Prospective deficits and the asian currency crisis

The authors argue that the recent Asian currency crisis was caused by large prospective fiscal deficits associated with implicit bailout guarantees to failing banking systems. They articulate this view using a simple dynamic general equilibrium model, whose key feature is that a speculative attack is inevitable once the present value of future government deficit rises. This is true regardless of the government's foreign reserves position or the initial level of its debt. The government cannot prevent a speculative attack but it can affect its timing. The longer the delay, the higher inflation will be under flexible exchange rates. The authors present empirical evidence in support of the two key assumptions of their model: 1) Large losses in the banking sector were associated with large increases in Asian governments'prospective deficits. 2) The public knew that the banks were in trouble before the currency crisis.