A simple public choice model of currency crises

by on December 29, 2005 at 6:38 am in Economics | Permalink

Assume two classes of asset holders.  The first is liquidity-constrained and does not have rational expectations.  These people extrapolate from present conditions and do not understand intertemporal governmental budget constraints.  Most of their assets are held in a local currency, shall we call it the Argentine peso?  Even if they had more foresight, they cannot afford to set up foreign bank accounts.

The second class of people is wealthier.  They convert all savings into dollar-based accounts, held in Miami, as quickly as possible. 

When the fiscal position of the government deteriorates and a currency collapse comes, both the nominal and real value of the domestic currency will fall.  In Argentina the peso went from 1 to 1 — the former pegged rate — to 3 to 1, the current floating rate.  Prices are a bit higher, but the latter class of investor is much wealthier today.  At home, their overseas dollar holdings are worth more than twice as much as before.  They have greater purchasing power over the local economy, especially over non-tradeables.

The country as a whole is poorer, if only because the currency collapse disrupts  economic activity.  The first class of asset holders is much poorer and many are wiped out altogether.  Non-tradeables are oriented ever more toward wealthy, sophisticated demanders.  Culture will boom, non-shippable foods will improve in quality, and perhaps the women will become more beautiful.  Relatively wealthy vacationers will find that this place is just right for them.  Yet the streets will have more litter and there will be more beggars than before.

This is no conspiracy theory, but it does explain why we do not see greater domestic pressures for fiscal stability.

1 Maria December 29, 2005 at 10:38 am

Also, fiscal stability must come to some extent from actually collecting taxes. And tax evasion is quite prevalent among relatively wealthy professionals (doctors, lawyers, architects, economists, and the like) who are usually self-employed, or partners in a firm, etc. These people happen to coincide with those who take their assets to Miami.

2 Dan December 29, 2005 at 1:23 pm

Is it true that only the wealthy can keep their assets in foreign currency?

I don’t know about Argentina, but this certainly isn’t the case in Russia. There, everybody keeps their savings in dollars or euros. And you don’t need a foreign bank account – you just change the money and keep dollar bills in a sock under your bed.

But I guess your argument still more-or-less holds, because:
– the rich will be paying their workers’ wages in pesos
– the real poor will have no savings in any currency

3 Maria December 29, 2005 at 4:46 pm

Plus, the important thing is that accounts and deposits are outside the government’s jurisdiction. All dollar-denominated deposits in Argentinean banks were forcibly converted into pesos when the dollar was devalued.

4 Anthony December 30, 2005 at 10:08 am

The political pressure is low because the class of non-asset-holders is large, and does not have rational expectations of the results of government action.

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