A successful economy offers high yields and profits to international investors. If these investors can find ways to enter these economies, or if their entrance is facilitated by capital account liberalisation, they will rush in. This surge of capital inflows will affect key macro-economic variables. Exchange rates tend to become greatly over-valued; the prices of key assets - like shares and land - tend to rise significantly and quickly. As a result there is both an increase in real income (as imported goods become cheaper) and an increase in perceived wealth (as asset prices become at least temporarily higher). Banks tend to increase lending, lifting liquidity constraints. As a result of these factors, individuals consume more, hence private companies increase their investment.

The sum of these individual decisions has extensive macroeconomic implications. The current Balance of Payments account deteriorates, often quite rapidly, as both consumption and investment rise. Initially, this is not seen as a problem, as foreign lenders and investors are happy to continue lending, investing, or both, given high profitability combined with the perception of low risk, as they are going into what is broadly seen as a successful economy. Then, something changes. The change could be domestic or international. It could be economic or political. It may be an important change or a relatively small one. The key element is that this change triggers a sharp modification in perceptions, leading to a large fall in confidence in the economy among internationally mobile investors. These could be either foreign investors in the country or nationals able and willing to take their liquid assets out of the country, or both.

The fact that they first stop lending and investing and then pull out contributes greatly to making their worst nightmares come true. As a result, there can be much overshooting. Exchange rates can collapse, as can stockmarkets and property prices. Governments or central banks are forced to raise interest rates to defend the currency. As a result, banking systems become far more fragile than they were before, as previous weaknesses are magnified and new faultlines emerge.

Currency crises have punitive development costs. This makes preventing them absolutely essential. A condition for crisis prevention is that countries follow prudent macroeconomic policies. This is a necessary but not sufficient condition, in particular as capital surges distort key macroeconomic variables. It follows that additional measures are needed, nationally and internationally, to discourage excessive surges of potentially reversible capital flows. Recipient countries can tax short-term capital inflows without discouraging long-term flows. Chile's reserve requirements are one example. Even so, national measures may not be enough. Added international measures are required to discourage such surges, using levers like risk weighted cash requirements (see box ).