil of Finance
Guillermo A. Calvo
The paper claims that conventional monetary theory obliterates thecentral role played by media of exchange in the workings and instabilityof capitalist economies; and that a significant part of the financial systemdepends on the resiliency of paper currency and liquid assets that havebeen built on top of it. The resilience of the resulting financial tree isquestionable if regulators are not present to adequately trim its branches
to keep it from toppling due to its own weight or minor wind gusts.
The issues raised in the paper are not entirely new, but have been ignoredin conventional theory. This is very strange, because disregard for thesekey issues has lasted for more than half a century. Are we destined tocontinue making the same mistake? The paper argues that a way toprevent this is to understand the issues’ roots, and traces them to theKeynes/Hicks tradition. In addition, the paper presents a narrative andsome empirical evidence suggesting a key channel from Liquidity Crunch
to “Sudden Stop,” which supports the view that liquidity/credit shocks
have been a central factor in recent crises. In addition, the paper claims
that liquidity considerations help to explain (1) why a credit boom may
precede a financial crisis, (2) why capital inflows grow in the run-up tobalance-of-payments crises, and (3) why gross flows are procyclical.
Keywords: Financial crises; Bubbles; Sudden Stop
JEL Classification: E32, E65, F32

Columbia University and National Bureau of Economic Research (E-mail: guillermo.calvo@
sipa.columbia.edu).........................................................................................................................................................
I wish to thank Pablo Ottonello for useful comments. Views expressed in this paper are those of
the author and do not necessarily reflect the oﬃcial views of the Bank of Japan.

MONETARY AND ECONOMIC STUDIES/NOVEMBER 2013
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I. Introduction
General equilibrium theory and monetary theory are strange bedfellows. Generalequilibrium theory can achieve Olympian heights without any reference to money.
Monetary theory, in turn, cannot run on its own without some reference to the “realeconomy,” which is the realm of general equilibrium theory. The secondary role
traditionally attributed to money is best portrayed by the classical expression “veil ofmoney.” Money is just there to determine nominal prices, and no more than that. Of
course, this extreme view has been debunked by Irving Fisher’s “money illusion”—
that is, the tendency of some economic agents to confuse nominal with real variables—and “price stickiness” emphasized in Keynesian models. However, money still plays
a second-fiddle role. Whenever possible, theorists prefer to work in terms of models
in which money is absent. This state of aﬀairs among theorists contrasts sharply withthe current macroeconomic policy debate in which “liquidity”—a quality that money
exhibits but is not alone in that respect—has taken center stage. Several observers
attribute the real estate boom to a liquidity mirage and deep crisis following the Lehman
2008 episode to a liquidity crunch. Moreover, it is common to hear that the liquidity
crunch seriously compromised the health of the financial sector and is behind theslow and jobless recovery. None of these issues is addressed in a useful manner inconventional general equilibrium or monetary theory.
Part of the reason is that conventional monetary theory ignores crises that stem fromthe financial sector. This shows another victory of general equilibrium methodology,
where—in its pure form—the term “credit” is replaced by “intertemporal and statecontingent prices,” and market disruption is not highlighted. Thus, conventional theory
has acknowledged the fact that money is not neutral but has, unwittingly perhaps,
adopted the view of “finance as a veil.” It should thus come as no great surprisethat the Federal Reserve (Fed) and many other prominent world central banks haveignored a possible malfunctioning credit market in their design of monetary policy(e.g., Inflation Targeting)—and found themselves bereft of ideas and instruments when
hit by the current crisis.1
Nature abhors a vacuum: bad theory quickly takes the place of no theory—or, atleast that is the risk we are running. I do not claim to have the magic key, but in thispaper I will try to put forward variables and considerations that I think are central but
ignored by conventional theory, such as liquidity and a credit crunch (or the “Sudden
Stop”). To this end, I will bring to bear empirical studies that show the relevance of
these variables, and discuss some open puzzles. In addition, I will trace the intellectualroots behind finance as a veil.
Section II will show channels, relevant from a macro point of view, through which aliquidity crisis becomes a “Sudden Stop.” Section III will briefly discuss some relevant
empirical results that highlight the importance and peculiarities of the credit market incrisis episodes. Section IV is, in a manner of speaking, a “visit to the shrink,” in which
I try to sort out the reasons why, for a long period of time, most mainstream economists......................................................................................
1. To be fair, the Fed and other G-7 central banks displayed great creativity in adopting eﬀective heterodox policies.
My guess is that this reflects the high quality and admirable courage of their economists, even though thesebanks are institutionally and technically unfit to face the new challenges.

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The Mayekawa Lecture: Puzzling over the Anatomy of Crises—Liquidity and the Veil of Financehave been oblivious to financial shocks—a feature that still lingers in the well-trained
economist’s subconscious. Section V discusses three puzzles that empirical researchon booms and busts has brought to light: (1) that credit booms precede financial crises;(2) that capital flows become exacerbated in the run-up to a balance-of-payments crisis;
and (3) that gross capital inflows and outflows (in the balance of payments) are procyclical. The answer to these puzzles has important policy implications. Dependingon the answer, optimal policies may call for putting severe constraints on financial
markets, or just implementing market-friendly regulations to avoid falling into financial
traps. The paper closes with a few concluding remarks in Section VI.
In writing this paper, I have tried to stay away from formal models. I think we are at
the stage of identifying areas that have been ignored in macroeconomics and designinga strategy to fill the gaps.2 In the process, which turned out to be more arduous than
expected, I learned to appreciate the wisdom of Hayek’s (1974) dictum: “It sometimes
almost seems as if the techniques of science were more easily learnt than the thinking
that shows us what the problems are and how to approach them.”

II. From Liquidity Crisis to Credit “Sudden Stop”:
An Analytical Narrative
Monetary theory is a strange field. From birth, it has been the odd man out of generalequilibrium theory because the market value of paper currency cannot be justified interms of individualistic (Robinson Crusoe-type) preferences or production functions.
From this perspective, the output value of paper currency (cash, for short) far exceeds
its “intrinsic” value, that is, its equilibrium value if cash is not a Medium of Exchange(MOE). Hahn (1965), for example, shows that, unless one makes special technical assumptions, one cannot rule out the existence of barter equilibrium, even if money entersutility functions (for a discussion, see Calvo [2012a]).3 The proof is straightforward: if
the output price of cash is zero, then the demand for cash is undetermined and can be set
equal to supply. This implies, by Walras’ Law, that—assuming existence—equilibrium
relative prices of the barter economy clear all real markets when the output price of
cash is equal to zero. This proves the existence of a barter equilibrium even if there isan MOE. Notice that cash diﬀers from regular goods in that when the output price of aregular good is equal to zero, as a general rule it exhibits positive excess demand.
In standard monetary models, Hahn’s problem is bypassed by simply ruling out
barter equilibrium.4 In contrast, microeconomists have explored several explanations,
including legal tender and the requirement that taxes be paid by means of (local) cash.
These explanations help to rule out barter equilibrium but are seriously incomplete,a fact that becomes glaringly clear in an international context in which several paper
currencies circulate at the same time. Therefore, available microfoundations are not......................................................................................
2. Borio (2012) and several economists from the Bank for International Settlements (BIS) are opening up
fascinating new vistas along similar lines.
3. In what follows, and to simplify the exposition, I will assume that cash’s intrinsic value is zero.
4. Notice that even a cash-in-advance constraint does not necessarily generate the positive equilibrium output priceof cash. If the latter is zero, no market transaction will be feasible and the economy reverts to complete autarky.

