EconThesisSecondDraft

When is Berlin like
Bangkok? Misconceptions
and Moral Hazard in the
East Asian and European
Financial Crises
By James Supeene
Economics Honours Essay
July 25 2013

Contents
1. Introduction.................................................................................................................. 2
2. The East Asian case study ........................................................................................... 4
3. The neoclassical model................................................................................................ 5
4. The Multiple Equilibrium model................................................................................. 5
5. Applying the models to the east Asian crisis............................................................... 7
6. Critique of the international response ........................................................................ 14
7. The international lender of last resort........................................................................ 16
8. The cause of the European financial crisis ................................................................ 18
9. Contagion and the response to the crisis.................................................................... 19
10. Conclusion ............................................................................................................. 23
Table of Figures
Figure 1: Growth rates of GDP per capita in selected Asian countries. Low- and middle-
income countries provided for comparison. Data from World Bank Development
Indicators. Under the World Bank classification, low income countries are those with a
GNI...................................................................................................................................... 9
Figure 2: Inflation (consumer prices) in selected Asian countries. Low- and middle-
income countries (using World Bank classification) provided for comparison. Data from
World Bank Development Indicators. ................................................................................ 9
Figure 3: Indonesian external debt statistics, 1980-1996.................................................. 10
Figure 4: Malaysian external debt statistics, 1980-1996 .................................................. 10
Figure 5: Philippines external debt statistics, 1980-1996..................................................11
Figure 6: Thailand external debt statistics, 1980-1996......................................................11
Acknowledgements
The author is grateful to Jean-Paul Lam, Associate Professor of the University of
Waterloo, for all his guidance, patience, and contributions. The support and input of
Svenja Morgan, Max Palamar, Carleigh Pope, and Tom Slee were invaluable throughout
the writing process. Any remaining flaws are the sole responsibility of the author.

1. Introduction
This paper will analyze and compare the causes and international response to two recent
financial crises. In 1997, East Asia was struck by an unexpected wave of recessions and
bank failures, sparked by a swingeing attack on the region’s currencies. An emergency
round of bail-outs, funded and directed by the International Monetary Fund (IMF),
succeeded in halting the slide. But the IMF also imposed harsh conditionalities which
greatly slowed the region’s recovery. This paper will argue that this lacklustre response
can be explained by two factors. Firstly, the underlying causes of the crisis were
misdiagnosed. The IMF’s response is consistent with a neoclassical explanation of the
crisis where the principal factors are the buildup of excessive debt and underlying
distortions caused by government intervention. The paper will compare a neoclassical
model of the crisis with an alternative view, the multiple equilibria model, which
characterizes the crisis as a self-fulfilling panic brought on by asset-liability mismatches.
The paper will show that the multiple equilibria model better explains the stylized facts of
the East Asian crisis than the neoclassical model. If this had been comprehended at the
time, the response may have been much different. Secondly, the paper will argue that, in
the context of financial crises with multiple equilibria, the lender of last resort (LOLR) is
a key actor in the system. However, contradictions inherent to this role, such as the
potential for introducing moral hazard and the need to maintain a “constructive
ambiguity,” explain why international LOLR operations such as the bail-outs conducted
in East Asia are so often carried out in a hasty, poorly formulated manner, on an ad-hoc
basis.
This analysis can also be applied to the contemporary crisis in the Eurozone. The two
case studies share much in common: both are regional financial crises which spread
through the international banking system and required coordinated international
responses. In Europe, as in East Asia, the response was slow and muddled, prolonging
and worsening the economic consequences. The failure of the response can, again, be
partially explained as a result of the contradictions inherent to the role of LOLR, played
in Europe by the European Central Bank (ECB). However, the two cases also have
important differences. Whereas the East Asian crisis is most accurately characterized as
confidence-driven, structural factors are more important in the Eurozone crisis. The
adoption of the common currency awkwardly lashed a number of very different
economies to a single monetary policy. The Eurozone lacks several of the factors key to
an “optimal currency area.” For example, it has no mechanism for cross-border fiscal
transfers, and its members’ business cycles are out of phase with one another. In this
context, international events caused asymmetric shocks to the component economies of
the Eurozone, causing booms in some and busts in others. An distinct but contributing
factor was Germany’s longstanding use of policies promoting underconsumption and
overinvestment, which generated substantial trade surpluses for that country, but at the
expense of the peripheral economies in the common market. The result was a buildup of
structural imbalances, leading to unsustainable debt buildup in the periphery.
Finally, the failure of the response to the Eurozone crisis can, as in East Asia, be partially
explained as a result of a misdiagnosis of the underlying problems. Tight monetary
policies and fiscal austerity were again pursued, in the apparent belief that the debt
buildup had occurred due to fiscal profligacy and distortionary policies in the peripheral

economies. But nothing has been done to address the underlying structural flaws which
this paper will show were the ultimate causes of the European crisis.
2. The East Asian case study
For most of the late 20th century, East Asia seemed to have the key to the future of
capitalism. As the rest of the world went through the trials of stagflation, recession, and
high interest rates, East Asia chugged along at a steady 7-9% growth rate and low
inflation for decades. By the mid-90s, the conversation in the academic world had shifted
from whether this was sustainable, to how it might be emulated (Stiglitz, 1996). On cue,
disaster struck. On May 14th and 15th of 1997, the Thai baht, pegged to a basket of
currencies including the U.S. dollar, came under intense speculative attack. The Bank of
Thailand, attempting to defend the peg, lost most of its reserves. Investors lost
confidence, and began pulling capital out of the country. The valuation of the baht
plummeted rapidly, further weakening confidence and sparking a vicious cycle.
Contagion quickly caught hold. Thailand’s neighbours, some of whom were heretofore
pictures of economic good health, found their own currencies under speculative attack.
Malaysia and Indonesia both had extensive trade ties with Thailand, and their perceived
economic fortunes in the eyes of investors fell with that of their trading partner. As the
crisis spread, twitchy investors began pulling out from other emerging markets. South
Korea and the Philippines quickly succumbed; other countries in the region also suffered
economic damage; shockwaves l.;even reached Mexico. As their currencies devalued,
foreign-denominated debt held by private banks and corporations became more and more
burdensome. Inflation threatened to run out of control, and governments, consistent with
the economic orthodoxy of the day, began raising interest rates to try to restore investor
confidence. The higher interest rates and worsening economic outlook sent huge sectors
of their economies into bankruptcy, and unemployment rates soared. This sudden failure
in one of the world’s most promising regions, which almost sparked the world’s first
global financial crisis, came to be known as the Asian Financial Crisis (AFC) of 1997.
What could have provoked such an overnight reversal of fortune? The role played by
flows of speculative capital, or so-called “hot money,” is crucial to understand. In the
early-to-mid 1990s, with a recession in Japan and low interest rates in the United States,
investors had few attractive destinations for their capital. The East Asian economies,
pushed by the United States and international organizations, had adopted policies of
highly liberalized capital accounts and few restrictions on foreign investment (Stiglitz
2002). As a result, between 1994 and 1996, over $200 billion in private capital flowed
into East Asia (King 2001: 439). But investors, as is their wont, preferred to make
short-term bets in the highly liquid real estate and equity markets rather than long-term
commitments in economically productive “greenfield” investments. These short-term
capital flows could, and in the event did, rapidly reverse direction at the first sign of
trouble.
The story told so far is mostly uncontroversial in academic circles, but it is far from a
complete explanation. Significant questions remain about the underlying nature of the
crisis and its implications for the Asian development model. In the immediate aftermath,
academic opinion quickly clustered around two different viewpoints with very different

