International Review of Economics and Finance 20 (2011) 44–58

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International Review of Economics and Finance

j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / i r e f

Crisis and self-fulfilling expectations: The Turkish experience in 1994

and 2000–2001
Unay Tamgac ⁎
Department of Economics, University of California, Santa Cruz, CA 95064, United States

a r t i c l e i n f o a b s t r a c t

Available online 23 July 2010 In this paper we analyze the role of fundamentals and self-fulfilling expectations in the crisis
episodes of Turkey in 1994 and 2001. The question is how much of the occurrence of a crisis can
JEL classification: be attributed to market expectations and how much to fundamentals. The model is estimated
F31 using a Markov switching framework in which the devaluation expectations affect crisis
O52 probability via three different specifications. Such a framework which allows for sunspots
performs better than a purely fundamental-based model. The study shows that besides the
Keywords: fundamentals in the economy, shifts in agents' devaluation expectations have played a crucial
Currency crises role and that a Markov switching model with constant transition probabilities provides better
Exchange rate regime estimates for the Turkish currency crises.
Turkey
© 2010 Published by Elsevier Inc.
Self-fulfilling expectations

1. Introduction

Financial crises have and remain to be one of the major research areas in economics. The recent global financial crisis has shown
that more needs to be done to explain, predict and prevent crises. Although the recent crisis is unprecedented in terms of size and
coverage, since the 1990s there have been other instances of crises, most spectacular being: Mexico in 1994; Thailand, Korea, and
Indonesia in 1997; Russia in 1998; Brazil in 1999; Turkey and Argentina in 2001.
There are different views regarding the cause of the current financial crisis: capital market imperfections, failure of prudential
supervision and regulation (Freixas, 2009) lack of lender of last resort as well as agency problems, monetary excess caused by the
housing boom (Taylor, 2009), high risk taking and the low interest monetary policy.
Besides the contribution of these factors to the crisis what was the initial kick for the crisis? Calvo (2009) provides a rationale
for the behavior discontinuity in the recent financial crises. He explains the recent meltdown driven by financial innovation and
collapse in line with the Diamond and Dybvig (1983) bank run literature. The model displays equilibrium multiplicity where no
real shocks are needed and the trigger for the meltdown is viewed as self-fulfilling behavior.
Liquidity is, by its very nature, based on confidence and can therefore be self-fulfilling. “Financial crises can just erupt because
people expect that other people expect that financial instruments issued by shadow banks will be bereft of liquidity” (Calvo, 2009).
Financial markets are always subject to self-fulfilling prophecies: if they believe that things will go wrong, things go wrong
(Wyplosz, 2007) and the debt crisis in Greece is the latest evidence.
There are other indebted countries in Europe and the fear is that a default on Greece can be a trigger for a wave of speculative
attacks on other potential defaulters, such as Portugal and Spain, an action likely to be self-fulfilling and massively damaging to the
stability and prestige of the currency.1 To prevent such a self-fulfilling speculative attack on the currency Eurozone has agreed on a

⁎ Corresponding author. Tel.: +1 408 596 1175; fax: +1 831 459 5077.
E-mail address: utamgac@ucsc.edu.
1
For how self-fulfilling expectations play an important role in the spread of crises across countries, i.e. contagion, see Goldstein and Pauzner (2004), Guimaraes
and Morris (2004) and Keister (2009).

1059-0560/$ – see front matter © 2010 Published by Elsevier Inc.

doi:10.1016/j.iref.2010.07.005
 U. Tamgac / International Review of Economics and Finance 20 (2011) 44–58 45

rescue package of €110 billion over the next three years including assistance from the International Monetary Fund as well as
bilateral loans from the euro area countries.
Experience and research has shown that market expectations can contribute to the occurrence of a crisis that would not have taken
place if such expectations could have been prevented at first place. Hence any analysis on crises should consider the existence of self-
fulfilling expectations. This requires a consideration of the effect of fundamentals together with the possibility of multiple equilibria.
While fundamental-based crises can be predicted (Saqib, 2002) what sets self-fulfilling crises is a harder question. In principle
anything could be a trigger to increase devaluation expectations and hence to the generation of a self-fulfilling crisis. This is like
“sunspot” dynamics, in which any arbitrary piece of information becomes relevant if market participants believe it is relevant. Self-
fulfilling crises can result even when the fundamentals were not week ex-ante. As Obstfeld (1994) points out we do not have a
convincing account of how and when market expectations coordinate on a particular self-fulfilling set of expectations.
This paper is an attempt to understand the factors that make a country vulnerable to a financial crisis. In the middle of the quest for
solution to the current crisis we study the experience of Turkey, an emerging country that has gone through several crises in the past
couple of decades. We follow a similar approach to Jeanne and Masson (2000) and use a Markov regime switching framework, explained
in Section 3, which incorporates the effect of self-fulfilling expectations to analyze the Turkish crisis episodes for the period 1980–2005.
Since liberalizing its economy in the 1980s Turkey has experienced two major currency crisis episodes: the first in 1994 and the
second in 2000–2001.2 Since then Turkey has better regulated and supervised its banking system, recapitalized the banks, reduced
inflation, reduced the government debt and opened the industry to international competitors, all these contributed to ward off the
current crisis. The motivation is to determine the driving factors that lead to the occurrence of the Turkish crisis episodes.
Particularly, to test the existence of self-fulfilling behavior and to detect how much of the crises can be attributed to self-fulfilling
expectations and how much to the fundamental components in the economy.
We first estimate the pure fundamentals based model using a standard OLS regression. Then we estimate the model allowing
for multiple equilibria via self-fulfilling expectations using a Markov switching framework. Finally we update the model to allow
for time varying transition probabilities where agents' expectations are influenced by the fundamentals in the economy. The
results show that shifts in agents' devaluation expectations have played a crucial role in the Turkish crises of 1994 and 2000–2001
and that a Markov switching model (MSM) with constant transition probabilities provides better estimates for the crises.
Following is a methodological discussion on regime switching models and their application in the study of currency crises in
Section 2. The empirical framework developed by Jeanne and Masson (2000) to test self-fulfilling expectations in crises using a
Markov switching methodology is discussed in Section 3. After the description of the data and the estimation results in Sections 4
and 5 respectively the paper is concluded in Section 6.

