Financial Crises and Political Crises / Roberto Chang.

By:

Chang, Roberto

Contributor(s):

National Bureau of Economic Research

Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w11779.Publication details: Cambridge, Mass. National Bureau of Economic Research 2005.Description: 1 online resource: illustrations (black and white)Subject(s):

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Abstract: This paper is an analysis of the simultaneous determination of financial default and political crises and its consequences. It focuses on a small open economy that faces a debt default decision. Crucially, this decision is made by a government that has superior information than the public about the social costs of default. Citizens can dismiss the government, and overrule its default decision, at the cost of a political crisis. If there is a divergence between the objectives of the government and its people, a political crisis may emerge in equilibrium. For this to be the case, the foreign debt must be large enough, and international reserves low. When this political equilibrium is seen as a part of a larger investment problem, there are equilibria in which crises are "only financial," and equilibria in which both default and political crises occur. In some cases, these two kinds of equilibria coexist and, in this sense, a loss of confidence by foreign lenders can exacerbate the likelihood of a political crisis. If so, international intervention in financial markets may ensure financial and political stability at little cost.

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November 2005.

This paper is an analysis of the simultaneous determination of financial default and political crises and its consequences. It focuses on a small open economy that faces a debt default decision. Crucially, this decision is made by a government that has superior information than the public about the social costs of default. Citizens can dismiss the government, and overrule its default decision, at the cost of a political crisis. If there is a divergence between the objectives of the government and its people, a political crisis may emerge in equilibrium. For this to be the case, the foreign debt must be large enough, and international reserves low. When this political equilibrium is seen as a part of a larger investment problem, there are equilibria in which crises are "only financial," and equilibria in which both default and political crises occur. In some cases, these two kinds of equilibria coexist and, in this sense, a loss of confidence by foreign lenders can exacerbate the likelihood of a political crisis. If so, international intervention in financial markets may ensure financial and political stability at little cost.