Black Swan: Economic Crises, Volume II 9819923174, 9789819923175

Table of contents :
Preface
Contents
Editor and Contributors
List of Tables
List of Charts
1 Introduction: Models Related to the Contagion of Financial Crises
1.1 Introduction
1.1.1 Contamination by Spillover
1.1.2 Pure Contagion
1.1.3 Herd Behavior
References
2 Great Economic Depression of 1929: First Global Economic Crisis
2.1 Introduction
2.2 Historical Development of the Great Depression of 1929
2.3 Pre-crisis Economic Understanding in the US
2.4 Causes of 1929 Great Depression
2.4.1 Stock Market Crash of October 1929
2.4.2 Decline in Consumer Demand
2.4.3 Abundance of Money
2.4.4 Declining Trust in the Economy and Bank Panics
2.4.5 Inexperienced Economy Management
2.4.6 Insisting on Gold Standard in Money
2.4.7 Inequality in Income Distribution
2.4.8 Smoot-Hawley Tariffs Act
2.5 Impact of the Great Depression
2.5.1 Its Impact on the US
2.6 Its Impact on the World
2.6.1 World Trade Volume
2.6.2 Degree and Duration of Its Impact on the World Economy
2.6.3 Industrial Production
2.6.4 Unemployment Rate
2.6.5 Growth
2.6.6 Interest Rates
2.6.7 Political Impact
2.7 Its Impact on the Turkish Economy
2.7.1 Its Impact on Gross National Product
2.7.2 Its Impact on Consumer Price Index
2.7.3 Its Impact on Foreign Trade
2.7.4 Its Impact on Foreign Exchange Rate
2.7.5 Its Impact on Economic Views
2.8 Exit Strategies from the Great Depression
2.8.1 Exit Strategies Implemented in the US
2.8.2 Exit Strategies Implemented in Other Selected Countries
2.8.3 Germany
2.8.4 United Kingdom (UK)
2.8.5 Italy
2.8.6 Exit Strategies Implement in Turkey
2.9 Conclusion
References
3 1973 Oil Crisis: An Economic Illness-Stagflation!
3.1 Introduction
3.1.1 Factors Leading to the Oil Crisis
3.2 New Illness of the Economy: Stagflation
3.2.1 Growth, Inflation and Unemployment in Developed Countries
3.2.2 Policies Against Stagflation
3.2.3 Impact of Stagflation on World and Turkish Economy
3.3 Conclusion
References
4 Chilean Economic Crisis (82–86): Twin Crisis-Finance/Banking Crisis
4.1 Introduction
4.2 Chilean Economy
4.2.1 Long-Term Chilean Economy (1970–1990)
4.2.2 Shifting from Closed Economy to Open Economy
4.2.3 Development of Chilean Banking and Finance Sector
4.3 Increasing Current Account Deficit Following Increasing Capital Movements
4.4 Monetary Liberalization and Twin Crisis
4.4.1 The Effect of Dollarization in the Emergence of the Crisis
4.4.2 Importance of Oil Crisis of 1973 in Monetary Liberalization
4.4.3 Liberalization and Misguided Fiscal Policies
4.4.4 Outbreak of the Crisis
4.5 Descriptive Analysis of the Crisis
4.6 Conclusion
References
5 Stock Market Crash of 1987: Black Monday
5.1 Introduction
5.2 Black Monday Crisis
5.3 Pre-crisis Developments
5.4 Causes of the Crisis
5.5 After the Crisis
5.6 Conclusion
References
6 Mexican Tequila Crisis of 1994
6.1 Introduction
6.2 Mexican Economy
6.3 Background of Mexican Economy (1950–1980)
6.4 Pre-crisis Outlook
6.5 Tequila Crisis
6.6 Background and Causes of the Crisis
6.7 Views on Explaining the Crisis
6.8 Post-crisis Period
6.9 Conclusion
References
7 1994 Financial Crisis in Turkey
7.1 Introduction
7.2 Causes of Economic Crisis of 1994
7.2.1 Overall Impact of January 24, 1980 Stability Program
7.2.2 Short-Term Speculative Foreign Capital Inflows Under Liberalization of Financial Markets (1989–1994)
7.2.3 Deterioration in Foreign Trade Balance
7.2.4 Public Deficits Reaching Unsustainable Size
7.2.5 Inflation Phenomenon
7.2.6 Excessive Public Debt and Public Sector Borrowing Requirement
7.2.7 Low Exchange Rate Effect (Overvalued National Currency)
7.2.8 Banks’ Open Positions
7.2.9 Change in the Financing Method of Public Deficits
7.3 Misguided Policies of Economic Management
7.3.1 Decrease in Central Bank International Reserves
7.3.2 Decreasing Share of Manufacturing Industry in Total Investments
7.4 Impacts of Turkey Financial Crisis
7.4.1 Excessive Depreciation of Turkish Lira
7.4.2 Economic Growth
7.4.3 Inflation
7.4.4 Stock Market
7.4.5 Foreign Capital Inflow
7.4.6 Interest Rates
7.4.7 Banking Sector
7.5 Exit Strategies
7.5.1 Nisan Economic Stability Program
7.5.2 Results of the April Economic Stability Program
7.6 Conclusion
References
8 1997 Asian Crisis
8.1 Introduction
8.2 An Overview of Asian Tigers
8.3 Financial Crisis Models
8.4 1997 Asian Crisis Process and Its Causes
8.4.1 Thailand: Where the Crisis Began
8.4.2 Indonesia
8.4.3 South Korea
8.4.4 Malaysia
8.5 IMF Aids and Criticisms of IMF
8.6 Conclusion
References
9 1998 Russian Financial Crisis
9.1 Introduction
9.2 Before the Crisis
9.3 Causes of the Crisis
9.4 After the Crisis
9.5 Conclusion
References
Index

Citation preview

Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application

Bernur Açıkgöz   Editor

Black Swan: Economic Crises, Volume II

Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application Series Editor Kıymet Tunca Çalıyurt, Iktisadi ve Idari Bilimler Fakultes, Trakya University Balkan Yerleskesi, Edirne, Türkiye

This Scopus indexed series acts as a forum for book publications on current research arising from debates about key topics that have emerged from global economic crises during the past several years. The importance of governance and the will to deal with corruption, fraud, and bad practice, are themes featured in volumes published in the series. These topics are not only of concern to businesses and their investors, but also to governments and supranational organizations, such as the United Nations and the European Union. Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application takes on a distinctive perspective to explore crucial issues that currently have little or no coverage. Thus the series integrates both theoretical developments and practical experiences to feature themes that are topical, or are deemed to become topical within a short time. The series welcomes interdisciplinary research covering the topics of accounting, auditing, governance, and fraud.

Bernur Açıkgöz Editor

Black Swan: Economic Crises, Volume II

Editor Bernur Açıkgöz ˙Iktisadi ve ˙Idari Bilimler Fakültesi ˙Izmir Katip Celebi Üniversitesi ˙Izmir, Türkiye

ISSN 2509-7873 ISSN 2509-7881 (electronic) Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application ISBN 978-981-99-2317-5 ISBN 978-981-99-2318-2 (eBook) https://doi.org/10.1007/978-981-99-2318-2 Translation from the Turkish language edition: “Siyah Ku˘gu: Ekonomik Krizler 1634–2020” by Bernur Açıkgöz, © The Author 2020. Published by Dora Publishing. All Rights Reserved. © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Singapore Pte Ltd. The registered company address is: 152 Beach Road, #21-01/04 Gateway East, Singapore 189721, Singapore

Preface

Crisis is defined as “a difficult period, slump or depression seen in the life of a society or an organization in a country or between countries” (TDK, 2019). This book addresses all financial, fiscal and economic crises and their financial solution methods, which arouse from the complexity, instability and speculation of the economic and financial system since the 1600s, in the historical order in detail. Before the discovery of Australia, it was impossible to imagine a black swan in the world because all swans seen before were white in color, and so people thought all swans were white. When the first black swan was seen with the discovery of Australia, everyone was quite surprised. For this reason, the concept of “black swan” is used as a metaphor to explain the idea that some events that are thought to be impossible will produce more important and greater effects than events that are continuous or regular. The “black swan” describes events that are thought to have a low probability of occurrence and are often ignored, or the events that create unexpected strong effects, when combined with other possibilities, even if they are not ignored. The so-called black swan parameters can also be formed with the occurrence of random events. For example, the reason why many important events such as reform movements, industrial revolution, world wars, economic crises of 1929 and 2008 are unpredictable can be attributed to the existence of black swans. The main reason why black swans are overlooked is that the people who lead the society have certain prejudices and their trust in the correct functioning of the system. The concept of the black swan, introduced by economist and risk analyst Nassim Nicholas Taleb in the book “Fooled By Randomness” in 2001, was used to describe the events that were thought to be impossible but had a huge impact when they happen. Some economists and investors have also used the term “black swan” to describe these crises due to the unpredictable and unavoidable nature and effects of economic, fiscal and financial crises. This book aims to present to the reader all the economic, fiscal and financial crises in world history that have had a great impact and the fiscal measures taken by governments for each, in the historical chronology.

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Preface

I would like to thank Melih Kabayel, who supported the book at every step, and Prof. Dr. Atilla ˙Ibrahim ACAR for his valuable contributions and the Assistant Professor Metin Özdemir. I hope it will be of great benefit to all our readers… ˙Izmir, Türkiye 2021

Prof. Dr. Bernur Açıkgöz

Contents

1 Introduction: Models Related to the Contagion of Financial Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bernur Açıkgöz

1

2 Great Economic Depression of 1929: First Global Economic Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mesut Ardan

9

3 1973 Oil Crisis: An Economic Illness-Stagflation! . . . . . . . . . . . . . . . . . . Abdulcelil Gazio˘glu 4 Chilean Economic Crisis (82–86): Twin Crisis-Finance/ Banking Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Melih Kabayel

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57

5 Stock Market Crash of 1987: Black Monday . . . . . . . . . . . . . . . . . . . . . . Do˘gancan Akata

69

6 Mexican Tequila Crisis of 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Muhammet Kaya and Göksel Çetinkol

81

7 1994 Financial Crisis in Turkey . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mesut Ardan

95

8 1997 Asian Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 Abdulcelil Gazio˘glu 9 1998 Russian Financial Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 Do˘gancan Akata Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

vii

Editor and Contributors

About the Editor Prof. Dr. Bernur Açıkgöz was born in 1979 in Ankara. After attending Ankara Finance High School, she continued her undergraduate studies at Dokuz Eylül University, Department of Finance. She received her master’s degree in Financial Law from Dokuz Eylül University. In 2006, she was awarded her Ph.D. degree from Dokuz Eylul University Department of Public Finance. Her Ph.D. thesis covered the topics of poverty and development. In 2006, she won the Harvard University Project scholarship and worked as a visiting professor at Harvard University. In 2009, she received a scholarship from the Swiss Government for a post-doctorate degree in economics at the University of Neuchatel/Switzerland and taught courses at Bern Universities. She then began to work in the fields of experimental economics and game theory, and for three consecutive years as a guest lecturer in the economics laboratory of the Montpellier University in Montpellier, France. Afterward, she went to Missouri University, Indiana University and Arizona University with a scholarship from Missouri University. She then worked as a visiting professor at the University of East Anglia and took some courses from Exeter Universities in the UK with a Tubitak scholarship. Professor Dr. Bernur Açikgöz has books, articles and papers on foreign direct investments, economic growth, panel econometrics, experimental economics and game theory. She is currently working in the Department of Public Finance and Financial Management at Izmir Katip Çelebi University/Turkey. In addition, Açıkgöz teaches in the Department of International Trade and Finance at Izmir University of Economics/Turkey and the Department of Economics at University of Life Sciences in Pozna´n (Uniwersytet Przyrodniczy w Poznaniu)/Poland.

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Editor and Contributors

Contributors Do˘gancan Akata Department of Public Finance and Financial Management, Faculty of Economics and Administrative Sciences, Graduate School of Social Sciences, Izmir Katip Celebi University, Izmir, Turkey Mesut Ardan ˙Izmir Sectoral Audit Department, Tax Inspection Board, Ministry of Finance, ˙Izmir, Turkey Bernur Açıkgöz Department of Public Finance and Financial Management, ˙Izmir Katip Çelebi University, ˙Izmir, Turkey Göksel Çetinkol Department of Public Finance and Financial Management, Graduate School of Social Sciences, Izmir Katip Celebi University, Izmir, Turkey Abdulcelil Gazio˘glu Department of Public Finance, Faculty of Economics and Administrative Sciences, Izmir Katip Celebi University, Izmir, Turkey Melih Kabayel Department of Public Finance and Financial Management, Izmir Kâtip Celebi University, Izmir, Turkey Muhammet Kaya Department of Public Finance and Financial Management, Graduate School of Social Sciences, Izmir Katip Celebi University, Izmir, Turkey

List of Tables

Table 2.1 Table 2.2 Table 2.3 Table 2.4 Table 2.5 Table 2.6 Table 2.7 Table 2.8 Table 2.9 Table 2.10 Table 3.1 Table 3.2 Table 3.3 Table 5.1 Table 6.1 Table 6.2 Table 6.3 Table 7.1 Table 7.2 Table 7.3 Table 7.4 Table 8.1

Dates of Great Depression in various countries (in quarters) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Peak-to-trough decline in industrial production in various countries (annual data) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Indices of total industrial production, 1927 to 1935 (1929 = 100) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rates in various countries, 1929–1932 (%) . . . . . . . . . . . . . . . . GDP growth rates in various countries (% annual growth rate, 1923–1935) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Political interest rates in various countries, 1923–1935 (%) . . . GNP, 1923–1935 (at current prices, Million TL) . . . . . . . . . . . . Consumer Price Index (CPI, 1918 = 100) . . . . . . . . . . . . . . . . . Various foreign trade indicators, 1923–1935 (Million $) . . . . . . Exchange rates, 1923–1935 (TL/$) . . . . . . . . . . . . . . . . . . . . . . . Annual GDP growth rates in advanced economies (1971–1980) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inflation rates in advanced economies (1971–1980) . . . . . . . . . Unemployment rates in advanced economies (1971–1980) . . . The all-time biggest losses DJIA . . . . . . . . . . . . . . . . . . . . . . . . . Tariff levels in Mexico (1982–1992) (percent %) . . . . . . . . . . . . Inflation and exchange rate changes (1991–1995) . . . . . . . . . . . Components of domestic debt (millions of dollars) . . . . . . . . . . Balance of payments (% of GNP) . . . . . . . . . . . . . . . . . . . . . . . . Foreign trade, 1980–1994 (thousand $) . . . . . . . . . . . . . . . . . . . Short-term advances extended by the Central Bank to the treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Auctions of treasury bills and bonds in 1993 (in Billion TL) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Economic growth rates of Asian tigers between 1981–1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

24 25 26 26 28 29 30 31 32 32 47 49 50 71 84 88 89 99 102 111 113 128

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Table 8.2 Table 8.3 Table 8.4 Table 8.5

List of Tables

Some macroeconomic indicators of Thailand before and during the Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Some macroeconomic indicators of Indonesia before and during the Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Some macroeconomic indicators of South Korea before and during the crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Some macroeconomic indicators of Malaysia before and during the Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

133 135 137 139

List of Charts

Chart 2.1 Chart 2.2 Chart 2.3 Chart 2.4 Chart 3.1

Chart 3.2

Chart 3.3

Chart 4.1 Chart 4.2 Chart 4.3 Chart 4.4 Chart 4.5 Chart 5.1 Chart 5.2

Money and output in the United States. Source Romer and Pells (1998) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Export values in selected countries, 1923–1935 (Million $). Source UN (2019) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Import values in selected countries, 1923–1935 (Million $). Source UN (2019) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Duration of Great Depression in various countries. Source Rogoff and Reinhart (2011: 297) . . . . . . . . . . . . . . . . . . Annual GDP growth rates in advanced economies (1971–1980). Source Created by the author by using the data from the World Bank database . . . . . . . . . . . . . . . . . . . Inflation rates in advanced economies (1971–1980). Source Created by the author by using the data from the World Bank database . . . . . . . . . . . . . . . . . . . . . . . . . . . Unemployment rates in advanced economies (1971–1980). Source Created by the author by using the data from the OECD database . . . . . . . . . . . . . . . . . . . . . . . . Revaluation and decrease in interest costs after globalization. Source World Bank (2019) . . . . . . . . . . . . . The current account of Chile (1975–1989). Source World Bank (2019) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . GDP size (1975–1989). Source World Bank (2019) . . . . . . . . . Change of inflation and unemployment rates (1971–1981). Source World Bank (2019) . . . . . . . . . . . . . . . . . . The emergence of the financial crisis in financial indicators. Source World Bank (2019) . . . . . . . . . . . . . . . . . . . . US inflation and interest rates of effective Federal funds (1970–1990). Source https://fred.stlouisfed.org . . . . . . . . . . . . . Crude oil prices per barrel between 1970 and 1990. Source https://www.macrotrends.net . . . . . . . . . . . . . . . . . . . . . .

16 22 23 25

48

50

51 60 61 62 65 66 72 73

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Chart 5.3 Chart 5.4 Chart 6.1 Chart 6.2 Chart 6.3 Chart 7.1

Chart 7.2 Chart 7.3 Chart 7.4 Chart 7.5

Chart 7.6 Chart 7.7 Chart 7.8 Chart 7.9 Chart 7.10 Chart 7.11 Chart 7.12

Chart 7.13 Chart 9.1 Chart 9.2 Chart 9.3 Chart 9.4 Chart 9.5

List of Charts

Yield rates of US treasury bonds (1987). Source https:// fred.stlouisfed.org . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . DJIA (1980–2000). Source https://www.macrotrends.net . . . . . Mexican Consumer Price Inflation 1980–1993 (%). Source Dornbusch and Werner (1994) . . . . . . . . . . . . . . . . . . . . Import as a percent of Mexican GDP 1970–1992 (%). Source Dornbusch and Werner (1994) . . . . . . . . . . . . . . . . . . . . Saving-investment gap and current account (% of GDP) (1988–1994). Source Sachs et al. (1995) . . . . . . . . . . . . . . . . . . Capital flows (million $) (FDI foreign direct ınvestment, FPI foreign portfolio ınvestment (medium and long-term), STC short-term capital). Source Celasun (1998: 30) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total public sector (% GNP). Source Celasun (1998: 23) . . . . . The primary deficit (% GNP). Source Celasun (1998: 23) . . . . WPI and CPI inflation. Source Celasun (1998: 34) . . . . . . . . . . Public sector borrowing requirement (PSBR) and the primary deficit (% GNP). Source Celasun (1998: 29) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real exchange rate (1986.01 = 100). Source Celasun (1998: 27) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credit to public sector by Central Bank. Source Celasun (1998: 31) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . International reserves, 1990–1994 September (billion US$). Source Celasun (1998: 32) . . . . . . . . . . . . . . . . . . . . . . . . Annual economic growth rates (%). Source TCMB (2019) . . . . CPI and WPI (%). Source Celasun (1998: 34) . . . . . . . . . . . . . . Istanbul stock exchange index (1991.06 = 100). Source Celasun (1998: 40) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign capital flow (% of GNP). Source Created by the author from the data shown in the table of Özatay (2000:29) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest rates of treasury bills, 1990–1995 (%). Source Celasun (1998: 38) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Russia inflation rate 1993–2000 (%). Source World Bank (2019a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Russia GDP growth (annual %). Source World Bank (2019b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . USD/RUB (1995–2004). Source Investing (2023) . . . . . . . . . . . Crude oil prices per barrel (1993–2000). Source Macro Trends (2023) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Russia crude oil: exports (1993–2000/barrel). Source CEIC (2019) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

74 78 85 87 88

100 104 105 106

107 108 111 114 117 117 118

119 120 147 149 150 151 151

Chapter 1

Introduction: Models Related to the Contagion of Financial Crises Bernur Açıkgöz

Abstract Economic crises are times of disaster in which the results of economic mistakes made by governments reflect on the people. Although economic crises are seen as opportunities in some cases, they have created a burden for the people. Some economic crises even triggered the World War. A recent example, Adolf Hitler, was seen as a hope of salvation in Germany due to the Great Depression and was brought to power. The second volume of the book series of the Black Swan: Economic Crises (1634–2020) will discuss, all financial and economic crises of the twentieth century in detail after the introductory chapter on the Models Related to the Contagion of Financial Crises. This chapter will initially discuss Models Related to the Contagion of Financial Crises, namely “contagion” and “negative spillover” effects to better understand all the financial, fiscal, and economic crises in 20th-century world history. With globalization in the twentieth century, economic and financial problems in a country or a region spread from the banking system to the real economy at a disastrous rate and affect global financial stability. Economists define this phenomenon by using the terms “contagion” and “negative spillover”. The financial crises of the twentieth century revealed the impact of the risk of contagion on the economy, acting like an extremely dangerous virus that contaminates all cells in the body. Keywords Contagion · Negative spillover · Economic crisis · Financial crisis

1.1 Introduction Generally, economic, and financial crises cannot be isolated within one market. Instead, it has a contagion effect which one can define as an economic and financial crisis originating from one market and spreading to other markets causing simultaneous or sequential crises (Huang and Chen, 2018). It has been observed that the B. Açıkgöz (B) Department of Public Finance and Financial Management, ˙Izmir Katip Çelebi University, ˙Izmir, Turkey e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 B. Açıkgöz (ed.), Black Swan: Economic Crises, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-99-2318-2_1

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financial crisis that emerged in one region spread to other regions in a very short time. Examples of this situation are the 1992–93 European crisis, the 1994 Mexican crisis, and the 1997 Asian crisis. Some policy changes in developed countries (such as increases in international interest rates, shifts in the economies of industrialized countries, or increases in the exchange rate of industrialized countries’ currencies) may cause crises in developing countries. Such increases cause capital outflows in developing countries. If the cause of the financial crisis in one country creates a financial crisis or a speculative effect in another country, the crisis has infected that country. However, the negativity experienced in the other country is not a sufficient reason for the crisis to infect one country. It may be that the macroeconomic variables in the relevant country are in a very bad state or that the expectations of the private sector may be negative. At the same time, this effect, which causes financial crises in more than one country, is called the monsoon effect. Financial crises spread from one country to another in the form of contagion or herd psychology (Bastı, 2006).

1.1.1 Contamination by Spillover A devaluation in one of the two countries with economic relations will cause a decrease in commercial competition in the other country, and a decrease in the competition will cause a decrease in foreign trade and depletion of reserves in the relevant country. If it is good in the middle between two trading countries, there is a direct commercial agreement. The existence of a direct commercial agreement will also cause a financial crisis to spread from one country to another. If we assume that these two countries are competing in foreign trade, this indicates that the devaluing country has an indirect trade relationship with the other country. The devaluing country will hurt the demand for the other country’s goods. Since a country has a direct or indirect commercial relationship with another country, devaluation in one of the countries will reduce the chance of competing in the other country, so wage increases in the other country will lead to a decrease in production. A decrease in production will cause a decrease in the demand for money and an increase in the money supply. It can be said that when the investor wants to convert the excess money supply into foreign currency, an invitation to the crisis has been issued (Bastı, 2006).

1.1.2 Pure Contagion The crisis in one country may not have had any negative impact on the economic data of another country. However, even if there is no negativity in the economic indicators, a crisis that starts in one country causes investors to assume that there will be negativities in another country, and the crisis spreads to the second country. This condition is referred to as Pure Contagion. Another simple meeting can manifest itself as follows. Due to negativity that started in a country, investors’ desire to

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dispose of their mutual funds in another country, which is in better condition, causes the economy of the country to go into crisis (Cooper, 1999). Contagion occurs in three different ways: The first one is economic policies implemented by developed countries causing a crisis in developing countries, “Mussuonal Effect”: Here, the crisis originates from developed countries. The main factors are the openness of the economies of developing countries, the high level of external debt, and the lack of a solid foundation in the banking sector. The second one is the crisis in a developing country that puts the economy of another country in trouble: The main factor in this crisis is that countries follow policies that are close to each other financially. The third one, another form of contamination is due to the negativity of expectations. For example, a negative economic program in one country creates the idea that this situation will create negativity in other countries.

1.1.3 Herd Behavior It emerges as investors act with hearsay market information, not macroeconomic indicators, in guiding their investments. For example, because of a decrease in the price of real estate, investors act with the belief that the price decrease will continue. This situation, which starts with the sale of real estate, then negatively affects all investors in waves, creating gaps in the economy and accelerating the outflow of money is expressed with the concept of herd psychology. Two reasons are cited as the reason for the emergence of herd psychology. The first one is the Bandwagon effect. It is that other investors follow the movements exhibited by some investors. Take, for example, three investors. Let’s assume that these three investors have information that the market does not. The first investor can get negative information and start selling. Although the second investor does not have any negative information, he will go on sale just because the first investor has gone on sale. Even if the third investor has positive information, it tends to sell because the other two investors are selling. The second one is the behavior of institutional investors in countries where the crisis probability is high. Funds direct investors’ money and are compared with each other because of their returns. Since the perception of a negative situation in a market will mean that the returns of the funds will decrease, investors will immediately act to sell their funds in this market (Aslanta¸s & Odyakmaz, 1998). After giving a short introduction to the Models Related to the Contagion of Financial Crises, in this chapter we will discuss the 20th-century crisis. The twentieth century, when two great world wars took place on the stage of history, witnessed major economic crises as well as wars. These crises have caused social and economic paradigm shifts to be experienced much faster and more effectively than in previous centuries. The transformation of the demand-oriented economic understanding created by the Great Depression in 1929 into an interventionist social state understanding, especially after World War Two, increased the intervention of states in the socio-economic field. In this period, the reconstruction of the countries,

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the development of social welfare services, the assurance of human rights, the acceleration of industrialization and development, and the economic growth and income growth of the countries resulted in the golden age enjoyed by the societies of the period. Economic crises may result from excess supply or contraction in demand in the real and financial sectors. There are various reasons for the emergence of both supply and demand crises. Economic crises can arise from cyclical reasons outside the organization as well as from within the organization. The cause of economic crises may not always be “economic reasons”. For example, a country-level natural disaster (such as an earthquake, fire, flood) may cause an economic crisis. Rapid changes in political, economic, technological, and ecological fields can cause economic crises as well. For example, government crises in the political arena, military coups, and political instability may cause crises. The interventionist social state, seen as a prescription and opportunity in the past crisis, was one of the cornerstones of the crisis in the last quarter of the century in the 1970s. Against interventionism; with the rise of neo-liberalism, financial liberalization, information society, and technological discoveries, globalization has become the new phenomenon of the age. This volume of the book will examine in detail the causes, occurrences, and results of the 20th-century crises. It will start with the Great Economic Depression of 1929: First Global Economic Crisis, then 1973 Oil Crisis: An Economic Illness-Stagflation, Chilean Economic Crisis (82–86): Twin Crisis-Finance/Banking Crisis, Stock Market Crash of 1987: Black Monday, Mexican Tequila Crisis of 1994, 1994 Financial Crisis in Turkey, 1997 Asian Crisis, and 1998 Russian Financial Crisis. The Great Economic Depression of 1929 is accepted as one of the most important crises in terms of impact, duration, extent of spread and results among the economic crises experienced in the historical process. The economic crisis that first emerged in the USA turned into a great depression with the effect of the factors explained in detail in the following sections and turned into a global economic crisis that affected the whole world. The oil shocks, which were experienced for the first time in 1973 after the Great Depression, also caused a deep economic crisis on a global scale. It was seen that this great crisis could be solved not with the current economic approach as in the 1929 crisis, but with a new economic understanding. The 1973 crisis, called the Oil Shocks, is a crisis in which macroeconomic policies such as fiscal and monetary policies could not be implemented, but micro-based policies were insufficient. The crisis in question, which introduced concepts such as stagflation and the Petro Dollar into the economic literature, left the Keynesian policies unsolved, which opened and closed an era in the history of economics. Even today, a definite and clear solution has not been developed for the way out of this crisis, which should be emphasized and considered with all these aspects. The crisis that Chile began to experience in the 1980s is referred to as a twin crisis in the literature. The simultaneous existence of a money-financial crisis and a banking crisis in Chile caused this situation to be described as a twin crisis. In the following period, the currency crisis that emerged with the devaluation caused by the deterioration of economic stability increased dollarization after revaluation,

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and banks’ tendency to foreign exchange transactions and borrowing caused the exchange rate risk to increase. A banking crisis followed as the banking system could not anticipate the risk. Although this crisis, which entered the economic literature, is a lesson to be learned for many countries, many similar crises were observed in the following periods. This is because the fiscal policies are voluntary and inefficient, and because the wrong economic instruments are used. The Chilean Twin Crisis is clear proof of the importance of political effectiveness and financial controls in economic management. The stock market crash of October 19, 1987, also known as Black Monday, takes its place in history as a crisis in which developing technology and human factors manifest themselves. With the transition to the computer age, Black Monday took its place in history as the first great tragedy of an age where winning and losing were much faster than before, by leaving the tools and decision-making elements in stock market transactions to the computer. Although it was a bitter experience, the losses in the US economy and financial system on October 17, 1987, were compensated in a short time by the trust provided by the FED to the economy and by the fast and determined policies it implemented. Mistakes made in past crises. On the other hand, the transition of the FED to the low-interest regime that came with this process paved the way for future crises. However, in this period, the right steps were taken to overcome the crisis and provide the liquidity needed to compensate for the losses in the markets. The 1994 Mexican crisis is an important lesson, especially for developing countries, about the sustainability of large current account deficits and the risks of sudden shifts in capital flows. The use of the exchange rate as a nominal anchor and the political permissiveness of the real exchange rate overvaluation and the foreign debt reaching significant dimensions damaged external debt management, to encourage foreign capital inflows into the country and to borrow more easily from foreign markets. The uneasiness about the inability to maintain national reserves and existing debts in 1994 triggered the outflow of foreign capital from the country with the outbreak of a series of events on a global and national basis. At the end of the 1994 crisis, the country’s currency fell to half of its pre-crisis value, inflation peaked at 52%, interest rates peaked at 80%, and the country’s economy shrank by 7% in total. The 1994 crisis in the Turkish economy is referred to as the currency crisis by many economists. The 1994 currency crisis is not a crisis that emerged out of nowhere, but a crisis that broke out because of some policies implemented in the past. With the liberalization that started in the foreign trade and commodity markets with the 24 January 1980 Decision, the Turkish economy was not yet fully ready and the full liberalization in the financial markets in August 1989 showed its effect in the long term, and as a result, the Turkish economy began to experience a period intertwined with contractions and crises. When the weaknesses of the economic management of the period combined with the facts mentioned above, the 1994 economic crisis was inevitable. As a result, the economic management could not do its part in the formation phase of the 1994 financial crisis and in the measures taken to overcome the crisis. Neither the stability program of 24 January 1980 nor the economic decisions of 5 April 1994 could achieve the desired results on paper.

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The crisis, which is called the Asian or East Asian crisis, has pushed the whole world to question the crisis theories again. Asian tigers, which broke records every year with their economic growth, whose inflation did not reach double digits, did not experience unemployment problems, and even provided cheap labour from neighbouring countries, came to the brink of bankruptcy in just 6 months in 1997. These countries, which are the new favourites of the world in exports, became unable to pay their debts in the mid-90s from a position that the world envied with the performance they showed in industrialization every year in the 80s. The crisis, which started in Thailand in July 1997, spread to the countries of the region until 1998 and caused major crises, especially in Indonesia. Low value-added investments are the most important factor driving Asian tigers, which are the focus of attention of investors all over the world, with their strong economic structures and inflation, growth, and unemployment rates targeted by many developing countries. This clearly shows that even with high growth rates for over a decade, inflation rates have been kept at a reasonable level and there is no unemployment problem and that despite these sound macroeconomic fundamentals, mismanagement of resources will inevitably lead to an environment of crisis. Finally, when we look at the Russian crisis, we can say that internal and external factors had common effects on the development of the process that brought Russia to the moratorium in 1998. After the collapse of the Soviet Union, with the deterioration of economic indicators, the negative effects of the course were tried to be suppressed through the policies implemented by the state and the reforms carried out with the recommendations of the IMF. In the second half of the 1990s, the crises arising from speculative short-term capital movements in developing countries naturally had a global impact, while negatively affecting commodity prices. The fall in oil prices, which is among Russia’s most important export items, has put the economy in a deadlock. The failure to prevent tax evasion and the ineffective use of IMF aid, the state’s loss of income, and thus the inability to achieve the desired effect, were important reasons that paved the way for the crisis in Russia. The political and economic reforms carried out after the crisis yielded positive results and the recovery process started with an increase in commodity prices. The domestic market benefited from the devaluation, in other words, the revival of domestic production as a result of the increase in import costs and the revival of the industry, as a result, was effective in overcoming the crisis shock in a short time. I would like to thank my esteemed teacher and dear friend Prof. Dr. Ronald Harstad who guided and supported me at every stage of my academic life and read and gave his suggestions and contributions to this book.

References Aslanta¸s, M., & Odyakmaz, N. (1998). “Para Krizleri”, Dünya ekonomileri Bülteni, Nisan, s. 19–20. Bastı, E. (2006). “Kriz Teorileri Çerçevesinde 2001 Türkiye Finansal Krizi” Sermaye Piyasası Kurulu, Ankara, s. 17–18.

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Cooper, R. N. (1999). The Asian crises: Causes and consequences. In A. Harwood, R. E. Litan, & M. Pomerleano (Eds.), Financial market and development: The crisis in emerging markets (s. 21–22). Brooking Institution Press. Huang, W., & Chen, Z. (2018). Modelling contagion of financial crises. The North American Journal of Economics and Finance, 54. https://doi.org/10.1016/j.najef.2018.06.007

Bernur Açıkgöz was born in 1979 in Ankara. After attending Ankara Finance High School, she continued her undergraduate studies at Dokuz Eylül University, Department of Finance. She received her master’s degree in Financial Law from Dokuz Eylül University. In 2006, she was awarded her Ph.D. degree from Dokuz Eylül University Department of Public Finance. Her Ph.D. thesis covered the topics of poverty and development. In 2006, she won the Harvard University Project scholarship and worked as a visiting professor at Harvard University. In 2009, she received a scholarship from the Swiss Government for a post-doctorate degree in economics at the University of Neuchatel/Switzerland and taught courses at Bern Universities. She then began to work in the fields of experimental economics and game theory, and for three consecutive years as a guest lecturer in the economics laboratory of the Montpellier University in Montpellier, France. Afterwards, she went to Missouri University, Indiana University, and Arizona University with a scholarship from Missouri University. She then worked as a visiting professor at the University of East Anglia and took some courses from Exeter Universities in the UK with a Tubitak scholarship. Professor Dr. Bernur Açıkgöz has books, articles, and papers on foreign direct investments, economic growth, panel econometrics, experimental economics, and game theory. She is currently working in the Department of Public Finance and Financial Management at Izmir Katip Çelebi University/Turkey. In addition, Açıkgöz teaches in the Department of International Trade and Finance at Izmir University of Economics/Turkey and the Department of Economics at University of Life Sciences in Pozna´n (Uniwersytet Przyrodniczy w Poznaniu)/Poland.

Chapter 2

Great Economic Depression of 1929: First Global Economic Crisis Mesut Ardan

Abstract The great economic depression of 1929, which is one of the most important economic crises ever in the history of the world economy and continued its effects for decades, first appeared in the United States of America and caused some economic, sociological, and political consequences by affecting almost the whole world. It would not be wrong to attribute the causes of the great depression that emerged in 1929 to the economic developments and policies in the United States. To put it more clearly, the stock market crash because of speculative and credit purchases, the decrease in consumption compared to overproduction, abundance of money, declining trust in the economy and bank panics, inexperienced economy management, applied customs tariffs caused the crisis. The practices of other world countries deepened the crisis and turned it into a world economic depression. This chapter aims to give detailed information about the great economic depression of 1929, which has an important place in the history of the world economy and has led to the emergence of a new economic approach. The historical development of the Great Depression, the reasons for its emergence, its effects on the selected countries in various ways, the changes in the economic policies, and the strategies of selected countries implemented to exit the Great Depression constitute the main parts of the study. Pre-depression and post-depression economic data of both the USA and selected countries are incorporated to reveal the historical development of the Great Depression, the reasons for its emergence and its consequences. Thus, the effects of the Great Depression on world economies were explained through data such as unemployment, growth, interest rates, trade volume. In many countries, with the Great Depression, the gross domestic product fell at high rates, the world trade volume decreased significantly, and unemployment rate increased. The effects of crisis lasted for years, and it took a long time to recover. The Great Depression also played an important role in the political structures and economic policies of the countries. The classical economic approach, which was accepted until the Great Depression, has been replaced by the Keynesian economic approach. The new approach that foresees direct state intervention in the economy influences the world M. Ardan (B) ˙Izmir Sectoral Audit Department, Tax Inspection Board, Ministry of Finance, ˙Izmir, Turkey e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 B. Açıkgöz (ed.), Black Swan: Economic Crises, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-99-2318-2_2

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economy for about 40 years after the Great Depression. The negative effects of the Great Depression were tried to be eliminated by applying exit strategies from the crisis within the framework of Keynesian economic policies in both the USA and other countries. Keywords Great Depression · First global economic crisis · Stock market crash · Classical economics · Keynesian economics · Black Thursday

2.1 Introduction The Great Economic Depression of 1929 is considered as one of the most important crises among the economic crises experienced in the historical process in terms of impact, duration, degree of spread and results. The economic crisis that first appeared in the United States of America (the US) turned into a great depression with the effect of the factors explained in detail in the following sections and became a global economic crisis, affecting the whole world. The Great Depression, which spread almost all over the world, adversely affected the economies of many countries along with the US for decades and became a turning point in terms of economic approaches in the world economy. As a matter of fact, the classical understanding of economics, which had prevailed until 1930, was replaced by the Keynesian Approach, and the governments started to apply economic measures based on this approach as a prescription for exit from the crisis. In this section elaborates the Great Depression, which has an important place among the world economic crises and, first, it will mention the historical development of the crisis which will be followed by brief information on the economic understanding prevailing in the US in the pre-crisis period. Then the reasons of the emergence of the Great Depression, its impact on the US and selected countries as well as economies understanding, and the way out of the crisis followed, particularly, by the US, and selected countries including Turkey.

2.2 Historical Development of the Great Depression of 1929 The Great Depression is a worldwide depression that emerged in the US and lasted for about 10 years starting from 1929. It is stated that the beginning of the depression was the collapse of the New York Stock Exchange on the day described as Black Thursday on 24 October 1929. However, the US stock market was in a troubled state before October 1929. Despite increasing unemployment and falling production, stocks were overvalued in August 1929 and inflated like a bubble. This depression experienced by the industrialized Western world has the characteristic of being the longest-lasting, worst and most severe depression in the world (Amadeo, 2019b).

