What If Ireland Defaults? (7 page)

Destabilising Market Processes

The collapse of the exchange rate may restore the market equilibrium (by increasing exports and reducing imports), but it may sometimes have the opposite effect on the economy. If domestic firms have foreign currency denominated debt, the change in exchange rates has large real balance effects (Greenwald and Stiglitz, 1993a), which leads to large changes in behaviour – production, investment, inventory holdings, etc. – and can precipitate an economic downturn. It affects the ability to repay loans, and that in turn affects banks' ability to lend. Limited access to credit and weak balance sheets impede the normal foreign exchange adjustment mechanism. A decline in the exchange rate can weaken aggregate demand and exacerbate the downturn.
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This is but one example of how economic processes that in simplistic models help the economy equilibrate may, in more realistic models, have just the opposite effect. In a recession, wage and price declines weaken aggregate demand, exacerbating the gap between supply and demand and the economic downturn.
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Trend Reinforcement and ‘Orbits of Attraction'

Battiston, Delli Gatti, Greenwald and Stiglitz (2007) describe a variety of other destabilising circumstances where there is a process of
trend reinforcement
, that is, a negative shock is followed by consequences that worsen the firm's (or the economy's) future prospects. Consider the evolution of a firm's net worth as a stochastic process. A negative shock increases the likelihood that the firm will go bankrupt (reach the zero boundary at an earlier date), but that means that lenders will demand higher interest rates, increasing the pace at which a firm with negative drift moves downward.

There can exist a range of state variables (here, net worth) such that in one set of conditions the firm (economy) converges to bankruptcy (crisis), while in another it does not. Shocks can move the economy from one ‘orbit of attraction' to another.

How Crises Spread

We have provided a brief and by no means exhaustive overview of finance and macroeconomics research into the causes of financial crises. As Stiglitz (2010b) notes, the mechanisms behind shock amplification can help explain not only the onset of crises but also the spread of crises across countries. As countries remove restrictions on international capital flows, crises that arise when small shocks snowball due to market frictions increasingly involve multiple economies. In today's global financial and banking marketplace, the issue of propagation of shocks and crises across countries is arguably of predominant importance. Therefore, we next turn to the role of contagion
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and other factors contributing to the spread of financial crises.

It should be obvious that substantial trade or capital linkages can contribute to the spread of crises. But that does not mean that the linkages exacerbate crises. They may dampen the crisis in one country, while at the same time bringing about a downturn in another. Had the US not exported so many of its securitised mortgages leading up to the recent crisis, arguably the US crisis would have been worse. In standard models, however, the global aggregative effect is reduced through interdependence. The worry, however, is that financial interdependence leads to the opposite effect, in a process which is called contagion, by analogy to the spread of disease, where interaction amplifies the overall incidence of the disease.

Of course, even if diversification leads to better overall global economic performance, countries may worry about their own exposure to risks. The last section explained how, as a result of financial constraints, economic systems may amplify shocks; and the costs of offsetting and managing risks may be significant, and not worth the benefits of increased integration. Stiglitz (2006) has, for instance, discussed the high costs associated with reserves that countries maintain to enable them to better manage the shocks that they face.

Financial linkages can take on several forms:

• A reduction in foreign direct investment, as a result of either financial constraints in the investing country or in the markets for which the goods to be produced are destined
  
• A decrease in financial inflows, not adequately offset by actions of domestic monetary authorities, that leads to financial constraints and/or higher cost of capital
  
• A reversal of financial flows – from inflows to outflows – which typically is associated with large changes in exchange rates
  

While these changes in exchange rates would, in the standard trade models, enhance aggregate demand through an increase in net exports, balance sheet effects (especially important when debt is denominated in foreign currencies) often dominate. Moreover, the changes in financial flows can be motivated either by changes in information or beliefs (investors suddenly realise that the risk of investing in foreign countries is greater than they had previously believed), by changes in financial constraints or by real shocks amplified through financial constraints. The financial constraints can arise from regulation or institutional/informational imperfections. Finally, investor actions can bring about a correlated onset of crises, if investors update their views about the likelihood of a crisis based on witnessing a crisis in another market or if investors (including banks) have exposure to several different markets through their portfolios.

One example of what is sometimes called ‘pure contagion' involves investors fleeing a country after observing a crisis in another economy that has no trade or capital ties to the original economy. The idea that investors can infer an economy's prospects from crises in other economies is central to the information contagion view (Chen, 1999; King and Wadhwani, 1990; etc.) Intuitively, falling asset prices in one market can convey information about the value of securities in other markets if the two markets share some common risks.
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Imperfectly informed investors learn about the odds of a crisis in their economy by observing crisis episodes overseas.

The caveat about investor rationality applies here as well. The explanations above focused on rational investors. Often at least some degree of irrationality is involved in investor panics. If investors overreact to news or make other mistakes when drawing inference from other crises, contagion can spread faster as a result of investor irrationality. Even if investors do not perceive a dramatic shift in risk, an expectation that other investors will update their beliefs about risk may be sufficient to spur a sell-off.

The channels through which pure contagion exerts its effects are all of those described in the previous section, including the impact of prices (especially through fire sales) on borrowing constraints and real balances.

Several studies focus on the role of direct financial linkages in shock diffusion. Financial linkages can take the form of risk-sharing arrangements or balance sheet exposure to distressed countries or financial institutions. In a series of papers, Battiston et al. (2007), Gallegati, Greenwald, Richiardi and Stiglitz (2008), and Stiglitz (2010b, 2010c) ask when will it be the case that such risk-sharing arrangements exacerbate rather than reduce systemic risk. Gallegati et al. (2008) model diffusion of shocks among interlinked financial institutions. (Linkages can be, for example, viewed as loans extended to other banks.) Interbank loans allow individual banks to diversify away idiosyncratic shocks to their loan portfolios, reducing the likelihood of failures. However, when economic tides turn, bank failures are more likely to be systemic in nature if banks are interconnected. Moreover, bank managers who have incentive conflicts or who do not fully internalise the spill-overs of bank failures tend to establish too many interbank links.

