Sudden stops , currency crises , and twin deficits

Abstract

Twin Deficits and Sudden Stops Over the last thirty five years many emerging and developing countries have suffered financial crises. Most recently, in the 1990s, the nature and severity of Mexican, Asian and Russian financial crises shocked many observers. Sudden capital flow reversals, known as sudden stops, often accompany these crisis episodes. The explanations of the crises vary among the crisis models. The latest models discount the importance of twin deficits. This paper investigates the effect of twin deficits (fiscal and trade deficits) on the likelihood of sudden stops and whether the role of twin deficits changed across the decades of the 1970s, 80s and 90s. Probit analysis is conducted on the data of 42 developing countries from 1970 to 2004. This sample includes 25 emerging market countries as well. Results support the hypothesis that the influence of twin deficits declined over the decades, but they still played a significant role in the 90s. Sudden Stops and Currency Crises This paper compares empirical characteristics of commonly used measures of international financial crisis, specifically sudden stop and currency crisis measures. It focuses on the following questions: Do these measures capture different types of crisis? What are the output costs of each type of crisis? And can we detect the type and severity of a crisis in advance? Several sudden stop and currency crisis measures are analyzed using the annual data of 25 emerging market countries from 1990 to 2003. According to this study sudden stops are more likely to precede currency crises and the output costs are higher when both crises occur simultaneously. Countries that have higher current account deficits, real exchange rate appreciation and domestic credit growth are more likely to experience these costly crises in subsequent years. Moreover, the findings suggest that the empirical results in crisis modeling may depend on the selection of a crisis measure. Asset Bubbles and Manias in the Brain Booms and busts in stock, commodity, and other markets have not disappeared as participation in these markets has broadened. For example, the collapse of stocks in 2000 erased an approximate 7 trillion dollars in wealth. Currently, the U.S. real estate markets seem to be experiencing the deflation of a bubble in many locations. These roaring economic events do not appear to be driven by rational decisions as prices radically exceed market fundamentals. Why is this? Several laboratory experiments, pioneered by Vernon Smith, have produced market bubbles without offering much explanation for them (see Vernon L. Smith, Gerry L. Suchanek, and Arlington W. Williams 1988; Martin Dufwenberg, Tobias Lindqvist, and Evan Moore 2005). The cognitive neuroscience and behavioral finance literature suggests that the sources of these deviations from rationality could be linked to the mammalian brain's emotional responses that inhibit higher level cognitive decisions. This study uses double auction laboratory experiments to both identify the brain mechanisms involved in creating bubbles, and intervene neurologically to study if this causes bubbles to deflate. By identifying this mechanism, money managers and traders can take steps to inhibit it and avoid losses in frothy markets.