The South Korean financial crisis: competing explanations and policy lessons for financial liberalization

There are two types of explanations of the Asian financial crisis: the 'fun damentalist', which focuses on macroeconomic imbalances; and the 'self-fulf illing', which ascribes the crisis to beliefs. This article argues that whi le both have some merit in explaining the Korean crisis, neither fts the fa cts very well. The authors put forward a new explanation which emphasizes t he role played by financial liberalization and the structural weaknesses in the banking system. They explain that the combination of these factors cre ated conditions that made the Korean banking system vulnerable to the senti ments of foreign investors, simultaneously eroding the ability of the Korea n central bank to act effectively as a lender of last resort. The authors e xamine how various policy mistakes aggravated the crisis and draw some conc lusions that may be useful for other emerging market economies.