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BahtulismWho poisoned Asia's currency markets?

By Paul Krugman
Posted Friday, Aug. 15, 1997, at 3:30 AM ET

I often run into people who assert confidently that massive speculative attacks on currencies like the ones on the British pound in 1992, the Mexican peso in 1994-1995, and the Thai baht in 1997, prove that we are in a new world in which computerized trading, satellite hookups, and all that mean that old economic rules, and conventional economic theory, no longer apply. (One physicist insisted that the economy has "gone nonlinear," and is now governed by chaos theory.) But the truth is that currency crises are old hat. The travails of the French franc in the '20s were thoroughly modern, and the speculative attacks that brought down the Bretton Woods system of exchange rates in the early '70s were almost as big, compared with the size of the economies involved, as the biggest recent blowouts. Currency crises have been a favorite topic of international financial economists ever since the 1970s. In fact, they are among my favorite topics--after all, I helped found the field.

The standard economic model of currency crises had its genesis in a brilliant mid-'70s analysis of the gold market by Dale Henderson and Steve Salant, two economists at the Federal Reserve. They showed that abrupt speculative attacks, which would almost instantly wipe out the government's stockpile, were a natural consequence of typical price-stabilization schemes. In 1977 I was an intern at the Fed, and realized that Henderson and Salant's story could, with some reinterpretation, be applied to currency crises that suddenly wipe out the government's foreign exchange reserves. A bit later Robert Flood, now at the International Monetary Fund, and Peter Garber, of Brown, produced the canonical version of that conventional story.

The key lesson from that conventional model is that abrupt runs on a currency, which move billions of dollars in a very short time, are not necessarily the result of either irrational investor stampedes or evil financial manipulation. On the contrary, they are the normal result when rational investors contemplate the implications of unsustainable policies.

Some economists, however--notably Berkeley's Maurice Obstfeld and Barry Eichengreen--argue that the standard model is too mechanical in its representation of government policy, and that the more complex motives of actual governments make speculation a more uncertain and perhaps more pernicious affair. Self-fulfilling crises, in which a currency that could have survived is nonetheless brought down, are a hot topic these days. But everyone agrees that a sufficiently credible currency will never be attacked, and a sufficiently incredible one will always come under fire.

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Paul Krugman is a professor of economics at MIT whose books include The Age of Diminished Expectations and Peddling Prosperity. His home page contains links to many of his other articles and essays.
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