Over two decades ago, Reuven Glick and Michael Hutchison published their seminal paper on banking and currency crises. In it, they hypothesized that the crises were usually ‘twins’, with currency crises generally following on from banking ones. Here, we analyze whether these conclusions are still true today.
Why is it important we know these issues?
Although academic discussions about economic crises can feel distant, it’s important we acknowledge they have real-world impacts. For example, the devaluation of a currency can have a huge effect on travelers who may be forced to pay more for their holidays as a result. Similarly, for economics and finance experts, continually assessing the state of the banking sector can lead to policy changes. In addition to this, their expert opinion can inform the public about how government decisions affect their lives.
On top of this, movement in currency prices can impact anyone involved with forex trading. Forex trading involves buying and selling currency pairs as people speculate on price movements. It’s the world’s most-traded financial market and the slightest currency price movement can create an opportunity for traders. As a result, traders who understand the indicators of an impending banking/currency crisis are subsequently best-placed to trade successfully.
What exactly did Glick and Hutchison find?
In their paper, Glick and Hutchison analyzed crises in 90 industrial and developing countries between 1975 and 1997. In doing so, they discovered a correlation between currency and banking crises, labeling them ‘twins’.
They found that in emerging markets, a banking crisis is a good indicator of a forthcoming currency crisis. But, they also discovered that the converse was not true and a currency crisis could not be seen as a useful indicator of a banking crisis. In emerging markets, they hypothesized that a liberalized financial structure combined with international capital flows made a developing banking structure much more vulnerable to ‘twin crises’ than a banking structure in a developed nation.
Are their conclusions true today?
Although it’s undoubted the emerging markets suffered from the twin crises more than advanced economies did in the 1900s, emerging nations subsequently developed more regulated banking systems to counter this.
However, since the Glick and Hutchison paper was published back in 1999, we’ve witnessed some of the world’s most severe crises unfold, namely the 2007 global financial crises and the European debt crisis. As a result of this, an academic study by Carmen Reinhart and Kenneth Rogoff now argues that the frequency of banking crises is similar in both developing and developed nations. In their study ‘Banking crises: an equal opportunity menace’, they use a dataset going back to the 1800s to prove this. However, they agree with Glick and Hutchison that banking crises are preceded by large capital inflows.
Overall, not only were Glick and Hutchison incorrect about emerging markets being particularly vulnerable, but they were also wrong in stating that a banking crisis will lead to twin crises. After all, following the global financial crises and the European debt crisis, only Iceland suffered from a currency devaluation. This was likely because huge Eurozone countries such as Greece and Portugal could not use the exchange rate as a policy instrument due to the fact every country affected was part of the euro.
To summarize, although Glick and Hutchison were correct that large capital inflows lead to crises, their findings on developing nations being more susceptible to banking crises does not hold weight in the modern world. Neither does their conclusion that a banking crisis will lead to a currency crisis. This new, different way of thinking can be partially attributed to a period of deregulation in the late 1990s and early 2000s (after Glick and Hutchison’s study), which increased the level of financial risk each developed economy was exposed to. This, in turn, has left the economies of developed nations more exposed than Glick and Hutchison predicted.
