9780241988084

‘Almost alarmingly timely’ Guardian

‘The perfect primer on the worst economic disasters of the past 100 years’ The Times

Praise for The Great Crashes

‘An important contribution that can help society anticipate and tackle potential crashes in the future’ Christine Lagarde, President of the European Central Bank and former Managing Director of the International Monetary Fund, 2011–2019

‘A first point of entry for anybody who wants to learn how the world economy sleepwalked into multiple crashes over the last century’ Daron Acemoglu, Institute Professor at MIT and author of Why Nations Fail

‘Timely, entertaining and full of useful insights’ Gideon Rachman, Chief Foreign Affairs Commentator, Financial Times

‘Fascinating, well written and authoritative’ Tim Harford

‘An accessible and insightful overview of modern financial crises, incorporating both historical detail and thoughtful analysis’ Kenneth Rogoff, Thomas D. Cabot Professor of Public Policy and Professor of Economics at Harvard University, and former Chief Economist of the International Monetary Fund

‘Linda provides many with a very readable summary of all the great crises, but also more importantly derives the big lessons and how to have a better policy framework to avoid getting caught up in too much “this time it is different” when the next big risks appear’ Lord Jim O’N eill, author of The Growth Map and former Chairman of Goldman Sachs Asset Management

‘A masterclass in spotting the early signs of a crisis. Linda Yueh expertly shows how we can understand these crashes better when they occur and even prevent them from happening in the future’ Nouriel Roubini, author of Megathreats

‘Draws out the many different ways in which markets can crash and she’s willing to chance her arm predicting the next one’ Sir Vince Cable, author of How to be a Politician and former UK Secretary of State for Business, Energy and Industrial Strategy, 2010–2015

‘Comes in the midst of a global polycrisis that threatens the economic and social well-being of all, especially the world’s poorest citizens. Linda Yueh makes a heroic effort to tease out lessons fundamental to managing future crises. The question is: will we learn?’ Dr Ngozi Okonjo-Iweala, Director-General of the World Trade Organization (WTO ) and former Finance Minister of Nigeria, 2003–2006 and 2011–2015

‘Troubled times call for a historical perspective and this is the historical perspective we need’ Sir John Kay, author of Radical Uncertainty and former member of the Independent Commission on Banking of the UK Government, 2010–2011

‘Crashes are an integral part of the history of capitalism. The last century has seen plenty of them. All crashes begin with debt-fuelled euphoria and end in disappointment. Yet how bad that disappointment turns out to be also depends on where in the economy the crash falls, and how determined and credible are the responses. In this lively and blessedly brief book, Linda Yueh does a lovely job of explaining the history, and drawing the necessary lessons’ Martin Wolf, Chief Economics Commentator, Financial Times

‘Demonstrates how that old saying – “this time is different” – is both so true and so wrong!’ Lord Stephen Green, former CEO and Chairman of HSBC and UK Minister of State for Trade and Investment, 2011–2013

‘This excellent overview identifies the ingredients that are specific to each crisis and common to all. She provides a lucid assessment of the efficacy of policy responses, highlighting credibility as a necessary condition for successful resolution’ Lord Nick Macpherson, former Permanent Secretary of the UK Treasury, 2005–2016, and Chairman of C. Hoare & Co.

about the author

Linda Yueh CBE is Fellow in Economics at St Edmund Hall, University of Oxford and Adjunct Professor of Economics at London Business School. The former Economics Editor at Bloomberg TV, she also hosted Talking Business with Linda Yueh as Chief Business Correspondent for BBC News. She was Adviser to the UK Board of Trade and has advised the World Economic Forum in Davos, the World Bank, the European Commission and the Asian Development Bank. She has recently been appointed by the UK Treasury to review the banking regulatory system. She is the author of The Great Economists, a Times Best Business Book of 2018.

The Great Crashes

Lessons from Global Meltdowns and How to Prevent Them

LINDa Yueh

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To the pack

Introduction

The Great Crash of 1929

‘There can be few fi elds of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present,’ observed J. K. Galbraith, the eminent economist who advised US presidents, including John F. Kennedy.1

The near century since the Great Crash of 1929 has proven to be as financially tumultuous as the centuries that came before. It has witnessed multiple financial crises striking nations, regions and – in more recent years – the global economy. The Great Crashes tells the stories of ten of these events. They serve as a series of cautionary tales, each with its own set of lessons. As this book will show, there is very little that is certain in economics, but there will always be another financial crisis. The chapters that follow will aim to analyse the crashes of our past to determine how best to mitigate the damage of fi nancial crashes in the future, when they inevitably come.