2. Methodological discussion

2.1. Self-fulfilling crisis

Self-fulfilling crises are not new phenomena. The failure of the “first generation” crisis models to explain the speculative attacks
on EMS currencies 1992–1993 and Mexico 1994–1995 lead to the development of “second generation models” led by Obstfeld
(1996), Eichengreen, Rose, and Wyplosz (1994).3 In this class of models, the interaction between market expectations and policy
outcome can generate self-fulfilling crises. These models are characterized by multiple equilibria, where depending on agents'
expectations different outcomes, crisis or no crisis, can occur.
Attempts of estimating escape clause models have been few, which is due in no small part to the difficulty of estimating
nonlinear models with multiple equilibria. One of the initial attempts to detect self-fulfilling expectations is based on Jeanne and
Masson (2000). They provide a theoretical framework in which agents' expectations give rise to multiple equilibria in which under
certain macroeconomic conditions; these expectations can generate a self-fulfilling crisis. Linearization of their model gives a
Markov switching regimes model for the devaluation probability. Based on this model they suggest the application of a MSM that
allows for the representation of the agents' expectations as different states in the economy where switches across different states
corresponds to jumps between different equilibria governed by a Markov process. Their model provides a justification of the use of
the Markov switching regimes approach in empirical work on currency crises.

2.2. Regime switching models in crisis literature

Regime switching models are used to model time series data in which the behavior of the series seems to change quite
drastically.4 Such apparent changes can be seen in almost any macroeconomic or financial time series and can result from events
such as wars, significant change in government policy or financial panics.
After Engel and Hamilton's (1990) pioneering work, there have been many studies that have found that a regime switching
model outperforms the random walk or other specifications when it comes to modeling and forecasting exchange rates.5 These
findings suggest regime switching models as appealing alternatives in modeling the behavior of exchange rates.
2
2000–2001 crisis is a shortcut to refer to the two consecutive crisis episodes: in November 2000 and February 2001. For references on the Turkish crises refer
to Celasun (1998), Ozatay and Sak (2002), Ekinci and Erturk (2004).
3
For the first generation crisis models refer to Krugman (1979), Flood and Garber (1984) and Jeanne (1997).
4
See Hamilton (1989).
5
See Engel (1994), Bergman and Hansson (2005) and Lee and Chen (2006).
46 U. Tamgac / International Review of Economics and Finance 20 (2011) 44–58

Staring with Jeanne and Masson (2000) Markov switching models have been used in the crisis literature. There are various
papers that employ different regime switching models to detect crisis signals. Jeanne and Masson (2000) use MSM to analyze the
speculation against the French franc in 1987–1993, Boinet, Napolitano and Spagnolo (2002) use a similar MSM for the analysis of
the 2002 Argentinean crisis, Alvare-Plata and Schrooten (2003) for the EMS crisis. There is also a literature that uses MSM in a
multivariate framework (e.g. Sarantis and Piard (2004), Soledad and Peria (2002)).
Abiad (2003) who provides a survey on the empirical crises literature shows that a Markov switching estimation procedure
performs better than probit and signaling models as an early warning system for currency crises. One advantage of regime
switching model over a deterministic model is their flexibility. By specifying a probability law consistent with a broad range of
different outcomes, and choosing particular parameters within that class based on the data alone this framework allows the data
to tell the nature and incidence of significant changes.
MSM provide simplicity compared to the standard models that require many ad hoc assumptions. Using MSM, we can directly
estimate the probability of a crisis. The direct use of a measure of the market pressure instead of a crisis dummy, avoids
information loss compared to logit or probit models. Flood and Marion (1999) argue that the change in the SPI jumps is reduced at
the attack time by the extent to which the attack is anticipated. Thus, a binary crisis dummy is more likely to pick up unpredicted
crises. This reduces the share of predictable crises that are likely to be correlated with fundamental economic determinants. This
introduces a sample bias into the estimation procedure which is avoided in MSM.
Besides the listed advantages, MSM allow for nonlinearities between the fundamentals and the crisis probability which cannot
be estimated by ordinary regressions. Thus MSM provide an analytical framework to estimate multiple equilibria which is the
most important consideration in estimating models with self-fulfilling expectations.

