Will the economic crisis in East Asia have a silver lining? That depends on whether the blame is ultimately placed on unregulated capitalism run amok or on the failure of interventionist policies. The current mess can act as a prod for beneficial reforms, but only if advocates of free markets place the blame where it belongs.

First, let’s be clear that the “Asian miracle” was not a mirage — it really happened. Over the course of a single generation, per capita income has multiplied many times over, life expectancy has soared, and poverty levels have dropped sharply. Although times are rough now, that historic transformation has not been reversed. It stands as a continuing testament to the creative power of relative economic freedom: low taxes, decent respect for property rights and openness to the world economy.

Still, as the saying goes, mistakes were made. The details differ for each country, but as a general matter the Asian economic mess is attributable to three different kinds of policy (not market) failure: (1) mismanaged exchange rates, (2) backward and closed financial systems, and (3) reduced punishment for bad investments provided by an IMF safety net. Admittedly, there is probably also a herd instinct during boom times that leads investors to overrate the quality of investment opportunities. But that human foible alone could not have produced the present calamity; the herd was driven over the cliff by egregious policy errors.

The countries that have experienced currency collapses — Thailand, Indonesia, Malaysia and Korea most prominently — all tried to maintain independent monetary policies while at the same time pegging their exchange rates. Like Mexico before them, they have learned a cruel lesson: you can’t do both indefinitely. Over the long term, you must either give up monetary policy and adopt a currency board (as Hong Kong and Argentina have done), or you must give up the peg and let your currency float.

If East Asia is to resume its miracle, its only option is to move further in the direction of free markets. The region must abandon manipulation of exchange rates; it must allow competition to sweep through and transform its financial sectors.

By maintaining untenable exchange rates, those countries encouraged banks to borrow short term in foreign currency and lend long term at home. From the banks’ perspective, taking advantage of the big spread between foreign currency and local currency interest rates was like printing money — as long as the exchange rate held. When it didn’t, the debt levels became crushing — and the rest is history.

At a deeper level, East Asian countries are suffering from dysfunctional financial sectors. The economic crisis is fundamentally one of malinvestment: those wonderful Asian savings rates have been squandered on unneeded factories and office buildings. And the malinvestment comes from overreliance on politicized and uncompetitive banks. Banks have been shielded from foreign competitors, as well as competition for capital from securities markets, and then used as slush funds for the powerful (though not necessarily the creditworthy). In hindsight, it’s a wonder Asia’s financial crackup didn’t happen earlier. Glittering growth rates blinded us to the increasing rot in the system.

Fickle foreign money eventually exposed the rot. Foreign investors were attracted by the fat spreads in interest rates, and the possibility of an IMF bailout in case risky investment strategies failed allowed them to ignore the risks. I don’t know if anyone actually explicitly counted on IMF money if loans went sour; I am sure, though, that investors would have been much more cautious had they been forced to pay for their mistakes in Mexico.

Critics of free markets argue that unregulated international capital flows produce excessive volatility and therefore new capital controls are in order. While it is true that foreign money catalyzed the present crisis, inhibiting investment flows is no answer. Such a move may mask countries’ bad policies, but it won’t cure them.

If East Asia is to resume its miracle, its only option is to move further in the direction of free markets. The region must abandon manipulation of exchange rates; it must allow competition to sweep through and transform its financial sectors. The carnage of recent months makes clear that liberalization in the global economy is like riding a bicycle: if you don’t keep going forward, you fall down.