Economic Volatility and Capital Account Liberalization in Emerging Countries

Korkut Erturk

International Review of Applied Economics, 2005, vol. 19, issue 4, 399-417

Abstract: Economic volatility has increased drastically in the age of financial liberalization. The tendency among mainstream economists has been to explain this trend by government misdeeds and various market imperfections. For instance, government overspending was the main culprit in the first generation models of currency crises. Following the Asian crisis the emphasis shifted onto capital flow reversals, and arguments based on the 'moral hazard' problems began to replace the emphasis on the monetized government deficits. This paper outlines an explanation of economic volatility that is not based on moral hazard problems or other market distortions. Two stylized facts associated with the aftermath of financial and capital account liberalization are singled out for emphasis and brought together in the context of a macroeconomic framework that draws from Keynes' Treatise. These are: (i) liquidity preference becomes intertwined with currency substitution, producing a macroeconomic destabilizer that explains procyclical changes in bank credit independently of moral hazard problems; and (ii) asset prices become fairly easy to predict, stimulating destabilizing 'trend' speculation by foreign investors, which means that profit seeking and market rationality might lie behind erratic shifts in capital flows.

Keywords: Economic volatility; financial liberalization; currency crises; capital flows; asset price speculation (search for similar items in EconPapers)
Date: 2005
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DOI: 10.1080/02692170500208475

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