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doi:10.1016/j.jet.2003.06.002 
Copyright © 2003 Elsevier Inc. All rights reserved.
Government guarantees and self-fulfilling speculative attacks*1
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Craig Burnside
, a, Martin Eichenbaum
, , b, c and Sergio Rebelo, d, e
Received 2 May 2002;
Abstract
We develop a model in which government guarantees to banks’ foreign creditors are a root cause of self-fulfilling twin banking-currency crises. Absent guarantees, such crises are not possible. In the presence of guarantees banks borrow foreign currency, lend domestic currency and do not hedge the resulting exchange rate risk. With guarantees, banks will also renege on their foreign debts and declare bankruptcy when a devaluation occurs. We assume that the government is unable or unwilling to fully fund the resulting bailout via an explicit fiscal reform. These features of our model imply that government guarantees lead to self-fulfilling banking-currency crises.
Author Keywords: Fixed exchange rate regimes; Hedging; Government guarantees; Debt denomination
Article Outline
Corresponding author. Department of Economics, Northwestern University, 2001 Sheridan Road, , Evanston, IL 60208, , USA
*1 This paper was previously circulated under the title “On the Fundamentals of Self-Fulfilling Speculative Attacks.” We gratefully acknowledge grants from the National Science Foundation through the NBER, financial support from Kellogg's Banking Research Center, and the Hoover Institution for a National Fellowship. The opinions in this paper are those of the authors and not necessarily those of the Federal Reserve Bank of Chicago. We are thankful to Larry Christiano and Olivier Jeanne for their comments.
