Burnside, Eichenbaum, and Rebelo argue that the recent Asian currency crisis was caused by large prospective fiscal deficits associated with implicit bailout guarantees to failing banking systems.
They articulate this view using a simple dynamic general equilibrium model, whose key feature is that a speculative attack is inevitable once the present value of future government deficits rises.
This is true regardless of the government's foreign reserves position or the initial level of its debt.
The government cannot prevent a speculative attack but it can affect its timing. The longer the delay, the higher inflation will be under flexible exchange rates.
The authors present empirical evidence in support of the two key assumptions of their model:
This paper - a product of Macroeconomics and Growth, Development Research Group - is part of a larger effort in the group to study the causes and effects of currency crises. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Emily Khine, room MC3-347, telephone 202-473-7471, fax 202-522-3518, Internet address kkhine@worldbank.org. The authors may be contacted at aburnside@worldbank.org, eich@nwu.edu, or s-rebelo@nwu.edu. (51 pages)
The full report is available in PDF format.