Prospective Deficits and the Asian Currency Crisis
This paper argues that the recent Asian currency crisis was caused by large prospective de…cits associated with implicit bailout guarantees to failing banking systems. We 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 de…cits rises. This is true regardless of the government’s foreign reserve position or the initial level of its debt. While the government cannot prevent a speculative attack, it can a¤ect its timing. The longer the delay, the higher in‡ation will be under ‡exible exchange rates. We present empirical evidence in support of the three key assumptions in our model: (i) foreign reserves did not play a special role in the timing of the attack, (ii) large losses in the banking sector were associated with large increases in governments’ prospective de…cits, and (iii) the public knew that banks were in trouble before the currency crises.