Each of the ten crashes that follow has a unique set of causes and consequences but, despite their di erences, they all feature three distinct phases: euphoria, credibility and aftermath. Euphoria or exuberance, often used interchangeably, leads people to invest in markets they believe will rise and rise. To resolve a financial crisis, credible policies are essential. These two aspects can shape the aftermath: the di erence between a quick recovery or a long, protracted recession. In each chapter the past responses (or lack thereof) of governments or institutions to these early phases will be analysed to determine which led to the best outcomes, and which to the worst,

in the hope that these lessons will help us understand how best to act in the future.

The Great Crash of 1929, and the ensuing depression of the 1930s, is understood to be among the worst of all time. It holds a special place in the annals of financial crises throughout history. Some of the lessons hard-won in this period went on to inform policy in the crashes that followed. So, it’s a good place to begin.

In the period after the First World War, the US economy recovered and boomed. It was growth fuelled by the belief of investors in the transformative impact of innovations such as the expansion of the telephone and highways networks, the electrification of millions of homes and the mass production of cars. Real-estate prices rose too, though not as exuberantly as stocks. The US blue-chip stock index, the Dow Jones Industrial Average, had increased six-fold between August 1921 and September 1929 during the economic expansion that occurred during the period known as the Roaring Twenties.2 Euphoria drove the stock market to dizzying heights, almost tripling its value between the beginning of 1927 and September 1929.3 But the boom couldn’t last and, when the market collapsed a month later, it was the worst financial crash in American history.

The great economist Irving Fisher was caught up in this belief in an ever-rising market. After the Great Crash, he insisted: ‘the ensuing rally will see the markets quickly return to previous highs’.4 Unfortunately for him, it did not. He lost not only his $10-million fortune (about $170 million in today’s money), but also his reputation. Like other investors who believed that prices would only go up, he borrowed from his sister-in-law to invest in shares, believing he could recoup his losses. He never did and ended up indebted to her until her death.

The stock market was booming despite a mild recession in 1927, which led to a rise in unemployment and a drop in production as well as falling prices known as deflation. The US central bank, the Federal Reserve, became concerned about the booming market and raised interest rates in 1928, which further dampened economic activity by increasing the cost of borrowing.5

On what was later called Black Monday, 28 October 1929, the Dow declined by nearly 13 per cent, falling into correction territory, which is a 10 per cent drop, caused by investors selling their shares as they lost confidence in the contracting economy. And on Black Tuesday, the Dow fell an additional 12 per cent and collapsed into a bear market (a term usually referring to share prices falling by 20 per cent). Within a couple of weeks, the index had declined by nearly 50 per cent. Investors saw the value of their shares, or their wealth held in stocks, cut in half. But it was to get worse. In the ensuing Great Depression, the stock market continued to fall for several years, hitting its lowest value in the summer of 1932. The Dow closed at 41.22 at its trough, which was a staggering 89 per cent below its peak, and did not recover to its pre-crash high for another two decades, until November 1954.6

The Great Depression saw widespread bank failures as property prices crashed. When the market is surging, an increase in household wealth leads to greater spending. As people begin to feel wealthier due to their stocks performing well, they tend to spend more, including on homes. For instance, the housing market in Manhattan is correlated with the bonuses on Wall Street, New York’s financial centre.7 Similarly, firms invest more, and in riskier projects, when their cost of borrowing falls. But when the market turns, and when asset prices fall, economic activity slows. Those riskier investments that households or firms might have made are not undertaken in case they don’t pay o . As the number of borrowers defaulting on their repayments rises, banks and lenders get into trouble. And in 1929, this was exactly what happened: real-estate loan defaults were the largest factor in bank failures and an astounding one third of all US banks failed between 1930 and 1933.8

