Why a country's currency can collapse overnight from a self-fulfilling prophecy
In short: When investors believe a government can no longer defend its currency, their collective flight can make that belief a reality. This isn't just market panic; it is a complex interaction of debt, reserves, and the psychological threshold where a stable peg suddenly becomes a target.
Currency crises often stem from chronic balance of payments deficits, where a country's spending exceeds its income. This creates a vulnerability that can be exploited by speculative attacks in the foreign exchange market. When the value of a home currency drops, any debt denominated in foreign currency rises drastically, potentially triggering a banking or default crisis. This creates a feedback loop: a banking crisis can lead to a currency crisis, which in turn enlarges the economic cost of both, often resulting in 'twin' or even 'triple' crises.
Economists have developed three 'generations' of models to explain these collapses. The first generation, notably adapted by Paul Krugman, suggests that speculative attacks can be rational. If investors foresee a government running an excessive deficit, they anticipate the country will run short of the 'hard' foreign currency needed to maintain a fixed exchange rate. They flee the currency en masse the moment they believe the peg is about to break. The second generation, starting with Obstfeld in 1986, introduces the idea of self-fulfilling prophecies. If investors believe a government is unwilling to maintain a peg—perhaps because doing so would cause unbearable unemployment or economic pain—their expectations can force the government's hand.
The third generation focuses on the interaction between banking systems and the real economy. For instance, if local banks hold debts in foreign currencies, a currency crash can directly cause a banking collapse. Conversely, government guarantees can encourage banks to take on risky foreign debt, making the entire system vulnerable. These crises are especially destructive for small open economies or larger but unstable ones, often resulting in measurable socioeconomic collapse and frequent changes in government leadership.
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Sources
- Summary by Intellect · source: Currency crisis
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