Twin Crises

Twin crises is term in economics that refers to a simultaneous crises in banking and currency (also called a balance of payments crisis). The term was introduced in the late 1990s by economists Graciela Kaminsky and Carmen Reinhart, after the occurrence of several episodes with this characteristic around the globe.

The wave of twin crises in the 1990s, which started with the 1994 Mexican crisis, also known as the "Tequila crisis", and followed with the 1997 Asian financial crisis and the 1998 Russian financial crisis, gave rise to a huge discussion on the relations between banking and currency crises. And although the literature on financial crises provided several theoretical Economic models that tried to understand the linkages between these two types of crises, the causality direction was not unambiguous. While one research stream argued that currency crises could cause banking crises, another stream argued that banking-sector problems could cause currency crises, Moreover, there was yet a third stream of researchers that defended the idea that there would not be a causality relation between banking and currency crises, arguing that both types of crises would be caused by common factors.

To address this ambiguity in the theory, Kaminsky and Reinhart (1999) conducted an extensive empirical work for 20 countries over a 25-year sample and found that banking-sector problems not only are generally followed by a currency crisis, but also help to predict them. A currency crisis, on the other hand, does not help to predict the beginning of a banking crisis, but does help to predict the peak of a banking crisis. That is, although it doesn't cause the beginning of a banking crisis, a Balance-of-Payment crisis may help to deepen an existing banking crisis, creating thus a "vicious cycle". This result is supported by Goldstein (2005), who found that with the existence of strategic complementarities between speculators and creditors in the model, an increase in the probability of one type of crisis generates an increase in the probability of the other type. This "vicious cycle" would be responsible for the severity of twin crises if compared to single crises, resulting in much higher fiscal costs for the affected economy.

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