Perspective Paper on Financial Instability

Financial instability is a major problem for the world's middle-income developing countries. Barry Eichengreen's proposal for dealing with the problem treats currency mismatches--the fact that developing countries borrow in dollars instead of their own currency--as the principal cause. I argue that institutional flaws, with monetary and fiscal policy for example, drive financial instability and also account for countries' inability to place local-currency denominated debt contracts. Since weak institutions are to blame, efforts to help countries build stronger institutions will likely yield greater benefits than narrow attempts to address currency mismatches per se.