Several other papers explain how the interconnectedness of bank balance sheets can facilitate the spread of shocks affecting an individual bank to other financial institutions. Allen and Gale (2000) provide a model of balance sheet contagion in the banking sector. Contagion occurs due to overlapping claims between different banks. Liquidity shocks to one bank lead to losses at other banks in the economy because their claims on the troubled bank decline in value. This channel can augment the effects of relatively small shocks and lead to contagion and financial fragility in the banking system. Wagner (2010) similarly concludes that banks motivated by the diversification of idiosyncratic risk can contribute to systemic risk. Haldane (2009) shows that these interlinkages may reduce the risk of failure when there are small or uncorrelated shocks, but increase the risk of failure when there are large and correlated shocks.

The analysis of the consequences of financial linkages across countries is, in many ways, parallel to that of interlinkages among banks (or banks and firms) within a country (Greenwald and Stiglitz, 2003; Stiglitz, 2010c). In the international finance setting, capital flows between countries can serve as a similar risk-sharing mechanism (Stiglitz, 2010b). Capital market integration allows individual countries to smooth country-specific shocks to output. Assuming a high level of country-specific risk and a cost of such variability to consumers, risk sharing through international capital flows is beneficial. On the flipside, a major adverse event that affects a single economy has the potential to cause a systemic failure in all economies interlinked through capital markets.

The underlying intuition behind these seemingly perverse results is that in the presence of non-convexities risk sharing may lower expected returns. Non-convexities are pervasive – they arise whenever there are information constraints, bankruptcy costs or learning processes.
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The process of trend reinforcement described earlier implicitly entails a non-convexity. In that model, with a negative drift to the stochastic process when equity falls below a critical level, increases in risk increase the chance that the firm escapes the death trap.

Cross-border financial flows may exacerbate financial constraints, and therefore increase the magnitude of the global consequences of shocks and imply that much of the burden of a shock to a given country is experienced by countries with which it is financially integrated. For instance, creditors may impose more stringent collateral requirements on foreign borrowers because of the greater information asymmetries. In Caballero and Krishnamurthy (2001) contractual distortions in the treatment of domestic and international collateral can induce fire sales (presumably that are worse than those that would have arisen if cross-border lending was limited), resulting in liquidation of assets at a significant discount in the event of a shock. In a related vein, in Mendoza (2010) information costs, high leverage and borrowing constraints combine to cause fire sales. Traders facing high debt levels and borrowing constraints can be forced into fire sales of assets to less informed foreign buyers, even though the shock is only temporary. Such fire sales can precipitate rapid shutdowns of external capital markets (i.e. countries facing these fire sales lose access to foreign funds) and large consumption contractions.
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Stiglitz (2002) described how these effects served to deepen the East Asia crisis of 1997–1998.

The spread of crises to economies that have the same creditors or investors (such as global banks or hedge funds) as the economy in crisis constitutes another channel for the transmission of shocks. Creditors or investors that suffered losses in a crisis in one economy are likely to modify their lending or investment strategy with respect to seemingly unrelated economies. When banks face loan defaults, they are likely to scale back lending to all borrowers, even those unaffected by the initial adverse event, due to capital requirements or balance sheet effects. The worse the effect of defaults on the bank's financial health and ability to raise equity, the more pronounced the cutbacks in lending to other borrowers. Because of information asymmetries, lending cuts may be disproportionately large for foreign borrowers. Chava and Purnanandam (2011) find empirical support for the role of lender portfolios in the transmission of shocks to previously unaffected firms in a study of borrowers dependent on bank debt around the 1998 Russian financial crisis. Rashid (2011) similarly finds that foreign banks play an important role in the transmission of shocks across borders.

Similarly, investors who lose money in one market might liquidate their positions in other economies (to cover losses or meet margin requirements). Shocks, therefore, can be transmitted as a result of portfolio rebalancing by investors with stakes in multiple markets (Kodres and Pritsker, 2002). Investors are expected to respond to shocks that affect a given market by modifying portfolio exposures to shared macroeconomic risk factors. Such cross-market linkages are likely to spread shocks faster during bad times and in the presence of high levels of foreign debt, as was the case for emerging economies in the Asian financial crisis. But even if there are no shared macroeconomic risks, globally diversified investor portfolios can also speed propagation of individual country shocks to other economies through investor wealth effects (Kyle and Xiong, 2001; Goldstein and Pauzner, 2004). A crisis in one country leads to a reduction in the wealth of those invested in that country. The decline in wealth causes investors to rebalance portfolios, and possibly even to act in a more risk-averse manner, so they scale back holdings of risky assets in other countries, even when those other countries share no ties or risk factors with the original economy in crisis.

Finally, crises can be transmitted via the real sector, for example, through trade ties and competitive (terms-of-trade) effects. Shocks affecting developed countries eventually affect developed countries' trade partners. The recent US economic downturn resulted in a slowdown in gross domestic product growth and a reduction in import demand, adversely affecting many developing economies that traditionally exported to the US (Stiglitz, 2010b). Adverse exchange rate effects would, in the standard model, be viewed as purely redistributive – one country gains what the other country loses – but with financial constraints, as we have noted, the aggregative effect may still be negative (see also Paasche, 2001.)