THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 250

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PA R T I I I

Financial Institutions

Mexico and particularly the East Asian countries of Thailand, Malaysia, Indonesia,
the Philippines, and South Korea to a sharp decline in economic activity.2
Before their crises, Mexico and the East Asian countries had achieved sound
fiscal policies. The East Asian countries ran budget surpluses and Mexico ran a
budget deficit of less than 1% of GDP, a number that most advanced countries
would be thrilled to have today. The key precipitating factor driving these crises
was the deterioration in banks balance sheets because of increasing loan losses.
When financial markets in these countries were liberalized and opened to foreign
capital markets in the early 1990s, lending booms ensued. Bank credit to the private nonfinancial business sector accelerated sharply, with lending expanding at
15% to 30% per year. Because of weak supervision by bank regulators, aided and
abetted by powerful business interests (see the Global box, The Perversion of the
Financial Liberalization/Globalization Process: Chaebols and the South Korean
Crisis) and a lack of expertise in screening and monitoring borrowers at banking
institutions, losses on loans began to mount, causing an erosion of banks net
worth (capital). As a result of this erosion, banks had fewer resources to lend. This
lack of lending led to a contraction of economic activity, as outlined in the previous section.
In contrast to Mexico and the East Asian countries, Argentina had a wellsupervised banking system, and a lending boom did not occur before the crisis.
The banks were in surprisingly good shape before the crisis, even though a severe
recession had begun in 1998. This recession led to declining tax revenues and a
widening gap between government expenditures and taxes. The subsequent
severe fiscal imbalances were so large that the government had trouble getting
both domestic residents and foreigners to buy enough of its bonds, so it coerced
banks into absorbing large amounts of government debt. Investors soon lost confidence in the ability of the Argentine government to repay this debt. The price of
the debt plummeted, leaving big holes in banks balance sheets. This weakening
led to a decline in lending and a contraction of economic activity, as in Mexico

and East Asia.
Consistent with the Canadian experience in the nineteenth and early twentieth
centuries, another precipitating factor in the Mexican and Argentine (but not East
Asian) financial crises was a rise in interest rates abroad. Before the Mexican crisis in February 1994, and before the Argentine crisis in mid-1999, the Federal
Reserve in the United States began a cycle of raising the federal funds rate to head
off inflationary pressures. Although the Fed s monetary policy actions were successful in keeping U.S. inflation in check, they put upward pressure on interest
rates in both Mexico and Argentina. The rise in interest rates in Mexico and
Argentina added to the already increased adverse selection and moral hazard
problems in their financial markets. As discussed earlier, it was more likely that the
parties willing to take on the most risk would seek loans, and the higher interest
payments led to a decline in firms cash flows.

2

This application does not examine the four recent crises in Russia, Brazil, Ecuador, and Turkey. Russia s
financial crisis in August 1998 can also be explained with the asymmetric information story here, but it
is more appropriate to view it as a symptom of a wider breakdown in the economy. The Brazilian crisis in January 1999 has features of a more traditional balance-of-payments crisis (see Chapter 20) rather
than a financial crisis. Ecuador s crisis of 1999 and the Turkish crisis of 2001 have features of both types
of emerging-market financial crises discussed in the Application, with mismanagement of financial liberalization and globalization and severe fiscal imbalances playing a prominent role.