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The collapse of the New York Stock Exchange and the Great Depression can be thought of as two different events. Initiating the great depression that will last for years, it resulted in a significant decrease in the production and employment of many Western countries, including the US (Romer & Pells, 1998). As stated above, the Great Depression, which adversely affected the whole world, including Turkey, first appeared in New York City of the US. After World War I, the US reached a superior position compared to other countries both economically and politically. Towards the end of World War I, the significant amount of gold stocks held by the US provided an advantage to the US in the world economy and increased its production capacity. The rapid development in the American industry during the 10 years after World War I was supported by the abundance of money and to some extent by the policies of the Central Bank. However, in the 1920s, with the decrease in the foreign demand of European countries, in other words in their import, the US products sold to these countries decreased, and with the effect of the decrease in product prices, the US’s sales revenues and profit obtained from abroad decreased or even dried up(Özdemir, 2015) In 1928, the US Federal Reserve slightly increased the interest rates in order to restore stability in the markets, and as a result, the capital used for investments abroad started to return to the country (Eichengreen & Mitchener, 2003: 25). The growth of the US was interrupted by the stagnation that started with the bursting of the price bubble in the real estate sector in 1926 and in the automotive sector at the beginning of 1929. However, the investors leaving these sectors and the capital leaving other countries and turning to the US domestic market, as a result of the increase in the interest rates by the Federal Reserve, turned to speculative stock purchases in the New York Stock Exchange. With the remarkable increase in demand for stocks, there were extraordinary increases in prices (Selim, 2013) The stock market has inflated like a bubble, with many banks pouring large amounts of funds into speculative purchases. Thereupon, the US Federal Reserve’s increasing the interest rates from 7 to 15% in the summer of 1929 (White, 1990: 74) in order to stop the speculative increase caused distrust in the markets. The artificial rise in stock prices in the New York Stock Exchange gave way to dramatic declines on 21 October with the spread of distrust. With the collapse of the New York Stock Exchange on 24 October, many banks that gave loans to investors in speculative stock purchases and received stocks as collateral in return began to go bankrupt one by one, due to both the non-repayment of the loans and the unsecured loans. In particular, the bankruptcy of banks caused the economic crisis that started with the collapse of the New York Stock Exchange to affect the entire US economy, and the crisis that emerged in the US and turned into a depression with a number of policy mistakes spread almost all over the world(Özdemir, 2015) As a result, the world economic crisis that emerged in 1929 has been recorded as one of the most important crises in world history.

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2.3 Pre-crisis Economic Understanding in the US As a result of the mechanization that increased with the industrial revolution, the production level of the US increased and in this period, less importance was given to the supply side of the economy compared to the demand side. While production increased in the US economy in the 1920s, wages not increasing enough compared to production and the economic understanding that ignored consumer behaviour caused the consumption reached the saturation point, which resulted in the crisis. The economic crisis of 1929 took place at a time when classical economics, which did not accept the intervention of the State in the economy and adopted the thought of “laissez-faire, laissez-passer” and the neo-classical economics understanding which was its derivative prevailed (Yardımcı et al., 2017: 252).

2.4 Causes of 1929 Great Depression The reasons for the great depression that emerged in the US on 24 October 1929 and affected the whole world and lasted for about 10 years are explained in detail below.

2.4.1 Stock Market Crash of October 1929 Increasing its efficiency economically and politically after the World War I, the US significantly increased its gold stock. The accumulated capital turned to real estate and land purchases in the mid-1920s, especially in 1926, and the resulting real estate bubble led to an increase in housing supply. With the end of speculation on real estate, there was a decrease in real estate prices, and this time the capital turned to the stock market (Smiley, 2002: 10). With the increase in investments in stocks, the prices of stocks, which were at their lowest level in 1921, increased by 4 times and reached the highest value in 1929. With speculative and credit purchases made by brokers, stocks exceeded their real value and price bubbles were formed. Despite warnings that the markets were ruled by speculation, many people were convinced that they would be rich in the stock market, and in this context, the prices of stocks increased continuously between 1920 and 1929, by purchasing more stocks with debts from banks. 80–90% of the stock purchases using the leverage system were made on loans. Thanks to the leverage system and purchases on loans, the prices of stocks have increased excessively; however, as a result of the crisis of confidence in the market, sharp declines occurred in stock prices and as a result, the New York Stock Exchange collapsed. The statement “Expectations are bought, the facts are sold in the stock market” reflects the behaviour of the US investors in the period between 1926 and October 1929. As a matter of fact, the said investors initially purchased the expectation that the prices of stocks

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would rise significantly and caused the formation of a price bubble with the stocks purchases on loans. However, when the real situation was perceived, they started to sell, this time causing a dramatic decrease in stock prices ( (Selim, 2013) Banks giving loans to investors for the purchase of stocks accepted stocks as collateral for their loans. However, with the collapse in the stock market, sudden drops occurred in stock prices and banks started to recall their loans. However, with the decrease in the value of the stocks accepted as collateral, many loans that could not be paid left without collateral, which led to the bankruptcy of a significant number of US banks (Yardımcı et al., 2017: 252). The fact that stocks, which were put up as collateral for loans given by banks, covered only a small part of the loan was also effective in the disposals and collapse of the New York Stock Exchange. In 1928 and 1929, the Federal Reserve Bank (Central Bank) increased the interest rates to curb the speculative increases in the stock market (Bernanke & James, 1991: 40). Increasing the interest rate from 7 to 15% in the summer of 1929 negatively affected some interest-sensitive expenditures such as construction and automotive and caused a decrease in the demand for durable consumer goods. The measure of increasing interest rates taken to prevent speculation in the stock market had a negative impact on the real sector, and increased interest rates led to a decrease in production (Kazgan, 2012: 42). In addition, many people lost almost all of their savings due to the collapse of the New York Stock Exchange in an environment of mistrust which was also affected by the interest rates increase when the stock prices were at their highest, and thus, people whose wealth decreased, consumed less. Dow Jones dropped by 11% on 24 October 1929, which is described as Black Thursday, and investors sold a significant number of stocks in panic due to this decline in stock prices. Between 28–29 October 1929, stocks lost more than $30 billion in value, and the index decreased approximately 33% between September and November (Fiorillo, 2019) In brief, with the sharp decline in the New York Stock Exchange, the crisis began to be felt deeply in the US economy, production and total demand decreased rapidly and many banks went bankrupt. The collapse of the New York Stock Exchange ignited an economic crisis that would spread not only in the US but would spread all 2001: 6). over the world and last for 10 years (Aktan & Sen, ¸

2.4.2 Decline in Consumer Demand In the 1920s, when the supply-side economy was dominant, less importance was attached to consumption than to production in the US economy. While production increased with mechanization, no significant increase was observed in total consumption in the US. In the early 1920s, products produced in the US could be sold, especially in European countries. However, the demand for US goods from European countries and the contraction in the US domestic market are considered as one of the important causes of the great depression in the US.

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Neglecting the consumption behavior in the US domestic market and the quite low levels of worker wages caused a decline in consumer demand. The fall in consumer demand also led to a decrease in economic production, and the economic crisis was felt more deeply in both supply and demand side (Tarihibilgi, 2019). Unemployment rates, which reached 15%, also caused a further decrease in consumption and spending which had been expected to improve the economy.

2.4.3 Abundance of Money The 1920s can be considered as a period of prosperity for the US in general. However, bursting of the bubble, which started to inflate in the stock market since the early 1920s, in 1929, and thus the mentioned period can actually be considered as a phase towards the emergence of the Great Depression. The monetary policies followed by the Federal Reserve in the 1920s enabled the amount of money and loans to increase, which caused the real estate sector to bubble first in 1926 and finally the stock market in 1929. As a result of the cash pumping, the private sector’s borrowing opportunities increased; and increasing demand for housing and stocks through borrowing resulted in price bubbles in these sectors (Crafts & Fearon, 2013: 9). With the help of easy money in the market, both the banking sector and the housing and stock investors initially displayed a profitable image, but when it was understood that the price bubbles with large debt accumulation could not be sustained in the long term, mistrust and fragility emerged in the economy (Yardımcı et al., 2017: 256).

2.4.4 Declining Trust in the Economy and Bank Panics With the collapse of the New York Stock Exchange, both the stock market and the banks which gave loans in return for stocks and whose loans were left without any collateral, the trust was hardly there. The decline in trust in banks led depositors to demand their deposits in cash by rushing into banks. Bank panics spread throughout the US, and widespread bank panics occurred in the autumn of 1930, spring and autumn of 1931, and finally in the autumn of 1932 (Romer, 1993: 32). The massive deposit withdrawals led to the emergence of the money stock deficit in the US, and the bank panics that continued until the winter of 1933 ended upon the President Roosevelt’s announcement of the National Bank Holiday on 6 March 1933 (Romer & Pells, 1998). The highest concentration of wealth in the US economy occurred in 1929. Consequently, risky loans reached very high levels in the banking sector in the same year (Açıkgöz & Özkan, 2009). The most important factor was the bank loans given for speculative stock purchases made in the New York Stock Exchange, and 80% -90% of the stock purchases between 1927 and 1929 were financed by these loans. Banks went into a crisis due to both the inability to repay the speculative loans given in large

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amounts due to the collapse of the stock market, and the bank panics that emerged in an environment of mistrust (Bernanke, 1983: 4); many depositors who had deposits in bankrupt banks lost substantial savings due to their bank assets not being covered by insurance. The banks still operating, on the other hand, hesitated to provide loans due to economic uncertainties, which led to a decrease in investment and consumption expenditures (I¸sık & Duman, 2012a, 2012b: 79). Both the concentration of wealth and the increase in risky loans in banks’ assets caused the economic crisis in 1929 to turn into depression.

2.4.5 Inexperienced Economy Management Delay in state intervention in the market and implementing wrong monetary policies played an important role in the formation and aggravation of the Great Depression. In the 1920s, a liberal economic understanding expressed as “laissez-faire, laissezpasser” (let them do, let them pass) prevailed in the US. It was argued that the influence of the state on the economy should be as little as possible. In this framework, there was no control over the financial markets and banks, the State did not intervene in the financial markets in any way, and it was believed that the markets would find balance automatically. The fact that the Federal Reserve of the period and the President of the US did not tend to intervene in the market and establish a surveillance system, or any delay in both caused the economic crisis to occur and caused the depression to aggravate and last for years (Calomiris, 1993: 62). Below is the discussion on the policy mistakes from the perspective of the then US President and the US Federal Reserve. Chart 2.1 is important in terms of showing the money supply and production amounts in the US in the 1920s when the Great Depression emerged and in the following years when its effects were still felt. As can be seen from Chart 2.1, the money supply and production level followed an ordinary course in the normal times of the 1920s. As a matter of fact, in the said period, the money supply increased and as mentioned before, a period of prosperity was experienced in which price bubbles appeared, albeit partially. Since 1928, when things started to deteriorate, the Central Bank began to follow a tight monetary policy, thereby reducing the money supply, and continuing this policy after the Great Depression broke out. It is stated by some researchers that the Central Bank followed a tight monetary policy that was more than necessary and continued it after the crisis emerged, causing depression to occur and aggravated (Christiano et al., 2004: 8). One of those who thought the Central Bank was wrong at that time was Ben Bernanke. According to Bernanke, the mistakes of the American Federal Reserve can be summarized as follows (Amadeo, 2019b): • The Central Bank, which started to increase the interest rates in the spring of 1928, continued this in August 1929, when the recession occurred, • Did not increase money supply to combat deflation, and

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Chart 2.1 Money and output in the United States. Source Romer and Pells (1998)

• Taking a passive attitude towards bank panics and not taking the necessary precautions against the decrease in the confidence in financial institutions in the eyes of investors. The Central Bank’s tight monetary policy before and after the crisis affected the real sector more than the finance sector. As can be seen from Chart 2.1, following a tight monetary policy significantly decreased the production level in parallel with the decrease in the money supply, the investments decreased, and caused the economy to drift further into stagnation. The decrease in money supply and prices increased the deflation expectations of consumers and investors, and consumption was suppressed by keeping the money under the pillow as the confidence in financial institutions decreased (Yardımcı et al., 2017: 256). Consecutively elected Harding, Coolidge and Hoover administrations were hesitant to intervene in the markets and hence the crisis. It is said that Hoover, who was elected as the 36th President of the US in March 1929, the year the crisis broke out, and the inexperience of the economic management were an important factor in the formation of the crisis (History.com, 2019). Having a liberal economy view, Hoover did not approve of the State intervention in the economy and took measures to ensure that the State budget was balanced. These measures led to further decrease in production level, decrease in income, increase in unemployment and decrease in total demand. With the 1932 Revenue Act, budget balance was intended, and the increased tax rates, in this context, caused a decrease in consumption, which in turn aggravated the severity of the depression (Romer & Pells, 1998).

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2.4.6 Insisting on Gold Standard in Money The gold standard is based on the principle that the value for money created is freely exchanged with gold of a predetermined quality and quality. According to this standard, national currencies are determined according to gold, and the Central Banks follow the necessary monetary policies in order to maintain the fixed value of the national currency (Temin, 1991: 8). Some researchers suggested that the FED reduced the money supply in order to protect gold standard of the US. The deflation that emerged with the US entering into an economic crisis decreased the price of products of US origin compared to other countries, and this increased the gold inflow to the US, in return for cheap US goods. Central banks of other Western countries that adopted the gold standard also raised interest rates in order to protect the value of their national currency and prevent gold outflow, interest-sensitive expenditures in these countries declined and production and consumption decreased (Crafts & Fearon, 2010: 290). The insistence of many countries, including the US, on the gold standard led to the great depression and its spread all over the world.

2.4.7 Inequality in Income Distribution In the pre-crisis period of the 1920s, the US industry developed considerably, and production increased remarkably with the effect of mechanization. Company profitability increased in the said period, yet workers’ wages did not increase at the same rate. Again, from 1920 to 1929, the unionization rate has decreased by almost 40%. During the mentioned industrialization period, workers were neglected, some investors turned to the stock market between 1925 and 1929, and a certain segment of the society had an artificial prosperity on paper. Since the farmers had to sell their products at cheaper prices, their income decreased considerably between 1920 and 1929. Therefore, workers and farmers, who made up a large part of the country’s population, did not benefit much from the artificial prosperity brought by industrialization and price bubbles in the stock and housing market. In 1928, 19.6% of the US national income belonged to 1% of the population; again in 1929, 5% of the population had 33% of the total national income (Johnston, 2019). These data are important in terms of showing that the income distribution in the US was unfair and distorted just before the crisis and in the year when the crisis occurred. The worsening of the justice in the distribution of income caused the consumption segment to spend less, such as workers whose financial power and economic security decreased. While the production capacity reached its peak by increasing continuously over the years until July 1929, the insufficient increase in consumer demand compared to the supply of goods led to the emergence of the so-called inventory recession. The Great Depression of 1929 occurred as a result

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of the stock market investors’ loss of confidence, who had a significant portion of the national income, with the total demand being far below the total supply due to the majority of the population having a small portion of the national income (Selim, 2013)

2.4.8 Smoot-Hawley Tariffs Act The Tariffs Act put on the agenda of the US Congress in 1929 and started to be implemented on 18 June 1930. Mentioned act aimed to protect US farmers from foreign competition, and within this framework, customs tariffs were increased for agricultural products to be imported. When other countries increased the tariff, with the aim of retaliation, for agricultural products subject to foreign trade between countries, there was a decline in world trade volume lasting for many years (Eichengreen, 1992: 216–231). Hence, the impact of the Great Depression on both the US economy and the world economy lasted for a long time.

2.5 Impact of the Great Depression The Great Depression had some negative effects on the US and countries across the world and left deep marks on social lives as well as on economies. Although varying from country to country, this effect lasted for about 12 years in some countries. The impact of the Great Depression on the United States, some selected Western countries, Turkey and finally on economic opinions are discussed below.

2.5.1 Its Impact on the US The economic crisis of 1929 started in the US with the collapse of the New York Stock Exchange and spread to the real sector as a result of actions such as banks refusing to give loans, affecting the entire US economy (Calomiris & Mason, 2003: 937), and then spread to the whole world. The effects of the Great Depression in the US are generally explained under titles such as Unemployment, Inflation, Banking Sector and Stock Market.

2.5.1.1

Unemployment

The US population was approximately 123.1 million in 1930. With the emergence of the Great Depression, unemployment started to increase and the unemployment

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Fig. 2.1 1929 Great Depression Unemployment Protests. Source (Selim, 2013)

rate, which was 3.7% between 1920 and 1929, reached 20% in 1932 and 25% in 1933 (Fiorillo, 2019) (Fig. 2.1). As mentioned above, the rise of unemployment to high levels caused the wages to decrease even more, and the role of women, both in the society and at home, increased during the crisis compared to men (Lange , 2007: 44).

2.5.1.2

State of the Banks

Nearly 90% of the value of the stocks traded in the New York Stock Exchange in 1929 was purchased with the loans given by the banks, and these stocks were also put up as collateral. However, with the collapse of the New York Stock Exchange in October 1929, the value of the stocks decreased dramatically, and the loans left without any collateral as a result of the non-repayment of the loans and the decrease in the value of the stocks (James, 2010: 136). Therefore, many banks went bankrupt. Again, due to the stock market crash, the decreasing confidence in the US financial system caused the deposits in banks to be withdrawn in a panic atmosphere in cash. As a result of the banks’ inability to find enough cash to meet these withdrawals and the failure of FED to adequately and timely intervene in the financial market, bank

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closures have increased. As a result, more than 9000 banks in total were closed due to the Great Depression (Fiorillo, 2019)

2.5.1.3

Stock Exchange

Between the dates 24–29 October 1929, when the Great Depression broke out, stocks in the New York Stock Exchange lost more than $ 30 billion in value. The Dow Jones index continued to decline for 3 years and approximately 4.2 billion dollars of investments in the stock market disappeared (Erbay & Hemen, 2019: 126).

2.5.1.4

Gross Domestic Product (GDP)

Following the Great Depression, partly due to deflation, the US GDP fell by nearly half (Wheelock, 1992: 4). GDP, which peaked at 105 billion dollars in 1929, decreased to 57 billion dollars by 1933 .(Amadeo, 2019a) Real production and prices have fallen rapidly, while industrial production has decreased by almost 47%.

2.5.1.5

Inflation/Deflation

According to the data of the Bureau of Labour Statistics, the consumer price index in the US fell by approximately 27% between November 1929 and March 1933. In the same period, the decrease in the producer price index was approximately 33% (cpiinflationcalculator, 2019).

2.5.1.6

Trade Volume

Panicked with the outbreak of the 1929 economic crisis, the US Government began to enforce the Act known as the Smoot-Hawley Tariffs Act in 1930, in order to protect domestic industry and farmers and workers, by increasing the customs tariff applied to products imported from abroad. However, this Act led to the emergence of trade wars against other countries, and things worsened for the whole world as the countries where the US sold goods increased their tariffs with the aim of retaliation (Grossman & Meissner, 2010: 326). As a result, in parallel with the decrease in the world trade volume, the US trade volume also decreased. With the implementation of the Smoot-Hawley tariffs, the import and export volume of the US decreased by approximately 41% between the second quarter of 1929 and the third quarter of 1932 (Irwin, 1998: 326).

2 Great Economic Depression of 1929: First Global Economic Crisis

2.5.1.7

21

Supervision of and Regulations on the Financial Sector

With the effect of the Great Depression that started in 1929, supervision of and regulations on the US financial markets increased. In this context, the US Securities and Exchange Commission (SEC) was established in 1934, which had a regulatory and supervisory role on financial markets. This new system was further strengthened with the Central Bank, which controlled monetary mechanisms (Dean, 1959: 700).

2.5.1.8

Change in Economic Policy

Before the Great Depression, a radical change took place in the economic understanding, which foresaw that the budget should be balanced and small, and that the state intervention in the market and economy was at the lowest level, based on the laissez-faire concept and that the market could come to balance automatically. With the new system, an economic policy emerged in the US with a large budget, attaching importance to growth and income distribution, and involving an intense government intervention in the economy. The US President Roosevelt introduced Keynesian policies providing for the direct intervention of the government in the economy in order to get out of the Depression and revive the economy. As a matter of fact, the fact that the US budget constantly had deficit between 1931 and 1936 paved the way for the implementation of Keynesian economic policies, which envisaged the effective intervention of the government in the economy, shifting from the classical liberal economic understanding known as Roosevelt’s laissez-faire laissez-passer (Erbay & Hemen, 2019: 128).

2.5.1.9

Social Effects

During the Great Depression, especially economic crimes increased in the US. When the figures for the period are examined, the embezzled amount is around 3.6 billion dollars. A large part of the society experienced enormous social suffering for reasons such as unemployment, hunger, etc. The farmers lost nearly 25% of their land. The famous US novelist John Steinbeck’s novel “Grapes of Wrath” is an important work in terms of shedding light on the social suffering experienced during the Great Depression (Yılmazok, 2014: 17).

2.6 Its Impact on the World The Great Depression occurred in the US in 1929 and had its effects in many countries outside the US. The impact of the Great Depression on other world countries will be evaluated below in terms of trade volume, degree of impact, political results, employment, industrial production, gross domestic product and interest rates.

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2.6.1 World Trade Volume As a result of the negative effects of the Great Depression on the economy, many countries started to take various protective measures and all states compromised the principle of free trade. In this framework, customs tariffs were increased and measures restricting imports were taken (Madsen, 2001: 849). The measures taken by countries to become a self-sufficient economy due to the Great Depression resulted in a 60% decrease in world trade between 1929 and 1932, when measured in US dollars. The course of import and export values of some countries during the times of the Great Depression is evaluated below by means of charts. As can be seen from Chart 2.2, where export values are shown, export figures of many countries increased in general from 1923 until 1929, when the crisis broke out. After the start of the Great Depression in 1929, exports started to decrease, and from 1932 it started to increase again. The country with the highest decrease in exports compared to other countries in the charts is the US. US exports of 5.2 billion dollars in 1929 (CQ Press, 2019) decreased 3.5 times, amounting to 1.6 billion dollars in 1932. Regarding the highest decrease in export values the US if followed by the UK and Germany, respectively. Import values of some countries in the period between 1923 and 1935 are shown in Chart 2.3. With the start of the Great Depression in 1929, there was a dramatic decrease in the import values of many countries, including the US, and after 1932, these values started to increase again. Between 1929 and 1932, the US experienced the highest decrease in import values as was the case in export values compared to other countries. Similar decreases occurred in import values of the UK and Germany (I¸sık & Duman, 2012a, 2012b: 249).

Chart 2.2 Export values in selected countries, 1923–1935 (Million $). Source UN (2019)

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Chart 2.3 Import values in selected countries, 1923–1935 (Million $). Source UN (2019)

2.6.2 Degree and Duration of Its Impact on the World Economy Following the spread of the Great Depression in the US to other countries, the duration and degree of impact of the crisis varied from country to country. Table 2.1 shows the periods in which the economy worsened and recovered in some selected countries after the Great Depression. As can be seen from Table 2.1, recovery did not occur immediately after the onset of depression, and symptoms of recovery began to appear 2–3 years after the onset of depression. However, it should be noted that the start of recovery does not mean that the economic crisis is completely over. As a matter of fact, the duration of the impact of the Great Depression for some selected countries is shown, in years, in Chart 2.4. It is clear in the chart that the impact of the Great Depression on Argentina, Chile and Canada lasted longer, with 12 years, compared to other countries. In the US, France and Austria, the Great Depression lasted an average of 10 years. The country that survived the Great Depression in the shortest time, i.e. 4 years, is Japan.

24 Table 2.1 Dates of Great Depression in various countries (in quarters)

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Country

Depression began

Recovery began

USA

1929:3

1933:2

Great Britain

1930:1

1932:4

Germany

1928:1

1932:3

France

1930:2

1932:3

Canada

1929:2

1933:2

Switzerland

1929:4

1933:1

Czechoslovakia

1929:4

1933:2

Italy

1929:3

1933:1

Belgium

1929:3

1932:4

Netherlands

1929:4

1933:2

Sweden

1930:2

1932:3

Denmark

1930:4

1933:2

Poland

1929:1

1933:2

Argentina

1929:2

1932:1

Brazil

1928:3

1931:4

Japan

1930:1

1932:3

India

1929:4

1931:4

South Africa

1930:1

1933:1

Source Romer and Pells (1998)

2.6.3 Industrial Production Industrial production of many countries decreased during the Great Depression, and the degree of reduction in production varied from country to country. Table 2.2 indicates the percentage of decrease in industrial production in various countries. The greatest decrease in industrial production was observed in the US, which was 46.8%, followed by Poland, which was 46.6%. It is understood that the decrease in industrial production in the UK and Germany were close. In Brazil and Japan, the decrease in industrial production was quite low compared to other countries. The total industrial production index values for some countries in the period between 1927 and 1935 are shown in Table 2.3, based on 1929 = 100. As stated before, industrial production in the US decreased by half between 1929 and 1932, and it started to increase again as of 1932. Among the countries in Table 2.3, except for the UK, industrial production started to increase only in 1932, after 1929 when the Great Depression started, and the recovery in industrial production in the UK became apparent in 1931. The UK was the country that reached the industrial production values of 1929 the earliest, and in 1934, it reached the production values of 1929, even slightly exceeded it. As of 1935, Canada, France and Germany as well as the US could not reach the industrial production values of 1929 yet.

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Chart 2.4 Duration of Great Depression in various countries. Source Rogoff and Reinhart (2011: 297) Table 2.2 Peak-to-trough decline in industrial production in various countries (annual data)

Country

Decline (%)

USA

46.8

Great Britain

16.2

Germany

41.8

France

31.3

Canada

42.4

Czechoslovakia

40.4

Italy

33.0

Belgium

30.6

Netherlands

37.4

Sweden

10.3

Denmark

16.5

Poland

46.6

Argentina

17.0

Brazil

7.0

Japan

8.5

Source Romer and Pells (1998)

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Table 2.3 Indices of total industrial production, 1927 to 1935 (1929 = 100) 1927 Great Britain

95

1928

1929

1930

94

100

94

1931

1932

1933

1934

1935

86

89

95

105

114

Canada

85

94

100

91

78

68

69

82

90

France

84

94

100

99

85

74

83

79

77

Germany

95

100

100

86

72

59

68

83

96

Italy

87

99

100

93

84

77

83

85

99

Sweden

85

88

100

102

97

89

93

111

125

USA

85

90

100

83

69

55

63

69

79

Source Parker (2008)

2.6.4 Unemployment Rate The change in unemployment rates between 1929, when the Great Depression occurred, and 1932, when the general recovery began, is shown in Table 2.4 for selected countries. Belgium is the country with the highest unemployment rate in the aforementioned period. Unemployment, which was as low as 4.3% in 1929, approached 40% in Table 2.4 Rates in various countries, 1929–1932 (%) 1929

1932

Artı¸s

USA

3.2

24.9

21.7

Germany

–

31.7

–

Australia

11.1

29

17.9

Austria

12.3

26.1

13.8

Belgium

4.3

39.7

35.4

Great Britain

10.4

22.1

11.7

Czechoslovakia

2.2

13.5

11.3

Denmark

15.5

31.7

16.2

Netherland

7.1

29.5

22.4

Sweden

10.7

22.8

12.1

Switzerland

3.5

21.3

17.8

Japan

–

6.8

–

Canada

5.7

22

16.3

Norway

15.4

30.8

15.4

Poland

4.9

11.8

6.9

Average

8.2

22.5

14.3

Source Yardımcı et al. (2017: 262)

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27

1932 with an astronomic increase. Unemployment increased by an average of 16.8% between 1929 and 1932 in selected countries.

2.6.5 Growth In order to see the impact of the Great Depression on growth, the growth rates of selected countries before and after the crisis are shown in Table 2.5. Examining the annual growth rates of the selected countries in the table, an increase is observed in the growth rates of GDP between 1924 and 1929. It is striking that after the Great Depression began in 1929, there was a downward trend in growth rates. In particular, it is noteworthy that the US ranks first regarding mentioned decrease rate, and the contraction in GDP in countries such as Japan, Italy, Austria and France is remarkable. The US was the country most negatively affected by the Great Depression due to economic contraction, followed by Japan with a contraction of 8.9%.

2.6.6 Interest Rates Interest rates applied in various countries were also affected by the 1929 Great Depression. Table 2.6 shows the policy interest rates of the selected countries between 1923–1935. When the course of policy interest rates of the relevant countries in the table is analysed in the post-Great Depression period, it is seen that the interest rates of 1930 decreased compared to the interest rates of 1929 in all selected countries. It is clear that the aim here is to increase aggregate demand by stimulating interest-sensitive investment and consumption expenditures in order to overcome the crisis.

2.6.7 Political Impact The Great Depression terrorising the world had some political consequences, and the ruling powers of the countries changed hands (Klapsis, 2014: 192). For example, the social consequences of deflation in Germany brought Hitler to power. Despite being in a period of peace, great importance was attached to the production of war vehicles in Germany under Hitler’s rule, thus Germany started to gradually recover from the effects of the economic contraction. Germany started war preparations before the actual war period in 1939s (Bayhan, 2020). In Italy, Mussolini took over the administration in the post-crisis period. In the US, after being elected as the President, Roosevelt put the New Deal Policy into practice and adopted the economic approach defending the intervention of the

17.07

5.18

− 16.91

France

4.13

3.17

0.07

13.19

Great Britain

Japan

USA

2.32

4.12

4.88

0.60

6.60

11.23

0.43

6.52

0.89 1.00

1.46

8.05

− 3.68 1.12

8.17

1.21

3.05

7.15

− 2.16 3.17

4.38

6.97

10.01

6.75

7.84

3.39

5.24

4.65

1928

− 2.08

1.99

3.71

3.02

1927

7.95

1.05

2.82

2.65

3.82

5.84

− 2.28

5.71

3.39

1.69

1926

1.54

6.78

1925

Source I¸sık and Duman (2012a, 2012b: 243)

3.06

2.8

5.29

5.09

0.98

6.04

Sweden

2.61

Italy

Germany

12.55

7.35

Finland

0.31

10.54

Denmark

3.27

11.60

− 1.00

3.58

Austria

Belgium

1924

1923

6.12

3.11

2.94

6.97

3.30

− 0.41

6.75

1.18

− 5.13 0.84 − 7.68

− 7.27 − 8.90

− 13.20

8.37

0.76

3.23 − 3.08

− 1.03

− 7.53

− 6.52

− 0.43

− 2.62

− 4.50

− 10.32

1932

− 0.58

− 7.62

− 0.71

4.19

− 4.93

− 1.40

− 5.98

− 2.43

− 1.17 − 2.90

1.11

− 1.77

− 8.02

1931

5.95

− 0.96

6.69

− 2.76

1.45

1930

− 0.87

1929

Table 2.5 GDP growth rates in various countries (% annual growth rate, 1923–1935)

− 2.10

9.82

2.92

3.03

− 0.67

6.27

7.15

6.65

3.20

2.14

− 3.32

1933

7.73

0.20

6.59

8.16

0.42

9.13

− 0.98

11.33

3.04

− 0.84

0.86

1934

7.65

2.76

3.86

5.48

9.63

7.52

− 2.55

4.28

2.24

6.18

1.95

1935

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Table 2.6 Political interest rates in various countries, 1923–1935 (%) Austria Belgium Finland France Germany Italy Japan Sweden Great USA Britain 1923 9

5.5

10

5

10

5.5

8.03

5.5

4

4.5

1924 13

5.5

9

7

10

5.5

8.03

5.5

4

3

1925 9

7

7.5

6

9

7

7.3

4.5

5

3.5

1926 7

7

7.5

6.5

6

7

6.57

4.5

5

4

1927 6.5

4.5

6

4

7

7

5.48

4

4.5

3.5

1928 6.5

4

7

3.5

7

5.5

5.48

4.5

4.5

5

1929 7.5

4.5

7

3.5

7

7

5.48

5

5

4.5

1930 5

2.5

6

2.5

5

5.5

5.11

3.5

3

2

1931 8

2.5

8

2.5

7

7

6.57

6

6

3.5

1932 6

3.5

6.5

2.5

4

5

4.38

3.5

2

2.5

1933 5

3.5

4.5

2.5

4

3

3.65

2.5

2

2

1934 4.5

2.5

4

2.5

4

4

3.65

2.5

2

1.5

1935 3.5

2

4

6

4

5

3.65

2.5

2

1.5

Source I¸sık and Duman (2012a, 2012b: 252)

government in the economy, abandoning classical liberalism. Again, the negative results of the liberal policies implemented in France resulted in The Popular Front coming to power. After the Great Depression, liberal policies were generally abandoned, instead, policies in which governments behaved more interventionist in the economy and took more role in economic life were put into practice.

2.7 Its Impact on the Turkish Economy Between the years 1923 and 1930 before the Great Depression, a liberal economic approach prevailed in Turkey. The public sector mostly assumed a regulatory and supervisory function and had not been involved in the real economy much. Production was mostly carried out by the private sector (Yardımcı et al., 2017: 263). Great Depression had a negative impact on Turkey’s economy as was the case for many countries in the world. The main problems can be listed as; the foreign payments deficit, the depreciation of the Turkish currency, a deflationary process, and the reduction of cultivation areas in agriculture (Kazgan, 2009: 65). While Turkey was affected by the Great Depression, the effect was not as much as that of experienced in other Western developed countries. The main reasons were that there were not many foreign investors having entered Turkey, compared to other countries; that Turkey’s market economy relations were not sufficiently developed, and its low share in world trade (I¸sık & Duman, 2012a, 2012b: 81).

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The effects of the Great Depression on Turkey are discussed by means of the main economic indicators mentioned below.

2.7.1 Its Impact on Gross National Product It is important to analyse the course of the pre-crisis and post-crisis GNP figures, to understand the impact of the Great Depression of 1929 on Turkish economy. The GNP values between 1923 and 1935, including before and after the Depression, and its changes over the years, as well as the contribution of agriculture, industry and services sectors to GNP and its change over years are shown in Table 2.7. As clear from the table, there was an increase in GNP from 1923, when the Republic was established, until 1929, when the Great Depression occurred, except for 1927. In 1927, Turkey’s economy contracted by 11%, which was due to the agricultural sector (Duman, 2011: 66). While the industry and services sector grew in the said year, there was a 26% shrinkage in the agricultural sector. The fact that being affected more by the agricultural sector in the mentioned period indicates that the agriculture was a kind of engine of the economy in the early years of the Republic of Turkey (I¸sık & Duman, 2012a, 2012b: 82). Turkey’s economy shrank since the Great Depression of 1929 until 1934. Between the years 1929 and 1933, the biggest shrinkage occurred in 1930, accounting for 24%. In the said period, the agriculture, industry, and services sector contracted, but the agriculture sector was the most adversely affected by the Great Depression. The Table 2.7 GNP, 1923–1935 (at current prices, Million TL) GNP 1923

Agriculture

Industry

Services

value

%

value

%

value

%

value

%

953

–

377

–

126

–

450

–

1924

1204

26.4

570

51.2

118

−6

515

14.6

1925

1526

26.7

730

28

145

22.8

651

26.2

1926

1651

8.2

815

11.7

163

12.1

673

3.4

1927

1471

− 10.9

602

− 26.1

186

14.3

683

1.5

1928

1633

11

719

19.4

184

− 1.1

730

6.9

1929

2073

27

1069

48.8

199

8.3

805

10.2

1930

1581

− 23.8

719

− 32.8

176

− 11.6

686

− 14.8

1931

1392

− 12

628

− 12.7

171

− 2.8

593

− 13.5

1932

1171

− 15.8

467

− 25.6

161

− 5.7

543

− 8.5

1933

1141

− 2.5

426

− 8.8

182

12.5

534

− 1.6

1934

1216

6.5

414

− 2.7

214

18

588

10.1

1935

1310

7.7

462

11.5

233

8.6

616

4.7

Source TUIK (2012: 691)

2 Great Economic Depression of 1929: First Global Economic Crisis

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Table 2.8 Consumer Price Index (CPI, 1918 = 100) 1923

1924 1925 1926

CPI 76.02 88.5

95.3

1927

1928

1929

1930

1931

1932

1933

1934

1935

97.07 85.23 84.91 90.26 83.15 78.63 76.61 68.44 67.38 62.56

Source I¸sık and Duman (2012a, 2012b: 84)

reason for this can be shown as decreasing agricultural products and decreasing cultivation areas in world markets (Kazgan, 2009: 65). The shrinkage in the agricultural sector continued in 1934; and in general, the contraction in the economy caused an increase in unemployment during the crisis, affecting unemployment rates negatively.

2.7.2 Its Impact on Consumer Price Index The dominant sector in Turkey’s economy was agriculture during the Great Depression of 1929. Thus, developments occurring in the agricultural sector affected Turkey’s economy much more than other sectors. In this context, the change in the price of agricultural products somehow determined the price changes in the country. Table 2.8 presents the changes in the consumer price index (CPI) according to the CPI based on 1918 = 100 between 1923 and 1935. The depression experienced in world agricultural product markets was also experienced in Turkey, and Turkey’s economy experienced a deflationary process in parallel with the economic contraction. As can be seen from the table, deflationary process continued in Turkey from 1929 to 1935, and the consumer price index constantly declined.

2.7.3 Its Impact on Foreign Trade It was stated before that the Turkey had an economy with agriculture being the dominant sector during the Great Depression. It is clear that agricultural products have a significant share in the export of a country with an agriculture-dominated economy (Ertuna, 2004: 6). During the period starting with the foundation of Turkish Republic in 1923 until the emergence of Great Depression, including the period when its effects were still felt, agricultural products constituted a considerable portion of Turkey’s exported goods. In this context, that agricultural product prices were in decline in many countries due to the depression (Samuelson, 2012: 39) and that the countries followed protectionist policies on imports of these products adversely affected export figures of Turkey after 1929. Table 2.9 provides some of Turkey’s foreign trade indicators during 1923–1935.

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Table 2.9 Various foreign trade indicators, 1923–1935 (Million $) 1923

Foreign trade balance

Export

Import

Foreign trade volume

− 36.1

50.8

86.9

137.7

1924

− 18.1

82.4

100.5

182.9

1925

− 26.3

102.7

129

231.7

1926

− 25

96.4

121.4

217.8

1927

− 27.1

80.7

107.8

188.5

1928

− 25.4

88.3

113.7

202

1929

− 48.8

74.8

123.6

198.4

1930

1.9

71.4

69.5

140.9

1931

0.3

60.2

59.9

120.2

1932

8.9

48.8

39.9

88.7

1933

13

58.1

45.1

103.2

1934

4.2

73

68.8

141.8

1935

5.5

76.2

70.7

146.9

Source (Kazda˘glı, 1996)

As a result of the protectionist policies of individual countries in the aftermath of the Great Depression, the decreasing trend in world trade volume was also observed in Turkey’s foreign trade volume. As can be understood from the table, there was a decrease in export and import figures as of 1929 and a decrease in foreign trade volume until 1932. In addition, the price of wheat which was 12 cents in 1927 in Turkey dropped down to 3 cents in 1932 with the effect of the crisis. The decrease of nearly 60% in grain products between 1929 and 1933 was significantly effective in the decrease in export values due to the fact that the agricultural products constituted a considerable portion of the products subject to export (Yardımcı et al., 2017: 266).

