The Case for Prudent Financial Liberalisation and its Policy Implications

It is interesting that there is a recent econometric literature showing that financial crises are often preceded by booms of capital flows (for example Agosin and Huaita, 2012 and Borio, 2012). In the case of Latin America, net capital flows during the pre- 1980’s debt crisis years (1977-1981) reached 4.5% of GDP annually (Ffrench-Davis and Griffith-Jones, op cit.). It is important to stress a somewhat neglected fact that capital flows (in this case mainly intra-European ones) have played a major role in the origins of the recent European sovereign debt crisis. Indeed, it is not often emphasized that in Europe capital flows were numerically larger than in Latin America. Thus, in Greece, the cumulated capital flows grew from around 30% of GDP in early 2002 to around 80% of GDP in early 2008 (almost 10% of capital flows as proportion of GDP annually). In Spain this stock grew from just over 20% of GDP in early 2002 to 60% mid 2008, around 7% of capital flows as proportion of GDP annually, with similar increases reported for Portugal (Pisani-Ferry and Merler, 2012, based on Eurostat data).

From this comparison, it can be seen that capital flows were on average higher to the periphery European countries during the 2002-2008 years then they were to Latin America in the 1977-1981 pre-debt crises years. These massive capital flows were accompanied in Europe, as they had been previously in Latin America, by very low spreads as lenders and investors massively under-estimated risk. As crises started in both cases, spreads either shot up, often to unsustainable levels, or credit rationing occurred so that countries became unable to raise new funds or loans.