Journal of International Money and Finance

22 (2003) 1089–1094
www.elsevier.com/locate/econbase

Three generations of crises, three generations

of crisis models
Barry Eichengreen
Economics Department, University of California at Berkeley, Berkeley, CA 94720-3880, USA

Abstract

This paper considers the three devaluation of the pound sterling in 1931, 1949 and 1967 as
a window onto the recent theoretical literature of currency crises.
# 2003 Elsevier Ltd. All rights reserved.

Keywords: Currency crises; Devaluation

It is a pleasure to give the Key Note remarks.1 My first book, Sterling in Decline
(Cairncross and Eichengreen, 1983), was on three currency crises: the devaluations
of 1931, 1949 and 1967. Alec Cairncross and I began that study in 1979, a year
better remembered as when Paul Krugman published his theory of balance pay-
ments crises (Krugman, 1979). I recently went back to look at those three crises
and found that they provide a very nice illustration of how the subsequent litera-
ture on the topic has evolved.
Taking the 1931, 1949 and 1967 sterling crises as the subject of my talk is self-
indulgent, to be sure. But it is important to recall that before the debt crisis of the
1980s and the emerging market crises of the 1990s, the three balance-of-payments
crises experienced by the United Kingdom were probably the three most important
examples we possessed of the phenomenon with which this conference is con-
cerned, namely, disruptive attacks on pegged exchange rates.
So let me take you back time, starting with the 1931 sterling crisis. Recall that
this was a period when sterling was pegged to gold and therefore to the dollar, and
the world was spiraling downward into the Great Depression. Britain’s exports

E-mail address: eichengr@econ.berkeley.edu (B. Eichengreen).

1
These remarks were delivered in the Conference on Regional and International Implications of
Financial Instability in Latin America, University of California, Santa Cruz, 11 April 2003.

0261-5606/$ - see front matter # 2003 Elsevier Ltd. All rights reserved.
doi:10.1016/j.jimonfin.2003.09.003
1090 B. Eichengreen / Journal of International Money and Finance 22 (2003) 1089–1094

were tailing off, and its foreign investment income was collapsing. The result, pre-
dictably, was a steady loss of international reserves.
But attempt to apply the Krugman model to the 1931 crisis, and you immedi-
ately come face to face with an important limitation of that model, namely, that it
provides no explanation for what governments are doing. While Krugman’s cur-
rency speculators are smart—they maximize profits, making efficient use of all the
available information—his governments and central banks are dumb. They follow
rigid policy rules, mechanically issuing domestic-currency-denominated debt to
finance constant budget deficits while mindlessly intervening to support the
currency. Because the model makes no attempt to characterize the government’s
objectives, it offers no explanation for why the authorities react as they do.
In fact, in 1931 the explanation for the latter was no mystery. The government
was preoccupied not just with the fragility of the financial situation but with the
level of unemployment. When pressure on the currency was felt, unemployment
had already reached 20 per cent of the insured labor force. In this context, raising
taxes or cutting public support for the unemployed threatened to provoke a polit-
ical backlash. While the government wished to avoid being tarred with a devalua-
tionist brush, it did not relish having to implement economies that would only
aggravate an already excruciating unemployment problem. In terms of the ‘‘second
generation models’’ of balance of payments crises that followed Krugman, which
added optimizing governments to his framework (Ozkan and Sutherland, 1994;
Eichengreen and Jeanne, 2000), Labour was trading off the fixed cost of devaluing,
and thereby tarnishing its reputation for being able to govern, against the budget-
ary economies needed to reassure the markets.
In principle, the Bank of England could have tightened domestic credit more
aggressively to support sterling’s position on the foreign exchange market. Its fail-
ure to do so is striking. After raising the rate from 2.5 per cent to 3.5 per cent on
July 23rd and then to 4.5 per cent on July 30th (rather modest increases by modern
standards), it left monetary policy unchanged until the final surrender to the mar-
kets on September 19th.
The point is that neither the Government nor the Bank lacked instruments with
which to defend the currency; they were simply reluctant to use them. The political
context is key to understanding this fact. These events took place less than a dec-
ade after the Labour Party had formed its first government. They occurred in a
period when Labour was in the ascendancy and the Liberal Party was in decline.
But, given the continued electoral viability of both parties, neither of them could
marshal a Parliamentary majority. The Labour Government formed in 1929 relied
on the Liberals for Parliamentary support, leaving it incapable of decisive action.
And the Bank of England, while nominally independent, was sensitive to political
considerations and in particular to the gravity of the unemployment problem.
Unable to move decisively, the Labour Government fell even before the currency
peg collapsed. The peg was quickly abandoned by the newly-formed government of
national unity, which could assign the blame to its predecessor. With no sterling
parity left to defend, the Bank of England was no longer reluctant to use interest
 B. Eichengreen / Journal of International Money and Finance 22 (2003) 1089–1094 1091