interpretations. Since these questions are fundamental to understanding the nature of the
East Asian crisis, it is worth exploring these two camps in some detail.
3. The neoclassical model
The first viewpoint, which might be termed the neoclassical view, held that the crisis,
while precipitated and transmitted by capital flight, was ultimately caused by
distortionary economic policies in the countries of origin (Corsetti et al 1999). Adherents
hold that the “miraculous” growth experienced by these countries for decades was in fact
a mirage. The Asian development model relied heavily on direct government
intervention in and influence over private industry. In pursuit of export-led development,
governments tried to foster competitive export industries at home in hope of creating
comparative advantages for themselves on the global market. These policies were
targeted at capital-intensive industries, like the automotive and chemical sectors, rather
than labour-intensive sectors. Governments used subsidized loans, moral suasion, and
other industrial policy tools to achieve their goals. This development strategy was
anathema to neoclassical economists, whose models suggested that any involvement by
government would necessarily make markets less efficient than they would be otherwise.
These economists held the view that the only proper path to development was for
countries to allow their private industries to exploit their pre-existing comparative
advantages, which, for the poor-yet-populous Asian countries in the mid-to-late 20th
century, were entirely concentrated in labour-intensive sectors like textiles and cash
crops. Although interventionist government policies could perhaps prop up growth in the
short term, this would create distortions which would inevitably hurt long-run growth. In
the wake of the financial crisis, many of them claimed that the neoclassical view had
finally been vindicated. The flight of the speculators, in this account, was only the
market’s way of imposing discipline on wayward governments; to blame the speculators
for the crisis would be like blaming the symptoms for the disease.
4. The Multiple Equilibrium model
The other popular interpretation of the Asian crisis holds that it was not inevitable at all.
This viewpoint, which might be called the “multiple equilibria” view, models the crisis
similarly to a bank run (see Chang 1998 and Cole 1998 for two examples of this
approach). The banks in the countries of origin developed substantial short-term debt
obligations to foreign creditors, which they invested in long-term assets that could not be
easily liquidated. This closely resembles conventional models of domestic banking
systems, in which banks take in short-term liquid deposits and use the money to make
illiquid long-term loans (Bryant 1980, Diamond and Dypvig 1983). Both models have the
same implication: an exogenous shock, even quite a minor one, can change expectations
of the future solvency of the bank and provoke some creditors (or depositors) into
withdrawing their money. As the banks’ liquid assets are drawn down, their balance sheet
worsens, and the perceived risk of lending to them increases even further. If the banks are
forced to liquidate assets for far less than their long-term value, or if some banks in the
financial system go into default on their short-run obligations, the situation will spiral out
of control even more rapidly. This becomes a self-fulfilling panic which, if left alone, can
do substantial damage to the financial system and the broader economy.

In a closed economy, such a crisis could be resolved—albeit painfully—by allowing
heavily indebted banks to go into default. But in an open economy, dependent on inflows
of international capital, such a solution could potentially scare away international
investors. The alternative solution to default is for the government to assume some or all
of the private sector’s excess liabilities: a bail-out. But if the costs of doing so are
sufficiently high to threaten the government’s own solvency, then the panic can repeat
itself: a self-fulfilling run on the country’s debt, driving up interest rates to the point
where they can no longer service debt and must potentially default themselves. In either
case, given the presence of substantial easily-liquidated foreign investment in the region,
we would expect large outflows of private capital to follow.
In cases where the economy operates under a fixed exchange rate (as was the case in East
Asia), there is one further point of vulnerability. As investors move their money out of
the country, this puts downward pressure on the exchange rate. The government is faced
with a familiar dilemma: they may try to uphold the currency rate peg, drawing on their
limited foreign exchange reserves, but risking a run on their currency. Or, they could
abandon the peg and allow the currency to depreciate, possibly catastrophically so.
The account so far has shown the potential for self-fulfilling panics in the markets for
private debt, sovereign debt, and currencies. Regardless of the market, the potential for a
run on debt exists when there is a systemic mismatch between assets and liabilities. In the
case of a classic bank run, the mismatch is temporal. Deposit-taking banks are effectively
issuing highly liquid short-term debt, which they then use to issue longer-term illiquid
loans. Although their books might appear to balance, in the event of a fast-paced run on
deposits, the bank is incapable of liquidating its assets quickly enough to cover its
liabilities.
The same can be true of sovereign debt crises. Bond issues by a government vary in
maturity according to the policy of its treasurers, from a few days to decades. But these
are not a government’s only liabilities. Most governments have social welfare programs,
such as subsidies for food or unemployment insurance, whose budgets cannot be cut
without provoking significant social unrest. These programs tend to expand in times of
recession to provide assistance to the swelling ranks of unemployed and underemployed.
Furthermore, during times of economic crisis, the government may be forced to assume
significant private-sector liabilities on short notice, if it becomes necessary to bail out a
major financial institution. Finally, a government’s most important asset—its tax
revenue—will also suffer during a recession. Thus, there are a wide variety of
mechanisms by which imbalances may arise in a government’s debt structure.
Finally, a currency collapse may also be conceptualized as arising from a mismatch
between assets and liabilities: here, a country’s assets are the reserves of foreign
currencies held by its central bank, whereas every local currency unit (LCU) held by a
foreigner is a liability. The mismatch is not temporal, but purely structural. If a country
does not have sufficiently large reserves to purchase every extant LCU at the official rate,
then it is vulnerable to a run on the currency.
This model has three features which are particularly relevant to this paper’s topic. The
first is that the economic damage caused by a self-fulfilling debt panic is “real”, that is, it
is not reflective of underlying factors in the economy (Dybvig and Diamond 1983). The
second is that the damage caused is entirely disproportionate to the initial shock. Finally,

