The Source of Financial Crisis
There have been four waves of financial crisis in the last thirty years. Each wave involved the failure of a significant number of banks in three, four, or more countries at about the same time. Moreover, the prices of the currencies of most these countries that were impacted in each wave declined, and many of the borrowers defaulted on their liabilities denominated in the U.S. dollar, the Euro, or some other foreign currency.
Mexico and ten other developing countries were engulfed in the first wave in 1982. Japan and several of the Nordic countries were the casualties in the second wave in the early 1990s. The Asian Financial Crisis that began in the summer of 1987 was the third in the series. The real estate busts in the United States, Britain, Iceland, Spain, and Ireland in 2008 were components of the fourth wave.
Each country that experienced a banking crisis had an economic boom in the several years before the crisis. Moreover each of these had also experienced an investment inflow, which led to an increase in the price of securities in the country and an increase in the price of its currency in the absence of intervention and a commitment to limit the increase in the price of the currency.
One of the unique features of this period is that ninety percent of the countries that had banking crisis also had a currency crisis at the same time. And every country that had a currency crisis had a banking crisis, which became more severe because the sharp decline in the price of each currency led to significant increase in the domestic equivalent of the liabilities denominated in a foreign currency.
Banking crisis have occurred when currencies had parities in terms of gold, and when countries like Spain and Ireland were members of a monetary union. Nevertheless these crisis have been more frequent and more severe when currencies have been floating because the economic booms stimulated by the investment inflows led to increases in the anticipated rates of return on investments in these countries and even further inflows.
Robert Aliber highlights the impact of surges in the cross border investment flows on the prices of securities and the prices of currencies and their contribution to the economic booms that precede the banking crisis. His analysis provides an explanation of why these crisis are more frequent and more severe when currencies float freely.