rates to stimulate employment. Bank rate was cut to 2 per cent, a more appropri-
ate stance for the deflationary circumstances of the time.
In a sense, then, the 1931 devaluation is a classic illustration of a ‘‘second gener-
ation’’ balance-of-payments crisis model, in which the authorities trade off the
costs of fiscal austerity, which take the form of additional unemployment and a
depressed economy, against the benefits of protecting their reputation for financial
probity. In this episode, the deepening slump ultimately sapped the government’s
appetite for economies, and currency speculators acted on this fact.
If the 1931 devaluation illustrates the relevance of factors highlighted by so-
called second-generation models of balance-of-payments crises, then the 1949
devaluation demonstrates the relevance of the third-generation models developed
in response to the Asian financial crisis. The problem in Asia in 1997, as you will
recall, was large amounts of short-term foreign borrowing by banks and firms. In
Britain in 1949, the analogous problem was that of the ‘‘sterling balances.’’ Sterling
was pegged again, and in 1947 made convertible, at US insistence. But World War
II had forced the UK to borrow heavily from its allies, from the Commonwealth
and Dominions, and from the Sterling Area formed when other countries followed
Britain off the gold standard in 1931. In some cases, exchange controls were used
to prevent their holders from using them to purchase goods and services in Britain
or from exchanging them for more attractive (typically, US dollar-denominated)
assets. Attempts were made to immobilize the rest using moral suasion.
A lesson of the Asian crisis is that external liberalization can have disastrous
consequences in the presence of a financial overhang. That is what happened in
1947–1949. Current account convertibility created additional scope for other coun-
tries to use their blocked sterling balances to purchase imported merchandise and
to employ leads and lags to undertake disguised capital-account transactions. Con-
trols were still sufficiently pervasive to prevent a crisis from erupting at once; the
1949 crisis was more of a slow-motion train wreck. But a wreck it was. Despite the
absence of obvious signs of internal imbalance, devaluation was needed to reduce
the financial overhang.
Thus, the 1949 crisis was a classic third-generation crisis in which financial fac-
tors dominated. What is striking from this point of view is that the aftermath was
not disastrous; growth actually stabilized and picked up. The reason is not hard to
see: because their liabilities were denominated in the domestic currency, British
banks and firms were not thrust into bankruptcy. Britain emerged from World
War II with an unprecedented sovereign debt of nearly 250 per cent of GDP, yet
devaluation did not force the government to default. Sterling’s status as an inter-
national currency, in which both residents and foreigners were prepared to borrow
and lend, allowed the UK to avoid these dislocations.
At first glance the 1967 devaluation is the most difficult of this trio to reconcile
with modern theories of currency crises. You will recall that this was the time when
sterling was pegged to the dollar under the Bretton Woods System. It was also a
period when the current account of the balance of payments was in balance—
indeed, it sometimes was in substantial surplus—between 1964 and 1967. Britain
was not suffering from high unemployment. To the contrary, in 1965–1966 the
1092 B. Eichengreen / Journal of International Money and Finance 22 (2003) 1089–1094

percentage of insured workers recorded as unemployed fell to an historically

unprecedented 1.5 per cent.
It is thus necessary to search for deeper vulnerabilities. One was that even faster
growth abroad rendered investment relatively unattractive. Throughout the period,
British savers invested abroad, where returns were higher. It was in this context
that the current account surplus proved inadequate. In addition, wages rose at
double-digit rates between mid-1964 and mid-1966, reflecting the scarcity of labor.
Given the stability of costs abroad, anemic rates of productivity growth were not
sufficient to neutralize the impact on Britain’s competitiveness. Expansive monet-
ary and fiscal policies stimulated consumption, pushing up prices. The policy
stance actually grew more expansionary over time. The budget deficit was not
inordinately large, and inflation and money growth were restrained by the desire to
defend the currency peg. But the fact that the budget was not in substantial surplus
and that money was not tight in this period of high employment suggests that both
internal and external balance were seriously out of whack. If you are reminded of
Argentina in the second half of the 1990s, then you are not alone.
The question is why all this stimulus to aggregate demand, resulting in rising
labor costs and deteriorating competitiveness, did not result in a larger current
account deficit. In part the answer lies in policy expedients such as import sur-
charges and exchange controls. These started with the 15 per cent import surcharge
proposed by the Labour Government within days of taking office.
What were the officials thinking? The government that came to power in 1964
was committed to the pursuit of growth and full employment, memories of the
high unemployment over which Labour had presided in the 1920s never being far
from its consciousness. The postwar economy had already demonstrated an ability
to function at low levels of unemployment. The question was how long this favor-
able situation would last. In fact, insofar as part the explanation for low unem-
ployment was the wage moderation bequeathed by memories of the 1930s, then as
recollections of that earlier era began to fade and restraint broke down, it was
possible that the age of full employment was already drawing to a close.
Here the Labour Government, demonstrating a considerable capacity for wishful
thinking, convinced itself that by avoiding stop–go policies it could encourage even
faster growth, in turn enhancing the economy’s competitiveness and relaxing the
external constraint. Stimulus to aggregate demand would encourage investment.
And more investment would enhance the competitiveness of British goods. Britain
would be able to utilize the new technologies embodied in the latest capital equip-
ment and move into industries characterized by economies of scale. Thus, where
attempts to stimulate aggregate demand would otherwise run up against the bal-
ance-of-payments constraint, in these circumstances it was thought that such initia-
tives were sustainable. Eminent economists, such as Nicholas Kaldor, advanced
this dubious view.
In reality, of course, the government had made two incompatible commitments,
to faster growth and to not devalue the currency, and it was only through this feat
of intellectual gymnastics that it could reconcile the two. Similar arguments that
policy makers were not causing the economy to overheat or courting balance-of-
 B. Eichengreen / Journal of International Money and Finance 22 (2003) 1089–1094 1093

