Grabel: Trip Wires and Speed Bumps

Grabel, I, United Nations Conference on Trade and Development, Group of Twenty-four, and Intergovernmental Group of Twenty-four on International Monetary Affairs. 2004. Trip wires and speed bumps: managing financial risks and reducing the potential for financial crises in developing economies. United Nations.

There are four things outlined in the abstract that are accomplished by this paper: "First, it demonstrates that efforts to develop EWS [early warning systems] for banking, currency and generalized financial crises in developing countries have largely failed...Second, the paper advances an approach to managing financial risk through trip wires and speed bumps. Trip wires are indicators of vulnerability that can illuminate the specific risks to which developing economies are exposed...Third...the proposal for a trip wire-speed bump regime is not intended as a means to prevent all financial instability and crises in developing countries...Fourth, the paper responds to likely concerns about the response of investors, the IMF and powerful governments to the trip wire-speed bump approach" (abstract).

It is assumed that there is a link between financial liberalization and financial crises. It is also assumed that developing countries are keen to avoid financial crises, as recoveries can be quite difficult.

"Trip wires are indicators of vulnerability that can illuminate the specific risks to which developing economies are exposed. Among the most significant of these vulnerabilities are the risk of large-scale currency depreciations, the risk that domestic and foreign investors and lenders may suddenly withdraw capital, the risk that locational and/or maturity mismatches will induce debt distress, the risk that non-transparent financial transactions will induce financial fragility, and the risk that a country will suffer the contagion effects of financial crises that originate elsewhere in the world or within particular sectors of their own economies" (2).

EWS models have an incredibly poor track record. When a model is calibrated to be able to identify a crisis, it is thus tuned to a certain set of circumstances and is unable to predict subsequent crises.

"I argue that the failings of existing predictive models stem from the fact that they are based on six misguided initial assumptions" (6).

The assumptions about informational accuracy are too rigid, the people analyzing the data do not take into consideration that the analysis and the economy are overdetermined, crises do not have the same set of causal drivers, crises will not be averted with EWS systems, it has never been possible to predict economic tipping events, and investors do not necessarily have to respond to increased information with stabilizing actions.

The trip wire solution proposed by the author is distinct from the EWS method. Trip wires are diagnostic tools. They are designed to potentially stop market transactions when a certain point has been reached. They can be designed to solve a variety of problems associated with financial crises.

Speed bumps work in conjunction with trip wires: "Speed bgumps are narrowly targeted, gradual changes in policies and regulations that are activated whenever trip wires reveal particular vulnerabilities" (11).