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which markets can be relied upon and those in which they cannot. Critics might argue that in the case of crises the market inefficiencies are so large that they simply can’t be ignored, but they are likely present at other times as well (Greenwald and Stiglitz, 1987).
    More broadly, however, the models that we have delineated in this paper provide a rationale for such exchange rate interventions. Markets with rational expectations but imperfect and asymmetric information are typically not efficient; even more so if markets are subject to irrational pessimism. Then the effects of such irrationalities (even if relatively small) can be large and persistent; markets may exhibit excessive volatility, and there can be real benefits to government efforts at stabilisation.
    Optimal Financial Architecture
    Stiglitz (2000, 2002, 2006, 2010b, 2010c) analyses the optimal design of international financial architecture given both the benefits of financial integration in achieving diversification and smoothing of negative consumption shocks and the costs of adverse spill-overs across markets due to financial contagion. Financial integration raises the overall risk of spill-overs of large negative shocks (Stiglitz, 2010c). Stiglitz (2010b) examines the trade-off between contagion and diversification associated with open capital markets in a risk-sharing context. He shows that risk-sharing arrangements can become a negative-sum game in the presence of bankruptcy costs and other commonly accepted financial market frictions. In the absence of such frictions, diversification achieved through risk-sharing arrangements benefits risk-averse investors and consumers. However, a number of plausible market frictions can set in motion a financial accelerator effect that leads the initial shock to gain magnitude and persist. With bankruptcy costs, full diversification may result in lower aggregate output (net of such costs), so much lower that it more than offsets the benefits from diversification. Capital market integration could increase, instead of lower, the likelihood of a financial crisis in a given economy. Even if risk sharing does not initially increase the likelihood of a crisis but only increases the probability of a near-crisis state, the resulting increase in borrowing costs accounts for trend reinforcement, which raises the odds of a crisis in the long run. 21
    One analogy is with fuller integration of electricity grids, which saves on generating capacity but increases the risk of a broader systemic failure. In practice, well-designed electricity networks make use of circuit breakers. In international finance capital controls serve as such circuit breakers.
    If well-designed capital controls could be incorporated to prevent contagion during crisis episodes without compromising the risk-sharing benefits of integration, integration would always be preferred. However, designing and implementing such a mechanism is very challenging in practice. Therefore, the choice of integration depends on the likelihood of a large shock (and ensuing systemic failure) relative to the level of country-specific risk and the costs associated with variability. Moreover, the types and severity of informational and other frictions present in different countries must be considered for a complete assessment of the trade-offs and benefits of capital market integration.
    In their analysis of the Asian financial crisis, Furman and Stiglitz (1998) 22 and Stiglitz (2004) argue that while the adverse events affecting East Asian economies were at least to some extent exogenous (irrational investor perceptions, sudden changes in investor willingness to bear risk, interest rate increases in industrialised countries), the rapid liberalisation of capital flows and integration of domestic markets into global financial markets in the absence of a sound bank supervisory and regulatory framework contributed to the severity of the crisis. They find evidence that rapid growth in