2.7.4 Its Impact on Foreign Exchange Rate The Great Depression of 1929 also affected the exchange rate. As can be seen from Table 2.10, the Turkish Lira started to depreciate against the US Dollar since 1929, which continued until 1933. Table 2.10 Exchange rates, 1923–1935 (TL/$) 1923

1924

1925

1926

1927

1928

1929

1930

1931

1932

1933

1934

1935

1.67

2.12

1.87

1.93

1.96

1.97

2.07

2.12

2.11

2.11

1.66

1.26

1.26

Source TÜ˙IK (2012: 477)

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2.7.5 Its Impact on Economic Views According to classical economics, there is no such problem as unemployment in the economy. The economy will stabilize at a level that everyone would like to work due to the flexibility of workers’ wages. Based on this view, governments did not intervene in employment in times of crisis. Classical and Neoclassical approaches were accepted until the Economic Depression of 1929. Say’s law is respected in this approach. According to Say’s law, it is stated that full employment will be provided automatically, each supply will create its own demand and the economy will automatically find balance. The classical approach also opposes the government intervention in the economy and argue that the crises are temporary (I¸sık & Duman, 2012a, 2012b: 77). Since the economists could not explain the global increase in the unemployment rate, the economic understanding put forward by John Maynard Keynes started to be effective on the world economy policies. The book titled the general theory of employment, interest and money, published by Keynes, shed light on post-depression world economies (Can, 2018). Countries changed their economic policies after the Great Depression; they started to apply Keynesian economic policies, in which the government directly intervened in the economy and took a more active role in economic activities, abandoning the liberal economic policies dominated by the “laissez-faire, laissez-passer” approach. Keynesian policies, which were applied for about 40 years until the 1970s, when other crises emerged in the post-crisis period, provided States with a long-lasting welfare environment and was successfully implemented.

2.8 Exit Strategies from the Great Depression The effects of the Great Depression of 1929 spread almost all over the world, and countries took some measures and developed strategies to exit the crisis. Below are the exit strategies implemented by the US, where the Great Depression first emerged, which will be followed by exit from the crisis measures taken by some selected Western countries and finally those taken by Turkey.

2.8.1 Exit Strategies Implemented in the US The main reasons of the great depression in the US were the excessive monetary tightening and the resulting decrease in interest-sensitive consumption and investment expenditures due to the increase in interest rates, which led to a decrease in total demand and production and were referred to as the reasons for the crisis that the US economy contracted after 1929 (Romer, 1992: 780).

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It was previously stated that the inexperience of the people who were elected as the President of the US and his team before Roosevelt increased the impact and prolonged the duration of the crisis. Franklin D. Roosevelt, elected as President in 1932, pledged to create a Federal Government Program to end the Great Depression. In this context, Roosevelt enacted the economy package, called the “New Deal”, which included some measures to take the economy out of the crisis (Fishback, 2010: 405). Forty-two new units were established with the introduction of the program known as the New Deal. Main units can be listed as; Social Security Unit (Social Security), The Securities and Exchange Commission, the Federal Deposit Insurance Corporation and the National Recovery Administration (NRA). One of the important Laws enacted to end the crisis is the Agriculture Adjustment Act (AAA). Measures taken under the New Deal Program are; allowing unionization, providing unemployment insurance, increasing worker wages for the increase in consumption and total demand, preventing speculation, providing incentives to increase purchasing power of consumers and production, increasing public services, making exchange rate adjustments for an increase in exports, increasing employment opportunities and infrastructure expenditures. (Açıkgöz & Özkan, 2009). Among the measures taken within the scope of the New Deal Program, Roosevelt, the President of the US, put into practice Keynesian policies foreseeing the direct intervention of the government in the economy in order to end the Depression and to stimulate the economy (Fishback, et al., 2001: 6). As a matter of fact, the continuous deficit of the US budget between 1931 and 1936 was a clear indication that Roosevelt switched from the classical liberal economic understanding known as laissez-faire laissezpasser to Keynesian economic policies that suggesting efficient intervention of the government in the economy. With the Agriculture Adjustment Act, agricultural surpluses were destroyed in order to prevent the price decrease in agricultural products, within this scope, pigs were killed, grains were burned, and farmers were paid for not planting. However, this regulation was later revoked as it was against the Constitution. Roosevelt and his team had various practices not only in the field of public finance, but also in the reorganization of money, credit and bank policies (Bulut, 2003: 82). With the help of a significant amount of gold coming from Europe to the US, monetary expansion started in 1933 and the money supply was increased by about 37% until 1937. The only reason for the massive flow of gold from Europe to the US was the political tensions that broke out in Europe and would also end in World War II. The monetary expansion, which contributed significantly to the recovery of the US from the Great Depression, showed its effect with the decrease in interest rates and stimulated the economy by increasing interest-sensitive consumption and investment expenditures (Romer & Pells, 1998). The Keynesian Economic Understanding was applied from the 1940s to the 1970s when new crises emerged and formed the basic economic program of the US for 40 years after the Great Depression. Roosevelt, who took radical measures to end the Great Depression, marked the history as the only US President who was elected 4 times.

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2.8.2 Exit Strategies Implemented in Other Selected Countries In many countries affected by the Great Depression, some measures were taken to overcome the crisis. Although these measures differed from country to country, the common feature of most of them in general was that they abandoned the classical liberal policies applied until the Great Depression and started to apply Keynesian policies in which the government had more role in economic life. The measures taken in some selected countries to overcome the recession will be mentioned below, as per the respective countries.

2.8.3 Germany After the Great Depression of 1929, the political power in Germany changed, and Hitler came to power (Eichengreen & Temin, 1997: 34). The policies implemented by Hitler to stimulate the economy in the country were like Roosevelt’s “New Deal”. Such that Hitler made large public works investments between 1933 and 1936 to increase employment, thus unemployment fell from 6 million to 2.6 million between 1933 and 1934. The German economy, which gained momentum until 1937, resulted in Hitler’s implementation of a new economic program based on war equipment production and investment (Bulut, 2003: 82).

2.8.4 United Kingdom (UK) In order to get out of the depression and stimulate the economy, the UK implemented some policies in which the government intervenes more in economic activities. In this framework, in January 1930, the Workers Party Government established a commission under the chair of Keynes, and it was suggested that the government should take a more active role in economic activities both as a regulator and a supervisor. In this framework, proposals were made to accelerate investments, to give incentives to increase exports, to control imports and to increase customs tariffs (Eichengreen, 1981: 6). With the Housing Law enacted in 1930, the demolition of old houses in poor neighbourhoods and the construction of new houses were encouraged, and in this context, construction expenditures were increased by 70% between 1931 and 1933. In addition, the Development and Improvement Act, which started to be implemented in 1934, aimed to develop poor and economically depressed regions. Since 1937, the government started to give incentives and financial aid to the private sector that

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would invest in underdeveloped regions. The government undertook the infrastructure investments in the regions to be included in the development program (Bulut, 2003: 83).

2.8.5 Italy One of the countries negatively affected by the Great Depression was Italy. The fascist party ruling in Italy took some measures to reduce unemployment and ensure economic growth. These measures foresaw the efficient intervention of the government in the economy. Accordingly, the government bought the company shares from banks in 1933 in order to prevent the bankruptcy of banks that have partnership relations with the industry, as the crisis also negatively affected the industry (Samuels, 2015). Moreover, public expenditures were increased and economic enterprises started to be operated by the government. As a result, the government actively intervened in the economic life in Italy to get rid of the world economic crisis (Bulut, 2003: 83).

2.8.6 Exit Strategies Implement in Turkey To reduce the effects of the 1929 World Economic Depression, especially between the years 1929–1933, Turkey took a number of measures. In this context, it abandoned the liberal economic policy determined at the Izmir Economy Congress in 1923 and started to apply a more statist economic policy. State-owned enterprises were established by the state in sectors where the private sector was insufficient, and their number was increased and the State assumed an important role in production. As the negative impact of the Great Depression on the Turkish economy began to diminish, the state became more involved in the economy between 1933 and 1938. This way, the State took steps to accelerate industrialization on its own and tried to carry it out in a planned manner (Ezer, 2010: 437). Despite all the difficulties in the economy, strategic companies such as electricity, gas and railways owned by foreigners were nationalized. The mixed economy system of Keynes, which was given the opportunity to produce in the private sector and started to be implemented after the Great Depression, continued in different forms until the 1980s. The negative situation caused by the Great Depression resulted in the transition to the planning period in which the state was dominant. In the 10-year period after the Great Depression, 5-year Development Plans were prepared, the first covering the period between 1934–1938 and the second between 1938–1943. For the realization of these Development Plans, loans were borrowed from foreign countries, and the amounts received were used in financing military supplies and foreign trade. As mentioned before in the industrial plans, statist economic policies were pursued.

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It devalued its own national currency for the first time in 1929 in order to protect itself from the world economic crisis and to reduce its impact. In addition, customs tariffs were increased, high-rate taxes were imposed on the imports of agricultural products, customs duties on imports of consumption goods were increased to encourage industry, and taxes on imports of raw materials and machinery were reduced (Yardımcı et al., 2017: 266). In addition, imports were restricted, and an import-substitution industrialization was aimed this way. Thanks to these measures taken, later in the process Turkey became a country with a foreign trade surplus. In addition to the measures above, The Law Regarding the Protection of the Value of Turkish Currency entered into force on 25 February 1930 and The Law on the Central Bank of the Republic of Turkey entered into force on 11 June 1930. With the help of these laws, restrictions were imposed on capital movements and foreign exchange controls were tightened (Çelebi, 2002: 25). Turkey also attached particular importance to institutionalization, as well as economic measures listed above, and in this context, the National Economic and Savings Society was established, an example of the first institutionalization after the Great Depression. The main objective of this institution can be expressed as ensuring that Turkish economy become more competitive and be positioned at a higher level in international markets (Çapraz, 2001: 128).

2.9 Conclusion The New York Stock Exchange collapsed with the burst of the bubble in the stock market on 24 October 1929. The economic crisis that breaks out in the US with the collapse turn into the Great Depression and affected many countries. When the US economy is analysed considering the pre-depression period, it is clear that the production level increased significantly with the effect of industrialization. The increase in production can be considered as a good indicator for the US economy before the depression at first glance. However, the fact that there is not an increase or even a decrease in both domestic and international demand for US goods reveals that something went wrong in the pre-crisis period. This phenomenon, which was ignored by the economy management, which adopted the classical economic understanding where the Say’s Law is valid, led to the deepening of the economic crisis and the emergence of depression together with the problems caused by various events and situations. Factors such as the burst of the price bubble in the New York Stock Exchange stock market, the decrease in consumer demand compared to production, the bank panics that spread across the US, the decrease in confidence in the economy, the inexperience of the economy management and the inequality in the income distribution are noteworthy in terms of increasing the impact of the economic crisis, especially in the US attracts. On the other hand, the insistence of the US on keeping the gold standard in money and the fact that other countries followed similar policies for retaliation and similar motives in response to the protectionist tariffs the

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US imposed, caused the crisis to turn into a major depression and had an international dimension. The Great Depression had negative effects on the economic indicators of both the US and other world countries, including Turkey. These effects were mainly; increase in unemployment, closure of many banks, decreases in GDP growth rates, economic shrinkage, deflation and significant decrease in world trade volume. The negative effects of the depression were not only reflected in the economy but also in social and political life where important problems arose. Many countries, including the US, sought ways out of the crisis by taking measures in which government intervention in the economy was at the forefront. In this framework, the classical economic approach, which predicted that full employment would be provided automatically, each supply would create its own demand and the economy would automatically come to balance, was replaced by economic practices dominated by Keynesian economic policies. The use of “Fiscal Policy” as a tool in the history of economic ideas and policy implementations is also one of the most important consequences of the 1929 Crisis.

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Christiano, L. J., Motto, R., & Rostagno, M. (2004). The great depression and the FriedmanSchwartz hypothesis (Working Paper No. 10255). National Bureau of Economic Research. Cpiinflationcalculator. (2019). Retrieved February 25, 2019, from https://cpiinflationcalculator. com/ Crafts, N., & Fearon, P. (2010). Lessons from the 1930s great depression. Oxford Review of Economic Policy, 26(3), 285–317. Crafts, N., & Fearon, P. (2013). The great depression of the 1930s: Lessons for today. Oxford University Press. CQ Press. (2019). Foreign trade of the United States. Retrieved April 27, 2019, from https://library. cqpress.com/cqresearcher/document.php?id=cqresrre1930110100 Çelebi, E. (2002). Atatürk’ün ekonomik reformları ve Türkiye ekonomisine etkileri (1923–2002). Do˘gu¸s Üniversitesi Dergisi, 3(1), 17–50. Dean, A. H. (1959). Twenty-five years of federal securities regulation by the Securities and Exchange Commission. Columbia Law Review, 59(5), 697–747. Duman, E. (2011). Krizlerin anatomisi: 1929 ekonomik buhranı ve 2008 Küresel Krizi’nin kar¸sıla¸stırılması (Doktora Tezi), Karamano˘glu Mehmetbey Üniversitesi Sosyal Bilimler Enstitüsü, Türkiye. Eichengreen, B. (1981). Sterling and the tariff, 1929–32. Princeton University Press. Eichengreen, B. (1992). The origins and nature of the Great Slump revisited. The Economic History Review, 45(2), 213–239. Eichengreen, B., & Mitchener, K. (2003). The great depression as a credit boom gone wrong (BIS Working Papers No. 137). Bank for International Settlements. Eichengreen, B., & Temin, P. (1997). The gold standard and the great depression (Working Paper No. 6060). National Bureau of Economic Research. Erbay, E. R., & Hemen, B. (2019). 1929 Ekonomik Buhranı’nın Türk Ekonomisi’ne etkileri ve buhran döneminde Keynesyen yakla¸sım. Balkan ve Yakın Do˘gu Sosyal Bilimler Dergisi, 5(3), 124–130. Ertuna, Ö. (2004). 1923’ten bugüne Türkiye ekonomisi ve 2023’e do˘gru hedefler. Muhasebe ve Finansman Dergisi, 21, 1–17. Ezer, F. (2010). 1929 Dünya Ekonomik Krizi’nin Türkiye’ye etkileri. Fırat Üniversitesi Sosyal Bilimler Dergisi, 20(1), 427–442. Fiorillo, S. (2019). Great Depression: Causes, effects and timeline. Retrieved December 19, 2019, from https://www.thestreet.com/politics/great-depression-causes-14663720 Fishback, P. (2010). US monetary and fiscal policy in the 1930s. Oxford Review of Economic Policy, 26(3), 385–413. Fishback, P., Horrace, W. C., & Kantor, S. (2001). The impact of new deal expenditures on local economic activity: An examination of retail sales, 1929–1939 (Working Paper No. 8108). National Bureau of Economic Research. Grossman, R., & Meissner, C. M. (2010). International aspects of the great depression and the crisis of 2007: Similarities, differences, and lessons. Oxford Review of Economic Policy, 26(3), 318–338. History.com (2019). Herbert Hoover. Retrieved from July 20, 2019, from https://www.history.com/ topics/uspresidents/herbert-hoover Irwin, D. A. (1998). The Smoot-Hawley Tariff: A quantitative assessment. The Review of Economics and Statistics, 80(2), 326–334. I¸sık, N., & Duman, E. (2012a). 1929 Ekonomik Buhranı ve 2008 Küresel Krizi’nin Türkiye ˙ ˙ ekonomisi üzerindeki etkileri. Çankırı Karatekin Üniversitesi Iktisadi Ve Idari Bilimler Fakültesi Dergisi, 2(1), 73–101. I¸sık, N., & Duman, E. (2012b). Reel ve finansal göstergeler açısından 1929 Ekonomik Buhranı ve 2008 Küresel Krizi: Kar¸sıla¸stırmalı bir analiz. Yönetim ve Ekonomi. Celal Bayar Üniversitesi ˙ I.B.F, ˙ I. 19(2), 239–260. James, H. (2010). 1929: The New York stock market crash. Representations, 110(1), 129–144.

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Yılmazok, L. (2014). Cinematic narration of the great depression: Recalling John Ford’s the grapes of wrath. The Turkish Online Journal of Design, Art and Communication, 4(1), 16–24.

Mesut Ardan He was born in Fethiye in 1983. He graduated from Fethiye Mehmet Erdo˘gan Anatolian High School in 2001. He studied business administration at Hacettepe University and graduated in 2005. He joined the Finance Inspection Board in Ministry of Finance in 30.11.2006. He was appointed as Finance Inspector in 03.04.2010. In 2014, he received his master’s degree in Accounting from Tulane University in the USA, where he was sent for graduate education abroad. Between 27.07.2015 and 23.12.2018, he served as Tax Inspection Board Izmir LargeScale Taxpayers Group Vice President, and between 24.12.2018 and 15.10.2020, he served as Group President in Tax Inspection Board Izmir Large-Scale Taxpayers Group Presidency. He has been working as Head of Izmir Sectoral Audit Department of Tax Inspection Board since 16.10.2020. He is single and speaks fluent English and intermediate Spanish.

Chapter 3

1973 Oil Crisis: An Economic Illness-Stagflation! Abdulcelil Gazio˘glu

Abstract The 1973 oil crisis marked a significant global economic downturn with simultaneous stagnation and inflation, a condition known as stagflation. This essay explores the factors leading to the crisis, its global impact, and the policies implemented to mitigate its effects. Drawing parallels with the Great Depression of 1929, it examines the emergence of a new economic understanding in response to the 1973 crisis. The Arab-Israeli war played a pivotal role in deepening the crisis, as tensions escalated between the Arab countries and the Western world. The study analyzes the macroeconomic indicators of affected countries and delves into the political factors that exacerbated the crisis. Additionally, it highlights the concept of stagflation and its impact on the global economy. By examining growth, inflation, and unemployment rates in developed countries, the essay illustrates the profound effects of the oil crisis on their economies. Through data analysis and historical context, this study provides insights into the 1973 oil crisis and its repercussions on the global economic landscape. Keywords 1973 oil crises · Economic crises · Stagflation · Great depression

3.1 Introduction Economic crises in the world are considered as old as the economy. Some of these crises went beyond the borders of the country they were in and affected the whole world. The policies developed for these crises that caused global recession or inflation led to radical changes in economic thought movements and formed the basis of new ideas. The Great Depression, which took place in 1929 and was among the greatest economic crises of the world history, caused the questioning of the classical economic thought that guided the world economy until the beginning of the twentieth century A. Gazio˘glu (B) Faculty of Economics and Administrative Sciences, Department of Public Finance, Izmir Katip Celebi University, ˙Izmir, Turkey e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 B. Açıkgöz (ed.), Black Swan: Economic Crises, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-99-2318-2_3

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and became the milestone of a new economic thought movement. The oil shocks experienced for the first time in 1973 after the Great Depression also caused a deep economic crisis on a global scale. It was seen that this great crisis could be solved with a new economic understanding, not with the current economic approach, just like in the 1929 crisis. In the mentioned crisis, which was experienced in the last quarter of the twentieth century and the world economy had not experienced before, stagnation and inflation were experienced together. In the struggle with this situation, which was encountered for the first time, the dominant economic understanding of the period was not successful, and the crisis gradually deepened. This study addresses the reasons for the emergence of the 1973 oil crisis, the underlying factors of its global spread and the policies followed in combating this crisis. In addition, how the policies proposed by different economic approaches produce a solution and the prescriptions they offered to end this crisis are discussed. The feature that distinguishes the 1973 crisis from other crises is the term stagflation it brought to the economy. Stagflation, which is one of the important economic diseases in which stagflation and inflation are experienced at the same time, is explained in detail. While conducting these examinations and evaluations, the macroeconomic indicators of the countries affected by the crisis were displayed in tables and evaluated, constituting the framework of the study. In addition to the economic factors, there are also political factors that deepened this crisis. The Arab–Israeli war, which escalated the tension between the Arab and the Western world, further deepened the oil crisis. In this study, the developments in the Arab–Israeli war are discussed in terms of their effects on the global economy.

3.1.1 Factors Leading to the Oil Crisis After the Second World War, when industrialization increased the fastest, the excessive demand for the energy industry, the reduction of demand elasticity of oil that allowed better energy production compared to coal, speculative statements about the existence of oil shortages, various of political and economic factors such as oil exporting countries using oil prices as policy tools were effective in the emergence of the oil crisis (Ay, 2011). Public expenditures made as a result of Keynesian policies and financed by foreign borrowing are seen as the most important economic factor. However, the long-lasting tension between Israel and the Arab countries, which hold the vast majority of oil reserves, is shown as the biggest factor that caused the crisis to break out. Such that, during this tension process that resulted in a war in 1973, Western countries with developed industries, especially the US, became the target of Arab countries due to their pro-Israel attitudes (Embel, 2014).

3 1973 Oil Crisis: An Economic Illness-Stagflation!

3.1.1.1

45

The Depression of 1929 and New Economic Understanding

In order to understand the oil shocks, it is necessary to analyse the causes of the crisis well. For this reason, it is useful to mention the 1929 crisis and especially the policies implemented as an exit strategy from the crisis. Because the economic policies pursued after the great depression also had an important effect on oil shocks. It would not be inappropriate to describe the Great Depression of 1929 as the biggest and deepest crisis experienced by the modern economy. The stagnation caused by this crisis, which was rare in the history of the crisis, in the world economy was not of the kind that could be solved with the classical economic understanding. This period was called the roaring years in the US economy, which took the lead in the world economy after World War I and had incredible growth with its production. The most important factor in the growth of the US economy in these years was the mass production. This method, which was used in car production by Ford, was integrated into other sectors and production capacity increased dramatically with the help of technology. In addition to this growth and economic development, there was an incredible dynamism and growth in the financial markets. As a matter of fact, the number of investors who used the loans given by banks with a certain profit margin for the purchase of stocks increased considerably, and as a result, the New York stock exchange, which was 191 in January 1928, increased to 382, i.e. increased by 100%. The increase in the stocks purchased with loans from an amount of 5 million dollars to 850 million dollars was also effective in this incredible increase, which doubled in less than two years (Aracı, 2010). The crisis that broke out on 24 October 1929 with the depreciation of the stock market, caused a panic in all sectors with the effect of the bad management of the banks, and the mentioned day went down in the history as the black Thursday, became the turning point of the great depression. Claiming that the crisis arose from the lack of effective demand and mentioning that this problem would be solved by further inclusion of the public sector, which is a major economic actor, in the market, J.M. Keynes pioneered ending the economic recession with the policies he suggested for the crisis. Classical economics, which advocates that there should be no budget deficit and that the public sector should have the smallest possible share in the market with the equivalent budget and the gendarmerie state understanding, and which has very strict rules on these issues, lost its validity with this crisis, and Keynesian policies started to be accepted commonly. At this point, the effects of the 1929 Great Depression on the oil crises emerge. That is to say, this new understanding in the economy was adopted especially by developing countries and the focus had been on financing policies through foreign borrowing for growth and development, facing the budget deficit. These policies were successfully applied in especially counteracting the negative economic effects of the World War II. However, these policies could not achieve the same success due to economic and political instability in developing countries and failure to use the financing obtained through foreign borrowing efficiently, effectively and properly. Foreign borrowing, especially by developing countries, made their economies more fragile.

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3.1.1.2

A. Gazio˘glu

Arab–Israeli War

Foreign borrowing, which started to play a leading role in the development of developing countries with the monetary and fiscal policies implemented after the Great Depression, only made these countries foreign-dependent, and with the abuse of these resources, they became financially extremely weak and fragile due to heavy interest burden and the appreciation of the dollar used as the international currency. Although all these factors affected the depth and magnitude of the crisis, which had a global spreading effect with oil shocks, the factor that started the crisis was the Arab– Israeli war. The tension between Israel and the Arab countries, which had been at war throughout the twentieth century, turned into a war when the Arab countries led by Egypt and Syria attacked Israel during the Yumi Kupir, a religious holiday of the Jews, in 1973. The economic dimensions of this war, which had heavy political and social consequences, were at least as much. Arab countries, which thought that the Western economies, which were among the most developed countries of the period, adopted a pro-Israeli attitude towards them, used the oil they held in the majority of the world reserves as an argument and increased its price much above normal. Crude oil price, which was 1.8 between 1960 and 1970, did not increase at all, and started to increase in the early 70 s and almost quadrupled and rose to over $ 10 in 1973 upon the crisis. It can be clearly seen from the chart that the oil prices which increased significantly upon the second oil crisis approached 20 times the price between 1960 and 1970 (Öztürk & Saygın, 2017).

3.2 New Illness of the Economy: Stagflation The basic judgment about inflation and stagnation, the two major illnesses of the economy, was that they could not happen at the same time in an economy. However, since the 1970s, in addition to the increases experienced in the general level of prices due to the reasons mentioned in the previous section, the stagnation gradually dominated the economy. This economic situation, which could not be foreseen by economic thoughts and which was called an economic illness by Western economies, was expressed by the term Stagflation, which was derived from the combination of the words stagnation and inflation. While the collapsed Bretton Woods system and the increase in oil prices were in favour of the oil exporting countries, they put production into a crisis in Western countries and the increasing costs also prolonged stagflation by causing inflation (Altınok, 1999). The concept of stagflation can be defined as the situation where stagnation prevails in production, wages and prices increase, but the demand for goods and labor does not increase or even decrease. While Samuelson simply defines inflation during a stagnation, the OECD has defined this concept as stopping production, inflation and rising unemployment.

3 1973 Oil Crisis: An Economic Illness-Stagflation!

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3.2.1 Growth, Inflation and Unemployment in Developed Countries The shocking effects of the oil crisis, which the Arab world started by targeting the Western economies, on the economies of developed countries at that time were reflected in basic macroeconomic indicators. In some of these economies, which entered a magnificent growth phase in the 60s, unemployment was below 1%, double-digit growth figures were recorded and inflation was not exceeding 4%, when oil crises reversed the basic macroeconomic indicators of these countries. Growth, unemployment and inflation rates, which prove that stagnation and inflation were experienced simultaneously in these economies, are explained by means of both tables and charts. OAPEC (Oil Exporting Arab Countries) increased the oil prices claiming that Western countries were on the side of Israel during the Arab–Israeli war, which negatively affected the growth rates in countries that were among the largest economies of the developed world and where the production industry was dependent on oil. The growth rates between 1971 and 1980 belonging to Japan, which stood out especially with its production industry, America and Canada which had an important share in the world economy, and France, Italy, the United Kingdom and Germany, which were among the leading economies of the Western world are shown in Table 3.1. This table prepared in line with the information obtained from the World Bank database, aimed to reveal the change in growth rates from a broader perspective by considering the situation before and after the oil crisis of 1973. In addition, the average growth rates of the countries in the table for the relevant year are included in the row under the country names and called the average. The arithmetic average of the ten-year growth rates of the relevant country is given in the column named as average, which is next to the years in the table. When we look at the valuations in this column, it is clear that the average of all these countries, which had double-digit growth in the 60s, remained below 5%. Table 3.1 Annual GDP growth rates in advanced economies (1971–1980) Growth

1971 1972 1973 1974

Canada

3.97

France

3.13

4.30

4.78

0.89 − 0.87 4.95

3.35

3.01

4.15

1.41 2.91

Germany 5.32 ˙Italy 3.48

4.51

6.34

4.30 − 0.96 4.36

3.46

3.98

3.55

1.58 3.64

4.30

6.51

− 2.46 − 1.48 2.91

2.44

4.20

3.74

− 2.03 2.16

Japan

5.51

6.84

3.28

1975

1976 1977 1978 1979 1980

1.46 5.88

5.50 − 2.09 7.13

1.82

3.69

7.13

United 4.70 Kingdom

8.41

8.03

− 1.23

3.09 3.97

3.44

3.68

3.71

2.56

3.24

5.96

3.43 3.84

4.39

5.27

5.48

2.82 4.50 − 0.26 3.19

USA

3.29

5.26

5.65

− 0.54 − 0.21 5.39

4.62

5.54

3.17

Average

3.67

5.14

6.47

1.39 − 0.15 4.94

3.47

4.13

4.25

Source OECD (2019a)

Average

2.16 3.99

1.30

48

A. Gazio˘glu

In 1974 and 1975, when the effects of the crisis began to affect the growth rates of these countries that steered the world economy, a significant negative change occurred and the average growth rates of the 7 countries in the table were 1.39 and − 0.15, respectively. In 1975, while France, Germany, Italy, America and Japan were contracting, Canada only grew by 1.46% and the UK by 3.09. Among the economies shown in the table, the change in growth rates of the United Kingdom and Italy is more striking compared to other countries. Because, in this period when every country was experiencing fluctuations, the change rates of the two countries mentioned were higher. Italy shrank three times in the mentioned ten-year period, two in a row, and the UK reduced growth rates above 8% to 3%. Chart 3.1 was generated to express the changes and fluctuations in these growth rates, which are striking indicators of the stagnation in the economy, more clearly. While there was an increase in growth rates in many countries in the first years of the said period, it is clear from the chart that there was a sharp decline after the crisis broke out in 1973. It is understood that, in 1974, 3 of the countries considered as the 7 strongest economies of the world at that time shrank, and only two countries grew in the next year, 1975. When the inflation rates are examined in the stagflation period, when stagflation and inflation occurred simultaneously, quite remarkable data are encountered. It is observed that the inflation rates, which were analysed since 1971 in order to have information about the period before 1973, when the effects of the crisis started to take effect, started to increase in 1973. However, it is seen that the noteworthy increase was

Chart 3.1 Annual GDP growth rates in advanced economies (1971–1980). Source Created by the author by using the data from the World Bank database

3 1973 Oil Crisis: An Economic Illness-Stagflation!

49

in 1974, which was the next year, and that inflation in all countries except Germany, one of the countries included in the table, was in double-digit numbers. With the radical reforms in its economy and the solid steps taken, it can be said that Germany, which had a good recovery process after the World War II, was less affected than the other countries in the table. In the said period, the highest inflation rates were in Japan, Italy and the United Kingdom. Just before the crisis, Japan had 5% inflation, yet it increased to almost five times of the said level in 1974, accounting for 23.2%. Among the 7 countries, the UK experienced the highest inflation rate in 1975, which was 24.2%. In this new economic illness where high inflation rates and unemployment coexist, these developed economies, which mostly had inflation below 5% in non-crisis periods, took their place among the economies experiencing high inflation during the crisis period. The data presented in Table 3.2 has been visualized in Chart 3.2 for enabling an easier understanding. It is clearly seen in Chart 3.2 that there were significant increases in inflation of all countries in 1974 and 1975. While there were no countries with an inflation rate below 5% in the said years, only 1 and 2 countries had an inflation rate under 10%, respectively. While it was observed that there were countries approaching the limit of inflation at 25% in these years, the rates fluctuated in the following years. The level of employment can also be considered as an important proof of the stagnation in the economy. Among the countries examined in other macroeconomic indicators, the unemployment rates of 4 countries whose unemployment rates reached the rates of the mentioned period are shown in Table 3.3. An overview of the table reveals the rates that are not very high compared to developing countries. However, these rates are considered high for these industrialized countries that led the world economy. Because while the unemployment rate in Canada and America was only 4% in the 1960s, it rose to 7–8% by an increase of 100% during the years when the crisis took effect. Especially in Germany, which imported workers in the 60s and had an average of 0.5% unemployment, this rate rose to 3%. In Japan, which has very low Table 3.2 Inflation rates in advanced economies (1971–1980) Inflation

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

Canada

2.7

5.0

7.5

11.0

10.7

7.5

8.0

9.0

9.1

10.1

France

5.4

6.1

7.4

13.6

11.7

9.6

9.5

9.3

10.6

13.6

Germany

5.2

5.5

7.0

7.0

5.9

4.2

3.7

2.7

4.0

5.4

Italy

4.8

5.7

10.8

19.2

17.0

16.6

17.1

12.1

14.8

21.1

Japan

6.4

4.8

11.6

23.2

11.7

9.4

8.2

4.2

3.7

7.8

United Kingdom

9.4

7.1

9.2

16.0

24.2

16.6

15.8

8.3

13.4

18.0

USA

4.3

3.3

6.2

11.1

9.1

5.7

6.5

7.6

11.3

13.5

Average

5.5

5.4

8.5

14.4

12.9

10.0

9.8

7.6

9.6

12.8

Source Created by the author by using the data from the World Bank database

50

A. Gazio˘glu

Chart 3.2 Inflation rates in advanced economies (1971–1980). Source Created by the author by using the data from the World Bank database

unemployment rates like Germany, unemployment increased by 100% compared to the previous period. As it can be easily understood from Chart 3.2, which reflects the changes in unemployment rates between 1971 and 1980, oil crises adversely affected growth, increased inflation and increase the unemployment rate. It is clearly seen that there was a significant increase in the unemployment rates of each country in 1975 when the effects of the crisis were felt. It is noteworthy that these increasing unemployment rates remained higher in the following years than before (Chart 3.3). Table 3.3 Unemployment rates in advanced economies (1971–1980) Unemployment

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

Canada

6.20

6.23

5.57

5.33

6.92

7.08

8.06

8.38

7.55

7.55

Germany

0.53

0.71

0.78

1.67

3.10

3.09

3.01

2.89

2.53

2.47

Japan

1.23

1.42

1.27

1.38

1.89

2.01

2.03

2.24

2.08

2.01

USA

5.96

5.62

4.89

5.59

8.47

7.72

7.07

6.07

5.83

7.14

Source Created by the author by using the data from the World Bank database

3 1973 Oil Crisis: An Economic Illness-Stagflation!

51

Chart 3.3 Unemployment rates in advanced economies (1971–1980). Source Created by the author by using the data from the OECD database

3.2.2 Policies Against Stagflation If there is inflation in an economy, while contractionary fiscal policies get the economy back onto the track, expansionary fiscal policies are needed to reduce unemployment and improve economic growth in an economy dominated by stagnation (Yegen, 2019). As shown in the previous section with charts and tables, if you implement a contractionary policy to combat inflation in economies where stagflation occurs, this already worsening unemployment and growth will worsen, while expansionary fiscal policies will cause inflation to reach much higher levels. As a matter of fact, they did not provide a solution to the problem, on the contrary, it caused the crisis to deepen even in countries whose economic foundations were quite solid compared to other countries and whose macroeconomic indicators were included in

52

A. Gazio˘glu

the previous section. During the same period, while inflation rates in some developing countries increased to 3-digit numbers, unemployment and growth rates were affected quite negatively. It is understood that it is not possible to lower inflation while reducing unemployment and to achieve both targets at the desired level of success. Therefore, it is necessary to reach an optimal combination of two goals (Turhan, 1987). Generally, micro-based solutions are suggested to combat stagflation, which contain many macroeconomic problems. One of these suggestions is the revenue policy, gradually implemented from light to hard to eliminate the factors that causes and increases inflation. In this method, which is to ensure that companies that want to increase wages and price give up this idea as the lightest measure, there are also measures that can be considered as direct intervention to the market such as price freezing. The main criticism of this method is that intervention in the competitive market will distort resource allocation and this will cause new economic problems. France, USA, Canada and the United Kingdom were among the countries that applied this method after the oil crises in combating stagflation. The tax-based revenue policy, which is applied by the US and some European countries and cannot give the desired result, is a method of struggle that provides tax advantages to companies that do not exceed the wage and price quota determined by the state and impose tax penalties on companies that do not comply with this quota. Another method is the production incentives and total supply method, which was implemented by the Reagan administration in the 80s and ended in failure and defended by supply-side economists. While it is argued that high taxes affect production negatively in this method, the decrease in the tax burden with the incentives will increase production and employment, and the growth, which is positively affected by increasing production, will reduce inflation (Sen ¸ & Sa˘gba¸s, 2015).

3.2.3 Impact of Stagflation on World and Turkish Economy The economic effects of stagflation, which emerged as an inevitable consequence of oil shocks, on the most developed industries of the world at that time were not limited to these countries. In fact, developing countries, whose economic foundations are based on much weaker and more fragile structures than these countries, had to struggle with much deeper and more challenging economic crises. The US, not taking into account the threat that the Petroleum Exporting Countries (OPEC) Members would have limited their production, if their demands had not been not fulfilled, helped Israel, and thus Libya imposed an oil embargo on the US. First, Saudi Arabia and then other members supported this radical decision of Libya (Öztürk & Saygın, 2017). The embargo started with the United States and included the Netherlands and western European countries as well as Japan. In 1974, the first year of the crisis, when oil prices quadrupled, the production systems of Western countries, which designed their industry for cheap oil, were adversely affected. In such a situation, the first measure taken in order not to decrease

3 1973 Oil Crisis: An Economic Illness-Stagflation!

53

the profitability of the increasing costs was to increase the prices. Inflation rose as a natural result. However, high inflation in developed countries was not the only result of the increase in oil prices. Since oil, whose demand elasticity is almost zero, is an indispensable expenditure item, most of the resource allocated for imports was spent here and the demand for other imported products decreased (Karaaslan, 1999). Thus, while the capital structures of oil-exporting countries improved and gained momentum, the situation was not very pleasant for the importing countries, and the increasing costs reduced the growth rates and increased unemployment as well as inflation. Increasing costs and the need for oil led importing countries to different energy sources such as nuclear reactors and coal. While the Netherlands aimed to limit consumption and reduce demand by penalizing those who consumed excessive electricity, the US intended to achieve the same goal in oil consumption through rationing. While the people in many countries were encouraged to save energy, low speed limits were determined in vehicle use, the most important feature of a vehicle, in manufacturing companies, was now low fuel consumption. It can be said that Japan put in the most successful performance in oil crises other than oil exporting countries. Because after the oil crisis, they became the leading actors of the US market, which they had difficulty in entering before, with the vehicles that consume less fuel while they were doing very successful works in the electronics sector. As a result of this impact on the economy caused by the Arabs, international energy agency was established by Japan, Norway, Spain, Sweden, Austria and Switzerland as well as Turkey, which aimed to cooperate in the use of oil resources (Armao˘glu, 2010). Countries that could not implement an efficient fiscal and monetary policy in the fight against stagflation did not succeed in solving the problem in a short time by turning to alternative sectors and energy resources, yet they enjoyed the fruits of these steps in the long term (Balkanlı, 2002). In the period of 1970–80 when oil crises broke out, quite surprising things happened in Turkish economy. First of all, the Financing Law, enacted in 1970, independent of the developments in the world, had a positive effect on public revenues 2011). However, due to factors such as the oil crisis affecting the world and (Sahin, ¸ the Cyprus Peace Operation, the increase in public expenditures and rising inflation shortened the life of this positive effect. Due to the fact that Turkey was an oilimporting country, the crisis deteriorated the trade deficit and balance of payments deficit. Increasing costs almost brought production to a halt, causing negative effects on growth. Wrong policies implemented in Turkey against the crisis exacerbated the crisis and ‘70s were very tough for the national economy. In the years when the use of the oil and energy consumption were restricted around the world, Turkey intended to increase oil production by subsidizing it, but it failed in practice. Mentioned subsidy increased the foreign trade deficit to 2.3 billion dollars and foreign borrowing was used to solve the foreign exchange bottleneck (Öztürk & Saygın, 2017). Besides, following the oil embargo, oil companies were allowed to prospect for oil around the world, while it was banned in Turkey by the oil reform law, providing only the state with the authority to prospect for oil, which in turn blocked entry of foreign capital (˙Ilseven, 1991).

54

A. Gazio˘glu

3.3 Conclusion Considering the study as a whole, the oil crisis appears as a crisis different from the previous global crises. As a matter of fact, while the Great Depression, one of the biggest crises in the world history, is a crisis that can be more explained and resolved with fiscal policies, the 1973 crisis, called the Oil Shocks, is a crisis in which macroeconomic policies such as fiscal and monetary policies cannot be implemented and yet micro-based policies fall short. Mentioned crisis, which introduced concepts such as stagflation and Petro Dollar into the economic literature, left Keynesian policies that opened an era and also closed an era in economic history without a solution. Even today a definite and clear solution has not been developed regarding the way out of this crisis, which should be focused on and thought about considering all these aspects, the most important measure against stagflation has been to prevent stagflation. While there are theories developed by many economic currents to explain stagflation, it is not possible to say the same for theories about how to end stagflation. Because many developed countries, especially the US, were far from achieving the successful results they imagined while applying the theories developed by economists. This situation that shook the world economy, including the second oil shock, covered a period of almost 10 years, which lasted longer than the treatment of the 2008 global crisis. In addition, the recipe for ending the stagflation environment created by the oil shocks were not composed of fiscal policies; but of growth policies in new and different sectors that require less oil in their production and use, such as energy restrictions, search for different energy resources, electronics, telecommunication and the internet. As a result, the 1973 oil crises are an economic crisis that includes many lessons to be learned and distinguishes from other crises not only with the terms it brought to the economy and the reasons for its emergence, but also as a recipe for ending the crisis. Considering that it is so difficult to end the crisis environment it causes, the most important way to combat stagflation is to analyse its causes, take measures and ensure that such a situation does not occur at all.

