What role does fear play in causing an economic crisis?

What role does fear play in causing an economic crisis?

Fear is an intrinsic and primal human emotion that can drive sudden and at times irrational behaviour. It is a necessary and innate response to threat. Despite this, history has repeatedly shown that uncontrollable human fear can have devastating impacts on civilization and bring about a range of economic and societal repercussions. Through the lens of the Asian Financial Crisis and the Turkish economic disaster, I shall discuss the role of fear as an instrument for currency crises and subsequently, economic collapse.

The trading of currencies is conducted through the foreign exchange market. Like any other market, the value of domestic-denominated currency can be analysed through a simple supply and demand diagram. If a particular individual is holding Australian currency and wishes to exchange a portion of their savings for American dollars, they would supply their own currency to the foreign exchange market. Analogous to the above, an individual holding American currency who wishes to fund an Australian trip will demand Australian dollars with their savings. From a macroeconomic perspective, the intersection between the total supply and demand for Australian dollars with American currency will determine the exchange rate for the AUD/USD currency market.

Conversely, certain governments restrict the ability of market forces to determine their domestic-currency exchange rate, by fixing the exchange value to a predetermined rate through purchasing or selling their own holdings of foreign reserve to influence the total supply or demand in the respective markets. This practice usually involves ‘pegging’ the domestic currency to a major currency such as the US dollar.

The Asian Financial Crisis was a financial catastrophe that sent shockwaves to the economies of many East Asian nations. It is generally agreed by economists that the “hot money” bubble was instrumental in causing this meltdown. Hot money is the rapid and regular flow of funds across different countries by investors who target short-term profit aim to capitalise on interest rate and exchange rate differences [1]. Widely coined as the Asian economic miracle, many Southeast Asian countries experienced impressive rates of economic growth in the early 1990s as favourable interest rates and exchange rates fixed to the US dollar boosted export and foreign investment activity.

Following the recessionary recovery of the US in the mid-1990s however, the Federal Reserve hiked interest rates to combat inflationary pressures, which attracted foreign investment on American assets, and thereby appreciated the US dollar. Unfortunately, the Thai baht was pegged to the US dollar at the time and underwent a similar trend of appreciation, hurting their exports and foreign investment. This sent widespread fear and panic amongst investors who began to withdraw their Thai asset holdings by shifting their hot money to other more promising nations. Known as a speculative attack, the exchange market was suddenly flooded with Thai Bhat, placing unsustainable pressure on the Thai government to sell their limited supply of foreign reserves and maintain a fixed exchange rate. Unfortunately, no country’s foreign reserves are ever infinite, and this proved true for the Thai government who quickly exhausted their foreign reserves and were forced to float the currency [2].

Following this, the Thai Bhat underwent massive devaluation and capital flight ensued immediately as financial assets denominated in the domestic currency lost significant value in terms of other currencies. An uncontrollable Thai asset selloff initiated an international chain reaction as investor confidence fell to new lows, causing foreign investment to plunge in other Asian countries soon after. The severity differed depending on country, however Indonesia and Thailand notably recorded a 43.2% and 21.1% decline in GDP in 1997 respectfully [3]. While the American interest rate hike could be attributed as the root cause of this crisis, one cannot neglect the role that investor fear played in crashing the exchange market and exacerbating the situation.

Turkey may also be on the verge of replicating the downfall experienced by the Southeast Asian economies in 1997. Some economists believe that Turkish President Erdogan’s unorthodox views on monetary policy was the root cause for their currency depreciations. After repeatedly lowering interest rates, Turkey now faces immense inflationary pressure as import prices balloon and wages are forced upwards to cater for rising costs. Similar to the Asian Financial Crisis, holders of the Turkish Lira have flooded the exchange market with their domestic currency over fears that uncontrollable levels of inflation will ensue following low interest rates – causing the Turkish Lira to lose more than 40% in value against the US dollar in 2021 [4]. Massive devaluations of the Turkish Lira have only encouraged more exports, and when coupled with high domestic and foreign investment due to low interest rates, resulted in Turkey facing immense inflationary pressure. Sure enough, Turkey recorded an inflation rate of 54% in February 2022 [5]. While refusal to hike interest rates on President Erdogan’s part may have contributed to the rise to inflation, fears from Lira holders undeniably aggregated the price level increase.

At the time of writing, it is far too early to fully assess the economic consequences suffered by Turkey, but a close comparison of the similarities between the Asian Financial Crisis and the current situation in Turkey reveals the role of fear as an accelerator for economic decline. Fear is a highly contagious emotional response and from an economic standpoint, it can derail the sustainable growth of an economy. Many factors can put an economy at risk, but one cannot neglect the power that fear alone can carry in worsening or even sparking an economic crisis.

[1] Hot money – Wikipedia. Retrieved 14 March 2022, from https://en.wikipedia.org/wiki/Hot_money

[2] 1997 Asian financial crisis – Wikipedia. Retrieved 14 March 2022, from https://en.wikipedia.org/wiki/1997_Asian_financial_crisis

[3] Asian Financial Crisis. Retrieved 14 March 2022, from https://corporatefinanceinstitute.com/resources/knowledge/finance/asian-financial-crisis/

[4] Sabga, P. (2022). Why is Turkey’s lira crashing and will currency crisis worsen?. Retrieved 14 March 2022, from https://www.aljazeera.com/economy/2021/12/1/turkey-lira-crashing-will-currency-crisis-worsen

[5] Turak, N . (2022). Retrieved 15 March 2022, from https://www.cnbc.com/2022/03/03/turkeys-inflation-rate-hits-a-new-20-year-high-of-54percent-.html#:~:text=The%20Turkish%20lira%20has%20lost,rates%20as%20inflation%20consistently%20climbed.