Isabel Schnabel and Hyun Song Shin write (the same paper is also here),

Shortly after the beginning of the Thirty Years War (1618-1648), the small German states and neighboring principalities that comprised the Holy Roman Empire experienced one of the most severe economic crises ever recorded, with rampant hyperinflation and the breakdown of trade and economic activity. The crisis became known as the “Kipper- und Wipperzeit” (i.e., the clipping and culling times), named after the practice of clipping good coins and sorting good coins from bad…

Unlike many episodes of currency debasement in which the sovereign engineers a controlled debasement so as to generate revenue, the Kipper- und Wipperzeit gives all the impressions of an uncontrolled “race to the bottom” in which the debasement gathers momentum and takes on a life of its own. The crisis spread from one state to another, and even spilled over to neighboring states such as Poland…

Indeed, the economic performance during the Kipper- und Wipperzeit of those regions that successfully established public deposit banks, namely Hamburg and the Netherlands, appears to have been much better than that of other regions. One may even speculate that the following rise of Amsterdam and Hamburg as the economic and trade centers of Northern Europe may have been related at least partly to innovations in the Þnancial sector, stimulated by the foundation of public deposit banks.

I think of the Kipper- Und Wipperzeit, which I mentioned recently, as the prototypical international financial crisis. I have seen the term translated and explained differently elsewhere.

For important lessons, read on below.According to Schnabel and Shin (SS), the crisis was resolved by deposit banks that were backed by credible governments. The deposit banks weighed the debased coins and bought them at fair value. In exchange, the holders of the coins received bank money, which was more readily accepted in transactions.

According to SS, currency debasement created a “lemons” problem, in which individuals were reluctant to accept coins because of uncertainty about their worth. I think that this is a generic characteristic of financial crisis. People become very uncertain about the value of certain assets or financial instruments, and the result is to paralyze trade in those instruments. Economic activity is adversely affected (in ways that may not fit with models.)

Suppose that in the used car market, services like Bluebook value and Carfax disappeared, and consequently people became very uncertain about the value of used cars. As a result, prices collapse and trading stops, because owners of used cars do not want to trade at prices they are convinced are too low.

One way to resolve such a “used car crisis” would be to set up a bank that will exchange its own standard car, with a well-understood value, for each idiosyncratic used car owned by individuals. The bank will assess the value of your used car and the difference between that value and the value of the car it gives you will be made up in cash. The government guarantees the value of the standard cars exchanged by the bank. Eventually, the bank will sell the assets that it acquires this way.

The resolution of the crisis has three elements.

1. A bank takes the “lemon” instruments off the market, absorbing them at prices determined by an agreed-upon procedure.
2. The bank replaces the “lemon” instruments with its own instruments, which have a well-accepted value.
3. The government guarantees that the instruments of the bank will maintain their value.

Examples that sort of fit this include Brady Bonds and the Resolution Trust Corporation.

TARP was originally supposed to work like this, by purchasing “toxic assets.” However, the value of these instruments was so uncertain that step (1) could not be executed.

A challenge with resolving sovereign debt crises is that settling the value of a bond issued by, say, Greece, is a political decision. The challenge is to find a third-party assayer acceptable to everyone. And how will the bonds of other PIIGS be valued? How about the liabilities of the banks that hold those bonds?

Another challenge with today’s debt crises is that there may no longer be a government with the credibility and desire to back a bank big enough to buy up all the shaky debt, which, may include the debt of a number of banks with exposure to sovereign debt.