A simple public choice model of currency crises

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.