The role of government in international financial crises

The impoverishment caused by broken promises on the part of governments that fail to protect private property rights, enforce contracts, and limit taxing and spending to prudent levels is evident in the increased frequency of financial crises in emerging market economies, says James Dorn.

Argentina's default in December 2001 and the Brazilian crisis in 2002 are the latest examples of how bad government polices can undermine confidence and destroy wealth.

To contain and prevent such crises requires that governments pursue transparent pro-market policies that cannot easily be reversed. There must be a long-term commitment to free trade, the rule of law, and sound money management; otherwise global investors will take their capital elsewhere.

Charles Calamiris, professor of economics at Columbia University, presents five policy lessons learned from the Argentine and Brazilian debt crises:

  • Fiscal policy ultimately shapes monetary policy in emerging market countries without a credible central bank; debt monetisation is always a danger.

  • Without political stability, there is no guarantee of banking stability even in a well-regulated banking system; in time of crisis, the net value created by safe and sound banking practices can be confiscated by government officials.

  • The International Monetary Fund should not try to prevent government defaults on debts; bailouts provide the wrong incentives and prevent market solutions.

  • The extent of economic freedom is a more meaningful measure of an emerging market country's debt capacity than the ratio of debt to gross domestic product.

  • Bad policies in one emerging market country can adversely affect another emerging market only if similar policies are followed in both countries.

    The United States and other developed countries can help emerging market countries by following sound fiscal and monetary policies and by opening markets more fully to the developing world.

    Source: James Dorn, International Financial Crises: What Role for Government? Cato Journal, Spring/Summer 2003, Cato Institute.

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    FMF Policy Bulletin\2 December 2003
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