self-fulfilling panics can be avoided, at almost no cost, by the presence of a lender of last
resort (LOLR)1(Bryant 1980, Dybvig and Diamond 1983, Chang and Velasco 1998).
Hence, the use of the name “multiple equilibria” models.
5. Applying the models to the east Asian crisis
Having set out the competing explanations in their most general forms, the next step is to
identify which model best fits the East Asian case. The neoclassical model holds that the
crises were caused by domestic distortions, imbalances, or inefficiencies in the
economy—some structural flaw, in other words, which could have predicted the onset of
the crisis if only it had been noticed. This is not to say that expectations play no role
whatsoever in the neoclassical model: they are the mode by which markets punish
underperforming economies and profligate governments. The neoclassical model also
does not require that every country which suffered during the crisis did so for structural
reasons, only those in which the crisis originated: the model is compatible with
contagious crises that spread via the expectations of international markets. But these
behavioural or expectations-based factors are of only secondary importance; it is key to
the neoclassical model that the crisis was ultimately a reflection of underlying structural
flaws, not of the vicissitudes of the international bond market. Commentators have
attempted to locate these flaws in several different areas of the East Asian economy, to
little success.
One reason why the crisis was so unexpected (Radelet, Sachs et al 1998; Stiglitz 2002;
Krugman 1998) is that it followed several decades of largely uninterrupted, seemingly
sustainable growth. Figures 1 and 2 show GDP growth rates per capita and inflation,
respectively, in the five countries hardest-hit by the crisis, between 1980 and 1996.
Aggregated data for low- and middle-income countries are also provided for comparison
purposes. Figure 1 shows that the East Asian countries experienced positive growth over
the entire timeframe, with the exception of the Philippines, which experienced several
recessions. The other four Asian countries also consistently out-performed both low- and
middle-income countries as a whole. Figure 2 shows that, while brief bursts of high
inflation did occur in the Philippines during its recessions and in South Korea from 1980
to 1982, on the whole inflation in the region did not exceed 10% in most time periods.
And, again, the Asian countries generally experienced lower inflation than did other low-
and middle-income countries.
Both macroeconomic variables thus behaved as one would expect in a prolonged period
of generally stable growth. But is it possible that the growth was merely a mirage? If
1
This is not the only theoretically efficient means of preventing bank runs—for a
simple example, allowing banks to temporarily suspend repayment of short-term debt
obligations can achieve the same goal, assuming that they can accurately identify an
impending run on their accounts (Diamond and Dybvig 1983). Even that informational
assumption can be relaxed if banks are allowed to use complex partial suspension
schemes (Wallace 1988). However, the lender of last resort is the most feasible and
frequently-observed solution on an international scale (Rogoff 1999) and is most relevant
to the topics considered here.

significant misinvestment was occurring during this time—as neoclassical commentators
have argued—then the growth rates may not reflect a strong underlying economy. One
way to test this is to look at the distribution of proceeds from growth. If the East Asian
economic model was, as claimed by neoclassical commentators, largely underpinned by
crony capitalism and misinvested resources, then we would expect that the average Asian
citizen would have seen little benefits from the decades of growth. Table 1 shows the
percentage of the population living under $2 per day in each of the countries over two
periods: one as close to 1980 as possible (given the constraints of data availability) and
one as close to 1996 as possible. Poverty levels varied widely across the region, from as
low as 12.3% in Malaysia to as high as 88.4% in Indonesia. Yet each country saw its
poverty levels drop during the time period—in the case of Thailand, by almost 30
percentage points. Even more remarkably, low-income countries as a whole displayed no
improvement in the proportion of their populations living below the poverty line over the
same time periods.
So the growth did occur, and the countries’ populations saw enough benefits to suggest
that growth was underpinned by real economic development. Radelet, Sachs et al (1998)
identify two further possible structural explanations for the crisis. The first is that it was
caused by changes in the international economic environment—perhaps the emergence of
China as a major competitor in the labor-intensive export sector, or the signing of NAFTA
giving Mexico privileged access to the enormous American market. The second is that
significant misinvestment may have occurred in the few years leading up to the crisis:
specifically, the fear is that the inflows of speculative capital to the region may have
caused equity or real-estate bubbles to form. This argument was advanced by Krugman
(1998), among others. While Radelet, Sachs, et al’s analysis will not be reproduced here
for brevity, they find that the East Asian countries’ share of world exports did not
significantly decline in the run-up to the crisis. And they find that, while real-estate
bubbles did exist in Thailand and Korea in the years before the crisis, none of the other
countries experienced significant increases in real-estate prices. Indeed, Indonesia, which
was hardest-hit by the crisis, showed no change in real-estate prices at all between 1992
and 1996.

Figure 1: Growth rates of GDP per capita in selected Asian countries. Low- and middle-
income countries provided for comparison. Data from World Bank Development
Indicators. Under the World Bank classification, low income countries are those with a
GNI
Figure 2: Inflation (consumer prices) in selected Asian countries. Low- and middle-
income countries (using World Bank classification) provided for comparison. Data from
World Bank Development Indicators.
Table 1: Percentage of population living on less than $2 per day (at 2005 prices), over
two periods.
Country First Period (year) Second Period (year)
Thailand 44.1 (1981) 14.6 (1996)
Philippines 61.9 (1985) 52.6 (1994)
Indonesia 88.4 (1984) 77.0 (1996)
Malaysia 12.3 (1984) 11.0 (1995)

Country First Period (year) Second Period (year)
Low income 83.4 (1981) 83.4 (1996)
Middle income 70.0 (1981) 57.0 (1996)
Figure 4: Malaysian external debt statistics, 1980-1996
Figure 3: Indonesian external debt statistics, 1980-1996

Figure 5: Philippines external debt statistics, 1980-1996
Figure 6: Thailand external debt statistics, 1980-1996

Figure 7: Aggregated external debt statistics for all developing countries, 1980-1996
Therefore, the structural explanation of the crisis fails to be convincing, since no common
structural factor or combination of factors can explain why the crisis arose. The multiple
equilibrium model performs better. Recall that this model is based on the idea of a
mismatch between assets and liabilities. Since the crisis was an international one, the
relevant variables to examine are related to external debt. Figures 3 through 6 show
external debt statistics for four of the five crisis countries—statistics for Korea were not
available for the time period in question. Figure 7 shows the same statistics aggregated
across all developing countries, for comparison. The figures support the multiple
equilibrium explanation in each crisis country for which data is available.
Begin by considering Indonesia, the hardest-hit of the countries. Indonesia's external debt
remained high, at 60% of GNI, for the decade leading up to the crisis. However, its total
currency reserves were very low, at less than 20% of total external debt. For a country
with a peg on its currency, this situation was unsustainable: the external debt effectively
represented liabilities far greater than the assets, in the form of foreign currency reserves,
could possibly cover. Making matters worse, the temporal composition of debt also
changed during this time: an increasing proportion of debt was short-term in maturity. As
discussed in the model above, since much of this debt is likely invested in assets that are
illiquid in the short-term, this represents a temporal mismatch making Indonesia
vulnerable to a self-fulfilling panic.
Malaysia's external debt stocks in the years leading up to 1997 were the lowest of the
four countries, which may explain why it was the only country to make it through the
crisis without accepting an IMF bailout. Nonetheless, problematic patterns can be
observed. The amount of debt denominated in US dollars increased dramatically in the
time observed, to over 50% of its total external debt stock. Unlike in other countries,
Malaysia's currency was not pegged to the US dollar before the crisis. This meant that a
sudden devaluation of the ringgit, as occurred in July 1997, immediately led to an