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helpful to answer basic and very topical questions such as “Will the euro survive?” or“Will gold replace the U.S. dollar?” and so on.
In Calvo (2012a), I argue that if one starts from a situation in which the output valueof cash is positive, sticky and staggered prices help to sustain an equilibrium in whichcash has a positive output value going forward. Staggered prices, in particular, may ruleout the case in which cash prices of regular goods posted at time t, for instance, will
be unbounded (i.e., the cash price in terms of goods whose prices are posted at t are
equal to zero). This is so because, if that were the case, the relative price with respect
to all regular goods whose prices are predetermined at time t will also be unbounded—
implying that the demand for goods whose unbounded prices are set at time t will be
zero, which is unlikely to be an optimal price-setting strategy. In Calvo (2012a), I havecalled these value-of-cash foundations the Price Theory of Money (PTM).5 Notice that
the PTM suggests that the euro will not disappear unless Europeans stop quoting theirprices in euros, and that despite the large depreciation of the U.S. dollar with respect togold, the dollar will keep circulating as long as prices and wages in the United States
are quoted in dollars.
Paper currency is not the only MOE. There are “inside monies” that also playthis role, for example, bank deposits. Thus, I think it is more useful to carry out thediscussion by starting from a more encompassing concept: liquidity. Liquidity, likeother monetary concepts, is hard to define in a precise manner.6 Here I will follow
Menger (1892), where liquidity is defined by a central characteristic: salability. Few
will disagree with the statement that in normal economies (domestic) paper currency
is perfectly liquid. Other assets are less liquid if it takes time to find a customer or theasset’s price is highly sensitive to the quantity being sold by a microeconomic agent.
Everybody will agree, for instance, that cash is more liquid than a used car. Going
beyond this would bring the discussion onto shaky ground; fortunately, however, there
are still relevant issues that can be dealt with in this imprecise manner.
In general, a liquid asset can be employed as an MOE7 or as credit collateral,that is, assets that can be confiscated by the creditor in case of default and, barring
systemic shocks, keep their market value relatively constant under these circumstances.
Liquidity is important for collateral assets because the main role of these assets is toensure that the lender will emerge whole if the debtor is unable or unwilling to repay
his debt obligations. Therefore, a collateralizable asset must potentially be an MOE.
This shows that liquid assets and MOE have much in common.
In what follows, and for the sake of simplicity, I will focus on a closed economy
with only one type of paper currency in terms of which all prices are set. Extensions
will be discussed later. I will also assume that the output value of paper money ispositive and stable and, realistically, that it bears no interest. Thus, there is fertile
ground for the creation of assets that oﬀer services similar to paper currency and yield......................................................................................
5. Keynes foreshadows the PTM, as he writes, “The fact that contracts are fixed, and wages are usually somewhat
stable in terms of money, unquestionably plays a large part in attracting to money so high a liquidity-premium”(Keynes [1961, Chapter 17, p. 236]). “Liquidity premium” in Keynes’s terminology is the diﬀerence between
the market output value of cash and its intrinsic value.
6. “Money” is a popular variable in macroeconomic models, but the corresponding empirical variable is typicallynot well defined. Should it be the “monetary base,” M1, or M2?
7. In what follows, MOE will stand for both Medium of Exchange and Media of Exchange.

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The Mayekawa Lecture: Puzzling over the Anatomy of Crises—Liquidity and the Veil of Financea positive interest rate. Bank deposits are a classic example and are a standard staple inmonetary textbooks. Thus, I will focus the discussion on banks to keep it within familiar
grounds and facilitate intuition for those, like myself, who live outside the boundaries ofthe financial jungle.
Familiar bank deposits illustrate how an additional MOE that dominates cash canbe created. The “formula” consists of setting up deposit accounts denominated in termsof cash—that under our assumptions are firmly rooted in output—in such a way thatthey can be utilized as an MOE. This is the hard part. In practice, setting up deposit
accounts that can be utilized as an MOE could be helped by government support (e.g.,a Lender of Last Resort), or the reputation of the issuing financial institution (e.g.,Goldman Sachs). The next step is selling the new MOE to the public and investing
the proceeds in illiquid assets yielding a positive rate of return, allowing the bank to
pay interest on deposits. This arrangement works to the extent that deposit withdrawals
do not exceed bank reserves, for example, the stock of paper currency held at banks.
However, as illustrated in the seminal paper by Diamond and Dybvig (1983), there
exists an equilibrium in which all depositors attempt to withdraw their deposits at thesame time: a bank run. This is akin to Hahn’s example discussed above. In addition,
Diamond and Dybvig (1983) illustrate the role of “securitization,” risk pooling, inthis context. The Diamond-Dybvig model assumes that depositors’ liquidity needs
are random and independently distributed across depositors. Barring a bank run, these
conditions—thanks to the Central Limit Theorem—allow the bank (or banking system)with a large number of depositors to have a fairly precise assessment of the amountof deposit withdrawals, which allows the bank to confidently invest a large share ofdeposits in highly illiquid projects that yield a positive rate of return. It is worth noting,though, that despite this age-old securitization arrangement, it has not been suﬃcient
to prevent bank runs, a fact that was a major motivation behind the creation of central
banks as Lenders of Last Resort.
Securitization has mushroomed in the last 20-odd years. Early and prominent
examples are Mortgage-Backed Securities (MBSs). These are bonds collateralized bya myriad of mortgage contracts. Contrary to bank deposits in the Diamond-Dybvig
example, which involves pooling of lenders’ risks, MBSs involve pooling of borrowers’
risks. A parallel between these two securitization examples is that they are both subject
to runs, because their market values partly depend on their liquidity. The impact of arun on MBSs on credit collateral deserves special attention. As carefully discussed inseveral papers by Gary Gorton and associates (e.g., Gorton and Metrick [2010]), there
has been a revolution in advanced-economies’ banking practices, partly triggered byattempts to attract large depositors who are not covered by deposit insurance. The new
system is called “securitized banking.” Under securitized banking, the lack of deposit
insurance is partly oﬀset when the bank enters into repo agreements with depositors,
according to which, in exchange for deposits, the bank sells depositors’ assets that thebank is obliged to repurchase at a predetermined price and date (typically the next day).
As a general rule, the market price of repo bonds exceeds the value of the associateddeposits (a diﬀerence that is called a “haircut” and is measured in terms of the market
value of the repo bond). Let us assume that the bonds involved are MBSs. The bank
can then utilize the funds associated with the new deposits to extend new mortgage

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loans, and sell them to a securitization agent that packages the new mortgages withmany others and pays the bank with new MBSs. The bank can then restart the process
to get new deposits, and so on. This deposit creation mechanism is not very diﬀerent
from the one that textbooks use to explain the “money multiplier,” that is, the process
by which old-fashioned banks create deposits by an amount far larger than the stock of
paper currency they hold in their vaults. An interesting diﬀerence, though, is that under
securitized banking the money multiplication process can be carried out by a single
bank and an eﬃcient “securitizer” that packages a myriad of mortgages into MBSs. The
liquidity of MBSs substitutes for the liquidity of paper currency plus deposit insurancein traditional banking. However, there is room for a self-fulfilling prophecy in which
there is a run on repos (taking the form of an increase in haircuts) that forces a massive
liquidation of MBSs. Mortgages that underlie MBSs are long-term financial contracts.
Hence, a massive liquidation of MBSs brings about a fall in their prices, which—as shown during the Lehman episode—could be major. This may discredit MBSs asliquid assets, but even if the MBSs keep their liquidity reputation intact, the fall in theirmarket value has a negative impact on the stock of collateralizable (or safe) assets.
The impact can be huge. Some estimates claim that the Lehman crisis brought about
a fall of collateralizable assets equivalent to more than 20 percent world GDP (seeCalvo [2012a]). Therefore, a run on liquid assets may have a severe impact on grosscredit flows, a phenomenon that, when it is highly unexpected,8 I have labeled the“Sudden Stop” (see Calvo [1998] and Calvo, Izquierdo, and Mejia [2008]).9 A large
and highly unexpected contraction in credit flows could have deleterious eﬀects on thereal sector, because these types of shocks are unlikely to be contemplated in statecontingent contracts. They could lead to costly discontinuation of investment projects
and generate a large number of bankruptcies, causing further deterioration in the credit
market. Notice again that these real eﬀects can occur even though the financial systemmanages to survive in one piece. This is usually forgotten in policy discussions inwhich keeping financial institutions (especially, large institutions) afloat is tantamountto bringing credit flows back to normal.
In a system dominated by traditional banks, the central bank can create liquiditythat oﬀsets the fall in bank deposits and, occasionally, even nationalize banks to preventthe credit “Sudden Stop.” This is very powerful ammunition to quickly get credit flows
back to normal. The situation was very diﬀerent during the subprime crisis. An enormous chunk of the credit market in the United States, for example, was dominatedby securitized banking, which was oﬀ the Fed’s radar. The Fed (especially Chairman
Alan Greenspan) assumed that securitization was safe because it was conducted bysophisticated financial specialists. What the Fed missed is that when liquidity
shocks are involved, bank runs may occur even if banks are managed by highlysophisticated bankers.
Liquidity is a two-edged sword. It helps credit to flow toward socially valuable
projects such as housing and foreign direct investment in Emerging Market Economies......................................................................................
8. Identified as shocks that exceed two standard deviations from the historical mean, for example; to be discussed
below.
9. “Sudden Stops” were originally defined for net capital inflows in the balance of payments. However, they canbe equally applied to any other type of credit flow.

