This paper argues that principal cause of the 1997 Asian currency crisis was large
prospective associated with implicit bailout guarantees to failing banking
systems. The expectation that these future deficits would be at least partly financed
by seigniorage revenues or an inflation tax on outstanding nominal debt led to a
of the fixed exchange rate regimes in Asia. Authors 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 deficits rises.
While the government cannot prevent a speculative attack, it can affect its timing.
The longer the delay, the higher inflation will be under the subsequent flexible
rate regime. We present empirical evidence in support of the four key assumptions
in our interpretation of the crisis: (i) the currency crises could not have been
predicted on the basis of standard macroeconomic indicators; (ii) the exchange rate
crises were preceded by publicly available signs of imminent banking crises; (iii)
failing financial sectors were associated with large prospective government deficits;
and (iv) governments were either unwilling or unable to raise the resource required
to pay for bank bailouts via fiscal reforms.
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Journal of Political Economy