Are Currency Crises Self-Fulfilling?

Recent theoretical analyses of currency crises have argued that, when a government's decision to defend its exchange rate depends on the government's broader macroeconomic objectives, then an exchange-rate crisis can be triggered by self-fulfilling expectations of traders. Some authors have been willing to draw strong policy implications from this result, in particular that fixed exchange rates cannot coexist with free capital mobility. This paper shows that the recent literature's result that expectations of crisis can be self-fulfilling is due less to the new assumption of endogeneity of government policy than to the dropping of the classical assumption that fundamentals are deteriorating. When objective economic conditions are steadily deteriorating, these fundamentals can be shown to determine uniquely the timing of a currency crisis, even if policy is endogenous and even if people are uncertain about the government's objective function. If fundamentals evolve randomly and are not certain to deteriorate, then self-fulfilling expectations can play a role, though even here this role may be tempered by the presence of well-financed speculators. The paper also argues that, as an empirical matter, the actual currency experience of the 1990s does not make as strong a case for self-fulfilling crises as has been claimed by some researchers. In general, it is very difficult to distinguish between currency crises that need not have happened and those that were made inevitable by concerns about future viability that seemed reasonable at the time.