Self-fulfilling crisis refers to a situation that a financial crisis is not directly caused by the unhealthy economic fundamental conditions or improper government policies, but a consequence of pessimistic expectations of investors. In other words, investors' fear of the crisis makes the crisis inevitable, which justified their initial expectations.
Self-fulfilling mechanism
Self-fulfilling crisis is a mechanism of crisis which highlights the role of expectations. This is one application of the self-fulfilling prophecy in economics.
Typically financial crises happen as a consequence of the government's inability to maintain its commitments, and a benevolent government will compare the benefits and costs of maintaining the original policies. When investors believe the government is unable to honor its commitments, the expectation itself and the following optimal behaviors of the investors, such as stopping purchasing the newly issued government bond or selling the local currency for foreign currency, will increase cost for the government to adhere to the promised policy. When the cost of maintaining the committed policy is very high, the government finds it optimal to abandon the existing policy. Consequently, a crisis happens when government's inability to maintain the committed policy ends up justifying investors' pessimism.
The most widely studied self-fulfilling crises include currency crisis and debt crisis.
Self-fulfilling currency crisis
General concept
Self-fulfilling currency crisis lies in the center of the 2nd generation currency crisis theory. First proposed by Obstfeld, the Self-fulfilling mechanism is constructed as a complement of 1st generation theory. In the 1st generation theory a country's currency will be attacked by speculators only if fundamental inconsistency exists in domestic policies, typically inflationary budget deficits and fixed exchange rate. Obstfeld etc. provided another way to analyze the happening of currency crisis focusing effect of self-confirming of pessimism.
Instead of blindly adhering to fixed exchange rate until running out of its foreign reserve, in the self-fulfilling model the government will abandon pegged exchange rate when it is optimal. The possible benefits from maintaining a fixed exchange rate include the following: facilitating international trade and international investment, using fixed exchange rate as nominal anchor to prevent inflation, gaining good reputation of policy consistency. Meanwhile, the government usually needs to raise the domestic short-term interest rate to prevent speculative attacks, and the associated cost from raising interest rate includes higher deficit pressure, harming financial stability and higher unemployment rate and economic recession consequently. Therefore, conflicts arise between the government's incentives, or between internal balance and external balance. If people believe that the currency will depreciate in the future, by uncovered interest parity, the short-term interest rate will rise as a result, which makes defending fixed exchange rate more costly. When the cost is sufficiently high, fixed exchange rate is abandoned and currency crisis happens.
A theoretical framework
The general idea of self-fulfilling currency crisis can be illustrated in the following example modified from Obstfeld (1996), which explains why pegged exchange rates that could be sustained in the absence of speculative attack can be overthrown by market pessimism among investors.
This prototype model contains three agents, a government and two investors. The government will buy or sell its foreign reserves to fix its currency's exchange rate, while the two investors hold domestic currency and can continue holding it or sell it for foreign currency. In reality, there should be many money holders, but this simplified model captures key features of most cases.