Around one in four Americans lost their life savings. The US economy contracted by a staggering 29 per cent. Prices fell by some 25 per cent. Millions of people lost their jobs. Around a quarter of the country’s workforce were unemployed and many were in desperate circumstances, poignantly captured in John Steinbeck’s Pulitzer Prize-winning novel, The Grapes of Wrath. Steinbeck said: ‘I want to

put a tag of shame on the greedy bastards who are responsible for this [Great Depression].’9

Yet it wasn’t until February 1932 that the Fed injected cash to try to refl ate the economy. Its actions helped industrial production and commodity prices start to recover. In the summer of that year, when deflation seemed to be under control, the Fed discontinued its supportive policies despite the ongoing depression.10

The slowness to act and then the premature withdrawal of support worsened the Great Depression. This was the conclusion of the seminal work of another great economist, Milton Friedman, and his co-author, Anna Jacobson Schwartz. In their 1963 book A Monetary History of the United States, 1867–1960, their crucial observation was that the money supply contracted by one-third between August 1929 and March 1933, which meant that there were fewer funds available to fuel economic activity. Despite the stock market and the economy both being in crisis, the Fed only belatedly o ered monetary support and then withdrew it too soon.

The economy hit rock bottom in March 1933. The brake on its downward spiral was applied by the actions of the new US president. Franklin D. Roosevelt was inaugurated on Saturday 4 March 1933, and immediately had to contend with a month-long bank run. The next day, he declared a bank holiday and shut down the entire banking system and the stock market. On 9 March, within days of his becoming president, Congress passed the Emergency Banking Act of 1933. It included a provision that essentially provided 100 per cent deposit insurance. On Sunday 12 March, in FDR’s first ‘fireside chat’ radio broadcast to millions of Americans, he reassured the country that only the sound banks will reopen: ‘I can assure you that it is safer to keep your money in a reopened bank than under the mattress.’11 They believed him. The next day, people were queuing to deposit rather than withdraw their money. On 15 March, the first day of reopening, the stock market also registered its largest ever one-day rise. This marked the turning point of the Great Depression. FDR had managed in a few days what his predecessor Herbert Hoover could not in

three years. Why? Because the unprecedented bank holiday and ‘fireside chat’ –  backed up by legislation –  were viewed as credible.

But the depression was far from over. Despite, or perhaps because of, his misfortunes during the 1929 Great Crash, Irving Fisher devised the influential debt-deflation theory. Deflation happens after a crash because firms and households are repaying debt, also known as deleveraging. After a financial crash, the prices of securities and commodities fall. This leads to a decline in the value of those securities and commodities that banks hold as collateral against money they have loaned. These lenders would then ‘call in’ the loans, that is, ask for them to be repaid, since the securities that secured the loans are worth less. This leads firms to sell those assets in a ‘fire sale’, since they need the money to repay their loans regardless of the price they can sell at. Households are also a ected, since they may also need to sell securities to repay debt. This drives further price falls, and firms will begin to fail. Firms either can’t borrow or postpone borrowing, since they are not investing, so prices fall further. Falling prices also lead people to put o purchases, since they expect the items to be cheaper in the future. Lower demand in turn contributes to falling prices. As prices collapse, there are more firm failures. Banks are also incurring losses and failing too. As banks fail, depositors will take their money out, which can precipitate bank runs. (This was especially so during the Great Depression, since deposit insurance didn’t exist until after the 1930s debacle.) When people withdraw their deposits, banks have to call in more loans, which leads to more ‘fire sales’ by companies. Until deleveraging is complete, this dynamic drives the debt-deflation cycle, which is highly damaging and di cult to break out of.

Global deflation was also worsening the situation, exerting downward pressure on prices in the United States. There was growing stress on the gold standard, which was a system of fixed exchange rates whereby currencies were pegged to gold at a set rate. In May 1931, Austria stopped intervening to support its currency after speculators sold o the Schilling because they did not believe the parity with gold could be maintained. Contagion followed as speculators sold o other currencies, including sterling. After the UK ’s departure from the gold

standard in September 1931, foreign investors feared that the United States would do the same and began converting their dollar assets to gold. Speculators also did not believe that the US would defend the $20.67 per troy ounce parity to gold and attacked the dollar. It wasn’t until March 1933 that the US established a new parity of $35/oz, but also left the gold standard shortly thereafter. Speculators then turned their attention to the ‘gold bloc’ countries of France, Belgium, Italy, the Netherlands and Switzerland, who started buying gold to o set speculators selling their currencies, which added to global deflation. The ‘gold bloc’ suspended their currencies’ convertibility into gold in 1936. Thus, the gold standard worsened deflation during the most protracted depression in American history.