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The Mayekawa Lecture: Puzzling over the Anatomy of Crises—Liquidity and the Veil of Finance(EMEs). But on the other hand, to the extent that finance relies on the attendant financial
assets’ liquidity, a “Sudden Stop” will always be lurking in the background, unless there
are eﬀective instruments to cushion the shock. This fact has not escaped the attentionof EME policymakers, as shown for instance by the substantial accumulation of international reserves by EMEs and the creation of automatic credit lines at the International
Monetary Fund (IMF). These solutions, however, are predicated on the existence ofa core of advanced economies to which EMEs can moor their ships, so to speak. The
subprime crisis raises the stakes. Now the whole world is in need of an anchor. This isan elusive issue, because it calls for new or overhauled institutions to help coordinate
eﬀective monetary, fiscal, and regulatory policies. The European Union (EU) is still
struggling to reach workable arrangements in this respect, which does not bode wellfor equivalent projects that involve a greater number of advanced economies. If we failto make progress in that direction, we may see the world return to a more autarkic
equilibrium. This retrenchment involves eﬃciency costs but may also have dire consequences for world peace. From this perspective, policymakers should be made awarethat as the subprime crisis recedes, a new chapter begins in which it is imperative
to find a new global system that makes liquidity work in terms of growth and social
objectives, while minimizing the chances of another episode of the Great Recession.
To make progress, we can try to learn from history. The next section will summarize
some of the lessons from recent crises that highlight the role of financial factors.10

III. Financial Crisis: Some Evidence on Incidence and Recovery
After a long absence, “Sudden Stops” reappeared in EMEs around the 1990s (Bordo[2006]). Mexico’s 1994–95 Tequila crisis was the first of a series of crises in which
the credit crunch was not associated with an obvious mismanagement of the economy.
Up to this point, Mexico had been closely following the IMF’s procedures almost to theletter. Proof of this is that Mexico was featured as the “poster boy” at the IMF/WorldBank meetings in Madrid in October 1994. Moreover, prior to the crisis, the country
had signed the North American Free Trade Agreement (NAFTA) protocols with theUnited States and Canada, and had become a permanent member of the Organisation
for Economic Co-operation and Development (OECD). Despite these achievements,
however, after the crisis became evident, markets were quick to declare the country a“basketcase,” and International Financial Institutions (IFIs) sent their envoys to find out
what went wrong. The culprit was soon found to be a large hidden fiscal deficit, inconsistent with the exchange rate peg. This is not the place to enter into further discussion
about the accuracy of the assessment because, even granting the existence of a large
fiscal deficit, one would be hard put to find an economic rationale for an output collapse......................................................................................
10. The following section is not intended to be a comprehensive survey. Most of the literature cited contains
papers for which I am one of the authors, although their lists of references cover a wide spectrum of papers
dealing with similar issues. Some of the papers broke new ground or unearthed forgotten issues when they
were written, a fact that helps to illustrate the “dark ages” in which the economic literature was immersed
before the onset of the crisis episodes that began in the 1990s. Moreover, I feel that these papers are worthhighlighting because there is still a tendency to dismiss EME crises as irrelevant for advanced economies.
A prominent exception in this respect is Reinhart and Rogoﬀ (2009).

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exceeding 6 percent in 1995 as the result of an unsustainable fiscal deficit. There has
to be more to the story. But at the time, the conventional view was that crises in EMEs
were a consequence of not following the Washington Consensus, and thus the fiscal
deficit became a primary suspect.11 The financial sector, particularly the central capital
market located in the United States and Europe, did not appear on the list of suspects.
Prior to the Tequila crisis, Calvo, Leiderman, and Reinhart (1993) showed thatexternal factors and, in particular, the U.S. nominal short-term interest rate can havea sizable impact on capital flows in Latin America. The paper was motivated by theobservation that capital had been flowing in all across Latin America, even thoughcountries in the region did not follow similar policies. Econometric analysis suggested
that about 50 percent of the variance of net capital flows in Latin America was due tovolatility of variables external to the region (the U.S. nominal short-term interest rate
being one of them). The paper was circulated when the three authors were at the IMF’s
Research Department. The negative reaction from the staﬀ was immediate and harsh.
We had dared to question the gospel—which held that not only could the central capital
market not be the source of EME crises but, if EMEs kept their houses in order capital
flows would be countercyclical—that is, funds would flow in if EMEs experienced afinancial deficit. The paper was written during a capital inflow episode following the
successful Brady Plan in the region. According to the gospel, the inflow of capital could
be attributed to good deeds—a view that, for obvious reasons, was wholeheartedly
promoted by the region’s policymakers.12
The controversy ended when the United States increased interest rates in 1994
and Mexico was hit by the Tequila crisis shortly after. The objective of telling thisstory is not to vilify the old gospel—that is water under the bridge, because the IMF
has incorporated the Calvo-Leiderman-Reinhart paper in the revised gospel with ahost of other even more radical additions—but to illustrate the strong faith in theworkings of the financial sector that prevailed in the mid-1990s, and that led policymakers to remain oblivious of shocks that stemmed from the capital market. Thisis the same view that prevailed prior to the subprime crisis in advanced economies.
The reader might wonder, though, why the advanced economies did not pay heed to
the lessons of the Tequila crisis (and the later EME crisis). As I will discuss lateron, the view that the capital market is part of the solution, not part of the problem,
was deeply ingrained in conventional monetary theory and especially in central bankmodels. One has to realize that it is very hard to see beyond conventional models
because “reality” is immensely complex. If a variable is not part of the conventionalmodel, chances are that observers—especially well-trained observers—will miss it.
Besides, there are always competing explanations that justify ignoring non-conventional
points of view. In this case, there was a tendency to dismiss lessons from EME crises on......................................................................................
11. Another possible reason for the bias is that Mexico had suﬀered a serious crisis in 1981 associated with a large
fiscal deficit. The 1981 crisis, however, came right after the 1980s’ unprecedented increase in U.S. interest
rates associated with Fed Chairman Paul Volcker’s stabilization program—a fact that, again, was dismissed
out of hand as a primary cause of the crisis.
12. Carmen Reinhart and I presented the paper at the Latin American meetings of the Econometric Society heldin Mexico in 1994, prior to the start of the Tequila crisis. Our discussant, a prominent Mexican public oﬃcial,claimed that we were employing incorrect data and promised to send us a corrected version. He never did, andour results have since been verified by a number of careful studies.