References Altınok, S. (1999). Stagflasyon ve stagflasyona kar¸sı uygulanan politikalar. Selçuk Üniversitesi Sosyal Bilimler Enstitüsü Dergisi, 1(4), 59–72. Aracı, K. A. (2010). 1929 Büyük Ekonomik Buhran’dan 2008 ekonomik krizi’ne dünya ekonomik krizleri ve Türk tekstil sektörüne etkileri (Yüksek Lisans Tezi), Namık Kemal Üniversitesi, Türkiye. Armao˘glu, F. (2010). 20. yy. Siyasi Tarihi (1914–1995). Alkım Yayınevi. Ay, A. (2011). Dünya Ekonomisinde Ya¸sanan Ba¸slıca Ekonomik Krizlerin Analizi ve Krizden Çıkı¸s Politikaları–Öneriler ve Görü¸sler (Yüksek Lisans Tezi), Karadeniz Teknik Üniversitesi, Türkiye. Balkanlı, A. O. (2002). Küresel ekonominin belirleyici faktörleri üzerine. Uluda˘g Üniversitesi, ˙ ˙ Iktisadi Idari Bilimler Fakültesi Dergisi, 21(1), 13–26.

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Embel, E. (2014). Avrupa için ortak dı¸s politika olu¸sturma sürecindeki ilk adımlar: 1973 Arap-˙Israil sava¸sı ve Avrupa Birli˘gi. Ankara Avrupa Çalı¸smaları Dergisi, 13(1), 75–90. ˙Ilseven, N. (1991). Petrol sorunu Ortado˘gu sorunları ve Türkiye. Türkiye Sosyal Ekonomik Siyasal Ara¸stırmalar Vakfı Yayınları. Karaaslan, A. (1999). Arz yönlü iktisat Laffer e˘grisi ve iktisadi istikrar açısından vergileme. Dumlupınar Üniversitesi Sosyal Bilimler Dergisi, 2, 47–70. OECD. (2019a). OECD databank data of annual growth. Retrieved October, 15, 2019, from https:/ /data.oecd.org/gdp/real-gdp-forecast.htm OECD. (2019b). OECD databank data of annual growth. Retrieved October, 15, 2019, from https:/ /data.oecd.org/price/inflation-cpi.htm OECD. (2019c). OECD databank data of annual unemployment rate. Retrieved October, 15, 2019, from https://data.oecd.org/unemp/unemployment-rate.htm Öztürk, S., & Saygın, S. (2017). 1973 Petrol krizinin ekonomiye etkileri ve stagflasyon olgusu. Balkan Sosyal Bilimler Dergisi, 6(12), 1–12. Sahin, ¸ H. (2011). Türkiye Ekonomisi (8. Baskı) Bursa: Ezgi Yayınevi. Sen, ¸ H., & Sa˘gba¸s, ˙I. (2015). Vergi teorisi ve politikası. Ankara: Kalkan Matbaacılık. ˙ ˙ Turhan, S. (1987). stagflasyon ve maliye politikası. Istanbul Üniversitesi Iktisat Fakültesi Mecmuası, 43(1–4). Yegen, B. (2019). Kamu kesimi açıklarının finansmanında maliye politikasının rolü. Politik Ekonomik Kuram, 3(2), 177–191.

Dr. Abdulcelil Gazio˘glu is a research assistant at Izmir Katip Celebi University, Faculty of Economics and Administrative Sciences, Department of Public Finance. He gained his Ph.D. degree from Izmir Katip Celebi University Department of Public Finance and Public Finance Management. He received his bachelor’s degree in Business Administration from Istanbul University. He received his master’s degree from Izmir Katip Celebi University with the thesis on Multiyear budgeting in theory and practice: Turkey evaluation. His areas of study: public finance, budget and fiscal planning, taxation, digitalization, digital economy, digital governance, cryptocurrencies and non-fungible tokens. He published articles and book chapter focused on effects of digitalization on taxation and fiscal management. He presented papers on international conferences about digital economy.

Chapter 4

Chilean Economic Crisis (82–86): Twin Crisis-Finance/Banking Crisis Melih Kabayel

Abstract The Chilean economy was forced to pursue liberalization policies in the 1970s. The increasing public deficit along with unemployment and inflation made the Chilean economy a financial market open to global capital movements. The liberalization movement brought along financial liberalization and the Chilean financial sector, which joined the international financial markets, contributed to the economic growth process with rapid growth. However, financial liberalization made financial markets vulnerable due to rapid capital flows, leading to increased economic risks. In this context, the Chilean economy, with its fragile-unregulated banking sector and its transactions in financial markets, faced due to rapid money outflows in the medium and short term, leading to a financial-based banking crisis. The Chilean Twin Crisis highlighted the need for financial liberalization to be regulated, limited or supervised by high-level national actors such as the central bank. In this context, the study analyses the Chilean Twin Crisis together with its historical economic indicators and explains the effects of the economic-fiscal policies and economic developments. Keywords Chilean economy · Economic crisis · Twin crisis · Globalization · Monetary liberalization · Dollarization · Oil crisis · Fiscal policies · Black swan · Monetary policy · Political economy · Democracy · Developing countries · Capital flows · Financial markets

4.1 Introduction Chile lost its economic gains made in a certain period due to mismanagement and inefficient management of capital. The crisis that Chile started to experience in the 1980s is referred to as twin crisis in the literature. The fact that Chile experienced the currency-finance crisis and the banking crisis at the same time caused this situation to be described as twin crisis. The currency crisis, which came along with M. Kabayel (B) Faculty of Economics and Administrative Sciences, Izmir Democracy University, Izmir, Turkey e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 B. Açıkgöz (ed.), Black Swan: Economic Crises, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-99-2318-2_4

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the devaluation caused by the deterioration of economic stability in the following period, because of the increased dollarization after the revaluation, banks opting for foreign exchange transactions and borrowing, resulted in an increase in the risk in the banking sector. Since the banking system could not foresee the risk, a banking crisis occurred afterwards. After the 1980s in Chile, the increase in the value of the national currency against the dollar due to the revaluation resulted in an increase in the use of dollars in the market. With dollarization and high wage increases, the strong economic climate was replaced by a fragile economy. Previously, the controlled monetary policy implemented until 1979 provided financial stability. Moreover, the monetary reserves in this period increased due to hot money investments coming along with free capital movement. However, after the 1979 revaluation, the current account deficit increased rapidly as imports became attractive and the financial resource was spent on electronic product imports. In addition, uncontrolled banking transactions resulted in dollarization and borrowing. However, it can be said that the Chilean economy achieved successful results in the following periods. The study will address the crises in the Chilean economy. A descriptive analysis will be made in the light of various sources considering the structure of Chilean economy. As a result, evaluations will be made.

4.2 Chilean Economy The Chilean economy is a typical Latin American economy. Latin America is a dynamic continent in terms of population and rich in natural resources. The countries in this continent are developing countries that benefit from this population dynamic and natural resource richness. However, the colonial period that lasted for centuries has affected the countries and societies living in this continent in many areas. One of the most affected is the Latin American economy. Because their oligarchic management approach is in place in Latin American countries since the colonial period. Although the countries that gained their independence were freed from being colonized, independence did not bring a reform process with it, and the established order continued in the same way. In this regard, Latin American countries consist of similar country models where there is no justice in the distribution of wealth, the distribution of income is against the poor, the democratic structure is interrupted or confiscated. In this context, Chile has the characteristics of a typical Latin American country. However, it can be said that the Chilean economy has achieved economic stability by pursuing a more successful economic policy compared to other Latin American countries. The reason for this is that the Chilean economy is regulated and structured more efficiently than other Latin American countries (Davis, 2002).

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4.2.1 Long-Term Chilean Economy (1970–1990) The concept of globalization started to be at the top of the economic policies of the governments as a concept that has a great importance on world politics in the 1970s. However, the integration of this concept with the concept of economy was in the 1980s. The increase in global trade volume along with the increasing free capital flows in the 1980s resulted in many countries abandoning their protectionist (closed economy) economic policy. Especially developing economies were in favour of meeting their resource needs through financial markets and following a comfortable economic development policy. Chile is a developing economy that also had mentioned political trend. Opening its markets to international markets in the 1970s, Chile benefited from the increase in trade and portfolio volume provided by globalization. However, the foreign trade volume of the Chilean economy developed against exports. On the other hand, the share of increasing portfolio investments in GDP increased rapidly. In this case, the current account deficit of the Chilean economy started to increase rapidly and a constant borrowing requirement emerged to cover the deficit1 (Herrera & Valdes, 2004).

4.2.2 Shifting from Closed Economy to Open Economy The Chilean economy adopted a closed economic model, as was the case for many Latin American countries, with a fixed exchange rate policy (before 1973). During this period, the Chilean economy was closed to the effects of external shocks and the import costs that could create a foreign exchange deficit were low. However, with the transition to free market economy (1973), local currency appreciated because of revaluation (1979), which caused an increase in the country’s purchasing power in economic terms. However, with the appreciation of the local currency, imports became attractive. This has led to the demand for imported products by the country’s administration and people, who just left a closed economic policy and adopted the free-market economy and international trade dynamics (Hruzik, 2015: 41–42) (Chart 4.1). After 1977, the rapid decrease in interest costs compared to the previous period resulted in the appreciation of the national currency (decrease in the inflation compared to the previous years) and the increase in purchasing power with revaluation. Chile was struggling with inflation rates exceeding 500% in the 1970s. The Chilean economy, which had high interest rates due to high inflation before, experienced a serious decrease in interest rates after 1977. Chile entered the 1980s in a relatively safe way, with nearly fourfold reduction in interest rates and foreign exchange revaluation (Margitich, 1999). 1

In fact, this is called “vicious circle of debts”. Increasing borrowing created an important example of financial crisis for Chile and the world economy.

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Chart 4.1 Revaluation and decrease in interest costs after globalization. Source World Bank (2019)

4.2.3 Development of Chilean Banking and Finance Sector As a result of the financial activity that started in the 1970s, the Chilean finance and banking sector was privatized by 80% until 1979. On the other hand, a cartel was formed in the banking system. Most private banks were run by conglomerates and bank resources were used to finance their own companies. In fact, this did not lead to a financial crisis. The real problem started with the liberalization that started at the end of the 1970s and the opening of the economy to international markets. Financial freedom made financial supervision difficult. With the removal of financial restrictions in 1979, borrowing increased in an environment of the hot money inflow. The political efficiency and depth of influence of the central bank remained ineffective with this liberalization movement (Hruzik, 2015: 37).

4.3 Increasing Current Account Deficit Following Increasing Capital Movements See Chart 4.2. The current account allows us to make an inference about all economic transactions that take place within a year. It is determined with the help of the current account whether the country had a surplus or deficit as a results of the goods, services and capital transactions. Considering the example of Chile, it is seen that the Chilean economy had a current account deficit since the mid-1970s. Actually, this is not strange. Because growth along with the current account deficit is an economic policy.

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Chart 4.2 The current account of Chile (1975–1989). Source World Bank (2019)

However, this needs to be sustainable. It is observed that the current account deficit started to increase again after 1979. This stems from the 1979 revaluation. The attractiveness of imports increased the import tendency. Chart 4.3 reveals the increasing import trend. The current account deficit increases in Graphic 26 is due to foreign trade. This became unsustainable with the reserves that tended to decrease in 1980 and a debt crisis occurred in 1982 (Edwards, 1995: 69). The related Chart shows that the financial crisis encountered in 1982 created a similar trend in some economic indicators. In fact, with the decrease in reserves in 1980, financial sustainability became difficult. However, since it was not possible to see this and react rapidly during the economic process, the upward trend in other indicators continued. In particular, the continuing increase in the amount of imports caused a sharp decrease in the reserves and GDP in 1982, which was followed by the pains of getting out of economic depression until 1986 (Yava¸s, 2007: 55).

4.4 Monetary Liberalization and Twin Crisis 1982 is a year going down in history for the Chilean economy. Because such a crisis had not been experienced before. The Chilean economy, which had been growing steadily since 1975, faced a monetary crisis. With this crisis, unemployment increased and the economy shrunk significantly in the medium term. On the other hand, the 1982–1986 Crisis is considered as a banking crisis, and the term “twin crisis” emerged with the coexistence of two crises. In fact, these two crises are two crises interacting with each other. That is, the currency crisis and the banking crisis are a single crisis integrated with each other (Hornbeck, 2008).

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Chart 4.3 GDP size (1975–1989). Source World Bank (2019)

The Chilean twin crisis was caused by the unregulated banking system which also lacked standards as well as the deterioration of financial stability, as mentioned earlier. Financial stability, on the other hand, is directly related to the terms of balance of payments and current account deficit. As a result of the rapid increase in the current account deficit and the deterioration of the balance of payments, national reserves decreased in the medium term, resulting in financial insufficiency. As a result, a financial crisis became inevitable (Kaminsky & Reinhart, 1999).

4.4.1 The Effect of Dollarization in the Emergence of the Crisis The financial fragility of the Chilean economy increased as a result of the increasing dollarization after 1977. Dollarization is a situation where, as long as the dollar is cheap, the collaterals are put up in dollars, the deposits are converted into foreign currency and the demand for foreign exchange of the banks and markets increases in order to prevent the loss of value of the income, in the face of inflation in countries with high inflation. The Chilean economy entered the dollarization process for the first reason. The valuable currency of the country caused transactions to be made in dollars. In fact, as a result of the liberal initiative initiated by the Chilean government in the 1970s, a dollar-centred investment and trade system emerged because the global

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system operated on the US dollar, a convertible currency. As a result of this situation which is also the case in today’s economy, Chile experienced official dollarization as it is referred to as in the literature (Duncan, 2003). The system change made with the approval of legal and official institutions brought official dollarization with it. However, dollarization poses a risk to many countries undergoing system changes. Over-dollarization can create an economic crisis (Herrera & Valdes, 2004). However, unlike some Latin American countries, Chile managed to reverse the dollarization process. This concept, referred to as de-dollarization in the literature, is the opposite of the dollarization process. This success was achieved by the macro-economic policies initiated in the Twin Crisis Period (1982–1986). In fact, the high public deficit and current account deficit that emerged in the 1970s forced the Chilean Government (military government) to official dollarization. Liberal policies were preferred in order to close the deficits in the short and medium term. Financial and commercial liberalization steps were taken for the achievement of this policy. Fiscal discipline was ensured through tax reform. In addition, the 1976 current account deficit was eliminated by applying a controlled monetary policy. However, the 1979 revaluation in the later period once again disturbed the economic and financial balances. On the other hand, with the privatization of state banks in 1970s, financial markets were largely under the control of the private sector. The increasing fund demand of private banks after 1979 and the lack of control of the Chilean Central Bank in this sense caused the financial risk to increase exponentially within a few years. That is, while the borrowing interest rate was at the bottom in 1981, it reached 90% in 1982. Financial risk continued until 1986. This was a result of the economic policy chosen in the 1970s. Official dollarization caused the Chilean economy to face the crisis in 1980s (Barandiarán & Hernández, 1999: 9). However, with the orthodox measures implemented later, the Chilean economy had the opportunity to start the next decade more dynamically. Moreover, the political activity that Chile achieved had not been achieved in many Latin American countries. For example, Mexico, which had an economic crisis in the 1980s like Chile, could not achieve political activity in the field of economy (Bergoeing et al., 2001).

4.4.2 Importance of Oil Crisis of 1973 in Monetary Liberalization The most important point of understanding the Chilean Economic Crisis is to understand the economic conjuncture that emerged in the 1970s. Many countries that had to cope with the Global Oil Crisis in 1973 encountered the term stagflation for the first time by facing inflation and unemployment at the same time as well as increasing financial and current account deficits. This situation also negatively affected the Chilean economy and led to similar results. However, between 1971 and 1973, Chile preferred a way to fold inflation through seigniorage policy in order to compensate its fiscal deficits. Increasing inflation trend caused hyper-inflation when

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combined with the 1973 oil crisis. The seigniorage, which was 15% of the GDP in 1970, continued until 1980, albeit gradually decreasing. During this period, the seigniorage made was greater than public deficit (Caputo & Saravia, 2019).

4.4.3 Liberalization and Misguided Fiscal Policies Failure to eliminate the public deficit with seigniorage instead of austerity measures—and thus failure to eliminate the deficit in real terms—caused the general level of domestic prices to move upwards. Price stability and full employment are essential for the economic stability to be in place in a country. These two indicators should work in a balanced process with each other. These indicators need to be properly balanced with economic and fiscal policy. However, the extraordinary economic conjuncture in the 1970s (1973 Oil Crisis) caused many countries to implement economic and fiscal policies that they knew by heart. Because, in an unknown economic conjuncture, it may not be possible to switch to new policies due to both political interest and the reflex of bureaucrats. In this case, it is not surprising for the Chilean government and administration to apply misguided policies. But it is unwise to continue this. In other words, a government that does not want to give up its seigniorage income has put forward a negative economic policy that increases both inflation and unemployment (Caputo & Saravia, 2019) (Chart 4.4). The 1970s are a milestone for the global economy. World politics, while focusing on the cold war, had to face the 1973 Oil Crisis that emerged as a result of global conflicts. This crisis brought along increased unemployment along with cost inflation. This situation, called stagflation, is an economic problem that economics literature confronts for the first time. This is true for the Chilean economy. During this period, with the effect of the existence of a socialist government in Chile (later military coup), a positive relationship appeared between the negative externality brought about by the oil crisis, in addition to the extreme Keynesian policies, unemployment and inflation. Mentioned relationship is clear in the figure above. Unemployment rates have increased linearly with the inflation rate since 1974 (Fuentes, 2011: 171–173).

4.4.4 Outbreak of the Crisis Economic crises are seen in sudden changes in economic indicators. The important thing is to understand and interpret these indicators. These sudden changes are called black swan in the economics literature. This concept, which means “siyah ku˘gu” in Turkish, resembles the bending of the sudden changes in economic indicators to a curved swan neck. The black swan analogy, on the other hand, emphasizes that the crisis is a negative situation (Taleb, 2007: 3). In this context, we can characterize the sudden bends in the previous figures with this concept. The previous figures display some of the situations before or during the crisis. However, since the 82–86 crisis

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Chart 4.4 Change of inflation and unemployment rates (1971–1981). Source World Bank (2019)

is a financial based banking crisis, it would be correct to describe the crisis through some of the financial indicators. Chart 4.5 shows that the Chilean Economic Crisis has financially basis. With the liberalization movement explained under the previous titles, it was mentioned that foreign assets created additional resources for the Chilean economy through financial markets. With the 1979 revaluation, this fund generation brought along financial uncontrollability and caused negativities in terms of financial sustainability in the following years. The sharp decline in total reserves and net foreign assets after 1980 can be seen in Chart 4.5 as the black swan of a financial crisis. On the other hand, it is noteworthy that net foreign assets continued to decline after 1983 (unlike total reserves), which shows that both the flight of foreign capital and the financial crisis continue. This is also the reason why it is described as the 82–86 Crisis in the Economics Literature. In addition, the negative externality of the banking system through financial markets is the reason why this crisis is described as a financial and banking crisis (Twin Crisis) (Glick & Hutchison, 1999).

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Chart 4.5 The emergence of the financial crisis in financial indicators. Source World Bank (2019)

4.5 Descriptive Analysis of the Crisis The 1973 Oil Crisis forced the Chilean economy to reform, and it was the intention to apply a more explicit economic model with limited financial liberalization. This is the reason for the policy change we described in previous sections. This paved the way for the Chilean Economy to grow faster by revealing its potential. The reason for the GDP spike seen in Chart 4.3 is the changing economic policy after this crisis. Chile, which experienced an economic leap, actually achieved this with a controlled monetary policy. The reason behind the decrease in interest costs seen in Chart 4.1 was that the risks became manageable as a result of this policy. However, with the 1979 revaluation, as imports became attractive, economic balances deteriorated again. The sudden increase in the unemployment rates in 1982 seen in Chart 4.4 stemmed from that. Stability in employment rates, which must be achieved for economic stability, suddenly deteriorated that year (Goldfajn & Valdés, 1997). In the studies conducted in the literature, the economic conjuncture of 1975–1981 before 1982 is called a balance of payments crisis. It has already been stated under Chart 4.2 that this was the harbinger of the crisis in 1982. However, it is important that this situation is separately called a crisis. Because it is a harbinger of a financial crisis that may come after a problem in the balance of payments. Flight of foreign capital and a sudden decrease in reserve are observed in Chart 4.5, a. The reason why this crisis is a twin crisis is that it is a financial-currency crisis, and the banking sector is a fragile actor in the country’s economy. With the measures

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taken after these years, the Chilean economy eliminated this fragility. However, in the 1990s, many developing countries faced similar crisis scenarios again.

4.6 Conclusion The Chilean economy had to pursue liberalization policies due to the global and national economic conjuncture it experienced in the 1970s. Because both unemployment-inflation and public deficit were increasing rapidly. Liberalization movement brought along financial liberalization and the Chilean financial sector, which participated in international financial markets, contributed to the economic growth process with a rapid growth. However, the liberalization of financial controls in a developing country such as Chile led to the formation of a negative externality at the national level. The rapid movement of capital flows is one of the biggest threats to the financial stability of developing countries, as is the case today. In this context, the Chilean economy, the fragile and irregular banking sector and the transactions it made on the financial markets, encountering rapid money outflows in the medium and short term caused a financial-based banking crisis. The Chilean Twin Crisis revealed the need for financial liberalization to be regulated, restricted or monitored by top national actors such as the central bank. In addition, it is a proof of that the increasing purchasing power as a result of the increase in the national currency value because of the revaluation made in 1979 did not comply with the reality of the Chilean economy, and exchange rate regulations might cause deterioration at macro level. The Chilean economy could have maintained its financial expansion process had it not experienced a decline in the level of net foreign resources. However, the global financial sector is built on capital mobility. Especially indirect foreign capital investments (hot money) tend to behave this way. Developing economies such as Chile, which did not have a lot of capital accumulation, faced a great economic risk in times of such financial flights. This is one of the disadvantages of the globalization system, which has not been fully resolved even today. However, the significance of the Chilean economic crisis in this regard is that it is the first country in the global economic model to face a twin crisis. However, although this crisis, which entered the economics literature, was a lesson to be learned for many countries, many similar crises were observed in the following periods. This is because the fiscal policies are voluntary and inefficient and wrong economic tools are used. The Chilean Twin Crisis is clear evidence of the importance of political effectiveness and financial controls in economic management.

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References Barandiarán, E., & Hernández, L. (1999). Origins and resolution of a banking crisis: Chile 1982–86, Working Papers Central Bank of Chile 57, Central Bank of Chile. Bergoeing, R., Kehoe, P. J., Kehoe, T. J., & Soto, R. (2001). A decade lost and found: Mexico and Chile in the 1980s. In Research department staff report (Vol. 5). https://doi.org/10.1006/redy. 2001.0150 Caputo, R., & Saravia, D. (2019). The monetary and fiscal history of Chile: 1960–2016. In Macro finance research program. https://doi.org/10.2139/ssrn.3238188 Davis, R. F. (2002). Economic development in Chile since the 1950s. In R. F. Davis (Ed.), Economic reforms in Chile from dictatorship to democracy (pp. 2–28). University of Michigan Press. Duncan, R. (2003). Floating, official dollarization, and macroeconomic volatility: An analysis for the Chilean economy (No. 249). Huérfanos. Edwards, S. (1995). Crisis and reform in Latin America: From despair to hope. Oxford University Press. Fuentes, R. (2011). A unified growth model for independent Chile. Latin American Journal of Economics, 48(2), 157–179. Glick, R., & Hutchison, M. (1999). Banking and currency crises: How common are twins? (No. PB99-07). Goldfajn, I., & Valdés, R. O. (1997). Capital flows and the twin crises: The role of liquidity. In IMF Working Papers (Vol. 97). https://doi.org/10.5089/9781451850987.001 Herrera, L. O., & Valdes, R. O. (2004). Dedollarization, indexation and nominalization: The Chilean experience (No. RE1–04–015). Hornbeck, J. F. (2008). The U.S. financial crisis: Lessons from Chile. In CRS report for congress (Vol. 1). Hruzik, J. (2015). Causes of the Chilean financial crisis in the 1980’s. The Bonn Journal of Economics, IV (2), 33–48. Kaminsky, G. L., & Reinhart, C. M. (1999). The twin crises-the causes of banking and balance-ofpayment problems.pdf. The American Economic Review, 89(3), 473–500. Margitich, M. (1999). The 1982 debt crisis and recovery in Chile. In Chile in transition (No. 5). http://preserve.lehigh.edu/perspectives-v17/5 Taleb, N. N. (2007). The black swan: The impact of the highly improbable (1st ed.). https://doi.org/ 10.4324/9781912281206 World Bank. (2019). World bank data of Chile. https://data.worldbank.org/country/chile (Reached: 09.09.2019). ˙smekte Olan Ülkelerde Ya¸sanan Finansal ˙ ˙ ˙ Yava¸s, H. (2007). 1980 Sonrasi Geli¸ Krizler, Finansal ˙ Modelleri˙ Ve Çözüm Öneriler ˙ i.˙ Sosyal Bilimler Enstitüsü Finans ve Bankacılık Anabilim Kriz Dalı, Kadir Has Üniversitesi.

Melih Kabayel is a Ph.D. Melih Kabayel received his B.A. from the Department of Public Finance, Celal Bayar University, Manisa, Turkey, in 2013. He received M.D. in Public Finance with his thesis entitled as “Applicability of Obesity Taxes As Tool of Public Policy In Turkey and Selected Countries” from Izmir Katip Çelebi University, Izmir, Turkey, in 2017. He received Ph.D. in Public Finance with his doctoral thesis entitled as “Effect of Digital Transformation on Taxation and Applicability in Turkey” from Izmir Katip Çelebi University, Izmir, Turkey, in 2022. His research focuses on fiscal theory, public economics, public goods theory, obesity taxes, international taxation, public debts, public expenditures, economic-fiscal crises, and Industry 4.0, digital transformation with aspect of taxation. Melih Kabayel has authored and contributed to book chapters, papers, and articles on these research areas.

Chapter 5

Stock Market Crash of 1987: Black Monday Do˘gancan Akata

Abstract The research subject is the crisis in the DJIA on 19 October 1987 and its impact on financial markets. The research aims to explain the technical reasons underlying this stock market crisis and evaluate the effectiveness of the measures taken after the crisis. The main line of the research is as follows: Definitions, the reasons that led to the collapse of the DJIA, the causes of the crisis and the measures taken after the crisis. Black Monday is the first test for the financial markets due to the technological development of the market and the first major crisis that occurred after the transition to a computer-based system. It is of great importance to see the shortcomings of the market. In addition, the successful policies of the FED and the establishment of an environment of trust are important in overcoming the crisis with the most minor damage. Keywords Financial crisis · Stock market anomalies · Program trading

5.1 Introduction In daily life, almost everyone has come across finance terms such as stock market, investor, stock, on television, in newspaper or Internet, and many people have even been interested in the stock market, even to some extent. With its deep-rooted history, stock markets brought buyers and sellers together and went through many stages over time. Crises have an important role in the beginning and end of many of these phases. Each crisis brought along new practices and regulations; however, over time, when these practices and regulations began to fail to meet the development in real life, they were subjected to abuse for more profit by the people (investors). It was observed that the financial order started to deteriorate when the regulations and practices were not sufficient, and as a result, it turned into crises on a local or global scale. The D. Akata (B) Department of Public Finance and Financial Management, Graduate School of Social Sciences, Izmir Katip Celebi University, Izmir, Turkey e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 B. Açıkgöz (ed.), Black Swan: Economic Crises, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-99-2318-2_5

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stock market crash of 19 October 1987, a.k.a. Black Monday, on the other hand, takes its place in history as a crisis in which developing technology and human factors manifested themselves. This section includes the definition of Black Monday, developments before and after the crisis, new practices and regulations implemented after the crisis.

5.2 Black Monday Crisis Three centuries ago, while Joseph de la Vega enumerated the principles of speculation in his book “The Confusion of Confusion”, he explained the volatility of profits from stock market as, “… profits from the stock market are like the treasure of a genie. Profits suddenly turn into rubies, then coal, then diamonds, then flint, then morning dew and finally tears” (Mackay & Vega, 2017). In time, stock markets kept up with technology in the field of finance and even became the pioneer of development and the first application areas. Of course, this development has brought along the speed factor, which is the biggest advantage. The development of mass media has reached such a point today that in the fibre age, the phases in the treasure of the genies mentioned by Vega take place within milliseconds, not months or even weeks. Besides, one of the important turning points in the last thirty years is the information revolution. In this framework, the speed of information circulation around the world indicates that international borders have almost disappeared. With the famous expression of T. Friedman, “the world is flat” metaphor depicts the information speed of our age. All these developments also affect the general climate of investments. The size of the stock markets in the United States of America (the US) on a monetary scale and the fact that they have global investors means that the developments in these markets will have global consequences. Of course, it can be concluded that this interaction may be in the opposite direction (Cagan, 2018). Today, 16 stock markets, whose size exceeds the 1 trillion-dollar threshold, are called “1 trillion-dollar club”. These 16 stock markets account for more than 80% of the global market size. Among these stock markets, the New York Stock Exchange, founded in 1792, has been the world’s largest stock market since the end of World War I when it took over the London Stock Exchange. It has a volume of 22.9 trillion dollars. The National Association of Securities Dealers Automated Quotations (NASDAQ), founded in New York in 1971, ranks second today with a transaction volume of 10.8 trillion dollars and is considered the centre of technology companies (Shukla, 2019). Stock exchanges in the USA, which are among the top two of the world’s largest stock exchanges, have an important share in world trade. The US also has the Dow Jones Industrial Average (DJIA), one of the most popular indices globally. DJIA is an index of the 30 most valuable companies traded on the New York Stock Exchange. DJIA, which has an important place in the decisions of investors, has experienced many crises in more than a century of activity, and the most important one is the crisis of 19 October 1987 experienced by the US and stock markets around the world, which is called Black Monday.

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Table 5.1 The all-time biggest losses DJIA History 1

Markets close

12.12.1914

54.62

Change

Change (%)

− 16

− 23.52

2

19.10.1987

− 508

− 22.61

3

28.10.1929

260.64

− 38.33

− 12.82

4

29.10.1929

230.07

− 25.55

− 11.73

1.738

5

06.11.1929

232.13

− 25.55

− 9.92

6

18.12.1899

58.27

− 5.57

− 8.72

7

12.08.1932

63.11

− 5.79

− 8.40

76.23

8

14.03.1907

− 6.83

− 8.29

9

26.10.1987

1.793

− 156.83

− 8.04

10

15.10.2008

8.577

− 733

− 7.87

Source Sizzlers ve Fizzlers (2019)

Although there have been different events throughout history, many black Mondays have occurred. Many examples can be given, such as the massacre in Ireland in the Middle Ages, the deadly storms that took place in England in the fourteenth century and the closure of the steel factory in Ohio in 1977. However, the term black Monday will always be linked to 19 October 1987 for stock investors (Dundon, 2018). As it can be understood from Table 5.1, the decrease in the shock effect occurred on 19 October 1987, leaving behind the percentage of the decline experienced in the Great Depression of 1929, one of the most devastating crises on a global scale, is in the second place in DJIA history with a daily decrease of 22.61%. The crisis that started with the decline in the Hong Kong stock market was reflected in the European and US stock markets, which opened later due to the time difference, and this stock market crisis spread throughout the world. The reasons behind this large-scale crisis and the measures developed afterwards will be explained in the following sections.

5.3 Pre-crisis Developments Some global and some national events before the crisis paved the way for Black Monday. In their studies, many researchers have tried to explain the events that affected the formation of the crisis. The first event having an effect on the crisis is the recession that affected all world economies in the early 1980s. The recession in the early 1980s is characterized as a severe and global economic recession. The US and Japan came out of the recession relatively earlier than other countries, but the high unemployment rates that came with the recession continued in other OECD countries at least until 1985 (Moy, 1985).

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The recession in the 1980s brought with it the Savings and Loan Crisis of the 1980s. Between the years 1980–90, the savings and loan industry in the US suffered serious financial losses, because high interest rates caused institutions to pay high rates in deposits and other funds while achieving low returns on their long-term loan portfolios. During this period, state capital standards were lowered, and alternative accounting procedures were allowed to increase reported capital levels. While these conditions were created, institutions were allowed to turn their investments into potentially more profitable but risky activities. The profitability of many of these activities was heavily dependent on continued inflation in property values to make them economically feasible. In many cases, diversification, insufficient internal controls and failure to comply with laws and regulations consequently increased the risk of these activities (United States General Accounting Office, 1996) (Chart 5.1). In another aspect, with the appointment of Paul Volcker, who was the chairman of the Federal Reserve Bank (FED) between 1979 and 1987, his primary goal was to decrease inflation from double digits—result of the policies implemented by his former FED president G. William Miller—to single digits. With the decisions known as the “October Massacre” in 1979, Volcker tried to contain inflation by sharply raising interest rates. This decision constitutes the main reason for the recession experienced in the early 1980s (Hutchinson, 2008). In late 1985 and early 1986, the US economy went through a brief slow-landing phase as a slow expansion started and inflation declined after a rapid recovery from the recession of the early 1980s. The stock market developed significantly, DJIA

Chart 5.1 US inflation and interest rates of effective Federal funds (1970–1990). Source https:// fred.stlouisfed.org

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Chart 5.2 Crude oil prices per barrel between 1970 and 1990. Source https://www.macrotrends.net

increased by 2722 points in August 1987, or 44% increase compared to the previous year’s closing score of 1895. Along with all these, the financial uncertainties and the collapse in OPEC at the beginning of 1986 caused crude oil prices to fall by more than 50% in mid-1986 (Therramus, 2010) (Chart 5.2). Finally, another important negative development before the crisis can be the military tensions that the US experienced in the Middle East. On 16 October 1987, Iranian missiles hit a US-flagged tanker off the coast of Kuwait. Just five months earlier, an Iraqi missile hit the US frigate Stark, which resulted in the deaths of 37 sailors, and the fears of elevated tensions as a result of the inevitable US retaliation caused the DJIA to drop 108.35 points, closing at 2246. Treasury Secretary James Baker expressed concern about stock prices but stated that “prices have dropped from a very high level”. Many economists argued that the Federal deficit and the trade balance should have been considered together and referred to the considerable increase in bond yields that accelerated the decline in stocks as a bad sign. In the weekend before the crisis, millions of people became increasingly concerned about tensions in the Middle East as a worsening economic picture. Government officials described the increase in bond yields at that time as “unnecessarily high” and attributed it to “exaggerated inflation fears” (The Motley Fool, 1997) (Chart 5.3). Ultimately, those who claimed that the US would retaliate were justified and the “Operation Nimble Archer” was carried out on 19 October 1987, the Black Monday, when the US Navy attacked two Iranian oil rigs in the Persian Gulf.

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Chart 5.3 Yield rates of US treasury bonds (1987). Source https://fred.stlouisfed.org

5.4 Causes of the Crisis Regarding the causes of the crisis, many studies have focused on different reasons. Specifically, these studies focused on Program Trading, Margin Call and the behaviour of stockholders. Considering the period in which the crisis occurred, although more elements can be added, it can be said that the combination of these three elements contributed significantly to DJIA’s sharp decline. First, programme trading is the simultaneous trading of a stock portfolio as opposed to just trading one stock at a time. The New York Stock Exchange defines programme trading as a transaction involving fifteen or more stocks whose total value exceeds 1 million dollars. Basic programme trading started in the 1970s, and techniques have become much more sophisticated and efficient since then (Furbush, 2002). The focus is on two strategies that can cause sudden stock market crashes in programme trading, namely “Portfolio Insurance” and “Index Arbitrage”. Let us explain portfolio insurance first; portfolio insurance is defined under portfolio insurance strategies class as the portfolio strategies designed to reduce risk and at the same time gain profit from emerging markets. It participates in the trading strategy as well as the potential gains of a reference portfolio, as a strategy that guarantees a minimum level of wealth in a given time frame (Balder & Mahayni, 2009).

