THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 249

CHAPTER 9

Financial Crises and the Subprime Meltdown

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rise in value in terms of pesos, while the debt does. The depreciation of the
domestic currency increases the value of debt relative to assets, and the firm s net
worth declines. The decline in net worth then increases adverse selection and
moral hazard problems. A decline in investment and economic activity then follows (as shown by the Stage Three section of Figure 9-3).
We now see how the institutional structure of debt markets in emergingmarket countries interacts with the currency devaluations to propel the economies
into full-fledged financial crises. Economists often call a concurrent currency and
financial crisis the twin crises.
The collapse of a currency also can lead to higher inflation. The central banks
in most emerging-market countries have little credibility as inflation fighters. Thus,
a sharp depreciation of the currency after a currency crisis leads to immediate
upward pressure on import prices. A dramatic rise in both actual and expected
inflation will likely follow. The resulting increase in interest payments causes
reductions in firms cash flows, which lead to increased asymmetric information
problems since firms are now more dependent on external funds to finance their
investment. As the asymmetric information analysis suggests, the resulting increase
in adverse selection and moral hazard problems leads to a reduction in investment
and economic activity.
As shown in Figure 9-3, further deterioration in the economy occurs. The collapse in economic activity and the deterioration of cash flow and balance sheets
of firms and households means that many are no longer able to pay off their debts,
resulting in substantial losses for banks. Sharp rises in interest rates also have a negative effect on banks profitability and balance sheets. Even more problematic for
the banks is the sharp increase in the value of their foreign-currency-denominated
liabilities after a devaluation. Thus, bank balance sheets are squeezed from both
sides the value of their assets falls as the value of their liabilities rises.
Under these circumstances, the banking system will often suffer a banking crisis in which many banks are likely to fail (as happened in the United States during the Great Depression). The banking crisis and the contributing factors in the
credit markets explain a further worsening of adverse selection and moral hazard

problems and a further collapse of lending and economic activity in the aftermath
of the crisis.

A PP LI CATI O N

Financial Crises in Mexico, 1994 1995; East Asia,
1997 1998; and Argentina, 2001 2002
When emerging-market countries opened up their markets to the outside world in
the 1990s, they had high hopes that globalization would stimulate economic
growth and eventually make them rich. Instead of leading to high economic
growth and reduced poverty, however, many of them experienced financial crises
that were every bit as devastating as the Great Depression was in the United States
and other countries.
The most dramatic of these crises were the Mexican crisis, which started in
1994; the East Asian crisis, which started in July 1997; and the Argentine crisis,
which started in 2001. We now apply the asymmetric information analysis of the
dynamics of financial crises to explain why a developing country can shift dramatically from a path of high growth before a financial crisis as was true in