Financial Liberalization and Price Stability

Abstract

Since the seminal works of McKinnon (1973) and Shaw (1973), the idea of financial liberalization for the development of the financial sector and higher economic growth has become an orthodoxy in academia as well as in international economic institutions. With the seal of approval, many developing countries followed, experimenting with their own economy. Yet most of the results so far have been puzzling. Instead of prosperity, the countries have found themselves in financial crisis and instability. They have been forced back to the repressive financial policy, regressing back to economies riddled with bankruptcies and lacking in capital. Observing these disappointing experiences, economists have tried to investigate the cause of failures and to provide new policy recommendations: there have been many studies on the experience of Southern cone countries' experiences (Corbo, de Melo and Tybout 1986; Diaz-Alexandro 1985; McKinnon 1982, 1986; Tybout 1986). These studies do not, however, provide an answer to the question on what would be an appropriate financial liberalization policy. The studies fall short of identifying the fundamental factors that drove the financial liberalization policy to end up with disastrous outcome.