NBER WORKING PAPER SERIES FROM SUDDEN STOPS TO FISHERIAN DEFLATION: QUANTITATIVE THEORY AND POLICY IMPLICATIONS Anton Korinek Enrique G. Mendoza Working Paper 19362 http://www.nber.org/papers/w19362 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 August 2013 We would like to acknowledge An Wang for his superb research assistance. Korinek thanks Olivier Jeanne for his coauthorship and inspiration on a number of projects on which we draw in this survey. He also acknowledges financial support from INET/CIGI. Mendoza would like to thank Javier Bianchi, Emine Boz, Bora Durdu, Katherine Smith, Marco Terrones, and specially Guillermo Calvo for the opportunity to collaborate with them on several papers on the Sudden Stops phenomenon that served as background material for this article. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. Data for our event analysis of sudden stops, Matlab source codes and supplementary materials are available at http://www.korinek.com/suddenstops NBER working papers are circulated for discussion and comment purposes. They have not been peer- reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2013 by Anton Korinek and Enrique G. Mendoza. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. From Sudden Stops to Fisherian Deflation: Quantitative Theory and Policy Implications Anton Korinek and Enrique G. Mendoza NBER Working Paper No. 19362 August 2013 JEL No. E44,F34,F41 ABSTRACT The 1990s Sudden Stops in emerging markets were a harbinger for the 2008 global financial crisis. During Sudden Stops, countries lost access to credit, causing abrupt current account reversals, and suffered Great Recessions. This paper reviews a class of models that yields quantitative predictions consistent with these observations, based on an occasionally binding credit constraint that limits debt to a fraction of the market value of incomes or assets used as collateral. Sudden Stops are infrequent events nested within regular business cycles, and occur in response to standard shocks after periods of expansion increase leverage ratios sufficiently. When this happens, the Fisherian debt-deflation mechanism is set in motion, as lower asset or goods prices tighten further the constraint causing further deflation. This framework also embodies a pecuniary externality with important implications for macro- prudential policy, because agents do not internalize how current borrowing decisions affect collateral values during future financial crises. Anton Korinek Department of Economics Johns Hopkins University 440 Mergenthaler Hall 3400 N. Charles Street Baltimore, MD 21218 and NBER [email protected] Enrique G. Mendoza Department of Economics University of Pennsylvania 3718 Locust Walk Philadelphia, PA 19104 and NBER [email protected] From Sudden Stops to Fisherian Deflation Quantitative Theory and Policy Implications Anton Korineky Enrique G. Mendozaz August 2013 Abstract The 1990s Sudden Stops in emerging markets were a harbinger for the 2008 global financial crisis. During Sudden Stops, countries lost access to credit, causing abrupt current account reversals, and suffered Great Recessions. This paper reviews a class of models that yields quantitative predictions consistent with these observations, based on an occasionally binding credit constraint that limits debt to a fraction of the market value of incomes or assets used as collateral. Sudden Stops are infrequent events nested within regular business cycles, and occur in response to standard shocks after periods of expansion increase leverage ratios suffi ciently. When this happens, the Fisherian debt-deflation mechanism is set in motion, as lower asset or goods prices tighten further the constraint causing further deflation. This framework also embodies a pecuniary externality with important implications for macro-prudential policy, because agents do not internalize how current borrowing decisions affect collateral values during future financial crises. JEL Classification: F34, F41, E44 Keywords: sudden stops, financial crises, balance sheet effects, pecuniary externali- ties, macroprudential regulation 1 Introduction From the surface, the debacle of the Mexican economy that began in Decem- ber 20th of 1994 seemed a familiar event. Episodes of failed stabilization plans We would like to acknowledge An Wang for his superb research assistance. Korinek thanks Olivier Jeanne for his coauthorship and inspiration on a number of projects on which we draw in this survey. He also acknowledges financial support from INET/CIGI. Mendoza would like to thank Javier Bianchi, Emine Boz, Bora Durdu, Katherine Smith, Marco Terrones, and