Looking like a normal credit crisis - expect the Scandi scenario

Currency crises have been extensively analyzed over the last 30 years and a recurring conclusion is that these crises are often coupled with banking crises. In fact, many of the currency crises are precipitated by a internal banking crisis. The internal shock spills over to the demand for the currency through a change in expectations on the sovereign risk of the country and the expectation that a there will be a slowdown in growth.

The banking crises will have different lengths but the end result has often been the nationalization or recapitalization of the bank system. This government bail-out restores confidence for investors both domestic and foreign. We look like we are heading down this path in the US except the form of the bank bail-out is still not clear and we may not have not seen the end of the currency run.

A good example to compare the current US currency crisis is the Scandinavian banking and currency crisis of the early 1990's. There was a combination of an overheated real estate market, liberalization of financial regulation, and pro-cyclical government policies which led to overvaluation in real estate. When a recession hit the economy, the banking system especially for those institutions with heavy real estate exposure saw a huge erosion of capital. The bail-out cost approximately 3% of GDP.

The Swedish currency saw a 60% change in the currency in about 18 month. Now Sweden is a small open economy so that any shock may have a greater impact on the currency than what may occur in the US but we should not be at all surprised if we see a dollar slide that continues into 2009 if there is uncertainty on whether the current bail-out plan will work.