increase in Malaysia's liabilities and a decrease in its asset prices in US dollar terms. This
was sufficient to make a panic-driven run on the country's debt possible, dramatically
increasing interest rates overnight.
The Philippines actually decreased their external debt stocks dramatically, from 100% of
GNI in 1989 to just over 50% of GNI in 1996. This is nonetheless higher than average for
developing countries. Their total reserves were also built up during this time, to 25% of
external debt—not particularly poor, compared to other developing countries, but not
sufficient to defend their currency from a concerted speculative attack, as occurred in
July 1997. As in other countries during the crisis, once the peso's valuation began to
slide, this worsened the country's balance-sheet by increasing the value of its liabilities
and decreasing the value of its assets.
Thailand was “ground zero” for the crisis, and it is thus not particularly surprising that its
external debt statistics show a number of potential imbalances in the years leading up to
1997. Thailand's external debt rose to over 60% of GNI, compared to an average of 40%
in all developing countries. Of this, more than 40% was composed of short-term debt, the
highest in any of the countries considered and more than twice the average proportion
found across developing countries. Thus, despite relatively high reserves of 30% of
external debt, Thailand faced a huge temporal mismatch between its assets and liabilities.
Under these conditions, the multiple equilibrium model predicts that a minor exogenous
shock can provoke a quick rush to the exit by investors, sparking a self-fulfilling panic—
just as occurred in 1997.
Of the two views—structural and multiple equililbria—the latter has proven the more
influential. Macroeconomic variables in the Asian countries displayed no signs of deep
structural distress before the crisis, even with hindsight (Radelet and Sachs 1998). At the
time, the structuralist view was already starting to look weak at its foundations: earlier
economic crises in Chile (1982) and Mexico (1994) also proved resistant to structuralist
explanations (Velasco 1987 and Sachs et al 1996a, respectively, as cited in Chang and
Velasco 1998). Chang and Velasco identify a number of desirable characteristics that
models of financial crises should possess: they should not rely on government
misbehaviour; they should be applicable in a variety of different macroeconomic
contexts; they should explain why some countries go into crisis and not others with
similar macroeconomic characteristics; they should account for the high correlation
between banking crises and currency crises; and they must explain the disproportionality
between the triggering event of a crisis and the economic damage the crisis can cause
(Chang and Velasco 1998:1-2). In each of these respects, neoclassical models perform
more poorly than multiple equilibria.
To be sure, there were elements of what might be called “crony capitalism” at work: for
example, the close cooperation between government and business often included the
development of personal ties between private and public figures, and businesses that had
these ties to government benefited greatly from them. In conventional Western
neoclassical analysis, this would generally be called corruption. Many advocates from the
structuralist camp thus argued that this “pervasive corruption” (as they saw it) was a
necessary outcome of the export-led development model. But other scholars respond that
this is all part of business-as-usual in Asia, and that in any case personal ties can be an
efficient means of transmitting information between government and business and in that

way aid policy formulation (Park and Luo 2001). Other structuralist accounts have
focussed on supposedly unsustainable debt levels in Asian corporate and banking sectors
in the run-up to the crisis (Corsetti et al 1999), but Dissanaike and Markar (2009) find
that these conditions were only present in Korea and arguably Thailand.
6. Critique of the international response
But while the crisis showed every sign of being self-fulfilling in nature, rather than
structural, the international response was clearly based in a neoclassical, structuralist
paradigm. In previous emerging-market debt crises, such as Mexico in 1995, the G7,
working alongside the IMF, World Bank, and OECD showed a willingness to step in and
provide bailout funds. The pattern was repeated in East Asia. The four countries worst hit
by the crisis—Thailand, Indonesia, South Korea, and the Philippines—each requested
and received IMF assistance between 1997 and 1998. Only Malaysia narrowly avoided
seeking financial assistance. South Korea, as the largest and most industrialized economy
of the five, received what was then the largest bailout in IMF history, totalling $55
billion. What is telling is not the fact of the bailouts—which is compatible with both
structuralist and multiple-equilibria interpretations—but the conditionalities attached to
them.
Conditionalities on IMF loans are, pro forma, set out in Letters of Intent written by the
bailed-out government. In reality, the terms of the loans are effectively dictated to the
recipient countries (Stiglitz 2002:pp XX). IMF conditionalities are prescribed with the
intention of ensuring the repayment of the loans by putting the recipient country on a
sustainable growth trajectory. Many critics have expressed concern that these conditions
are not prescribed with the best interests of the recipient countries at heart, but rather
serve the interests of the IMF itself and other international financial institutions.
Regardless of any ulterior motives, the IMF clearly believes that its prescriptions will
have the effect of restoring economic growth—recessions are as bad for business, and for
creditors, as they are for households. The conditionalities attached to a bail-out therefore
indicate the IMF’s diagnosis of a country’s economic problems.
The policies imposed on bailed-out countries by the IMF were all substantively quite
similar (IMF 1997a, b, c; IMF 1998). Countries committed to restoring balanced budgets,
eliminating subsidies for industry or consumer goods, cutting back on their nascent
welfare states, cutting education spending, privatizing many government entities or
functions—in other words, classic fiscal austerity measures. In terms of monetary policy,
bail-out recipients agreed to pursue tight monetary policies in an effort to restore
confidence to their currencies. This required raising interest rates to high levels—in
Indonesia’s case, rates soared to almost 100%, a level that would be unthinkably high in
any industrialized country.
The prescription of fiscal austerity is only coherent if the IMF was acting under the
assumption that excessive debt (whether public or publicly-guaranteed) was at the root of
the crisis. In the context of otherwise solvent countries subjected to self-fulfilling panics,
fiscal austerity makes no sense. The limitation on Asian countries’ ability to borrow (or
their ability to maintain their currency pegs, which is much the same thing) was one of
credibility, not solvency. As would be expected, the conditionalities failed at their stated
intention of restoring economic good health. Fiscal austerity measures ruled out any sort

