Abstract:
This paper argues that the recen Southeast Asian currency crisis was caused by large prospective deficits 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 speculativ attack is inevitable once the present value of future government deficits rises. This is true regardless of the government's foreigh reserve position or the initial level of its debt. While the government cannot prevent a speculative attack, it can affect its timing. The longer the delay, the higher inflation will be under flexible 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 sectoer were associated with large increases in government's prospective deficits, and (iii) the public knew that banks were in trouble before the currency crisis.
