The Dismal Science
Illustration by Robert Neubecker Bahtulism
Who poisoned Asia's currency markets?

By Paul Krugman
(1,683 words; posted Thursday Aug. 14)

       Currency-crisis connoisseurs cherish the memory of George Brown, Britain's minister of economic affairs in the mid-1960s--the man who blamed his troubles on the "gnomes of Zurich." (He was misinformed; the relevant gnomes are actually in Basel.)
       But we may have to remove Brown from his pedestal, and make room for Malaysian Prime Minister Mahathir Mohamad. Last month Malaysia's neighbor Thailand, after months of promising that it wouldn't, devalued the baht; and spooked investors began selling Malaysian ringgits (and Philippine pesos, Indonesian rupiahs, and so on) as well. This provoked an outburst on Mahathir's part that surely counts as an instant classic. Where Brown was vague about both the identity of the villains and their motives, Mahathir had a full-fledged conspiracy theory: The U.S. government had prompted palindromic speculator George Soros to undermine Asia's economies, because it wants to impose Western values (like democracy and civil rights) on them. And Mahathir's ministers expanded on his remarks with a rhetoric that was unusual for a government with a long-term interest in maintaining the goodwill of international investors: Currency fluctuations are caused by "hostile elements bent on ... unholy actions" that constitute "villainous acts of sabotage" and "the height of international criminality."

These remarks were entertaining both because, as far as we can tell, Soros was not a major player in the crisis (indeed, he seems to have taken a bit of a bath by failing to anticipate this one), and because in the early 1990s one of the world's most ambitious and reckless currency speculators was ... Malaysia's government-controlled central bank, which got out of the business only after losing nearly $6 billion.
       Currency crises often provoke hysterical reactions in government officials. One day your country's economy is humming along nicely, your bonds are triple-A, you have billions of dollars in foreign exchange reserves socked away. Then all of a sudden the reserves are depleted, nobody will buy your paper, and you can only keep money in the country by raising interest rates to recession-inducing levels. How can things go wrong so fast?

The standard response of economists is that to blame the financial markets in such a situation is to shoot the messenger, that a crisis is simply the market's way of telling a government that its policies aren't sustainable. You may wonder at the abruptness with which that message is delivered. But that, says the canonical model, is simply part of the logic of the situation.
       To see why, forget about currencies for a minute, and imagine a government trying to stabilize the price of some commodity, such as gold. The government can do this, at least for a while, if it starts with a sufficiently large stockpile of the stuff: All it has to do is sell some of its hoard whenever the price threatens to rise above the target level.

Now suppose that this stockpile is gradually dwindling, so that far-sighted speculators can foresee the day--perhaps many years distant--when it will be exhausted. They will realize that this offers them an opportunity. Once the government has exhausted its stockpile, it can no longer stabilize the price--which will therefore shoot up. All they have to do, then, is buy some of the stuff a little while before the reserves are gone, then resell it at a large capital gain.
       But these speculative purchases of gold or whatever will accelerate the exhaustion of the stockpile, bringing the day of reckoning closer. So the smart speculators will try to get ahead of the crowd, buying earlier--and thereby running down the stocks even sooner, leading to still earlier purchases. The result is that, while the government's stockpile may decline only gradually for a long time, when it falls below some critical point, all hell suddenly--and predictably--breaks loose (as actually happened in the gold market in 1969).
Illustration by Robert Neubecker

With a bit of imagination this same story can be applied to currency crises. Imagine a government that is trying to support the dollar value of the ringgit--or, what is the same thing, to keep a lid on the price of a dollar measured in ringgits--through foreign exchange market "intervention," which basically means selling dollars to keep the ringgit price down. And suppose the government's policies are, for whatever reason, inconsistent with keeping the exchange rate fixed forever. Then there is a complete parallel with the previous story, with foreign exchange reserves taking on the role of the gold stockpile. And by the same logic as before, we can conclude that speculators will not wait for events to take their course: At some critical moment they will all move in at once--and billions of dollars in reserves may vanish in days, even hours.
       The abruptness of a currency crisis, then, does not mean that it strikes out of a clear blue sky. In the standard economic model, the real villain is the inconsistency of the government's own policies.