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The Mayekawa Lecture: Puzzling over the Anatomy of Crises—Liquidity and the Veil of Financethe grounds that the latter were due to severe domestic financial fragilities and exchange
rate pegging—imperfections that most people believed were not shared by advanced
economies. In short, the EME experience—especially the Russian 1998 crisis thatshowed serious faults in the global financial system (see Calvo [2002])—persuaded
analysts and policymakers that EMEs could be very vulnerable to shocks stemmingfrom the central capital market. But advanced economies were believed to be immune
to these shocks because of their deep and well-functioning domestic financial sectors.
The error is now clear: liquidity shocks and their possibly severe impact on the credit
market were ignored.
EMEs oﬀer a laboratory where the experiments are more transparent than inadvanced economies due to the relative simplicity of their financial systems and because
in many instances victims lie outside the crisis epicenter. This allows the analyst to
observe how buildings resist the strength of the wind, so to speak, without necessarily
having to explain the cause that triggered the hurricane. For example, there have beena series of recent systemic financial crises, primarily impacting EMEs, in which formost individual economies the initial shock is external, allowing to identify internalfaulty lines that help to magnify the shock and transform it in a major crisis. This is
the research strategy adopted in Calvo, Izquierdo, and Mejia (2008), the next paper
reviewed here.
In Calvo, Izquierdo, and Mejia (2008) a set of crises are labeled “Sudden Stop”(SS) and defined as a situation in which international capital flows fall by more than
two standard deviations (based on their historical record).13 The intuition behind thisdefinition is that these episodes are the result of shocks which diﬀer significantly fromshocks hitting the economy on a regular basis. Furthermore, to ensure that the unusual
shocks primarily stem from the capital market, the empirical implementation selects
an SS that takes place during a global credit squeeze. The latter is identified as periods
in which the average J. P. Morgan Emerging Markets Bond Index or some alternative
global interest-spread yardstick rises by more than two standard deviations (in relation
to their historical record). An SS that occurs during a global credit squeeze is calleda Systemic Sudden Stop (3S). Calvo, Izquierdo, and Mejia (2008) construct a panel of
3S episodes across all economies for which relevant data are available over the period
1990–2004. The paper estimates the probability of an SS in a 3S episode as a functionof a set of variables motivated by a simple model, and several control variables thatare standard in these kinds of studies. The paper shows that the probability increases
with the current account deficit (as a share of tradables) and Domestic Liability Dollarization (DLD)—that is, foreign-denominated debts vis-à-vis domestic banks as a shareof GDP—and that, beyond a critical point, the probability declines with the country’s
integration into the global financial market. Notice that the probabilities are conditionalon the existence of a global financial squeeze. Therefore, these results would not havehelped to, say, predict the subprime crisis—that is, to predict the “hurricane” in themetaphor I mentioned earlier. Rather they help to identify variables that could make it
more or less likely that a given economy will suﬀer an SS if there is a global financial......................................................................................
13. Monthly data for these variables are not available. In the empirical implementation, total capital inflows areapproximated by the trade balance deficit (plus) accumulation of international reserves.

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squeeze. These results are helpful in designing a strategy that cushions the economy
from external liquidity shocks. One implication is that it may be advisable to discouragebanks from extending foreign currency denominated loans.14 These results, incidentally, were dismissed in the European context with the argument that their association
with central Europe put their financial systems in the same league as those in Germany
or France.
The theory presented in Calvo, Izquierdo, and Mejia (2008), attributes the relevanceof the current account deficit and DLD to the fact that, as a general rule, the SS is
associated with a dramatic shrinking of the current account deficit which, given the realexchange rate, gives rise to a contraction in aggregate demand. Thus, restoring equilibrium under an initially large current account deficit may call for large real currency
depreciation (i.e., an increase in the real exchange rate). This by itself may not causea major financial problem. However, trouble arises if DLD is also large, because realdevaluation could trigger over-indebtedness. Integration with the global financial
market may help to roll over the foreign currency denominated debt and soften theblow, but empirical results suggest that integration must be deep enough to work in thisfashion. In fact, if integration is less than a critical level, it could have opposite results.
This makes sense, because the paper’s measure of financial integration employs theLane and Milessi-Ferretti (2006) index, which is defined as the ratio of gross assets
plus gross liabilities (of foreign direct investment and portfolio flows) to GDP. Therefore, low integration could be associated with incipient flows that are highly unstable
and may call for a larger—not lower—current account adjustment during a crisis. An
extension including international reserves as an additional factor is presented in Calvo,
Izquierdo, and Loo-Kung (2013). The paper defines net DLD as DLD minus grossinternational reserves (excluding gold). Net DLD is statistically significant and has thesame sign as DLD in the previous study, implying that larger international reserves
lower the probability of an SS in the context of a global crisis.
Recovery from 3S raises interesting new phenomena. Calvo, Izquierdo, and Talvi(2006) show that recovery after 3S (associated with an output contraction greater than
4 percent from peak to trough) is not accompanied by an equivalent increase in thestock of domestic bank credit to the private sector, a phenomenon that the paper labelsa “Phoenix Miracle,” in reference to the mythological bird rising from the ashes. These
results suggest that even though a credit crunch puts strong downward pressure on output, output may bounce back if firms are able to accumulate non-borrowed liquid assets(NBLAs) to substitute for the old credit lines. How the NBLAs are secured depends
on the circumstances. For instance, it may result from a sharp fall in real wages, aninvestment contraction or a large currency devaluation (all of which, incidentally, takeplace on average in the Calvo-Izquierdo-Talvi sample). A large devaluation appears tohave played an important role, given that in the Calvo-Izquierdo-Talvi sample exports
increase, on average, by about 25 percent from peak to recovery.15 It is worth pointing......................................................................................
14. There is a link with the pioneering Bernanke-Gertler financial accelerator papers (see Bernanke, Gertler,
and Gilchrist [1999]) in which agency problems amplify nonfinancial shocks. A diﬀerence is that in Calvo,
Izquierdo, and Mejia (2008) the shocks are financial and external, and amplification is associated withincompleteness of state-contingent markets.
15. See Calvo and Loo-Kung (2010).

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The Mayekawa Lecture: Puzzling over the Anatomy of Crises—Liquidity and the Veil of Financeout, however, that it is common practice to conclude that real devaluation worked byenhancing the demand side (specifically, raising the demand for exports). This may be
so, but an explanation that is more in line with the liquidity angle stressed here is that alarge devaluation may speed up the accumulation of working capital and thus increase
capacity utilization—a supply-side response.
The research summarized above illustrates the relevance of understanding thechannels through which a financial shock could be magnified. Latin America seems
to have learned some of these lessons. Figure 1 shows the probability of a “Sudden
Stop” based on Calvo, Izquierdo, and Mejia (2008) using estimated parameters for1998 and 2008. For Latin America (LAC7 in the figure, representing the seven largest
countries in the region), the probability falls from about 45 percent in 1998 to less than
4 percent in 2008. This is due to two factors: improvement in the current accountand de-dollarization. These factors shifted in the opposite direction in Eastern
Europe. As a result, the probability of a “Sudden Stop” in Eastern Europe went fromabout 58 percent in 1998 to more than 71 percent in 2008.16
Another puzzling outcome during an output recovery is a “jobless recovery,” that
is, an output recovery that fails to restore full employment. This phenomenon has been
detected since the 1980s (see Gordon and Bailey [1993]), but it has acquired greater
prominence in the current crisis due to the size and persistence of unemployment. The
issue is explored in Calvo, Coricelli, and Ottonello (2012), which oﬀers strong support
for the view that joblessness is exacerbated during financial crises.17 The paper claims
that in the United States and Europe financial crises have contributed to increasing the
Figure 1 “Sudden Stop” Probabilities

80

Percent

2008

60
50

71.3

1998

70

44.8

58.4

41.1

40

35.2

30
20
10

3.7

0
LAC7

CAC5

Eastern Europe

Notes: 1. LAC7 comprises Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.
2. CAC5 comprises Costa Rica, Guatemala, Honduras, Nicaragua, and Panama.
3. Eastern Europe comprises Estonia, Hungary, Latvia, Lithuania, Poland, Romania,
and Turkey.
......................................................................................
16. CAC5 corresponds to the five largest Central American countries, a region where the probability of “Sudden
Stop” also went down in 2008, but not as sharply as in LAC7.
17. This is in line with the finding in Reinhart and Rogoﬀ (2009) and Reinhart and Reinhart (2010).

