Causes of Financial Crises

In the case of Argentina’s financial crisis of 2001, the blame for the country’s fourth crisis in two decades was heaped on the Government, for creating an unsustainable budget deficit. But as Hausmann and Velasco (2004) have pointed out, the lack of a sophisticated financial system in Argentina due to its being an emerging economy may not be the real issue at all. because just a few years earlier, its fiscal policies were being praised on Wall Street, for successfully privatizing, deregulating, linking its currency to the dollar and reducing inflation.Argentina’s crisis was precipitated by several events, including the crises in Brazil and Russia, which caused the economy to decline but with the large extent of the debt, the fiscal stimulation that could be undertaken by the Government was limited. (Allen and Gale, 2007). The root cause of the financial crises in Argentina may have been both (a) debt intolerance and (b) faulty institutions (Hausmann and Velasco, 2004). These authors point out that foreign borrowing is essential for emerging economies to invest in infrastructure and development that would take them years to achieve otherwise and debt intolerance cannot be faulted for financial crises. Improving institutions can also go only so far because even the best institutions will tumble if necessary pressure is applied.For instance, Hausmann and Velasco (2004) have cited the example of countries like France and Germany who violate the fiscal rules of the Maastricht Treaty, which they were responsible for writing because those rules were potentially costly to follow. In a similar way, Argentina’s institutions also collapsed when sufficient pressure was applied. These authors have argued that building better institutions in any emerging country if it must bear fruit, should be complemented with better development of international markets in emerging market currencies.