While first generation models (Krugman, 1979) explained currency crisis as the inevitable outcome of unsustainable fiscal and monetary policies, economists in the 1990s noticed a puzzling fact: many countries suffered currency crises despite having fairly sound fundamentals.
This was especially true in the European Exchange Rate Mechanism (ERM) crisis of 1992–1993, where countries like the UK and France were attacked even though they did not have large deficits or runaway debt.
To explain such cases, economists such as Maurice Obstfeld (1994, 1996) developed second generation models, which emphasize the role of expectations, credibility, and government trade-offs.
These models introduced the idea that crises can be self-fulfilling: investor beliefs alone can trigger collapse, even if policies were initially sustainable.
Core Idea of Second Generation Models
The central argument is that governments often face a policy dilemma:
- On one hand, defending the currency peg enhances stability, lowers inflation, and builds credibility.
- On the other, defending the peg can be extremely costly when it requires high interest rates, austerity, and economic recession.
If markets believe the government will eventually abandon the peg to reduce these costs, speculative attacks can occur even if reserves and deficits look manageable. Thus, crises in these models arise not only from weak fundamentals, but also from shifts in expectations about government commitment.
Mechanism of the Second Generation Models
- Government Trade-Off
- Defending the peg requires painful measures (high interest rates, unemployment, fiscal cuts).
- Abandoning the peg brings short-term relief but damages credibility and causes inflation.
- Investor Expectations
- If investors believe the government will prioritize growth and jobs over defending the peg, they expect devaluation.
- Anticipating losses, they sell the domestic currency.
- Self-Fulfilling Crisis
- The speculative attack itself raises the costs of defense (forcing interest rates up, reserves down).
- The government, now under pressure, chooses to abandon the peg.
- A prophecy becomes reality — a multiple equilibria situation.
This means that even countries with strong fundamentals can face crises if markets doubt political will or policy credibility.
Key Features of Second Generation Models
- Multiple Equilibria: The economy can either remain stable (if confidence is strong) or collapse (if confidence is lost). Both are possible outcomes under the same fundamentals.
- Role of Expectations: Market psychology and credibility are central, unlike in first generation models.
- Policy Trade-Offs: Governments may rationally choose to abandon a peg if the economic and political costs of defense are too high.
- Contagion Effects: Loss of confidence can spread across countries, even if fundamentals differ.
Real-World Examples
European Exchange Rate Mechanism (ERM) Crisis, 1992–1993
- The UK and Italy faced speculative attacks while trying to keep their currencies within the ERM bands against the German mark.
- Fundamentals were not disastrously weak, but markets doubted governments’ willingness to maintain high interest rates amid rising unemployment.
- When George Soros and other investors attacked the British pound in 1992 (“Black Wednesday”), the government was forced to withdraw from the ERM — a classic example of a self-fulfilling crisis.
Brazil (1999)
- Brazil defended its currency peg through tight monetary policy, but investors doubted political commitment to austerity amid high social costs.
- Expectations of devaluation led to capital flight, forcing Brazil to abandon its peg despite IMF support.
These crises illustrate how expectations and credibility matter just as much as, if not more than, fiscal imbalances.
Criticisms of Second Generation Models
While they improved upon first generation frameworks, second generation models also face limitations:
- Overemphasis on Expectations
- Not all crises can be explained by shifts in psychology; fundamentals still matter.
- Difficulty in Prediction
- Multiple equilibria mean economists cannot easily forecast which outcome will prevail.
- Neglect of Financial Sector Weakness
- The models do not fully account for how banking fragility and private debt magnify crises (a gap later filled by third generation models).
Second generation models mark an important shift in the understanding of currency crises. By introducing expectations, credibility, and multiple equilibria, they explain why crises can occur even in countries with seemingly sound fundamentals. The ERM crisis and Brazil’s devaluation highlight the importance of investor psychology and government trade-offs. Although not perfect, these models paved the way for third generation frameworks, which incorporate financial sector vulnerabilities and balance sheet effects.
In short, while first generation models show that crises can be inevitable when policies are inconsistent, second generation models reveal that crises can also be self-fulfilling when confidence is lost.