Is Mahathir's complaint therefore unadulterated nonsense? No--as Art Buchwald once said of his own writing, it is adulterated nonsense. The truth is that speculators may not always be quite as blameless as the standard model would have it.
       For one thing, markets aren't always cool, calm, and collected. There is abundant evidence that financial markets are subject to occasional bouts of what is known technically as "herding"; everyone sells simply because everyone else is selling. This may happen because individual investors are irrational. It may also happen because so much of the world's money is controlled by fund managers, who will not be blamed if they do what everyone else is doing. One consequence of herding, however, is that a country's currency may be subjected to an unjustified selling frenzy.
       It is also true that the long-term sustainability of a country's policies is to some extent a matter of opinion--and that policies that might have worked out, given time, may be abandoned in the face of market pressures. This leads to the possibility of self-fulfilling prophecies--for example, a competent finance minister may be fired because of a currency crisis and the irresponsible policies of his successor end up ratifying the market's bad opinion of the country.

All this, in turn, creates a possible way for private investors with big enough resources to play a nefarious financial game. Here's how it would work, in theory: Suppose that a country's currency is in a somewhat ambiguous situation--its current value might be sustainable, or it might not. A big investor quietly takes a short position in that country's currency--that is, he borrows money in pounds, or baht, or ringgits, and invests the money in some other country. Once he has a big enough position, he begins ostentatiously selling the target currency, gives interviews to the Financial Times about how he thinks it is vulnerable, and so on. With luck he provokes a run on the currency by other investors, forcing a devaluation that immediately reduces the value of those carefully acquired debts, but not the value of the matching assets, leaving him hundreds of millions of dollars richer.
       In short, speculative sharp practice can play a role in destabilizing currencies. But how important is that role in reality?

Well, George Soros pulled the trick off in Britain in 1992, but as far as anyone knows, even he has done it only once. True, it was an amazing coup: He is supposed to have made more than a billion dollars. It's also true, however, that there were good reasons for the pound's devaluation, and it is unclear whether Soros really caused the crisis or was merely smart enough to anticipate it. Maybe he brought it on a few weeks early.
       The other currency crises of the '90s--and it has been a great decade for such crises--have taken place without the help of sinister financial masterminds. This is no accident; opportunities like the one Soros discovered in 1992 are rare. They require that a country's currency be vulnerable, but not yet under attack--a narrow window at best, since there is a sort of Murphy's Law in these things: If something can go wrong with a currency, it usually will. Financial markets are not in the habit of giving countries the benefit of the doubt.

Does this mean that there is no defense against speculative attack? Not at all. In fact, there are two very effective ways to prevent runs on your currency. One--call it the "benign neglect" strategy--is simply to deny speculators a fixed target. Speculators can't make an easy profit betting against the U.S. dollar, because the U.S. government doesn't try to defend any particular exchange rate--which means that any obvious downside risk is already reflected in the price, and on any given day the dollar is as likely to go up as down. The other--call it the "Caesar's wife" strategy--is to make very sure that your commitment to a particular exchange rate is credible. Nobody attacks the guilder, because the Dutch clearly have both the capability and the intention of keeping it pegged to the German mark.
       Oh yes, there is also a third option. You can erect elaborate regulations to keep people from moving money out of your country. Of course, if investors know that it will be hard to get money out, they will be reluctant to put it in to begin with. There is a case to be made--an unfashionable case, but not a totally crazy one--that it is worth forgoing the benefits of capital inflows in order to avoid the risk of capital outflows. But Asian leaders uttered not a word of complaint when they were receiving huge inflows of money, much of it going to dubious real-estate ventures. Only when irrational exuberance turned into probably rational skittishness did the accusations begin.
       So Mahathir's claims that he is the victim of an American conspiracy are just plain silly. He has nobody but himself to blame for his difficulties. Or at least that's what George, Bob, and Madeleine told me to say.


The Federal Reserve Bank of San Francisco posts an essay discussing currency speculation. One trading firm maintains a whimsical A-Z of market crashes. The Soros Foundations Network Web site includes a George Soros page, complete with a bio, personal statements, and speeches in RealAudio. The PACIFIC group at the University of British Columbia charts hundreds of currencies, listing denominations, currency regimes, and a link to daily exchange rates. Traveloco offers this useful currency converter. Also, see Paul Krugman's piece on the crisis in Mexico, as well as Bradford De Long's essay on the same topic.

Paul Krugman is a professor of economics at MIT whose books include The Age of Diminished Expectations and Peddling Prosperity. His home page contains links to many of his other articles and essays.

Illustrations by Robert Neubecker.