In Financial Stabilization, Nothing Fails Like Success


Paul Krugman’s The Return of Depression Economics quite smartly opens with an overview of a financial crisis that didn’t create a huge economic slump, the 1994 “Tequila Crisis” in which a Mexican currency run turned into a bank run in Argentina but then everything was set straight by timely intervention by the Mexican, Argentine, and American governments:

Two years after the tequila crisis, it seemed as if everything was back on track. Both Mexico and Argentina were booming, and those investors who had kept their nerve did very well indeed. And so, perversely, what might have been seen as a warning instead became, if anything, a source of complacency. While few people laid out the lessons learned from the Latin crisis explicitly, an informal summary of the post-tequila conventional wisdom might have run as follows: First, the tequila crisis was not about the way the world at large works: it was a case of Mexico being Mexico. It was caused by Mexican policy errors—notably, allowing the currency to become overvalued, expanding credit instead of tightening it when speculation against the peso began, and botching the devaluation itself in a way that unnerved investors. And the depth of the slump that followed had mainly to do with the uniquely tricky political economy of the Mexican situation, with its still-unresolved legacy of populism and anti-Americanism. In a way you could say that the slump was punishment for the theft of the 1988 election.

You can think of it as the “Committee To Save The World Problem.” Insofar as your regulators’ ad hoc efforts at crisis management succeed, everyone involved in the system tends to become more complacent and the system becomes riskier. People are often aware of the small sub-set of the problem known as “moral hazard,” but what I think Krugman is pointing too here is the existence of a much broader issue. Even if the successful resolution of any particular financial crisis does entail severe punishment of wrongdoers, that doesn’t change the fact that the press, the political system, the bureaucracy, the public, and the business community will all start to feel more complacent in ways that shape their decision-making. Regulatory success, as such, ends up changing the regulatory climate.