3. The empirical framework

3.1. Markov switching regimes framework to detect self-fulfilling expectations

In the following sections we look at the driving factors of the Turkish crisis episodes in 1994 and 2000–2001. We follow a
similar approach to Jeanne and Masson (2000) and use a MSM to identify the existence of self-fulfilling expectations in the crises.
Jeanne and Masson's (2000) model is a based on the second generation crises models where occurrence of crises is jointly
determined by the fundamentals in the economy and the agents' expectations.
In second generation currency crises models a crisis, which is unlikely to happen when agents do not have crisis expectations,
can happen when the agents develop expectations of a crisis occurring hence making the expectations self-fulfilling even though
the fundamentals can be far from irrelevant. Higher devaluation expectations lead to higher probability of a devaluation by
increasing the policy maker's desire to devalue, and eventually leads to a self-fulfilling crises. The most obvious way in which they
do so is by raising interest rates. Faced with a dilemma between high interest rates and devaluation, the policymaker may choose
the latter, especially if the fundamental economic situation is fragile. In fact, the policymaker may prefer devaluation to high
interest rates even though she would have maintained the fixed peg if interest rates had been low; in that case, whether or not
devaluation occurs depends purely on market expectations. Jeanne and Masson (2000) show that this idea can be applied for the
identification of self-fulfilling crises using a Markov switching regimes framework. This framework allows the theory of self-
fulfilling crises to be brought to the data.

3.2. The model specification

In the model of Jeanne and Masson (2000) the government is assumed to minimize a loss function so there is a continuous
comparison of the government's net benefits from changing the exchange rate versus defending it. The net benefit of the exchange
rate peg depends on the fundamentals, and it is sensitive to the devaluation expectations through the level of interest rates. Other
things equal, higher devaluation expectations force the government to set a higher interest rate, making the peg more costly
through a number of channels (lower economic activity, fragilization of the banking sector, higher interest burden on public
debt etc.). The government abandons the peg whenever the net benefits are less than zero given the devaluation expectations in
that state. Thus for each state of devaluation expectations, there is a corresponding level of fundamentals that triggers a
devaluation. Agents' expectations are forward looking and expectations are influenced by the state the economy will transition to
in the next period. The net benefit of the policy maker, thus the occurrence of a crisis, depends jointly on the current state of
expectations, the fundamentals and the transition probability from current state to other states. Consequently the level of
fundamentals that triggers a crisis is different for each state: in states with high devaluation expectations the fundamentals
thresholds for a crisis can be lower than those in which devaluation expectations are higher.
Jeanne and Masson (2000) show that fundamentals based equilibria with different average levels of devaluation expectations
may coexist. Multiplicity of equilibria makes it possible to construct a model in which the economy jumps across states with
different levels of devaluation expectations. They show that this idea can be applied for the identification of self-fulfilling crises
using a Markov regime switching framework in which the states characterize different devaluation expectations. The transition
across states, i.e. shift in the agents' expectations, is assumed to follow a Markov process independent of the fundamentals.6

6
Jeanne and Masson (2000) use this model for the experience of French Franc between 1987 and 1993 find that the devaluation expectations were influenced
by sunspots.
 U. Tamgac / International Review of Economics and Finance 20 (2011) 44–58 47

3.3. Markov switching model (MSM)

In the model the devaluation probability at time t, Π t, is specified as

Πt = ast + b1 x1;t + b2 x2;t + b3 x3;t + …et ð1Þ

Where xit are the fundamental variables that affect the probability of a crisis at time t, bi is the coefficient of explanatory
variable i that will be estimated and et is the normally distributed error term with variance σ2e . The value of the constant term ast
depends on the state st with st = 0 or 1.
There are two regimes in the economy. Regime 0 is a so-called “tranquil” regime (low state or no crisis state), during which the
probability of devaluation is low; whereas regime 1, the so-called “taut” regime (high state or crisis state) represents times of high
economic tensions and reflects periods during which the devaluation probability is considerably higher for the same level of
fundamentals. Specifically,

In regime 0 ðno crisisÞ Πt = a0t + b1 x1;t + b2 x2;t + b3 x3;t + …et ð2Þ

In regime 1 ðcrisisÞ Πt = a1t + b1 x1;t + b2 x2;t + b3 x3;t + …et ð3Þ

The only difference in the two regimes is the state dependent constant ast. This term identifies the contribution of the agents'
expectations to the probability of devaluation. If self-fulfilling elements are in play we expect the model to generate different
estimates for ast. We expect a higher estimate for ast in regime 1 than in regime 0, i.e. that the agents' higher devaluation
expectations lead to higher probability of crisis occurring in the crisis state. The contribution of the fundamental variables to crisis
probability is assumed to be the same in both regimes, reflected by the same coefficients for the explanatory variables in both
regimes.
Whenever the crisis is driven by second generation models we should see a shift in agents' expectations that increase the
probability of devaluation for the same level of fundamentals. Depending on the agents' expectations the economy can be in a low
devaluation expectations state (regime 0) or in a high devaluation expectations state (regime 1). The regime will switch from low
state to high state when agents develop high expectations for devaluation and these higher expectations increase the probability
of a crisis for the same level of fundamentals.

