2007 REVIEWS

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Private Sector Involvement and InternationalFinancial Crises: An Analytical Perspective

, byMichael Chui and Prasanna Gai (OxfordUniversity Press, New York, NY, 2005), pp. viii

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209.

Two questions that baffle policy-makers andexperts in the financial world are how to preventfinancial crises from occurring and how to dealwith them when they happen. This book is areview of the literature on the treatment of inter-national financial crises. It looks at issues to dowith the international financial architecture byconcentrating on the coordination of creditor anddebtor actions. The authors focus mainly ondifferent types of theoretical models coveringtopics such as debtor discipline in the sovereigndebt market, sovereign bankruptcy, and the role ofofficial organisations in organising debt workouts.In the process, this book exposes the majorstrands of the financial crises literature. Generally,the authors conclude that many suggestions forimprovement either give ambiguous effects, or canrun into practical difficulties upon implementationthat render much of the optimism on financialarchitectural reform unjustified.

The book is divided into two parts. Part 1covers the theoretical foundations of financial crisesand introduces the analytical tools necessary forassessing proposed reforms in Part 2. It describesthe two main types of financial crisis models:sunspot-based models that rely on changes inexpectations and fundamentals-based modelsregarding underlying weakness in economies.Sunspot-based models are ones where crises areconditional on investors’ expectations simultane-ously turning pessimistic. They are so describedbecause the reason for this turn in sentiment isunknown and exogenous. Fundamentals-basedmodels provide details on how weaknesses ineconomies; for example, pressures generated bypolicies incompatible with the fiscal position ofthe government can lead to its systemic collapse.But they do not take account of the herd behav-iour of imperfectly informed investors, whichsunspot-based models deal with. This part con-tains no new material but does a very good job ofgiving a short introduction to the main models inthe literature. The way these models are cleanlyseparated into two groups reveals a clear gap inthe current understanding of the dynamics offinancial crises.

The two approaches are somewhat tied togetherin a global games framework of equilibrium selec-

tion later on. By doing so, the book demonstrateshow financial crises can precipitate due to a com-bination of economic weakness and expectationalshifts among investors. Coupled with the incompletenature of contracts in sovereign debt markets, itmeans that healthy economies can be in a greyarea where sudden reversals of investor beliefsplunge them into crisis. The insight that there ismuch uncertainty surrounding the timing of crisesdrives the agenda for the rest of the book. Thisframework represents one plausible way of unitingthe two strands of financial crises models and afruitful area of future research. The treatment onthis topic is, like most of the book, short and con-cise. Interested readers should turn to the originalarticles.

In Part 2 the focus of attention turns to howbest to reform the international financial system.Again, there is no new material, but a good,organised summary of recent research. Itaddresses three main issues: the currency of debtextended to sovereign debtors, the horizon overwhich these loans are made, and arrangingsovereign debt workouts. Typical symptoms ofcreditor apprehension are to extend shorter termloans, and to do so in foreign currencies, so thatthe creditors can shoulder less risk. Largelybecause there is no collateral in most sovereigndebt contracts, and no international jurisdiction toenforce bankruptcy procedures on governments,private sector creditors here are generally morecautious than in other collateralised debt markets.The issue of balancing

ex ante

rationing ofcredit and

ex post

punishment levied on debtors isa delicate one. Put simply, the less severe are thepost-default consequences for debtor economies,the more likely lenders will reduce credit madeavailable at the beginning. The authors show thatthese considerations are in conflict with eachother, and that inaccuracies in observing the truestate of debtor economies cloud the effect of offi-cial sector assistance (this point is discussed in aseparate chapter that deals with crisis indicatormodels).

The book provides a very thorough treatment ofthese problems and their suggested remedies, andhighlights some difficulties in putting them intopractice. Theoretical modelling suggests a usefulrole for the official bodies in trying to make workoutprocedures more orderly. This will make it possibleto strike a better balance between minimising lossesto both sides post-default and reduced lending

exante

. The least effect that the official sector canhave is in regard to the currency composition of

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© 2007 The Economic Society of Australia

the debt. It is demonstrated that there is little thatcan help except a good reputation built up over along time.

