# **Box 3: Three Generations of Crisis Models**

The first generation model attributes balance of payments crises to _budget deficits financed by domestic credit in a fixed exchange rate regime with perfect capital mobility_ . This leads to current account deficits and a steady loss of reserves at a rate equal to the pace of credit creation; but a speculative attack resulting in a discrete exhaustion of remaining reserves occurs _before_ these would have been used up based on credit expansion alone. A float will then be forced. Such macroeconomic overexpansion and overvaluation were the standard diagnoses of balance of payments crises in developing countries before 1993, and were the basis of most adjustment programs administered by the International Monetary Fund. The international debt crisis of the 1980s is an example.

The second generation argues that there are “crisis” and “no-crisis” _multiple equilibria consistent with unchanged fundamentals_ . This approach was inspired the European Exchange Rate Mechanism (ERM) crises of 1992--93. The speculative attack on France in 1993 was puzzling, because the government had over the preceding years succeeded in attaining a level of macroeconomic discipline comparable to that of Germany, its partner in the ERM. Moreover, after the bands were widened, the crisis passed without a substantial further depreciation of the franc, even though there had been no tightening of macroeconomic policy in the meantime. How then could the fundamentals have been responsible for the earlier speculative pressure? The second generation argument is most simply illustrated by a “prisoners’ dilemma.” Consider two speculators. Each realizes that if the other sells, the resulting depreciation will reduce the value of his holdings of domestic currency. Neither wants to stand pat if the other might sell. One equilibrium is for both to sell, even though the economy may be worse off after the devaluation.

The third generation model was developed as an explanation of the East Asian crisis of 1997-98, where expansionary macroeconomic policy was not the problem, but a different kind of weakness in fundamentals appeared: _structural distortions in the financial system combined with implicit exchange rate guarantees_ . Well-connected banks and businessmen are able to borrow in foreign currency to finance risky projects, including those in the non-traded sector such as real estate development or construction of new factories in the already-glutted steel industry. They are aware of the risk, but reasonably confident they will be bailed out by the government if things go badly. The timing of the attack again stems from the calculations of speculators who worry that if they wait too long, there will not be enough foreign exchange reserves to go around. But there is a key difference from the first generation model, where reserves fall in the run-up to crisis. In this case, liabilities artificially encouraged by moral hazard rise to a point at which investors suddenly cash in their investments, fearful that if they wait any longer, they might not be able to get their money out. The speculative attack forces the central bank to abandon the exchange rate.

## **_Source_** _:_ Frankel and Wei (2004).

The models have three implications for MACs:

- First, it is difficult to predict exactly when and, equally importantly, why the next crisis will occur and what shape it will assume.  For example, the Lawson Doctrine posited that private external debt did not pose the same threat that public external debt did, presumably on the assumption that private-to-private flows would be better monitored and used.  But this doctrine was proved wrong by the East Asian crisis of 1997-98.  Similarly, how crises will be resolved is not clear.  The comprehensive Brady Plan response to the 1980s debt crisis has given way to an _ad hoc_ country-by-country approach.

- Second, crises of the first and third generations, which might be regarded as the most pertinent for (non-G-7) MACs, have highlighted the importance of the government’s intertemporal budget constraint.  While the 1980s debt crisis, Russia 1998 and Argentina 2001 all involved overtly expansionary macroeconomic policies and/or explicitly unsustainable public debt dynamics, the East Asian crisis involved large fiscal costs associated with financial sector bailouts.  These were contingent liabilities which became actual liabilities once the implicitly fixed exchange rate pegs were abandoned, leading to

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