3.4. CTP and TVTP Markov switching model (MSM)

In the first part of the analysis we assume that the regime shifts, i.e. the shifts in expectations of the agents, are governed by a 2
state Markov process with CTP from state i to state such that: 7

P ðSt = jj St−1 = iÞ = Pij ; ði; j = 0; 1Þ for t = 0; …T ð4Þ

Pi0 + Pi1 = 1; ði = 0; 1Þ ð5Þ

The unconditional probabilities that the system is in state i, Pi, can be calculated as:

1−P11 P10
P0 = P ðSt = 0Þ = =
2−P00 −P11 P01 + P10
ð6Þ
1−P00 P01
P1 = P ðSt = 1Þ = =
2−P00 −P11 P01 + P10

In the CTP framework the switching probability from one state to the other depends only on the initial state at the time of
change and is exogenously determined. This corresponds to the case where the change in agents' expectations exhibits sunspot
dynamics, uncorrelated with any information about the fundamentals in the economy.
In Section 5.3 we allow for the transition probabilities to vary with time and use the MSM with Time Varying Transition
Probabilities (TVTP) which involves the nonlinear parameterization of the transition probabilities in terms of a set of
predetermined explanatory variables.8 In this specification the probability that St = j depends not only on the value of St − 1 but also
on a vector of exogenous variables zt, where zt may include elements of xt. Formally:

P ðSt = jjSt−1 = i; St−2 = k; …; zt Þ = P ðSt = jjSt−1 = i; zt Þ = Pij ðzt Þ ði; j = 1; 2; …NÞ ð7Þ

Where Pij(zt) may have either a probit or logistic specification of the history of the economic-indicator variables zt = {zt, zt − 1…}.
In this framework the probability of switching from one regime to another is time varying and endogenously determined. In our

7
Pij are conditional probabilities, they specify the probability to be in state i, given that the previous state was j.
8
The first work in this area is by Lee (1991), followed by the studies on business cycle fluctuations (Filardo, 1994; Ghysels, 1992), interest rate dynamics
(Gray, 1996), bubbles and asset pricing (van Norden & Schaller, 1997), and exchange rates (Diebold, Lee & Weinbach, 1994; Engel & Hakkio, 1994).
48 U. Tamgac / International Review of Economics and Finance 20 (2011) 44–58

Fig. 1. Evolution of the variables e, r and i.

analysis we assume the transition probabilities to evolve according to a logistic function of economic fundamentals. This logistic
functional form maps the information variables, zt, into the open interval (0, l) and thereby guarantees a well-defined log-likelihood
function.
 0 
exp zt β o
Pt00 = P ðSt = 1jSt−1 = 1; zt Þ = pðzt Þ =
1 + expðz0t−1 βo Þ
 0  ð8Þ
11
exp z t β1
Pt = P ðSt = 0jSt−1 = 0; zt Þ = qðzt Þ =
1 + expðz0t β1 Þ

where zt is a (kx1) vector of economic variables that affect the transition probabilities, βiis a (kx1) vector of parameters for state i
that govern the transition probabilities from that state.9 Finally in Section 5.4 we estimate the model with regime dependent
coefficients.
The TVTP specification is consistent with the idea that the agents' expectations can be influenced by fundamentals in the
economy. In this setting we acknowledge that the periods leading to crisis are intrinsically different from tranquil, non crisis
periods since there is an association between the agents' expectations and the state of the economy. Therefore the occurrence of a
crisis cannot be considered as the result of sunspot equilibrium alone.

4. Data description and sources

4.1. Definition of a crisis: the dependent variable

The dependent variable is the estimate of the devaluation probability, Πt. Jeanne and Masson (2000) approximate the devaluation
probability with the interest differential (i − i⁎) between Euro–DM and Euro–Franc instruments. However in the crisis literature it is
common to look for a broader range of indicators and include episodes of unsuccessful attacks, in which the government could defend
the currency by a sizable loss in international reserves or through large increases in domestic interest rates. We follow this method and
use the Speculative Pressure Index (SPI) to proxy for the devaluation probability.10 The SPI is calculated as the weighted average of the
monthly percentage changes in the real effective exchange rate (Δe) and international reserves (Δr) and monthly change of the
interest rate differential [Δ(i − i⁎) = Δi].11

SPI = we %Δe–wr %r–wi Δi ð9Þ

Following Eichengreen et al. (1994) to equate the conditional volatilities of the three components we use the weights as inversely
related to the standard deviation of each of the three variables12:
         
1 Δe 1 Δr 1
SPI = * − * + *ðΔiÞ ð10Þ
σe et−1 σr rt−1 σi

9
The CTP model is a nested alternative to the TVTP model. It corresponds to the case where the last (k − 1) terms of the (k x 1) transition probability
parameter vectors are set to zero so that p00 11
t and pt and are constant, meaning the economic-indicator variables are not informative about the evolution of the
state of the economy.
10
This method, called as an ad hoc method to measure exchange market pressure, is based on the earlier work by Girton and Roper (1977) and is first
introduced by Eichengreen et al. (1994) for the identification of crises.
11
There are variations in the construction of the SPI and some studies only use exchange rate and reserve changes and omit the interest rate differential such as
Kaminsky and Reinhart (1999).
12
Eichengreen at al. (1994) conduct a sensitivity analysis to measure the effect of different weighting schemes for the index. They showed that different
weights do not have significant impact on the empirical results.
 U. Tamgac / International Review of Economics and Finance 20 (2011) 44–58 49

Fig. 2. Components of SPI.