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rate of unemployment (at the output-recovery point) by more than 2 percent from peakto (output) recovery. However, for EMEs that display high inflation (i.e., episodes that
achieve a maximum annual rate of inflation above 35 percent), joblessness tends todisappear and be replaced by a sharp fall in real wages. In the high-inflation sample
average, the real wage falls by about 17 percent from peak to recovery. All of this
implies that labor appears to be a major casualty in financial crises. The jury is still out
about the causes behind this phenomenon. However, Calvo, Coricelli, and Ottonello(2012) put forward a model in which a basic assumption is that physical capital canbe much more easily attached by the creditor in the case of default than labor. As aresult, a tighter collateral constraint (which, as pointed out in Section II, appears to begigantic in the aftermath of the Lehman crisis) associated with financial crisis lowers
the demand for labor relative to capital. Evidence from advanced economies oﬀers
some support for this conjecture.
Moreover, in ongoing research, Calvo, Coricelli, and Ottonello (2013) claim that
real currency depreciation may not be enough to restore full employment at the output
recovery point, unless real wages suﬀer a sizable drop. These facts are relevant for thecurrent debate in the euro zone. Abandoning the euro, for example, will help reduce
unemployment only insofar as it generates lower real wages, real currency depreciation
may not suﬃce.

IV. Missing Finance: Genesis of the Blind Spot
The objective of this section is to trace the roots of the economist’s blind faith in theworkings of the financial system. The exercise is like a visit to the shrink to help reveal
the problems that impair our daily life and, more to the point, that may drive us into
harmful behavior. Understanding our economic subconscious, so to speak, may help us
eschew models that generate dangerous policy strategies.
The Great Depression took place during the lifetime of two giants of the economics
profession: Irving Fisher and John Maynard Keynes. For most of the 20th century,
Keynes (alone and in later manifestations: Keynesians, Post-Keynesians, New
Keynesians) ran far ahead of Irving Fisher. An important reason for Keynes’ academic
sway, in addition to Keynes’s own personality, was the paper “Mr. Keynes and theClassics” (Hicks [1937]), which put key features of the General Theory (GT) (Keynes[1961]) in terms of a general (dis-)equilibrium model with amiable simplicity. Easy todigest, the model yields the two best-known implications of the GT, namely, (1) fiscal
expansion raises output and lowers unemployment; and (2) if the capital market is in
disarray and individuals envision cash as one of the few available safe havens, monetary policy may become completely ineﬀective (a phenomenon that has become known
to us as a “liquidity trap”).
The main “market imperfection” in the model of Hicks (known as the IS-LM model)
lies in the labor or product markets, and takes the form of wage or price rigidities.
Imperfections in the financial market are completely obliterated. In the original IS-LM
model, for instance, the financial market is acknowledged through the introduction of
an interest rate, which subsumes everything that the model explicitly says about the

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The Mayekawa Lecture: Puzzling over the Anatomy of Crises—Liquidity and the Veil of Financefinancial sector. The demand for money and output are assumed to depend on theinterest rate. Moreover, in modern versions of the model it is customary to assume
that the model’s interest rate coincides with the reference or policy interest rate set
by the central bank (e.g., the U.S. federal funds rate).18 Therefore, it is not unfair
to say that the Keynes/Hicks tradition is responsible—unwittingly, no doubt—for
the utter disregard of the financial sector as a source of macroeconomic instability
in mainstream macroeconomics.19
Irving Fisher was less lucky. First, his seminal insight (to be discussed below) cameafter heavily betting (and losing) that Black Tuesday was not in the cards, and thestock market boom was there to stay. Second, his insight was ignored by policymakers
until the recent subprime crisis. Fisher published his seminal paper in Econometrica
in 1933, when he put forward the conjecture that Debt Deflation (DD) was a key
phenomenon behind the large and persistent collapse in the stock market and the large
fall in output and employment during the Great Depression. DD is a phenomenon inwhich a change (typically large) in relative prices results in over-indebtedness in somecritical sectors of the economy. During the Great Depression, DD was triggered by alarge fall in nominal prices and wages, while most debt obligations remained constantin terms of U.S. dollars. Notice that, in contrast with the Keynesian paradigm, DD canoccur even if prices and wages are perfectly flexible. Therefore, Fisher’s insight oﬀers
a completely diﬀerent perspective on the Great Depression. Actually, the deleterious
eﬀects of DD would be minimized if the economy displays GT characteristics, thatis, complete price/wage inflexibility!20 Notice that DD may have toxic eﬀects even ifbankruptcy is not inevitable. This is so because DD may lower debtors’ “willingness topay.” This is a common phenomenon in financial crises, and has surfaced in the UnitedStates during the current one.
Mainstream literature points to price deflation as the major cause for the Great
Depression. Friedman and Schwartz (1963) conjecture that, without price deflation, theGreat Depression would have boiled down to a run-of-the-mill recession; and Bernanke(2000) agrees, making explicit reference to DD. But DD did not make it into most
20th-century macro textbooks and, if it did, it did not take center stage. In his highly
influential book Money, Interest and Prices, Patinkin (1965), for example, recognizes
DD as a relevant phenomenon, but ignores it in the book’s formal models, which arguably helped to keep DD out of textbooks. However, thanks to the profound impact
of Friedman and Schwartz (1963), what remained in our subconscious is the thoughtthat large price deflation should be prevented. Unfortunately, this valid policy lesson
was mostly associated with the costs of lowering prices and wages, ignoring DD—
a financial issue—as a critical factor.
......................................................................................
18. Hicks’s original model does not even distinguish between nominal and real interest rates. This was a natural
assumption, given that the model was born during a period of low inflation. Later on, as inflation surged inadvanced economies (especially in the United States), textbooks made a distinction between nominal and realinterest rates (a minor victory for Irving Fisher, who is credited with having stressed the distinction), which
required inserting “inflation expectation” in the models, an important issue that I will turn to below.
19. I could not find a single reference to the word “finance” in the GT, and neither in Woodford’s (2003) recent
magisterial graduate textbook. It is worth noting, however, that the financial sector played a prominent role in
Tobin’s writings; see, for example, Brainard and Tobin (1968). But not as a source of financial disarray.
20. Keynes was aware of DD but failed to push it forward as a significant eﬀect in the GT. There seems to be noreference to DD in the GT, although the phenomenon is mentioned in Keynes (1924) with no attribution.

