Private Sector Involvement and International Financial Crises: An Analytical Perspective

By Michael Chui; Prasanna Gai | Go to book overview
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Foreword

How should the international financial architecture be designed? This book provides a theoretical framework to answer this important question. It starts with an accessible account of the literature on financial crises. There are two types of explanation for the occurrence of financial crises. These are the sunspot-based and fundamentals-based explanations. According to the sunspot-based approach, there are multiple equilibria. If people believe there will be no crisis then this belief is self-fulfilling. On the other hand if people believe there will be a crisis then these beliefs will also be self-fulfilling. What determines which equilibrium will occur? One way of modelling this is to suggest that an exogenous event such as a sunspot will be the coordinating device. This is not a very satisfactory explanation of equilibrium selection. The second approach is based on the business cycle. If people believe the economy is going to enter a recession they worry about the ability of banks and other agents to make payments on debt contracts. In order to ensure that they can receive the full amount they are owed they demand early payment and this leads to a crisis.

The book does a nice job of showing how these two approaches can be reconciled using developments in the recent literature on global games. The weakness of the sunspot-based approach is the equilibrium selection mechanism. If there is a lack of common knowledge about future economic prospects then it can be shown that a unique equilibrium exists even when there exist common knowledge multiple equilibria. When on average signals about future economic prospects are above some critical level there will not be a crisis, but when they are below there will be. This approach underlines the importance of leading economic indicators for crisis prediction. The first part of the book closes with a critical examination of this literature.

The second part of the book considers how the international financial architecture should be reformed. Sovereign bankruptcy is at the centre of this debate. Ex ante it is desirable to provide good incentives for debtors to repay creditors by having tough penalties in the event of default. Ex post it is desirable to try and work out defaults with the minimum waste of resources possible. These two goals are usually in conflict and the policy problem is to balance them in a sensible way.

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