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Buying portfolio insurance is compared to putting an option that allows investors to continue to protect their earnings on the upward movement of stocks, but to limit the risk on the downside movement. In practice, many portfolio insurers operate in the futures market rather than the cash market. Portfolio insurers protect against losses from falling stock prices without trading by purchasing stock index futures in an emerging market and selling them in a falling market. Trading transactions in the futures market are generally preferred because they are cheaper; however, many of the institutions that provide portfolio insurance are not authorized to exchange their customers’ shares. As an important point, portfolio insurers did not continuously update their analysis on the optimum stock portfolio and cash holding portfolio, as transactions were time-consuming and transaction costs could lead to constant reoptimization; instead, portfolio insurers ran the models periodically and then traded in batches. There were already concerns that the use of portfolio insurance could cause many investors to simultaneously sell stocks and futures. In an article published in the Wall Street Journal on 12 October 1987, an article was published that stated the concern that the use of portfolio insurance in the downturn in the stock market could lead to “snowball effect on the stocks” (Carlson, 2006). The other strategy, index arbitrage, is an investment trading strategy that uses the differences between real and theoretical forward prices, according to the definition on the NASDAQ’s official website. For example, when selling (buying) stocks in the index in question, the simultaneous purchase (sale) of stock futures is in the form of obtaining the temporarily inflated profit between these two stocks (the case of trading multiple stocks at the same time is also called a basket). This programme trading strategy is designed to make profits using discrepancies between the value of stocks in an index and the value of stock index futures contracts. If the value of the stocks is less than the value of the futures contract, index arbitrage practitioners will buy stocks in the cash market and sell the futures contract knowing that prices must meet when the futures contract expires. In case the stock is above the futures contract, reverse transactions can be made; however, the rules restricting short-term sales made this trade difficult for arbitrage practitioners without stocks (Carlson, 2006). Accordingly, institutional investors traded stock portfolios in order to obtain shortterm risk-adjusted returns on their investments. Modern portfolio theory has shown that investors in the stock market face two types of risk: systematic and unsystematic risks. Unsystematic risk is the risk associated with a particular company or industry. The stock market price of a firm is affected by events such as lawsuits, strikes, new products, awarded or not awarded with major contracts, or other events specific to that firm. Since events affecting a particular stock are generally random, the risk can be greatly reduced by diversifying the purchase of securities of firms whose effects on total return are not affected by the same variables. Accordingly, unexpected price increases of a company’s shares can be offset by unexpected losses in another. Unsystematic risk rapidly decreases as stocks are added to portfolios. Hence, firmspecific risk can be almost completely eliminated by correctly diversifying a portfolio of stocks. While diversification works well in reducing unsystematic risk, it is not effective against systematic (or market) risk associated with the overall movement

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in the stock market. Market risk arises from factors such as inflation, recession and interest rates that affect all companies at the same time. Therefore, the risk of systematic participation in the stock market cannot be reduced by careful stock selection. As a result, investors who are involved in the timing strategy of a market and detect a crisis can sell their long positions (exit the stock market) and buy money market instruments. Because stocks are just one form of investment, some money managers use a tactical asset allocation strategy. They balance their investments based on relative returns and risks in stocks, bonds and money market instruments. These institutional investors believe that they can perform better than the stock market by making appropriate investments and exit the market when the return of other investment instruments is high (Solomon & Dicker, 1988). It is useful to examine the margin call together with the concept of short sale and margin buy. First, short selling is the act of a person who believes that a stock price will fall, borrowing this share from its real owner and selling it. If the price falls, that person will buy back the stock in the open market (thus maintaining his position in terms of the number of shares) and return the share to the owner. Thus, it will gain the difference between the original price of the share at the time it borrows and the stock exchange price when it returns to the owner (McGavin, 2010). The concept of margin buy refers to the purchase of stocks by the investor through using own money and borrowing the remaining part from the brokerage house. In order to realize this borrowing, an account containing the stocks you have purchased as a collateral is required. The account containing the stock as the collateral is called the maintenance account. According to US Federal laws, there must be a maintenance deposit of at least 25% in the maintenance account. Mentioned 25% rate is calculated from the total amount of the borrowed stock price. If a pessimistic scenario occurs under these circumstances, the margin call comes into play. In the event of a decrease in the borrowed stock price, the brokerage house makes a margin call to the investor that it is necessary to deposit money (to complete the margin) into the account if the conditions of maintenance collateral cannot be met in the collateral account (Cagan, 2018). This means that the loss increases exponentially in times of crisis. Even if these practices are not the cause of the crisis, it can be considered as the trigger of the panic that causes the crisis to grow like a snowball. Finally, the behaviours of stockholders are evaluated within the scope of Behavioural Finance related to Behavioural Economics, which is a developing field today. Behavioural finance attempts to explain understanding of investors’ reasoning patterns, including emotional processes and the degree to which they affect decisionmaking. Basically, behavioural finance intends to explain what, why and how to finance and invest from a human perspective. For example, behavioural finance has explained many stock market anomalies (such as the “January Effect”), speculative market bubbles (Dot-Com bubble) and crashes (1929 and 1987 crash), as well as studying financial markets (Ricciardi & Simon, 2000). The field of behavioural finance argues that the behaviours different from the values represented by “Homo Economicus” may cause prices in financial markets to deviate from their basic values. As an emphasis in the field of behavioural finance, although some investors are not wholly or partially rational, rational investors quickly

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turn into opportunities the mispricing or wrong decisions caused by less rational investors. This does not have favourable consequences for efficiency in terms of finance. However, they made important conclusions that the mispricing creates an attractive, risk-free and cost-free investment opportunity for rational investors (i.e. an arbitrage opportunity). Moreover, strategies to correct mispricing can have significant risks and costs (Baltussen, 2008). Therefore, the behaviours of irrational investors in times of crisis can be considered as factors affecting the inability to control the crisis and the magnitude of the loss.

5.5 After the Crisis In a press release published right after the crisis, Alan Greenspan, who took office as the FED president a few months before Black Monday on 11 August 1987, stated that “FED is ready to be a source of liquidity to support the economic and financial system”. As an important point, the FED made a 50 basis-point cut in the interest rate of the funds following the crisis, but that cut should not be evaluated as the “loosening” of the monetary systems, which is frequently discussed today. According to the book “Monetary Policy, A Market Price Approach”, written by former FED Deputy Chairman Manuel Johnson with Robert Keleher, the fact that the long-term treasury bond yields fell following the crisis and the difference between long-term bond yields and federal funds interest rates decreased made the situation more difficult for the markets (Tamny, 2008). This statement is the justification of the FED’s interest policy in that period. While the support from the FED allowed banks to lend money without worrying about defaults, this provided the markets and the US economy with a space to breathe. More importantly, it reinforced the idea that the US economy works despite what happened and that what happened was a natural process. When the Black Monday in 1987 is compared with the 1929 Great Depression, the recovery of the losses of the Great Depression took almost 25 years, whereas in the case of Black Monday, DJIA gained 288 points within three working days right after the crisis, and it made up all its losses until September 1989, thanks to the confidence created by the FED. What happened in a time of crisis remained as a bad memory for investors, companies and stock markets, yet the financial industry learned several lessons from the event. The lessons learned by established investors have been deemed highly valuable and taught investors to spread portfolio risk for these one-day sudden crashes, which will eventually be called “Flash Crashes” and showed that the future goal will be to create an investment portfolio that can withstand the difficult conditions experienced in October 1987. Apart from this, it resulted in policies to lead to stronger and sustainable regulations. For example, programme trading was restructured. Audit was also introduced for derivative programmes and portfolio insurance programmes. Along with these, as an important development, the regulations called Trading Curb or Circuit-Breaker were implemented in the short term, and the investors and the market gained confidence (O’Connel, 2018) (Chart 5.4).

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Chart 5.4 DJIA (1980–2000). Source https://www.macrotrends.net

The circuit breaker application that came to life in the New York Stock Exchange was arranged as “Rule 80b” and according to the statement on its official website; “It was developed to reduce volatility and gain investors’ trust as a response to the declines experienced in 1987 and 1989. The application is defined as a rule that will save time for investors to absorb incoming data and make informed decisions in case of high market fluctuations”. With the new regulation on 9 April 2019, the stock market will stop trading in all stocks and if there is a decrease defined as Level 1, 2 or 3, it will not reopen for the periods specified below. A Market Drop means a decrease in the price of the S&P 500 Index between 9:30 and 16:00 on a trading day compared to the closing price of the S&P 500 Index for the previous business day. Level 1, Level 2 and Level 3 drops that will apply for the trading day will be made public before 9:30. Description of the levels; (NYSE, rule 80b). • Level 1: 7% market drop • Level 2: 13% market drop • Level 3: 20% market drop In practice, if, after 9:30 a.m. and until 3:25 p.m. or at the early scheduled closing time, after 12:25 p.m., a level 1 market drop or a level 2 market drop occurs, the exchange trading will be suspended. After a level 1 or level 2 market drop, the exchange will halt trading based on a level 1 or level 2 market drop only once on the trading day for 15 min on all stocks. The trade will halt if the level 1 market drop or

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the level 2 market drop occurs after 3:25 p.m. or after 12:25 p.m. at an early scheduled closing time. If a Level 3 market drop occurs at any time during the trading day, the halting clause will apply to all stocks until the stock market’s main list market opens on the next trading day (NYSE, rule 80b).

5.6 Conclusion Black Monday is an experience for the financial system. Although it was a painful experience, the losses in the US economy and financial system experienced on 17 October 1987 were compensated in a short time with the confidence environment provided by the FED to the economy and the fast and determined policies implemented, without falling into the mistakes made in the past crises. On the other hand, the FED’s transition to a low-interest regime that came with this process paved the way for future crises (such as the Dot-Com bubble). However, in that period, correct steps were taken to overcome the crisis and to provide the liquidity needed to compensate the losses in the markets. With the transition to the computer age, Black Monday has claimed its place in history as the first major tragedy of an age where winning and losing are much faster than before, with the tools and decision-making elements in stock market transactions being left to computer programmes using algorithms.

References Balder, S., & Mahayni, A. (2009). How good are portfolio insurance strategies? https://www.resear chgate.net/publication/228792286 Baltussen, G. (2008). New insights into behavioral finance (Unpublished doctoral thesis), Stern School of Business, New York Cagan, M. (2018). Yatırım 101: Mevduat ve Dövizden Tahvil ve Hisse Senetlerine, Yatırım Hakkında Bilmeniz Gereken Her Sey. ¸ (M. Do˘gan, Trans.). Say Yayınları. (Original work published 2015). Carlson, M. (2006). A brief history of the 1987 stock market crash with a discussion of the Federal Reserve response. Finance and Economics Discussion Series. Federal Reserve Board Dundon, R. (2018). Black Monday, The 1987 market crash that made us rethink greed’s good. https://timeline.com/1987-black-monday-market-crash-8241f126521 Furbush, D. (2002). Program trading. http://www.econlib.org/library/Enc1/ProgramTrading.html Hutchinson, M. (2008). To treat the fed as Volcker did. https://www.nytimes.com/2008/11/05/bus iness/05views.html Mackay, C., & Vega, J. (2017). Ola˘ganüstü Kitlesel Yanılgılar ve Kalabalıkların Çılgınlı˘gı & Karı¸sıklı˘gın Karma¸sası. (A. Per¸sembe & L. Cinemre, Trans.). Scala Yayıncılık. (Original work published 1995). McGavin, K. (2010). Short selling in a financial crisis: The regulation of short sales in the United Kingdom and the United States. Northwestern Journal of International Law & Business, 90(1), 201–239. Moy, J. (1985). Recent trends in unemployment and the labor force, 10 countries. International Unemployment and Labor Force Trends, 108(8), 9–22.

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O’Connell, B. (2018). What was Black Monday and what has changed since then? https://www.the street.com/politics/black-monday-1987-14738772 Ricciardi, V., & Simon, H. (2000). What is behavioral finance? Business, Education and Technology Journal, 2(2), 1–9. Shukla, V. (2019). Top 10 largest stock exchanges in the world by market capitalization. https:// www.valuewalk.com/2019/02/top-10-largest-stock-exchanges/ Sizzlers ve Fizzlers. (2019). Research the all-time biggest gain and losses The Dow and S&P 500. https://us.spindices.com/indexology/djia-and-sp-500/sizzlers-and-fizzlers Solomon, L., & Dicker, H. (1988). The crash of 1987: A legal and public policy analysis. Fordham Law Review, 57(2), 191–252. Tamny, J. (2008). In 2008, shades of October 1987. http://www.forbes.com/2008/07/01/fed-ber nanke-greenspan-oped-cx_jt_0702dollar.html The Motley Fool. (1997). Black Monday 10th anniversary 1987 timeline. http://aol.fool.com/Fea tures/1997/sp971017CrashAnniversary1987Timeline.htm Therramus, T. (2010). Oil caused recession. http://www.oil-price.net/en/articles/oil-caused-recess ion-not-wallstreet.php/Oil United States General Accounting Office. (1996). Financial audit: Resolution trust corporation’s 1995 and 1994 financial statements. General Accounting Office.

Do˘gancan Akata has a doctoral degree in Finance and Financial Management at Izmir Katip Celebi University in 2022. His doctoral thesis is titled “Evaluation of Cryptocurrencies and HighFrequency Trading Within the Framework of Tax Security Measures”. He did his master’s degree in Financial Law at Celal Bayar University in 2016. His master’s thesis is titled “Comparison of Tax Dispute Settlement of Administrative and Judicial Process—Examples in Izmir After 2010”. He did his bachelor’s degree in Finance at Celal Bayar University in 2013. Also, he has associate’s degree in Securities and Capital Markets Program in 2020 and Law Program in 2014 at Anadolu University. He has academic work in areas such as public goods, government debt, financial law, cryptocurrencies and economic crises. His academic interests are public finance, financial economy, economic crises, cryptocurrencies and high-frequency trading.

Chapter 6

Mexican Tequila Crisis of 1994 Muhammet Kaya and Göksel Çetinkol

Abstract The Mexican Peso Crisis, also known as the Tequila Crisis, is an important lesson especially for developing countries about the sustainability of large current account deficits and the risks of sudden changes in capital flows. Although the Mexican economy has gained a certain momentum with the effect of financial liberalization policies, which have been widely applied since the 1980s, the increasing import volume has increased the need for foreign exchange with the abandonment of import substitution policies since 1986. When the decrease in national savings is added to the increasing need for foreign exchange, the country’s current account deficit has reached significant dimensions. With the policies implemented to encourage foreign capital inflows and to borrow more easily from foreign markets, the real exchange rate was allowed to overvalue, and the country’s external debt management weakened, and in 1994, one of the first major currency crises in the South American continent was experienced. Keywords Financial liberalization · Capital inflows · Pemex · Depth of poverty · Oil shocks · Moratorium · Privatization · Tariff and non-tariff barriers · Inflation rate · NAFTA · Tequila crisis · Loan volume · The capital outflow · Tesobonos · Adverse shocks

6.1 Introduction In the world economy, financial liberalization policies were implemented to a large extent by the 1980s. What should be understood from financial liberalization is liberalization of interest rates, lowering the rates of required reserves allocated by banks, and liberalization of capital inflows and outflows from the country. M. Kaya (B) · G. Çetinkol Department of Public Finance and Financial Management, Graduate School of Social Sciences, Izmir Katip Celebi University, Izmir, Turkey e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 B. Açıkgöz (ed.), Black Swan: Economic Crises, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-99-2318-2_6

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However, the financial liberalization policies put into practice were not always successful. Latin American countries faced economic crises due to the democratic problems in the countries and the deterioration in market economies with the removal of the borders of the countries due to liberalization (Kızılta¸s, 2015: 54–55). As a matter of fact, one of the countries where financial liberalization policies failed is Mexico, a Latin American country (Kınayturk, 2006: 30). In the late 1980s, the debt crisis problem in Latin America was resolved and economic growth indicators in Mexico were positive. Along with the financial liberalization and globalization movements, the recovery in the Mexican economy and the uncertainty regarding economic policies were also removed. This led to an increase in the volume of loans, the amount of money and similar assets in the country, and an acceleration in the entry of foreign investments into the country. One-fifth of the capital inflows to developing countries between the years 1990–1993 occurred only in Mexico (Cakmak, 2004: 138). Economic crisis, in the simplest terms, is the interruption of the connections between all economic factors, as unforeseen circumstances in the economy cause deterioration in the supply and demand balance of goods and services in the market (Kınayturk, 2006: 1). This part of the book discusses the 1994 Mexican Crisis, also known as the “Tequila Crisis” due to the prominence of the tequila effect. In this context, the causes, emergence, and development of the crisis as well as its consequences are addressed.

6.2 Mexican Economy Being a typical Latin American country, Mexico, with its rich cultural history, abundant and diverse natural resources, and a population of approximately 130 million, is the second economy in Latin America following Brazil and the 11th largest economy in the world. It is also the 15th largest exporter in the world, with oil, the most important underground resource, as well as products integrated into the regional and cultural value chain, diversified with other raw materials (The World Bank, 2020). Oil revenues have an important place in the country’s economy. However, although its share has decreased in recent years, 10% of export revenues and approximately one third of all public revenues are still provided from oil revenues. The state-owned oil company Pemex is the 7th largest oil company in the world, and a significant portion of the country’s income is the earnings of this company (Ministry of Trade, 2020). Mexico, which preferred the free market economic model since the early 1980s due to the destructive effect of the 1980 debt crisis on the country’s economy, took its economy to a quite liberal dimension with the North American Free Trade Agreement (NAFTA), concluded with the US and Canada in 1992 and entering into force in 1994; and thus, it set an example of one the world’s most protective states becoming one of the world’s most open states (Dolu & Göksel, 2017: 916).

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Mexico is a typical Latin American country model where there is no justice in the distribution of wealth and the distribution of income develops against the poor, although it has tripled its trade with the US and Canada with the effect of the economic transformation it has undergone since the 1980s and the NAFTA which entered into force in 1994 (Dolu & Göksel, 2017: 924). Approximately 44% of the country is poor, and inadequate per capita growth rate and poor organization of social policies to ensure justice in income distribution are the contributing factors (IMF, 2019).

6.3 Background of Mexican Economy (1950–1980) After World War II, Mexico’s quest for economic development was indexed to public intervention to achieve industrialization through import substitution. In this context, import taxes and pre-import permits were used to protect the domestic market from the pressure of import competition, and active industrial policies and subsidies were used in consumption and intermediate goods production to strengthen the manufacturing industry. In the same period, many public institutions were also established to intervene in key markets or prevent the bankruptcy of some private companies, and thus protect employment (Brid et al., 2009: 156). Mexico was one of the symbolic countries of financial stability and economic growth in the period 1950–1970. In the period when the exchange rate was fixed to the US dollar and convertibility was unlimited, inflation was moderate and per capita income was high (Dornbusch & Werner, 1994: 256). The industrialization strategy based on import substitution made significant contributions to the economic development of Mexico. During this period, real GDP per capita grew more than 3% on average, Mexico transformed from an agricultural area into an urban and semi-industrial society with the dynamism created by the importance attached to the manufacturing industry, and the rate and depth of poverty decreased (Brid et al., 2009: 157). However, the industrialization strategy based on import substitution was the solution to Mexico’s key problems. Contributing factors were the inability of the strategy to create a strong export sector or a competitive capital goods industry other than oil, the inability to implement fiscal reforms that would reduce dependence on oil and foreign debt by diversifying tax revenues, and the inability of social policies to support the basic needs of the rapidly growing population with financial income. On the other hand, the unequal distribution of the benefits of continuous economic growth in the period in question and, therefore, the uneven distribution of income and wealth pushed poverty to unacceptable limits (Brid et al., 2009: 157). In the late 1970s, while the world economy slowed down due to oil shocks, Mexico’s economic expansion began to lose momentum. By 1977, the Mexican government launched an ambitious development program financed by large oil revenues and foreign debt inflows, and this program had a very positive impact on the country’s economy. GDP grew over 8% annually in 1977–81 (Brid et al., 2009: 157).

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Overvaluation of the country’s currency and the need for additional resources, which emerged with the increase in imports of intermediate and capital goods, increased the dependence on oil exports on the one hand and public debt on the other. During this period, oil corresponded to 70% of the country’s total export revenues. However, growth brought about a serious deterioration in fiscal discipline. Thus, the fiscal deficit led to an increase in inflation rates and foreign trade deficit, but the fiscal and external deficit was intended to be closed through external borrowing. Thus, the total public debt rose from 23 billion dollars in 1977 to 53 billion dollars in 1981 (Lustig, 2001: 86). The collapse of the international oil market in 1981, coupled with the rise in US interest rates, and the deterioration in the balance of payments forced Mexico to declare a moratorium on debt service payments in 1982. Thus, nearly 40 years of stable economic development and the state-led industrialization strategy based on import substitution came to an end (Brid et al., 2009: 156–157). The radical macroeconomic reforms implemented since 1982 introduced commercial and financial liberalization, the abolition of market regulations, and the drastic reduction of the state’s intervention in the economy, along with privatization. By the mid-1980s, many tariff and non-tariff barriers on imports were removed with the effect of Mexico’s membership of GATT, public expenditures were reduced, the domestic financial market was rapidly and significantly opened to foreign competition, and obstacles to foreign direct investment in production were removed (Brid et al., 2009: 157–158). The reflections of the liberalization policies implemented in the 1980s in Mexico can be seen in Table 6.1. Accordingly, the average tariff, trade-weighted average rate, tariff distribution ratio, and import quota coverage ratio dramatically decreased from 1980s to 1992. In this framework, according to Table 6.1, the average level of customs tariff rates fell below 20% from 1980s to 1992. This decline in the customs tariffs occurred especially on consumer goods. The quotas, which were widely used in the 1980s, were at an insignificant level by 1992. Indeed, as seen in Table 6.1, the import quota coverage ratio was 100% in 1982, while it was 11% in 1992 (Dornbusch & Werner, 1994: 261–262). However, inflation rate also increased sharply in reform implementation period and reached triple digits in 1987 as shown in Chart 6.1 (Krueger & Tornell, 1999: 5). Table 6.1 Tariff levels in Mexico (1982–1992) (percent %) Tariff statistic

1982

1986

1992

Average tariff

27.0

22.6

13.1

Trade weighted average

16.4

13.1

11.1

Tariff dispersion Import quota cover rate*

24.8

14.1

4.5

100.0

28.0

11.0

Source Dornbusch and Werner (1994) * Percentage of total value of imports subject to quantitative restrictions

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Percent 180 160 140 120 100 80 60 40 20 0 1980

1985

1990

Chart 6.1 Mexican Consumer Price Inflation 1980–1993 (%). Source Dornbusch and Werner (1994)

6.4 Pre-crisis Outlook With the effect of radical macroeconomic policies aimed at financial and commercial liberalization, the country’s economy gained a certain momentum in the 1990s. Achieving an annual average growth rate of 3.8% between 1990 and 1994, when inflation was reduced to single digits, Mexico continued its fiscal prudential policies by reducing its long-term debt and made market-oriented reforms, all of which seemed aiming at macroeconomic stability. During this period, Mexico, which invested significantly in social services and social development programs, has achieved improvements in socio-economic status, including greater access to basic social services (Pereznieto, 2019: 8). Fiscal reforms implemented in the late 1980s and early 1990s led to two major results in the country. The first one is the privatization and liberalization of the banking sector, which means the elimination of quantitative restrictions on interest rates and lending and the need for reserves on banks, and the other is facilitating the inflow of foreign capital into the country (Musacchio, 2012: 10). The reform strategy implemented in this period was mainly to reduce inflation by using the exchange rate as the nominal anchor. However, although this would constitute a real valuation of the exchange rate, concerns about how long Mexico could maintain this real valuation, which did not have enough foreign exchange reserves to finance a rapidly growing current account deficit, was replaced by a positive atmosphere with the effect of the Brady Debt Reduction Agreement,

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which was signed in 1990, on foreign debt, opening to foreign markets and privatization of banks, foreign capital inflows to finance the current account deficit (Edwards, 1997: 9). Thanks to the favorable economic atmosphere in Mexico, more than half of the foreign capital that went to all Latin US countries in the period of 1990–1993—91 billion dollars—was received by Mexico. The attractive interest rates, low inflation rate, and stability in the exchange rate were among the important reasons for the foreign portfolio investments directed to Mexico (Edwards, 1997: 8). Increasing positive expectations about foreign capital after Mexico entered NAFTA at the end of 1993 had a significant effect on the economic expectations in the country (Has, 2007: 12). In this context, it was envisaged, in 1994, that macroeconomic policies implemented would continue unchanged, for example, inflation would remain at single digits, and expansionary macroeconomic policies would be implemented to ensure tax reductions and increase in social expenditures considering upcoming elections and the decrease in production in 1993 (Hacıhasanoglu, 2005: 30). While this was the current economic outlook, it was not possible to predict the Tequila Crisis in 1994.

6.5 Tequila Crisis By 1994, the rise in world interest rates, a peasant revolt, an earthquake, and two political assassinations in the country caused the deep uneasiness in the markets about Mexico to surface. Foreign investors started to leave the country and interest rates rose to 16% in July, triggering fear of devaluation. Thus, the peso lost 15% in value in December. Due to the loss of confidence triggered by political mistakes, the peso fell to half of its pre-crisis value. Inflation peaked at 52% and interest rates at 80%. As a result, real GDP contracted by 7% (Doyle et al., 2019: 4). How did this happen, considering the optimism that emerged as a result of the reform policies implemented in the 1988–1993 period?

6.6 Background and Causes of the Crisis Although the reforms implemented in the period of 1988–1993 provided a certain improvement in the economy, especially the imbalance in two subjects was apparent as of 1994. An enormous current account deficit reflects the decline in national savings rates with the overvaluation of the peso (Sachs et al., 1995: 4). The most important component of the Mexican reform strategy in this period was to fix the value of the Mexican Peso to the US dollar. This strategy, which aimed to reduce inflation this way by using the exchange rate as a nominal anchor, also provided the confidence that foreign investors’ investments

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Percent 19 18 17 16 15 14 13 12 11 10 9 8 1970

1975

1980

1985

1990

Chart 6.2 Import as a percent of Mexican GDP 1970–1992 (%). Source Dornbusch and Werner (1994)

would not lose value under normal conditions and allowed Mexican firms to borrow from international markets. Another effect of the fixed exchange rate strategy was that the prices of imported goods remained constant, which negatively affected the profitability of export goods (Musacchio, 2012: 9–10). Because of the stabilized prices of imported goods due to the fixed exchange rate strategy and other deteriorations in trade balances, the ratio of imports to GDP in Mexico increased dramatically especially after 1985, as can be seen in Chart 6.2. Despite the adoption of a fixed exchange rate policy, which served as a basis for efforts to combat inflation at the beginning of 1988, the exchange rate system was changed several times until 1994. The fixed exchange rate system was replaced by a system based on the devaluation rate announced to the public in the first place and then an exchange rate band system with a fixed base and flexible ceiling. Thus, short-term capital inflows would be deterred and necessary adjustments would be made in the real exchange rate, if needed (Edwards, 1997: 8–9) (Table 6.2). However, the width of the exchange rate band was 1.2% in November 1991, 4.3% in December 1992, and 8.7% at the end of 1993 (Kahler, 1998: 113). On the other hand, although the inflation rate decreased to 25% in the period 1988–1991 and to 7% in 1994, this decline was not fast or large enough to stop the real exchange rate (Doyle et al., 2019: 4). The expanding loan volume due to the credit boom caused by the liberalization and privatization of the banking sector, on the one hand, led to a decrease in savings by increasing private expenditures, on the other hand, increased growth in imports. As a result, the current account deficit, which was financed by short-term capital inflows that increased due to the facilitation of foreign capital inflows, increased from 1.4% of GDP in 1988 to 8% of GDP in 1994, with a rapid growth (Doyle et al., 2019: 4) (Chart 6.3).

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Table 6.2 Inflation and exchange rate changes (1991–1995) Inflation 1991

1992

1993

1994

1995

Nominal exchange rate change (%)

Real exchange rate index (1980 = 100)

I

7.32

0.67

127.09

II

3.61

1.22

124.88

III

2.74

1.30

124.08

IV

4.60

0.90

120.61

I

5.40

− 0.03

115.15

II

2.71

0.92

114.11

III

2.00

0.10

112.82

IV

2.52

0.73

111.68

I

3.27

− 0.42

108.58

II

1.85

0.19

107.69

III

1.62

0.10

106.46

IV

1.66

0.30

105.80

I

1.94

1.34

105.84

II

1.54

5.51

110.66

III

1.45

1.56

111.75

IV

1.85

5.95

116.76

I

8.00

58.09

172.41

Source Sachs et al. (1995)

4 2 0 -2 -4 -6 -8 -10 1988

1989 Public

1990

1991 Private

1992

1993

1994

Current Account

Chart 6.3 Saving-investment gap and current account (% of GDP) (1988–1994). Source Sachs et al. (1995)

6 Mexican Tequila Crisis of 1994

89

Although there was a foreign capital inflow of 91 billion dollars in the 1990–1993 period, the panic atmosphere at the end of 1994 caused Mexico’s foreign exchange reserve to fall from 26 billion dollars to 6 billion dollars. The devaluation that followed this decline deepened the financial crisis (Sachs et al., 1995: 7). The Mexican government’s attempt to respond to the capital outflow from the country, which started with a panic atmosphere, by issuing short-term dollardenominated bonds called “Tesobonos”, increased the Tesobonos stock from 1.2 billion dollars at the end of 1993 to 29 billion dollars in December 1994. Considering that the reserves were 12.5 billion dollars at the beginning of December, the government’s move led the country to a de facto illiquid position in debt management (Krueger & Tornell, 1999: 11) (Table 6.3). Politically allowing the peso, which is the Mexican currency, to be overvalued, the loans were expanded rather than narrowed when speculative movements started, and the devaluation was made in a way that damages the confidence of the investors rather than gaining the trust of the investors are also shown as important reasons of the crisis (Kınayturk, 2006: 31). High unemployment rate and the crease in expectations that the fixed exchange rate would be quit and the expansionary monetary policy would be implemented were triggering effects in the crisis. For this reason, with the emergence of the crisis, the reserves of the Central Bank began to decrease rapidly, and the local currency was devalued by 50%. Thus, as a result of the increase in import costs, inflation also increased, interest rates increased to 80% in order to stabilize the peso and inflation, and as a result, the country’s economy contracted by 7% (Has, 2007: 13). Considering the causes of the crisis, the main reason was that the speculative hot money left the country due to the high deficit of current payments, the overvalued exchange rate, and the decrease in private savings (Kınayturk, 2006: 31). Table 6.3 Components of domestic debt (millions of dollars) 1989

1990

1991

1992

1993

1994

Cetes

20,437

24,445

23,567

19,047

26,084

7456

Bondes

21,082

21,903

18,871

11,827

5485

1562

Ajustabonos

1221

4859

12,696

11,642

10,849

5371

Tesobonos

75

408

302

296

1237

17,780

Others

3661

3193

24

8

7

2

Total

46,476

54,808

55,459

42,820

43,662

32,170

Source Sachs et al. (1995)

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6.7 Views on Explaining the Crisis Three views come to the fore to explain the 1994 Mexico Crisis: (i) the view of adverse shocks, (ii) the view of unsustainable external position, and (iii) the view of inadequacy of policies (Hacıhasanoglu, 2005: 34). According to the view of adverse shocks, it was not possible for the authorities to predict the size of domestic political and foreign economic shocks in Mexico in 1994 and their recurrence. In a conjuncture where inflationary pressures were eased, the authorities thought that the measures taken against the events were sufficient to establish confidence in the exchange rate regime. The unsustainable foreign position view suggests that implementing an exchange rate-based stabilization policy in a country where capital movements are free will result in a permanent current account deficit and an overvalued real exchange rate by decreasing the real interest rate and increasing the total demand level. The exchange rate, which is valued in real terms and current account deficit, becomes unsustainable at some point, and the economy can only reach the old competitive level and maintain the current account balance by re-adjusting the exchange rates. The insufficient policies view suggests that the adverse shocks in Mexico in 1994 and the fragility of the economy in its external position required the implementation of a tighter monetary policy and earlier supporting of the exchange rate with expansionary policies. Thus, officials could reassure confidence of the markets in the exchange rate.

6.8 Post-crisis Period The most important consequence of the crisis is the collapse of the Mexican peso. Investors investing in Mexican bonds lost 15% of their investments in value in one day and 40% in the long term, and it can be seen how devastating the result is given the remote possibility of losing money on fixed yield bonds (“The Mexican Currency Crisis”, n.d.). Without sufficient reserves to continue trading in the Forex market and manage the exchange rate, the Mexican government had to abandon the anchor to the US dollar. This led to the rapid devaluation of the Peso as well as significant economic, political, and social turmoil in Mexico (“The Mexican Currency Crisis”, n.d.). The Mexican government, which was on the verge of defaulting on its national debt, required a bailout to survive financially. The rescue came from its neighbor, the United States, with which it shared a fairly long border. The United States made a total recovery of 51 billion dollars in exchange for Mexico’s pledge of national oil reserves. In addition, Mexico was forced to apply tight monetary and expansion policies until debts were paid by investors. The fact that Mexico is a major importer

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of American goods has a significant effect on the rescue decision of the US (“The Mexican Currency Crisis”, n.d.). With the impact of the post-recovery economic policies, the country achieved a relatively stable economic structure. In the 15 years following the crisis, there were no similar financial or foreign currency crises. Expanding its foreign trade volume especially with the US, Mexico became the biggest receiver of foreign direct investments among developing countries. In this context, the GDP per capita, which was 8000 USD in 1995, reached 15.000 USD by 2008 (Musacchio, 2012: 24).

6.9 Conclusion Mexico had to abandon the industrialization strategy based on the import substitution, which it had been pursuing for nearly 40 years under the conditions of the global and national economic conjuncture at the end of the 1970s, and rapidly implement financial and commercial liberalization policies with a sharp turn from the early 1980s. Its economy gained a certain momentum with the effect of the financial and commercial liberalization policies implemented. With financial liberalization policies, many public banks were privatized, and the quantitative restrictions on interest rates and lending as well as the reserve requirement of banks were eliminated, facilitating the foreign capital inflow to the country. On the other hand, the current account deficit reached significant amounts due to the increasing import volume as a result of the removal of many tariff and non-tariff barriers following the trade liberalization policies and especially the GATT membership in 1986, the need for foreign currency, and decrease in national savings. Foreign debt management was also damaged as the foreign debt reached a significant level with the political permission of the real exchange rate to be overvalued as a result of the use of the exchange rate as the nominal anchor by fixing the value of the peso to the US dollar, in order to encourage foreign capital inflow to the country and to borrow more easily from foreign markets. In 1994, the uneasiness that the national reserves and the existing debts could not be sustained, triggered the flight of foreign capital from the country with the outbreak of a series of events on global and national basis. At the end of the 1994 crisis, the country’s currency declined to half of its pre-crisis value, inflation peaked at 52%, interest rates peaked at 80%, and the country’s economy shrank by 7% in total. The 1994 Mexican crisis is an important lesson especially for developing countries on the sustainability of large current account deficits and the risks of sudden shifts in capital flows.

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References Brid, J. C. M., Carpizo, J. E. P., & Bosch, J. R. (2009). Economic development and social policies in Mexico. Economy and Society, 38(1), 154–176. https://doi.org/10.1080/03085140802560652 Cakmak, S. (2004). Kar¸sıla¸stırmalı Finansal Kriz Analizleri: Latin Amerika, Asya ve Türkiye (Doctoral thesis). Available from Turkish Council of Higher Education’s Digital Theses database. (Record No. 146769). Dolu, A., & Göksel, T. (2017). NAFTA’nın Meksika Ekonomisi Üzerindeki Etkileri: Sentetik ˙ ˙ Kontrol Metot Yakla¸sımı. Süleyman Demirel Üniversitesi Iktisadi ve Idari Bilimler Fakültesi Dergisi, 22(3), 915–926. Retrieved from https://dergipark.org.tr/tr/pub/sduiibfd/issue/52994/ 704182 Dornbusch, R., & Werner, A. (1994). Mexico: Stabilization, reform and no growth. Brookings Papers on Economic Activity 1, 253–315. Retrieved from https://www.brookings.edu/wp-con tent/uploads/1994/01/1994a_bpea_dornbusch_werner_calvo_fischer.pdf Doyle, R., Scott, D., & Crimmins, C. (2019). Was the “tequila effect” rational? Trinity College Dublin, 1–11. Retrieved from https://www.tcd.ie/Economics/assets/pdf/SER/1999/ Doyle_Scott.pdf Edwards, S. (1997). The Mexican peso crisis: How much did we know? When did we know it?. NBER Working Paper, 6334, 1–41, Retrieved from https://www.nber.org/papers/w6334.pdf Has, H. (2007). Spekülatif sermaye hareketlerinin kontrolü ve türkiye için politika önerileri. SPK Denetleme Dairesi. Retrieved from https://www.spk.gov.tr/SiteApps/Yayin/YayinGoster/978 Hacıhasanoglu, B. (2005). Meksika 1994 ve arjantin 2001–2002 krizlerinin geli¸smekte olan ülkeler ve türkiye için önemi. Uzmanlık Yeterlilik Tezi, Türkiye Cumhuriyet Merkez Bankası Piyasalar Genel Müdürlü˘gü, 30–46. Retrieved from https://www.tcmb.gov.tr/wps/wcm/con nect/0fe9491e-3b50-4dbf-9e0a-97a0edcf5e03/burcinhacihasanoglu.pdf?MOD=AJPERES& CACHEID=ROOTWORKSPACE-0fe9491e-3b50-4dbf-9e0a-97a0edcf5e03-m3fB9.l International Monetary Fund. (2018). Mexico’s Economic Outlook in Five Charts. Retrieved from https://www.imf.org/en/News/Articles/2018/11/07/NA110818-Mexico-Economic-Outlook-in5-Charts Kahler, M. (Ed.). (1998). Capital flows and financial crises. Cornell University Press. http://www. jstor.org/stable/10.7591/j.ctv5rdvd8. Kınayturk, Z. (2006). 1990 Yılından Sonra Ya¸sanan Ekonomik Krizlerin Küçük ve Orta Büyüklük˙sletmeler (Kobi) Üzerindeki Etkileri (Unpublished master thesis) Available from Turkish teki I¸ Council of Higher Education’s Digital Theses database. (Record No. 187580). Kızılta¸s, S. (2015). 28 Subat ¸ Sürecinin Ekonomik Yansımaları (Unpublished master thesis) Available from Turkish Council of Higher Education’s Digital Theses database. (Record No. 399659). Krueger, A. & Tornell, A. (1999). The role of bank restructuring in recovering from crises: Mexico 1995–98, NBER Working Paper, No. 7042, 1–56, Retrieved from https://www.nber.org/papers/ w7042. Lustig, N. (2001). Life is not easy: Mexico’s quest for stability and growth. Journal of Economic Perspectives, 15(1), 85–106. Retrieved from https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep. 15.1.85 Ministry of Trade (2020). Ticaret Bakanligi Dis Temsilcilikler ve Uluslararasi Etkinlikler Genel Mudurlugu, Meksika Ulke Profili. Retrieved from https://ticaret.gov.tr/data/5f05ce3613b8761 868766d76/Meksika.pdf. Musacchio, A. (2012). Mexico’s financial crisis of 1994–1995. Harvard Business School Working Paper, No. 12–101, 5–29. Retrieved from https://dash.harvard.edu/bitstream/handle/1/9056792/ 12-101.pdf?sequence=1&isAllowed=y Pereznieto, P. (2019). The Case of Mexico’s 1995-Peso Crisis and Argentina’s 2002 Convertibility Crisis, 5–38. Retrieved from https://www.researchgate.net/publication/254453032_The_Case_ of_Mexico’s_1995_Peso_Crisis_and_Argentina’s_2002_Convertibility_Crisis

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Rueger, A., & Tornell, A. (1999). The role of bank restructuring in recovering from crises: Mexico 1995–98. NBER Working Paper, No. 7042, 1–56. Retrieved from https://www.nber.org/papers/ w7042 Sachs, J., Tornell, A., & Velasco, A. (1995). The collapse of the Mexican peso: What have we learned? Nber Working Paper Series, Working Paper No: 5142, 1–57. Retrieved from https:// www.nber.org/papers/w5142 The Mexican Currency Crisis (Tequila Crisis) of 1994. (n.d.). Retrieved from https://www.manage mentstudyguide.com/mexican-currency-crisis-tequila-crisis-of-1994.htm The World Bank. (2020). The World Bank in Mexico. Retrieved from https://www.worldbank.org/ en/country/mexico/overview#1 Ticaret Bakanligi Dis Temsilcilikler ve Uluslararasi Etkinlikler Genel Mudurlugu. (2020). Meksika Ulke Profili. Retrieved from https://ticaret.gov.tr/data/5f05ce3613b8761868766d76/Meksika. pdf

Muhammet Kaya is a Ph.D. candidate at Izmir Katip Celebi University. He received his bachelor’s degree in public administration from Izmir Dokuz Eylül University and his master’s degree from Izmir Katip Celebi University. He also works as Chief Inspector in The Ministry of Commerce of the Republic of Turkey. He served as Vice President of Guidance and Inspection at the same ministry in 2011–2013. He has been conducting research, examination and investigation for approximately 22 years in the field of customs and foreign trade, including money laundering crimes. He was in England in 2010–2011 and 2015 for his language and professional development. Göksel Çetinkol He completed his undergraduate studies in the Department of Finance in the Faculty of Economics and Administrative Sciences at the University of Dokuz Eylül and his master’s degree in the Fiscal Law Program of the Institute of Social Sciences at the University of Dokuz Eylül. He is currently a Ph.D. student in the Ph.D. Program in Finance and Financial Management at ˙Izmir Katip Çelebi University. Göksel Çetinkol, who served as Deputy Tax Inspector under the Chairmanship of the Tax Supervisory Board of the Treasury and Finance Ministry for close to two years after winning the competition exams opened, then he was appointed Deputy Inspector of Customs and Trade in the Directorate of Guidance and Inspection of the Ministry of Customs and Commerce, having succeeded in the examinations conducted by the Ministry of Customs and Trade. He was appointed Trade Inspector after qualifying exams and served as Chairman of Customs Group for 7 years. He has several articles on tax and customs legislation published in various journals.

