A Fisherian approach to financial crises: Lessons from the Sudden Stops literature

A Risk Management Perspective on Macroprudential Policy

“…The early warning literature identified vulnerability indicators such as credit or leverage dynamics that tend to anticipate financial or banking crises by several years and sow the seeds for these crises (see Schularick and Taylor, 2012;Lang et al, 2019, for a comprehensive assessment of leading indicators for the euro area). These stylised facts are in line with recent theoretical models featuring endogenous credit booms and the associated build-up of systemic risk which can trigger severe recessions without relying on large exogenous adverse shocks; see Boissay, Collard and Smets (2016) and Bianchi and Mendoza (2020). In such models, market imperfections including asymmetric information (moral hazard and/or adverse selection) may first feed a financial boom and then cause its sudden reversal owing to market freezes, banking runs and credit crunches, and ultimately end up in severe "financial" recessions.…”

Sudden Stops and Optimal Foreign Exchange Intervention

“…Emerging economies are prone to 'sudden stops'. As described by Calvo et al (2008), Bianchi and Mendoza (2020) and others, in a sudden stop there is a sharp forced reversal in net capital inflows, leading to a fall in net external debt, a fall in imports, and a depreciation in the real exchange rate. The typical experience of sudden stops involves a tightening of borrowing constraints, leading to a fall in the real exchange rate which further constrains borrowing, generating a downward spiral in net external debt, consumption and a large fall in welfare.…”

The Prudential Use of Capital Controls and Foreign Currency Reserves

“…Underlying this externality, often labeled a "pecuniary fire-sale externality" or "systemic risk externality" is a large literature on macroprudential policy in both open and closed economies. Similar externalities emerge for example when assets rather than income serve as collateral, as in Bianchi and Mendoza (2018) and Jeanne and Korinek (2019), or more generally when there is a financial accelerator mechanism by which lower demand feeds back into financial markets by tightening financial constraints. 22,23 The opimal policy in this environment is to tax borrowing at t − 1, when the constraint does not bind, whenever there is a positive probability of a binding constraint in period t. In short, the government prudentially restricts the build-up of credit to reduce the frequency and severity of financial crises.…”

“…They show that when only future prices enter the constraint, the planner under discretion does not use capital controls. 23 Other dimensions of this externality, reviewed in Bianchi and Mendoza (2020), are the subject of a large literature including Benigno, Chen, Otrok, Rebucci, and Young(2016;) Ottonello (2021; Basu, Boz, Gopinath, Roch, and Unsal (2020); Coulibaly (2021); Schmitt-Grohé and Uribe (2016). Basu, Boz, Gopinath, Roch, and Unsal (2020) in particular, explore interactions between aggregate demand externalities and pecuniary externalities and cover a broad set of policies, including monetary policy, FX intervention and capital controls.…”

“…There are other recent reviews that partially overlap with this paper, including Rebucci and Ma (2019); Bianchi and Mendoza (2020); Erten, Korinek, and Ocampo (2021). The main distinguishing feature of our approach here, is our effort at connecting three dimensions of the problem: financial stability, macroeconomic stabilization, and exchange rate objectives.…”