The second driver shaping financial development policy thinking in the region has been the onslaught of recurring financial crises and, in particular, the policy lessons that emerged from the _hermeneutics of financial crises_ .<sup>11</sup> To illustrate this, we briefly discuss three major lessons and the associated policy prescriptions that flowed from the process of interpreting and reinterpreting financial crises.

First, recurrent crises confirmed that _poor macroeconomic fundamentals are particularly dangerous in open financial systems_ . This central lesson was conceptually enshrined in the so-called first generation models of financial crises.<sup>12</sup> Krugman’s seminal 1979 article on balance of payments crises paved the way in this regard and was followed by an avalanche of theoretical work that clarified the dynamic processes whereby fundamental imbalances can set the stage for a sudden attack on the currency or the banking system. This type of attack is deterministic, in the sense that it anticipates the inevitable (i.e., the devaluation of the currency or the collapse of the banking system will come with or without the attack), even if its exact timing is difficult to predict and is not associated with appreciable changes in fundamentals.<sup>13</sup> Subsequent empirical work (e.g., Kaminsky and Reinhart, 1999) found that a deterioration in fundamentals preceded financial crises in most countries. This led to efforts to identify early warning indicators that could signal in advance the probability of a financial crisis and could, thus, allow policymakers to take countermeasures to avert it.

In all, a first and enduring lesson of financial crises was that financial openness dramatically raises the importance of strong liquidity and solvency (fiscal and financial) positions. The associated policy prescription was thus to avoid bad macro and financial policies that generate imbalances. In particular, the policy advice was to closely monitor certain indicators that have been empirically found to precede financial crises— fiscal/external disequilibria, real exchange rate overvaluation, large amounts of short-term debt, rapid money printing and accelerating inflation, fast credit growth, and real estate price bubbles, among others. Such an early detection of problems would have to be followed by the earnest adoption of preventive actions.

A second lesson that financial crises drove home was that such phenomena as _multiple equilibria, self-fulfilling attacks, and contagion are not just theoretical curiosities; they are real threats_ , especially as domestic financial markets become exposed to large flows of international capital and to investors that can diversify risk across countries. Again, these phenomena received significant theoretical attention in the so-called second generation

> 11 Latin America was the region with the highest incidence of banking crises during the 1974-2003 period.  The 1990s and early 2000s constituted a particularly turbulent period for the region, with many twin (currency and banking) crises, including Venezuela 1994, Mexico 1995, Brazil 1999, Ecuador 1999, Argentina 2001, Uruguay 2002, and Dominican Republic 2003.  See Caprio and Klingebiel (2003) and IADB (2004).

> 12 A succinct but lucid discussion of models of financial crises is found in Eichengreen (1999).

> 13 In this connection, see also Dooley (2000), who argues that, where there is fear of floating, international reserves provide a “double guarantee,” for bank deposits and the currency, which heightens the country’s vulnerability to runs engineered at a time where there are no perceptible changes in fundamentals by agents that, to avoid capital losses, anticipate the inevitable.  See also Aghion, Bacchetta, and Banerjee (2001) and Burnside, Eichenbaum, and Rebelo (2001).

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