In 1937–38 there was in the US a ‘double dip’ downturn, known as the ‘recession within a depression’, where GDP fell by 10 per cent and unemployment rose to 20 per cent.12 It was also due to premature withdrawal of monetary support when policymakers thought the economy had recovered but it hadn’t su ciently. Throughout the 1930s, the economy was stuck in the debt-deflation cycle. It wasn’t until 1941 that the Great Depression finally ended, in the midst of the Second World War.13 The severity and length of the 1929 Great Crash have given it an unrivalled status in the history of financial crises.

Economists around the world learned a great deal from this catastrophic event. They extracted lessons that helped inform their responses to future crashes. We will try to do the same. First, by analysing the three phases, euphoria, credibility and aftermath, displayed clearly by the events of the Great Crash. Euphoria, whether in a stock or housing market or in an entire country or region, is the belief (always proved wrong) that markets will continue to rise, and so growing debt levels are not a source of concern. The 1929 crash was fuelled by a belief that technological marvels would lead to ever-rising stock markets, and so investing in the market was a sure-fire way to make money.

Next, we saw the importance of credibility. The slowness of the US central bank in loosening financial conditions to support the

economy contributed to the depth of the Great Depression. FDR restoring confidence in the banks started the recovery. It also highlighted the importance of having e ective banking regulations, specifically the need for deposit insurance so depositors can feel confident that their money is safe. Thus, credible economic policies matter. And go a long way to determining the aftermath.

The 1929 Great Crash led to the worst depression in US history because the market crash brought down the entire banking system. It takes a long time to recover from a systemic banking crisis; banks must be rescued and there’s a ‘credit crunch’ since banks aren’t lending, which a ects firms and households, who can no longer readily borrow or invest. The mistakes of the Fed and the slowness of the US government in sorting out the banks meant that policymaking was found lacking. Thus, the combination of a banking crisis and a lack of credible policies meant the aftermath of the Great Crash was not a swift recovery but rather the Great Depression, in which millions of people su ered hardship for a decade.

Despite the lessons learned after the Great Crash, the late twentieth century and early twenty-first century have seen a bonanza of financial crises. A series of financial crises of all kinds, including banking, housing and stock market crashes, and currency and sovereign debt crises, have accompanied the opening up and globalization of financial markets. Since the 1970s, the expansion in o shore banking and currency trading has led to close linkages among markets, with the result that an economic downturn can spread rapidly from country to country. Although there have been crises of all shapes and sizes over the centuries, the past several decades have seen a series of financial disasters regularly encompassing economies around the world.

There have been three generations of currency crises since this globalization of financial markets. The first was the early 1980s Latin American currency crisis. It was followed by the 1992 collapse of the European Exchange Rate Mechanism, whereby European currencies had been pegged to the German Mark. The third-generation model was the 1997–98 Asian financial crisis, which ultimately spread across

the world to Turkey, Russia, Brazil and Argentina. Simultaneously, a savings-and-loan crisis was raging in the United States and a spectacular real-estate crash was toppling the once-thriving economy in Japan.

At the start of the twenty-first century, there was no respite as the dot com bubble burst, triggering a recession in the US that spilled over into the international market. Then the world witnessed the worst systemic banking crisis since the 1929 Great Crash. The 2008 global financial crisis, with its origins in reckless sub-prime mortgage lending in the US , led to a near meltdown of the American financial industry that almost brought down the British banking system and deeply a ected others.

In the slipstream of the US sub-prime crisis came the 2010 euro crisis, which saw the bailouts of Ireland, Portugal and Greece (the largest in history) as well as the rescue of the entire banking systems of Spain and Cyprus. Shortly thereafter the world was hit by the Covid-19 pandemic. The ensuing market crashes were the sharpest in history. Financial markets fell from record highs and unemployment claims jumped more sharply than at any time since the Great Depression. The financial markets rebounded, but the real economy struggled. The massive government actions to rescue the economies around the world revealed the extent to which the lessons from history have been heeded or ignored.