specially Guillermo Calvo for the opportunity to collaborate with them on several papers on the Sudden Stops phenomenon that served as background material for this article. Data for our event analysis of sudden stops, Matlab source codes and supplementary materials are available at http://www.korinek.com/suddenstops yDepartment of Economics, Johns Hopkins University, Baltimore, Maryland 21218 and NBER, Cambridge, Massachusetts 02138; email: [email protected] zDepartment of Economics, University of Pennsylvania, Philadelphia, Pennsylvania 19104 and NBER, Cambridge, Massachusetts 02138; email: [email protected] anchored on managed exchange rate regimes abound in the annals of the de- veloping world, and in Mexico in particular this was a recurrent event that had coincided with every presidential election since 1976. Yet, the 1994 Mexican crash was different. It was the beginning of a new era of financial instability in the newly-created global financial system. It was the first of a collection of similar events that swept through emerging markets wordlwide during the 1990s and that we now refer to as Sudden Stops.1 The defining characteristic of a Suddent Stop is a sharp reversal in external capital inflows, which is often measured by a sudden jump in the current account. At about the same time as the access to foreign financing is lost, or shortly after, the economies a­ icted by Sudden Stops experience deep recessions, in many countries the largest since the Great Depression, sharp real depreciations and collapses in asset prices.2 Moreover, Sudden Stops typically come in clusters: The 1994 Mexican Crash triggered a Sudden Stop in Argentina in 1995 —this spillover effect is often referred to as the Tequila Effect. In 1997-98, the East Asian crisis engulfed Korea, Malaysia, Indonesia, Thailand, Singapore, Hong Kong and the Philippines, and before the 1990s were over there were Sudden Stops in emerging economies across the world in Bulgaria, Chile, Colombia, Ukraine, Ecuador, Morocco, Venezuela, Russia and Turkey.3 Academic research on Sudden Stops surged starting in the second half of the 1990s and led to many valuable contributions that aimed to connect the dots between the financial instability at the root of Sudden Stops and their disas- trous macroeconomic consequences. Many of these contributions are collected in prestigious conference volumes and reviewed in related surveys.4 They were also published in leading academic journals.5 The central focus of research on Sudden Stops was precisely on the intersection of macroeconomics and finance, and especially on the connection between financial instability and macroeco- nomic collapse. This was at a time when much of modern macroeconomics was not paying attention to financial frictions and their potentially catastrophic consequences for the real economy. Moreover, many of the developments in theoretical analysis and quantitative tools produced by this literature are now 1 The term “Sudden Stop”was first used in this context in a paper by Dornbusch, Goldfajn and Valdés (1995), inspired by an old bankers’adage. 2 Interestingly, nominal devaluations are not a necessary condition for Sudden Stops. In Argentina in 1995 and Hong Kong in 1998, the nominal exchange rate remained constant, yet the real exchange rate collapsed and deep recessions followed. 3 Moreover, the 1998 Russian crash was followed by a sudden “flight to quality”in global capital markets, which caused the infamous collapse of hedge fund Long Term Capital Man- agement. Conditions in capital markets in the United States worsened to the point that the Federal Reserve was forced into lowering interest rates to ease access to liquidity and brokering an arrangement for the orderly winding down of LTCM amongst its creditors. 4 See for example the symposia issues of the Journal of International Economics (1996, 2000 and 2006), the Journal of Money, Credit and Banking (2001), and the Journal of Economic Theory (2004), as well as the NBER conference volumes edited by Krugman (2000), Edwards and Frankel (2002), and Dooley and Frankel (2003). 5 See e.g. Calvo and Mendoza (1996, 2000), Cole and Kehoe (2000), Caballero and Kr- ishnamurty (2001, 2003, 2004), Chang and Velasco (2001), Kaminsky and Reinhart (1999), Martin and Rey (2006), Mendoza (2010). 2 Declining Relative Prices Falling Individual Spending Tightening Constraint Figure 1: Financial amplification effects serving as a key building block in the growing literature on the 2008 financial crash and the reinassance of the macro/finance field (see e.g. the handbook article by Gertler and Kiyotaki 2010). In this paper,