Financial Crisis: A Hardy Perennial

The years since the early 1970s are unprecedented in terms of the volatil-
ity in the prices of commodities, currencies, real estate and stocks, and
the frequency and severity of financial crises. In the second half of the
1980s, Japan experienced a massive bubble in its real estate and in its
stock markets. During the same period the prices of real estate and of
stocks in Finland, Norway, and Sweden increased even more rapidly than
in Japan. In the early 1990s, there was a surge in real estate prices and
stock prices in Thailand, Malaysia, Indonesia, and most of the nearby
Asian countries; in 1993, stock prices increased by about 100 percent
in each of these countries. In the second half of the 1990s, the United
States experienced a bubble in the stock market; there was a mania in
the prices of the stocks of firms in the new industries like information
technology and the dot.coms.

Bubbles always implode; by definition a bubble involves a non-

sustainable pattern of price changes or cash flows. The implosion of

the asset price bubble in Japan led to the massive failure of a large num-

ber of banks and other types of financial firms and more than a decade

of sluggish economic growth. The implosion of the asset price bubble

in Thailand triggered the contagion effect and led to sharp declines in

stock prices throughout the region. The exception to this pattern is that

the implosion of the bubble in U.S. stock prices in 2000 led to declines

in stock prices for the next several years but the ensuing recession in

2001 was brief and shallow.

The changes in the foreign exchange values of national currencies

during this period were often extremely large. At the beginning of the

1970s, the dominant market view was that the foreign exchange value of

the U.S. dollar might decline by 10 to 12 percent to compensate for the

higher inflation rate in the United States than in Germany and in Japan

in the previous few years. In 1971 the United States abandoned the U.S.

gold parity of $35 an ounce that had been established in 1934; in the

next several years there were two modest increases in the U.S. gold parity

although the U.S. Treasury would no longer buy and sell gold. The effort

to retain a modified version of the Bretton Woods system of pegged

exchange rates that was formalized in the Smithsonian Agreement of

1972 failed and there was a move to floating exchange rates early in

1973; in the 1970s the U.S. dollar lost more than half of its value relative

to the German mark and the Japanese yen. The U.S. dollar appreciated

significantly in the first half of the 1980s, although not to the levels of

the early 1970s. A massive foreign exchange crisis involved the Mexican

peso, the Brazilian cruzeiro, the Argentinean peso, and the currencies of

many of the other developing countries in the early 1980s. The Finnish

markka, the Swedish krona, the British pound, the Italian lira, and the

Spanish peseta were devalued in the last six months of 1992; most of

these currencies depreciated by 30 percent relative to the German mark.

The Mexican peso lost more than half of its value in terms of the U.S.

dollar during the presidential transition in Mexico at the end of 1994

and the beginning of 1995. Most of the Asian currencies—the Thai baht,

the Malaysian ringgit, the Indonesian rupiah, and the South Korean

won—depreciated sharply in the foreign exchange market during the

Asian Financial Crisis in the summer and autumn of 1997.

The changes in the market exchange rates for these individual cur-

rencies were almost always much larger than those that would have

been inferred from the differences between national inflation rates in

particular countries. The scope of ‘overshooting’ and ‘undershooting’ of

national currencies was both more extensive and much larger than in

any previous period.