What will spark the next great crash? China’s recent propertymarket woes could point to it being the next global meltdown. There will undoubtedly be financial crises in other countries and other sectors that could arrive first, but China stands out as its sheer economic size makes any crisis a potentially seismic one – not only for itself but also for the global economy. And China is overdue for one. Its economy has the rare distinction of having escaped a serious financial crisis during four decades of pretty much uninterrupted growth. It has, of course, had booms and busts, but not yet a crash. One reason is because of the state dominance of the financial system, which benefits from government support. But, with mounting debts and looming fragility, it would be entirely consistent with economic history

throughout the ages for China to experience one. If so, then it would likely be a true ‘great crash’. Even though the nature and impact of a crisis in China will be distinct, the traits of debt driven by euphoria and the challenge to the credibility of its institutions already point to similarities with other financial crises.

Often, crises will involve several elements. For example, the late1990s Asian crisis was both a financial crisis and a currency crisis. The 2008 global financial crisis was both a housing market collapse and a banking crash. So, a single taxonomy will never quite cover the complexity and unique features of each crisis, but the broad contours help in assessing what the aftermath of the next crisis could look like.

As with all books like this one, choices have had to be made about which events to cover. There have been many more financial market crashes than are included here, but not all of them ended up inflicting widespread economic pain. All of the crises in the book led to recession, which also marks them out as ‘great crashes’, since not all financial crises lead to an economic slump, even though all recessions come with a stock market decline. For instance, Black Monday on 19 October 1987 was the worst one-day stock market fall in history until the 2020 pandemic crash. US and global markets fell dramatically into bear markets in a matter of days and yet no recession ensued.14 By contrast, the dot com bubble bursting in 2000–2001 led to a US recession, though not a deep one, and so it is covered while others are not. There have also been numerous housing market crashes, but most did not trigger financial meltdowns like the US sub-prime crisis that precipitated the 2008 global financial crisis. That was certainly the case with the Japanese crash. The early 1990s real-estate crash wasn’t limited to Japan; a number of countries experienced the bursting of a housing bubble after an exuberant 1980s, which led to a global recession. However, those economies did not end up in a long stagnation, unlike Japan, which, three decades on, is still struggling to recover its precrash growth rates. Thus, Japan warrants a chapter because focusing on that economy o ers lessons to try to minimize the impact of a housing bust, and avoid it resulting in lost decades of growth.

The Great Crashes

All the crashes in this book qualify, in one way or another, as ‘great’. Financial folly has existed for centuries and will surely continue. The Great Crashes aims to highlight what we can learn, if not to avoid the inevitable next crisis, then at least to avoid the worst when it arrives. And we can only hope that enough lessons have been learned from history to prevent another global meltdown.

1 Three Generations of Currency Crises

Since the 1970s, the scale of international investment has grown dramatically. The majority of this funding is known as ‘hot money’, short-term and highly liquid capital that can move quickly in and out of markets and from country to country, leading to episodes of high volatility in currency markets. Too much ‘hot money’ can trigger a currency crisis by putting a currency under huge selling pressure on international foreign exchange markets, forcing a very large and dramatic devaluation. Currency crises can be extremely damaging to developing and emerging economies.

This chapter will look at three generations of currency crises that have resulted from changes in the international market. The first is the Latin American crisis of 1981–82 and the second is the European Exchange Rate Mechanism crisis of 1992. The third, the Asian financial crisis of 1997–98, is somewhat di erent because it was a combined currency and a financial crisis, as opposed to currency only, stemming from domestic financial crises in a number of Asian countries that led to dramatic money outflows.

The past fifty years have seen a tremendous change in the nature and the scale of financial markets. For much of the twentieth century, most financial activity was purely domestic, with financial institutions acting as intermediaries between domestic savers and borrowers. Most countries imposed exchange controls, which restricted both the access of households and firms to foreign currency and international capital mobility. Consequently, opportunities for international trades were scarce.

Since the 1970s, though, there has been a dramatic reduction in exchange controls globally, leading to much greater movement of capital across borders. This has helped to promote international trade,

and particularly so in financial assets. As a result, the world’s financial markets have become increasingly interlinked.

