The effectiveness of self-protection policies for safeguarding emerging market economies from crises

The recent financial crises in emerging markets have motivated a number of proposed measures that might regulate or provide protection against readily reversible external capital flows. Possible reforms include the adoption of self-protection policies by developing countries that augment traditional macroeconomic and financial sector measures for preventing crises. One set of proposals seek to enhance the liquidity of governments during a crisis, while other proposals seek to reduce exposure to short-term external debt. This paper analyzes some major proposals for self-protection using alternative models of the causes of financial crises in open economies. The effectiveness of liquidity enhancing measures and of capital controls for crisis prevention is shown to depend upon the alleged underlying cause of potential crises. It is also possible that liquidity enhancement could be counterproductive. The economic impact of recent crises on afflicted countries has led some economists to question whether the benefits of capital account liberalization outweigh the costs of exposure to greater volatility in real economic performance. A simple approach for comparing, in simulation, the benefits of capital account openness to the costs of exposure to financial crises is discussed in the first part of the paper.