Chapter 7

1994 Financial Crisis in Turkey Mesut Ardan

Abstract One of the deepest crises Turkey experienced in the 90s was the 1994 Economic Crisis. The crisis did not arise out of nowhere. Its roots date back to 1980. The mistakes made in some of the policies that started to be implemented with January 24, 1980, stabilization program, the seeds of the 1994 economic crisis began to be planted. Financial liberalization and liberalization in foreign trade in the following period resulted in the Turkish economy, which was not yet ready, to face a crisis. This chapter aims to give detailed information about the 1994 Economic Crisis that occurred in Turkey. In the study, the place of the 1994 economic crisis in the literature and the reasons for its emergence were tried to be explained in detail. With the onset of the crisis, its effects on the country’s economy were revealed, and the exit strategy from the crisis was explained. While explaining the causes and effects of the crisis, some economic indicator figures before and after the crisis were used. In this context, data sets such as growth, foreign trade, interest rate, international reserve amount, foreign capital inflow and outflow figures, inflation, and exchange rate were used for certain periods between 1980–1994. Although there are many factors that led to the 1994 economic crisis, each one has a different effect and cannot be said to have caused the crisis on its own. Intense short-term speculative capital inflows to the capital markets with the financial liberalization, the deterioration of the current account balance as a result of the overvaluation of the Turkish lira, the unsustainable level of public deficits, high inflation, excessive public debt and public sector borrowing requirement, attempt to keep treasury borrowing rates below market rates, open positions of banks, decrease in international reserves of the Central Bank, borrowing from the Central Bank to finance public deficits can be counted among the main causes of the crisis. The 1994 economic crisis, which was one of the deepest crises in the 90s, caused the country’s economy to shrink by as much as 6%, the national currency to depreciate excessively, inflation to hyperinflation levels, and overnight interest rates to reach astronomical levels. As the exit strategy from the crisis, the economic decisions of April 5, 1994, were announced, and the policies expected to eliminate the effects of the crisis in theory began to be implemented. Unfortunately, M. Ardan (B) Tax Inspection Board, Izmir, Turkey e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 B. Açıkgöz (ed.), Black Swan: Economic Crises, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-99-2318-2_7

95

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April Economic Stability Program did not provide a permanent stability and recovery in the economy and could not prevent the emergence of new economic crises in the medium and long term, because the necessary structural reforms were not fully made and implemented decisively. Keywords Financial crises · Turkey · 1994

7.1 Introduction The crisis of 1994 in Turkish economy is specifically called currency crisis by many economists. The 1994 currency crisis is not a crisis that emerged out of blue, but a crisis that has a history dating back to past years and broke out as a result of some policies implemented in the past. With the liberalization which started in foreign trade and commodity markets upon the Decisions of 24 January 1980, full liberalization which the Turkey’s economy was not yet fully prepared and took place in financial markets in August 1989 took effect in the long term, and as a result, Turkish economy began to live a period nested with contractions and crises (Gerni et al., 2005: 40). When the weaknesses of the economic management of the period combined with the aforementioned facts, the economic crisis of 1994 was inevitable. Before giving details about the economic crisis experienced in Turkey in 1994, it is useful to briefly discuss the types of crises. Economic crises may be divided into two as real and financial crises. Financial crises can be classified into subgroups such as currency crisis, banking crisis, systemic financial crisis, and foreign debt crisis (Ural, 2003: 12). Currency crisis is defined as, in the event of any speculative attack on the exchange value of a country’s national currency, it is necessary to counter the attack, in other words, to prevent the excessive depreciation of the national currency, hence the national currency is forced to be defended through extensive use of the country’s international reserves and the resulting extraordinary decrease in foreign exchange reserves as well as increasing the interest rates to astronomically high levels. Furthermore, raising interest rates to astronomical levels and forcing the country’s currency to be defended is called the currency crisis (I¸sık et al., 2004: 47). Theoretical studies have been conducted in various periods on currency crises, which also mean a sudden change in exchange rate and capital movement, and the theoretical models that have been put forward are classified as 3 generations. Without going into details, the theoretical models in question are named as 1st generation models, 2nd generation models, and 3rd generation models (Danı¸so˘glu, 2007: 2). The economic crisis of 1994 experienced in Turkey is described as currency crisis, which is widely acknowledged that it can be explained by the 1st generation currency crisis model. Especially, the critical levels of public deficits in the 1994 crisis and the actions of the economy management avoiding borrowing at high domestic debt interest coincide with the problems presented by the 1st generation currency crisis model (Türel, 2010: 34).

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Recently, there have been various financial crises in the world. Among the most important of these financial crises in international financial markets are the European Currency Crisis in 1992–1993 and the “Tequila Crisis” in Latin America in 1994– 1995 (I¸sık et al., 2004: 46).

7.2 Causes of Economic Crisis of 1994 It is a known fact that some deterioration occurs in some financial indicators before the outbreak of financial crises. Although it is not possible to say for sure which financial indicator should be below or above what kind of threshold value for the occurrence of financial crises, it is possible to predict the possibility of encountering financial crises by analyzing the historical course and its relationship with other indicators. There are some generally accepted economic indicators regarding financial crises: international foreign exchange reserves, real exchange rate, ratio of budget deficit/GDP (Gross Domestic Product), ratio of Central Bank Monetary Amounts/International reserves, Government borrowing interest rates, public sector borrowing requirement, export coverage ratio, ratio of total public debt/GDP, ratio of short-term foreign capital balance/GDP, and ratio of current account deficit /GDP (Ural, 2003: 13). When the leading indicators of financial crises are analyzed, it should not be expected that all of the above indicators will suddenly deteriorate for a crisis to emerge. While some problems can be observed in some indicators, it may not be the case for the others. The course of the aforementioned economic indicators can often give an idea of whether the economy is alarming or deteriorating. It should also be noted that crisis symptoms cannot be revealed on the basis of the indicators per se. Other factors such as political instability, incompetent economy management, economic turmoil in the external world, an environment of insecurity, and the effects of previous economic decisions also play a role in the emergence of crises. As a matter of fact, in the 1994 economic crisis, along with the course of the indicators, other uncertainties, weaknesses, and political instabilities were effective in the decisions of investors and caused sudden capital movements, borrowing problems, and thus the outbreak of the currency crisis. In the following sections, the reasons of the 1994 economic crisis will be addressed under relevant headings.

7.2.1 Overall Impact of January 24, 1980 Stability Program With the stability program put into effect on January 24, 1980, important steps were taken toward liberalization in foreign trade, and in this context, more open policies were put into practice. The policies envisaged in the economic stability decisions

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taken on the said date are briefly to gradually liberalize imports, support exports, liberalize the foreign exchange market and capital inflows, reduce the share of the public in the economy, privatize State Economic Enterprises (SEEs), and ensure that the interest rates are freely determined by the market and the general price levels are freely formed in accordance with the supply and demand (Karaçor, 2006: 384). Turkey’s current political and economic structures cannot be said to be fully ready for a number of January 24, 1980 stability program policies to be implemented. In particular, a number of policies such as full financial liberalization by liberalizing foreign capital flows into and out of the country in 1989, liberalization of interest rates, and gradual liberalization of imports were put into practice without the necessary structural measures. The foreign trade deficit and current account deficit increased enormously since the early 1990s due to the policies implemented without being adequately ready, and it led to a number of economic problems such as high inflation due to releasing prices and real wages that had been under pressure for a long time without taking necessary structural measures (Gaytancıo˘glu, 2010: 142). The negative course created by the aforementioned policies in various economic indicators is important in terms of showing that something went wrong in the onset of the crisis in 1994.

7.2.2 Short-Term Speculative Foreign Capital Inflows Under Liberalization of Financial Markets (1989–1994) With the stability program put into effect on January 24, 1980, important steps were taken toward liberalizing the foreign trade, and in this context, more open policies were put into practice. This liberalization in the goods market was followed by full financial liberalization with the liberalization of capital movements in August 1989. Turkish citizens were given the opportunity to have foreign currency deposits as of 1984, and important steps were taken in financial liberalization with the establishment of the Istanbul Stock Exchange in 1986. When the Istanbul Stock Exchange was first established, it was not opened to foreign investors, and in the first stage, State debt securities and stocks of state economic enterprises included in the privatization scope began to be traded. In the following periods, private sector stocks were also allowed to be traded on the stock exchange (Ardıç, 2004: 92). With the Decree No. 32 on the Protection of the Value of Turkish Currency, which entered into force on 11/08/1989, the full liberalization of capital movements and the convertibility of the Turkish lira were ensured. Foreign capital which was mostly composed of portfolio investments and short-term capital entered the stock exchange market in Turkey on the same date. High amount of capital inflows and outflows with speculative purposes emerged upon the full financial liberalization in 1989, Turkey’s high public deficits in 1989– 1994, and public sector borrowing requirement aggravated some domestic problems such as those in the banking system. Political instability, terrorist attacks, and the other abovementioned domestic problems led to further destabilization of Turkey’s

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Table 7.1 Balance of payments (% of GNP)1 Capital inflows Total

Current In Real Short-term Direct Portfolio Other account reserves exchange rate investment investment long balance term 0.5

0.4

− 0.1 − 1.7

1990

2.7 2.0

1991

− 1.6 − 2.0

0.5

0.4

− 0.5 0.2

1992

2.3 0.9

0.5

1.5

− 0.6 − 0.6 − 3.5

1993

4.9 1.7

0.3

2.2

0.8

1994

− 3.2 − 3.9

0.4

0.9

− 0.6 2.0

1995

2.7 2 2

0.4

0.1

0.0

− 1.4

0.9

100.2

− 0.7

98.4

0.9

94.6

0.2

93.6

0.2

75.9

2.7

87.2

1996

5.3 3.8

0.3

0.3

0.9

− 2.9

2.5

86.7

1997

4.7 1.2

0.3

0.8

2.4

− 2.4

1.7

86.7

1992–1993

3.6 1.3

0.4

1.8

0.1

− 2.1

0.5

94.1

1996–1997

5.0 2.5

0.3

0.6

1.6

− 2.7

2.1

86.7

Source Özatay (2000: 9)

economy in the stated period with being in interaction with instantaneous foreign capital inflows and outflows in high amounts (Arı & Cergibozan, 2014: 44). Therefore, although it is not correct to say that the liberalization of capital account movements in 1989 was the only reason for the 1994 crisis, this liberalization played an important role in the increasing economic internal and external imbalances after 1989. Table 7.1 shows the percentage of foreign capital inflows between 1990 and 1997, and the ratio of change in current account balance and international reserves to GDP. It is useful to analyze the foreign capital inflows and outflows, which stand out in the form of short-term, direct investment, and portfolio investments, as they show the relationship with some economic indicators such as current account balance, change in foreign exchange reserves, and real exchange rate, which played an important role in the formation of the 1994 economic crisis. Liberalization of capital movements led to an increase in interest rates, and foreign capital, aiming to maximize profit depending on rising real interest rates, turned to the Turkish bill market with high interest yield and the stocks traded in the Istanbul Stock Exchange. As can be seen from Table 7.1, in the period after 1989, when full financial liberalization began, excessive speculative short-term foreign capital inflows caused an excessive appreciation of the Turkish lira against foreign currencies, which led to the formation of internal and external imbalances such as deterioration of the current account balance until 1994, when the crisis occurred, and a foreign trade deficit. As a rule, it would not be correct to say that full financial liberalization will always affect the economy of a country negatively, as there are examples of countries that 1

The increase in the exchange rate indicates the appreciation of the national currency. The average exchange rate between 1982–1989 is 85.9. The weight of the US dollar in the currency basket is 0.75, the weight of the German Mark is 0.25.

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have positive effects on the economy. However, the countries which are not ready for financial liberalization such as Turkey often face negative consequences in the medium term. The worst negative outcome caused by portfolio investments and net capital inflows in 1990 when short-term capital inflows increased is; reduction of Turkey’s foreign trade competitiveness with overvalued national currency, i.e., foreign trade deficit due to increase in the price of imported goods and decrease in the price of exported goods (Ardıç, 2004: 101, 147). This situation, which also caused deterioration of the current account balance, increased the ratio of current account deficit to GDP 4% before the 1994 crisis. During 1989–1994, more foreign capital inflows required to finance the current account deficit increased the ratio of short-term foreign debt in international reserves. The increase in the short-term foreign debt ratio makes the countries economically more fragile. Economic fragility also increased significantly for the stated reason prior to the 1994 crisis in Turkey. As can be seen from Chart 7.1, net inflows and outflows were experienced considering significant foreign capital flows in 1991–1994 after financial liberalization was achieved. There may be some political and economic factors that affect the direction of sudden capital movements. As a matter of fact, the gulf war that took place in 1991 created an atmosphere of panic and uncertainty in capital markets and caused a shortterm capital outflow of approximately 2% of GDP. Its various effects can be listed as a slight increase in interest rates, shortening of borrowing maturity, and difficulties in external financing (Celasun, 1998: 13).

Chart 7.1 Capital flows (million $) (FDI foreign direct ınvestment, FPI foreign portfolio ınvestment (medium and long-term), STC short-term capital). Source Celasun (1998: 30)

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In the period 1989–1994, the highest foreign capital inflow was realized in 1993. Short-term capital and portfolio investments constitute the majority of the said foreign capital. As it is known, sudden capital flows are mostly the case for short-term foreign capital, and their effects on the economy may be more destructive compared to other types of foreign capital, depending on the situation. Indeed, short-term foreign capital leaving the country in 1994, upon the outbreak of the crisis, resulted in a huge increase in the real exchange rate and the borrowing rate, affecting negatively the fragile Turkish economy. In brief, Turkey was exposed to large and growing internal and external financial imbalances, following the financial liberalization that took place in 1989, in the period including the 1994 crisis. Short-term foreign capital aims at obtaining speculative profits and has the ability to easily and suddenly exit the country in the event of any insecurity arising from various reasons and also made Turkish economy more fragile (Korkmaz et al., 2010: 2822). As a result, it is stated that liberalization of capital movements creates a temporary equilibrium, such as high interest rate and low foreign exchange rate, in an environment where public deficit and foreign trade deficit exist; hence, shifting to financial liberalization without fully being ready was an important factor, as a misguided policy, in the formation of 1994 Turkey crisis (Ardıç, 2004: 154).

7.2.3 Deterioration in Foreign Trade Balance Within the framework of the January 24, 1980 Stability Program, it is understood that the State followed a trade policy, between 1980–1984, based on the support of exports and liberalization of imports, instead of “import substitution” policies based on internal procurement instead of buying from abroad. In the aforementioned period, with the effect of the military administration, savings were made in the public sector with the restrictive wage policies, and export-supportive policies were implemented, including the decrease in the value of the Turkish lira. Table 7.2 shows the annual foreign trade values between 1980–1994. As can be seen from Table 7.2, the foreign trade deficit followed a horizontal course between 1980–1984, which is Phase I of the stability program of January 24, 1980. There was no significant increase or decrease. Financial liberalization, including the liberalization of capital flows and interest rates, which is one of the policies in the program, was significantly achieved in the period 1985–1989 which was considered Phase II of the January 24 Stability Program (Arı & Cergibozan, 2014: 33). With the gradual abolition of import quotas and price controls, import liberalization brought along the current account deficit and foreign trade deficit problem, and these problems began to appear more prominently on the agenda of the country. The liberalization of imports in 1983 was followed by the reduction of tariffs in 1989 and the removal of a significant part of the quantity and price restrictions in 1990. As will be explained in detail later, in addition to the above policies, the foreign

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Table 7.2 Foreign trade, 1980–1994 (thousand $) Export Value 1980

2,910,122

Import Rate of Value change (%) 28.7

7,909,364

Foreign trade balance Rate of Value change (%) 56.0

− 4,999,242

Ratio of exports to imports % 36.8

1981

4,702,934

61.6

8,933,374

12.9

− 4,230,439

52.6

1982

5,745,973

22.2

8,842,665

− 1.0

− 3,096,692

65.0

1983

5,727,834

− 0.3

9,235,002

4.4

− 3,507,168

62.0

1984

7,133,604

24.5

10,757,032

16.5

− 3,623,429

66.3

1985

7,958,010

11.6

11,343,376

5.5

− 3,385,367

70.2

1986

7,456,726

− 6.3

11,104,771

− 2.1

− 3,648,046

67.1

1987

10,190,049

36.7

14,157,807

27.5

− 3,967,757

72.0

1988

11,662,024

14.4

14,335,398

1.3

− 2,673,374

81.4

1989

11,624,692

− 0.3

15,792,143

10.2

− 4,167,451

73.6

1990

12,959,288

11.5

22,302,126

41.2

− 9,342,838

58.1

1991

13,593,462

4.9

21,047,014

− 5.6

− 7,453,552

64.6

1992

14,714,629

8.2

22,871,055

8.7

− 8,156,426

64.3

1993

15,345,067

4.3

29,428,370

28.7

− 14,083,303

52.1

1994

18,105,872

18.0

23,270,019

− 20.9

− 5,164,147

77.8

Source TU˙IK (2019)

trade balance started to deteriorate significantly in 1990 with the effect of the full financial liberalization that took place in 1989 which caused the national currency to gain value (Celasun, 1998: 5). As can be seen from the table, there was an increase of more than 100% in the foreign trade deficit in 1990 compared to the previous year, and the foreign trade deficit, which was 4.2 billion dollars in 1989, increased to 9.3 billion dollars in 1990. It is natural that this adverse deterioration in the foreign trade balance is the result of the abovementioned practices. Between 1989 and 1994 when the crisis broke out, 60% of the growth in imports is due to the increase in domestic demand for imported goods, which are final products. Due to the relatively high value of the national currency against foreign currencies, the increase in demand for final goods abroad continued until the import boom in 1993. In 1993, imports increased by 28.7% compared to the previous year and reached a record size in the 1980–1994 period. The most important reason for this increase is that short-term speculative foreign capital flows decrease the domestic saving tendency and cause consumption and import volume to increase (Ardıç, 2004: 98). In this context, the export-based growth model followed in the mid-1980s was replaced by import-based growth, so foreign trade deficits were 3% of GNP in 1992 before the crisis, but rose to 8.5% in 1993, with the effect of liberalization in financial markets and foreign trade (Celasun, 1998: 5).

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7.2.4 Public Deficits Reaching Unsustainable Size One of the major causes of the financial crisis experienced in Turkey in 1994 is unsustainable public deficit reaching high levels. Prior to the crisis, budget deficits and current account deficits, at unsustainable levels, and the mistrust created by the government, which resorted to methods other than borrowing in financing the deficits, were among the important factors in the emergence of the 1994 crisis. Budget deficits can be understood in cases where the state should take an active role in the economy. As a matter of fact, many countries managed to recover from the 1929 World Economic Crisis by increasing public expenditures and having budget deficits up to a certain level. The United States of America was also able to get rid of the effects of the 1929 Great Depression by having budget deficits from 1932 to 1936 (Erbay & Hemen, 2019: 128). However, it should be noted that in order for countries to grow their economies in a sustainable and stable manner by having current account deficit and budget deficit, they should not have any problems in financing both the current deficit and the budget deficit. In order to eliminate these deficits, it is not possible, in the long term, to continue to use continuous and excessive foreign borrowing directly or indirectly through creditors in the domestic market. In particular, the fact that foreign financing consists of speculative short-term foreign capital, which has the ability to leave the country suddenly due to various reasons such as lack of trust, may put countries in a difficult position in the long term in terms of eliminating these deficits. In this case, the level of domestic savings is important in the stable and smooth eliminating of the deficits, such as the current account deficit and the budget deficit which are also referred to as twin deficits in the literature (Emirkadı, 2017). Elimination of public deficits in Turkey with financial liberalization since 1989 has been achieved through capital movements, rather than domestic savings. Being dependent on foreign capital to eliminate the budget deficits, without sufficient domestic savings, especially benefiting from short-term foreign capital, may be a problem if the budget deficits and current account deficits exceed the level that would create trust problems for foreign investors. Indeed, this was the case in Turkey for budget deficit and current account deficit before the 1994 crisis, and as a result, the crisis broke out due to the sudden outflow of the short-term foreign capital and the problem of attracting foreign capital into the country (Oktar & Dalyancı, 2010: 12). Therefore, it can be said that pre-crisis low domestic savings in Turkey have an indirect effect on the crisis. There are a number of factors that caused public deficits, which had an important effect on the emergence of the 1994 crisis, to reach unsustainable dimensions. These factors are discussed below. After the Stability Decisions were taken on January 24, 1980, real wages were kept under pressure by both the military and civilian administration between 1981 and 1987, thereby struggling with inflation. However, the pressure on wages could not be continued after 1987, and populist practices emerged with the effect of local and general elections; the wages of personnel working in the public sector increased

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at an extremely high rate of 188% during the period 1988–1989. From 1988 to 1992, the real wage increases in the public sector exceeded 200%. These astronomical increases in the real wages of public personnel further increased public deficits. The increase in personnel expenditures due to the aforementioned hikes was recorded as one of the most important reasons for the excessive increase in public deficits in the pre-crisis period. Extremely generous agricultural subsidies between 1989–1993 also led to an increase in public deficits. Besides, Turkey’s defense expenditures increased significantly between 1990 and 1994 due to the Gulf War starting in 1990 and terrorist attacks in the eastern region of Turkey and, thus, played a remarkable role in increasing the public deficits. In the post-1980 period, the increase in duty losses of state economic enterprises and public banks and the state’s compensation for these losses are also factors in the increase of public deficits, which has an important role in the outbreak of the 1994 crisis (Ardıç, 2004: 115). During the period between 1989 and 1994, when high public deficits and foreign deficits were present, especially short-term foreign capital of a speculative nature was relied on for the financing of these deficits, upon liberalization of capital movements in 1989, and as a result, a balance of high interest and low exchange rate was created. In the said period, as domestic savings were insufficient to finance public deficits, these deficits were tried to be compensated by speculative foreign capital movements at the expense of high interest payments. High interest payments resulting from excessive indebtedness caused a vicious circle in establishing public balance. High interest expenditures led to a further increase in the public deficit, and while the economic management was on its way to the 1994 crisis, it resulted in the economy management to follow misguided economic policies regarding reducing the interest expenditures, which will be stated among the other reasons of the crisis in the following sections (I¸sık et al., 2004: 51) (Chart 7.2). Chart 7.3 shows the total public expenditure and the ratio of public revenues to GDP between 1988–1995. As can be seen from the chart, a significant increase is observed in public expenditures from 1989 when financial liberalization took place until 1993. However, in the period in question, public revenues are decreasing and in parallel to this, the basic deficit tends to increase, as it can be understood from Chart 7.3. As it is known, the basic deficit is the deficit found by deducting interest Chart 7.2 Total public sector (% GNP). Source Celasun (1998: 23)

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Chart 7.3 The primary deficit (% GNP). Source Celasun (1998: 23)

payments from the budget deficit, and it can also be expressed as primary deficit (Rangarajan & Srivastava, 2003: 4856). Despite the increase in public deficits since 1989, the fact that the budget announced in 1994 did not contain a significant measure for austerity further deteriorated the lack of confidence in the economy and caused an atmosphere of panic by increasing the concern in the financial sector. Negative atmosphere both in the domestic and external market further deteriorated when Turkey’s credit rating was downgraded by well-known major credit rating agencies, and the mentioned downgrade was an important factor on the road to the 1994 financial crisis (Celasun, 1998: 2). As it will be stated in the misguided policies of the economic management in the following chapters, mistakes made in the financing method of public deficits dragged the country into a crisis.

7.2.5 Inflation Phenomenon In parallel with the economic stability decisions taken on January 24, 1980, the restrictive policies on real wages and prices and the policies implemented by the military administration to reduce the real exchange rate were continued by the civil administration in 1984–1987. The government tried to combat inflation by determining the low prices for the products produced by the State Economic Enterprises and suppressing the real wages. However, from a political and macroeconomic perspective, lowering or suppressing real wages and prices is not a sustainable policy for a long time. As a matter of fact, this policy was implemented, from 1981 to 1987, by both the military administration and the civilian administration, but it was revealed that this policy could not be sustained after the 1987 elections. There was a significant and rapid improvement in real wages, with a huge increase in wages by 129% in the private sector and 188% in the public sector during the period 1988–1989 (Celasun, 1998: 5). In the aforementioned period, the dramatic increases in wages in both the public and private sectors caused a significant increase in inflation; as a result, the

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inflationary expectation was high in the economic circles in the first periods of 1994 before the crisis. Chart 7.4 shows the course of Consumer Price Index (CPI) and Wholesale Price Index (WPI) inflation between 1987–1996 October. As can be seen from the aforementioned chart, there was a sharp increase in producer and consumer price index between 1987–1988 period. As stated above, the most important reason for these increases is the public and private sector real wages, which were tried to be kept low by suppressing them between 1980–1987 but increased significantly after it became clear that it was not possible to sustain. From the third quarter of 1988 to the last quarter of 1993, inflation had a partially stable phase between 50 and 80%; however, it has followed an upward trend from the level of 80% since the last quarter of 1993 with the postponement of the price increase of the products produced by the state economic enterprises due to the local elections to be held in March 1994 and the increase in the expected prices for these products after the elections. Therefore, as can be seen from the chart, inflation increased significantly between the last quarter of 1993 and the beginning of the second quarter of 1994, which included the period when the crisis occurred, as the crisis environment became evident, but the inflation rate remained high but stable in the pre-crisis period. Therefore, after 1987, when inflation came to the fore as an important problem, it started to have a negative effect on the expectations of the economic circles toward the country’s economy and became apparent both as a cause and result upon the crisis. In other words, inflation, which was normally high under normal conditions, spiked further and approached hyperinflation.

Chart 7.4 WPI and CPI inflation. Source Celasun (1998: 34)

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7.2.6 Excessive Public Debt and Public Sector Borrowing Requirement In 1989, public deficits increased due to the liberalization of capital movements, political and military developments, and the implementation of populist economic policies. Especially between 1988 and 1993, the public sector borrowing requirement increased significantly, as can be seen from Chart 7.5. The high public sector borrowing requirement, which reached 12% in 1993, clearly shows that borrowing is an important tool in financing public deficits in the said period. There are two options for eliminating the public deficits, which increased significantly between 1987–1994. These can be listed as borrowing and/or monetary expansion. When the situation is evaluated in terms of borrowing, domestic and foreign borrowing are the options used in financing the deficits in question. In general, fiscal deficits may be covered by borrowing in order to avoid monetary expansion and inflation as a result. However, the increase in the borrowing requirement of the governments at this stage leads to an increase in real interest rates and the interest to be paid again by borrowing, causing an impasse (Akyüz & Boratav, as cited in Toprak, 2010: 35). The unsustainable level of interest payments and debt stock may force governments to finance their deficits through monetary expansion. The reasons for monetary financing, which can be explained as the Treasury’s borrowing from the Central Bank, are the government’s inability to borrow money or having to borrow at very high interest rates above the threshold amounts it can pay due to excessive borrowing, which causes an increase in inflation and a deterioration of economic stability, resulting in further deterioration of confidence in the country’s economy among economic actors. Although the public debt/GDP ratios were not extremely high in the pre-crisis period, the public deficit/GDP ratios were at unsustainable levels. From 1989 when financial liberalization took place to 1993, public deficits, which reached high levels, began to be financed by the method called ponzi financing. Ponzi financing is briefly defined as a country borrowing at a higher interest rate in order to pay its current debt. As a matter of fact, the fact that government debt securities interest rates Chart 7.5 Public sector borrowing requirement (PSBR) and the primary deficit (% GNP). Source Celasun (1998: 29)

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followed a course rather higher than the term deposit rates in the 1994 crisis is a clear indicator of Ponzi Financing (Türel, 2010: 37, 44). Therefore, the excessive debt burden and borrowing requirement that the State had to endure led to higher interest payments to borrow; in search of alternative methods other than borrowing, misguided economic decisions made by the government in the last period of 1993 and the monetary financing method preferred by the government caused the crisis of confidence, playing a very important role in the emergence of the 1994 financial crisis.

7.2.7 Low Exchange Rate Effect (Overvalued National Currency) The liberalization of capital movements in August 1989 resulted in the savings and investment priorities of Turkey’s economy went under the control of international financial markets and led to a gradual increase in borrowing interest rates. Especially after 1989, foreign capital, which aimed at high profit and was mostly composed of short-term portfolio investments, turned to the Turkish Bill market and the Istanbul Stock Exchange, causing the national currency to appreciate significantly after 1989 due to the high real interest rate (Karaçor & Alptekin, 2006: 310). The course of the real exchange rate between 1986 and 1996, including the period before and after the 1994 crisis, is shown in Chart 7.6. Chart 7.6 shows the course of TL/$ real exchange rate since 1986. As it can be understood from the aforementioned chart, from 1989, when full financial liberalization took place, toward the last quarter of 1991, the Turkish Lira appreciated considerably, in other words, it was overvalued. Toward the last quarter of 1993, it had a relatively stable phase, maintaining its partially valuable position. The policy of the Central Bank to keep nominal interest rates high within the scope of combating inflation caused short-term foreign capital inflows, also known as hot money, to Chart 7.6 Real exchange rate (1986.01 = 100). Source Celasun (1998: 27)

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the country with the liberalization of capital flows, and with the abundant foreign exchange, an overvaluation in the national currency manifested itself in the mentioned period (Özçoban, 2011: 112). In terms of numbers, the appreciation of Turkish Lira against US Dollar between 1989–1994 was more than 20%. The national currency, which appreciated with the leap in short-term capital and portfolio investments right after 1989, caused a significant increase in the demand for imported consumption goods and contributed to a further increase in the foreign deficit, which is one of the important indicators of economic stability (Emsen, 2003: 93). The demand for imported fixed investment goods and imported raw materials to increase domestic production by using them in production sectors did not increase as much as the demand for imported consumption goods. It can be said that both the increasing foreign capital and the cheaper imports were not benefited in productive areas, and with the trust problem that occurred between the last quarter of 1993 and the first quarter of 1994, the economy had a fragile structure in the process leading to the 1994 crisis. With the effect of speculative short-term foreign capital, the inflow of abundant and cheap foreign currency into the country, the artificial growth period based on imported goods, and low value-added service consumption rather than production turned into a financial crisis in April 1994 with the emergence of the fragilities in the economy (Yeldan, 2002: 51). In the period between 1989–1994, the increase in the prices of export goods together with the appreciation of the exchange rate also appears to be a disadvantageous situation in terms of competition in international trade. Overvalued national currency became a major problem for Turkey’s economy in terms of increasing export revenues, causing further increase in the current account deficit and need for more short-term foreign capital. Increasing speculative short-term foreign capital which had the ability of sudden inflow/outflow made Turkish economy, going under the supervision of international financial markets, more vulnerable to internal and external shocks. In the period leading up to the 1994 economic crisis, the exchange rate got out of the control of the Central Bank and came under the control of international financial markets with the financial liberalization, causing the national saving tendency to decrease. In addition, the measures taken by the Central Bank for the erosion of the exchange rate were ineffective due to the increasing short-term foreign capital flows in connection with the imbalances caused by the overvaluation. The increase in the short positions of the banks as a result of keeping the national currency valuable, by the Central Bank, in combating inflation is one of the reasons that led to the 1994 crisis, as will be explained in detail in the following section (Binay & Kunter, 1998: 32).

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7.2.8 Banks’ Open Positions One of the major causes of the 1994 financial crisis in Turkey is high open positions of domestic commercial banks. The increasing open position of banks before the crisis posed a significant risk for the economic course. With the effect of financial liberalization, commercial banks intensively used offshore borrowing in 1992–1993 and held assets mostly in TL (Celasun, 1998: 2). This resulted in the open positions of commercial banks to increase considerably in the period leading up to the 1994 financial crisis. As a matter of fact, the foreign capital outflow along with various factors causing the crisis and the subsequent need for banks to eliminate their high open positions (Okay, 2002: 113) caused the demand for foreign currency to increase further and the Turkish Lira to lose more value. In order to reduce the depreciation of the Turkish Lira against the foreign currency, the Central Bank sold foreign exchange mostly to commercial banks, and they were used to eliminate open positions. However, with the sale of foreign exchange, the Central Bank lost a significant amount of international reserves yet failed to reduce the depreciation of the Turkish Lira alone. The decrease in the Central Bank’s reserves further increased the concern in the financial markets. Another reason that led to the crisis is the growing mistrust in Turkish economy in the economic environment as a result of the decrease in The Central Bank’s international reserves.

7.2.9 Change in the Financing Method of Public Deficits With the effect of financial liberalization in 1989, public sector deficits were mostly financed by domestic borrowing. In some cases, financing by central banks through lending or advancing loan to the Treasury is one of the methods used, but it is a known fact that it is not preferred because it increases inflationary pressures. In early 1989, restrictions were imposed on the use of short-term advances from the Central Bank, one of the financing methods of the Treasury. Accordingly, the advance amount to be used by the Treasury from the Central Bank would not exceed 15% of the total budget appropriations, in the mentioned period. However, the excessive increase in public deficits affected the government’s financing policies, and the government increased the share of the financing through monetization method in 1992 due to the high domestic debt service payments. The excessive increase in domestic borrowing to finance high public deficits and the accompanying high interest burden caused the Treasury to focus more on short-term advances given by the Central Bank, leading to an increase in inflationary expectations (Yılmaz, 2017: 20). Below is a graphical representation of the loan amount provided by the Central Bank to the Treasury as per terms. As can be seen from Chart 7.7, from October 1993 to April 1994, there is a sharp and continuous increase in the amount of loan given by the Central Bank to the Treasury. This sharp and steady rise shows that the Treasury relies on the Central

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Bank to finance its fiscal deficits through monetary expansion rather than market borrowing. It is understood that after April 1994, when the crisis broke out, the use of loans from the Central Bank had a decreasing trend, and with the effect of the 5 April Decisions, borrowing from the markets started again as of May 1994. Table 7.3 shows, again, the short-term advances given to the Treasury by the Central Bank from October 1993 through the third week of the first month of 1994. Within the scope of the government’s goal to reduce the high public domestic debt stock and high interest expenditures by artificially lowering the interest rates of Treasury securities, it was preferred to finance the increasing public deficits mostly through monetization as of the second half of 1993. In fact, the ratio of short-term advances given by the Central Bank to the Treasury to the Central Bank reserves, which was 8.8% in October 1993, increased significantly and reached 13.9% in the

Chart 7.7 Credit to public sector by Central Bank. Source Celasun (1998: 31)

Table 7.3 Short-term advances extended by the Central Bank to the treasury Short-term advances

Reserves

(Billion TL)

(Million $)

(Million $)

Advances/reserves (%)

October 1993

8027

604

6853

8.8

November 1993

9469

678

7198

9.4

December 1993

10,967

740

6213

11.9

The first week of 1994

10,038

659

5886

11.2

The second week of 1994

12,726

808

5825

13.9

4869

295

5887

5.0

The third week of 1994 Source Özatay (2000: 33)

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second week of 1994. Quitting somehow domestic borrowing by canceling various tenders for short-term Treasury securities and artificial intervention in the borrowing market in the last months of 1993 led to further deterioration in the confidence in Turkey’s economy in the domestic and external debt market (Çö˘gürcü, 2012: 98). Therefore, the increase in the amount of credit used by the Treasury in the form of short-term advances from the Central Bank toward the end of 1993 and partially abandoning the domestic borrowing method was quite costly; this change in the financing method of public deficits appears to be an important factor in the emergence of the currency crisis in 1994.

7.3 Misguided Policies of Economic Management It is claimed by some circles that the economic management made wrong decisions which resulted in the 1994 currency crisis. As stated in the previous sections, in the country, which has already faced difficulties in financing the unsustainable budget deficits, the lack of confidence caused by some economic decisions regarding debt payment and borrowing is seen as an important factor in the emergence of the crisis. In other words, in the pre-crisis period, interventions in the borrowing market with the aim of lowering the interest rate below the market interest rate in borrowing required for cheap financing of budget deficits caused the market to collapse (Özatay, 1995: 18). Such that, the state could not find short-term debt after the crisis at rates that were even higher than the balance interest rates, which had been considered to be high before the crisis. With the laws enacted in August and October 1993, the short-term advance amount that the Central Bank could provide to the Treasury was increased. As a result of the gradual increase in interest expenditures in 1993 and becoming a heavy burden on the budget, the economy administration, aiming to save on interest expenditures and extend the maturity by reducing interest rates as a short-term economic target, canceled some short-term Treasury Bills tenders in late 1993. As can be seen from Table 7.4, 80% of the auctions were canceled, most of which consist of 3, 6, and 9-month term Treasury bills. Again, in December 1993, there were no Treasury Bill tenders with a term of less than 1 year (Celasun, 1998: 12). Toward the end of 1993, canceling many short-term Treasury Bills tenders and the attempt to finance the budget deficits through monetization also emerged as a misguided monetary policy that harmed the confidence environment in the economy (Samur, 2008: 294). Although budget deficits were considerably high in the pre-crisis period, no austerity measures were taken in the budget announced by the government for 1994. Failure to take measures to tighten the fiscal policy in the already fragile economy was evaluated as a negative situation by foreign investors and especially by credit rating agencies and led to an even greater concern in the financial sector. Indeed, Turkey’s credit rating was downgraded by international credit rating agencies in the mentioned period.

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Table 7.4 Auctions of treasury bills and bonds in 1993 (in Billion TL)2 September

October

November

December

Maturity; 12 months Amount of offers

18,730

28,866

14,942

9743

Amount of offers accepted

6290

26,159

6582

7957

Acceptance percentage

33.6

90.6

44.1

81.7

Average interest rate (%)

87

86.7

87.9

89.2

Amount of offers

20,263

10,699

1433

828

Amount of offers accepted

3772

3502

701

0

Acceptance percentage

18.7

32.7

48.9

0

Average interest rate (%)

85.9

86.2

87.9

91.3

Maturity; 9 months

Maturity; 6 months Amount of offers

16,566

10,007

2917

1577

Amount of offers accepted

1943

1946

0

0

Acceptance percentage

11.7

19.5

0

0

Average interest rate (%)

84.8

82.1

86.7

91.1

Maturity; 3 months Amount of offers

4521

6174

2278

1453

Amount of offers accepted

974

1000

0

0

Acceptance percentage

21.5

16.2

0

0

Average interest rate (%)

82.3

79.6

91.8

90.3

Source Özatay (2000: 32)

Trying to achieve two nominal anchors at the same time, namely appreciating the TL and lowering interest rates until 1993, is another misguided policy. Achieving these two goals at the same time is difficult and the cost can be high. As a matter of fact, attempts to reduce interest rates by not allowing exchange rates to depreciate resulted in collapse of the domestic borrowing market. In this framework, continuing to achieve two nominal anchors at the same time has been evaluated as an unsuccessful economic policy in the literature (Özçam, 2004: 10). It was previously stated that in late 1993, the credit given to the public sector by the Central Bank increased, on the other hand, borrowing was less frequent. In a turbulent period when short-term Treasury bills tenders were canceled and public deficits were financed through monetization, the Government announced that the income tax rate, which had been previously applied as 0% on government securities, would be applied as 5% by the Government toward the end of 1993, and it can be considered as another misguided policy implemented by the economy management on the way to crisis. 2

Note: Interest rates are annual compunded rates.