where σe, σr, σi are the standard deviations of the exchange rate, international reserves and the interest rate differential over the
sample period respectively.13
An increase in the index reflects stronger selling pressure on the domestic currency (a depreciation pressure). That way the
index captures either a successful attack (a sharp devaluation), or a successful defense (the monetary authorities deter an attack
by a combination of interest rate increases and foreign market interventions and the exchange rate remains unchanged), or an
unsuccessful defense (all three variables move sharply).
We use the CPI based trade weighted effective exchange rate as the real exchange rate. Reserves correspond to the total
international reserves minus gold and the interest rate differential is calculated as the difference between Turkish and US three month
deposit interest rates. There is a noticeable variation in the behavior of these variables during crisis times of 1994 and 2000–2001
(Fig. 1). Specifically there is a sharp fall in the real exchange rate and reserves and a rise in the interest rate differential. The crisis times
are evident from the weighted components of the SPI (Fig. 2). The exact timing of the crisis can be seen from the spikes of the SPI in
Fig. 3, and the crisis dummy is construed from the SPI for a threshold level of mean plus two standard deviations in Fig. 4.

4.2. Crisis indicators: the explanatory variables

Studies have found that different set of variables have different explanative power for different countries. As Kaminsky, Lizondo
and Reinhart (1998) conclude currency crises seem to be usually preceded by multiple economic problems and an effective warning
system should consider a broad variety of indicators.14 Since there is no definite rule for the “right” set of variables we consider a broad
set of indicators, including general macroeconomic variables, indicators related with the real sector, the financial sector, government,
as well as political and institutional variables, which might have influenced the Turkish crisis episodes. The data is obtained from IMF's
International Financial Statistics (IFS; CD-ROM version), The Turkish Under Secretariat of Treasury and the electronic data distribution
system of Central Bank of the Republic of Turkey.15
The analysis is carried for the post liberalization period of Turkey which starts in 1980, until May 2005. Monthly data is used since it
is more useful as a policy tool. Being available almost immediately with a fifteen to twenty days lag it gives the policymaker a faster
knowledge of the proximity of a crisis and a faster reaction capacity when the indicators start sending signals.16

5. Estimation results

5.1. OLS estimation

First we assume there is no multiple equilibria and estimate the model without regime switches using OLS. This allows us to test a
purely fundamentals based model. After estimating the model for different combinations of variables we a get reduced the set of
variables that have the highest R-square values. The results of the OLS estimation for these variables are presented in Table 1. All

13
In the literature a currency crisis is identified by “large” changes in the SPI, relative to their “normal” values. “Large” defined as changes in the index that
exceed a threshold value. The threshold value is usually taken as the mean plus two standard deviations, provided that it also exceeds five percent. If index value
exceeds the threshold level, a crisis signal is issued. The studies also use alternative criteria in their identification of the “threshold” value.
14
Kaminsky et al. (1998) provide a list of 103 indicators used in literature.
15
The full set of the explanatory variables are: Bank deposits/M2 (level and growth), bank reserves/total bank assets, current account/GDP, central bank credit
to banks/total bank liabilities, foreign debt/exports, short term foreign debt/reserves, short term debt, government fiscal deficit/GDP, private credit by domestic
money banks/GDP, export growth, import growth , loans/deposits (level and growth), growth rate of broad money to reserves, growth rate of M1 ,cumulative
non-FDI flows, growth rate of portfolio investment/GDP, industrial production, world real interest rate, growth rate of real domestic credit, growth rate of real
GDP, deviation of the real exchange rate from trend ,stock market performance, terms of trade, trade balance, external debt, long term debt, short term debt/
exports.
16
For some variables that were available only in a lower frequency the conversion to a monthly frequency was made via quadratic interpolation. These
variables are: external debt, GDP, GDP deflator, current account, direct investment, portfolio investment, government budget balance and government's debt
position.
50 U. Tamgac / International Review of Economics and Finance 20 (2011) 44–58

Fig. 3. Speculative Pressure Index (SPI).

Fig. 4. Currency crisis dummy.

variables except the current account to GDP ratio, and export growth have the expected signs. The positive coefficient for export
growth is consistent with the findings of Kaminsky and Reinhart (1999) that export growth is lower under balance of payments and
twin crisis episodes. The expected sign on import growth can be either way since import growth is expected to decline during a balance
of payments crisis, and rise during a banking crisis. The estimation results show a negative coefficient as would be predicted by a
balance of payments crisis. The significant variables are: the deviation of real exchange rate from trend, annualized growth rate of M2
to reserves ratio, trade balance, growth rate of the ratio of bank deposits to M2 and ratio of short term debt to reserves.
The OLS model has a poor performance since it gives a false crisis signal in 1990 as can be seen from the predicted SPI and crisis
signals in the upper and lower panels of Fig. 5 respectively.

5.2. CTP–MSM estimation

Next we estimate the devaluation probability allowing for multiple equilibria using the MSM explained in Section 3.3 by
implementing the Expectation Maximization (EM) algorithm, programmed in RATS. 17 We use only the reduced set of the 16
variables based on the OLS estimation results. Since the MSM estimation is sensitive to missing observations the estimation is
carried over the period 1987:01–2005:12 where there are no missing data points.

17
For the EM algorithm see Dempster, Laird, and Rubin (1977).
 U. Tamgac / International Review of Economics and Finance 20 (2011) 44–58 51

Table 1
OLS estimation results.

