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As the ravages of the subprime crisis that started in 2007 and became fully evident in 2008 are sinking into the collective conscience, the self-assertiveness that dominated the developed market economies (DMs) is fading away, and giving rise to a nagging sense of insecurity. Prior to 2007, financial crisis episodes in emerging market economies (EMs) had already shown that both saints and sinners could be casualties. The Asian Tigers, the paragon of good macro policy, suffered major setbacks in 1997, a crisis that was followed by an even more disconcerting one: the Russian 1998 crisis, which spread its wings all across the EM landscape. Nonetheless, these episodes were discounted by DMs under the presupposition that their economies had much stronger financial institutions and the fact that they had enjoyed a high degree of macroeconomic stability since the 1980s (which included a period called the Great Moderation).
That was then. The subprime crisis that started in 2007 has changed economists’ views in a radical way. There is now no major disagreement that a key source of trouble in the current episode is the financial sector’s dysfunctionality, possibly induced by populist policies and institutions such as Fannie Mae (e.g., see Calomiris 2009). As the narrative goes, financial excesses were eventually revealed by problems in the subprime mortgages’ market, which gave rise to a massive liquidity crisis and a flight to quality—the latter taking the form of excess demand for “hard currencies” (also called safe currencies in this book), a phenomenon that is usually labeled liquidity trap.1Close These concepts are only now being subject to rigorous analysis.
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