Abstract

Throughout the 1990s and into this century, analysts have failed to predict the emergence of major financial crises in Latin America. From the Mexican peso crisis of 1994 to the Argentine convertibility crisis of 2001, most analysts have focused on identifying possible threats to or weaknesses of an economy using current situation analysis techniques that in one way or another measure the strength of an economy to overcome probable risks. The problem is that the globalization of financial markets has exponentially increased the possible sources for macroeconomic shocks, making it very difficult to accurately analyze the risk of financial crises based on identification of probable threats.

The dynamics of today's international financial markets call for a new type of analysis: one that does not try to predict future events, but looks at the capacity of countries to deal with an unknown future—that is, a policy flexibility analysis approach that helps us determine the ability of governments to act in order to pre-empt or prevent future financial crises. Political variables-such as the balance of political forces, actors, and institutions that determine the degree of flexibility for action a government enjoys to shape and operate its fiscal and monetary policies—are key in anticipating a country's capacity to react positively and effectively when facing events or surprises that threaten its financial stability. By looking at the capacity of a government to act when confronted with a negative event, we can focus our analysis and understand not only the weaknesses of a country, but also how those weaknesses can be mitigated. A policy flexibility framework allows us to move from an analysis of economic capability to one of political capability.

What governments do or fail to do politically, and the steps they take or fail to take institutionally, determine the country's ability to pre-empt or prevent a crisis. An analysis of both the Mexican crisis of 1994 and the Argentine crisis of 2001 confirm the existence of a set of political factors that limited government action.

In attempting to accurately predict upcoming crises, we are better served not by looking at financial risk in terms of identifying threats or considering the strength of a country's “financial armor,” but by analyzing a country's capability and will to implement time-sensitive (and process-limited) reforms to prevent or pre-empt a crisis.