to firms or individuals as a result of government directive, rather than on a commercial basis. all these developments often take place against a background of limited transparency, where investors and depositors have difficulty monitoring the capital adequacy of individual banks. there appear to be no problems during the initial phase of rapid economic growth and rising asset prices, but doubts begin to arise when asset prices fall. the recognition that some banks ( and companies ) have become insolvent is difficult enough in sophisticated capital markets, but is harder again where there is little necessity to revalue assets and disclose the results. bank supervisors, as well as market participants, are thwarted by the lack of transparency. inevitably, insolvent entities continue to operate, and there is widespread distrust of all banks because lenders and depositors cannot distinguish between creditworthy and insolvent institutions. as a result of the presence of type ii economic crises, it is now recognised that governments require improved policies directed at financial system stability. within this general field of policy, the one that has the most direct relevance is the prudential regulation of banks. this includes both preventative measures and crisis resolution. but prudential supervision of banks is only one policy, although an extremely important one, among the range of policies that are required to achieve reasonable financial stability. other important policies are those that pertain to the payments system and, of course, the whole field of securities regulation, including disclosure provisions and the enforcement of commercial and criminal law. in fact, it is possible to consider the whole body of law relating to claims over property and accountancy standards as being part of the necessary infrastructure for system stability. 4. relevance for australia it is being increasingly recognised that, in the modern world, the most likely route to a self - inflicted economic crisis or, at its extreme, an economic collapse is through a systemic failure of the banking system. therefore, in order to get good economic outcomes in terms of sustainable economic growth, we need more than just good monetary and fiscal policies. we need good policies directed at financial system stability, including, of course, good prudential supervision of banks. there is a close inter - relationship between monetary policy and policies that affect the stability of the financial system. while the principal aim of monetary policy should be to maintain low inflation as a pre - condition for sustainable growth, it cannot be conducted in isolation from developments in the financial system. for example, how far interest rates need to be raised to bring about

although it has become common in the past decade in a wide range of countries, the best examples at present are to be found in asia. type ii economic crises are not caused primarily by bad fiscal policy or bad monetary policy. one of the reasons i have a lot of sympathy for the asian countries at the moment is that they did not get into their present trouble through undisciplined fiscal policy, and their monetary policy in the conventional sense1 was quite good. this is shown by the fact that their budgetary positions are on average much better than oecd economies, and most have inflation rates that are quite low for developing countries. a type ii crisis is really financial in nature, rather than stemming from poor macro - economic policies. its central dynamic is the credit cycle and the main players are companies and banks, or financial institutions more generally. a type ii crisis usually traces its roots to a period when the economy was doing well, growing quickly and becoming popular with investors and lenders. usually, but not always, 2 an inflow of foreign capital is part of the process which bids up asset prices ( and attracts more foreign capital ). domestic banks do not sit idly by - - they join in to 1 conventionally loose monetary policy in a type i sense would involve monetisation of the budget deficit, low ( or negative in real terms ) interest rates, continual downward pressure on the exchange rate and rising inflation. in most asian countries over the past decade, these conditions did not apply ; in fact, the opposite was more typically the case. on the other hand, monetary policy was not tight enough to prevent the strong expansion of the balance sheets of the banks. such a degree of tightness would not have been compatible with the maintenance of a fixed exchange rate. 2 japan in the 1990s is a classic drawn - out type ii episode, but one in which foreign capital played only a minor role. lend money for all sorts of promising projects and asset purchases. if the economy is growing strongly at the time, which it usually is, it looks as though everyone can make money. some of the finance is invested wisely and makes a good return, but much of it is inevitably invested unwisely. a lot of it goes into property or is invested in industries which are already oversupplied. at some point, something happens and the whole process goes into reverse. in the case of south east asian countries, the event that triggered the reversal was the realisation that