Introduction and Motivation

Financial instability matters. Table 5.1, drawn from Dobson and Hufbauer (2001), shows some representative estimates of annual average output losses per year from currency and banking crises. Losses like these are of first-order importance. 2.2 percentage points of growth per year – which is what Latin America lost as a result of financial instability in the 1980s – makes incomes and living standards two-thirds higher in a generation. Raising per capita incomes to this extent transforms a society's living standards, providing the resources to address critical social problems. For developing countries as a class, Dobson and Hufbauer's estimates suggest that since 1975 financial instability has reduced the incomes of developing countries by roughly 25 percent. Back-of-the-envelope calculations like these can reasonably be questioned. But they nonetheless show how profoundly financial instability matters.

Economies without financial markets cannot have financial crises. This is a pointer to what sorts of countries suffer most from financial instability. Generally, these are not the poorest countries, which have relatively rudimentary financial markets. In these countries, households are only loosely linked to the financial economy and feel only indirect effects when financial markets malfunction or collapse. It is in the next tier of developing countries and emerging markets where the costs of financial instability are greatest.

Thus, ameliorating problems of financial instability may not meet the immediate needs of the poorest countries.