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Where Did All the Financial Crises Go? J. Bradford DeLong delong@econ.berkeley.edu http://www.j-bradford-delong.net/ June 2000 1164 words In the past year real GDP in South Korea has grown by 13 percent; in Malaysia it has grown by 12 percent; in Thailand 7 percent; and in Mexico 8 percent. Of the emerging market economies most badly hit by the financial crises of the 1990s only in Brazil and Indonesia is real economic growth--3 percent over the past year--still disappointing. But think back to only two years ago, when the light at the end of the financial-crisis tunnel was thought to be a train coming fast the other way. Back then people spoke of the "epic, slow-motion crisis unraveling the global economy" that had "taken down" the economies of Mexico, East Asia, Japan, and Brazil. Analysts like Charles Wolf of RAND claimed that East Asia's crisis was the end of the "perverse" East Asian development model (never mind that over the past generation East Asia's economies had grown more rapidly than any other economies, anywhere, anytime): growth would not resume without the leveling of East Asia's economic institutions. Everyone seemed to agree that the international financial institutions needed major reform--even though half of critics (the Jeffrey Sachs-Joseph Stiglitz wing) believed the institutions were too scrooge-like, and the other half (the Ralph Nader-Wall Street Journal wing) believed the institutions were too generous and liberal. The IMF was forcing countries into deflationary policies that caused severe depressions, or the IMF's generosity had encouraged overlending and overproduction that had caused widespread crisis. But even though the directions of the proposed reforms were directly opposed, everyone seemed to agree that such major reforms were absolutely necessary: all agreed that, in the words of William Greider of the Nation, "the usual financial remedies [would] lead only to failure." Yet here we are. So it is time to ask not the usual question--"what went wrong?"--but the unusual question--"what went right?" There were no major domestic economic reforms in East Asia (or Mexico). There was no restructuring of international financial institutions. Yet growth--rapid growth--has resumed in the newly industrializing countries. I believe that three principal things have gone right in the past two years, and have driven the rapid recovery from the crisis. First, the potential economic gains from globalization have been and remain enormous. Second, market economies truly are much more resilient and flexible than commentators believe. And, third, that institutions of global financial management--the IMF, the World Bank, the G-7--did a much better job of handling the crises of the 1990s than the folk wisdom holds. First, the potential economic gains from globalization have been and remain enormous. Even in an economy as prosperous and as developed as Korea, real wage levels are only a third of levels in the United States. This means that the potential for further growth and development is very large. As long as this wage gap remains unclosed, the opportunity to profit from investments in East Asian factories that achieve first-world levels of productivity is immense. And East Asia's fundamentals--a well-educated labor force, good transportation and communications infrastructure, low taxes, a relatively honest government, and close communications links with the first world--make it much easier to attain first-world levels of productivity in East Asia than elsewhere. What all this means is that fear on the part of investors in New York and elsewhere can cause them to flee from investments in East Asia--and Mexico, and Brazil, and India--but that any such capital flight is likely to be transitory, because greed--the opportunity to profit from closing a piece of the wide technology and productivity gap between first and third world today--is likely to soon reassert itself. Second, market economies truly are much more resilient and flexible than commentators believe. Introductory economics courses and policymakers' expectations are still shaped by the memory of the Great Depression: panic happens, demand falls, unemployment rises, confidence collapses, the economy stagnates with tens of millions out of work,, and it doesn't recover. And this is what did happen in the Great Depression in the United States. But Great Depressions are rare events--that is why we remember them. As long as an economy's banking system remains solvent and remains able to channel savings from households and investors to businesses seeking opportunities, it is much more likely that widespread panic and a collapse in production will soon be followed by a bounce-back--and the deeper the recession, the deeper the bounce-back. Third, that institutions of global financial management--the IMF, the World Bank, the G-7--did a much better job of handling the crises of the 1990s than the folk wisdom holds. The blizzard of commentary carries the message that the IMF, the World Bank, and the U.S Treasury made a bunch of bad mistakes. The U.S. Treasury demanded early repayment of its loans to Mexico, worsening Mexico's situation in order to show a large profit for the Treasury and score political points against the Alfonse D'Amatos and Jack Kemps who claimed that somehow U.S. taxpayers' money was being "wasted." The IMF closed down some but not all of Indonesia's insolvent banks, causing each Indonesian to fear that their bank was insolvent too and deepening the panic. The IMF demanded that fundamentally healthy East Asian economies showing budget surpluses raise taxes, thus shrinking aggregate demand further and deepening the recession. I agree with all three of these criticisms. But there is a sense in which they miss the point. For more than a hundred years we have known what to do in a financial crisis: have some organization show up with a lot of money to restore confidence, have it lend freely to fundamentally sound organizations that need cash, and have it rapidly close down and liquidate businesses that aren't going to make it even if the crisis is successfully resolved. This is the way to restore confidence, and to keep the financial system doing its job of channeling money from savers and investors on the one hand to businesses that need capital on the other. And this was what was done, with approximately $20 billion of public money committed to Mexico and approximately $60 billion committed to East Asia, all of which looks like it will be repaid with healthy interest now that the crises are over. After 1929 unemployment in the U.S. remained well above normal for twelve years. After the 1982 crisis it took six years before growth resumed in Mexico. Japan--having failed to restructure its banking system--is still in stagnation eleven years after the start of its crisis. But Mexico had one and East Asia had two bad recessionary years, followed by a resumption of rapid economic growth. In my view at least, we got more than our money's worth out of the IMF and its partners in the 1990s.