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7.3.1 Decrease in Central Bank International Reserves There was an increase in open positions of the domestic commercial banks between the full financial liberalization in 1989 and 1994 Turkey crisis. Such that, banks borrowing from abroad at low interest rates bought Treasury Securities at home and lent to the State at higher interest rates. Along with the financial liberalization, commercial banks made intensive offshore borrowing, especially between 1992– 1993, and held mostly TL-weighted assets. Many banks remained in short position on the exchange rate and lent at high rates in the domestic market, including the Treasury. However, canceling the Treasury bills tenders in the last two months of 1993, the sharp decline in the stock market at the beginning of 1994 and the depreciation of the TL against foreign currencies caused banks to focus heavily on the exchange rate markets in order to eliminate their open positions. Chart 7.8 is important in terms of showing the sharp decline in the Central Bank’s foreign exchange reserves from November 1993 to April 1994, when the crisis broke out. The banks turning to foreign exchange markets prompted the Central Bank to take certain actions to protect the parity, and within this framework, it sold foreign currencies below market value by using international reserves. While the market exchange rate and the official exchange rate followed a parallel course between January 1992 and October 1993, the gap between the two exchange rates widened since October 1993 and reached its highest level during the crisis period in April 1994 (Özatay, 2000). Despite the devaluations in the first three months of 1994, the Central Bank selling the foreign currency below the market value in order to protect the value of the Turkish

Chart 7.8 International reserves, 1990–1994 September (billion US$). Source Celasun (1998: 32)

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Lira caused the foreign exchange reserves to decrease significantly (Uysal et al., 2008: 53). The common reason for the devaluations made in the aforementioned period is the common belief in that the trust in the Turkish lira and foreign exchange reserves have decreased significantly (Alkıno˘glu, 1999: 313–314). Mostly, banks bought foreign currencies that the Central Bank had sold below the market rate and used them to eliminate their open positions. Thus, the Central Bank’s intervention in foreign exchange rate, by using the foreign exchange reserves, in order to prevent excessive depreciation of the Turkish lira and losing nearly half of its reserves, which had no effect on the appreciation of the Turkish lira, resulted in a greater mistrust in the Turkish economy, which took Turkey one step closer to the crisis of 1994.

7.3.2 Decreasing Share of Manufacturing Industry in Total Investments With the financial liberalization that started in 1989, the increase in foreign capital inflows caused the national currency to appreciate in real terms against foreign currencies, and both consumer goods and tradable foreign goods became relatively cheaper. However, foreign capital entering the country was evaluated mostly in the service sector and in the non-commercial housing sector, and the manufacturing industry was not attached due importance. Therefore, the share of the manufacturing industry in private investments decreased to 24%, especially in the period between 1989–1993. The share allocated to the manufacturing industry within the public investments also decreased in the period 1989–1993. The share allocated to the manufacturing industry from public investments was 11.7% between 1983–1987, and this rate decreased to 4.7% between 1989–1993 (Yeldan, 2002: 47, 48). As it is clear in the ratios above, the decrease in the share of high value-added manufacturing industry investments in public investments and private investments after financial liberalization had an indirect effect on the emerge of the crisis, even if it did not directly trigger the crisis. In other words, the utilization of foreign funds in sectors such as housing and service sectors with low added value and low contribution to gross domestic product in the medium and long term causes the country’s economy to easily have a downturn in sudden shocks and have a severe impact (Karaçor & Alptekin, 2006: 310). That is what Turkey experienced in the 1994 crisis.

7.4 Impacts of Turkey Financial Crisis 1994 Turkey financial crisis had heavy and severe impact on Turkey’s economy. Below the effects of the crisis on Turkey’s economy will be discussed under relevant titles.

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7.4.1 Excessive Depreciation of Turkish Lira Although the value of the Turkish lira against foreign currencies fluctuated between 1987–1993, it was followed by a more stable course compared to the crisis period. As of January 1994, Turkish Lira started to depreciate significantly against the US Dollar; the exchange rate, which was approximately 15,000 TL/USD in January 1994, was 39,000 TL/USD in the first days of April 1994. The depreciation of Turkish Lira against the US Dollar was 16%, 6%, 18%, and 35%, respectively, in the first four months of 1994 (Celasun, 1998: 14). In the first quarter of 1994, Turkish Lira lost nearly 70% in total against the US Dollar. In particular, the banks’ turning to foreign currency due to their open positions caused the Central Bank’s international reserves to decrease from 7 billion USD in January 1994 to approximately 3 billion USD after the 5 April 1994 decisions. However, even the decrease in international reserves by more than half could not prevent the Turkish Lira from experiencing an excessive depreciation (Turan, 2011: 62). The foreign exchange was allowed to freely fluctuate upon the 5 April 1994 decisions taken by the government with a view to exiting from the crisis and ensuring a more stable structure in Turkey’s economy.

7.4.2 Economic Growth Turkey’s economy shrank by about 6% following the 1994 financial crisis, as seen in Chart 7.9. This rate is one of the highest annual level of production loss in the history of the Republic of Turkey. With the impact of the crisis on the real sector, real wages decreased and unemployment increased as a result of the contraction of the economy.

7.4.3 Inflation After the financial crisis in April 1994, the inflation rate increased to 3 digits. Chart 7.10 showing the annual change in the producer price index and consumer price index as per months following the crisis. As can be seen from the chart, it is observed that inflation rates were more stable and did not fluctuate excessively in the pre-crisis period. From January 1993 to early 1994, annual inflation rates were between 54 and 71%. However, with the effect of the crisis, the inflation rate increased to three digits in April 1994 and reached 120%.

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Chart 7.9 Annual economic growth rates (%). Source TCMB (2019)

Chart 7.10 CPI and WPI (%). Source Celasun (1998: 34)

7.4.4 Stock Market One of the economic structures affected by the 1994 financial crisis is the stock market. As stated before, after the financial liberalization in 1989, the year in which the foreign capital inflow was the highest between 1990–1994 was 1993. In the mentioned year, the ratio of foreign capital inflow to Turkey’s GDP was 4.9%, the

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Chart 7.11 Istanbul stock exchange index (1991.06 = 100). Source Celasun (1998: 40)

majority of which was composed of short-term capital and portfolio investments. As it is known, foreign capital of the aforementioned nature turns to stock and bill markets in countries where it flows in (Chart 7.11). The course of the Istanbul Stock Exchange index for the period 1991.06–1996.01 with the basis of 1991.06 = 100 is shown in the figure above. As can be seen from the mentioned figure, the stock market index followed an upward trend from the beginning of 1993 to the last quarter of 1993. Intensive foreign capital inflow in 1993 turning to the stock market contributed significantly to this increase. However, stock market index was in a downward trend as of the last days of 1993. The index, which started to decline as of December 1993, hit the bottom in May 1994, right after the crisis. As a result of the confidence crisis about Turkey’s economy, starting in late 1993 and becoming more severe with the impact of the crisis, investors began to withdraw from the stock market, which caused a dramatic decline in the index as of December 1993.

7.4.5 Foreign Capital Inflow As regards the foreign capital movements, it is important that countries are stable and reliable both politically and economically. In this context, the foreign capital inflow to Turkey is another factor affected by the 1994 financial crisis. Chart 7.12 showing

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Chart 7.12 Foreign capital flow (% of GNP). Source Created by the author from the data shown in the table of Özatay (2000:29)

the foreign capital inflow in terms of percentage of GDP between 1993 and 1994, when the crisis took place, and afterward. The aforementioned chart is very helpful in terms of showing the effect of the 1994 crisis on foreign capital movements. As can be seen from Chart 7.12, net short-term foreign capital outflow was 3.9% of GDP in 1994, when the crisis broke out. The fact that the short-term foreign capital amounting to 1.7% of the net GDP, which entered the country in 1993, flew out the country in 1994 can be considered as one of the most important consequences of the crisis in 1994. As a matter of fact, the said capital outflow further exacerbated the impact of the crisis, causing a collapse of both the borrowing market and the stock market. It is seen that there was no net capital outflow in 1994, when the crisis occurred, as it was not possible to flight foreign direct investments in a short time. This way, it is clearly seen how speculative and instantaneous short-term foreign capital can move in crisis environment. In the 1994 crisis, short-term capital was the most affected in total foreign capital, but in the following years, net short-term foreign capital inflows increased. Net short-term foreign capital entering the country in 1995 and 1996 was 2.2% and 3.8% of GDP, respectively.

7.4.6 Interest Rates With the emergence of the crisis, there was a very high increase in interest rates, overnight interest rates reached astronomical values. Despite the economic stability program announced on 5 April 1994 in order to restore the markets to normal and eliminate the effects of the crisis, the domestic borrowing market, which collapsed before the crisis, became operational only in May 1994. However, in the post-crisis period, the Treasury was able to borrow only at very high rates from the domestic borrowing market.

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Chart 7.13 Interest rates of treasury bills, 1990–1995 (%). Source Celasun (1998: 38)

Chart 7.13 showing the interest rates of Treasury bills with 3, 6, and 9 months of maturity for the period 1990–1995. The economy administration, which was reluctant to borrow at an interest rate of around 80% by canceling the Treasury’s short-term borrowing tenders in October and November 1993, could only borrow with a compound interest rate of 400% toward the end of May 1994, right after the crisis (Celasun, 1998: 13). As a result, borrowing costs increased significantly compared to the pre-crisis period in the postcrisis period, when borrowing became extremely difficult.

7.4.7 Banking Sector As a result of the financial crisis in April 1994, high amounts of money were withdrawn from Turkish Lira and foreign currency deposit accounts in Turkish banks. The currency crisis first spread to the banking sector, as a result of which some small commercial banks were transferred to the Savings Deposit Insurance Fund. Due to the negative impact of the 1994 crisis on the economy, foreign banks giving loans were given state guarantees (Küçük, 2005: 5), and bank deposits were guaranteed to a certain extent by the State through the Savings Deposit Insurance Fund. However, this led to the emergence of “Moral Hazard”, which will cause a crisis in the banking sector in the following years (Danı¸so˘glu, 2007: 7).

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7.5 Exit Strategies Due to the heavy burden that the 1994 money/financial crisis brought to the State and the economy, it was necessary to take some measures by the Government. In this context, the government announced the Economic Stability Program on 5 April 1994 to overcome the crisis (Bahar & Erdo˘gan, 2011: 35). The aforementioned stability program, which was also referred to in the literature as the 5 April decisions, also provided for some structural measures.

7.5.1 Nisan Economic Stability Program The main objectives of the 5 April Economic Stability Program, which was prepared to overcome the 1994 monetary crisis, can be counted as ensuring budget discipline by increasing public revenues and reducing public expenditures, reducing inflation, and ensuring the Turkish Lira has a more stable and secure structure against foreign currencies and sustainable growth (Mangır, 2006:465). It was necessary to take some measures to ensure economic stability and make this stability sustainable, and the decisions including structural reform and stabilization measures were announced to the public by the Government on April 5, 1994. 5 April Economic Stability Program announced by Tansu Çiller, then Prime Minister, to stop the crisis and to ensure that the economic development is sustainable and healthy includes the following measures. • The Central Bank’s loans to the Treasury and other public institutions will be limited. In this context, the rate of short-term advance usage, which is 15%, will be reduced. • The Central Bank will be provided with a more independent structure. • Tax revenues will be increased, in this context, additional taxes will be imposed on income and corporate taxpayers. Tax loss and evasion will be reduced by intensifying tax audits. • In addition to tax revenues, rental prices of immovables owned by the State such as social facilities, lodgings, and camps will be increased to market level in order to increase the budget revenues. • State economic enterprises that suffered losses until the end of 1994 will be partially or fully privatized, thus ensuring sufficient income. • An exchange rate policy aiming at improving the exchange rate in line with the targeted inflation rate will be followed, and speculative movements will not be allowed. • With the purpose of eliminating the budget deficits, the share transferred from the fuel tax to the budget will be increased from 50 to 70%. • Fuel price stabilization fund cut will be increased from 10 to 25%.

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• Changes will be made on social security reform and agricultural support. Concerning agricultural supports, issues other than price support will be focused on, such as making direct payments to the target audience and providing credit facilities. • Recruitment of public personnel will be stopped, and the personnel requirements will be met by transferring between institutions. • Regulations will be made regarding some securities, and repo use of the securities subject to repo and repo short sales will be prevented. • The prices of the products produced by the state economic enterprises will be increased from 70 to 100%, after which the prices will be frozen for 6 months. • Public sector salaries will be frozen, the budget deficit of 192 trillion TL, which was aimed at the beginning of 1994, will be reduced by almost half, and will be 110 trillion TL at the end of 1994.

7.5.2 Results of the April Economic Stability Program The 5 April Economic Stability Program aimed mainly at permanent stability and recovery in the economy but could not achieve the desired result due to the failure to implement many structural measures envisaged in the program. Under the stability program, it was tried to follow an austerity policy with some temporary stabilization measures and to stop the negative course in the field of public finance by drastically reducing public expenditures. However, the stabilization was lacking an important element. These are the measures to be taken in order to restore confidence in the collapsed borrowing market and to take the necessary steps to resolve the financing problem. The currency crisis came to an end, albeit to a certain extent, only after the 14-month stand-by agreement signed with the IMF toward the end of May 1994, when the Treasury was able to borrow again (Özatay, 2000). Examples such as the lack of medium and long-term structural arrangements in privatization and social security are an indication that the program in question is not decisively sustainable. Only a law was enacted on privatization and the targeted privatization revenue could not be achieved. While the inflation target was around 110% in the 5 April decisions, the inflation was 149% at the end of the year. Based on this, it is understood that the 5 April Stability Program has failed to achieve its goal of economic stability in the context of inflation (Gaytancıo˘glu, 2010: 144). In addition, the desired goal of growth could not be achieved. The economy shrank by 6% in 1994 compared to 1993. Therefore, it can be said that, considering its results, 5 April Decisions failed particularly in privatization, inflation, and growth (Fırat, 2009: 505). While it is aimed to increase tax revenues and to introduce additional taxes within this scope, the government’s reduction in some taxes as a result of the pressure from the industrial sector in June 1994 is also important in terms of showing that it is not adequately determined to implement the stability program.

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Following the 5 April decisions, the Treasury turned to state banks for funding, after the rate of short-term advances from the Central Bank was reduced. This would cause the state banks to have duty losses later at the point of financing the Treasury. In addition, the said financing method would be counted among the reasons of the banking crisis that would be experienced in the future. As stated in the previous sections, within the framework of the 5 April Decisions, a State guarantee was introduced for all deposits of banks and the establishment of banks was encouraged in a way. Taking advantage of this, the number of newly established banks increased exponentially in the future (Arı & Özkeskin, 2016: 54). However, providing State guarantees for all deposits, in a sense, created a moral hazard and paved the way for the banking crisis to occur in the coming years and to bring heavy burdens to the economy. 5 April Stability Program achieved successful results in some areas in the shortterm. Accordingly, it can be said that the Program was successful in issues such as current account balance, foreign trade deficit, and foreign exchange reserves in the first years following the implementation of the decisions. As a matter of fact, the foreign exchange reserve, which was USD 3 billion on 5 April 1994, rose to USD 11 billion. The current account balance had a surplus of 2.6 billion dollars due to the 6% increase in foreign currency revenues and the contraction in imports. As a result of the rapid increase in exchange rates, imports decreased by 21% and exports increased by 18% and the foreign trade deficit decreased from 14 billion dollars to 5.2 billion dollars (Alkıno˘glu, 1999: 316). As a result, the 5 April Economic Stability Program did not provide a permanent stability and recovery in the economy and could not prevent the emergence of new economic crises in the medium and long term, due to the fact that the necessary structural reforms were not fully made and implemented decisively.

7.6 Conclusion The financial crisis which caused considerable damages in Turkey’s economy in 1994 did not occur out of blue, considering its causes. With the economic stability package put into effect on 24 January 1980, the country opted for foreign trade and financial liberalization, and by the early 1990s, full liberalization was almost achieved in both areas. It cannot be said that Turkey’s economic structure, in the said period, was not exactly ready for financial liberalization or trade liberalization. As explained in detail in the section above, main factors causing leading to the Turkey financial crisis of 1994 can be summarized as follows: • Excessive short-term speculative foreign capital inflows, with the liberalization of financial markets, which are considered to have the property of making the economy fragile, • Distortions in foreign trade and current account deficit as a result of the use of foreign resources in financing of final imported consumption goods,

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• Domestic commercial banks use most of their foreign exchange resources to purchase TL Treasury securities that promise high real interest rates, and the related crowding-out effect, • Risky bank open positions and banks’ exchange rate risk, • The public sector borrowing requirement reaching unsustainable levels due to increasing budget deficits, • Political mistakes of the economy management that caused the collapse of the domestic borrowing market, • High inflation, • The mistrust in Turkey’s economy at the national and international levels. After the 1994 Financial Crisis, the country’s economy shrank by more than 6%, and the public sector’s borrowing facilities were significantly damaged. In addition to growth, there were also significant deteriorations in other macroeconomic indicators such as interest, unemployment, and inflation. In order to overcome the crisis, the economy administration introduced a stability program on 5 April 1994; however, due to various reasons stated in the previous sections, the stability program could not be implemented decisively by the Governments. As a result, although successful results were achieved in certain areas, the program failed in general. Certain decisions taken in the banking sector, such as the 100% government guarantee for savings deposits, caused moral risk and were considered, in the literature, among the reasons for the Banking Crisis that would emerge in 2001. As a result, the economy management could not do its part in the formation phase of the 1994 financial crisis and the measures taken to overcome the crisis. Neither 24 January 1980 stability program nor 5 April 1994 economic decisions could achieve, in implementation, the desired results aimed at on paper.

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Mesut Ardan He was born in Fethiye in 1983. He graduated from Fethiye Mehmet Erdo˘gan Anatolian High School in 2001. He studied business administration at Hacettepe University and graduated in 2005. He joined the Finance Inspection Board in Ministry of Finance in 30.11.2006. He was appointed as Finance Inspector in 03.04.2010. In 2014, he received his master’s degree in Accounting from Tulane University in the USA, where he was sent for graduate education abroad. Between 27.07.2015 and 23.12.2018, he served as Tax Inspection Board Izmir LargeScale Taxpayers Group Vice President, and between 24.12.2018 and 15.10.2020, he served as Group President in Tax Inspection Board Izmir Large-Scale Taxpayers Group Presidency. He has been working as Head of Izmir Sectoral Audit Department of Tax Inspection Board since 16.10.2020. He is single and speaks fluent English and intermediate Spanish.

Chapter 8

1997 Asian Crisis Abdulcelil Gazio˘glu

Abstract Japan, which recovered its economy very quickly and well after the Second World War, posed the greatest threat to the economic hegemony of America, which was hit by political and economic crises such as the Vietnam War and oil shocks. Asian countries led by Japan, on the other hand, rose in the 1980s, when globalization accelerated rapidly and became the most important goal in all fields, and had a growth performance with almost double digits every year. This situation, also known as the Asian miracle, continued without slowing down in the 90s, so much so that those countries such as South Korea, Hong Kong, Singapore, and Taiwan, whose export share was as low as 5% in the 70s, rose above 20% in the early 90s. Keywords 1997 Asian crises · Asian tigers · Economic growth

8.1 Introduction Japan, which recovered its economy very quickly and well after the Second World War, posed the greatest threat to the economic hegemony of America, which was hit by political and economic crises such as the Vietnam War and oil shocks. Asian countries led by Japan, on the other hand, rose in the 1980s, when globalization accelerated rapidly and became the most important goal in all fields, and had a growth performance with almost double digits every year. This situation, also known as the Asian miracle, continued without slowing down in the 90s, so much so that those countries such as South Korea, Hong Kong, Singapore, and Taiwan, whose export share was as low as 5% in the 70s, rose above 20% in the early 90s. But how could this fairy-tale-like economic development and growth turn into the opposite course with a sudden and rapid collapse? This is the fundamental question regarding this crisis which is called the Asian or East Asian crisis. The Asian tigers, A. Gazio˘glu (B) Department of Public Finance, Faculty of Economics and Administrative Sciences, Izmir Katip Celebi University, Izmir, Turkey e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 B. Açıkgöz (ed.), Black Swan: Economic Crises, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-99-2318-2_8

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which broke records every year with their economic growth, whose inflation rates did not reach double digits, had no unemployment problem, and even provided cheap labour from neighbouring countries, came to the brink of bankruptcy in just 6 months in 1997. These countries, which were the new favourite of the world in exports, became unable to pay debts in the mid-90s, from a position envied by the rest of the world with their performance in industrialization every year in the 80s to. To find an answer to this question, the economic development adventure of these countries, which came to the brink of bankruptcy with the crisis in 1997, is included. Then, the types of financial crises in the period between 1980–2000 which took place in economic history as the period of financial crises and the points where the Asian crisis differs from these types of crises are mentioned. The causes of the Asian crisis, the pre-crisis and during-crisis macroeconomic indicators of Thailand, Indonesia, South Korea, and Malaysia as well as their economic conditions are analysed. The role and effectiveness of the IMF and the World Bank in solving the Asian crisis are discussed and the post-crisis performances of these countries are evaluated.

8.2 An Overview of Asian Tigers Asian countries under the leadership of Japan had a very successful performance in economic development especially with the policies they followed in the second half of the twentieth century. These countries, led by South Korea, Singapore, Thailand, Malaysia, and Indonesia, strengthened their industries, and increased their exports with the incentive policies they had developed, and started to make a name for themselves in the world economy. In addition, it started to grow continuously by attracting the attention of the world with its cheap labour force (Demirgil, 2005). These countries, which had achieved a unique success story in economic growth and development, were then known as the Asian Tigers. The economic growth rates of Asian tigers between 1981–1996 are given in Table 8.1. Table 8.1 Economic growth rates of Asian tigers between 1981–1996 1981–85

1986–90

1991

1992

1993

1994

1995

1996

South Korea

9.258

10.466

10.3

6.17

6.84

9.2

9.5

7.6

Indonesia

4.7528

6.234

6.9

6.49

6.45

7.54

8.22

7.81

Thailand

5.444

10.338

8.55

8.1

8.2

8

8.12

5.65

Malaysia

5.1772

6.876

9.54

8.88

9.89

9.21

9.82

10

Singapore

6.926

8.672

6.68

6.64

11.46

11.09

7.2

7.47

7.986

9.29

14.21

13.86

13.05

10.94

9.92

7.81

5.7

6.23

6.2

6.03

2.37

4.25

China Hong Kong

10.7 5.766

Source World Bank (2019a, 2019b, 2019c)

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Annual economic growth of Asian tigers between 1981–1996 is given in the table. It is understood that especially between 1986 and 1990, all countries in the table had a growth average of over 6%. In the said period, South Korea and Thailand became the emerging markets of the world economy, with an average growth of 10% each year. It is noteworthy that until 1997, when the crisis broke out, all countries grew each year except for a few exceptional cases, and most of them grew above 10% some years. Given this successful graphic in the 1980s, due to factors such as the excessive young population and cheap labour, Asian Tigers became a centre of attraction for investors from all over the world. This situation was not only followed by a positive course in growth rates, but also a very positive course in basic macroeconomic indicators such as per capita income, inflation and unemployment. From 1981 to 1997, when the crisis broke out, the per capita income of the Asian Tigers increased by approximately 4% every year, except for 1985 (World Bank, 2019a). Inflation rates, on the other hand, remained at single digits throughout the period, except for a few exceptional cases in China is excluded. In the said period, China had a high volatile inflation history, unlike other country performances, and there were years of inflation above 20% (World Bank, 2019b). Considering the unemployment rates, it is seen that Asian tigers had an average of less than 4% in the 1981–96 period (World Bank, 2019c). This average is quite low compared to developing countries. In addition to all these factors, a successful saving and investment policy was very effective in the Asian tigers to mark the last quarter of the twentieth century. The fact that these countries are the most preferred by foreign investors and industrial giants was a natural result of their extraordinary economic performance.

8.3 Financial Crisis Models Especially the financial crises experienced by developing countries and breaking out since the 70s peaked in the period 1990–2000. Starting with the 1992 European currency crisis, this process then continued with Latin American countries and Asian countries, and the crises in Russia and Turkey were among the crises experienced in the mentioned period. Globalization and the development of international trade laid the foundation for these crises to pose a global threat every time. As a result of the studies initiated by Paul Krugman in 1979, different crisis models were first established in explaining these crises. There were many financial crises between 1970 and 2000, and as the models created were inadequate to explain these crises, new crisis models were created. This part of the study discusses the first-generation, second-generation, and third-generation crises. First-Generation Crisis Model: As mentioned above, macroeconomic problems were explained as the causes of the crisis in the first-generation crisis model made by Krugman and developed by the studies of Flood and Garber (Durmu¸s, 2010). The incompatibility and unsustainability of macroeconomic policies were considered as the main factors pushing the country into currency crises. This model, which is also called the Canonical model in the literature, Krugman explained the financial crisis

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by citing incompatible macroeconomic policies such as printing money to finance budget deficits and insisting on a fixed exchange rate. However, this model was insufficient to explain the European Currency crisis in 1992, and upon this, another model was needed to explain the crisis (Yılmaz et al., 2005). Second-Generation Crisis Model: It refers to the crises caused by the negative expectations created in the market, rather than the incompatibility or lack of sustainability of macroeconomic policies as is the case for the first-generation crises. These pessimistic expectations spread and grow rapidly in the market and affect the economic policies (Yılmaz et al., 2005). In fact, this situation sometimes becomes such that it can cause a crisis even in economies where no deterioration is expected in basic macroeconomic indicators (I¸sık & Togay, 2002). Third-Generation Crisis Model: This model, which is also called as contagious crisis or crisis with spill-over effect in the literature, expresses the crises that cannot be explained by the first- and second-generation crisis models that are sufficient in explaining many financial crises in the 1980s and 90s. In other words, it was necessary to create a new crisis model to explain the 1997 Asian crisis, which broke out in an environment where no signs of deterioration were seen or expected in the domestic market nor in the foreign market, and negatively affected many Asian countries and developing countries. In this crisis model, the main factor of the crisis was the risky borrowing (especially from the international market) of countries that could not put the banking and financial system on solid foundations after financial liberalization and could not make adequate regulations (Çakmak, 2007). Especially the developing countries have confronted with the phenomenon called “moral hazard” since they could not establish an effective system to regulate and audit excessive capital inflow from foreign markets after financial liberalization. With high-risk policies such as non-transparent public guarantee and capital insurance, foreign capital attracted attention and there was a serious capital inflow to these countries. However, the problems caused by a poor management system such as money-maturity mismatch and underdeveloped risk management caused banks to give excessive and risky loans to the domestic market, which in return increased consumption and overvalued especially the real estate and other investment instruments. This resulted in a fragile financial structure and any shock causing recession in the economy. In such crises, the possibility of a crisis can be predicted based on microeconomic indicators such as company profitability, capital/asset ratio, and debt/asset ratio instead (Birinci, 2001). In addition, another feature that distinguishes this crisis model from others is the spillover effect. As a matter of fact, the crisis that broke out in Thailand affected the rising economies of Asia in a very short time.

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8.4 1997 Asian Crisis Process and Its Causes As shown in the first part of the study, Asian countries with solid macroeconomic foundations faced a crisis that can be explained by the 3rd Generation Financial crisis model. There are many factors in the emergence of this crisis, which broke out in Thailand in July 1997 and spread to Asian countries in a short time. Thailand, which grew very rapidly with its economic performance, indexed its currency to dollars and implemented a fixed exchange rate policy. With this policy, the environment of trust established by the Thai Central Bank in private banks and financial institutions suddenly caused the country to become a favourite place for foreign capital. However, this unplanned and large-scale capital transfer to Thailand brought along some problems. Managing this capital flow at a level that would strain the capacity of the Thai economy was not an easy task. Although the increase in inflation was kept under control while making large infrastructure investments, especially the increase in wages and costs interfered with the competitiveness, the overvaluation of the dollar in the same period increased the value of the baht considerably. For Thailand, which achieved an export-based economic development, the appreciation of its money meant that the alarm bells began to ring. Upon this contraction in exports, investments were shifted to stock markets and real estate, and economic bubbles occurred in these markets. Banks that borrowed short-term loans from foreign sources did not also have a strong financial position. Later, due to the spread of the news that the Central Bank was not strong enough to cover the financial sector deficits, real estate and stock prices suddenly crashed. Interest rates rose and debtors were unable to fulfil their obligations. Although the central bank insisted on a fixed exchange rate with its foreign exchange reserves for a while, rising interest rates and the decline in stocks ended this insistence. Thai Baht, which was left to fluctuate, lost 50% of its value. It was understood that the $16 billion aid package made with the IMF in the first place was also insufficient and the Baht continued to lose value. Thailand was followed by Indonesia, gave up the fixed exchange rate policy and signed an agreement with the IMF, but its currency lost about 30% of its value. These events that took place in the same year spread to Malaysia and there was a large capital outflow from Malaysia. Korea was also among the Asian countries deeply affected by this crisis. Although the private sector wanted to solve the borrowing problem, which was way above their capital, through foreign borrowing because it was cheap, the banks did not allow, and the Korean Won lost value significantly with the effect of the insecure atmosphere created by Thailand (Sönmez, 2001). Considering the causes of the Asian Crisis, the slowdown in exports can be shown as the most important reason. As a result of the fixed exchange rate policy, the currencies of Asian countries also appreciated significantly due to the overvalued dollar since 1995, which negatively affected the competitiveness in exports. As a matter of fact, the difference between the export increase rates of the countries in 1995 and 1996 is a proof of this fact. During the period in question, export rate decreased in Thailand from 23.6% to 4.1%, in Malaysia from 20.3% to 6.1%, in South Korea from 30.2% to 3.2%, and in Indonesia from 13.4% to 9.6%. Among

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the countries addressed in the study, there was not a considerable decrease only in Indonesia, but it is seen that the export increase rate of other countries decreased significantly (Hacıismalo˘glu & Silah¸sör, 1998). Another important factor is the shortterm external borrowing. The regulations made with the financial liberalization and the lack of effective supervision in these regulations paved the way for these countries to have a significant amount of foreign borrowing in a short time. So much so that the amount of many borrowing by Asian countries from foreign banks and institutions almost doubled. When the resources provided through external borrowing were used, through local banks, in low value-added and inefficient areas, problems began to occur in repayments, and thus, the crisis deepened further. In many studies, capital movements were stated to be the most important factor among the causes of the Asian crisis. In this period when the fund started to flow at low costs, there was a great increase in international capital movements. These investments, which are mostly made in the form of short-term portfolios, may have negative effects on the economies of the country. As a matter of fact, in the period of their rapid rise, Asian countries received huge capital inflows as a centre of attraction and this capital flow caused artificial increases in asset prices and paved the way for a crisis in the banking sector (Allen & Gale, 1999). In addition, the rapid outflow of foreign capital from the country was the initiator of the Asian crisis. Increasing current account deficits of the countries in the region, excessive rise in securities and real estate prices, institutional and structural deficiencies, lack of supervision, and low value-added investments are other factors that caused the crisis to begin and grow.

8.4.1 Thailand: Where the Crisis Began The main actor of the 1997 crisis that affected Asian countries in a series and spread was Thailand, the country where the crisis began. In this respect, it would be appropriate to start with Thailand when evaluating the crisis countries. Since Thailand was one of the rising countries of the 80s and 90s, its macroeconomic indicators were quite good in the said period. Growth rates, as regards to which we have mentioned pre-crisis inflation, growth and unemployment data at the beginning of the study, had negative values only in the crisis year and the following year in the 90s, while the average in other years was 8%. Inflation rates were between 3 and 5% except in 1998 which was 8%. These rates are perfectly acceptable for a developing economy. However, the current account balance had a deficit every year until 1997, when the crisis broke out. Increasing foreign borrowing and especially short-term debt having a high ratio in foreign debt made Thailand’s financial structure very fragile. Due to the overvalued dollar in 1995, the national currency indexed to the dollar with a fixed exchange rate also appreciated, which negatively affected Thailand in terms of exports. It is observed that the rate of increase in exports given in Table 8.2 was negative especially that year and decreased compared to the previous year.

− 7.71

− 8.53

29.54

Short-term debt/total external debt

Source World Bank (2019a, 2019b, 2019c)

39.02

33.42

Outstanding external debt/gross national income 33.07

15.14

13.39

Export growth rate

Current account balance (%GDP)

8.55

11.16

Growth

5.71

1991

5.86

1990

Inflation

Thailand

35.17

38.41

13.8

− 5.65

8.08

4.13

1992

Table 8.2 Some macroeconomic indicators of Thailand before and during the Crisis

42.93

41.6

12.9

− 4.93

8.25

3.31

1993

44.48

45.53

13.1

− 5.49

7.99

5.04

1994

44.05

60.29

15.37

− 8.02

8.12

5.81

1995

42.71

34.48

75.31

9.05 63.26

− 2.01

28.26

96.04

10.8

12.53

− 7.64

− 2.75 − 8.03

7.99

1998 5.62

1997

− 4.48

5.62

5.80

1996

24.16

78.9

8.63

9.81

4.57

0.28

1999

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It would be quite appropriate to infer from the data in the table that the fixed exchange rate system and the current account deficit drove Thailand into a crisis. The large capital inflow to the country was directed to real estate and caused a big bubble in this sector. Although financial institutions and banks supporting real estate investments were supported by the government, after this unsustainable price inflation burst, this support was not healthy and long-lasting, because it was far from sustainability (Toprak, 2001). This shook the confidence of private capital, and the crisis broke out when there was a serious capital outflow. In addition, at the time of difficulty to pay the borrowed short-term foreign debt, foreign banks refused the restructuring requests and new loan requests. The central bank, which melted its reserves considerably with its fixed exchange rate policy, sought help from the IMF. The devaluation when shifting to the floating exchange rate and other economic conditions prevented the success of the $17 billion aid package provided to Thailand to improve its economy. Measures taken by the government such as reducing spending, establishing an efficient audit system, and increasing transparency and closing 56 financial institutions other than banks alleviated the effects of the crisis and Thailand’s economy was back on track.

8.4.2 Indonesia Indonesia, the largest of the countries involved in the study, was the first country where the crisis spread. Table 8.3 containing some economic indicators of Indonesia was generated in the light of the information obtained from the data bank of the World Bank. According to the data in this table and the data obtained from the World Bank, an average of 6% economic growth was achieved in Indonesia every year from the 80s to 1997, when the crisis broke out. However, it remained below this average with a growth of 4.7% in 1997. The negative growth rate of 13.12% experienced in 1998 clearly demonstrated the impact of the Asian crisis on the Indonesian economy. In 1999, it entered a recovery period and had a growth rate of 50.79. A similar situation is the case for Indonesia’s inflation values before and during the crisis. Inflation, which was in single digits until the crisis, was at an acceptable and reasonable level for an emerging economy. However, the striking inflation rate of 75% in 1998 is an indicator of how big a crisis the economy is going through, just like the negative growth rate in the same period. Recovery period started with this ratio which decreased to 14% in 1999. As in Thailand, while growth and inflation rates are far from being a harbinger of a crisis in Indonesia, especially foreign borrowing and current account balance are the harbingers of the crisis. Because until the crisis year, the foreign debt stock corresponded to 65% of the national income on average. If we consider this together with the slowdown in the rate of increase in exports and the current account balance, which constantly has deficit, we can see how fragile Indonesia’s financial structure has become. In addition, Indonesia, which is a centre of attraction for foreign capital like other Asian countries, could not reach the desired levels in exports due

71.62 18.00 19.88 − 3.65

69.21 15.94 0.45 − 2.81

Outstanding external debt/gross national income

Short-term debt/total external debt

Export growth rate

Source World Bank (2019a, 2019b, 2019c)

Current account balance (%GDP)

6.91

7.24

Growth

8.77

1991

9.09

1990

Inflation

Indonesia

− 2.17

14.66

20.52

72.18

6.49

7.29

1992

− 1.33

6.61

20.17

58.65

6.49

19.15

1993

Table 8.3 Some macroeconomic indicators of Indonesia before and during the Crisis

− 1.57

9.94

18.05

62.63

7.54

7.78

1994

− 3.18

7.72

20.87

63.41

8.22

9.88

1995

− 3.37

7.56

24.98

58.3

7.81

8.68

1996

− 2.66

7.80

24.11

65.09

4.7

12.57

1997

4.29

11.18

13.28

4.84

− 31.80

13.19

117.37

0.79 168.19

14.16 − 13.12

1999 75.27

1998

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to the appreciation of the dollar and the overvaluation of the dollar-indexed national currency. Hence, the Indonesian currency Rupiah depreciated by 35% in July 1997, which means that the cost of foreign debt in foreign currency increased further. 15% of the loans became non-repayable in 1996 and 20% in 1997. The currency of Indonesia, which was the country most affected by this crisis among Asian countries, lost value by 5% against the dollar in October. The instability in the country caused the environment of confidence to disappear and paved the way for foreign capital flight from the country (Demir, 1999). A 43-billion-dollar aid package was prepared by the IMF, but this package was rejected due to the harsh measures it contained and the proposal to abolish dictator Suharto’s state subsidies and tax cuts to institutions owned by his close circle. This proves inefficient and ineffective use of the foreign capital coming to Indonesia. As a result, the society, which entered the economic depression with the stock bubbles and real estate bubbles that burst one after the other, rebelled and overthrew the government of 32 years (Toprak, 2001). With the new government, the IMF programmes were adhered to, and public expenditures were reduced by cutting the state support to non-productive sectors and stability was aimed this way.

8.4.3 South Korea South Korea, the country with the strongest economy among the countries studied, became the rising star of the 80s and 90s and became an OCED country as it ranked the 11th largest economy in the world, especially as it had a producing industry. Thanks to this, the crisis spread to the country at the latest compared to the other Asian countries. Some economic indicators of South Korea are included in the table created with the information obtained from the World Bank’s database. It is understood from these data that South Korea, which had a stable economic growth, experienced a negative growth of 5.47% only in 1998, when the effects of the crisis were felt, while an average growth of 8% was realized in other years. Considering the inflation rates, unlike other Asian countries, it did not have high inflation rate even during the crisis years. The current account balance, on the other hand, had an extremely unstable graphic. While they had a current account deficit at the beginning of the 90s, they had a current account surplus in 1993 and started to have a deficit again in the following years, and in 1996 they had a current account deficit of 4.09%, the highest rate of the period. The current account deficit, which was 8.5 billion dollars in the previous year, was around 23 billion dollars in the said year. The reason for this increase was sad to be the increase in imports. There was a great increase in imports in 1995 and 1996 and there were fluctuations in the current account balance because exports did not increase in a balanced way with the import increase. As can be seen in Table 8.4, in 1996, there was a significant decrease in the export growth rate compared to the previous year.