of ordinary Keynesian stimulative spending, so unemployment rates remained
persistently high for years after the bailouts. Cuts to food subsidies in Indonesia led to
riots in the streets. High interest rates actually worsened the ability of banks and
corporations to pay off their creditors, sending even more firms into bankruptcy and
doing long-term damage to their corporate sectors (Stiglitz 2002). The harsh measures
had been intended to restore confidence in the countries’ economic outlooks, but in
practice they only made the situation worse. The fiscal austerity measures, supposed to
attract investors by committing the government to a sustainable fiscal path, caused so
much damage that they had the opposite effect. The tight monetary policy, intended to
buoy the value of their currencies by attracting investment, utterly failed to do so
(Montiel 2003). In the context of a banking crisis, high interest rates further hurt the
creditworthiness of domestic firms and banks, discouraging foreign investment and
actually hurting the currency’s value rather than helping it (Stiglitz 2002, Goldfajn and
Gupta 2003).
In bailing out affected governments, the IMF was acting in effect as an international
LOLR. This much of its response is consistent with the multiple equilibria view, whereby
self-fulfilling crises are caused and perpetuated by a vicious cycle of deteriorating
investor confidence. The imposition of conditionalities is harder to understand. The use
of tight monetary policy was intended to restore confidence; its use was thus also
consistent with the multiple equilibria view. However, because the IMF believed itself to
be dealing with only a currency crisis, and seemed to ignore the coinciding banking
crises, its measures failed to restore confidence. The imposition of austerity policies, by
contrast, seems thoroughly inconsistent with the multiple equilibria view, or indeed with
basic macroeconomic theory. Balanced budget policies rule out the possibility of using
standard Keynesian countercyclical fiscal policy. Slashing social spending would make
sense only if the crisis had fundamentally structural roots, i.e. severe economic
distortions or overly high public debt levels, but we have seen that neither of these was
present for the East Asian crisis. Some advocates tried to justify the austerity policies as
confidence-boosters. If true, this would justify their use within a multiple equilibria
schema, but that is a big “if:” we have seen that the austerity policies caused high
unemployment and social unrest, hardly conducive to investor confidence. The use of
austerity policies, and their subsequent failure, can thus be explained by the conceptual
failings of the “structuralist” view.
The story thus far is that of how a loss of short-term investor confidence in Thailand
quickly spiraled into a full-blown international debt, banking, and currency crisis that
ravaged five countries and infected dozens more. By the time a lender of last resort, the
IMF, stepped in, a great deal of damage had already been done. The IMF’s bail-outs were
attached to conditionalities that forced the use of counterproductive fiscal and monetary
policies. The remainder of this paper will examine the implications of this analysis for the
contemporary Eurozone crisis. First, the learning effects (Hall 1993) from the failure of
the 1997 response will be discussed, particularly with regard to their impact on the IMF’s
role as international LOLR. Next, the Eurozone crisis itself will be discussed in terms of
its origins, response, and consequences, and contrasted with the East Asian case.

7. The international lender of last resort
Given the scale and scope of the failure of the international response to the 1997 crisis, it
should be not surprising that it provoked a great deal of soul-searching in the succeeding
years (Krugman 1998, Fischer 1999, Radelet & Sachs 1998). Much of the debate centred
on the need for an international lender of last resort.
The role of LOLRs in the domestic banking system has been well-known for over a
century, ever since Walter Bagehot described his classic “Bagehot rules” for an LOLR to
follow: it should lend unlimited amounts, to solvent-but-illiquid banks, at penalty rates, in
exchange for collateral that would be good in noncrisis times (Bagehot 1873). These
rules, in practice, are rarely followed. In a crisis situation, it is difficult to reliably discern
solvent banks from insolvent ones, or good collateral from bad. Modern highly complex
financial instruments make this task even more difficult than it was in Bagehot’s time.
And crisis lending is rarely done at penalty rates, since the idea is to restore banks to
good health, not to saddle them with even more burdensome debt.
The role of LOLR has a contradiction at its heart, which is commonly termed “moral
hazard.” The contradiction is that, for banks and corporations to work efficiently in a
market economy, they must believe they can fail and go bankrupt: yet, if a LOLR offers a
guarantee (implicit or explicit) of emergency help, then this is no longer true. Firms’
incentives are distorted. They invest more in risky assets, which drives up their prices
above equilibrium level. A virtuous circle can ensue, whereby banks take on more risky
assets, which further increases their value, which improves the banks’ balance sheets,
enabling them to invest more.
Concerns over moral hazard prevent most governments from issuing explicit guarantees
that they will serve as LOLRs. Instead, they must adopt an approach of “constructive
ambiguity” (Corrigan 1990 as cited in Rogoff 1999). Governments still implicitly serve
as LOLRs: indeed, they cannot credibly pretend that they will not serve in this role; in a
crisis situation, the costs from letting banks fail are so high that they will inevitably be
bailed out in one way or another. However, by refusing to make this role explicit (and
thus committing themselves to action in certain circumstances), governments can at least
preserve the threat of letting some banks fail as examples, or forcing share- and bond-
holders to take haircuts; in this way the problem of moral hazard is partially dealt with.
This is far from a perfect solution, especially on an international scale, where there is no
single actor who is obviously positioned to serve as an LOLR. One of the most important
functions of an LOLR is to serve as a crisis manager who coordinates and directs the
response to a financial crisis (Fischer 1999, Giannini 1999). Thus, in the fall of 2008, the
American government was able to use moral suasion to convince Bank of America to
purchase the struggling Merrill Lynch; this move strengthened the banking system
without requiring the commitment of any public money. A similar tactic was used in
August 1998, when Long Term Capital Management failed; the American government
convinced the hedge fund’s creditors to buy it, and forestalled a banking crisis. Goodhart
and Shoenmaker (1995) found that the organization of concerted lending was the most
common tool used to combat banking crises. But internationally, crisis managers are hard
to come by. The G-7 filled this role in previous episodes, but failed to respond quickly
enough in East Asia. The IMF is the most obvious candidate to play crisis manager. But
the need to maintain a “constructive ambiguity” around its role as LOLR militates against

the IMF’s ability to act quickly and decisively in response to potential banking crises. In
any case, sovereign countries do not tend to allow foreign meddling in their domestic
banking sectors until crisis has already struck. In the context of international sovereignty,
no supranational body is well positioned to play a crisis management role.
The 1997-1998 crisis shone a spotlight on these flaws in the international financial
system. The IMF found its legitimacy as an international financial institution (IFI) cast
into doubt. Its governing body, the Executive Board, was criticized for overrepresenting
interests of Western developed countries and underrepresenting the Global South (Woods
and Lombardi 2006). This came on top of longstanding allegations that IMF lending
programmes were administered primarily for the benefit of the Fund’s industrialized
backers, not its poor and developing members (Payer 1974). With stigma attached to
borrowing from the IMF, and a benign global economic climate, demand for IMF loans
dropped off precipitously (Bird and Rowlands 2010:1280). Nonetheless, during this time
the Fund undertook several reform efforts, which indicated that the lessons from East
Asia had been at least partly taken to heart.
Some governance reforms were undertaken to improve the representation of developing
countries (IMF 2008). The changes were not sufficient to restore fully the IMF’s stature
as an impartial international institution (Beeson and Broome 2008), but at least evince
some institutional learning capability. More relevant to this paper’s purpose were the
reforms to the Fund’s lending facilities. In the immediate aftermath of the East Asian
debacle, the IMF introduced a new programme of “Contingent Credit Lines” (CCL),
intended to make emergency funds more easily available to countries with good
governance track records and sustainable economic policies (IMF 1999). When the global
financial crisis began in 2008, the IMF was immediately called into action. The G-20, at
an emergency summit, agreed to triple the IMF’s lending capacity. In 2009, the Fund
announced a number of reforms that further facilitated its role as international LOLR.
These included: a new “Flexible Credit Line,” developed in consultation with developing
countries, which aimed to make funding more easily available to middle-income
countries; expanded access for low-income countries to the Poverty Reduction and
Growth Facility and the Exogenous Shocks Facility; and the promise of more flexible
conditionalities on stand-by arrangements (IMF 2009). These changes, while far from
adequate to silence critics, nonetheless represented a substantial improvement to the
Fund’s ability to play LOLR from 1998 (Broome 2010).
So it is that the IMF which confronted the 2008 global financial crisis was a better-
funded, more legitimate, and more flexible organization, less dependent on sovereignty-
breaching conditionalities. While far from perfect, it was nonetheless more acclimated to
the role of LOLR than it had been. It was not, however, the only international
organization that would be called upon to play that role. As the international crisis spread
to the Eurozone, the single currency’s masters in Brussels—the European Commission
(EC) and the European Central Bank (ECB)—were forced to play LOLR themselves. The
remainder of this paper will show how the failures of East Asia were repeated in Europe,
albeit with an ironic twist: this time, the IMF, now reduced to an advisory role as the
junior member of the Troika, was the experienced voice of reason, and the ECB was the
reluctant and inexperienced LOLR. And a still more fundamental irony is that the
European crisis does, unlike the East Asian crisis, have structural origins—it is not
fundamentally confidence-driven—but the structural problems were nonetheless

