Globalization was once believed to reduce the likelihood of widespread financial
crises. Spectacular crises, however, have persisted despite widespread
integration of economies, leaving observers to wonder whether crises will
coexist with international integration. The author reviews the latest models of
financial crises to understand how crises begin and how to contain them. He
concludes not only that postcrisis policies are largely ineffective but also
that crises will recur.
Decades ago, the inexorable trend toward increased globalization—the integration of
economies through reduced financial restrictions, which encourages trade—was
heralded as a panacea to curb financial crises and their aftershocks. The story went as
follows: As developing countries opened their economies to trade, Western lenders'
confidence in these countries grew; a large share of exports to overall economic
activity (i.e., GDP) was evidence that an emerging country was serious about avoiding
damage to its fledgling economy by defaulting.
Despite the proliferation of global trade in recent years, developing economies that have
opened to trade have been the catalysts of far-reaching, breathtaking crises—most
notably the Latin America debt crisis of the 1980s and, more recently, the 1997 Asian
currency crisis and its ongoing contagion. Observers now wonder whether globalization
promotes crises rather than assuaging them.
Krugman reviews the financial literature on modern crises to understand their causes
better, especially the interrelationship between international trade and the aggregate
balance sheets of private companies, now the main borrowers in developing countries
rather than the governments of developing countries, which dominated during the 1980s.
Krugman categorizes models into two camps: (1) those that view crises as the result of a
borrowing and investment frenzy gone bust and (2) those that view crises as a temporary
jump to an unstable equilibrium during a panic. Krugman reports that the second category
has edged out the first category in models developed since 1997.
The genesis of panic-driven crisis models is Diamond and Dybvig's work (
of Political Economy
an ever-present threat stemming from the intentional duration mismatch between a bank's
assets (long-term loans) and liabilities (short-term deposits). Chang and Velasco (NBER
working paper, 1999) apply the bank-run model to international financial crises, but
Krugman contends that more-accurate models must also account for an economy-wide
currency mismatch. Aghion et al. (mimeo, 1999) partially develop a model analogous to
Mundell–Fleming, the classic open-economy paradigm in which equilibrium is the
intersection of international trade and asset markets, defined in terms of the exchange
rate and GDP.
Krugman uses the Aghion et al. model to assess the ability of postcrisis macroeconomic
policies to fight a massive currency depreciation, which initially fuels a crisis. (Note
that the Aghion et al. model shows ambiguous effects on economic activity caused by
currency depreciation.) Justifying the model outcomes with empirical and anecdotal
evidence, Krugman reports that many policy choices may be costly or ineffective.
Krugman reviews methods that developing countries may adopt to prevent crises: floating
exchange rates; domestic adoption of a credible foreign currency, such as the U.S.
dollar or the euro (dollarization); and restrictions on either capital inflows or
outflows. Krugman points out, however, that some of these preemptive measures might
discourage rather than enhance globalization, which Krugman wishes to nurture.
Krugman contends that globalization has been generally successful in promoting economic
activity in emerging economies and that vulnerability to crises is the price to pay for
that growth. The continuing upward trend in economic integration, especially in the
populous economies of China and India, means that the threat of widespread financial
crisis will loom.