by Nancy Birdsall and Michael Gavin

First, we know today that policymakers cannot look to capital controls and financial repression to insulate an economy from external shocks. Several years ago, observers were blaming the "tequila crisis" of 1994-1995 on the lack of such controls and excessive financial liberalization in Mexico and Argentina. They contrasted Latin America unfavorably with Asia, where many countries restrict both foreign capital flows and the activities of domestic financial institutions.

But in retrospect, it is clear that in countries like Korea, tight controls went hand-in-hand with implicit (if not explicit) promises of government support for local banks in bad times. These unspoken promises undermined market discipline and perpetuated a system that lacked the transparency and effective supervision that are essential to a market economy.

The result: subsequent deregulation, without that transparency, led to reckless lending by domestic banks and excessive borrowing by local companies, which made Korea vulnerable to the currency panic that originated in Thailand last summer.

Another popular view was that a high level of domestic savings would help hold financial crises at bay. Here again, observers pointed to the low level of domestic savings in Mexico and other Latin American countries as one of the roots of the "tequila crisis". In Asia, the comparatively high saving rate in most countries was said to furnish protection from financial shocks.

But as shown by the desperate situation of many high-saving South East Asian countries today, savings on their own do not make an economy crisis proof.

Finally, it has become clear that prudent fiscal policy is not enough to prevent financial contagion. This was already apparent during the tequila crisis, where both Mexico and Argentina were pursuing relatively sound fiscal policies. Likewise, Indonesia, Korea, Malaysia, Singapore and Thailand have all had fiscal surpluses in recent years, and the Philippines' estimated budget deficit in 1997 was less than one percent of GDP. Yet each of these countries has been pummeled by the current crisis.

Why did capital controls, high savings and sound fiscal policies fail to protect the Asian countries? The most obvious reason is the dangerous combination of a weak banking sector and lending booms. Encouraged by macroeconomic stability and rapid economic growth in the years prior to the crisis, domestic banks lent injudiciously, leading to overspending by the private sector. Government banking regulators and supervisors, who should have been "leaning against the wind" and preventing banks from offering too many loans, generally failed to do so.

A completely effective vaccine against external financial shocks probably does not exist in our increasingly integrated world. But the Asian crisis serves as a reminder that a fast-growing economy that looks healthy on the outside can harbor serious systemic problems that can only be identified and cured through rigorous banking regulation and transparent accounting practices.

--The authors are, respectively, executive vice-president of the IDB and lead research economist in the Office of IDB's Chief Economist.