Variable Coefficient Std error T-stat Significance

Constant −5.080 ⁎⁎⁎ 1.193 −4.258 0.000

Deficit/GDP 3.355 3.897 0.861 0.390
Current account/GDP 22.145 17.540 1.263 0.208
Deviation of REER from trend −3.298 ⁎ 1.872 −1.762 0.080
Annual real GDP growth −0.028 0.021 −1.358 0.176
Domestic credit growth 0.132 0.107 1.229 0.220
M2/reserves growth 0.236 ⁎⁎⁎ 0.056 4.198 0.000
Trade balance −0.001 ⁎⁎⁎ 0.000 −2.728 0.007
Stock market growth −0.055 0.087 −0.634 0.527
Bank deposits/M2 growth −9.753 ⁎⁎⁎ 3.451 −2.826 0.005
CBCRE_BASSET 0.045 4.494 0.010 0.992
Loans/deposits growth 0.412 0.409 1.007 0.315
Short term debt/reserves 0.004 ⁎⁎ 0.002 2.368 0.019
External debt/exports 0.041 0.026 1.580 0.116
Export growth 1.855 1.219 1.522 0.130
Import growth −1.329 1.016 −1.307 0.193
DMB_private credit/GDP 0.400 0.327 1.223 0.223
⁎ Denotes variables significant at 10%.
⁎⁎ Denotes variables significant at 5%.
⁎⁎⁎ Denotes variables significant at 1%.

We test the null hypothesis of a single regime by comparing the parameter estimates of the two models. The strength and
existence of self-fulfilling expectations can be interpreted from the difference of the coefficient estimates for the constant term ast
in the two regimes.
The result of the two-regime CTP–MSM estimation is presented in Table 2. All the coefficients estimates, except for the deficit to
GDP ratio, have the same sign as in the OLS estimation. The estimate for the constant term, which captures the importance of the
agents' devaluation expectations, is −2.606 in regime 0 (a0) and 3.463 in regime 1 (a1), both significant at the 1 percent level. This
shows that we can distinguish between two states in the economy, one with lower devaluation expectations and the other with
higher devaluation expectations.
The estimated matrix of transition probabilities below shows that two fairly persistent regimes do exist, with the probability of
a high devaluation expectation state being much lower.

   
P00 P10 0:97989 0:49742
Θ= = ð11Þ
P01 P11 0:02011 0:50258

The steady state probabilities of the states are calculated using Eq. (6).

P0 = steady state probability of state 0 ðlow stateÞ = 0:96114

P1 = steady state probability of state 1 ðhigh stateÞ = 0:03886

The estimated SPI under the two regimes using the parameter estimates of the CTP–MSM are shown in Fig. 6. The jumps to regime 1
from regime 0 during the 1994 and 2000–2001 crises can be seen from the plots and the estimated SPI from the CTP–MSM closely
matches the realized SPI.
The smoothed probability estimates of being in state 1 (high state), P(st|YT), which is based on all T observations of Yt, as
generated by the RATS program, are shown in the lower panel of Fig. 7 together with the plot of the dependent variable, the SPI, in
the upper panel. These probabilities correctly pick the two crisis episodes in 1994 and 2000–2001 showing that during both crises
the economy had switched to a high devaluation expectations state. The CTP–MSM allows us to correctly estimate the Turkish
crisis episodes. The switch of the economy to a high devaluation expectations state during both crises shows that that the agents'
increased expectations for devaluation had a significant contribution to the occurrence of the crisis. Thus we can conclude that
besides the deteriorating fundamentals, self-fulfilling expectations were in play in the Turkish crisis episodes.

5.3. TVTP–MSM estimation

In the CTP–MSM, the transition probabilities are assumed to be constant over the estimation period. In other words the
likelihood that the regime will shift into a taut or a tranquil state is time independent and exogenously determined. We relax this
assumption and allow the transition probability to depend on the fundamentals in the economy. This modified model is estimated
using the TVTP framework explained in Section 3.2 where the transition probabilities are defined as a function of the exogenous
variables.
52 U. Tamgac / International Review of Economics and Finance 20 (2011) 44–58

Fig. 5. OLS estimation results. Estimated SPI and crisis probability based on OLS estimation results.

Transition probabilities are assumed to evolve according to the logistic function in Eq. (8). The vector of economic variables that
affect the transition probabilities, zt, consists of the same 16 economic indicators which are our fundamental variables xt. Excluding
the missing observations the model is estimated over the period 1987:01–2005:12.
The result of the two-regime TVTP–MSM estimation is presented in Table 3. Annualized growth rate of ratio of M2 to reserves,
trade balance, growth rate of bank deposits to M2, short term debt to reserves, and external debt to exports are the significant
variables. We again get two different estimates for the constant term: −2.419 in regime 0 (a0) and 4.361 in regime 1 (a1) which
are both highly significant. This shows that, allowing the transition probabilities to vary endogenously, we estimate two different
states in the economy: one with lower devaluation expectations and one with higher devaluation expectations.
The estimated values of the SPI under the two regimes using the parameter estimates of the TVTP–MSM are shown in Fig. 8. The
estimated value of SPI follows closely the realized value and a switch from regime 0 to regime 1 occurs during the crisis times in
1994 and 2000–2001.
The dependent variable, the SPI and the smoothed probability estimates of being in regime 1 (high state) for the TVTP–MSM
estimation as generated by the RATS program are displayed in the upper and lower panel of Fig. 9 respectively. As can be seen the
model correctly picks up the 1994 and 2000–2001 crisis by showing a spike for the probability of being in a crisis state (regime 1).
However the existence of another spike at the end of 1998 shows that TVTP–MSM performs relatively poorly compared to the
CTP–MSM by signaling a crisis that did not occur.18

18
Since the transition probabilities are time varying we cannot construct the transition probabilities matrix for the TVTP–MSM and nor can we calculate the
steady state probabilities.
 U. Tamgac / International Review of Economics and Finance 20 (2011) 44–58 53

Table 2
CTP–MSM estimation results.