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Dear Mr. Bradford,

I couldn't miss your comments on the remedies of the IMF for emerging markets. However one thing still strikes my mind, and that is: Why do economists at IMF use two remedies for the same illness ? If a First World economy is in recession, the remedy is, in general sense, an increase money supply. When a Third World economy is in recession, the remedy is an increase in interest rates, taxes, everything that decreases money supply. Why ? This certainly increases recession no matter what the outcome is after a few years...

Obviously the come back from such a recession must have other reasons than the rise in interest rates. The world has only completely overcome the 1929 recession with WW 2, isn't this right ?

I am not an economist, I am an engineer trying to understand a little of economics. Thank you in advance for your comments.

Contributed by Peter Bethencourt (hwbethencourt@openlink.com.br) on September 1, 2000.

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I think the asymmetry is less than you believe. For both first world and emerging market economies suffering from inflation, the IMF recommends an increase in interest rates, taxes, everything that decreases money supply. For both first world and emerging market economies that have low inflation and are in a recession induced by domestic causes, the IMF recommends a decrease in interest rates, cuts in taxes, everything that increases the money supply (as it is doing with respect to Japan today).

The difference comes with respect to what happens when countries suffer depressions induced by large-scale capital flight. When a first world country suffers large-scale capital flight and an approaching depression--for example Britain in 1992--the standard prescription is to lower interest rates, let the value of the currency float downward, and let expanding investment and exports bring the economy back to full employment (but to be moderate enough in the policies to keep them from causing an outburst of inflation). When na third world country suffers large-scale capital flight and an approaching depression--Mexico 1995, East Asia 1997, Brazil 1998--the IMF finds itself not sure what to do because an emerging market economy typically has borrowed a lot of money in foreign currencies. Thus letting the exchange rate float downward increases the burden of debt on the emerging market's government and companies. You're damned if you do and damned if you don't: if a country raises interest rates to keep the value of its currency from falling, high interest rates will kill investment and send you into deep depression; if a country lets the value of its currency fall, then its inability to service its public and private foreign debt will lead to widescale bankruptcy and a deep depression.

As Stan Fischer tells it, in the cases of Mexico, East Asia, and Brazil, the IMF tried to do four things:

--loan as much money as it could so that governments could use IMF loans instead of high interest rates as their tool of choice when they acted to try to keep the value of their currencies high.

--try to negotiate standstill agreements so that capital flight would stop being an issue.

--urge governments to do as much as they could as quickly as they could to restore the flow of finance and investment into the country.

--try to help the country's government figure out where the sweet spot was at which you suffered least from higher interest rates but also suffered least from the bankruptcies caused by the interaction of a falling value of the currency and large foreign-currency denominated debts.

When Sweden suffered capital flight in 1992--and turned out to have large foreign debts denominated in Germany's deutschmark--the advice the IMF gave to it then was the same as the advice the IMF gave to Brazil in 1998-1999.

Someone... who was it? I forget... said last week that it was clear in retrospect that everyone had gotten spooked by the magnitude of hidden and unknown foreign-currency borrowings in Mexico and East Asia, and thus spent much more time trying to keep the Brazilian currency from depreciating than was in fact necessary. For it turned out that Brazil's foreign-currency debts were small, and thus in retrospect it is clear that Brazil should have let its currency float downward in value earlier...

Contributed by Brad DeLong (delong@econ.berkeley.edu) on September 1, 2000.

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This is the Charles Wolf article I was thinking of--

Asia's Reckoning: What Caused Asia's Crash? --- Too Much Government Control By Charles Wolf Jr. 02/04/1998 The Wall Street Journal Page A22 (Copyright (c) 1998, Dow Jones & Company, Inc.)

Asia's financial earthquake is the second biggest international surprise of the past decade. The first, and weightier, one was the demise of the Soviet Union. Like the 1991 Soviet shock, Asia's financial hemorrhaging has had many causes. The ensuing debate has largely focused on their relative importance.

The primary cause of the Asian crisis, however, has been largely obscured: namely, the legacy of the so-called Japanese development model, and its perverse consequences. Subsequently relabeled the Asian development model as its variants were applied elsewhere in the region, this strategy of economic growth has been grandly extolled in the past two decades. Its strongest proponents included Eisuke Sakakibara, presently Japan's vice minister of finance, Malaysian Prime Minister Mahathir Mohamad, and such Western commentators as Karel van Wolferen, Chalmers Johnson, James Fallows and Clyde Prestowitz. What we are now seeing in Asia's financial turbulence are the model's accumulated shortcomings.