There are three main factors that have promoted the development of this international financial market: the historical change in exchange rate regimes, the growth in o shore banking and currency trading, and a change in ideology.

From the end of the Second World War until the 1970s, most countries operated a fixed exchange rate policy as laid down in the Bretton Woods Agreement. The agreement was the result of a meeting in Bretton Woods, New Hampshire, in July 1944 that led to the establishment of the International Monetary Fund (IMF ) and the World Bank. Led by Harry Dexter White of the United States and John Maynard Keynes of the United Kingdom, forty-four countries signed up to a new system designed to prevent competitive devaluations and to promote greater cooperation in the aftermath of the war. Countries pegged their currencies to the US dollar, which would convert to gold at a fixed exchange rate of $35 per ounce.1

By 1971 the amount of foreign-held US currency had exceeded America’s gold stock, causing President Richard Nixon to end the dollar’s convertibility to gold. The dollar’s central role as the world’s reserve currency meant that this was the collapse of the Bretton Woods system. Many countries that had pegged to the dollar were a ected (although this elicited little sympathy from US Treasury Secretary John Connally, who remarked: ‘the dollar is our currency, but your problem’).2

An important factor in the end of Bretton Woods was the growth of the Eurodollar market, an o shore short-term repository for US dollars. Here, the value of the dollar was determined in currency trading outside the boundaries of the United States. Consequently, any attempt made by the US Federal Reserve to assert exchange rate control could be circumvented by trading in the Eurodollar market, as this lay outside the jurisdiction of the US .

This was a large part of the second factor in the growth of international financial markets. There was a rapid expansion in the Eurodollar market when large banks and corporations started to

operate o shore during the 1960s to gain greater control over their finances.3 (For instance, an increase in the US interest rate couldn’t be passed on by banks because there was an interest-rate ceiling imposed on deposit accounts by the federal government under a measure known as Regulation Q.) The consequence was a move of US dollar-denominated deposits from US domestic banks to o shore banks, including foreign branches of US banks that were not subject to these ceilings.4

At the same time, commodity-exporting countries in the Middle East also increased their demand for US dollar securities due to growing exports of oil, which is priced in dollars. In the autumn of 1973 oil prices increased by a factor of five after the Arab–Israeli conflict known as the Yom Kippur War. Oil prices jumped again by a factor of three at the end of that decade, following the Iran–Iraq War. Oil exporters accumulated dollars at a rapid pace and invested them in US government debt so they could earn a return on their foreign exchange reserves. This added to the foreign holdings of US dollars, so contributing to the demise of the Bretton Woods system.

The third factor was a notable change in ideology towards opening up domestic financial markets. The abolition of the Bretton Woods era of exchange controls and the increasing freedom to undertake international financial transactions mirrored the deregulation in domestic financial markets. This change in ideology culminated in the ‘Big Bang’ in 1986 in the UK that deregulated the City of London and permitted foreign competition, amidst similar moves to open up financial markets around the world. By the 1980s, an international financial market was born.

International financial markets enable investors to invest anywhere. They can move their funds in order to achieve the highest return wherever that is in the world. But money invested in a country can just as easily be withdrawn when investors lose confidence.

What makes investors decide to sell up and get out? Why would anyone attack a currency? How do speculators make money from devaluations?

The Great Crashes

This is how. If a speculator thinks that a currency will devalue, then they can submit an order to the markets to sell the currency now and buy it back at a later date. If, in the meantime, the exchange rate depreciates, it means that the speculator is selling the currency for far more than it will be bought back for, representing in many cases a sizeable trading profit.

To maintain a fixed exchange rate, the government must use its gold and foreign exchange reserves to intervene in the currency markets. If a speculator tries to sell the currency, then the government will use some of its reserves to buy it, increasing demand and aiming to reduce downward pressure on the exchange rate. If the government isn’t wholly successful and a devaluation occurs, the currency loses value. In this case, the speculators’ profit is the loss that the government su ers through its intervention.

