The Volatility Machine: Emerging Economies and the Threat of Financial Collapse

By Michael Pettis | Go to book overview

Introduction

In this book I will argue that certain types of financial crises—like the crises that have affected many Latin American and Asian countries in recent years—are problems of sovereign balance sheet mismanagement and not economic mismanagement. In contrast to much of the analysis that has appeared recently, I will argue that these crises do not occur because domestic economic policies are flawed, or because capital flows are excessive, or because international investors behave irrationally, or even because currency regimes are mismanaged. They occur instead for two other, related, reasons. First, emerging market borrowers and investors have consistently underestimated the source and magnitude of volatility in emerging financial markets. Second, perhaps as a consequence, borrowers and investors have permitted and even encouraged sovereigns to put into place capital structures that systematically exacerbate this volatility.

In the world of international finance there is a disconnect between the work of corporate finance specialists and economists. While the former typically attempt to evaluate and quantify the way market risks are absorbed into a company's capital structure, the latter try to understand the development and functioning of the long-term processes that drive an economy. But countries and even regions are subject to market-related risks and shocks that can disrupt their behavior, just as companies are, and these risks are transmitted in the same way: through their capital structures. In fact any economic entity's capital structure can be seen as a sort of volatility machine, one of whose main functions is precisely to manage the way external markets impact internal processes. This volatility machine converts the price

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