Variable Coefficient Std error T-stat Significance

P12 0.020 ⁎⁎ 0.008 2.424 0.015

P21 0.497 ⁎⁎⁎ 0.180 2.765 0.006
A0 −2.606 ⁎⁎ 1.052 −2.477 0.013
A1 3.463 ⁎⁎ 1.360 2.546 0.011
Deficit/GDP −8.186 ⁎ 4.559 −1.796 0.073
Current account/GDP 19.003 18.651 1.019 0.308
Deviation REER from trend −1.636 1.580 −1.035 0.301
Annual real GDP growth −0.025 0.017 −1.410 0.158
Domestic credit growth 0.073 0.089 0.818 0.413
M2/reserves growth 0.203 ⁎⁎⁎ 0.049 4.180 0.000
Trade balance 0.000 ⁎⁎ 0.000 −2.141 0.032
Stock market growth −0.065 0.077 −0.838 0.402
Bank deposits/M2 growth −5.019 3.017 −1.664 0.096
CBCRE_BASSET 3.537 4.030 0.878 0.380
Loans/deposits growth 0.363 0.412 0.883 0.377
Short term debt/reserves 0.001 0.001 0.917 0.359
External debt/exports 0.013 0.021 0.593 0.553
Export growth 0.430 1.026 0.420 0.675
Import growth −0.252 0.864 −0.292 0.771
DMB_private credit/GDP 0.487 0.352 1.383 0.167
Sigma (σ2e ) 1.465 ⁎⁎⁎ 0.075 19.540 0.000
⁎ Denotes variables significant at 10%.
⁎⁎ Denotes variables significant at 5%.
⁎⁎⁎ Denotes variables significant at 1%.

Among the coefficient estimates for the βi's, the vector of parameters that govern the transition probabilities, only the
coefficient of short term debt to reserves ratio for switching from regime 1 to 2 (P10) is significant.19 This suggests that the
economic fundamentals do not have a good power to predict the shifts in the agents' devaluations expectations.
Both in the CTP and TVTP models the coefficient estimate of the constant term is larger in the high devaluation expectations
state (regime 1). This shows that besides the deteriorating fundamentals, agents' devaluation expectations were in play in the
Turkish crisis episodes. In both models, during crisis times the probability of being in regime 1 is estimated as one, i.e. crises
occurred when agents developed higher expectations for crisis occurring. Thus a crisis is influenced by agents' expectations
making the crisis self-fulfilling.
Both the CTP and the TVTP models correctly pick the two crisis episodes, however the CTP model does a better job at predicting
of the occurrence of crises. This shows that market expectations are not fundamentals driven. The expectations cannot be
explained by the economic fundamentals; rather they are like sunspot dynamics. Therefore the fundamental variables are not
enough to predict a crisis.
We have shown that devaluation probability is jointly determined by the fundamentals in the economy and the market
expectations. The importance of the fundamentals is evident by the significance of the external variables, and the existence of two
significant states with different devaluation expectations indicates the importance of expectations.

5.4. CTP–MSM with variable coefficients estimation

Finally we estimate a CTP–MSM with regime dependent coefficients:

Πt = ast + b1;st x1;t + b2;st x2;t + b3;st x3;t + …est ð12Þ

Where es,t is the normally distributed error term of regime i, with variance σ2ei. Specifically,

In regime 0 ðno crisisÞ Πt = a0 + b1;0 x1;t + b2;0 x2;t + b3;0 x3;t + …e1;t ð13Þ

In regime 1 ðcrisisÞ Πt = a1 + b1;1 x1;t + b2;1 x2;t + b3;1 x3;t + …e2;t ð14Þ

In this model the fundamental variables' effect on to the devaluation probability differs depending on the state of the economy,
reflected through the different coefficient estimates in the two regimes. The estimation is again carried over the period 01-2005:12.
The estimated SPI under the two regimes in Fig. 10 and the smoothed transition probabilities in Fig. 11 shows that the model has a poor
predictive power.20

19
The results for the coefficient estimates for theβi`s, the vector of parameters that govern the transition probabilities, are available from the author upon
request.
20
The results of this estimation are available from the author upon request.
54 U. Tamgac / International Review of Economics and Finance 20 (2011) 44–58

Fig. 6. CTP Markov switching simulation results. Estimated SPI based on CTP–MSM results.

