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THE GLOBAL CAPITAL MARKET: Market Failures and the Policy Response 3

Crises in the Capital Markets

The year 1982 marked the start of a global developing-country debt crisis. Private lending to the affected developing countries, many of them in Latin America, slowed to a reluctant trickle, while sovereign debtors and their creditors teetered on the edge of generalized default. But in the 1990s, the debt crisis gave way to renewed capital inflows, as a combined result of workouts of the old debt problems, widespread economic reforms, and low American interest rates (see Calvo, Leiderman, and Reinhart, 1996).

In the 1990s, foreign exchange crises have disrupted exchange markets in Europe, Latin America, and east Asia. Outside of Europe, the crises have spilled into stock markets, raised the specter of state default, and sometimes led to deep recessions. Most of the east Asian countries avoided debt problems in the 1980s, but several have been hit hard in the 1990s. The crises have sharpened debate over two opposing views. One claim is that otherwise successful economies have been victims of greedy market operators, usually foreign ones. This view is especially popular with government ministers in the afflicted countries. In the 1960s, anonymous “gnomes of Zurich” were blamed for Britain’s chronic balance of payments problems; in the 1990s, ministers name gnomes (like George Soros). The opposing view is that such crises are largely home-grown, and that the global capital market is simply performing a needed role in disciplining imprudent government policies.

Recent thinking on crises would argue that neither view is entirely correct. There may be extensive “grey areas” in which unwise policies make countries vulnerable to crises, but in which a crisis is not inevitable and might in fact not occur without the impetus of international capital outflows, typically carried out by domestic as well as foreign investors (see, for example, Detragiache, 1996, and Obstfeld, 1996). For example, a country with extensive short-term dollar-denominated government debts and few dollar reserves — Mexico’s’position in December 1994 -might find itself in a crisis if previous lenders all suddenly demand repayment of their dollars, and if no new lenders of dollars can be found. Thus, crises may contain a self-fulfilling element, just as bank runs do, which can generate multiple equilibria in international asset markets, and render the timing of crises somewhat indeterminate. What we see in these cases is a sharp break from an essentially tranquil equilibrium to a crisis state, rather than a gradual deterioration in domestic interest rates and other market-based indicators. This view helps explain why capital markets can appear to impose too little discipline before the crisis arrives, and too harsh a discipline afterwards.