Lessons from the Debt - Deflation Theory of Sudden Stops

The " Sudden Stop " phenomenon of the recurrent emerging markets crises of the last ten years is one of the key questions facing International Macroeconomics. Sudden Stops are defined by unusually large recessions marked by: sharp, abrupt current account reversals, large contractions in output and absorption, and collapses in goods and asset prices. In Mexico's 1995 Sudden Stop, for example, the current account shifted by nearly 9 percentage points of GDP, and GDP, consumption and investment fell by magnitudes that exceeded their business cycle standard deviations by about a factor of 3. Only the Great Depression shows a recession with comparable magnitudes in the country's economic history. The dominant paradigms of the early 1990s, International Real Business Cycle Theory (IRBC) and the New Open Economy Macroeconomics, were unable to explain Sudden Stops because they assume a perfect global credit market that allows households to smooth consumption, and firms to finance production and investment efficiently. For example, small open economy (SOE) models in the IRBC tradition predict that, when a negative, transitory productivity shock hits, households borrow to smooth consumption, firms keep investment and production plans unaltered, and the current account falls slightly. If the shock has some persistence, households borrow less and adjust consumption more, and firms cut investment and production, resulting in regular, countercyclical current account fluctuations. Indeed, SOE-IRBC models proved quite good at mimicking the business cycles of industrial economies. Sudden Stops are strikingly different. At the time that output experiences Great-Depression-size declines, the current account takes an abrupt jump up and domestic absorption plummets. Just when the dominant paradigms predict that agents need capital markets the most, agents cannot borrow at all. A growing literature aiming to explain Sudden Stops emerged in recent years. The starting point of this literature is to replace the assumption of perfect credit markets with plausible financial frictions. Despite important progress in theoretical work, three key issues are still unresolved: (a) Sudden Stops are modeled as large, unexpected shocks. account reversals are a surprise –a large, sudden exogenous shock to foreign borrowing. This assumption has several unappealing implications: First, the defining feature of Sudden Stops (the abrupt current account reversal) remains unexplained. Second, agents are not allowed to make optimal plans considering the probability that Sudden Stops may occur. Third, we cannot tell whether the predictions of particular models are robust to changes allowing agents to act on expectations of Sudden …