Balance Sheets, the Transfer Problem, and Financial Crises

In a world of high capital mobility, the threat of speculative attack becomes a central issue of macroeconomic policy. While “first-generation” and “second-generation” models of speculative attacks both have considerable relevance to particular financial crises of the 1990s, a “third-generation” model is needed to make sense of the number and nature of the emerging market crises of 1997–98. Most of the recent attempts to produce such a model have argued that the core of the problem lies in the banking system. This paper sketches another candidate for third-generation crisis modeling—one that emphasizes two facts that have been omitted from formal models to date: the role of companies’ balance sheets in determining their ability to invest, and that of capital flows in affecting the real exchange rate.