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Mainstream economists were not all cut from the same cloth. In the 1950s and1960s, for example, there was constant battle between “freshwater” and “saltwater”
schools: the monetarist and the (post-)Keynesian debate centered on whether the cycle
was due mostly to monetary or aggregate demand shocks, respectively. Interestingly,
however, the financial sector was not a bone of contention. Even a hardline Keynesiansuch as James Tobin (1989), in reviewing Minsky (2008), writes: “Nightmares of
1930s-style financial panics and epidemic bank failures haunt current discussions, even
Minsky’s, to an unreasonable degree. The problem then was a massive shift from bankdeposits in general to currency. That has not been a problem since 1932 and is nottoday. But if a generalized bank run, as opposed to a run from one institution to others,
were to occur, today’s Fed, unlike its 1930–32 predecessors, could and would supply
all the currency demanded. There would be no liquidity crunch.” We can see that faithin U.S. financial institutions is shining through unimpeded!
Minsky (2008) was thus not taken very seriously by mainstream economists,even by his presumed friends. Neither did prominent economists such as Galbraith(1954) and Kindleberger (1978)—preaching from the Olympus of Harvard and theMassachusetts Institute of Technology—who stressed the importance of financial
disarray in the Great Depression. Kindleberger in particular felt that bubbles and crashes
were not a mere historical curiosity: replays were possible. Moreover, Kindleberger(1978) is fully aware of the disregard of mainstream macroeconomics for financial
issues. In commenting about the two-waters’ debate mentioned above, he writes: “Thedebate between the monetarists and the Keynesians ignores the instability of credit
and the fragility of the banking system and the negative impacts on production andprices when the credit system became paralyzed because declines in the prices of many
commodities and goods caused many borrowers to default on their loans : : :”21 Thissentence expresses in a masterful way the issues and concerns that I have been raisinghere. It is quite remarkable that Kindleberger’s limpid prose did not succeed in putting
a dent in conventional monetary theory!22
DD was rediscovered in the EME literature in connection with liability dollarization or original sin. These two expressions are used to denote a situation in which
economic agents are heavily indebted in terms of foreign currency (see Calvo [2005]
and Eichengreen, Hausmann, and Panizza [2005]). Under these circumstances, a large
devaluation inflates the relative value of debts in terms of local-currency income,possibly resulting in DD. Perhaps the most dramatic EME example of this nature is the
2001–02 crisis in Argentina, an economy in which even private and public domestic
debt was largely denominated in U.S. dollars. A serious threat of massive bankruptcy
arose as the peso/dollar exchange rate (where the peso was the local currency) increased
by a factor greater than three soon after the start of the crisis. To avoid major financial
catastrophe, dollar debts vis-à-vis domestic banks were redenominated in terms of local......................................................................................
21. This quotation is taken from the Kindle revised version with Robert Z. Aliber, published in 2005.
22. More recently, but still prior to the subprime crisis, Robert J. Shiller sounded the alarm that skyrocketing realestate and stock market prices signaled unsustainable bubbles. But his warnings went unheeded even though
they were published in very prominent media. See, for instance, Shiller (2000). A possible reason for this fact
is that Shiller appealed to factors such as “animal spirits” that are inimical to conventional theory. Notice,incidentally, that the liquidity explanation pursued here is in principle consistent with rational expectations.

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The Mayekawa Lecture: Puzzling over the Anatomy of Crises—Liquidity and the Veil of Financecurrency. This weakened institutions even further and helped to bring about a decline
in output comparable to that in the Great Depression.
Liability dollarization is a major factor explaining the present predicaments inSouthern Europe. Despite avoiding CPI deflation, several European economies areundergoing a severe bout of DD, as the cases of Ireland, Portugal, Greece, and Spainclearly illustrate. These economies are tied to the euro. Euro debts were not madecontingent on a breakdown of the euro area (the unthinkable), while monetary policy isgeared to euro price stability. Thus, the stage was set for a massive DD eﬀect when thereal estate sector collapsed—especially given that the collapse was not uniform acrossthe euro area, making it diﬃcult to reach a political consensus to assuage the eﬀects of
DD through high inflation. It is worth noting that abandoning the euro is not a solution,
unless countries renege on their euro obligations.
In sum, the above discussion illustrates the strong professional resistance toseriously taking into account the potential malfunctioning of the capital market. Thereis a parallel here between mainstream macroeconomics prior to the subprime crisis andthe classical view of money as a veil. The Keynesian revolution did away with the viewof money as a veil by showing that it does not hold under sticky wages and prices. But
mainstream macroeconomists passed along the veil to the financial sector: money asa veil became finance as a veil (leaving aside micro regulatory concerns). Of course,
there were detractors and some of the finance-as-a-veil supporters occasionally raisedsome concerns about the possible systemic eﬀects of lifting some banking regulations,but on the whole the veil was thought to be a good first approximation. Thus, a deep
financial crisis was declared a thing of the past, at least in advanced economies. Little
did we know that we were actually putting a veil over our own eyes and stoppers on
our own ears, and thus failing to see and hear the lightning and thunder that presageda major economic upheaval!

V. Outstanding Puzzles: In the Throes of a Great Schism?
A central message from the above discussion is that financial issues, starting withliquidity issues, should not be ignored. Otherwise, a financial crisis can spring up froma dark corner of the economic system causing major damage. The EME experience andthe still partial one we are garnering from the subprime crisis, teach us about the existence of mechanisms that might help to amplify a liquidity shock. The discussion also
gives some ground for the conjecture that a financial crisis can erupt much unexpectedly and without being triggered by conventional fundamentals. In particular, crisis in
one part of the economy can spread to the rest of the economy by the mere fact that it
shows that a certain type of crisis is possible: contagion. And all of this follows without
necessarily having to drop the rationality assumption.
However, there are still several critical puzzles that require our attention. I will startthe discussion by mentioning two of them:
Critical Puzzle 1: There is a growing empirical literature purporting to showthat financial crises are preceded by credit booms (Mendoza and Terrones [2008],

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Schularik and Taylor [2012], Agosin and Huaita [2012], and Borio [2012]). This
was a central theme in the Austrian School of Economics (see Hayek [2008] andMises [1952]).
Critical Puzzle 2: As a general rule, net capital inflows increase, sometimes
sharply, in the run-up of a “Sudden Stop.” See, for example, Figure 2.
I call them puzzles because one can find rationales that radically diﬀer from eachother; and I call them critical because depending on the explanation, the policy
implications are also radically diﬀerent—does this herald a Great Schism among
economists and policymakers in the oﬃng, exacerbating the current acrid debates?
One explanation for the two puzzles listed above is that individuals do not satisfy
the standard rationality assumptions and, say, fall prey to a counterproductive herding
eﬀect. This amounts to a damning comment on the eﬃciency of the market mechanism.
Another explanation is that these puzzles are a consequence of the fact that credit
flows are strongly dependent on the liquidity of collateralizable assets which, as noted
above, can evaporate in a moment. This explanation could be made consistent withrationality, and regulation could help to prevent and manage financial crises by helping
to coordinate a “good” equilibrium. I will elaborate on these two radically diﬀerent
lines of explanations in the rest of this section.
A. Policy Mistakes and Imperfect Information: The Austrian School of the Trade
Cycle Was on the Right Track
I will argue that the Austrian School oﬀered valuable insights—disregarded by mainstream macro theory—that help to rationalize Critical Puzzle 1 without resorting toirrationality. Over-extension of credit was at center stage of the Austrian School theoryof the trade (or business) cycle, but authors diﬀered as to the factors responsible forexcessive credit expansion. Mises (1952), for instance, attributed excessive expansion
Figure 2 Net Capital Flows in the Run-Up to a “Sudden Stop”[1] Systemic “Sudden Stops”
Percent
6

Period▲ capital flows[2] Other “Sudden Stops”“Sudden
Stop”

Percent
4.5

5

3.5

4

2.5

3

1.5

2

0.5

1

–0.5

0

t–3

t–2

t–1

t

–1.5

t–3

Period▲ capital flows

t–2“Sudden
Stop”

t–1

t

Note: Includes “Sudden Stop” episodes identified with the methodology in Calvo, Izquierdo,and Mejia (2008) from 1996 to 2009 in a set of 35 emerging economies included in the
Emerging Markets Bond Index with available data.

