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An early draft of an oped that appeared in the Los Angeles Times, January 28, 1998.
J. Bradford DeLong
Professor of Economics
January 12, 1998
approx 980 words
"There's something wrong with our bloody ships today!" So the Rear-Admiral commanding the British Navy's battlecruiser squadron said upon watching a third of his ships explode at the Battle of Jutland.
Now we are watching the third international financial crisis in six years: the collapse of the European Monetary System in 1992, the unpleasantness surrounding the Mexican peso (that then spread to other Latin American currencies) in 1994-5, and now the East Asian financial crisis of 1997-8. One international financial crisis every two years is rather a lot. There's something wrong with our bloody economies today! But what? What should we have done differently? And what can we do now to fix things?
In both Mexico in 1994 and East Asia in 1997 at the root of the crisis is a sudden change of heart on the part of investors in the world economy's industrial core--in New York, Frankfurt, London, and Tokyo. In Mexico in 1993 international investors poured some $25 billion into the economy; in Mexico in 1995--even theough the peso had been devalued by two-thirds, every piece of property and every business in Mexico was thus three times cheaper, and the country was the same country--international investors took perhaps $10 billion out of the country. In East Asia in 1996 international investors poured perhaps $70 billion into the region's economies. In 1998--even though East Asian currencies have been lowered far enough to create some equally amazing bargains for those seeking long-term investments--we will be lucky if the net private capital flow is zero.
At the time the flood of capital out of Mexico was blamed on guerrilla uprisings in the south of Mexico, the lack of Mexican democracy, corruption of government officials by drug smugglers, and the absence of secure law and order. Now the flood of capital out of East Asia is blamed on crony capitalism, official corruption, over-extended banks, and an absence of honest and trustworthy corporate and government accounts.
But Mexico's ruling party was just as undemocratic (in fact, were more undemocratic) when capital was flowing in than when capital was flowing out. Drug smugglers bribing policemen, high-level corruption, banks making loans to the politically, the absence of trustworthy accounts, crony capitalism--all these were as salient and as troubling back when Mexico and East Asia were the darlings of the international capital market and places in which anyone who wanted to be surfing the leading edge of the wave of financial opportunity would place their money.
The root cause of the crises is a sudden change of state in international investors' opinions. Like a herd of not-very-smart cattle, they all were going one way in 1993 or 1996, and then they turned around and are all going the opposite way today. Economists will dispute which movement was less rational: Was the stampede of capital into emerging markets an irrational mania disconnected from fundamentals of profit and business, or is the stampede of captal out of emerging markets today an irrational panic? The correct answer is probably "yes"--the market was manic, it is now panicked, and the sudden change in opinion reflects not a cool judgment of changing fundamentals but instead a sudden psychological victory of fear over greed.
So if sudden changes of opinion by international investors cause so much trouble, shouldn't we keep such sudden changes of opinion from having destructive effects? Shouldn't we use capital controls and other devices to keep international flows of investment small, manageable, and firmly corralled? The first generation of post-World War II economists would have said "yes." The second and third generations of post-World War II economists regretted the fact that capital controls kept people with money to lend in industrial countries away from people who could make good use of the money to expand economic growth in developing economies, and noted that capital controls were not working effectively anyway as ingenious investors found more and more ways around them. The balance of opinion shifted to the view that the world economy was sacrificing too much in the way of economic growth to be worth whatever reduction in instability capital controls produced.
So now we have all the benefits of free flows of international capital. These benefits are mammoth: the ability to borrow abroad kept the Reagan deficits from crushing U.S. economic growth like an egg, and the ability to borrow from abroad has enabled successful emerging market economies to double or triple the speed at which their productivity levels and living standards converge to the industrial core.
But the free flow of financial capital is also giving us one major international financial crisis every two years.
So what is to be done?
The answer is probably that we should do exactly what the IMF is trying to do right now. The rules for how to try to handle a financial panic were codified a central and a quarter ago by Walter Bagehot, editor of the London Economist. He had three rules. First, in times of panic some central bank or lender-of-last-resort must throw money--not grants, but loans--at the problem: must "in time of panic... advance [money] freely and vigorously to the public.... The end is to stay the panic, and the advances [of money] should [be large enough]... to stay the panic. Second, calling for help in a panic must be expensive--governments, banks, businesses that draw on emergency lines of credit to get them through a panic must pay high enough interest to make the experience an unpleasant one that no one would willingly go through again. Third, the rescuers must be willing to separate sheep from goats, and lend only to solvent institutions and governments that will--if the panic is halted--eventually be able to pay the loan back.
We do not have a perfect international economic system. We do not know how to build a better one. So we need to make sure that we manage this one that we have as carefully and prudently as possible.
J. Bradford DeLong is Professor of Economics at the University of California at Berkeley, a Research Associate of the National Bureau of Economic Research, and Co-Editor of the Journal of Economic Perspectives. From 1993 to 1995 he served the Clinton Administration's Treasury Department as Deputy Assistant Secretary for Economic Policy. He is the author of, among other things, "The Case for Mexico's Rescue" (Foreign Affairs, 1996) and The Marshall Plan: History's Most Successful Structural Adjustment Programme (1993).
Professor of Economics
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University of California at Berkeley; Berkeley, CA 94720-3880
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