When the government runs out of reserves and is no longer able to defend the fixed exchange rate against heavy selling by speculators, a currency crisis will usually emerge. The actions of speculators are a vital part of the anatomy of a currency crisis. Speculators know that when the government is low on reserves, they may be able to force a devaluation and make a profit. Whether or not a speculative attack occurs depends on it having a good chance of succeeding, and this is most likely to occur when the government has few resources with which to defend against it.

What makes a currency vulnerable to attack? There are at least three possibilities. First, a balance of payments crisis, which occurs when a government runs down its reserves in the o cial financing of a trade deficit. Because reserves are limited, o cial financing cannot sustain deficits for ever. Eventually, the balance of payments deficit will require an exchange rate devaluation.

Second, runaway infl ation, which will erode competitiveness since there will be no o setting exchange rate depreciation. Because the currency value is fixed, it cannot fall even as everything costs more in the country and inflation reduces the buying power of the currency. This will lead to the exchange rate being overvalued, which means it’s more expensive to sell exports, so reducing

competitiveness and worsening the trade position. This again will require an exchange rate devaluation.

Third, a government running a substantial level of debt may be encouraged to produce some inflation (known as seigniorage revenues) in order to reduce the real value of its debt. Therefore, large deficits may be seen as inflationary, with similar consequences for competitiveness and the balance of payments as outlined above.

Speculators will strike as soon as they believe that an attack will be successful, usually when the government’s reserves fall to some critical level. Heavy selling will then exhaust those that remain. The fixed exchange rate is ultimately unsustainable because of the above fundamental factors. The actions of speculators just accelerated its demise.

The first generation of currency crisis, the Latin American crisis of 1981–82 exemplified these conditions. Chile, Brazil, Mexico and Argentina were operating a fixed exchange rate, collectively called the Tablita, in the form of a pre-announced schedule of depreciations against the US dollar known as a ‘crawling peg’.

Just as abruptly as the ‘hot money’ flowed into these emerging economies, the flows reversed when the US , under new Fed Chairman Paul Volcker, raised interest rates in late 1979 to curb inflation in the aftermath of the second oil price shock of that decade. Higher interest rates made it tougher for these Latin American countries to finance their external indebtedness since the cost of borrowing had increased. Moreover, monies started to flow back into the United States due to better returns from the higher interest rates on US securities. Pegged against the dollar, the Tablita exchange rate came under pressure, particularly as there was also a substantial inflation di erential between these countries and the US . Inflation in these Latin American economies rose in excess of the currency depreciations, which eroded their competitiveness and put pressure on their balance of payments.

The crisis erupted when these commodity-exporting countries said that they could not pay the interest on their external loans, which

had jumped from $125 billion in the late 1970s to a staggering $800 billion. The combination of high interest rates and commodity prices falling due to the global recession meant that they were at risk of defaulting on their debt. For the next seven years, Latin American countries negotiated with their creditors.

It wasn’t until March 1989 that the Brady Plan, named after then US Treasury Secretary Nicholas F. Brady, saw the crisis finally resolved. The Brady Plan was premised on how US domestic corporations were treated when they could not service their debts. First, bank creditors would grant debt relief in exchange for ‘Brady bonds’ that were backed by US Treasury bonds, which o er greater assurance of repayment. Second, the debt relief would be linked to economic reforms, and third, the debt would be made more tradable so that creditors could diversify their own risk.

Over $160 billion of Brady bonds were issued not only by Latin American emerging economies but by others as well, including Argentina, Brazil, Bulgaria, Costa Rica, Côte d’Ivoire, Dominican Republic, Ecuador, Jordan, Nigeria, Panama, Peru, the Philippines, Poland, Russia, Uruguay, Venezuela and Vietnam. About a decade and a half later, most Brady bonds had been exchanged or bought back by the debtor nations. Brady bond trading had accounted for 61 per cent of emerging market debt in 1994; it had dropped to just 2 per cent by 2005.5

The set of countries to su er what would become known as the second-generation currency crisis would encompass not only those in the emerging economies of Latin America but also in the advanced economies of Europe.

After the end of the Bretton Woods system, European countries looked to fix their currencies against each other. As intra-European trade grew, these countries saw the benefits of having stable rates of exchange. The 1970s also saw the drive to deepen European integration, so the European Exchange Rate Mechanism (ERM ) was created in 1979.

At its inception, the ERM members were Belgium, Denmark,