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The Mayekawa Lecture: Puzzling over the Anatomy of Crises—Liquidity and the Veil of Financeto central banks’ propensity to keep interest rates low to ensure full employment at
all times. As inflation flared up, interest rates were raised, causing recession. Thus, in
his view the cycle is triggered by procyclical monetary policy with a full-employment
bias that was not consistent with inflation stability. Hayek (2008), on the other hand,dismissed the explanation of Mises, not because it was not a good depiction of historicalevents, but because he thought that instability was something inherent to the capital
market and, in particular, it was related to what might be called the banking money
multiplier mirage. His discussion conjures up contemporary issues, such as securitizedbanking, for example. At the risk of oversimplifying Hayek’s views, a phenomenon
that seems central to his trade cycle theory is that credit expansion by bank A induces
deposit expansion in bank B which, in turn, has incentives to further expand credit
flows, and so on. If bank A makes a mistake, the money-multiplier mechanism amplifies
it. This is reminiscent of the misperception phenomena stressed in Lucas (1972).
Hayek’s discussion does not exhibit the same degree of mathematical sophistication but
focuses on a richer set of highly relevant issues. For example, credit expansion is not
likely to be evenly spread across the economy, partly because of imperfect informationor principal-agent problems. This implies that credit expansion is likely to have eﬀects
on relative prices that are not justified by fundamentals. Shocks that impinge on relative
prices are hardly discussed in mainstream close-economy macro models.23 Hayek’s
theory is very subtle and shows that even a central bank which follows a stable monetary
policy may not be able to prevent business cycles and, occasionally, major boom-bust
episodes. Unfortunately, Hayek does not quantify the impact of perception errors (hewas philosophically averse to quantification according to modern standards, see Hayek[1974]), and although I find the argument persuasive for regular business cycles, I
think it would be quite a stretch to claim that they help to explain episodes such as
the subprime crisis, unless we bring into the picture the hand of the central bank, as
postulated by Mises. Thus, I think the Hayek/Mises mix has a better chance of being
close to the mark—with the emphasis on Mises for the current event. As I will argue
below, however, the Hayek/Mises mix becomes more appealing when liquidity issues
are brought to bear.
Whatever one thinks of the power of the Hayek/Mises mix as a positive theoryof the business cycle, an insight from the theory is that once credit over-expansion
hits the real sector, rolling back credit is unlikely to be able to put “Humpty-Dumpty
together again.” Inflation may subside, but the credit contraction is likely to have severereal eﬀects. No hard proof is oﬀered, but the conjecture is not easy to reject. “Sudden
Stop” episodes discussed above are clear examples that seem to confirm the conjecture.
Hayek’s explanation, in particular, can be summarized in one word: complexity. Thisimplies the inability of policymakers to know the inner workings of a mechanism that
goes awry by excessive credit in such a way that when the boom reaches its peak,
the policymaker cannot possibly know where to operate due to the complexity of......................................................................................
23. Close-economy macro models are the gold standard of macroeconomic theory. In contrast, relative prices playa key role in most open-economy macro models, for example, the real exchange rate. But although there is alarge literature showing that real exchange rate volatility is harmful for growth, the topic never made it into
the top ranks in gold standard macroeconomics. This situation is likely to change owing to the recent realestate bubble.

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the situation, even leaving aside political considerations. Moreover, when account istaken of the fact that the policymaker has only a limited set of blunt instruments withwhich to operate, it is not hard to conclude that countercyclical policy may be largely
ineﬀective—in the lucky case in which it is not outright counterproductive.
Borio and associates are carrying forward a research program that contains several
elements akin to the Hayek/Mises mix. One intriguing conjecture is that there exists a
slow-moving, insidious financial cycle behind booms and busts, which is easily missed
if policymakers do not keep their eyes on balance sheets (see, e.g., Borio [2012]).
In sum, the Austrian School has made important inroads into solving Critical
Puzzle 1 above, although a modern reader will probably wish to see additional “microfoundations.” However, Critical Puzzle 2 is a bit out of their purview. This is probably
due to the fact that the “Sudden Stop” phenomenon had not been identified at thetime. The next subsection will claim that liquidity issues can help to give a more solid
foundation to the Austrian School theory and address Critical Puzzle 2.
B. Liquidity and All That
It should be clear by now that liquidity is a feature that exists or vanishes as a function ofan asset’s role as an MOE. The latter, in turn, depends on an explicit or implicit compact
among economic agents by which the MOE is accepted/rejected as a form of payment
without a major delay or discount. This is admittedly imprecise but it highlights thefact that the market value of a liquid asset will depend, beyond standard fundamentals,
on arrangements that are subject to self-fulfilling prophecies. Non-liquid assets are also
subject to these kinds of prophecies but in the case of liquid assets they are par for thecourse. It is hard to find a fairly liquid asset whose liquidity is not subject to the typesof runs illustrated in Diamond and Dybvig (1983), for example. Moreover, these runs
can take place with the speed of light and, as discussed above, have severe implications
for the credit channel.
Acknowledging the lability of liquidity is an important first step in understanding
its characteristics. A second important step is to realize that liquidity can arise throughmechanisms that are polar opposites of each other. There are situations in which an
asset’s liquidity is established top-down, such as when the government defines a newlegal tender and unit of account to stop hyperinflation, for example, the Rentenmark.
But there are many other instances in which assets become liquid from the ground up,
as is illustrated by Asset-Backed Securities (ABSs), Brazil’s C-bonds, and securitizedbanking. Ground-up liquidity will be the focus of our discussion in what follows.
Ground-up liquidity is unlikely to happen in the blink of an eye; it is a process thatinvolves many economic agents who are not deliberately coordinated by a central
authority like the government. There will be a penetration phase in which a few agentstake the lead in the creation and marketing of potentially new liquid assets and thenthe market slowly expands. As the asset’s recognition grows, its liquidity is likely toincrease. Greater liquidity translates into a higher price. Hence, investors who are aheadof the game and can foresee the liquidity potential of the asset will have incentives tobuy it, further raising its price. Therefore, the penetration phase attracts new funds tothe new liquid asset, channeling new investment funds to the sectors where the assets
originate. An example is the real estate sector in the case of MBSs discussed above.

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The Mayekawa Lecture: Puzzling over the Anatomy of Crises—Liquidity and the Veil of FinanceThis illustrates two phenomena: (1) the possibility that the penetration phase generates
a credit boom; and (2) the lopsided nature of credit booms. Not all sectors benefit in thesame degree, a fact that could give rise to a boom in relative prices in the sectors where
new investable funds are directed—reinforcing Hayek’s view that credit expansion has
eﬀects on the real sector. Point (1) helps to give an answer to Critical Puzzle 1. But this
explanation would be more satisfactory if we were able to argue that the penetration
phase increases the probability of a run on the assets in question.
Take the case of MBSs. This is an asset class “fed” by many mortgage originators.
The situation is not radically diﬀerent from a currency that can be printed by manybanks, for example, the 19th-century banknotes that circulated in the United States. If
there is no regulator controlling the total supply of banknotes, chances are that hyperinflation will arise—or, if the banknotes are backed by, say, gold, a run on banknotes
will eventually take place. The reason for this is that individual issuers do not take fullaccount of their joint impact on the characteristics of the asset class. However, liquidity
creation from the ground up, especially in securitized banking, is ridden by deeper
externalities. The liquidity of banknotes depends to a large extent on the characteristics of the bank of issuance, and thus there can be a run against a bank of issuancewithout necessarily involving other banks. Securitized banking, in contrast, gives rise
to a system such as one in which, say, banknotes from bank A are indistinguishable
from banknotes from bank B. Thus, the systemic eﬀect of expanding banknotes is lesslikely to be internalized.24
A formal model following up on the above observation could proceed by assumingthat the probability of a run on MBSs, say, is increasing with the total supply of MBSs.
This might be so because as the MBSs become more liquid, the share of MBS holders
that have a high probability of being hit by a liquidity shock (requiring selling their
MBS holdings) goes up. Thus, there are more states of nature in which a run against
MBSs may end up in a liquidity crisis. In addition, one could introduce considerations
such as those discussed in Morris and Shin (1998) to show that the above-mentioned
weakening of fundamentals might increase even further the probability of self-fulfilling
MBS runs. These eﬀects are not internalized by MBS holders, and hence the probabilityof a run or crisis will be larger than if total supply was centrally regulated. Therefore,
beyond a certain point, a credit boom associated with the penetration phase will movethe system closer to a socially costly liquidity crisis. This does not imply that every
penetration phase will end up in crisis. It rationalizes the case in which the penetration phase is conducive to a crisis, which market participants—as individuals—do nothave the incentives (or even the wherewithal) to stop, even if they completely understand the process.25 This helps to explain why a credit boom during the penetration
phase increases the chances of a liquidity crunch. But why are investors unfazed bya higher risk and even increase the flow of funds in the run-up to a financial crisis(Critical Puzzle 2)?
......................................................................................
24. Pecuniary externalities have recently been discussed in, for example, Rodrik and Velasco (1999), Lorenzoni(2008), Mendoza (2010), and Bianchi (2011).
25. Maybe this is what Citigroup’s Charles Prince meant by saying (Financial Times [2007]), “When the music
stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to getup and dance. We’re still dancing.”57