misdiagnosed, with painful consequences. It is thus important to begin by overviewing
the Eurozone crisis, as misconceptions about its origins and causes persist.
8. The cause of the European financial crisis
The Eurozone crisis finds its roots in systematic, structural imbalances which built up
within the euro zone between 1999 and 2008. The currency area was split in two. The
economically strong “core” countries, of which Germany is the quintessential example,
exported capital-intensive products; the weaker “periphery” countries, including Spain,
Greece, and Italy, had labour-intensive exports. These structural differences exposed the
Eurozone to “asymmetric trade shocks” to the competitiveness of their exports (IMF
2012). These shocks included the rise of China (and the subsequent fierce competition in
labour-intensive export markets), higher oil prices, and the integration of labour-intensive
Central and Eastern European countries into Western European supply chains. The core
countries were able to export their products to these emerging markets at great profits;
being in the Eurozone meant that their currencies were valued lower than (e.g.) a separate
deutschmark would have been. Peripheral countries found less to be glad over. The
globalized competition in labour markets had lowered competitive wages well below
their levels in peripheral countries. This effect would naturally be partially compensated
for if the periphery countries had their own floating currencies, but, sharing a currency
with the core as they did, that option was not available. Another option would be so-
called “internal devaluation,” or an extended period of deflation lasting until wages
returned to competitive levels. But this did not occur: wage are naturally “sticky” (exhibit
downward nominal rigidity) and do not deflate easily; in any case, the suffering brought
on by deflation would have been politically impossible to defend.
An easier solution was found. Core countries, flush with money from exports, had large
capital account surpluses to spend down; periphery countries, now importing more than
they exported, had the opposite problem. Investment naturally flowed from the core into
the periphery. This was generally accomplished through bank-to-bank lending, whereby a
bank in (e.g.) Germany loans to a bank in (e.g.) Spain. As a result, the years after the
formation of the Eurozone were characterized by an effectively undervalued currency in
core countries and corresponding trade surpluses and, conversely, an overvalued currency
in peripheral countries and corresponding trade deficits.
The impact of these changes on the economies of the European countries can be
understood by looking at the relevant accounting identities. Since national payments must
balance, a trade surplus implies an equal outflow of capital—and therefore, it requires an
excess of national savings over investment. This in turn implies either underinvestment or
underconsumption. In Germany’s case, domestic policies put into place after
reunification were used to restrain wages and expand productive capacity, with the goal
of increasing the competitiveness of German exports and, thereby, employment (Pettis
2012:127). These policies were not ended with the creation of the Eurozone. In fact, the
subsequent effective undervaluation of the German currency further served to suppress
consumption in favour of promoting growth in export industries. As a result, German
GDP growth steadily outpaced consumption growth, requiring a corresponding increase
in the savings rate.

These policies on the part of core countries had effects on the peripheral economies as
well. As described above, excess German savings were channeled into the periphery,
which developed a large current account deficit. A current account deficit implies an
excess of investment over savings. This, in turn, implies either overinvestment or
overconsumption. In Europe, both occurred. Excess investment was channeled into
unproductive sectors of the economy, particularly the housing market, where it caused the
well-known development of an enormous housing bubble. As in America, housing prices
were sustained by the availability of cheap consumer credit, resulting in a buildup of
household debt (effectively, negative savings) and systemic household overconsumption.
By 2005, Spanish household debt was 105% of disposable income, double the level it had
been in 1997 (Durán 2008:24)
9. Contagion and the response to the crisis
Once the imbalances had set in, only a small exogenous shock was needed to set a crisis
in motion. The collapse of Lehman Brothers, and subsequently of the American housing
market, served this purpose nicely. Housing markets in peripheral countries tanked (BBC
2012), and their banks’ balance sheets went with them. As in East Asia, governments in
the countries of origin had to bail out their banks, and took on significant public liabilities
to do so. Spain’s stock of short-term external debt soared from 16 billion euros in
Q12009 to 51 billion a year later (Banco de España 2013). Despite austerity measures, its
debt has continued to grow, and as of Q12013 total Spanish external debt is almost 350
billion euros, 100 billion more than it was in Q12009(Banco de España 2013). Greece has
fared even worse: its public debt soared from 263.3 billion euros in 2008 to 355.7 billion
by 2011, representing an increase worth 60% of Greece’s GDP (Eurostat 2013).
Bond yields on the peripheral governments quickly soared as their solvency came into
question. The spread of yields of 10-year greek bonds over the 10-year euro-area
benchmark rate (which includes only AAA-rated sovereign bonds) increased from 0.17
percentage points in January 2008 to 24.4 in June 2012 (source: Bank of Greece,
European Central Bank websites). As in East Asia, the lenders of last resort themselves
needed a bail-out. The Eurozone was not, at its inception, intended to be a fiscal union,
and no provisions had been made for the case when a Eurozone member was threatened
with bankruptcy. Although no formal responsibility to act as LOLR existed, there was
little choice but for the other members of the Eurozone to bail out their embattled
brethren. The alternative, to let them default on their debts, was unthinkable. East Asia
had emphatically shown how quickly contagion could spread. German and other
European banks were heavily invested in the financial systems of the crisis countries.
Had Greece, Spain, or any other threatened country been thrown to the wolves, the
collapse of their banking sector would have followed, and may have taken the rest of the
currency area’s banks with it. The East Asian crisis had shown how easily a financial
crisis in globally integrated economies could turn into a currency crisis, and a run on the
world’s second-most traded currency, the euro, would have had severe consequences for
the still-fragile global economy.
As the banker and issuer of the common currency, the ECB was naturally positioned to be
lender of last resort in a crisis scenario, just as the Federal Reserve plays this role in the
United States. But in the event, they were unusually reluctant to step up. As the crisis
played out, the ECB introduced several limited bond-buying programs, but none was

