Introduction

The world has not seen a major financial crisis since Argentina's meltdown in 2001, but history tells us that the current period of tranquility is unlikely to last. The world's major central banks continue to raise interest rates in an effort to stave off a resurgence of inflation, and in the past, rising interest rates have often triggered financial difficulties for developing countries. Indeed, the upswing in volatility of emerging market asset prices this past spring provides a stark reminder that the specter of financial instability is never far away. The prospect of more turbulent seas ahead makes now a good time to review the lessons of the Copenhagen Consensus 2004 Challenge Paper on Financial Instability (Eichengreen, 2004).

In that paper, Barry Eichengreen identifies three types of financial instability: banking crises, currency crises, and twin crises (the simultaneous occurrence of a banking crisis and a currency crisis). He demonstrates that the cost of a financial crisis is large – approximately one percentage point of the gross domestic product (GDP) of a country – and proposes four possible policy solutions to the problem: (1) reregulation of domestic financial markets to address the problem of banking crises; (2) reimposition of capital controls to address the problem of currency crises; (3) creation of a single global currency; and (4) pursuit of an international financial engineering solution to the problem. Eichengreen estimates that the costs associated with each of the first two options outweigh the benefits.