This is not to deny the role of other proximate causes, including short-term borrowing by Asian banks and companies, and their long-term lending or investing; the failure of the money-center banks in Japan, the U.S. and Germany that provided the mounting short-term credit to exercise due diligence; and foreign investors' unrealistic assumptions that Asian currencies' pegs to the U.S. dollar would be maintained. But these proximate causes are traceable to or abetted by the primary cause: widespread insulation from market forces.

The Asian development model began with a conceptual framework largely built by American and Japanese academic economists. Central to it is the phenomenon of "market failure": the predictable inability of market mechanisms to achieve maximum efficiency and to encourage growth when confronting "economies of scale" and "path dependence." These conditions may lead to monopolies in the advanced economies and the extinction of competition from late-starters in the development process. If the objectively based decisions of the marketplace are recognized to have such predictable shortcomings, the argument has run, then subjectively based decisions by government agencies or key individuals could improve upon market outcomes.

In the original version of the model, these subjective judgments were provided by Japan's Ministry of International Trade and Industry and Ministry of Finance, in collaboration with targeted export industries believed to be associated with economies of scale. MITI and the Ministry of Finance tagged these "winners" to receive preferred access to capital, as well as protection in domestic markets through the use of tariffs or nontariff barriers to limit foreign competition.

In the Korean variant of the model, the subjective judgments as to who and what would receive preferences -- often the same industries targeted by Japan -- were exercised by the president, the industrial conglomerates and these chaebols' associated banks. In the Indonesian variant, the subjective oracular sources have been President Suharto and his extended family and hangers-on, in conjunction with B.J. Habibie's self-styled technological community at the Ministry of Research and Technology.

To be sure, the Japanese model and its variants produced noteworthy accomplishments. Vast amounts of savings and investment were mobilized for and channeled to the anointed industries and firms. While substantial resources were wasted in the process -- for example, MITI's blunders in the case of steel, shipbuilding and aircraft -- the scale of resource commitments led to world-class performance in other cases -- notably in cars, consumer electronics, telecommunications equipment and semiconductors in Japan, similar heavy-industrial development in Korea, and light-industry development in Indonesia.

But the negative effects of the Asian model were cumulatively enormous, including the following:

-- Wasted resources when nonmarket choice processes made mistaken decisions, such as Indonesia's large investments in a national car and in a domestic aircraft industry. These nonmarket failures account for the fact that Asia's economic growth has been mainly due to large inputs of capital and labor, with relatively limited improvement in productivity.

-- Structural imbalances due to overemphasis on export industries and neglect of the domestic economy. As a result, domestic production has been shortchanged, and consumption standards held down in favor of aggressive pursuit of export markets.

-- Excess capacity has been built up in export industries through the arbitrary processes of "picking winners." Failure to take adequate account of demand saturation while production continued to expand has contributed to currency depreciation, falling prices and sharply adverse changes in Asia's terms of trade.

-- A sense of hubris among the favored industries, firms and individuals. When these entities confronted market tests that they could not meet, they and their foreign lenders expected to be bailed out with additional resources, often publicly funded or guaranteed. Whether the shortfall was in an old-line major banking house (Japan's Yamaichi Securities), or an established conglomerate (Korea's Halla group), or the start-up of questionable new ventures (Indonesia's Timor car), it was expected that some nonmarket (i.e., government) preference would make up the difference.

-- The favoritism, exclusivity and corruption of the Asian model's back-channel and nontransparent decision making has had a corrosive effect on the societies and polities of the region.

That market-mediated allocations of resources have shortcomings doesn't imply that the Asian model's subjectively mediated ones will not have still greater shortcomings. In fact, the legacy of the Japanese model and its Asian variants suggests that their associated shortcomings are enormously greater, because they tend to be protected and concealed. Lacking the corrective, mediating responses that market mechanisms and incentives provide, the shortcomings accumulate until a systemic breakdown occurs.

If this lesson is heeded, Asia's recovery can be rapid and enduring; if it is not, recovery is more likely to be slow and fitful -- and ultimately far more painful.

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Mr. Wolf is senior economic adviser and corporate fellow in international economics at RAND.

Contributed by Brad DeLong (delong@econ.berkeley.edu) on August 16, 2000.

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One provocative question we might ask from this analysis is why Japan has taken so long without recovering, while a range of countries in East and Southeast Asia have seen their economies recover so quickly. Perhaps "gaiatsu" (foreign criticism) through the media and via traditional intergovernmental links (bilateral, G-7) is less effective in the case of Japan than the intermediary roles played by the multilateral IGOs in the case of the other Asian economies referred to here. (The role of domestic institutions in helping or hurting economic recovery should also be considered).

It also raises the prospect that "Asian values" are too limited an explanation of the growth (and rapid recovery) underlying most Asian economies vs., for example, the malaise affecting the Japanese economy. Perhaps it is time to move beyond the Krugman analysis (Foreign Affairs, 1994) for the internal roots of growth and recovery within these economies. Any other Asian hands have some thoughts on this?

Contributed by David Shaw, Ph.D. (dsshaw47@yahoo.com) on July 18, 2000.

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