Lessons from Recent Financial Crises

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On September 30 through October 2, 1999, the Federal Reserve Bank of Chicago and the Bank for International Settlements (BIS) cosponsored a conference on Lessons from Recent Financial Crises at the Federal Reserve Bank.1 This was the third annual conference dedicated to international policy issues, following previous conferences cosponsored with the World Bank and the International Monetary Fund (IMF), respectively. Participants in the conference represented more than 25 countries.

In his opening remarks, President Michael Moskow, Federal Reserve Bank of Chicago, stressed the importance of fundamentals in protecting against financial turmoil. Ile likened a country's economy and infrastructure to the human immune system. When the immune system is strong, it is less susceptible to disease; however, in a weakened state, even minor concerns can pose a serious threat. During the conference, many argued that recent financial crises seemed to have been characterized by either a weakened system embodying weak institutional frameworks or a system overtaxed by massive international capital flows.

The conference began its comprehensive review of financial crisis with a discussion of the origins of financial crisis. In contrast to earlier conferences, which placed the blame on fixed exchange rate regimes, crony capitalism, and high short-term debt, this conference also focused on additional elements, such as the volatility of international capital flows, floating exchange rates, and weak institutions. Ricardo Hausmann, Inter-American Development Bank, and Masayuki Matsushima, Bank of.japan, cited the Latin American and Asian experience to cast doubt on the viability of floating exchange rate regimes. They argued that recent crises have shown that even under a floating exchange regime, a country with strong economic fundamentals can suffer adverse effects. While such a system protects against rampant speculative attack on the national currency, a floating exchange rate regime leaves an economy vulnerable to financial contagion.

Matsushima said that the democratization of capital flows, characterized by the financial and technological shift that has allowed organizations and individuals to move huge amounts of capital quickly and cheaply all over the world, was at the source of the Asian crisis. Financial contagion was transmitted from one country to another as a result of large foreign capital flows. These capital flows, which can be subject to herd behavior, left emerg@ ing economies vulnerable. The potential impact of these capital flows is leading many economists to look beyond stringent macroeconomic policy prescriptions, to strategies that foster international coordination of capital flows.

Mark Medish, U.S. Department of the Treasury, argued that the answers to resolving financial crisis lie in the basics of market enterprise. He said that a basic framework of economics, accounting, and law is required for economic growth and recovery to take root, noting that "Corruption and lawlessness are the quiet killers." Market reformers like those in Poland have been more successful with respect to economic growth than those in countries like Ukraine, which have been resistant to change. However, other examples raised questions about the value of such reform for developing countries. Countries such as Egypt, India, and China, where gradualists have prevailed, have avoided financial crisis. While economics 101 extols the benefits of the market, the recent experiences of reformers in countries in financial crisis have forced many to question the wisdom of Adam Smith. Medish addressed these seeming inconsistencies by proposing that the benefits of reform must be measured over time. Isolationism and protectionism may temporarily insulate countries from crisis, but they do so at a high cost, as these countries cannot benefit from the long-term gains that foreign capital and globalization have to offer.

Review of policy responses to crisis Invariably after a period of crisis, the policy responses to the crisis come under evaluation. …