6. Conclusion

In this paper we test whether self-fulfilling expectations were in play in the 1994 and 2000–2001 Turkish crisis episodes. We use
the methodology by Jeanne and Masson (2000) that employs a Markov switching model (MSM) for the estimation of the crisis
probability assuming two states corresponding to the market expectations of low and high devaluation probabilities. By allowing
nonlinearities MSM can be used to estimate models with multiple equilibria. The MSM generates better estimates compared to a
fundamentals based OLS model, indicating that two states of the economy with different devaluation expectations exists and crisis
occurs whenever agents' have high devaluation expectations.

Fig. 7. CTP Markov switching estimation results. Estimated SPI and smoothed transition probability of regime 1 based on CTP–MSM results.
 U. Tamgac / International Review of Economics and Finance 20 (2011) 44–58 55

Table 3
TVTP–MSM estimation results.

Variable Coefficient Std error T-stat Significance

A11 −2.42 ⁎⁎⁎ 0.16 −14.86 0.00

A21 4.36 ⁎⁎⁎ 0.57 7.70 0.00
B (deficit/GDP) −3.16 2.70 −1.17 0.24
B (current account/GDP) 2.01 12.66 0.16 0.87
B (deviation of REER from trend) −1.24 1.17 −1.06 0.29
B (annual real GDP growth) −0.01 0.01 −1.00 0.32
B (domestic credit growth) 0.10 0.07 1.30 0.19
B (M2/reserves growth) 0.20 ⁎⁎⁎ 0.04 4.96 0.00
B (trade balance) −0.0005 ⁎⁎⁎ 0.00 −61.44 0.00
B (stock market growth) −0.03 0.06 −0.48 0.63
B (bank deposits/M2 growth) −7.26 ⁎⁎⁎ 2.45 −2.96 0.00
B (CBCRE_BASSET) −1.14 2.89 −0.40 0.69
B (loans/deposits growth) −0.03 0.29 −0.10 0.92
B (short term debt/reserves) 0.00 ⁎⁎ 0.00 2.63 0.01
B (external debt/exports) 0.02 ⁎⁎ 0.01 2.60 0.01
B (export growth) 0.61 0.75 0.81 0.42
B (import growth) −0.19 0.70 −0.28 0.78
B (DMB_private credit/GDP) 0.20 0.16 1.26 0.21
Sigma (σ2e ) 1.47 ⁎⁎⁎ 0.06 22.84 0.00

⁎ Denotes variables significant at 10%.

⁎⁎ Denotes variables significant at 5%.
⁎⁎⁎ Denotes variables significant at 1%.

The model is estimated using different regime specifications. We test the model using a TVTP–MSM and a CTP–MSM with
regime dependent coefficients on the external variables. These specifications perform poorly compared to the initial CTP–MSM
specification. The two-regime CTP–MSM with state dependent constant term gives the best estimates of the crisis probabilities and
can detect the exact timing of the Turkish crises.
The MSM allows us to jointly determine the effect of self-fulfilling expectations and fundamentals in the Turkish crisis episodes.
The study shows that besides the fundamentals in the economy, shifts in agents' expectations have played an important role in the
Turkish crisis episodes. A crisis happens whenever agents' expectations of devaluation increases, i.e. the regime shifts to a taut
state from a tranquil state. Thus the Turkish crises can be viewed as a case of multiple equilibria where shift in agents' expectations
played a role in the occurrence of the crisis making it self-fulfilling. The transition probabilities between the two states of
expectations cannot be predicted with economic fundamentals, which indicate that the Turkish crisis episodes were driven by
sunspot equilibria.
The study shows that MSM can be used in crisis models with multiple equilibria where we observe behavior discontinuity like
in the recent financial crisis. Financial markets are always subject to self-fulfilling prophecies, specifically through agents'
expectations and investor confidence. Self-fulfilling behavior can function through various channels: through interest rates as in

Fig. 8. TVTP Markov switching simulation results. Estimated SPI based on TVTP–MSM results.
56 U. Tamgac / International Review of Economics and Finance 20 (2011) 44–58

Fig. 9. TVTP Markov switching estimation results. Estimated SPI and smoothed transition probability of regime 1 based on TVTP–MSM results.

the current Greek debt crisis, through inflationary expectations as in the EMS currency crises or through investor confidence as in
the asset bubble as in the 2000 dot-com crisis. We have shown that, besides the economic fundamentals, such expectations are an
important factor for the occurrence of a crisis. Whenever expectations are not fundamentals driven, the CTP–MSM model should
provide better estimates.
Market expectations can contribute to the occurrence of a crisis that would not have taken place if such expectations could
have been prevented at first place. Some examples of such self-fulfilling expectations are the collapse of a fixed exchange rate
regime, the burst of an asset bubble, the failure to service the debt, or a bank run. Thus there is good reason to take preventive
measures before it is too late. However we have shown that self-fulfilling expectations are more like sunspot behavior, they are not

Fig. 10. CTP–MSM with regime dependent coefficients simulation results. Estimated SPI based on CTP–MSM with regime dependent coefficients results.
 U. Tamgac / International Review of Economics and Finance 20 (2011) 44–58 57

Fig. 11. CTP–MSM with regime dependent coefficients estimation results. Estimated SPI and smoothed transition probability of regime 1 based on CTP–MSM with
regime dependent coefficients results.

fundamentals driven. Thus it may not be possible for a country to prevent self-fulfilling expectations, just as it cannot control
external factors. However it is possible to reduce domestic vulnerabilities that might aggravate the impact of negative external
shocks and give rise to self-fulfilling behavior.

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