The book is littered with theoretical models thatuse an array of techniques to deal with inter

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national financial issues and suggestions for futureimprovement. And like many books that go intominute details, the reader can drown in the sea ofdetail. It is not clear in the book, but there areonly two dominant themes underlying most models:incomplete information and imperfect legal andmarket structure of the sovereign debt market.Imperfect monitoring of debtors by the officialsector and creditors, and inability on both sides toknow clearly the options open to them in case ofdefault do much to lower efficiency in the market.All the suggestions for improving the inter

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national financial architecture are ultimately aimedat either breaching the informational constraint,and/or redressing the problem with the legal andincentive structure of the market. I agree with theauthors’ suggestions that more complete andtimely disclosure of debtors’ economic indicators,higher transparency in disclosing events leading todefault, and contractual constraints on both debtors’and creditors’ actions are useful in improving theinternational financial architecture. However,political factors that may affect sovereign debtmarkets in adverse ways are not considered at all.Vagaries of politics, international or domestic, cansometimes have overpowering consequences ondebt arrangements. There is no treatment of thepressures such factors can bear on the behaviourof any party, let alone equilibrium outcomes.Given that most suggestions for improvement aredemonstrated to encounter significant practicaldifficulties, it is small wonder that the authorssound a note of pessimism in concluding theirtreatment of the subject.

This book gives an overview of mainly theoret-ical and some empirical literature in topics relatedto financial crises and international financialreform. It does not attempt to traverse new groundby including original research, but its material isdense throughout and represents state-of-the-artresearch in the field. The authors do an admirablejob of presenting the main arguments of theiranalysis in simple terms and clear discussion,particularly in Part 2, which draws heavily oninsights from prior chapters. Graduate studentswill find a rich library of literature on the fieldplus an excellent demonstration of theoreticalmodelling techniques, but this book should provemost useful as a compact reference to the field

for researchers in central banks and officialorganisations.

Eddie Cheung

Crawford School of Economics and Government,Australian National University

Knowledge, Information, and Expectations inModern Macroeconomics: In Honor of EdmundS. Phelps

, by Philippe Aghion, Roman Frydman,Joseph Stiglitz and Michael Woodford (eds)(Princeton University Press, Princeton, NJ,2003), pp. xi

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586.

This book is a collection of papers and commentsfrom some of the leading academic macroecono-mists in the world today. The theme that connectsthis set of papers is that they are all related to thework of Edmund Phelps. It is a testament to hisproductivity and creativity that it covers such abroad spectrum of macroeconomic research. Thebook is divided into four sections, each containinga number of papers dealing with a major theme ofPhelps’s research. Rather than surveying eachindividual paper, which would be an impossibletask given the limitations of space, I will focus ontrying to extract important themes from eachsection.

The first section of the book is entitled ‘Infor-mation, Wage-Price Dynamics and BusinessFluctuations’. This is the section most similar tothe work for which Phelps was predominantlycredited for winning the 2006 Nobel Prize inEconomics. The expectations-augmentation of thestandard Phillips Curve, as noted by the Nobelcommittee, ‘radically changed our perception ofthe relationship between inflation and unemploy-ment’. Michael Woodford (Chapter 1) and GregoryMankiw and Ricardo Reis (Chapter 3) presentchapters that attempt to explain responses of theaggregate economy to monetary shocks by examin

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ing the role of information. This literature is, atleast in part, motivated by the empirical observa-tion that changes in money supply have persistentand sizeable effects upon the economy eventhough nominal prices are able to adjust relativelyrapidly. It is argued that limitations upon anindividual’s ability to process information areresponsible for this persistence. These chaptersare interesting examples of an important and