Calvo Discusses Financial Crisis at Ohlin Lectures in Stockholm

SIPA’s Guillermo Calvo recently visited the Stockholm School of Economics to deliver this year’s Ohlin Lectures on September 25 and 26. Each year the school honors Bertil Ohlin, the late Nobel Laureate, by choosing a notable economist to present on two topics in international economics. Past speakers have included the Columbia professors Jagdish Bhagwati, Ronald Findlay, and Robert Mundell.

Calvo, who is a professor of international and public affairs at SIPA and director of the School’s Program in Economic Policy Management, spoke on “Financial Crises: Back to Basics and Back.”

Calvo’s first lecture, “Liquidity Illusions and Delusions,” traced the roots of the most recent global crises, which took root in 2008, back to earlier financial crises in Mexico, Russia, and Asia. He suggested that finance is at the heart of much of the economic problems faced in these nations and regions, and examined how a relatively minor event can bring about a sudden, largely unexpected major global crisis, causing output and employment to suffer. Calvo went on to explain how finance, through different channels ranging from investment, capital flows, sudden stops, and subprime mortgages, can negatively impact an economy.

Slides, "Liquidity Illusions and Delusions" ›

In his second lecture, “Sudden Stop, Collapse of Output and Employment, and Overindebtedness,” Calvo compared the financial crises that took place in emerging market economies with those in advanced economies. Calvo has found that “sudden stops” — a term he coined to define a statistically significant fall in capital inflows — typically occur in emerging markets when they have large current account deficits and high domestic liability dollarization. In contrast, he said, the dominant view in the Eurozone was that there was no risk of a sudden stop because the ECB could easily prevent it.

During the recent crisis, however, the private sector in advanced economies experienced larger current account adjustments than those experienced by emerging markets in previous crises. Therefore, while the United States and Northern Europe did not experience a large devaluation, and real wages remained stable, the private sector suffered nevertheless, creating a sharp rise in the rate of unemployment. In Europe, numerous countries registered sudden stops in terms of large changes in their current accounts or real changes in capital flows. Since these nations were unprepared for a sudden stop, it became even more difficult to find and agree upon a possible solution. Therefore, Calvo noted, it is important to recognize that a liquidity crunch can bring about a sudden stop; central banks that focus on price stability may be able to prevent a financial collapse, but they cannot prevent a sudden stop or a collapse in other key economic indicators such as employment, real wages and output.

Slides, "Sudden Stop, Collapse of Output and Employment, and Overindebtedness" ›

These recent lectures suggest key implications for monetary policy in both emerging markets and advanced economies. In the former, increasing the money supply will help to restore employment but it will also create real currency devaluations and increase the risk of hyperinflation. These countries typically have non-reserve currencies — a liquid asset — that are victims of liquidity crunch. To help attenuate a liquidity crunch, emerging economies would benefit from the existence of a global lender of last resort. However, that kind of institution is not yet fully developed. Available institutions like the World Bank or the IMFare often times too slow to react.

In contrast, in advanced economies, increasing the money supply or lowering the reference interest rate can help against a liquidity crunch. If interest rates hit the zero lower bound, quantitative easing is a necessary approach but should be large enough. The evidence suggests that more QE is necessary both in the United States and Europe, which implies that QE3 in the US and recent QE-type strategies by the European Central Bank are welcome developments.