payments problems but merely allowing the country to exploit its full growth
potential were of course also heard in Asia in the 1990s. Asian policy makers ulti-
mately learned that high levels of investment do not solve all balance-of-payments
problems. Not all investments are equally productive, and time is required for even
productive investments to enhance competitiveness. This is what British officials
also learned, at considerable political cost, in 1967.
Thus, while the 1967 devaluation might at first seem difficult to explain in terms
of conventional models of balance-of-payments crises, the explanation is ultimately
consistent with the predictions of those models. Monetary and fiscal policies were
too expansionary to be consistent with the external constraint. The hope that
demand stimulus might raise the sustainable rate of growth and relax the external
constraint proved illusory. Yet the government, when confronted with these
uncomfortable facts, was reluctant to accept more restrictive monetary and fiscal
policies as the price for defending the currency. Joblessness may have fallen to low
levels, but policies that contemplated even marginally higher rates of unemploy-
ment were unacceptable. When foreign assistance proved limited, devaluation
became inevitable. This, then, is a classic example of a first-generation balance-
of-payments crisis.
So I would argue that the theory of balance-of-payments crises has come a long
way in the last 20 years. Today, with three generations of balance-of-payments-
crisis models in hand, one can write a better history of British monetary and
exchange rate policy in the 20th century was possible two decades ago.
But if our understanding of the phenomenon has advanced so significantly, why
haven’t we made more progress in preventing it? I would point to three reasons.
First, politics continue to lead governments to run policies that create conflicts
between internal and external balance. This was readily evident in my three British
crises. And the importance of the point is hard to ignore in the context of Latin
America today.
Second, the fact that none of these British devaluations was contractionary,
because balance-sheet effects were absent, points up a major constraint on stability
today—namely, the problem of original sin (Eichengreen and Hausmann, 1999),
for which we as yet have no solution.
Third, there is the progress of securitization. Today, the typical emerging market
bond issue is held by many thousands of different individual and institutional
investors. This is very different from the situation in the era of bank finance that
extended from the late 1960s through the early 1980s. The presence of large num-
bers of investors encourages herding that makes crises more likely and creates col-
lective action problems that render them more difficult to resolve. The difficulty of
creditor coordination is what recent initiatives like the Bank of France’s ‘‘Code of
Conduct’’ and the IMF’s Sovereign Debt Restructuring Mechanism are designed
to address. But these initiatives provide at best incomplete solutions to the problem
at hand. That the institutional environment is incomplete in important respects is,
at some fundamental level, simply what distinguishes international macro-
economics from closed economy macroeconomics. And it is what makes crises in
1094 B. Eichengreen / Journal of International Money and Finance 22 (2003) 1089–1094

financially open, financially dependent emerging markets so difficult to prevent and

manage.
My conclusion, then, is that more attention should be paid to the political econ-
omy of policy making in emerging markets. More attention should be directed to
why emerging markets are on such an undesirable point on the risk-return trade-
off—why they can only borrow in foreign currency. And more attention should be
devoted to understanding the incentives of market participants in the decentralized
setting of contemporary international financial markets. That is my modest
research agenda for international macroeconomics going forward.

References
Cairncross, A., Eichengreen, B., 1983. Sterling in Decline: The Devaluations of 1931, 1949 and 1967.
Blackwell, Oxford, (Second edition Palgrave Macmillan, 2003).
Eichengreen, B., Hausmann, R., 1999. Exchange rates and financial fragility, in Federal Reserve Bank of
Kansas City. New Challenges for Monetary Policy. Federal Reserve Bank of Kansas City, Kansas
City, Missouri, (pp. 329–368).
Eichengreen, B., Jeanne, O., 2000. Currency crisis and unemployment: sterling in 1931. In: Krugman, P.
(Ed.), Currency Crises. University of Chicago Press, Chicago, pp. 7–47.
Krugman, P., 1979. A model of balance of payments crises. Journal of Money, Credit and Banking 11
(3), 311–325.
Ozkan, F.G., Sutherland, A., 1994. A Model of the ERM Crisis, CEPR Discussion Paper no. 879.