Predicting Financial Crisis in Developing Economies: Astronomy or Astrology?

Abstract

In the aftermath of the European currency crisis of 1992-3, the Mexican financial crisis of 1994-5 and the Asian financial crisis of 1997-8, neoclassical economists in the academy and policy community have been engaged in a project to develop predictors or indicators of currency, banking and generalized financial crises in developing economies. This paper critically examines the efforts of the economics profession in this regard on both empirical and theoretical grounds. The paper argues that these predictors perform poorly on empirical grounds--indeed, the predictors developed after each of these crises failed to predict the next major crisis. These predictors are also rejected on theoretical grounds. From a post-Keynesian perspective, there is no reason to expect that the mere provision of information will prevent crises by changing agents' behaviors. The paper will also propose several indicators that are consonant with post-Keynesian economic theory, although it will be argued that these indicators do not represent a sufficient means to prevent financial crisis. Ironically, as agents develop confidence in the predictive capacity of crisis indicators, they may engage in actions that increase the economy's vulnerability to crisis. Far more important to the project of preventing financial crisis in developing economies is the implementation of constraints on those investor behaviors that render liberalized, internationally integrated financial systems inherently prone to instability and crisis. Hence, intellectual capital would be more productively expended on devising appropriate changes in the overall regime in which investors operate (such as measures that compel changes in financing strategies) rather than in searching for new predictors of crisis.Financial Crisis