10.35 12.39 − 2.47

9.81

4.59

− 1.00

Growth

Export growth rate

Source World Bank (2019a, 2019b, 2019c)

Current account balance (%GDP)

9.48

1991

10.11

1990

Inflation

South Korea

− 0.83

12.84

6.18

7.74

1992

0.44

9.59

6.85

6.20

1993

− 1.05

16.56

9.21

8.10

1994

Table 8.4 Some macroeconomic indicators of South Korea before and during the crisis

− 1.84

23.07

9.57

6.94

1995

− 4.09

11.34

7.59

4.26

1996

− 1.94

18.83

5.92

4.06

1997

10.72

4.49

13.08

11.31

− 5.47 14.25

− 1.18

1999 4.62

1998

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Another problem of South Korea is the foreign debt stock, as in other Asian countries. South Korea’s foreign debt was, on average, 31% of its national income between 1994–200. This ratio reached almost half of the national income in 1998 when the effects of the crisis were felt, reaching 47% (Toprak, 2001). The Korean national currency, the Won, which was indexed to the dollar with a fixed exchange rate policy, also increased since the dollar gained value in 1995, as was the case in the countries examined before, which, in turn, weakened Korea’s competitiveness in exports. In addition, the attractiveness of foreign borrowing due to the lower interest rate of foreign borrowing than the Won interest resulted in the interest in dollar-denominated short-term debt. When the national currency was left to fluctuate, it depreciated, which increased debt costs and large credit burdens led to the bankruptcy of many financial institutions (Demirgil, 2005). In addition, the conglomerates belonging to the prominent families of the country called CHAEBOL, which was supported by the government and transferred their shares in banks in the 80s, were extremely indebted free from audit thanks to their sovereignty in the banking sector and used resources inefficiently by directing their income to real estate rather than productive sectors with added value. These companies borrowed around 100 billion dollars at only one-year maturity (Demirgil, 2005). South Korea, one of the largest economies in the world, therefore, became the country receiving the most funding from the IMF and decided to close bankrupt banks, allow foreigners to buy domestic companies, remove state control over bank loans, and bring flexibility to the labour market in return for a $57 billion aid package. (Toprak, 2001).

8.4.4 Malaysia Malaysia is the country with the highest saving rate among the countries in the region. In addition, its economy is seen as the strongest economy in the region, following South Korea. Table 8.5, prepared with the information obtained from the data bank of the World Bank, includes some economic indicators of Malaysia. As can be understood from the data in the table, growth rate in Malaysia was below 4% between 1990 and 1997. This rate is quite low compared to other developed countries. Growth rates were approximately 9% every year until 1997, and a growth of 7%, which can be considered high, was realized in 1997. However, in 1998, when the effects of the crisis felt, the economy contracted and a negative growth of 7% was realized. In 1999, the situation reversed, and the economy grew by 6.14%. Malaysia, like other countries in the region, had a deficit in the current account balance. While there was a current account deficit every year until 1998, 1995 was the year with the highest rate of current account deficit, amounting to 9.74% in the mentioned period. The main reason for the current account deficit in this period was the increase in imports. Malaysia, which is on the path of development with an assembly-based industry, needs imports for production. This situation caused foreign

− 8.51

− 1.98

9.55 15.77

9.01

17.82

3.58

1991

3.81

1990

Source World Bank (2019a, 2019b, 2019c)

Current account balance (%GDP)

Export growth rate

Growth

Inflation

Malaysia

− 3.66

12.60

8.89

2.41

1992

− 4.47

11.54

9.89

3.99

1993

Table 8.5 Some macroeconomic indicators of Malaysia before and during the Crisis

− 6.07

21.91

9.21

3.94

1994

− 9.74

18.96

9.83

3.63

1995

− 4.42

9.23

10.00

3.68

1996

− 5.93

5.49

7.32

3.48

1997

6.14 13.20

15.92

13.16

− 7.36 0.49

0.05

1999 8.50

1998

8 1997 Asian Crisis 139

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borrowing to reach dangerous levels in Malaysia, as was the case in other countries addressed in the study. So much so that the foreign debt stock, which was 15 billion dollars in 1990, increased to 40 billion dollars in 1996. In addition, in 1997, when the crisis started, Malaysia’s ratio of foreign debt stock to GNP exceeded 50%. In addition, the share of short-term debt in total debt in this period increased up to 30% (Demirgil, 2005). The Malaysian national currency depreciated considerably against the dollar in 1997, making it even more difficult to pay off dollar-denominated debt. In 1998, it lost 84% in value compared to July 1997, when the crisis started. Chronic problems in Asian countries were also the case for the Malaysian economy. Foreign capital entering the country with expenditures far from developing the economy such as investments without any added value, industry based on assembly rather than production, and crony capitalism was poorly managed. Malaysia did not request any help from the IMF, and the government made statements accusing the speculators, claiming that there was no crisis. However, as the downturn in the economy continued, the need for reform was accepted by the government, changing their discourse. Tough measures were taken, including cuts in public spending and reforms in the banking sector. As in Indonesia, the crisis in Malaysia resulted in change in power.

8.5 IMF Aids and Criticisms of IMF As a result of the application by the Asian countries to the IMF to overcome the bottleneck they fell into, aid packages were prepared by the IMF for these countries and prescriptions containing strict monetary and fiscal policies to be followed were presented. In this context, South Korea was provided with an aid amounting to 57 billion dollars, Thailand with 17.2 billion dollars and Indonesia with 23 billion dollars. Through these prescriptions, policies including harsh measures especially for the banking and finance sector were put into practice and short-term debts were extended to long-term with the restructuring agreements made with banks. It was aimed to abandon practices that posed an obstacle to the functioning of the freemarket economy and to make it fully compatible with the free market (Ersoy, 2001). What should be done in the short term was determined by the IMF as, preventing the depreciation of the national currency and capital outflow by raising interest rates, reducing public expenditures through tight fiscal and monetary policies, increasing taxes, and decreasing the money supply. It was emphasized that structural changes should be made especially in the financial sector in the long term. In this context, the banking system would be supervised in accordance with the international standards, the stock market would be reshaped in order to provide companies with the opportunity to increase their equity options in order to meet their financing needs with a view to strengthening the capital markets, the restrictions on foreigners in purchase of stocks would be stretched, and especially the balance sheets of companies that direct the national economy would be reviewed by international audit firms before

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they are announced to the public. In addition, the obstacles for foreigners to establish banks in the banking sector would be removed. The IMF was subjected to harsh criticism both for not being aware of the signs of the crisis before the crisis and for its solution proposals to exit the crisis. So much so that even the existence of the IMF began to be questioned by international organizations. One of the main criticisms directed to the IMF was that Asian countries were suggested standard measures applied in many countries, without taking macroeconomic indicators into account because Asian countries experienced this crisis and an economic depression despite their economies that were robust according to macroeconomic indicators. For example, the proposal of tightening fiscal policies in order to achieve success in tight monetary policies was stated by many academics and organizations, especially the World Bank, that these measures would further deepen the problems in an economic environment where growth was negative, budget discipline could not be achieved and unemployment had an increasing trend. Because, when the pre-crisis period in these countries is analysed, it is clearly seen that there is no problem in terms of budget discipline, public income-expenditure balance or inflation. In addition, criticisms were raised, that the IMF’s request that banks or financial institutions that could not pay their loans to be closed immediately, would increase the mistrust environment created due to the crisis and especially accelerate the foreign capital flight. As a matter of fact, the investors frightened by the closed banks in Indonesia immediately withdrew their savings and investments in banks, putting pressure on the national currency and it lost 50% of its value in a week. The biggest criticism directed to the IMF was that it could not predict this crisis before. Relating this crisis, which broke out as a liquidity problem, with the foundations of the economy, which was not actually a problem, and showing it bigger than it really was, was the most important factor that deepened the crisis and aggravated the panic that occurred in the countries of the region (Arın, 1988). As a result, its functionality was questioned as it could neither predict the crisis nor identify the reasons correctly, considering the results of other suggested structural reform packages.

8.6 Conclusion The Asian crisis has an important place in the literature due to the fact that it cannot be explained with the models developed for the crises that occurred before it and it emerged despite the magnificent economic performance of the countries of the region, called the Asian Miracle. The crisis that started in Thailand in July 1997 spread to the countries of the region until 1998 and caused huge crises, especially in Indonesia. The most important factors that led the Asian tigers, which are centres of attraction for investors around the world impressed with their robust economic structures and have the inflation, growth and unemployment rates targeted by many developing countries, to the crisis are the investments with low added value, not having a production-based industry, import-dependent export and crony capitalism. This clearly shows that even if there have been high growth rates for more than

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ten years, inflation rates are kept at a reasonable level and unemployment is not a problem, poor management of resources will inevitably lead to a crisis environment despite these solid macroeconomic fundamentals. Another factor that distinguishes this crisis that ended the Asian Miracle from other crises is the inadequacy and simplicity of the IMF aid packages and solutions. The IMF was subjected to harsh criticism both for not being aware of the signs of the crisis before the crisis and for its solution proposals to exit the crisis. So much so that even the existence of the IMF began to be questioned by international organizations. One of the main criticisms directed to the IMF was that Asian countries were suggested standard measures applied in many countries, without taking macroeconomic indicators into account. Because, although there are no problems in the basic economic dynamics of Asian countries, a standard prescription was written, as in every aid package, without any changes, which caused the crisis to deepen. As a matter of fact, Malaysia, which did not request IMF assistance, exit the crisis with the resources it created and the measures it took. The aid packages for the countries receiving the IMF aid package were criticized in terms of their content and they did not prevent the crisis, even deepened it. However, Asian countries with high savings rates overcame the crisis in a very short time by correctly managing the funds they received from the IMF. In addition, the lack of supervision over capital movements was seen as an important problem, and after this crisis, even organizations such as the World Bank and the IMF, which advocated full free movement, decided to supervise capital movements and implement Tobin tax.

References Allen, F., & Gale, D. (1999). Bubbles, crises, and policy. Oxford Review of Economic Policy, 15(3), 9–18. ˙ Arın, T. (1988). Asya krizi ve kriz yönetiminde hegemonya. Iktisat Dergisi Ocak, 375, 5–20. Birinci, Y. (2001). Finansal krizler ve uluslararası finansal piyasaların yeni mimarisi. Yeni Türkiye Dergisi, 7(42), 1249–1261. Çakmak, U. (2007). Kriz modelleri çerçevesinde Türkiye 2001 finansal krizinin de˘gerlendirilmesi. ˙ ˙ Gazi Üniversitesi Iktisadi Ve Idari Bilimler Fakültesi Dergisi, 9(1), 81–101. Demir, G. (1999). Asya krizi ve IMF. Der Yayınevi. Demirgil, E. (2005). Küreselle¸smenin sermaye hareketlerine etkisi: Asya krizi örne˘gi (Yüksek Lisans Tezi), Süleyman Demirel Üniversitesi, Türkiye. Durmu¸s, S. (2010). Finansal krizleri açıklamaya yönelik yakla¸sımlar. Kafkas Üniversitesi Sosyal Bilimler Enstitü Dergisi, 1(5), 31–46. Ersoy, E. (2001). Asya krizi ve Türkiye ekonomisine etkileri (Yüksek Lisans Tezi), Marmara Üniversitesi, Türkiye. Haciislamo˘glu, M. L., & Silah¸sör, H. S. (1998). Güneydo˘gu Asya krizinin nedenleri, geli¸simi ve olası etkileri. TC Ba¸sbakanlık Hazine Müste¸sarlı˘gı. Ara¸stırma-˙Inceleme Dizisi No:17, Ankara, Mayıs 1998, s.7–14. I¸sık, S., & Togay, S. (2002). Para krizi modellerinin ele¸stirisi ve uluslararası para sisteminin ˙ ˙sletme Ve Finans, 17(191), 31–53. düzenlenmesine yönelik Keynesyen öneriler. Iktisat I¸

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˙ Sönmez, A. (2001). Do˘gu Asya “mucizesi” ve bunalımı: Türkiye için dersler. Istanbul Bilgi Üniversitesi Yayınları. Toprak, M. (2001). Yükselen Piyasalarda Finansal Kriz. Yeni Türkiye Dergisi, 7(2), 854–889. World Bank. (2019a). Retrieved October, 20, 2019a, from https://data.worldbank.org/indicator/NY. GDP.PCAP.KD.ZG?end=1996&locations=TH-ID-MY-KR-SG-HK-CN&start=1981 World Bank. (2019b). Retrieved October, 20, 2019a, from https://data.worldbank.org/indicator/FP. CPI.TOTL.ZG?end=1996&locations=TH-HK-MY-KR-ID-SG-CN&start=1981 World Bank. (2019c). Retrieved October, 20, 2019b, from https://data.worldbank.org/indicator/SL. UEM.TOTL.NE.ZS?end=1996&locations=TH-MY-CN-KR-ID-SG-HK&start=1981 Yılmaz, Ö., Kızıltan, A., & Kaya, V. (2005). ˙Iktisadi kriz kuramları, finansal küreselle¸sme ve para ˙ ˙ krizleri. Erciyes Üniversitesi Ikitsiadi Ve Idari Bilimler Dergisi, 24, 77–96.

Abdulcelil Gazio˘glu is a research assistant at Izmir Katip Celebi University, Faculty of Economics and Administrative Sciences, Department of Public Finance. He is also a Ph.D. student at Izmir Katip Celebi University, Department of Public Finance and Public Finance Management. He received his bachelor’s degree in Business Administration from Istanbul University. He received his master’s degree from Izmir Katip Celebi University with the thesis on Multi-year budgeting in theory and practice: Turkey evaluation. His areas of study are public finance, budget and fiscal planning, taxation, digitalization, digital economy, digital governance, cryptocurrencies and non-fungible tokens. He published articles and book chapter focused on effect of digitalization on taxation and fiscal management. He presented papers on international conferences about digital economy.

Chapter 9

1998 Russian Financial Crisis Do˘gancan Akata

Abstract The subject of the research is the crisis that occurred in Russia in 1998 and its financial effects. The research aims to evaluate the background of the political and economic reasons for the crisis. The main line of the research: the socio-economic situation of Russia before the crisis, the factors that caused the crisis, and post-crisis developments. The establishment of a new economic system after the collapse of the Soviet Union is the most important feature of the period. Speculative capital movements and commodity price fluctuations in the 1990s were important causes of the Russian crisis. The devaluation and new import prices realized in Russia have reduced the losses of the crisis along with the revival of the industry. Keywords Financial crisis · Moratorium · Economic reform

9.1 Introduction According to an old Russian folk tale, Empress Catherine II passes through a region ruled by her ex-lover Gregory Potemkin during her journey to Crimea in the eighteenth century. To impress the Empress, Gregory Potemkin sets up fake portable village views in the form of a one-sided plateau along the Dnieper River. At one side, there is a rich view of a very happy and prosperous life with no problems, while at the back are real settlements in the form of ruins of houses in villages where people barely make a living. The purpose of this was to create a false perception of wellbeing by concealing the existing poverty. Based on this story, Paul Krugman used the concept of “Potemkin Economy” as a metaphor in his book “The Return of Depression Economics and the Crisis of 2008” and explained the Russian economy with this concept in the second half of the 1990s. The transition from a centrally planned economy to a market economy was a painful process for Russia. The downsizing D. Akata (B) Faculty of Economics and Administrative Sciences, Izmir Katip Çelebi University, Izmir, Turkey e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 B. Açıkgöz (ed.), Black Swan: Economic Crises, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-99-2318-2_9

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phase of the large and cumbersome Soviet Bureaucratic system, the political degenerations, and the oligarchies that were formed after the disintegration and deployed in each sector negatively affected the economic life. Along with these, the economic moves and the political structure under the influence prepared the atmosphere of the crisis that would break out in 1998. In this section, the developments before the Russian financial crisis in 1998, the causes of the crisis, and finally the developments after the crisis are analyzed.

9.2 Before the Crisis In 1988, under the government of Mikhail Gorbachev, the first modest steps in reforming the stagnant Soviet economy (Openness “Glastnost” and Restructuring “Perestroyka”) were taken with laws that gave companies greater autonomy than state planners and allowed limited private sector activities. However, the impact of these measures aimed at eliminating the shortcomings in the command economy was limited (Russell, 2015). Yet, the process that started with a series of national conflicts in the second half of the 1980s and ended with the voting of the existence of the Soviet Supreme Council “Supreme Soviet”, the Union of Soviet Socialist Republics (USSR) following the Belavezha Agreements on December 26, 1991, has recently ended with an important breaking point. With the “Declaration on the Establishment of the Commonwealth of Independent States” published by the Soviet Supreme Council, the USSR officially ended its existence in international law (Soviet Supreme Council, Declaration No.142-N). The collapse of the Soviet Union in 1991 brought political and economic chaos with it. In line with the recommendations of the International Monetary Fund (IMF), newly elected Russian President Boris Yeltsin announced that radical economic reforms would be made to shift to the market economy (Russell, 2015). In the 1990s, Russia carried out comprehensive reforms, including privatization, market, and trade liberalization. In this period, the country encountered with a significant contraction in economic productivity (over 40% in GDP and over 50% in industrial output), declining investment, rising high inflation ranges, rising unemployment, and social troubles (OECD, 2008). Transforming the world’s largest state-controlled economy into a market-oriented economy involves an extraordinarily difficult process regardless of the policies chosen. The policies chosen for this difficult transition (liberalization, stability, privatization) were based on the neo-liberal Washington Consensus of the IMF, the World Bank, and the US Treasury Department. Washington Consensus is a set of 10 economic policy prescriptions for crisis that are thought to constitute the “standard” reform package for developing countries, promoted by Washington-based institutions such as the IMF, the World Bank, and the United States Treasury (Williamson, 1989). Washington Consensus includes fiscal discipline, public spending priorities, diverting both high economic returns and potential to improve income distribution, such as primary health care, primary education and infrastructure, tax reform (to lower marginal rates and broaden the tax

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Chart 9.1 Russia inflation rate 1993–2000 (%). Source World Bank (2019a)

base), interest rate liberalization, a competitive exchange rate, trade liberalization, liberalization of foreign direct investment inflows, privatization, and secure property rights (Centre for International Development, 2003) (Chart 9.1). Although the United States and other Western countries did not have a direct impact on Russia’s policies, they intervened in the pace of credit support reform from the International Monetary Fund to increase the rate of economic change. These policies were implemented throughout the Shock Therapy in the transition period (Sciolino, 1993). “The Shock Doctrine: The Rise of Disaster Capitalism”, written by Naomi Klein, brought the concept of shock therapy to the literature. According to Klein, Milton Friedman viewed crises as a way to surprise and confuse people. Engaged in with the public this way, he believed that the economy could be seriously liberalized without worrying about human costs. The concept that Klain uses as a metaphor in the book is based on the connection between the erasure of the past and the electrical shocks used as torture to create something new. This has been an inspiration for all reformers who welcomed conflicts, disasters, and wars (Norberg, 2008). In 1992, Russia was a giant country with weak central management, and as such, it had neither the will nor the capacity to force unwilling corporate executives to privatize. Western countries called for shock therapy as advice. As noted above, this therapy included immediate control of prices, liberalization of markets, and privatization of industry. Speed was thought to be critical, both to stimulate the economy and to reduce the role of the state in the economy, public tolerance of the economic destruction accompanied by shock was exhausted early and reform lost its political momentum. In developed countries and some transition countries, privatization of state-owned enterprises progressed through only one company tender

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at a time. However, most of the countries trying for transition from central planning to market economies had thousands of state-owned enterprises that had to be divested. One-time cash auctions failed to meet the shock therapists’ timetable and resulted in high transaction costs compared to business value. The risk of political backlash was tried to be minimized through individual auctions in the face of the risk of selling companies to wealthy opportunists, former government officials, or foreigners (Black et al., 2000). After six years of economic reform in Russia, privatization and macroeconomic stability achieved some limited success. However, in August 1998, after recording the first year of positive economic growth since the collapse of the Soviet Union, Russia defaulted on its state debt, depreciating the ruble, and inevitably declared the suspension of payments (Chiodo & Owyang, 2002). The study will address the fact that the Russian economy is faced with a financial crisis after such success, albeit limited, the reasons that put Russia in this situation and the consequences of this financial crisis.

9.3 Causes of the Crisis The second half of the 1990s started hopefully for the Russian economy. In April 1996, the Russian authorities started negotiations to re-arrange the foreign debt repayment inherited from the USSR. Negotiation to repay government debt was a major step toward regaining investor confidence. This development appeared to be a turning point toward economic stability in 1997. In September 1997, after Russia paid over 60 billion dollars in the former USSR debt to other governments, it was allowed to join the Paris Club. A month after this incident, a 33 billion dollar deal was signed with the London Club for 23 years of debt repayment. Analysts predicted that Russia’s credit ratings would be improved, and the country would need less debt. Restrictions on the purchase of state securities by non-resident investors were lifted, upon the promotion of foreign investments in Russia, at the end of 1997, roughly 30% of the short-term government bond (Gosudarstvennoye Kratkosrochnoye Obyazatyelstvo—GKO) market was acquired by non-residents. The economic outlook seemed optimistic, with Russia having an economic growth of 1.4% following negative figures (Chiodo & Owyang, 2002) (Chart 9.2). However, one of the main reasons of the crisis is the government bond policy implemented by Russia. Short-term government bonds in Russia were first issued in 1993. They were issued in two forms: quarterly and semi-monthly bonds. Some of the funds collected by the Ministry of Finance from these bonds were used to eliminate the budget deficit. However, budget revenues were insufficient to address previous problems and the Ministry of Finance had to issue more bonds. In 1996, the short-term government bond market was opened to foreign investors, despite some restrictions. By 1998, short-term government bond yields reached 140% annually, which was practically enough to eliminate Russia’s budget deficit. As a result, on August 17, 1998, the government delayed the payment of these bonds, causing the most serious

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Chart 9.2 Russia GDP growth (annual %). Source World Bank (2019b)

economic crisis in Russia’s modern history and the record-breaking depreciation of the ruble (Lossan, 2014). With the transition to the new system, while the portrait of Lenin was replaced by city portraits in 1992 after 55 years, in the Banknotes issued by Russia, another change took place in 1998 and three zeros were dropped from the ruble with the devaluation (Russian Money, 2007–2008) (Chart 9.3). The excessive depreciation of the ruble occurred as a result of the combination of many factors. The first of these factors is the Asian Financial Crisis. When investors suffered great losses as a result of the risky investments made in the Asian market, they avoided investing in a market they saw risky again. The fact that the Asian crisis has a global impact and a negative effect on the prices of the Russian export products (oil, etc.) can be considered important external factors. On the other hand, people’s lack of trust in the government can be considered as another important factor, as the government struggles to finance budget deficits and corruption, crime and incompetence are widespread. Finally, the failure to reform the tax and banking systems after the collapse of the USSR can be shown as one of the reasons for the crisis (Hays, 2008). First of all, the Asian Financial Crisis resulted in worsening of economic indicators for Russia, which had already gone through an important process. There was a global crisis that started in February 1997 and spread to the economies of the region and the world upon Thailand’s devaluation of its currency Thai Baht. The role of speculative capital movements in the crisis (because the crisis was both unpredictable and there was no problem in the real economies of the countries suffering from the crisis) brought the management and supervision problems of the international financial system to the agenda (Dorukkaya & Yılmaz, 1999). On the other hand,

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Chart 9.3 USD/RUB (1995–2004). Source Investing (2023)

the Asian Financial Crisis, a global crisis, had significant effects on the energy and oil prices for reasons of business environment, war, and meteorology. The effects of the Asian Financial Crisis, which intensified in 1998, spread strongly on Latin American countries, Russia, and other countries. As a result, oil which is among the most important export revenues of Russia was affected by this economic crisis and contributed to the decrease in oil prices in the world in 1998 (Hammoudeh & Li, 2004) (Charts 9.4 and 9.5). In terms of budgeting, soft budget constraint becomes apparent in the crisis. It is basically characterized as the lack of financial accountability of business managers. It was first developed by non-socialist economists for businesses under the socialist system. It is generally accepted that the term applies to businesses in transition economies and post-socialist economies. In the socialist system, the authority of the business manager had nothing to do with whether the business was profitable. Soft budget constraint was normally the result of a state budget process that was kept out of efficiency or profit. Under market conditions, since profits are the core of a manager’s authority, soft budget constraint is rarely applied and is always temporary. Under the socialist system, soft budget constraint coexisted with strict administrative constraints. As each business was part of a comprehensive hierarchy, strict control was made upon the appointment of state managers, and it was intended to ensure that they fulfill their assigned duties, including the achievement of broad social objectives. However, as totalitarian socialist regimes began to disintegrate, administrative control over business managers declined. In some stages of development in post-socialist economies, this phenomenon led to a fatal combination of soft budget controls and soft or non-existent administrative controls (Gaidar, 1999).

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Chart 9.4 Crude oil prices per barrel (1993–2000). Source Macro Trends (2023)

Chart 9.5 Russia crude oil: exports (1993–2000/barrel). Source CEIC (2019)

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The first Chechen War that took place between 1994–1996 can be cited as another negative development regarding the budget in this process. According to the statement of Mikhail Kasyanov, who served as the Minister of Finance between 1999–2000 and as Prime Minister between 2000–2004, direct expenditures for war were a burden of 2.5 billion rubles (90 million dollars) per month on the federal budget, he stated that pure military spending was twice as much as monthly spending on Russian health care. He is of the opinion that the military expenditures made in connection with the operations increased the figures much more. Moreover, it was emphasized that many Chechen refugees were provided with financial aid and there were also undisclosed expenses due to privacy. According to economist Nikolai Petrakov, this figure is 160 million dollars per month. It is estimated that over 2 billion dollars was spent for the reconstruction of destroyed cities and towns (Pain, 2001). Banking in Russia was a sector that was tried to be developed under the “laissezfaire” policy that started in 1989, where the capital requirement for license was insignificantly low, and monitoring and supervision were carried out officially in the best way. While the number of Russian banks was less than 10, their number increased rapidly in the 1990s to exceed 2500. Many banks simply applied cash management, capital flight, and money laundering services to businesses or shadowy organizations (industry groups such as “Pocket Banks” that need their own banking wings to finance the business world) and were also active in speculating against the ruble. In the period of high inflation, banks created a source of income by holding transfer payments. Non-bank entities quickly evolved into Ponzi plans, like the massive MMM program (a Russian company that ran one of the world’s largest Ponzi programs of all time in the 1990s) that collapsed in 1994. Some of the banks with connections highly benefited from political support, performing profitable roles to manage state authorities’ balance sheets or to finance certain expenditures (Perotti, 2001). In another aspect, IMF also contributed to the crisis to occur. The fault of the IMF lies in its willingness to repeatedly provide financial assistance, regardless of whether they are achieving the desired results. Russia has been the best example of how this can have disastrous consequences. For example, since 1992 (and the last time before the 22.6-billion-dollar bailout on July 20, 1998), the IMF has lent Russia over 18 billion dollars. With each loan, the IMF asked Russia to accept economic reforms. Although the Moscow government rarely kept its promises, the IMF continued to distribute the next tranche after the tranche passed. In other words, cheap loans allowed Russia to delay reforms, while the IMF rewarded Moscow for not reforming. In the press conference held by David Williams, IMF chief financial officer of the period, on July 13, 1998, the statement “We never say no” to a question about whether the lending transaction will take place due to the reduced liquidity of the IMF proves the IMF’s attitude (Cohen, 1998). Following these developments, the central bank policy of defending the exchange rate was unexpectedly abandoned, and in the third week of August, a new central rate was opted at a wider band for the ruble/dollar exchange rate, corresponding to a ruble depreciation of more than 25% compared to its previous level. This meant that the ruble was devalued. This decision was accompanied by other urgent measures, and on August 17, 1998, a 90-day moratorium was declared on selected private

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external debt with a maturity of more than 180 days and debts arising from margin calls and foreign exchange contracts. The government also declared a moratorium on its own debt before short-term government bonds and other bonds expiring in 1999 were subsequently forcibly converted into long-term debt instruments. With the moratorium on government debt, major losses were inflicted on foreign banks while the value of the debt was written, and additional losses arose from the cancelation of forward contracts on selected foreign debt under the moratorium. Russian banks’ losses associated with the crisis are estimated to correspond to 40% of their assets (UNCTAD and UNECE, 1998).

9.4 After the Crisis The deteriorating economic situation created another political crisis in Russia. Following the devaluation of the ruble, President Yeltsin dismissed Prime Minister Sergei Kiriyenko, who was appointed only six months ago. Yeltsin later reappointed former Prime Minister Viktor Chernomyrdin and allowed him to form a new government. However, the Duma, Russia’s lower house with strong prejudice against Yeltsin, twice rejected Chernomyrdin’s candidacy and pressed for Chernomyrdin’s name to be withdrawn. Seeking a more suitable candidate for the Duma, Yeltsin nominated Minister of Foreign Affairs Yevgeny Primakov. Primakov, backed by the Russian Communist party, won the majority of the votes in the Duma and he assumed the role of prime minister (Online News Hour: Russia’s Crisis, 1998). The first action of the new government established in September 1998 was to choose a smaller budget alternative. First, tax agreements were negotiated with the largest Russian taxpayers, thereby the tax obligations began to be defined by agreement, not by law. Second, a monetary balance system was implemented by also allowing businesses to pay taxes in kind and writing off debts of businesses in the agricultural sector. The purpose of the State’s choice of this method of collection was part of a comprehensive policy that is to ensure that the wealthy upper strata (even if they do not recognize the government) have control over valuable property and continue to run businesses (Gaidar, 1999). It was the economic boom encouraged by the resurgence of oil prices, partly due to the 1998 devaluation and partly due to improving Russia’s financial accounts, and allowing a huge foreign exchange reserve to accumulate, which led to the stabilization of the economy in 1999–2003. In early 2003, gross international reserves of the central bank increased to over 50 billion dollars (41.5 billion dollars in net reserves). More than anything else, these reserves served to protect the economy from future fluctuations and international investor sentiment (Treisman, 2006). Primakov took a quite liberal approach to tax reform. The main purpose of the policies was to reduce the tax burden and to create a suitable environment for the resumption of growth. The program provided for a progressive reduction in VAT rates (up to 10% as of January 1, 2000), a reduction in income tax from 35 to 30%, and the abolition of some unfair tax privileges. In early 1999, the Primakov

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Government had the Bundestag pass a basic package of laws implementing the tax part of the program, but the President later vetoed the VAT reduction law. However, despite the relatively liberal orientation of the tax part of the policy, the key issue of the tax system was not resolved. The very high ceiling of the payroll tax rate (taking into account the contributions to extra-budgetary funds) that encourages tax evasion created extremely unequal operating conditions for taxpayers and prevented the overall decline of tax rates. Moreover, at the beginning of 1999, the Duma Council increased the marginal income tax rate to 45%, but this figure was reduced to 30% at the end of 1999 (Vasilev, 2000).

9.5 Conclusion The fact that internal and external factors have common effects in the development of the process that brought Russia to moratorium in 1998 cannot be ignored. With the deterioration of economic indicators after the collapse of the Soviet Union, the negative effects of the course were tried to be suppressed through the policies implemented by the state and reforms realized with the recommendations of the IMF. Russia’s natural wealth (oil, natural gas, etc.) constitutes an important item in its foreign trade. In the second half of the 1990s, the crises arising from speculative short-term capital movements in developing countries naturally had a global impact, while also negatively affecting commodity prices. The decline in oil prices, which is among the most important export items of Russia, led the economy to an impasse. The loss of income of the state due to the inability to prevent tax evasion and the inefficient use of IMF aids and, thus, failure to achieve the desired effect were important reasons that paved the way to the crisis in Russia. The political and economic reforms that took place after the crisis yielded positive results and the recovery phase started with the increase in commodity prices. The domestic market benefited from the devaluation; in other words, the revival of domestic production because of the increase in cost of import and the recovery of the industry as a result of this was effective in overcoming the crisis shock in a short time.

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Economics. Retrieved from https://www.piie.com/commentary/speeches-papers/what-washin gton-means-policy-reform. Accessed on Feb 5, 2023. World Bank. (2019a). Inflation, consumer prices (annual %)—Russian Federation. Retrieved from https://data.worldbank.org/indicator/FP.CPI.TOTL.ZG?locations=RU. Accessed on Feb 5, 2023. World Bank. (2019b). GDP growth (annual %)—Russian Federation. Retrieved from https://data. worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?locations=RU. Accessed on Feb 5, 2023.

Do˘gancan Akata did his doctoral degree in Finance and Financial Management at Izmir Katip Celebi University in 2022. His doctoral thesis is “Evaluation of Cryptocurrencies and HighFrequency Trading Within the Framework of Tax Security Measures”. He did master’s degree in Financial Law at Celal Bayar University in 2016. His master’s thesis is “Comparison of Tax Dispute Settlement of Administrative and Judicial Process—Examples in Izmir After 2010”. He did his bachelor’s degree in Finance at Celal Bayar University in 2013. Also, he has associate’s degree in Securities and Capital Markets Program in 2020 and Law Program in 2014 at Anadolu University. He has academic work in areas such as public goods, government debt, financial law, cryptocurrencies, and economic crises. His academic interests are public finance, financial economy, economic crises, cryptocurrencies, and high-frequency trading.

Index

A Adverse shocks, 90 Aggregate demand, 27 Agriculture Adjustment Act, 34 Asian tigers, 6, 127–129, 141

B Bank panics, 9, 14–16, 37 Black Swan, 1, 64, 65 Black Thursday, 10, 13, 45

C Capital flows, 5, 57, 59, 67, 81, 91, 98, 100–102, 109, 119, 131, 132 Capital inflows, 5, 81, 82, 86, 87, 89, 91, 95, 98–101, 108, 115, 117–119, 123, 130, 132, 134 Capital outflow, The, 2, 89, 100, 110, 119, 131, 134, 140 Chilean economy, 57–67 Classical economics, 9, 12, 33, 37, 38, 43, 45 Cost inflation, 64 Coup, 4, 64 Crowding-out effect, 124 Currency crisis, 4, 5, 57, 61, 66, 90, 91, 96, 97, 112, 120, 122, 129, 130 Current account deficit, 5, 58–63, 81, 85–87, 90, 91, 97, 98, 100, 101, 103, 109, 123, 132, 134, 136, 138

D Democracy, 57 Depth of poverty, 83 Devaluation, 2, 4, 6, 58, 86, 87, 89, 90, 114, 115, 134, 145, 149, 153, 154 Developing countries, 2, 3, 5, 6, 45, 46, 49, 52, 58, 67, 81, 82, 91, 129, 130, 141, 146, 154 Dollarization, 4, 58, 62, 63

E Economic crisis, 4, 5, 10–15, 17, 18, 20, 23, 36, 37, 44, 54, 63, 65, 67, 82, 95–97, 99, 103, 109, 149, 150 Economic growth, 4, 6, 36, 51, 57, 67, 82, 83, 116, 117, 128, 129, 134, 136, 148 Economic leap, 66 Economic reform, 6, 146, 148, 152, 154 Economic stability program, 96, 119, 121–123 Economy of Argentina, 23, 24

F Financial crisis, 2, 4, 5, 59–62, 65, 66, 89, 96, 103, 105, 108, 109, 110, 115–118, 120, 121, 123, 124, 129, 131, 146, 148–150 Financial liberalization, 4, 57, 66, 67, 81, 82, 84, 91, 95, 98–104, 107–110, 114, 115, 117, 123, 130, 132

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 B. Açıkgöz (ed.), Black Swan: Economic Crises, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-99-2318-2

157

158 Financial markets, 5, 15, 19, 21, 45, 57, 59, 63, 65, 67, 69, 76, 84, 96–98, 102, 108–110, 123 Fiscal policies, 5, 38, 46, 51, 54, 57, 64, 67, 112, 140, 141 Foreign trade deficit, 53, 84, 98–102, 123

G Global investors, 70 Globalization, 1, 4, 59, 60, 67, 82, 127, 129 Gold standard, 17, 37

I Imf aids.Ç, 140, 154 Index Arbitrage, 74, 75 Indonesia, 6, 128, 131, 132, 134–136, 140, 141 Industrialization, 4, 6, 17, 36, 37, 44, 83, 84, 91, 128 Inflation, 5, 6, 18, 20, 43, 44, 46–53, 57, 59, 62–65, 67, 72, 73, 76, 83–89, 91, 95, 98, 103, 105–109, 116, 121, 122, 124, 128, 129, 131–137, 139, 141, 142, 146, 147, 152 Inflation rate, 6, 47–50, 52, 59, 64, 84, 86, 87, 106, 116, 121, 128, 129, 132, 134, 136, 142, 147 Inflation tax, 52, 86, 121, 122 Information revolution, 70 ˙International reserves, 95, 96, 99, 100, 110, 114, 116, 153

K Keynesian policies, 4, 10, 21, 33–35, 38, 44, 45, 54, 64

L Laissez-Faire, Laissez-Passer, 12, 15, 21, 33, 34 Liberalization, 5, 57, 60, 63, 65, 67, 81, 84, 85, 87, 91, 96–99, 101, 102, 104, 107, 108, 123, 146, 147 Loan volume, 87

M Macroeconomic policies, 4, 54, 85, 86, 129, 130 Malaysia, 128, 131, 138–140, 142 Margin call, 74, 76, 153

Index Market drop, 78, 79 Market-oriented economy, 146 MMM program, 152 Modern portfolio theory, 75 Monetary expansion, 34, 107, 111 Monetary liberalization, 61 Monetary policies, 4, 14–17, 53, 54, 58, 63, 66, 77, 89, 90, 112, 140, 141 Moral hazard, 120, 123, 130 Moratorium, 6, 84, 152–154

N New Deal, 27, 34, 35 North American Free Trade Agreement (NAFTA), 82, 83, 86

O Oil crisis, 4, 44, 46, 47, 53, 54, 63, 64, 66 Oil prices, 6, 44, 46, 47, 52, 53, 73, 150, 151, 153, 154 Oil shocks, 4, 44–46, 52, 54, 83, 127 OPEC, 52, 73 Open position, 95, 110, 114–116, 124

P Pemex, 82 Political crisis, 153 Political economy, 57 Portfolio insurance, 74, 75, 77 Potemkin economy, 145 Price bubble, 11–15, 17, 37 Privatization, 63, 84–87, 98, 122, 146–148 Program trading, 74, 75, 77 Protectionist policies, 31, 32 Public debt, 84, 95, 97, 107 Public deficits, 57, 63, 64, 67, 95, 96, 98, 101, 103–105, 107, 110–113 Public sector borrowing requirement, 95, 97, 98, 107, 124

R Recession, 15, 17, 35, 43, 45, 71, 72, 76, 130 1932 Revenue Act, 16 Rushed to the banks, 14

S Savings and Loan Crisis, 72 Say’s law, 33, 37

Index Shadowy organizations, 152 Shock effect, 71 Shock therapy, 147 Short-term advances, 110–112, 123 Slow expansion, 72 Smoot-Hawley Tariffs Act, 18, 20 Soft budget constraint, 150 South Korea, 127–129, 131, 136–138, 140 Stagflation, 4, 44, 46, 48, 51–54, 63, 64 Stagnation, 11, 16, 44–49, 51 State-controlled economy, 146 Stock market, 4, 5, 9–15, 17–20, 37, 45, 69–72, 74–79, 114, 117–119, 131, 140 Stock market anomalies, 76 T Tariff and non-tariff barriers, 84, 91

159 Tax evasion, 6, 154 Tax policies, 52, 154 Tax reform, 63, 146, 153 Tequila Crisis, 4, 81, 82, 86, 97 Tesobonos, 89 Thailand, 6, 128–134, 140, 141, 149 Third generation financial crisis, 129, 130 Trading curb, 77 Treasury bills, 112–114, 120 Twin crisis, 4, 5, 57, 61–63, 65–67

U Unemployment, 6, 9, 10, 14, 16, 18, 19, 21, 26, 27, 31, 33–36, 38, 46, 47, 49–53, 57, 61, 63–67, 71, 89, 116, 124, 128, 129, 132, 141, 142, 146