Policy conclusions

The model in this and the previous chapter provide simple and tractable frameworks for analyzing financially based crises in economies which are at an intermediate level of financial devel­opment.

Second, policies allowing firms to rebuild their creditworthiness quickly will at the same time contribute to a prompt recovery of the overall economy. In this context it is worth considering the role for monetary policy and, more generally, for policies affecting the credit market. While our model in its present form cannot be directly used for analyzing monetary policy since money is neutral in this model (and in any case the interest rate is fixed by the world interest rate), it can be extended to allow for both monetary nonneutrality and a less elastic supply of foreign loans. This is what we do in the next chapter (based on Aghion et al. 2000,2001).

This emphasis on creditworthiness as the key element in the recovery from a slump, also suggests that a policy of allowing insolvent banks to fail may in fact prolong the slump if it restricts firms' ability to borrow (because of the comparative advant­age of banks in monitoring firms' activities¹¹).

Third, our model also delivers ex ante policy implications for emerging market economies not currently under a financial crisis. In particular: (i) an unrestricted financial liberalization may actu­ally destabilize the economy and engender a slump that would otherwise not have happened. If a major slump is likely to be costly even in the long run (because, for example, it sets in pro­cess destabilizing political forces), fully liberalizing foreign capital flows and fully opening the economy to foreign lending may not be a good idea at least until the domestic financial sector is suffi­ciently well developed (i.e. until the credit-multiplier μ becomes sufficiently large); (ii) FDI does not destabilize. Indeed, as we have argued above, FDI is most likely to come in during slumps when engage in preemptive lending to speculators in domestic inputs and/or to produ­cers during booms. This in turn will further increase output volatility whenever inadequate monitoring and expertise acquisition by banks increases aggregate risk and therefore the interest rate imposed upon domestic producers.

¹¹ See Diamond (1984).

the relative price of the country-specific factor is low; furthermore, even if this price ends up fluctuating when the economy is open to FDI, these fluctuations will only affect the distribution of profits between domestic and foreign investors but not aggregate output. Therefore there is no cost a priori to allowing FDI even at low levels of financial development;¹² (iii) what brings about financial crises is precisely the rise in the price of the country specific factors. If one of these factors (say, real estate) is identified to play a key role in sparking a financial crisis, it would be sensible to control its price, either directly or though controlling its speculative demand using suitable fiscal deterrents. This, and other important aspects in the design of stabilization policies for emerging market eco­nomies, await future elaborations of the framework developed in this chapter.

¹² This strategy of allowing only FDI at early stages of financial development is in fact what most developed countries have done, in particular in Europe where restrictions on cross-country capital movements have only been fully removed in the late 1980s, whereas FDI to—and between—European countries had been allowed since the late 1950s.