The East Asian financial crisis plunged the most rapidly growing and successful economies in the world into financial chaos and deep depression. At the time of writing, 18 months from its onset, neither the events them selves nor the appropriate policy responses are properly understood; but the outlines of a picture are becoming clear.
We see the Asian crisis – as many others do – as the outcome of a flawed process of financial liberalisation. But the trouble with that diagnosis is that it has often been served up accompanied by a rather loose list of mistakes, and buttressed by no very clear argument. Accordingly, the question which we set ourselves is a precise one: why was the crisis so bad? In other words, why did ‘crisis’ turn into ‘collapse’? Our answer to this question is that it was because of the inter-relationship between currency crises and financial crisis. Our argument proceeds in four stages, which are set out schematically in figure 2.1.
(1) We argue that vulnerability was created both by liberalisation in the presence of a bank-based financial regime (which contained implicit promises of bail-out if its balance sheet deteriorated), and by liberalisation in the presence of a monetary policy regime based on pegged exchange rates (which led to boom and bust). These vulnerabilities were interconnected, and led to a risk of currency and financial collapse (levels 1 and 2 in figure 2.1).