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A great many features of the current international financial system have a significant bearing on international capital flows. Thus, proposed reforms of this system can generally be expected to affect the scale and character of these flows. The survey in this chapter concerns policies which have been at the centre of discussion since the East Asian crisis of 1997 but even so it is not comprehensive. This chapter reviews major features of developing countries' experience of external financing since the 1960s, paying special attention to shifts in the relative importance of private capital inflows and to their volatility. It contains a schematic account of the features of financial instability and crises, which is intended to serve as a backdrop for the policy discussion which follows and covers a selection of the policies. The policies in question include actions to be taken at both national and international levels as well as combinations of the two.

The gold standard is conventionally portrayed as synonymous with financial stability, and its downfall, starting in 1929, is implicated in the global financial crisis and the worldwide depression. A central message of this book is that precisely the opposite was true: far from being synonymous with stability, the gold standard itself was the principal threat to financial stability and economic prosperity between the World Wars I and II. To understand why, it is necessary first to appreciate why the interwar gold standard worked so poorly when its prewar predecessor had worked so well, next, to identify the connections between the gold standard and the Great Depression, and finally, to show that the removal of the gold standard in the 1930s established the preconditions for recovery from the Depression. These are the three tasks undertaken in the book (which is arranged chronologically), and they are summarized in the sections of this introductory chapter.

During the 2007 economic crisis, the various defenses against global recession and worldwide financial instability appeared to be very strong. As such, developing and developed economies agreed that during this period, markets were more efficient than governments in fostering stable growth and in providing consumers with better deals in terms of price, choice, and quality. The central bankers of the world all agreed on the most appropriate regulatory measure in which institutional failure risks are lessened, and financial instability is not passed on from country to country. Financial crises usually initiate from seemingly insignificant market misfortune. Although the crisis was experienced throughout the world, it was mainly rooted in the United States, the United Kingdom, and regulations.

This chapter looks at financial crises as a challenge to the international financial system and investigates the “public bad” nature of the phenomenon. The conclusion: excessive financial volatility is a global public bad. Instability is not purely a technical by‐product of the production of financial services. Rather, it is the outcome of market failures, for reasons not yet fully understood. Having laid out this diagnosis, the chapter looks at how existing institutions and policies deal with international financial instability, both to limit its acuity and to deal with its implications. The main emphasis is on drawing lessons from recent experiences (Europe, Mexico, and East Asia) and recent theoretical advances, especially those that have improved our understanding of crises. The chapter presents five main proposals. (1) Proceed with caution in promoting capital liberalization; (2) avoid the restrictive macroeconomic policies, huge loans, and deep structural policies of recent packages; (3) complement today's ex post conditionality with ex ante conditionality; (4) suspend debt repayment in the event of a major crisis accompanied by a collapse of the exchange rate; and (5) end the monopoly of the International Monetary Fund (IMF) by creating regional IMFs.

The question is how the advent of electronic money affects the size of optimal currency areas. In particular, we study whether currencies of small countries will tend to disappear as a result of electronic money. The three major forces that will be at work during the transition to a cashless society have different implications for the question at hand. These forces are (a) raising the potential for financial instability during the transition, (b) giving rise to new monetary network externalities that affect the costs and benefits of national media of exchange, and (c) leading to the emergence of new stores of value.

This chapter examines whether or not monetary policy should respond to asset price bubbles. More specifically, it asks how central banks respond while an asset bubble is growing and how they respond after the bubble bursts. It begins with a general overview of asset bubbles that supports the existence of the real and financial sectors of an economy before discussing how the bursting of asset price bubbles may cause financial instability that often adversely affects the real sector of an economy. It then describes the normative vs. positive responses of a central bank to asset price bubbles, along with the concept of macroprudential regulation as an approach for leaning against asset bubbles. It argues that the high costs associated with the 2007–2009 financial crisis undermined the so-called Jackson Hole Consensus and that the new central bank policy paradigm appears to have shifted toward “leaning against bubbles”.

This chapter explains the nature of endogenous financial crises by drawing on an alternative approach offered by Hyman Minsky, with particular emphasis on his understanding of the incentives of speculators and of financial cycles in relation to Frank Knight and John Maynard Keynes's stress on uncertainty. It discusses the main assumptions of Minsky's financial instability thesis, including the view that fragility grows over the extended period of prosperity as risk is rewarded, leading to the taking of greater risk. It also considers the “Minsky Moment,” when an overleveraged system encounters financial difficulties, along with the high cost of free financial markets. It suggests that debt-driven fiscal policy was not effective in rectifying the distortion to the economy caused by finance when the long-running accumulation by financialization faltered.

This chapter focuses on the financial instability that results from the bursting of asset price bubbles. It first defines the micro- and macroprudential perspectives before suggesting that the safeguards against financial instability can be improved by moving beyond microprudential regulation and taking into account the cross-firm interconnections and externalities that arise when financial institutions encounter problems. It also stresses the need to strengthen macroprudential regulation for financial supervision.

It is the goal of this chapter to articulate the purpose of this book and describe its contribution to the current literature on financial crises. The chapter argues that the complexity of the global financial crisis challenges researchers to offer more comprehensive explanations by extending the scope and range of their traditional investigations. The volume views the financial crisis simultaneously through three different lenses—economic, psychological, and social values. In this respect, what sets the volume apart is its discussion of what has gotten overlooked in the debates about the crisis, and how narrow framing, as opposed to a multidisciplinary methodology, has impacted social discourse about financial instability.

The optimal level of the capital stock occurs when the real interest rate equals the steady-state growth rate of the economy. Any factor that drives a wedge in this equality can cause prolonged economic dislocation and a misallocation of resources. The more prolonged the dislocation the greater the threat to financial stability. Economic dislocation drove misalignments in asset prices, but had particular effects on property markets in some of the peripheral countries that adopted the euro: Spain, Portugal, Ireland and Greece. The factor driving the wedge in these countries stemmed, firstly, from the dynamics that arose from the fact that these countries were coming from backgrounds of lower standards of living and price levels than those in the core of monetary union and, secondly, from the fact that the ECB's monetary policy bestowed low nominal interest rates on these peripheral countries. Hence real interest rates were very low relative to these countries’ high growth rates. The chapter's measure of economic dislocation can account for the financial-instability-induced output loss. There is a significant relationship between this measure and subsequent output loss both in the euro area and in a wider sample of 57 countries.