sufficient to restore confidence. The bank only committed to buying unlimited amounts
of sovereign bonds—thereby fulfilling its role as LOLR—in September 2012, after the
crisis had been underway for three years (Moulds 2012).
The response to the euro crisis exhibited many of the same failures as did the IMF’s
response to the East Asian crisis. In both cases, misguided austerity and tight money
policies worsened investor confidence rather than restoring it, and prolonged the regions’
recoveries. The negative impact of austerity policies in Europe is by now well-known
(Blyth 2013, Economist 2013). And the ECB’s approach to monetary policy has been
criticized as well. The Bank’s main refinancing rate was 3.75% in 2008, lowered to 2%
by January 2009, and 1% by May 2009. But this represents a laggardly response: during
the same time, the Federal Reserve’s discount rate was held steady at 0.5%. The ECB
then compounded its mistakes by raising interest rates in 2010, only to lower them back
to 1% over the course of 2011. The ECB only lowered interest rates to 0.5% on May 8th
2013. By this point, the American discount rate had been 0.5% for over four years,
despite comparatively better economic performance in that country.
It is tempting to write this poor response off as a case of history repeating itself, but this
is not accurate, for two reasons. The Eurozone crisis differs from the East Asian crisis in
one important way: whereas the East Asian crisis was, as we have seen, caused by a self-
fulfilling panic among investors, the Eurozone crisis had structural roots.
We have seen that the IMF learnt, at least partially, from its own mistakes. But the
learning effects were not transmitted throughout the international financial system. The
ECB, a relatively new actor on the international financial stage, did not foresee the
possibility that it could be called upon to act as a LOLR within the Eurozone. At the
euro’s inception, the common currency’s advocates were so concerned with the potential
economic and political gains to be had by implementing the new currency that the
question of how to maintain the stability of the currency area was not taken into account.
Since the Maastricht treaty which established the euro was signed in 1992, well before
East Asia made the perils of systemic instability apparent to all, this helps to explain why
such concerns were not part of the discussion.
Yet they very much should have been. The disasters in Europe and East Asia were far
from unforeseeable. The Great Depression showed what happens when multiple
countries, closely linked by trade, suffer from coinciding shortfalls in aggregate demand:
their exports to each other fall, worsening the situation even further. Keynes’ great insight
was that countercyclical government policy, including stimulative spending during
recessions, was vital to a fast recovery. How both the economists at the IMF and the ECB
appeared to forget these lessons more than half a century later is puzzling. One can only
imagine that, focused as they were on neoclassical explanations for the banking crises,
they were too preoccupied with eliminating or preventing structural distortions to see the
broader picture of multiple demand-driven recessions.
This does not excuse the creators of the Eurozone for their failure to foresee the single
currency’s problems. The theory of an optimal currency area (OCA) had been developed
by Mundell in 1961, and was a major part of the economic argument for the common
currency. The extent to which the Eurozone functions as an OCA has been hotly debated,
and it is beyond the scope of this paper to assess the merits of the arguments on either
side. In any case, the debate will likely evolve considerably in the coming years as the

Eurozone crisis forces participants to reevaluate their positions. But the seeds for concern
can be seen in two of Mundell’s original criteria for an OCA: the presence of a fiscal
transfer mechanism, and similar business cycles among participating countries. Neither is
the case in the Eurozone.
No fiscal transfer mechanisms existed; indeed, the Stability and Growth Pact of 1998
(SGP), intended to ensure the financial stability of the Eurozone, explicitly ruled out
bailouts. Instead, it placed limits on countries' ability to borrow, and imposed surveillance
mechanisms to enforce this. This represents a naive view of financial crises: that they
cannot happen in countries with sound budgetary situations. The East Asian crisis,
ongoing as the SGP was negotiated, showed that this was false. In any case, the limits on
borrowing proved unenforceable: France and Germany both circumvented these
provisions, without consequence. And Greece was able to use creative accounting, with
the assistance of Goldman Sachs, to disguise the extent of its own budget deficit
(Helmore 2010).
The requirement that participating countries' business cycles should coincide is also
violated in the EU. As we have seen, member countries had substantially different
economic makeups, particularly in terms of their export compositions. This left them
vulnerable to asymmetric shocks. In the event, changes in the global economic
environment, such as the rise of China, provided Germany with new markets for its
exports at the same time as countries like Spain and Greece were confronted with fierce
new international competitors. The resulting buildup of internal imbalances eroded the
common currency's stability even before the global financial crisis had begun. Coinciding
business cycles are also important for effective monetary policy (and fiscal policy, but
this was not a factor in the EU). If one part of the currency area is facing inflationary
pressures while another is facing deflationary pressures, then the central bank will have a
difficult time setting interest rates: it will have the unenviable choice of fostering inflation
in one country at the expense of fighting deflation in another, or vice versa. This effect
may help to explain the ECB's reluctance to lower interest rates as the eurozone crisis
unfolded: doing so would have risked sparking inflation in Germany, whose economy
was still strong.
A true fiscal transfer mechanism would have been far more effective in forestalling
contagion from financial crises. Here, an analogy to the United States is appropriate,
since it is the only currency area in the world comparable to the EU in the size of its
population and economy. The economies of individual states do not necessarily rise and
fall together; the past decades have seen stagnation in some parts of the United States and
economic booms in others. Yet this has not threatened the dollar's stability. The reason is
that American states are linked together by automatic fiscal stabilizers, such as Medicare,
Medicaid, SNAP (food stamps), and many others. When one state is suffering
disproportionately to the others, these programmes redirect tax dollars from its richer
neighbours. The result is that a rising tide will more-or-less lift every states' boat, and
vice-versa. No comparable mechanism exists in Europe.
Therefore, structural flaws were in fact the ultimate cause of the Eurozone crisis, in
contrast to the East Asian case. This should not be surprising: if the crisis was
fundamentally confidence-driven, then the ECB's announcement of an unlimited bond-
buying programmed should, in principle, have been sufficient to restore the affected

