Financial Crises
Financial crises often accompany the development of a financial system. Conventional wisdom says that financial crises are bad. Often they are very bad, as they disrupt production and lower social welfare as in the Great Depression in the US. Hoggarth et al. (2002) carefully measure the costs of a wide range of recent financial crises and find that these costs are on average roughly 15-20 percent of GDP. It is these large costs that make policymakers so averse to financial crises.
It is important to point out, however, that financial crises may be welfare improving for an economy. One possible example is the late nineteenth century US, which experienced many crises but at the same time had a high long run growth rate. In fact, Ranciere et al. (2003) report an empirical observation that countries which have experienced occasional crises have grown on average faster than countries without crises. They develop an endogenous growth model and show theoretically that an economy may be able to attain higher growth when firms are encouraged by a limited bailout policy to take more credit risk in the form of currency mismatch, even though the country may experience occasional crises (see Allen and Oura (2004) for a review of the growth and crises literature and Allen and Gale (2004a) who show that crises can be optimal).
In this section, we consider financial crises in China. Given China’s current situation with limited currency mismatches any crisis that occurs is likely to be a classic banking, currency or twin crisis. It is perhaps more likely to be of the damaging type that disrupts the economy and social stability than of the more benign type that aids growth. The desirability of preventing crises thus needs to be taken into account when considering reforms of China’s financial system. First, we examine how China can prevent traditional financial crises, including a banking sector crisis and a stock market or real estate crisis/crash. We then discuss how China should be better prepared for new types of financial crises, such as the “twin crises” (simultaneous foreign exchange and banking/stock market crises) that occurred in many Asian economies in the late 1990s.
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