Prospective Deficits and the Asian Currency Crisis
This paper argues that the recent Asian currency crisis was caused by
large prospective de…cits associated with implicit bailout guarantees to failing
banking systems. We articulate this view using a simple dynamic general
equilibrium model whose key feature is that a speculative attack is
inevitable once the present value of future government de…cits rises. This
is true regardless of the government’s foreign reserve position or the initial
level of its debt. While the government cannot prevent a speculative attack,
it can a¤ect its timing. The longer the delay, the higher in‡ation will be
under ‡exible exchange rates. We present empirical evidence in support
of the three key assumptions in our model: (i) foreign reserves did not
play a special role in the timing of the attack, (ii) large losses in the banking
sector were associated with large increases in governments’ prospective
de…cits, and (iii) the public knew that banks were in trouble before the
currency crises.