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There are two forces at play. One force is that penetration of new financial instruments increases their liquidity—thus increasing the attractiveness of the new financial
instruments. The higher probability of a liquidity crunch, highlighted above, pushes in
the opposite direction—but need not be dominant. Actually, there may be penetration
phases that do not end up in crisis because investors stop well before the probabilityof a liquidity crunch becomes critical or the “run” random shock does not materialize.
These would be booms that are not followed by busts. More research is necessary to beable to tell the diﬀerence between booms that fizzle out without causing major damage
and booms that end up in costly “Sudden Stops.” In the meantime, however, I think thisgoes a long way toward answering Critical Puzzles 1 and 2.
A point worth stressing is that the boom/bust literature that I am aware of relieson the existence of collateral constraints that become binding partly as a result ofexogenous shocks, which are exacerbated by pecuniary externalities. In contrast, thekey component in a liquidity model is that liquidity itself is vulnerable to runs à la
Diamond and Dybvig (1983), and thus multiple equilibria cannot be ruled out in general.
The switch from “good” to “bad” equilibria is the central mechanism behind a bust.
Pecuniary externalities help the generation of realistic booms (e.g., Critical Puzzle 2)
but are less central for rationalizing deep busts, because the latter critically depend on
the distance between “good” and “bad” equilibria.
To summarize, bringing in liquidity into the discussion shows the possibility thatliquidity may be responsible for the fragilities revealed in recent crises, and oﬀers an
appealing complementary explanation to the growing boom/bust literature. Moreover,it gives some foundation to support the conjecture that financial liberalization could bea breeding ground for future crises, and it opens up the possibility that monetary policy
induces the creation of liquid assets subject to runs, giving some support to those thatclaim that Fed Chairman Greenspan’s low interest rates were responsible for the subprime crisis (for a formal model bearing out this result, see Calvo [2012b]). However,none of these implications necessarily depend on deep-seated irrationality that cannot
be remedied by thoughtful regulatory policy. These are accidents that can happen in thecontext of perfectly well-run financial machinery under imperfect financial regulation.
Before closing, I will present another piece of evidence that, in my view,
reinforces the conjecture that financial crises are closely linked to episodes of liquidity
creation/destruction. I will list this piece of evidence as
Critical Puzzle 3: In an interval of time around a “Sudden Stop,” gross credit
flows move in the same direction. They both increase prior to crisis, anddecline afterward.
This is clearly seen in Figure 3. For systematic evidence supporting Critical
Puzzle 3, see Dvorak (2003) and Broner et al. (2013). A view in these papers isthat the evidence supports the assumption of asymmetric information. This may be
so, but casual evidence suggests that, given today’s financial sector, it is unlikely that
information asymmetry or shocks play a central role. Research departments in theleading investment banks and hedge funds are brimming with economists from around

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The Mayekawa Lecture: Puzzling over the Anatomy of Crises—Liquidity and the Veil of Finance

Figure 3 Bi-Directional Portfolio Flows in the Eurozone[1] Portugal[2] Italy

Ratio to GDP, percent
20
Portfolio investment assets
Portfolio investment liabilities
15

15

Ratio to GDP, percent
Portfolio investment assets
Portfolio investment liabilities
10

10

5

5

0

0
–5

–5

–10

–10
–15
1990

94

98

2002

06

10

[3] Ireland

–15
1990

98

2002

06

10

06

10

[4] Spain

Ratio to GDP, percent
150
Portfolio investment assets
Portfolio investment liabilities
100

25
20

Ratio to GDP, percent
Portfolio investment assets
Portfolio investment liabilities

15

50

10

0

5
0

–50

–5

–100
–150
1990

94

–10
94

98

2002

06

10

–15
1990

94

98

2002

Source: International Monetary Fund, “International Financial Statistics.”

the world, which detracts from the appeal of the information asymmetry assumption,for example.
In contrast, liquidity oﬀers a much more straightforward rationale, free fromasymmetric information or shocks. As Figure 3 shows for four economies that playeda critical role in the current European crisis, portfolio flows from the creation of the
eurozone until the subprime crisis shot up in both directions, and collapsed as the crisis
began. It is hard to argue that residents in these countries were privy to information
not available to the rest of the eurozone. Much more plausible is to conjecture thatthe creation of the eurozone gave rise to instruments that traveled in both directions,such as repos, for example. This is, after all, a salient feature of an MOE in financiallyintegrated economies. The eurozone crisis seriously interfered with financial
integration, as deposits in all of the countries stopped being perfect substitutes withdeposits in German banks, for example—putting a break on the flow of the MOE acrossthese economies.

VI. Final Words
Recent crises show that the capitalist system is less resilient than conventional wisdom
implied. The major challenge going forward is to repair the system without impairing
its proven potential for creating wealth and speeding the pace of poverty reduction.
The paper shows that general equilibrium models should be extended in a substantive
way to incorporate the critical role of the payments system. Devices such as the veil of59main :

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money and finance, and the representative individual, leave critical aspects out of sight.
This is dangerous.
The paper shows that one can begin to understand the nature of liquid assets bygoing back to the basics, bringing to bear the literature about the value of money andthe vulnerabilities of traditional banks—and then appending to the analysis instrumentsthat are new but bear some features common to age-old instruments and institutions.
The paper shows that the financial tree that has been created over the years has flimsy
foundations. A prominent example is paper currency and commercial banking. Paper
currency—as suggested in the paper—partly owes its resiliency to price stickiness.
I will not repeat what has already been said in Section II, but it is worth noting thatconventional theory pictures price stickiness as a weakness in a monetary economy,
and the main imperfection requiring the close attention of central banks. In contrast,
this paper suggests that price stickiness makes central bank policy more powerful (thePrice Theory of Money [PTM]). However, the buttresses that secure the real value of
paper currency are not available for the rest of the financial tree except, to some extent,commercial banking. Thus, the subprime debacle can be traced to the fragility of theupper branches of the tree.
There are many important related issues that have not been touched on in the paper.
International aspects have been mentioned but only in regard to financial contagion.
But the challenges posed by the existence of a multiplicity of units of account andcurrencies have been purposely ignored. This is a major issue that acquires greater
significance when one recalls the flimsy foundations of the financial tree. With thisin mind, floating exchange rates sound like sheer nonsense. Recalling the PTM, theymight undermine the resilience of national currencies, because not all prices are set inunits of the domestic currency, a phenomenon that is especially prevalent in emerging
market economies (e.g., “currency substitution”). This restricts the ability of central
banks to stabilize the domestic price level. Moreover, it could make price stickinessmore costly. For instance, liquidity shocks that have little to do with fundamentals may
give rise to gigantic swings in exchange rates and have real eﬀects. Central banks in asea of currencies may be at a loss to oﬀset these swings, unless they resort to pegging
the exchange rate and, at least momentarily, abandoning floating exchange rates (seeCalvo and Reinhart [2002]). These considerations are not suﬃcient to make a case infavor of fixed exchange rates. There are many attendant issues that will have to besorted out before doing so. But once liquidity issues are brought to bear, it becomes
clear that arguments put forward by Friedman (1953) in favor of floating exchange
rates, for example, may need to be critically revised.

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