In one of my classes here in Berlin (International Finance), we discussed the effects of currency crises. The professor mentioned the Mexican and the Asian currency crises in the middle of the 1990ies and described the detrimental effects of the currency devaluation on the domestic economies and world economies.

However, I wondered whether this is a general or a specific phenomenon. In my Bachelor Thesis, I argued for instance that the Russian Currency Crisis in 1998 was quite healthy for the Russian economy (at least in the long run). It stabilized the currency, stabilized the economy and helped domestic producers. So the question is: what makes a crisis a crisis?

In the case of currency depreciation, the domestic currency can buy less foreign goods. This is in fact not completely true since first of all it can buy less foreign currency which can be used for foreign goods. So the textbook answer for currency crises is the following: all owners of domestic currency who can free their assets will transfer these assets into another currency that seems stronger, such as from the Thai Bath, the Mexican Peso or the Russian Ruble into the Euro or the US-Dollar. In order to do this, they have to sell domestic currency and buy foreign currency, which makes foreign currency more expensive (due to increased demand) and domestic currency cheaper (due to increased supply). This creates some kind of self-enforcing effect in which holders of financial assets in domestic currency run for the exit as fast as possible – which only depreciates the currency even more. So due to small disturbances, free floating currencies plunge into unknown depth of devaluation.

But is this a problem? So far, only financial transactions took place and not real transfers of goods or values. One could argue the following case: if the transfered money was liquid anyway (in other words not bound in long-term contracts), then domestic consumers and producers are actually well advised to transfer their liquid finances into a more stable currency – because it does not restrict them from continuing their domestic business in the stronger foreign currency. Such has happened quite a lot, look for instance at the Balkan countries during the 1990ies in which the domestic currency was only used for official purposes but all trading was done in Deutschmark and later in Euro. Or look at other countries in which the US-Dollar has become the effective currency while the domestic currency only nominally exists.

So the exchange into foreign money does not seem to be the real problem. We have to look deeper into the problem. Not all assets are liquid and can be exchanged – most domestic currency will be bound in investments, such as machines, contracts with employees, contracts with other producers, or savings. They can not be freed and transferred immediately. But do these ‘bound finances’ really matter? If they are long-term and oriented towards domestic producers and consumers, they should not be effected by currency fluctuations with foreign currency– because the relative prices in domestic currencies remain the same.

In effect, neither the totally liquid nor the totally bound financial assets determine the character of a currency crisis – only those financial assets bound in cross-border transactions, such as exports and imports matter. If consumers and producers are bound in a contract to buy foreign goods, then during a currency devaluation these consumers and producers have to use their liquid finances to serve their contractual duties – which can only be done by taking money out of the domestic financial system. This however results in those effects observable in the Asian and Mexican currency crises – loss of jobs, decrease in domestic investments, slower growth.

An economist would argue that in the long run such processes are not bad at all - the old equilibria will be restored. First, consumers and producers will substitute foreign products for domestic products. This will in the medium-run increase domestic demand and decelerate the recessive effects. Secondly, the devaluated currency makes domestic products cheaper also for foreign consumers and producers, therefore exports will be fostered by a devaluation which increase foreign demand for domestic products and in most cases can even revert the recessive effects. So in the medium-run and long-run, the detrimental effects of currency crises can be recovered.

It seems that the problem lies in the different speed in which these effects take place. The short-term withdrawal of financial assets and the devaluation of the domestic currency is confronted with the long-term increase in demand for domestic products and an appreciation of the domestic currencies. This is what leads many to believe that the best counter-effects to currency crises is to slow down currency volatility – or in other words make it more difficult to withdraw money. Or at least make it more costly, such as through the introduction of a Tobin Tax on financial transactions.

But why not go all the way and completely forbid cross-border transactions in case of a currency crisis? Because such a measure would neither solve the real problem: the decreased utility of the consumers and producers.

And the real problem is not solved through that. A currency devaluation means less utility, since utility is a function of price and goods. Even though consumers and producers will substitute foreign goods through domestic goods, there were reasons why people ordered the foreign goods - maybe quality or certain non substitutable features. So since people are forced to buy domestic goods during a currency crisis, the real problem for an economy is that everybody in the economy who can only partially substitute his foreign demand will suffer from less utility.