Preventing Financial Crises
In a now famous, but initially ignored, paper published in 1985, “Good-Bye Financial Repression, Hello Financial Crash,” Latin American economist Carlos Diaz-Alejandro was way ahead of his time in warning of the dangers of financial globalization.1 As the recent experiences of Mexico, South Korea, Argentina, and many other countries have shown, financial globalization does not always work for emerging market countries. Without proper implementation and management, financial liberalization can lead to financial crises with disastrous and often long-term consequences for the economy. Can emerging market countries avoid these crises and reap all the potential benefits that financial globalization has to offer? Our understanding of how globalization can go wrong suggests a number of basic principles for financial reform that can promote stability while avoiding crises.
Banks are the main institutions that gather and process information about the financial state of businesses and households and that solve the asymmetric information problems (moral hazard and adverse selection) in the financial markets. Deterioration in banks' balance sheets, caused by the proliferation of bad loans and declines in net worth, can lead to banking crises in which banks cut back sharply on lending, financial information is not collected, and asymmetric information problems intensify. Banking crises, if severe, bring on financial crises. Problems in the banking sector also make a foreign