countries to growth. The fact that it has failed to do this suggests that either the ECB has
exceptionally poor credibility in the eyes of investors, or that there are real economic
reasons for the economic problems experienced by the European periphery. The analysis
above, of the mechanism by which German policies led to overconsumption and
undersavings in peripheral countries, shows the nature of these structural problems and
how the institutional nature of the common currency area caused them to develop.
But the nature of these structural flaws has nonetheless been persistently misdiagnosed.
The crisis in Europe has been blamed on the profligate spending and irresponsibility of
the peripheral governments. Inappropriate economic policies in Spain and other
peripheral countries, the story goes, damaged their countries’ ability to compete on the
world market, while at the same time propping up consumer spending with debt
financing, which in turn led to the buildup of unsustainable debt levels. But this paper has
shown that this is only an incomplete account. There is certainly much room to criticize
the economic policies of the peripheral countries. But this is not ultimately responsible
for their competitiveness problems. Joining the Eurozone forced them to use an
effectively overvalued currency, which increased their effective wage rates at the expense
of their exporters. This required the peripheral countries to adopt unpalatable economic
policies. They could have chosen to restore competitiveness through internal devaluation,
requiring years of real wage cuts and high unemployment, but this would have been
politically almost impossible to justify during economic good times. Instead, they chose
to subsidize consumption through debt financing—but it must be emphasized that, as
poor a policy as this may appear to be, all the alternatives were equally poor (Pettis
2013:129-131).
As a further corollary to this analysis, policies in Germany (and other core countries)
were just as responsible for the imbalances as those of Spain. As shown earlier, Germany
pursued export-led growth by maintaining artificially high savings rates and artificially
low consumption. In the Eurozone context, these policies necessitated overconsumption
and under-savings in the periphery. The only way for peripheral countries to escape this
would be for them to force Germany to accept lower savings and higher consumption.
To summarize, the Eurozone crisis was caused by structural imbalances which built up
after the formation of the common currency area. These were the result of German
policies of underconsumption and oversavings, which forced peripheral countries to
accept undersaving and higher consumption. Differences in the compositions of Eurozone
member economies meant that some of them were using an effectively overvalued
currency, while others were using effectively undervalued currencies. This also meant
that they were exposed differently to changes in the international environment, which in
turn meant that their business cycles failed to align, causing further economic divergence
and imbalance. Large German trade surpluses forced peripheral countries to accept large
trade deficits, and a consequential problem of overinvestment. Suffering from
underconsumption and uncompetitiveness in international export markets, peripheral
countries could not possibly absorb this investment by investing in profitable domestic
industries. Instead, investment went into the real estate and equity sectors, where it
caused bubbles to form and household debt to reach unsustainable levels.
The failure of the response to the Eurozone crisis has two explanations. First, the lack of
an effective lender of last resort worsened investor confidence and made the response

slow and sluggish. Secondly, and more importantly, the misdiagnosis of the structural
causes of the crisis led, as it did in East Asia, to a counterproductive response
characterized by relatively higher interest rates and damaging austerity policies.
10. Conclusion
This paper has analyzed and compared two recent global financial crises in two aspects:
their causes and the reaction by the international community.
The East Asian crisis was shown to be driven by self-fulfilling panics among investors,
not by macroeconomic factors like excessive public debt buildup. While public debt
burdens did reach unsustainable levels during the crisis, this was at least partially due to
their assuming the liabilities of their troubled banking sectors. Debt (public or private)
was thus not considered to be the ultimate causal factor.
Both regions experienced a buildup of balance of payments imbalances prior to their
respective crises. In East Asia, this was the result of premature capital account
liberalization in accordance with Washington-consensus style policies, as were
commonly promoted by the IMF and the World Bank in the early 1990s (Stiglitz 2002).
The result was large inflows of speculative capital which the East Asian countries’
regulatory systems were ill-equipped to handle.
In Europe, the balance of payments issues arose from the formation of the Eurozone.
Although it was at the time thought that Europe could function as an optimal currency
area, asymmetric shocks and a lack of fiscal transfer mechanisms introduced instability to
the system. Here too, international capital flows played an important role: this time,
though, rather than global speculators being to blame, the problems arose internal to the
Eurozone. It was an issue of core banks lending excessively to peripheral banks, leading
to the buildup of substantial privately-held (but publicly guaranteed) debt. When the real
estate markets began to crash, this provided a mechanism for contagion to spread quickly
throughout the Eurozone.
In both cases, the buildup of private debt did indeed play a role, but imbalances in the
balance of payments existed prior to the excessive debt and provided the conditions for
debt to rise to unsustainable levels. These imbalances must be considered a more distal
cause than debt levels. It appears that the international financial institutions responsible
for managing the financial crises did not, in the event, appreciate this aspect. In both
cases, bailouts were made conditional on the adoption of fiscal austerity policies. This
approach, which contradicts the standard Keynesian prescription of stimulative deficit
spending in a recession, can only be understood as the result of a mis-specification of the
crises. The IFIs behaved as if they were dealing with a series of balance-sheet driven
recessions, when in fact debt was not the ultimate cause of the crises.
We have furthermore seen that, in each case, tight monetary policies were prescribed
with apparently harmful results. In East Asia, high interest rates were imposed out of a
misguided desire to buoy exchange rates. This too was the result of a mis-specification of
the problem: their financial and corporate sectors were too indebted for the strategy to
work. Fear of runaway inflation, a traditional plague of developing countries, also played
a role. In Europe, the ECB maintained interest rates at relatively high levels—but in a
currency area that includes both Germany and Greece, it is unclear whether any optimal

interest rate existed at all. Lower interest rates could potentially have sparked inflation in
Germany, which would have had a great deal of political fallout.
The discussion has highlighted the contradictions inherent in playing the role of lender of
last resort, whether on a domestic or international scale. A LOLR cannot afford to make
its guarantee of private debt explicit and clearly delineated—doing so would incentivize
guaranteed institutions to make riskier investments, distorting financial markets and
causing the buildup of instability. In practice, however, governments cannot credibly
threaten to allow large domestic banks to go bankrupt. Some degree of a bail-out is
inevitable. The extent to which this was a factor behind the housing and equity bubbles in
East Asia and Europe is debatable.
International LOLRs face an even trickier problem. While in domestic crises, the central
government is clearly best positioned to play the role of LOLR, in international crises the
distribution of responsibilities is not as clear. In the case of East Asia the IMF stepped in
to play LOLR; in Europe, after a seemingly interminable period of muddling and half-
steps, the ECB grudgingly agreed to fill the same role. But these IFIs are not
governments, and cannot infringe willy-nilly on sovereign countries’ control over their
financial sectors. This leads to an even more intractable moral hazard problem:
international LOLRs are in the unenviable position of being effectively forced to bail out
crisis-stricken countries to avoid contagion, but have few ways to influence those
countries’ domestic policies to forestall the build-up of instability. This creates a perverse
incentive for countries to pursue risky, unsustainable, growth strategies. However, the
extent to which expectations of a bail-out influenced the actions of investors and
governments prior to the Eurozone crisis is difficult to assess. A trickier question is, now
that it has been made more-or-less explicit that the ECB will not allow a Eurozone
country to default on its debts, will this make the task of managing systemic risk in the
area even more difficult?
The patterns observed in these two crises are not new ones. In fact, the sort of
international capital account imbalances described here were important factors in many
international financial crises throughout the 20th century (Pettis 2013; Reinhardt and
Rogoff 2009). The integration of the world’s financial systems has been ongoing for
centuries, and while this has been responsible for great improvements in economic
efficiency, it has also threatened global systemic stability in ways that we still do not fully
understand. Karl Marx argued that capitalism is a fundamentally contradictory,
paradoxical system of social organization, and he believed that because of this, capitalist
society would always be characterized by repeated, severe, financial crises. It seems that,
in this respect if no other, history has vindicated him.

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